Newsletter – April 2018

April 17, 2018 By CFO Consulting Partners

Case Study: Financial Transformation

BACKGROUND

Engaged by a service provider (a boutique law firm) that had been in business for approximately 18 months. Firm was highly successful on the legal side but was immature on the operations/business process side. In 18 months, firm had had three Chief Operating Officers, all from “Big Law” and all who had not been successful. Position had been vacant for three months, placing great stress on the Managing Partner. Total staff the commencement of the engagement was approximately 50, with a ratio of 2 lawyers for each non-legal position.

WHAT WE DID

Our assignment was to perform a high-level assessment of all Firm operations: Finance, HR, IT; Billing and Payables and Administrative support; provide observations and make recommendations for improvement. Assessment also included evaluation of staff morale and related staffing issues. Expected duration of assignment; two weeks.
Assessment identified two issues requiring immediate attention; staff morale and need for full time Chief Operating Officer to relieve burden on Managing Partner. Remedial actions were taken within ten days and included the naming of our consultant as Interim Chief Operating Officer with undefined term of service.

Longer term recommendations included: steps to improve the Firm’s Information Security polices and IT infrastructure, execute a search for and implementation of new ERP system; actions to clarify and realign staff roles, hiring of a full time Finance Director; development of better reporting and creation of a capacity plan; establishment of a more formal HR function.

The firm was in the process of tripling the size of its primary offices as the engagement began. The subsequent six to eight weeks were devoted to managing the myriad of issues associated with that move while stabilizing and improving staff morale. In addition, significant planning was performed on the ERP and IT front while proposing a longer-term staff realignment plan.

Subsequent eight weeks were focused on ERP software selection, full scale IT and information security review, development of a new reporting dashboard for Partners; assessment of firm insurance coverage, development of a new 401K and profit-sharing plan and overseeing year end closing process including management of bonus recommendations.

Post year-end close focus has been on implementation of new ERP system, new 401K and profit sharing plan, complete rebuild of Firm’s IT infrastructure and creation of robust information security practices. In addition, an overall firm capacity plan and forecast was developed.

RESULT

Since our arrival, there has been no staff turnover. Key initiatives have been conceived and executed. Managing Partner is primarily practicing law. Firm is well on the way to having an back office operation that is of the same superior quality as the Firm’s legal practice.

Newsletter – March 2018

March 13, 2018 By CFO Consulting Partners

The CECL Approach, 3 of 3

For this newsletter CFO Consulting Partners has partnered with Ardmore Banking Advisors to review the potential material financial benefits of a well planned and executed implementation of the new current expected credit loss (“CECL”) accounting standard.

Most banks have an awareness of the need to prepare for the transition to CECL, and that many foundational activities need to be looked at now. Together CFO Consulting Partners (“CFO CP”) and Ardmore Banking Advisors (“Ardmore”) have constructed an approach to help banks address the “early must do’s” of CECL at a reasonable cost.

CFO CP leverages its extensive experience with banking industry finance, and Ardmore it’s deep expertise in credit and credit data to translate the CECL transition process into tasks and activities that create valuable efficiencies and bottom line impact for the Bank. Together we can cut through the noise and assess a bank’s CECL readiness and at the same time help create a CECL action plan that will drive real value for the bank.

We have discussed aspects of CECL implementations in prior newsletters, The New CECL Approach Part I, and Part II. Similarly, Ardmore’s webinar Step #1 Of the CECL Journey provides additional perspective.

CFO CP and Ardmore are each focused on complementary aspects of the CECL implementation process in the finance, accounting, and credit disciplines. Well executed CECL projects led by an interdisciplinary team of Credit, Finance, and other bank management, coordinated by experienced project managers and executed well, can produce tangible bottom line improvements, and better efficiency ratios.

Experienced CFO CP and Ardmore Project Managers can help the bank’s CECL team identify opportunities for process improvements. The resulting databases, internal control enhancements, and automation will produce faster decisions, easy access to controlled and trusted data, high functioning executive teams and, ultimately, improved efficiency ratios. If CECL implementation is managed well, a bank can leverage the implementation to break down silos, upgrade systems, improve processes, and reduce expenses.

