Accounting is a system of recording, analyzing and verifying an organization’s financial status. In the United States, all corporate accounting is governed by a common set of accounting rules, known as generally accepted accounting principles, or GAAP, established by the independent Financial Accounting Standards Board (FASB). The Securities and Exchange Commission (SEC) currently requires publicly owned companies to follow these rules. But starting in 2010, some large multinational companies may start using International Financial Reporting Standards (IFRS).
Accounting rules have evolved over time and for different users. Before the 1930s corporate accounting focused on management and creditors as the end users. Since then GAAP has increasingly addressed investors’ need to be able to evaluate and compare financial performance from one reporting period to the next and among different companies. In addition, GAAP has emphasized “transparency,” meaning that accounting rules must be understandable by knowledgeable people, the information included in financial statements must be reliable and companies must fully disclose all relevant and significant information.
Special accounting rules also evolved for industries with a fiduciary responsibility to the public such as banks and insurance companies. To protect insurance company policyholders, states began to monitor solvency and, as they did so, a special insurance accounting system, known as statutory accounting principles, or SAP, developed to help them. The term statutory accounting denotes the fact that SAP embodies practices required by state law. SAP provides the same basic information about an insurer’s financial performance as GAAP but, since its primary goal is to enhance solvency, it focuses more on the balance sheet than GAAP. GAAP focuses more on the income statement.
Publicly owned U.S. insurance companies, like companies in any other type of business, report to the SEC using GAAP. They report to insurance regulators and the Internal Revenue Service using SAP. Accounting principles and practices outside the U.S. differ from both GAAP and SAP.
In 2001 the International Accounting Standards Board (IASB), an independent international accounting standards setting organization based in London, began work on a set of global accounting standards. About the same time, the European Union (EU) started work on Solvency ll, a framework directive aimed at streamlining and strengthening solvency requirements across the EU in an effort to create a single market for insurance, see U.S. Solvency Regulation and Solvency II.
Ideally, a universal set of accounting principles would facilitate global capital flows and lower the cost of raising capital. Some 100 countries now require or allow the use of the international standards that IASB has already developed and more adopters are on the way.
Insurers support the IASB’s search for the highest quality financial reporting standards. However, some are concerned that some aspects of the initially proposed standards for insurance contracts will confuse more than enlighten and introduce a significant level of artificial volatility that could make investing in insurance companies less attractive.
- Two on-going major international accounting initiatives are of particular concern to insurers. The first is the development of a new financial reporting system, the International Financial Reporting Standards (IFRS), which could affect statutory accounting since SAP, the system currently in use, is based on a modification of GAAP to reflect a stronger emphasis on solvency. The second is a plan to create a global framework for insurance contracts.
- Financial Reporting: A much-awaited report from the Securities and Exchange Commission (SEC) published in July 2012 made no recommendations about whether the IFRS should be incorporated into the U.S. financial reporting system although it did say that there was little support among major U.S. corporations for adopting the IFRS as authoritative guidance. In a discussion of the issues, PricewaterhouseCoopers says that ultimately the U.S. could move slowly to “achieve a U.S.GAAP that is highly comparable (but not necessarily identical) to IRFS.”
- Insurance Contracts: It appears unlikely that the U.S. Financial Accounting Standards Board (FASB) and the International Accounting Standard Board (IASB) will be able to achieve a convergence of the two systems. Acknowledging that the boards of the two entities could not reach agreement on standards for insurance contracts, despite attempts to resolve major differences, the chairman of FASB said in June 2012 that in the meantime the board would explore making targeted improvements to the U.S.GAAP rather than issuing an entirely new insurance standard. According to the Property Casualty Insurers Association of America, the main disagreements are in the areas of unearned premium reserves, claim reserves and the deferral of acquisition costs, see Background section below.
- In July 2010, the IASB issued a draft of the insurance contracts standards it hoped would bring greater consistency and comparability to insurers’ financial accounts. However, U.S. property/casualty insurers said that that while they saw some benefits for the life insurance side of the industry, they saw very little gain for the property/casualty side. Some members of the IASB even say that accounting standards in property/casualty are not deficient. Insurers continued to ask the board to reconsider its decisions, particularly regarding short-term insurance contract such as homeowners insurance policies.
- The IASB first asked for comments on its discussion paper on international accounting standards proposal for insurance companies in 2007. Reponses were submitted by various groups and individual insurance companies.
