If you are management of an insurance carrier of almost any size, one of the largest expenditures you are currently wrestling with is the growing cost of new information systems. Over recent years, there has been a shift in the information technology (IT) systems market place for companies to enter hosting arrangements with IT companies to host IT systems.
Due to this shift in how insurance entities are acquiring their IT products and services, accounting guidance has adapted. On January 1, 2020, the Statement of Statutory Accounting Principle 16R was revised to add a section titled, Customer’s Accounting for Implementation Costs Incurred in a Cloud Computing Arrangement That is a Service Contract. Basically, this revision to the accounting principle only applies to “service contracts”. In summary, it will allow certain costs to be capitalized and amortized up to five years. The assets would be non-admitted, so this is a surplus neutral event, but it would improve financial ratios of the company, especially the expense ratio.
As defined in this accounting principle, the IT contract you have with your IT company cannot give your company the right to take possession of the software, run the software on your own hardware or contract with another party unrelated to the host. If your contract has those features, it’s simply a non-service contract and this new accounting guidance does not apply.
Although, if the IT contract is a service contract, your company will have the opportunity to capitalize costs which fall within the “application development stage”. Examples of these costs include the following:
- External direct costs of materials and services incurred in implementing the hosting arrangement, including fees paid to external contractors (such as, costs of integrating the hosting arrangement with current software owned, coding, configuring or customizing software)
- Internal costs for compensation and benefits for employees for the time they spend on the project’s application development activities (such as coding and testing).
The appropriate costs can be capitalized as an asset for the company and amortized over the lessor of the term of the service contract or five years. The allocation of internal costs that are capitalized should be tracked and supported by documentation maintained by the Company.
A key component to analyze is when does amortization of the asset begin? The Company would need to determine when the asset is “placed in service”. Especially with the implementation of IT systems, this can be a difficult question. Certain systems have various modules that are many times dependent upon one another. This answer is crucial for management to determine when the amortization of a capitalized asset would officially commence.
Other costs incurred during other phases of the service contract will all be expensed, such as the preliminary project stage and the post implementation stage. One major expense that we have discussed with our clients is “hosting fees”, and our research has concluded hosting fees would also be expensed.
This accounting guidance also includes impairment guidance for hosting arrangements which cease to be used or if circumstances change which cause the carrying amount of the asset to no longer be recoverable.
In summary, we would expect financial management of insurance carriers to use this accounting guidance to assist in the decision process of implementing hosted cloud based IT systems. The financial management of a company could use this new accounting guidance to develop financial projections of the cost over a multiple year period. Lastly, we expect companies entering future service contracts or service contracts currently being drafted will analyze this accounting principle carefully in order to negotiate terms to maximize opportunities within this accounting guidance to minimize the annual financial impact of the cost of hosted IT systems.
Please contact Scott Esworthy, Principal within the BSSF Insurance practice, if you would like assistance with your company on this or any matters.