CFOs can strategically manage the spending to required accomplish CECL goals AND drive efficiencies which will ultimately reduce the expense ratio. Opportunities exist in:

Credit Administration: Ensure that all credit practices are properly aligned with your CECL implementation, upgrade automation, and improve underwriting processes.
Finance: Re-engineer financial controls and loan accounting processes, optimize general ledgers, optimize risk adjusted capital levels, and Improve management information for the Board and Management.
IT: Improve data governance, develop and data management tools, and retire inefficient loan and credit systems.
Operations: Update credit processes (such as data entry and coding processes), and re-engineer controls and processes
Lending: Efficient analysis of deal structures and lending to minimize life of loan losses and capital impacts

An assessment for CECL readiness can reveal a lot that can be useful to the institution beyond the needs of CECL compliance including:

Assess the current state of the institution’s credit portfolio data and origination process, ALLL, Financial and
Credit policies, practices and governance – all within the context of CECL;
Review Current ALLL System & Processes;
Review controls on data used in the current ALLL process;
Identify data points required to support industry best practice portfolio data & regulatory compliance data for CECL;
Review loan origination process, stakeholders, criteria and coding;
Review data stored in the core for accuracy consistency and robustness;
Review all identified credit data source systems for data/database integrity; and
Review any existing data warehouse capabilities, and how portfolio data is organized, maintained, and retained.

CECL compliance practices and implementation plans should be in place in 2018. Auditors, regulators, boards of directors and investors will want to know bank’s plans for CECL, including the costs and the benefits beyond compliance.

Those institutions that leverage the potential benefits of the CECL implementation will have a competitive advantage over their competitors through increased efficiencies, automation and clarification of corporate risk management practices.

About the Authors

CFO Consulting Partners, Tom Van Lenten: Tom leads CFO Consulting Partners CECL consulting services to financial institutions. CFO CP’s CECL services include: CECL readiness assessment, analysis of the accounting and regulatory implications, project management, and assisting with updates of policies, procedures and internal controls which are impacted by CECL.

Ardmore Banking Advisors, Peter Cherpack: EVP, Partner. Peter is a nationally known thought leader in CECL implementation for community banks, and with other Ardmore consultants conducts CECL readiness assessments with a focus on credit and credit data readiness.

Newsletter – February 2018

February 13, 2018 By CFO Consulting Partners

A.M. Best Updates Its Rating Methodologies and Capital Model

Marc Liebowitz, CFO Consulting Partner LLC

A.M. Best (AMB) recently revised its rating methodologies, most of the changes relate to updated procedures and the underlying analytical components have generally remained in place. The below videos provide an overview of the methodology updates:
“A.M. Best’s Mosher: Methodology Update, Benchmarks Are Released”
“Market Issues, Methodology Updates Dominate A.M. Best’s NY Briefing”

As part of its revised rating methodology, AMB released its revised capital model, Best Capital Adequacy Ratio (BCAR). While the components and the equations to determine a group’s BCAR ratio have remained largely in place, the revised model applies updated technologies to better determine balance sheet risk. These technologies allow the model to quantify risk across various loss severity scenarios. Below are links that detail the updated processes:
“Understanding BCAR for U.S. Property/Casualty Insurers”
“Understanding BCAR for U.S. and Canadian Life/Health Insurers”

A.M. Best has termed its revised rating procedure the “building block approach.” The first step, or building block, is the capital assessment. Subsequent analytical steps either add or detract from the score assigned during the capital strength assessment. We discussed these steps in our previous articles on the ratings process. See our “Insurance Company Credit Rating Advisory Practice” Part 1 and Part 2

Balance sheet strength remains the foundation of the rating process, Best’s methodology will continue to review current capitalization and forecast future balance sheet strength. Operating performance, business profile and enterprise risk management are key elements which help to determine a groups prospective capital position. View A.M. Best’s Credit Rating Methodology

Benchmarks and peer group analysis remain an important factor in the determination of a group’s rating. Insurance companies which consistently outperform peer and/or industry benchmarks in terms of operating results and business profile are more likely to achieve higher rating categories. Peers are those that generally offer similar products, have approximate premium volume, operate in similar territories or otherwise compete in each other’s respective markets. Given the importance of benchmarks, companies should understand how they are developed and applied over the rating process.

AM Best expects the updates to the capital model and rating processes to support a more detailed rating analysis and lead to greater transparency relative to the assigned rating.

CFO Consulting Partners can guide companies through AMB’s revised rating processes and updated capital model. We can provide an understanding of the drivers of your current rating and develop strategies targeted at achieving your desired rating.