- The Property Casualty Insurers Association of America (PCI), which represents mostly medium to small insurance companies, said in its comments that while it supports the convergence concept it disagrees with some of the ideas contained in the paper, including the use of a single model for valuing property/casualty and life insurance reserves, the requirement that loss reserves be discounted to reflect the time value of money and then be adjusted with the use of a risk margin to compensate for any inaccuracy, and the recognition of profit at the inception of an insurance policy, among other things. PCI said that overall it was concerned about the cost of resources to implement the proposal and the minimal benefits that would be realized. Comments on the discussion drafts, 2007 and 2010, are posted on the IASB’s Website.
- According to a study of insurance industry comments on the IASB discussion paper by Ernst & Young, an accounting firm, while there is strong support for an international accounting model for insurance transactions, there is disagreement about how to arrive at that point. Most believe accounting for insurance should reflect the economics of the business and are unwilling to accept the concept of “exit value,” as described in the discussion document. An IASB vice president, Tom Jones, acknowledged in a speech at Pace University in April 2008 that the board faces a challenge in revising accounting standards. He said the IASB came up with the “current exit value” approach to measure the value of insurance contracts because, since insurance company assets, contracts and liabilities lack a ready market, using fair value or mark to market could cause problems. Others suggest that a more appropriate way to measure the value of insurance contracts would be to reflect the expected cash flows needed to settle the contract.
To assess the IASB proposal, it’s important to understand how the insurance industry functions and the current insurance accounting framework.
Insurance Basics: Insurers assume and manage risk in return for a premium. The premium for each policy, or contract, is calculated based in part on historical data aggregated from many similar policies and is paid in advance of the delivery of the service. The actual cost of each policy to the insurer is not known until the end of the policy period (or for some insurance products long after the end of the policy period), when the cost of claims can be calculated with finality.
The insurance industry is divided into two major segments: property/casualty, also known as general insurance or nonlife, particularly outside the United States, and life. Property/casualty insurers sell home, auto and commercial coverages; life insurers sell life, long-term care and disability insurance and annuities. In the United States, both types of insurers submit financial statements to regulators using a special set of accounting rules, see below, as opposed to GAAP, which is used for reporting to the SEC. But there are some significant differences between the accounting practices of property/casualty and life insurers due to the nature of their products.
Insurance is regulated by the states, whose main objective is to monitor and maintain the solvency of the companies they regulate. States also oversee rates, particularly for property/casualty insurers, to ensure they are adequate, not excessive and not unfairly discriminatory. To support these goals, all insurance companies are required to file annual financial statements with state regulators using an accounting system established by the National Association of Insurance Commissioners known as statutory accounting principles, or SAP. SAP generally recognizes liabilities sooner and at a higher value than GAAP and assets later and at a lower value.
Differences Between Property/Casualty and Life Insurance Contracts: Some differences between property/casualty insurance contracts have accounting implications. These include:
Contract duration: Property/casualty insurance contracts are usually short-term, six-months to a year. As a result, the final cost of most property/casualty contracts will be known within a year or so after the policy term begins, except for some types of liability contracts. By contrast, life, disability and long-term care insurance and annuity contracts are typically in force for decades.
Variability of Claims Outcomes Per Year: The range of potential outcomes with property/casualty insurance contracts can vary widely, depending on whether claims are made under the policy, and if so, how much the ultimate settlement (claims payments and claims adjustment expenses) costs. In some years, natural disasters such as hurricanes and man-made disasters such as terrorist attacks can produce huge numbers of claims. By contrast, claims against life insurance and annuity contracts are typically amounts stated in the contracts and are therefore more predictable. There are very few instances of catastrophic losses in the life insurance industry comparable to those in the property/casualty insurance industry.
Financial Statements: An insurance company’s annual financial statement is a lengthy and detailed document that shows all aspects of its business. The initial section includes a balance sheet, an income statement and a section known as the Capital and Surplus Account, which sets out the major components of policyholders’ surplus and changes in the account during the year. As with GAAP accounting, the balance sheet presents a picture of a company’s financial position at one moment in time—its assets and its liabilities—and the income statement provides a record of the company’s operating results from the previous year. An insurance company’s policyholders’ surplus—its assets minus its liabilities—serves as the company’s financial cushion against catastrophic losses and as its working capital for expansion. Regulators require insurers to have sufficient surplus to support the policies they issue. The greater the risks assumed, and hence the greater the potential for claims against the policy, the higher the amount of policyholders’ surplus required.
