UK: ART of Accounting

The transfer of risk to capital markets and the integration of reinsurance, banking and providers of capital are well known in the ART world. The complexities of accounting and finance in this area are, perhaps, less well understood. ART transactions are inevitably complex and involve many parties. As each transaction is often unique, it may require expertise in insurance, reinsurance, actuarial science, taxation, legal, accounting, investment banking and asset management.

There are fundamental differences between transactions involving traditional insurance/reinsurance and financial products and those arising from ART. Part of the difference in approach is the way banks and financial institutions do business, compared to insurance companies dealing with a traditional claim. The banks frequently require payments promptly, as they are counterparties to a number of other deals and are used to dealing with other financial institutions. They often view the contract as another financial instrument such as a swap or option. Insurers, on the other hand, expect a large amount of documentation to confirm liability and quantum of a claim, before any payments are made. They are also more likely than bankers to expect discussion and negotiation to reach a settlement.

The date of loss in a traditional policy is not usually controversial, but the trigger event in an ART policy could be. This often occurs when accounting and financial events trigger the policy response. For example, the calculation of financial ratios, or establishing whether costs exceed revenue, could give rise to much argument, particularly if the terms are not clearly defined and understood.

To illustrate the accounting and financial issues, consider a claim under a policy intended to cover a credit default swap. This is similar to ‘credit indemnity insurance’ as the intent of the product is for the insurer to provide credit insurance to a bank for corporate bonds held by it.

In this example, the insurer would be called on to purchase the bond from the bank at face value, should a trigger event occur. This provided the bank with security against default by the issuer of the bond.

In the event of a claim, the insurer would typically require a limited accounting and financial investigation, which could include the following:

• An investigation into the issuing company’s financial position prior to the issue of the bond to establish whether there was a likelihood of financial deterioration that insurers should have been informed of.

• The timing of the issuing company’s financial problems and when the bank became (or should have become) aware of this.

• Whether the bank had a role in assisting with the financial restructuring of the company.

• The specific events which gave rise to the deterioration in the company’s financial position.

The accounting review of the claim in this example is significantly different from the approach in a traditional insurance claim. Quantum is not in dispute, but the factors surrounding the claim may require investigation.

From the bank’s point of view, they simply require the bonds to be purchased from them. A swift clarification of the circumstances surrounding the event can assist with reaching settlement.

One of the concerns in ART transactions is the ease with which the financial position of a company can be manipulated. This could occur by simply recording transactions in a particular way which could cause the trigger event itself to be artificially created to give rise to a claim. For example, consider if a company trading at a loss constitutes a trigger event. The financial results of a company which is actually operating at a profit could be manipulated by expensing costs items in the profit and loss account, which should in fact be capitalised in the balance sheet. This could create an artificial loss and would trigger the policy.

Manipulation can also arise where some assets of a company are used to create an asset-backed security and others are not. For example, the income stream from shipping containers could be securitised to create a bond. A Financial Guarantee Insurance Policy can then be taken out to guarantee payments due under the notes, thus enabling a company to guarantee the bond’s financial performance and to secure its investment rating. If not all the containers were securitised, then a financial investigation may be necessary to establish the correct allocation of revenue and costs between those containers subject to the contract, and those that were not.

Where there is the suspicion that the accounting treatment of key transactions is unusual, then a financial investigation is advisable to provide the necessary guidance and reassurance.

One of the characteristics of ART transactions is that the parties include both banks and insurance companies. They often bring very different assumptions and expectations as to how matters will be dealt with in the event of a claim.

An experienced team, often including lawyers and accountants, will be required to carry out the investigations into these and other issues which will arise once a claim is submitted. The knowledge and experience of the team should assist in managing the different expectations of the parties and ensuring a quick and fair settlement of the claim under the ART arrangement.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.