Newsletter – January 2018

January 18, 2018 By CFO Consulting Partners

Implementations of the New Lease Standards Under the ASC 842

Mark Sloan, CPA, CFO Consulting Partners

On February 25, 2016, the FASB issued new guidelines under ASC Section 842 regarding the recognition and financial reporting of leases. The new standard will impact both lessees and lessors, with the most significant impact falling upon lessees. The standard is effective for years beginning after December 15, 2018 for public firms and December 15, 2019 for nonpublic firms.

This is one of the most comprehensive changes to accounting principles in many years, almost 250 pages long, and it will require major effort of firms to understand and implement its impact.

Due to the complexity of this pronouncement, this update will focus on the impact the new standard will have on lessees; a future update will focus on the impact on lessors.

In summary, the significant effect of this standard on lessees is as follows:

Transactions which had been previously reflected as rent expense on the income statement will now require a right-of-use asset and a related lease liability being reflected on the balance sheet;
Service arrangements for the use of assets over a period of years need to be evaluated and, if certain criteria is met, there needs to be a segregation of elements that are considered either lease components or non-lease components;
Lease liabilities must be continually evaluated for the occurrence of significant events and revised accordingly, and;
Criteria under previous guidance for determining a lease to be either an operating lease or a financing lease has been changed for the following:
1. eliminating specific guidance regarding thresholds for determining economic life and fair value of leased assets;
2. replacing such guidance with transaction specific judgement, and;
3. adding a criteria that the leased asset has no alternative use to the lessor at the end of the lease term.

As a result of the new standard, it is expected that balance sheets will increase with over $1.5 trillion of additional assets and liabilities.

As a starting point, contracts for services must be reviewed, and both the lease and non-lease components must be identified and segregated. In its simplest terms, the standard states that if a contract conveys the right to control the use of identified property, plant or equipment (an identified asset) for a period of time in exchange for consideration, without significant control or substitution rights by the lessor, then a lease exists.

This will be among the most challenging aspect of the new standard. There must also be an analysis to determine whether there are multiple lease components which need to be accounted for separately and whether there are multiple non-lease components which should be accounted for under other appropriate GAAP. Also, there needs to be an ongoing evaluation of contracts to determine when an event occurs that may change the recognition or measurement of the lease, and that the entity distinguish whether there is a modification of an existing lease or the recognition of a new lease arrangement requiring separate accounting.

In addition to arrangements which clearly demonstrate a lessee/lessor relationship (such as the lease of office space), other arrangements must be carefully evaluated to determine if a lease exists. Such arrangements may include:

Advertising agreements
Service agreements
Transportation agreements
Construction agreements
Related party arrangements

It is important to identify lease and non-lease component of a service arrangement. The arrangement must be carefully evaluated for any asset that could be construed to be a lease in nature. One example is a data storage arrangement with a service provider. If the service contract includes the installation of a server on the location of the lessee, the lessor has no substantive substitution rights and the lessee derives most of the benefit of the asset over the lease term, then the server represents a lease component. An allocation of the rent payments need to be made between the server (the lease component) and the data storage (the non-lease component). The lease component must then be evaluated for either an operating lease or a finance lease and treated accordingly. The major difference between the two types will be that the income statement effect of the operating lease will be through rent expense while the income statement effect of the financing lease will be through interest expense and amortization expense.

Similar to previous guidance, leases meeting certain criteria will be considered a finance lease and there will need to be a right-of-use asset with a corresponding lease liability reflected on the balance sheet. The two amounts will be initially set up as the present value of the lease payments discounted at an appropriate interest rate (e.g., the lessee’s incremental borrowing rate).

A lease meeting any of the five following criteria will need to be classified as a finance lease:

Ownership of the leased asset transfers at the end of the lease term;
A bargain purchase option (i.e., one that is reasonably certain to be exercised) for the leased asset exists;
The lease term, which does not commence near the end of the economic life of the leased asset, is primarily the remaining economic life of the leased asset;
The sum of the present value of the lease payments and the residual value guarantees is equal to, or more than, substantially all of the fair value of the leased asset, and;
The leased asset has no alternative use to the lessor at the end of the lease term because of its specialized nature.

What is important to bear in mind is the new pronouncement removes the 75% (for criteria #3) and 90% (for criteria #4) that former GAAP had provided as guidance and, instead, the lessee will need to take positions as to determining the remaining economic life or substantially all of the fair value of the leased asset. Also new is criteria #5 which needs to be taken into account in the determination of the character of the lease. The right-of-use asset will be amortized on a straight line basis (or any more systemic approach) over the term of the lease and the lease liability will be extinguished using the effective interest method. The income statement will reflect amortization expense for the reduction of the right-of -use asset and interest expense for the interest component of the lease payments.

