Friday, November 6, 2015

No. 125: Backdated Capital Contributions—the NAIC Response to Questions

In No. 123 (October 27, 2015), I discussed a capital contribution shown in the statutory statement of Senior Health Insurance Company of Pennsylvania (SHIP) as of December 31, 2014. The contribution was in the form of a $50 million surplus note issued February 19, 2015. Thus the issue date of the note was 50 days after the "as of" date of the statement. SHIP filed the statement with the Pennsylvania Insurance Department in a timely manner on March 2, 2015, or 11 days after the note was issued.

I said I would send No. 123 to the National Association of Insurance Commissioners (NAIC), I showed four questions about backdated capital contributions, and said I would report the responses. The communications department of the NAIC responded one week later.

The First Question
First, I asked whether the NAIC agrees with me that a backdated capital contribution falsely portrays the financial condition of a company as of the statement date. I also asked for an explanation if the NAIC does not agree with me. The NAIC did not answer yes or no to the basic question, but provided this explanation:
The statutory financial statements are the reporting mechanism in which state insurance regulators assess the financial condition of the insurance entities subject to their regulation. Pursuant to the Preamble of the NAIC Accounting Practices and Procedures manual, the primary responsibility of each state insurance department is to regulate insurance companies in accordance with state laws with an emphasis on solvency for the protection of policyholders.
The NAIC went on to explain surplus notes, although I had not asked for an explanation of surplus notes. Next, referring to Statutory Accounting Principles (SAP) and Statements of Statutory Accounting Principles (SSAPs), the NAIC said:
Ensuring timely receipt of funds, prior to the issuance of the statutory financial statements, which are first committed to policyholders and other claimants, should likely be perceived as an appropriate regulatory action consistent with the responsibility to provide protection to policyholders.

For SAP purposes, this approach is consistent with a Type 1 subsequent event under SSAP No. 9, as the conditions warranting the need for a surplus note existed as of the financial statement date. Furthermore, actions are perceived to be in place prior to the statement date to develop the note, obtain commissioner approval, and obtain funds from the actual issuance of the note timely to receive the funds prior to the issuance date of the statutory financial statement.
The Second Question
Second, I said SSAP No. 9 and SSAP No. 72 were effective January 1, 2001, and asked when the NAIC began to allow backdated capital contributions. In response, the NAIC mentioned Financial Accounting Standards (FAS), the Financial Accounting Standards Board (FASB), the FASB Emerging Issues Task Force (EITF), the American Institute of Certified Public Accountants (AICPA), and Generally Accepted Accounting Principles (GAAP). The NAIC said:
The guidance reflected in SSAP No. 9 is adopted from FASB. The Statutory Accounting Principles (E) Working Group [of the NAIC] adopted SSAP No. 9 to be effective January 1, 2001, as part of the original codification of SAP. The original guidance was adopted to be consistent with the AICPA Statement on Auditing Standards No. 1, Section 560—Subsequent Events. In 2009, FASB issued FAS 165, Subsequent Events, and revisions were reflected in SSAP No. 9 to reflect the adoption of this guidance. The adoption of FAS 165 should not have resulted in significant changes in the subsequent events that an entity reports, through either recognition or disclosure in the financial statements. The revisions adopted from FAS 165 included guidance to ensure assessment of subsequent events through the date the financial statements are issued, or when financial statements are available to be issued.

The Statutory Accounting Principles (E) Working Group [of the NAIC] adopted the guidance in SSAP No. 72 to be effective January 1, 2001, as part of the original codification of SAP. The referenced paragraph for capital contributions was included in the original adoption after considering GAAP guidance.

Although the SAP guidance in SSAP No. 72 provides an explicit direction regarding these notes or other receivables as Type 1 subsequent events, the guidance was developed after considering EITF 85-1 (currently reflected in 505-10-45 of the FASB Codification). The EITF 85-1 GAAP guidance is technically rejected in SSAP No. 72, but in Issue Paper No. 72, this rejection is noted as EITF 85-1 generally requires these contributions to be recorded as a debit to equity instead of an asset, but could allow for such notes to be recorded as assets if collected in cash before the financial statements are issued.

For SAP purposes, and the consistency concept, the statutory accounting guidance is explicit that such notes are admitted assets if they are satisfied by receipt of cash or readily marketable securities prior to the filing of the statement. If the notes or other receivables are not satisfied, they are nonadmitted. Furthermore, the domiciliary commissioner must approve the capital contribution under SSAP No. 72 and the cash or securities must be infused prior to the filing of the statutory annual financial statements.
The Third Question
Third, I asked why the NAIC allows backdated capital contributions. The NAIC said:
The NAIC does not establish statutory accounting provisions. The guidance reflects the decisions of the Statutory Accounting Principles (E) Working Group [of the NAIC]. See questions 1 and 2 regarding the ultimate objective of the regulators in providing protections to policyholders, the background for the guidance, and related FASB guidance.
The Fourth Question
Fourth, I asked whether banks and other regulated financial institutions are allowed to accept backdated capital contributions. The NAIC said it "cannot advise on specific rules regarding these institutions."

