How to Account For a Self-Insured Balance

Self-Insurance Insights from Our Actuaries

Self-insurance liabilities are an often-overlooked exposure for a company, coming to attention only when negatively impacting the organization’s financial results. To help avoid this stress and build a strong control environment, companies should establish processes to estimate these liabilities. This article is the second in a three-part series that provides insight from our actuaries into how companies can design such an estimation process to account for the self-insured balance and utilize tools to gauge how well it is working. Read on for more about common pitfalls in the estimation process and how a robust self-insured accrual is determined. 

Changes in Estimates

As highlighted in the first article in this series, unlike commercial insurance, establishing a self-insurance program does not result in the risk transfer of the liabilities from the company’s financial statements. Instead, companies may choose to keep the exposure to potentially reduce costs and/or obtain cash flow advantage; however, the importance of understanding the insurance risk should not be overlooked. Volatility in the company’s financial results is frequently an outcome of retaining insurance risks as claims often develop differently from what was estimated and recorded as a liability. If a company does not have a robust estimation process as well as control activities, the claim changes from year to year not only from new incidents, but changes from prior fiscal periods, can significantly impact a company’s financial results and its ability to successfully optimize the potential benefits of retaining the insurance risk.

A standard control process that tracks the change in projected ultimate losses between accounting periods can provide insight into how well the current estimation process is functioning. This hindsight analysis often identifies estimation process issues before they become material and provides an excellent measure of underlying claims volatility. 

Changes in Claims Administration

Changing third-party claims administrators (TPAs), regardless of the reason, frequently leads to a biased estimation process if not appropriately considered in the actuarial analysis. That is, accompanying the change in claims administrator is often a variance in case reserve adequacy (higher or lower average case reserves for the same claim cohort) and/or differing claim settlement patterns (shorter or longer time periods between the covered event and claim closure). As a result, historical development patterns, a key assumption in many common actuarial methodologies, may no longer be reflective of future claim emergence patterns. The methodology and/or assumptions used in the projections must reflect any changes in claims administration to help minimize unintended bias.

A strong change control function can provide input into claims administration changes, limiting the possibility of a significant impact to company financials.

Other Changes that May Introduce Volatility

Reactive changes to a company’s self-insurance program, including varying deductibles/self-insurance retentions, insurers, and types of insurance policies purchased, further complicate the ability for a company to estimate the total unpaid claim liabilities. With a change control function, these changes can consistently flow directly into the estimation process, leading to a better understanding of what is driving fluctuations in the estimate across financial reporting periods.

Changes in the regulatory environment and economic conditions also affect the approach to developing unpaid claim estimates. An actuary (on behalf of the company) should understand potential variations in benefit levels caused by legislative actions as well as economic indicators such as inflation, and then consider the impact on projected claim costs and the recorded liability.

Required Documentation & Communication

An actuarial report is often the primary evidence supporting a company’s unpaid claim estimate; however, not all actuarial reports are created equal. A detailed, evidence-based, well-documented actuarial report helps management better understand its risk, reduce avoidable changes in the recorded liability, and appreciate drivers of changes in estimates when they occur. The report should also clearly document significant revisions in approach and the corresponding impact on the estimate.

As generally the intended user of an actuarial report, management should read and understand the report’s content and why certain information is important. Further, a well-written actuarial report makes it easier for external auditors to understand and evaluate the company’s estimation process and the conclusions management has made about the recorded liability. Specifically, the auditors need documentation to support the methods, assumptions and data used in developing the estimate for the total claim costs. If the essential information supporting the estimate is contained within the report, fewer follow up questions to management and/or the actuary will be necessary, and the audit will likely be more efficient.

The financial statement auditor’s evaluation and conclusion on the recorded estimate are generally supported based on analysis prepared by the company’s actuary. One aspect is management’s involvement in and understanding of how the actuarially driven estimate was determined. While a well-documented actuarial report will provide a basis for that understanding, the ability to readily communicate with the actuary is sometimes necessary and often the more efficient route with external auditors. When documentation or communication is lacking, the external auditor may require significantly more time from personnel at the company, including management, or may charge the company a higher fee to complete all the required audit work, including preparing an independent actuarial estimate or range. These challenges are inefficient, inconvenient and may reveal control deficiencies within an organization.

Management’s Estimate: Discounting and Margin

Whether a self-insured company's unpaid claim liability is recorded including a margin for the risk of adverse deviation (e.g., confidence level) and/or on a discounted basis reflecting the time value of money depends upon the applicable accounting guidance and its accounting policy. 

Under US GAAP and GASB, management should record its best estimate of claim liabilities without a margin for the risk of adverse deviation. In practice, management generally records its specialist’s actuarial central estimate or an amount within a reasonable range of that estimate. US captive insurance regulations vary based on domicile, and some states may permit margins. Under other guidance, such as International Financial Reporting Standards (IFRS), margins are required.

Although the appropriate discount rate varies, a company may (but is not required to) discount the unpaid claim liability to reflect the time value of money under US GAAP and GASB if certain criteria are met. While US GAAP provides little guidance, a risk-free rate of comparable duration is generally considered appropriate. GASB is more explicit, indicating that the company’s investment yield and the settlement rate of the liabilities should be considered. As with margins, IFRS requires the estimate to be discounted using a current rate for high-quality bonds for workers’ compensation and the risk-free rate for other coverages.

Summary

Accounting for self-insured liabilities is a complex process, so having an actuary who understands the requirements and standards is key. It is worth investing time and resources into the actuarial process, including estimating liabilities, as a solid analysis generally decreases a company’s chance of incurring additional time and audit costs down the road. In our next article, we will explore how to choose an actuary.