If a lease arrangement is identified and considered not meeting the above criteria for a finance lease, then such operating lease will reflect, on the balance sheet, a right-of-use asset and a corresponding liability recorded at the present value of the rent payments, using an appropriate interest rate such as the lessee’s incremental borrowing rate. Both the amortization of right-of-use asset and the accreted interest on the lease liability will be reflected in rent expense on the income statement.
If an entity has both finance leases and operating leases, then the right-of-use asset and the lease liabilities must be presented separately for each type of lease.

If there are elements in the lease arrangement for step-up in rent payments, initial direct costs, payments of residual values, etc., such elements must be taken into account in calculating the right-of -use asset and corresponding liability.

Leases with terms of 12 months or less will be exempt from the standard as it relates to reflecting a balance sheet impact. Such leases will continue to be accounted for as under previous guidance, i.e., off balance sheet and footnote disclosure only.

As part of the transition process for the standard, there are practical expedients that an entity may elect, as a package and applied consistently, to all of its leases which commenced prior to the effective date of the standard:

An entity need not reassess whether any expired or existing contracts are or contain leases;
An entity need not reassess the lease classification (i.e., operating versus finance lease) made under previous GAAP for any expired or existing leases, and;
An entity need not reassess initial direct costs for any existing leases.

If an entity foregoes these practical expedients, then it must apply the standard to all previous periods presented for which there are leases or contracts which contain lease and non-lease components.

On January 5, 2018, the FASB issued an Exposure Draft revising some of the provisions of ASC 842. The Board is requesting comments to this Exposure Draft no later than February 5, 2018.

The two issues on which the Board is seeking comments are as follows:

Comparative reporting for initial adoption, and;
Separating and allocating lease and non-lease components in a contract.

As it relates to comparative reporting for initial adoption, the Board has proposed recognizing a cumulative-effect adjustment to the opening balance of retained earnings in the period of adoption. As it relates to separating and allocating lease and non-lease components in a contract, this proposed amendment would be applicable to lessors only. The amendment would provide lessors with a practical expedient that is currently available to lessees, which is to not separate non-lease components from related lease components for identified classes of underlying assets. This practical expedient would be available only upon meeting certain requirements, i.e., (i) the timing and pattern of revenue recognition for the non-lease component(s) and related lease components are the same, and (ii), the combined single lease component would be classified as an operating lease.

A subsequent newsletter will provide an update to the standard once the comment period has expired and the Board has finalized any revisions to ASC 842 regarding the aforementioned issues.

As can be seen from this brief summary, the new pronouncement on lease accounting will have a deep and profound effect on most entities. While the implementation date is still some time off, it would be prudent to begin to assess the effect this pronouncement will have on your financial statements. We here at CFO Consulting Partners have an extensive understanding of the new standard and stand ready to assist in evaluating and implementing this standard.

Newsletter – December 2017

December 28, 2017 By CFO Consulting Partners

Physician Practices: The Future is Changing

John DeLorenzo, MBA, CFO Consulting Partners LLC

The United States possibly has the most complex healthcare system in the world. The American healthcare system regulates the industry at both the federal and state level. It is paid for by private health insurance as well as from the government under its Medicare and Medicaid programs. Healthcare services are provided by the private sector; however, the government also provides services directly through the Veterans Administration. All of this, in a population with disparate levels of wealthy and poor citizens, leads to highly chaotic distribution of care and a complex payment system.

While half of all Americans receive healthcare coverage through their employers, most plans are subject to regulations both federally and at the state level. Those Americans receiving healthcare coverage through Medicare and Medicaid, subject the provider to lower reimbursements. As a result, some providers are less willing to take on Medicare and Medicaid patients, leading to a shortage of providers for that patient base. Patients that are not covered by their employer or a federally provided healthcare program are required to seek private insurance. However, because of the Patient Practice and Affordable Care Act (PPACA), patients are generally provided less options then employer plans, and those options may restrict their choices regarding providers.