The 1988 Executive Life Incident
Chapter 7 of my new book, The Insurance Forum: A Memoir, is entitled "The Collapse of Executive Life." On page 84 in that chapter, I discussed a backdated capital contribution to Executive Life Insurance Company (ELIC) from ELIC's parent company. The transaction was in the form of a $170 million surplus note that was reflected in ELIC's statutory statement as of December 31, 1987. However, the note was not executed until March 7, 1988. In response to my inquiry to ELIC, the company's general counsel said the
subject transactions were given effect for accounting purposes at year end 1987. They were given such effect because under the circumstances present, applicable statutory accounting principles so permit.
Back in 1988 I called that explanation nonsense. I said the company officers who sign the statutory annual statement swear the statement is "a full and true statement of all the assets and liabilities and of the condition and affairs of the said insurer as of the thirty-first day of December last." The backdated capital contribution was one of the factors that caused me to view ELIC as insolvent three years before the company failed.

The 2008 IndyMac Incident
On May 21, 2009, the Office of Inspector General (OIG) of the U.S. Department of the Treasury issued an "Audit Report" entitled "Safety and Soundness: OTS [Office of Thrift Supervision] Involvement with Backdated Capital Contributions by Thrifts." The report grew out of a May 2008 capital contribution from IndyMac's parent company backdated to March 31, 2008. The effect of the transaction "was that IndyMac was able to maintain its well capitalized status, and avoid the requirement in law to obtain a waiver from FDIC [Federal Deposit Insurance Corporation] to accept brokered deposits." In the report, OIG "reviewed the backdating of capital contributions at IndyMac and five other thrifts and concluded that "the backdating of these transactions was inappropriate under GAAP for all six thrifts."

Years before the financial crash of 2008, American International Group selected OTS to be its regulator. Today, as a result of investigations conducted in the wake of the crash, OTS no longer exists.

Evolution of the Jurat
At the bottom of the first page of the statutory annual statement form promulgated each year by the NAIC is a sworn, notarized statement called a "jurat." As a result of No. 123 and the NAIC's responses to my questions, I became interested in the evolution of the jurat. First, I looked at the 1960 statutory statement. Here is the language of the jurat:
[The officers of this company, with their names and titles shown in the jurat itself], being duly sworn, each for himself deposes and says that they are the above described officers of the said insurer, and that on the thirty-first day of December last, all of the herein described assets were the absolute property of the said insurer free and clear from any liens or claims thereon, except as herein stated, and that this annual statement, together with related exhibits, schedules and explanations therein contained, annexed or referred to are a full and true statement of all the assets and liabilities and of the condition and affairs of the said insurer as of the thirty-first day of December last, and of its income and deductions therefrom for the year ended on that date, according to the best of their information, knowledge and belief, respectively.
Second, I looked at the jurat in the statutory statement for 1999. By that time, the jurat had been modified. Near the end, this language was inserted beginning with the words "on that date" and ending with the words "according to":
on that date, and have been completed in accordance with the NAIC annual statement instructions and accounting practices and procedures manuals except to the extent that: (1) state law may differ; or, (2) that state rules or regulations require differences in reporting not related to accounting practices and procedures, according to
By 2014, the jurat had been modified to incorporate the names of the NAIC Annual Statement Instructions and Accounting Practices and Procedures manual. Also, two sentences had been added at the end of the jurat relating to electronic filing of the annual statement.

General Observations
The NAIC did not use the word "backdated" in its responses. Perhaps the NAIC views the word as pejorative.

It is interesting that the "NAIC does not establish statutory accounting provisions" even though "guidance reflects the decisions of" an NAIC working group. I do not know whether the NAIC membership as a whole, or the NAIC Executive Committee, or any other NAIC body signs off on the work of the Statutory Accounting Principles (E) Working Group of the NAIC.

I reviewed several FASB documents mentioned in the NAIC's responses. I believe that backdated capital contributions were not among the items FASB had in mind when it talked about "subsequent events." There were many examples of subsequent events, but backdated capital contributions were not among them.

In No. 123, I expressed dislike for backdating because it falsely portrays a company's year-end financial condition. I still believe that backdated capital contributions are contrary to accounting principles, and that insurance companies should not be permitted to use them.

Available Material
I am offering a complimentary 34-page PDF of the 2009 Treasury OIG Audit Report on Backdated Capital Contributions. Send an e-mail to and ask for the 2009 Treasury OIG Audit Report.