Premium Stabilization Reserves

A Case Study of a Missed Liability

The board of trustees of a large health and welfare employee benefit plan recently engaged the authors to advise on the accounting and reporting of premium stabilization reserves that the plan held for participating employers. The board of trustees worried that plan management was inappropriately accounting for these reserves. Specifically, the financial statements of the plan did not recognize the premium stabilization reserves as a plan liability; instead, they included only a footnote disclosure that referenced the premium stabilization reserves as a "contingent liability." In addition, the notes to the financial statements showed the premium stabilization reserves at the present value of the expected reductions in future premiums from the participating employers.

What Are Premium Stabilization Reserves?

The purpose of premium stabilization reserves is to stabilize the contribution or premium rates of participating employers over a number of years by allowing them to take advantage of their favorable claims experience. Premium stabilization reserves exist when, in accordance with a funding contract, contributions or premiums paid by participating employers to an employee benefit plan during a contract year (plus any investment income credited on such premiums) exceed the total benefit claims paid and the administrative and risk charges made by the plan. That is, rather than being rebated to participating employers at the end of a policy year, the plan retains experience-rate credits in accounts created for each participating employer. The plan will typically credit interest to each account based upon its average balance and the interest rate established in the contract. The excess premiums (i.e., premium surpluses) received by the plan and accumulated into these accounts may be (at participating employers' discretion)-

* used to offset future rate increases;

* used for premium holidays (i.e., to avoid payment of premiums for a period of time); or, based upon the provisions of the contract, * transferred to a successor trust designed to provide similar benefits in the event that the participating employer terminates participation in the plan.

On the other hand, depending upon the type of arrangement and risk-sharing provisions, the plan may use a premium surplus in one year to offset a premium deficit in another year. A premium deficit exists when, at the end of a contract year, the total benefit claims paid and the administrative and risk charges made by the plan to an employer's account exceed the total premiums received and the corresponding investment income credited during that year. If accumulated premium deficits exceed accumulated premium surpluses, the participating employer is not required to pay the difference; however, the negative balance in the participating employer's account is carried over and offsets any future additions to the account. When a plan enters into pooled funding arrangements with a group of employers, the negative account balance of one employer can be used to offset the positive account balances of other employers in the same pool, because the claim experience of the pool is the relevant consideration.

Management's View

In this situation, management contended that premium stabilization reserves are contingent liabilities; however, this argument was based upon management's misinterpretation of the definition of a loss contingency provided in Accounting Standards Codification (ASC) 450-10-20, as well as its misapplication of the respective accounting principle (ASC 450-20). In ASC 45010-20, a loss contingency is defined as "an existing condition, situation, or set of circumstances involving uncertainty as to possible loss to an entity that will ultimately be resolved when one or more future events occur or fail to occur."

After a loss contingency is identified, the likelihood that future events will confirm the loss must be assessed. The need to record or disclose a loss contingency in the current period is based upon a range of probable future outcomes, which may confirm the existence of a loss at the date of the financial statements. The likelihood that one or more future events will confirm the existence of a loss at the date of the financial statements is classified as either 1) probable (likely to happen), 2) reasonably possible (more than remote but less than probable), or 3) remote (little chance of occurring).

A loss contingency must be accrued as a charge to income as of the date of the financial statements if both of the following conditions are met:

* It is probable that an asset has been impaired or a liability has been incurred at the date of the financial statements, based upon information that exists prior to issuance of the financial statements or prior to the date the financial statements are available for issuance. This means that it must be probable that one or more future events confirming the loss will occur.

* The amount of the loss can be reasonably estimated.

When one or both conditions for the accrual of a loss contingency are not met and the likelihood of loss is deemed to be either probable or reasonably possible, accrual of the loss contingency is not permitted; however, a note disclosure is required in the financial statements.

In management's view, the accumulated excess premiums received and reflected in the premium stabilization reserves were an existing condition at the date of file financial statements that involved the uncertainty of possible losses to the plan, which would ultimately be resolved in the future. Losses to the plan would result when participating employers elected to use their positive account balances to reduce premium rates, request premium holidays, or request transfer of the balance to a successor trust if the employer terminates participation in the plan.

Management determined that the premium stabilization reserves, at the date of the financial statements, represented only a contingent liability to the plan. Moreover, management deemed the likelihood that employers would request reductions in premium rates, premium holidays, or transfers to a successor trust to be moderate, rather than high, based partly upon the frequency of such requests in the past. Management concluded that no accrual of the premiums stabilization reserves was permitted at the date of the financial statements because future events confirming the existence of a loss at the date of the financial statements were only reasonably possible; thus, in management's view, only disclosure was required in the financial statements. Furthermore, because the reduction in premium rates or requests for premium holidays would occur at some point in the future, the amount of premium stabilization reserves disclosed in the notes to the financial statements was discounted by management.