Because of a more recent development, a totally different method of reimbursement, from fee for service or volume payments, to outcome based reimbursements or Value Based Care (VBC) is being encouraged by both Centers for Medicare and Medicaid (CMS) and by private insurers. Essentially, fees for services under VBC are paid based on case outcome and the payment must be shared by all providers in the continuum. VBC reimbursement was originally introduced by the CMS. Both CMS and now private insurers are moving in the direction of value based reimbursement and providing incentives to providers to participate. What is essential to succeed in the VBC method of reimbursement lie in integration of providers and the ability to aggregate data.

Even prior to the movement to VBC, the PPACA is requiring all practitioners to utilize Electronic Medical Records, (EMR) which is costly in both software acquisition as well as implementation. While a burden to small practitioners and groups, EMR will ultimately allow groups to operate, integrate and bill more efficiently.

As new requirements continue to be heaped on single physician practices and small groups, they have been dwindling as more groups consolidate to gain scale and integration. Also, there is a significant trend toward physician groups selling their practices to hospitals as hospitals are a significant cog in the VBC wheel.

Sole practitioners and practice groups need to assess their situations and determine if they are positioned to continue independently or should they align with a network of providers or sell to a larger group or hospital.

Viability in the changing healthcare delivery model for practice groups will require a significant change in how a practice operates, will require investments in information technology, possibly require upgraded staffing as well as the development of relationships with other providers in the continuum.

CFO Consulting Partners healthcare practice is here to help you. We can assist you to access your current situation and help you create and implement a plan forward. We can also assist you should you decide to align with a network or sell or consolidate with another group or hospital.

Newsletter – November 2017

November 30, 2017 By CFO Consulting Partners

Are You Ready for the New Revenue Recognition Standard?

Oliver Brooks, CPA, CFO Consulting Partners LLC

INTRODUCTION

On May 14, 2014 the FASB issued the standard ASC 606 Recognition of Revenue from Contracts with Customers. The FASB issued an Accounting Standards update to the Standard (ASU 2016 -10) in April 2016.

The implementation date for the standard is:

For public business entities, certain not-for-profit entities, and certain employee benefit plan
- Reporting periods beginning after Dec 15, 2017
For all other entities
- Reporting periods beginning after December 15, 2018

ASC 606 will have a major impact on the reporting of revenue for all entities, public and private that enter into contracts that promise the exchange of goods and services to their customers with a relatively minor impact on some costs associated with fulfillment of the contracts.

The standard is both complex and far reaching. Consequently, implementation is likely to require considerable effort and expertise.

Entities that plan to report GAAP financials would be well advised to consider moving quickly to initiate a thoughtful plan of action to comply with the standard.

OVERVIEW OF THE STANDARD

The following recaps the author’s view of the key guidance in the standard.

Performance obligations

The basic economic transaction is the contract between an entity and its customers. The standard address the accounting for the promises embodied in the contract, which it refers to as performance obligations.

The core principle of the standard is that an entity recognizes revenue when goods and services are delivered or fulfilled.

To achieve the core principle the standard promulgates a series of actions that an entity must undertake are:

Identify the contract with the customer
Identify the distinct performance obligation(s) in the contract
Determine the transaction price
Allocate the transaction price to the distinct performance obligations in the contract
Recognize revenue when (or as) the entity satisfies the performance obligation(s)

Disclosures

ASC 606 requires considerably more disclosures about revenue. In general, the intent of the disclosures is to enable the reader to understand the nature and amount of the revenue being recognized and the uncertainty of the related cash flows. More specifically the entity shall disclose:

Contracts
- Disaggregation of revenue
- Contract Balances
- Performance Obligations
- Transaction price allocated to remaining obligations

Other

The standard provides guidance on several other situations that can arise in the administration of contracts. For example (Not a complete recap)

Measurement of progress completion
Change in estimate
Right of return
Contract modification
Bill and hold arrangements
Cash and non cash consideration

IMPLEMENTATION

Given the complexity of this standard and its impact on revenue, it is incumbent on entities to have a well thought out implementation and transition plan. Some key issues that the plan should address include:

Financial: Determine the revenue streams that are impacted. Assess the need to review all customer contracts, possibly cataloging them and detailing their performance obligations.
- Review the methodology in place for recognizing revenue and devise an intervention whether interim or final, systematic or manual, that brings revenue recognition into line with the standard
If the plan envisions significant manual effort be aware of the increased probability of errors and mitigate it with adequate quality control
Information System: Ascertain the need and /or feasibility of reconfiguring the ERP system to seamlessly produce financial information in compliance with the new standard
Organization: Communication to internal and external stakeholders. Determine the need for revised guidance to organization units that interface with customers or suppliers with regard to entering into, structuring of and reporting on contracts.
Transition: Decide on and prepare for full retrospective or modified retrospective presentation for financial statements presented after the implementation date. I.e.
- Full retrospective: Apply the new standard as of the implementation date and, for the prior comparative periods, restate all contracts on the same basis
- Modified retrospective: Apply the new standard as of the implementation date and, for the prior comparative periods, the data is not recast but instead apply a single adjustment to equity at the beginning of the initial year of application.