Asset Valuation: Property/casualty companies need to be able to pay predictable claims promptly and also to raise cash quickly to pay for a large number of claims in the event of a hurricane or other disaster. Therefore, most of their assets are high quality income paying government and corporate bonds that are generally held to maturity. Under SAP, they are valued at amortized cost rather than their current market cost. This produces a relatively stable bond asset value from year to year (and reflects the expected use of the asset.)
However, when prevailing interest rates are higher than bonds’ coupon rates, amortized cost overstates asset value, producing a higher value than one based on the market. (Under the amortized cost method, the difference between the cost of a bond at the date of purchase and its face value at maturity is accounted for on the balance sheet by gradually changing the bond’s value. This entails increasing its value from the purchase price when the bond was bought at a discount and decreasing it when the bond was bought at a premium.) Under GAAP, bonds may be valued at market price or recorded at amortized cost, depending on whether the insurer plans to hold them to maturity (amortized cost) or make them available for sale or active trading (market value).
The second largest asset category for property/casualty companies, preferred and common stocks, are valued at market price. Life insurance companies generally hold a small percentage of their assets in preferred or common stock.
Some assets are “nonadmitted” under SAP and therefore assigned a zero value but are included under GAAP. Examples are premiums overdue by 90 days and office furniture. Nonadmitted assets and limits on categories of investments may be reconsidered at some point in time in light of the European Union’s drive toward a single market for insurance, which includes a new regulatory framework for insurance company solvency known as Solvency II. While the frameworks for solvency regulation and accounting are not the same, the two are intertwined. Regulators look at balance sheets in evaluating solvency and balance sheets are the product of accounting. Solvency II envisions the removal of rules on nonadmitted assets. In their place will be a set of guiding principles based on the concept of a “prudent person.”
Real estate and mortgages make up a small fraction of a property/casualty company’s assets because they are relatively illiquid. Life insurance companies, whose liabilities are longer term commitments, have a greater portion of their investments in commercial mortgages.
The last major asset category is reinsurance recoverables. These are amounts due from the company’s reinsurers on claims that have been paid. (Reinsurers are insurance companies that insure other insurance companies, thus sharing the risk of loss.) Amounts due from reinsurance companies are categorized according to whether they are overdue and, if so, by how many days. Those recoverables deemed uncollectible are reported as a surplus penalty on the liability side of the balance sheet, thus reducing surplus.
Liabilities and Reserves: Liabilities, or claims against assets, are divided into three components: reserves for obligations to policyholders, claims by other creditors and policyholders’ surplus. Reserves for an insurer’s obligations to its policyholders are by far the largest liability. Property/casualty insurers have three types of reserve funds: unearned premium reserves, or pre-claims liability; loss and loss adjustment reserves, or post claims liability; and other.
Unearned premiums are the portion of the premium that corresponds to the unexpired part of the policy period. Premiums have not been fully “earned” by the insurance company until the policy expires. In theory, the unearned premium reserve represents the amount that the company would owe all its policyholders for coverage not yet provided if one day the company suddenly went out of business. If a policy is canceled before it expires, part of the original premium payment must be returned to the policyholder.
Loss reserves are obligations that an insurance company has incurred due to claims filed under the policies it has issued. Loss adjustment reserves are funds set aside to pay for claims adjusters, legal assistance, investigators and other expenses associated with settling claims. Property/casualty insurers only set up reserves for accidents and other events that have happened.
Some claims, like fire losses, are easily estimated and quickly settled. But others, such as products liability and some workers compensation claims, may be settled long after the policy has expired. The most difficult to assess are loss reserves for events that have already happened but have not been reported to the insurance company, known as "incurred but not reported" (IBNR). Examples of IBNR losses are cases where workers inhaled asbestos fibers but did not file a claim until their illness was diagnosed 20 or 30 years later. Actuarial estimates of the amounts that will be paid on outstanding claims must be made so that profit on the business can be calculated. Insurers estimate claims costs, including IBNR claims, based on their experience. Reserves are adjusted, with a corresponding impact on earnings, in subsequent years as each case develops and more details become known.
Revenues, Expenses and Profits: Profits arise from insurance company operations (underwriting results) and investment results.