Recognition under U.S. GAAP

Management's confusion in this case might have been caused by the fact that neither ASC Topic 965, "Plan Accounting-Health and Welfare Benefit Plans" (the source of U.S. GAAP that health and welfare benefit plans must follow), nor the audit and accounting guide for employee benefit plans ("Employee Benefit Plans," AICPA, Jan. 1, 2013) directly addresses premium stabilization reserves as a plan liability.

Both ASC Topic 965 (specifically, ASC 965-20-25-1) and the AICPA guide (para. 7.72) address accrued liabilities of a health and welfare benefit plan, but neither provides sufficient detail. ASC Topic 965 specifies that "a plan may have liabilities (other than for benefits) that should be accrued. Such liabilities may be for amounts owed for securities purchased, income taxes payable by the plan, or other expenses (for example, third-party administrator fees). These liabilities shall be deducted to arrive at net assets available for benefits." The AICPA guide states that plan liabilities may include accrued expenses, amounts due to claims processors on behalf of the plan, obligations to return securities lending collateral, derivatives related to payables, and amounts due to the plan sponsor. But premium stabilization reserves for participating employers are not explicitly discussed.

According to ASC Topic 105, "Generally Accepted Accounting Principles," if the guidance for a transaction or event is not specified within a source of authoritative GAAP for an entity, that entity must first consider accounting principles for similar transactions or for events that do fall within a source of authoritative GAAP for that entity; next, the entity must consider nonauthoritative guidance from other sources (ASC 105-1005-02). Accounting and financial reporting practices not included in the ASC are nonauthoritative-for example, FASB Concept Statements (ASC 105-10-05-03). Accordingly, the rationale for considering premium stabilization reserves as a plan liability is supported by the authors' interpretation of ASC Topic 965, as well as the definition of liabilities found in Statement of Financial Accounting Concepts (SFAC) 6, Elements of Financial Statements (A Replacement of FASB Concepts Statement No. 3).

The recognition of premium stabilization reserves as an actual plan liability (as opposed to a contingent liability) is implicit in ASC Topic 965. The standard refers to premium stabilization reserves in the context of a plan paying premiums to an insurance company, rather than receiving contributions or premiums from participating employers. Specifically, ASC Topic 965 explains that premium stabilization reserves exist when premiums paid by the plan to an insurance entity exceed the total of claims paid and other charges that the insurance company made on behalf of the plan. In this case, the premium stabilization reserves are held by an insurance entity and used to reduce the plan's future premium payments. The standard continues to state that premium stabilization reserves must generally be reported as plan assets, until such amounts are used to pay premiums (ASC 965-310-25-3).

If under these circumstances a plan is required to record the premium stabilization reserves as an asset, then, conversely, a plan should record the premium stabilization reserves as a liability whenever the excess premiums received from employers over claims paid and other charges may be used by them as premium holidays, reductions in future premiums, or transfers to successor trusts.

Under SFAC 6, liabilities are defined as "probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events" (para. 35). It is important to note that, under SFAC 6, the word "probable" is used with its usual generic meaning, instead of the specific accounting or technical sense found in ASC Topic 450, "Contingencies." That is, as used in the definition of liabilities, probable means something that can be reasonably expected, based upon available evidence or logic, but is neither certain nor proved; it does not mean a high likelihood. Its inclusion in the definition recognizes that business activities happen in an environment characterized by uncertainty, in which few outcomes are certain.

Based upon this definition, a liability has three essential characteristics:

(a) it embodies a present duty or responsibility to one or more other entities that entails settlement by probable future transfer or use of assets at a specified or determinable date, on occurrence of a specified event, or on demand, (b) the duty or responsibility obligates a particular entity, leaving it little or no discretion to avoid the future sacrifice, and (c) the transaction or other event obligating the entity has already happened (SFAC 6, para. 36)

Because premium stabilization reserves possess the three elements of a liability specified by SFAC 6, they are considered a liability of the plan. First, premium stabilization reserves embody a present duty of the plan to one or more participating employers, as reflected in the contracts between the plan and the employers, that entails settlement by probable future transfer or use of assets, as reflected in the employers' right to use, upon demand or at a specified or determinable date, the premium stabilization reserves as premium holidays, reductions in premium rates, or transfers to successor trusts upon termination of an employer's participation in the plan. Second, this duty or responsibility obligates the plan, leaving no discretion to avoid the premium holiday, reduction in premium rates, or transfer to a successor trust. Third, the transaction obligating the plan has already happened, reflected by the fact that the premiums received from employers exceeded their respective claim experience and other charges.

It is clear to the authors that premium stabilization reserves are not a plan benefit obligation, because they are not related to an obligation to provide benefits to or on behalf of plan participants. Premium stabilization reserves are an actual plan liability, rather than a contingent liability; this results from agreements between the plan and participating employers, in which the plan is obligated to refund the positive balance in the premium stabilization reserve accounts to the participating employers, upon their request, through a premium holiday, a reduction in the premium rate, or the transfer to a successor trust.