Companies are advised to begin the process early to ensure compliance. For complex revenue recognition issues, the company may want to consider outside professional resources to assist in the analysis.

More detailed information may be viewed here.

Newsletter – October 2017

October 3, 2017 By CFO Consulting Partners

The CECL Approach, Part 2

Tom Van Lenten, CPA, CFO Consulting Partners LLC

This is the second in the CFO Consulting Partners series of articles analyzing the new FASB Standard on accounting for credit losses (ASU 2016-13). Click here for the first article in the series

It has been more than a year since the FASB issued ASU 2016-13 Click here for article . The new Standard is most commonly referred to as CECL, which is an acronym for “Current Expected Credit Losses”. The CECL standard requires an entity to recognize a forward-looking estimate of the expected credit losses in the Allowance for Loan and Lease Losses (ALLL), when an asset is booked. Current GAAP requires that the estimate of credit loss is based on incurred losses and banks typically historical losses as the basis for the calculation

CECL is one of the largest and most complex accounting standard implementations ever undertaken in the banking industry. Despite this, many banks have not begun urgent and focused execution of CECL implementation plans. Privately-held companies can see the long transition timeline (implementation is required at January 1. 2021 for non-SEC filers) as a reason for delay. However, public entities must react faster. They are required to include disclosures in their first SEC filings after issuance of ASC 2016-13 on June 16, 2016. The FASB has recently highlighted this disclosure requirement by issuing ACU 2017-3 in January 2017 which gives additional guidance for certain disclosures of standards that are issued but not yet implemented for SEC filers.

The basic requirements of ASU 2017-3 are:
if an SEC filer does not know or cannot estimate the financial impact from adoption of a new ASU it should make a statement to that effect and should consider additional qualitative disclosures to assist the reader in assessing the impact that the standard will have
the ASU also requires additional qualitative disclosures to include a description of the effect of the accounting policies that the SEC filers expect to apply together with a comparison to their current accounting policies,
additionally, SEC filers should describe the status of the process to implement CECL and the significant implementation matters yet to be addressed.

In a recent informal survey of financial institutions by MST Click here for article covering the implementation of CECL, 5% of the respondents said that they have not yet begun preparation for CECL implementation, and 87% have only held internal discussions about CECL implementation. One experienced CFO has been quoted as saying, “the commonly followed CECL implementation strategy of waiting for other banks to report first is in fact dangerous.”

Considering the size and complexity of CECL implementation we agree that delay is a high-risk approach and that thoughtful planning now will yield significant benefits.

The major elements of CECL implementation include:
Analysis of CECL impacts on the bank,
Project management,
Credit modeling,
Accounting Policies,
Operations,
Systems integration [click here for a case study of a CFO CP systems integration].

In our next newsletter, we will discuss further considerations in CECL implementations.

Newsletter – June 2017

June 27, 2017 By CFO Consulting Partners

Insurance Company Credit Rating Advisory Practice, Part 2

Marc Liebowitz, CFO Consulting Partners LLC

There are three primary drivers of insurance credit ratings:

Risk adjusted capital levels
Operating results
Market profile which is the overall evaluation of strategies, products, underwriting strength and risk diversification.

In a previous article, we covered risk adjusted capitalization. Click here for the first article in the series. In this installment, we review how credit rating agencies evaluate operating results and market profile. Our focus is on the A.M. Best Company (AMB) and Kroll Bond Rating Agency (KBRA) methodologies as these agencies are most relevant to the mid-market insurance company ratings universe. The AMB and KBRA rating methodologies are available through their respective web sites:

A.M. Best’s Credit Rating Methodology
Global Insurer & Insurance Holding Company Rating Methodology

To measure the relative strength of a group’s operating results, analysts, develop a view of overall earnings power and compare those estimates to peer group averages and industry norms. The major components of this analysis are:

Comprehensive evaluation and trend analysis of financial outcomes, returns, and ratios
Development of multi-year projections and stress testing those forecasts
Review of key metrics for the consolidated organization and for individual business segments
Analysis of earnings by product and of investment portfolio earnings by asset type
Comparison of company specific results against peer group and industry-wide aggregates

Benchmarking comparisons are influential parts of the earnings analysis and management teams that demonstrate an understanding of key strategic and operational business elements which are apparent from this analysis are more likely to achieve their desired ratings outcome.