Policyholder premiums are an insurer’s main revenue source. Under SAP, when a policy is issued, the pre-claim liability or unearned premium is equal to the written premium. (Written premiums are the premiums charged for coverage under policies written regardless of whether they have been collected or “earned.”) On the asset side of the balance sheet, premiums are treated as deferred revenues and on the liability side, they increase the unearned premium reserve. Premiums are earned on a pro-rata basis as coverage is provided over the policy period.
Under GAAP, policy acquisition expenses, such as agent commissions, are deferred on a pro-rata basis in line with GAAP’s matching principle. This principle states that in determining income for a given period, expenses must be matched to revenues. As a result, under GAAP (and assuming losses and other expenses are experienced as contemplated in the rate applied to calculate the premium) profit is generated steadily throughout the duration of the contract. In contrast, under SAP, expenses and revenues are deliberately mismatched. Expenses associated with the acquisition of the policy are charged in full as soon as the policy is issued but premiums are earned throughout the policy period. Consequently, the policy is expected to produce a profit that grows throughout the policy period.
SAP mismatches the timing of revenues and acquisition expenses to enhance the likelihood of the insurer’s solvency. By recognizing acquisition expenses before the income generated by them is earned, SAP forces an insurance company to finance those expenses from its policyholders surplus. This appears to reduce the surplus available to pay unexpected claims. In effect, this accounting treatment requires an insurer to have a larger safety margin to be able to fulfill its obligation to policyholders.
The IASB Proposal for International Insurance Accounting Standards: IASB’s aim in creating new accounting standards for the insurance industry is to facilitate the understanding of insurers’ financial statements. Until recently, insurance contracts had been excluded from the scope of international financial reporting standards, in part because accounting practices for insurance often differ substantially from those in other sectors, both banking and other financial services and nonfinancial businesses, and from country to country.
Insurers’ Concerns: These concerns center on the IASB “exit value” approach to valuing liabilities. IASB defines exit value as “the amount the insurer would expect to pay at the reporting date to transfer its remaining contractual rights and obligations immediately to another entity,” and suggests that insurers measure their current liabilities using three “building blocks,” which together constitute the exit value approach. The three building blocks represent current estimates of liabilities, including loss reserves and unearned premiums reserves; a discount for the time value of money, meaning that the company can earn investment income on assets corresponding to these reserves until they have to be paid out at some time in the future; and a “risk margin,” which takes into account the uncertainty of the future outcome of the business and the possibility that the seller may need to provide assistance to the buyer.
Exit Value Does Not Reflect Reality: The exit value concept is based on the notion that there is a secondary market and a reliable price for insurance policies, as there are for securities of various kinds, and that, therefore, a profit or loss can be calculated immediately after the policy has been issued. However, in reality, such a transfer of liabilities would virtually never occur, particularly in the case of property/casualty insurance contracts.
Without a robust secondary market, the only way to value liabilities is to create a model to represent such a market. This would entail modeling cash flow patterns for all potential scenarios, establishing discount factors to calculate present value and setting risk margins to compensate for the uncertainty of results as envisaged by the IASB model. With inputs and assumptions that are not independently verifiable, the IASB model is likely to produce outcomes that are different from the reality of the insurance transaction.
This is particularly true for insurers that cover rare (low frequency) but potentially devastating (high severity) risks, where the range of potential outcomes is enormous and difficult to predict and where the timing of cash flows depends on many variables including legal proceedings which can be dragged out for years. The subjectivity of the estimates calculated in this manner and the possibility of errors is more likely to impair rather than enhance the understandability and comparability of financial statements. As recent experience with mortgage-backed securities including subprime loans shows, models can be wrong.
The Volatility and Complexity of the Exit Value Approach Could Lessen Investors’ Interest In Some Insurance Companies: Property/casualty insurers’ financial results naturally vary substantially from one year to the next, depending on the number and severity of natural and man-made disasters and the level and outcome of litigation, among other things. Under the exit value approach, many different factors could add extra volatility, including changes in the interest rates selected for discounting and risk margins. Artificial volatility could also come from all the various assumptions insurers are forced to make about how their business will develop over time. Some insurers would be forced to add voluminous notes to their financial statements to explain their assumptions and inputs to their model, dampening the enthusiasm of some potential investors who could be put off by the difficulty of weighing the import of each note. As a result, some companies fear it would be harder to raise money. If they have to pay more to entice investors, their cost of capital would increase which in turn will lead to higher insurance prices.
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