There is nothing uncertain about the fact that this obligation has been incurred at the date of the plan's financial statements, once a positive balance in the premium stabilization reserve account exists. The uncertainty is only related to the timing of the refund of this balance. In this respect, ASC Topic 450 states that not all uncertainties inherent in the accounting process generate contingencies. Many estimates are required in the financial reporting process of a plan; the mere fact that an uncertainty is involved does not necessarily constitute the type of uncertainty referred to in the definition of a loss contingency (ASC 450-10-05-6). For example, amounts due for services received, such as advertising, are not contingencies, even though the accrued amounts may have been estimated (ASC 450-10-55-3).

Consequently, because premium stabilization reserves are not a contingent liability, the recognition criteria for loss contingencies established in ASC Topic 450, based upon the probability of a future event and the estimation of a reasonable amount for the loss, are not applicable. Thus, for the purpose of recognizing premium stabilization reserves as a plan liability, it is irrelevant whether it is probable (high likelihood of occurrence) that a participating employer will request a reduction in premiums, a premium holiday, or the transfer of the positive balance in the premium stabilization reserve account to a successor trust.

As an actual liability of the plan, premium stabilization reserves should be deducted from plan assets in the statement of net assets available for benefits in order to arrive at the plan's net assets available for benefits. Increases in premium stabilization reserves should be recorded in the plan's statement of changes in net assets available for benefits as a reduction in contribution income, which could be accomplished through the use of a contra revenue account.

On the other hand, decreases in premium stabilization reserves due to settlement should be accompanied by a corresponding decrease in the asset account used. For example, if an employer requests a premium holiday, the amount of the premium holiday will reduce both premium stabilization reserves and employer contribution receivables. Similarly, if an employer terminates its participation in the plan and requests that its positive balance in the premium stabilization reserve account be transferred to a successor trust, a reduction in cash will accompany the reduction in the premium stabilization reserves.

Assuming that no pooled funding arrangements exist, a negative account balance in the premium stabilization reserve corresponding to a participating employer is not recorded as a receivable from the employer or as a reduction of the premium stabilization reserve liability, because the participating employer is not required to pay the net accumulated premium deficit and no other employers have agreed to use their positive account balances to fund other employers' negative account balances.

In those circumstances where pooled funding arrangements do exist, a negative account balance of one employer can typically offset the positive account balances of other employers in the same pool; therefore, the liability for the premium stabilization reserves is the net positive accounts balances pertaining to all employers in the same pool. But if the premium stabilization reserve for the pool is a net negative balance, a receivable is not recognized in the plan's statement of net assets available for benefits, because the participating employers in the pool did not agree to pay this balance.

Measurement under U.S. GAAP

Under a premium stabilization reserve agreement, the premium that the plan collects from a participating employer includes the expected claims, plus an additional percentage of those claims- for example, 115% of expected claims in total; the additional 15% the plan receives is analogous to a security deposit to cover the risk that the employer's actual claims exceed the expected claims. If the actual claims equal the expected claims, then the additional 15% will generate a positive balance in the premium stabilization reserve account, which will eventually be returned to the employer via a premium holiday, a reduction in the premium rate, or a transfer to a successor trust. This similarity to a security deposit makes the measurement of the premium stabilization reserve liability using a present-value methodology inappropriate.

Under ASC 835-30, long-term payables that represent contractual obligations to pay money with a due date exceeding one year must generally be measured at present value; however, amounts intended to provide security for one party to an agreement, such as security deposits received, are explicitly excluded (ASC 835-30-15-3c). Because the positive balances in the premium stabilization reserve accounts are akin to security deposits received from participating employers, the liability for premium stabilization reserves should be measured in the plan's statement of net assets available for benefits as the sum of the undiscounted positive account balances in the premium stabilization reserve.

Similarly, amounts that do not require repayment in the future but will instead be applied to the purchase price of the property, goods, or services involved are explicitly excluded from the scope of ASC 83530 (ASC 835-30-15-3b); this makes the use of present-value methodology inappropriate for measuring these amounts. In this respect, the positive balance in the premium stabilization reserve account may be viewed also as representing an advance premium that will be used to provide insurance coverage in the future via a premium holiday or reduction in the premium rate.

Getting the Accounting Right

When done in accordance with a funding agreement, participating employers can use premium stabilization reserves to reduce future premiums, request premium holidays, or request that such reserves be transferred to a successor trust in the event of contract termination. The plan should recognize the premium stabilization reserves as an actual liability, rather than a contingent liability. Furthermore, this liability should not be reduced by the effect of the time-value of money, but instead should be measured as the sum of the undiscounted positive account balances in the premium stabilization reserve. To the extent that there are pooled funding agreements, the undiscounted positive account balances can be offset by negative account balances, but only of the employers in the same pool. ?

Eduardo Singerman, CPA, CFE, is a director, and Gary Broder, CPA, is a partner, both at BDO USA, LLP, New York, N.Y.