The market profile is a qualitative evaluation of a company’s spread of risk, revenue composition, and management strength. Given the qualitative nature of this analysis, management should provide a clear view of strategic plans and other elements which can provide a full picture of the company and how management approached the competitive landscape in its key markets.

A clear presentation of management’s plans to grow the company and improve operational efficiencies is essential to getting the appropriate rating for an organization. Sometimes there are areas where the goals of management and credit agencies are at odds. For example, a strategy to grow revenues and build the bottom line can be seen by the credit agency as a plan to add risk to the balance sheet. CFO Consulting Partners can work with the clients on how to best communicate the benefits of strategic actions and review strategies to mitigate the perceived risk.

Newsletter – May 2017

May 24, 2017 By CFO Consulting Partners

Insurance Company Credit Rating Advisory Practice

CFO Consulting Partners has begun to work with insurance companies to help maximize a company’s rating potential. This article is the first of a two-part series which will discuss the credit rating process for insurance companies. Here we discuss how ratings firms look at capital levels, and how management can demonstrate effective capital management strategies. A subsequent article will review the roles of: operating results, market profile, and additional analytic considerations in the ratings process.

Marc Liebowitz, CFO Consulting Partners LLC

There are generally five Security and Exchange Commission (SEC) registered Nationally Recognized Statistical Rating Organizations (NRSRO), otherwise known as rating agencies, which follow the U.S. insurance industry: A.M. Best Company (AMB) and Kroll Bond Rating Agency (KBRA) are the primary providers of credit ratings to the mid-market segment of the industry. The three larger NRSROs: Fitch, Moody’s and Standard & Poor’s (S&P), tend to focus on the industry’s larger companies.

AMB and KRBA provide two types of ratings on insurance companies, debt and policy issuer strength ratings. Debt ratings are an indication of the insurer ability to meet their interest and principal obligations on specific bonds, a policy issuer strength rating considers the likelihood of a failure to honor a company’s insurance policy liabilities. For policy liability ratings AMB issues Financial Strength Ratings (FSR), and KBRA issues Insurance Financial Strength (IFSR) ratings. Insurance companies seek policy issuer strength ratings for several reasons, for example, ratings are required by insurance agents, by reinsurance brokers and companies, and to insure bonded construction projects. Also, ratings are utilized by boards and other stakeholders as a third-party evaluation of operations and capital adequacy.

There are three primary drivers of insurance credit ratings: risk adjusted capital levels, operating results, and market profile (the overall mix of products, underwriting strength, and risk diversification). These factors form the foundation of the rating and are quantified and evaluated relative to rated peer groups and to industry averages. Enterprise Risk Management (ERM) practices, management quality, and other qualitative factors are also considered and may raise or lower the rating.

AMB uses a proprietary capital model, Best Capital Adequacy Ratio (BCAR), details of AMB’s methodology can be reviewed here: Best’s Credit Rating. AMB is in the process of updating its BCAR model – the most significant change will be the incorporation of scenario modeling of an insurance company’s loss factors at various confidence levels. The revised BCAR model is currently open to public comment before it goes into production, likely prior to year-end 2017.

KRBA’s capital strength assessment uses the National Association of Insurance Commissioners (NAIC) Risk Based Capital (RBC) model. KRBA details their capital adequacy approach within their rating methodology here: Global Insurer & Insurance Holding Company Rating Methodology

Rating agencies look at companies differently than management and other stakeholders – investors, employees, etc. Therefore, as part of any rating review or update management must be able speak to the agency’s perspective and clearly demonstrate management’s understanding of the company’s capital position, how it is managed through existing risk management programs, and how and why it will change going forward. Analysts expect management’s knowledge to extend beyond the results of the agencies capital modeling. Accordingly, management should present a forecast which considers the unique and proprietary aspects of the company’s strategy and operations. The ratings team will also want to discuss the programs in place to manage the company’s long-term solvency. All information presented by management will be distilled and compared to peer groups composed of comparable firms. Also, rating agency analysts cannot, due to SEC rules, provide guidance to companies on how to improve ratings.

