Tokyo AFM

Prior to joining Tokyo Auto Fire and Marine (Tokyo AFM), a publicly traded Japanese casualty

insurance company, in June 2001, Nobu Matsumoto had held various management positions in the

insurance industry for 20 years, in both Japan and overseas. He was appointed chief executive officer

of Tokyo AFM after two financial service companies from the U.S. and Europe each acquired a 20%

interest in Tokyo AFM. The two new investors intended to rapidly expand the operations of the

company overseas.

Industry Background

Casualty insurance companies had two principal sources of revenue. The first source was

insurance premiums, which were payments that clients (hereafter policyholders)individuals or

businessesmade to insurance companies to provide protection against losses resulting from

adverse events such as fire or natural catastrophes. Typically, these premiums were paid up front in

cash for protection covering one-year to five-year periods. The main costs associated with insurance

contracts arose from the actual payment of losses that policyholders subsequently incurred and that

were covered by the contracts.1 Loss-related expenses were mainly divided between direct claim

payments and indirect expenses related to processing claims. Typically, insurers also incurred costs

to acquire customers and set up policies. The main categories of acquisition costs consisted of

commissions paid to agents and salespeople, administrative policy issuance costs, advertising

expenditures, and agent recruitment and training.

The second source of revenue for insurance companies was investment income. Insurers invested

their float in various financial instruments. In simple terms, the float was the amount of cash

collected from policyholders and not yet paid out for claims or other expenses. Since casualty,

particularly catastrophic, losses could occur at any time, one of the challenges for insurers was to

maintain an adequate level of liquidity in their portfolio to be ready to pay claims as they arose.

Brief Company History

Tokyo AFM was established in Tokyo in 1928 as Nippon Insurance Co., Ltd., which specialized in

property fire-damage insurance. Tokyo AFM gradually widened the range of its products over time

to become a more comprehensive property-casualty insurance group. The company was listed on the

Tokyo Stock Exchange in 1963. Over the years, the companys profits had grown at a slow but steady

pace until the casualty insurance industry was deregulated in the late 1990s. Soon after, the financial

performance of Tokyo AFM deteriorated.

Despite Tokyo AFMs desire to remain an independent insurer, the industrys deregulation

proved challenging. In early 2001, The American Banking Group acquired a 23.04% stake in Tokyo

AFM, and the German reinsurance group Bayern Re acquired 20.54% of the companys shares.

Soon after his appointment as CEO, Matsumoto became concerned that certain financial

accounting policies of the company did not reflect the economic reality of the underlying

transactions, particularly those related to revenue recognition, contract acquisition costs, reserves for

contingent future losses, and investments in marketable securities. He asked that you comment on

the companys current accounting practices and suggest any changes you might recommend, along

with your reasons. Be sure to identify the alternatives you rejected and your reasons for rejecting

them.2 Do not dismiss an alternative or reach a decision on the grounds of immateriality. If you

make any assumptions, please state them.

Financial Accounting Concerns

Matsumoto was concerned about the following Tokyo AFM accounting policies and wanted your

recommendation on each:

1. Tokyo AFM recognized premium revenue at the time it received the policyholders up-front cash

payment. The companys accountants argued that since the level of up-front payments received from

policyholders had been stable over the last few years, this method was an appropriate reflection of

economic reality.

For example, Fuji Computers entered into a five-year insurance contract with Tokyo AFM against

earthquake damage to its headquarters building. As is customary, it paid the 100 million premium

for the five-year coverage up front in cash.

Question How would you recognize revenues associated with this type of catastrophe

insurance contract?