To achieve rating upgrades, or to maintain a rating, management should plan to continuously improve risk management programs and strategies, create clear and achievable forecasts, and effectively communicate the various actions taken to maintain capital adequacy and manage the company’s risk profile. It’s critical for management to understand the agencies expectations prior to engaging discussions presenting material at an annual review.

Newsletter – March 2017

March 30, 2017 By CFO Consulting Partners

The New CECL Approach

Tom Van Lenten, CPA, CFO Consulting Partners LLC

In mid-2016 the FASB issued its long-awaited standard on accounting for credit losses (ASU 2016-13). The new standard adds to US GAAP an impairment model known as the current expected credit loss model or CECL. In a shift from current practice the CECL model is based on expected losses rather than incurred losses. Under the new CECL model an entity recognizes its forward looking estimate of the expected credit losses in the Allowance for Loan and Lease Losses, or ALL when an asset is booked.

The FASB believes that the new standard will result in more timely recognition of credit losses. There is a long transition timeline and implementation is required at January 1, 2020 for calendar-year reporters that are SEC filers, and January 1. 2021 for other entities.

The CECL approach is to be applied to most debt instruments that are not measured at fair value. This includes loan commitments, financial guarantees, lease receivables, trade receivables and held-to-maturity securities. Available for sale debt securities are specifically excluded and will continue to be evaluated for impairment under the AFS securities impairment model.

The Standard does not require use of any one method to compute expected credit losses. Management is expected to maintain complete data sets, documentation, and analysis to support how the selected method fits with the standard and produces realistic estimates of future losses. Examples of some of the acceptable methodologies are:

Loss rate: Historical loss rates can still be used as a starting point for determining expected credit losses. When using historical loss rates, the Bank would have to consider how conditions that existed during the historical charge-off period differ from current projections and adjust the future loss rates accordingly.
Discounted cash flow: Projections of principal and interest flows over the life of the asset.
Probability of default method estimates the probability loans in certain risk-stratified segments will default. This approach computes the percentage of loans that have defaulted in a pool over a look-back period.
Roll-rate method. The roll-rate method is often referred to as “migration analysis”. It is based on determining a prediction of credit losses based on segmentation (by delinquency or risk rating, for example) of a portfolio of financial assets. No standard roll-rate model is used throughout the financial institutions industry, but most of the models used are based on similar underlying principles.
Aging analysis: Banks use aging analysis in determining the effectiveness of their credit and collections functions and for estimating potential loan losses. The information from this analysis is used by Banks as a component of their estimate the allowance for loan & lease losses.
Collateral-value: For loans that are collateral dependent, evaluation of collateral and costs of disposal can be used to estimate expected credit losses.

Institutions with multiple loan types will likely need several methodologies to properly analyze the loss content of each portfolio segment and then aggregate the results to understand the expected losses for entire loan portfolio.

Expected credit impairment will be recognized as an allowance, instead of as a direct write-down of the amortized cost of the financial asset. Changes to the ALLL are recorded immediately through credit loss expense. The carrying amount of a financial asset that is considered to be uncollectible will be written-off in a manner similar to current US GAAP.

While there is significant time until required implementation, it is imperative that management begin the implementation process as soon as possible. The most problematic aspects of CECL implementation will likely be: a) developing the support systems and processes, b) gathering and organizing the historical data to support new methodologies, and c) developing going forward data capture and analysis processes.

With respect to a) above, existing modeling approaches currently used for Basel, and stress testing may be leveraged and adapted for CECL. However, new credit loss models will likely need to be implemented. It is anticipated that the development or purchase of credit models that estimate future credit losses may be the most time consuming phase of CECL implementation.
For b) the historical data requirements for the new models will often not be resident in current financial and credit systems. This data will have to be developed from the bank’s core operating system and organized into databases which the models can access.
For data capture and analysis c) the starting point for developing a future loss credit loss data base is current loan and credit loss data. Companies implementing CECL should undertake a robust review and analysis of its current loan and credit data so that the process of developing a future credit loss data base starts with historic data that has a high level of accuracy and integrity.

Many of the disclosures required under the new standard are similar to those required under current GAAP. For example disclosures on credit quality, ALLL roll-forward, policies tor determining credit losses, past due and non-accrual status, and collateral dependent assets are the same. There are, however, significant additional disclosures of credit quality indicators, disaggregated by year of origination for a five-year period.

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