Insurance Accrual Accounting

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Insurance AccrualAccounting

www.worldbank.org/nbfwww.worldbank.org/nbf

Oliver Reichert

non-bank financial

institutions group

global capital markets

development department

financial and private sector

development vice presidency

primer series on insurance

issue 6, june 2009

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Insurance Accrual

AccountingOliver Reichert

non-bank financial

institutions group

global capital markets

development department

financial and private sectordevelopment vice presidency

primer series on insurance

issue 6, june 2009

www.worldbank.org/nb

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Asset Structures for Insurersii

2009 The International Bank for Reconstruction and Development/The World Bank

1818 H Street, NWWashington, DC 20433Internet: www.worldbank.org/nbE-mail: [email protected]

All rights reserved.First printing June 2009

This volume is a product of the staff of the International Bank for Reconstruction and Development/The WorldBank. The ndings, interpretations, and conclusions expressed in this paper do not necessarily reect the viewsof the Executive Directors of The World Bank or the governments they represent.

The World Bank does not guarantee the accuracy of the data included in this work. The boundaries, colors,denominations, and other information shown on any map in this work do not imply any judgement on thepart of The World Bank concerning the legal status of any territory or the endorsement or acceptance of suchboundaries.

Cover and publication design: James E. QuigleyCover illustration: Imagezoo/Corbis

Author Oliver Reichert, B.Com, FCPA, FCIS, MAICD, has worked exclusively in the nancialservices industry for the past 23 years, both as a senior executive and as a consultant to industry.In addition, he has chaired a number of insurance industry forums and has published articleson topical nancial services matters.Through the World Bank and the Asian DevelopmentBank, Oliver has worked with 15 national regulators of non-bank nancial institutions in EasternEurope, Asia and Africa since 2001. His focus is to assist Governments of emerging economiesto develop their insurance industries by improving insurance accounting standards, insuranceregulations and insurance supervision through risk based methodology.

THIS ISSUE

Series editorRodolfo Wehrhahn is a senior insurance specialist at the World Bank. He joinedthe Bank in 2008 after 15 years in the private reinsurance and insurance sector and 10 years inacademic research. Before joining the World Bank, he served as President of the Federation ofthe Interamerican Insurance Associations representing the American Council of Life Insurers.He was board member of the AEGON Insurance and Pension Companies in Mexico, and wasCEO of reinsurance operations for Latin America for Munich Reinsurance and for AEGON.

For questions about this primer, or to request additional copies, please contact:[email protected].

The Primer Series on Insurance provides a summary overview of how the insurance industryworks, the main challenges of supervision, and key product areas. The series is intended forpolicymakers, governmental ofcials, and nancial sector generalists who are involved with theinsurance sector. The monthly primer series, launched in February 2009 by the World BanksInsurance Program, is written in a straightforward, non-technical style to share concepts andlessons about insurance with a broad community of non-specialists.

The Non-Bank Financial Institutions Group in the Global Capital Markets Development Depart-ment aims to promote the healthy development of insurance, housing nance, and pensionmarkets, and to expand access to a broad spectrum of nancial services among the poor. Thesemarkets provide opportunities for household investment and long-term savings, and can buf-fer the poor against the risks of sickness, loss of breadwinner, catastrophic events, and othermisfortunes.

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iii

Contents

Introduction ................................................................................................... 1

Unique insurance industry eatures ............................................................ 2

Te prot and loss statement ....................................................................... 3

Te balance sheet ........................................................................................... 8

Accounting or solvency and accounting or prot ................................ 11

Insurance accounting or prot ................................................................. 12

Insurance accounting or solvency ............................................................ 15

Insurance accounting in developing countries ........................................ 15

Should developing countries be encouraged to adopt IFRS orUS GAAP? ................................................................................................18

Appendix A: Simplied Non-Lie/P&C Insurance Prot and LossUsed in Developed Countries ................................................................ 20

Appendix B: Simplied Insurance Prot and Loss Used inDeveloping Countries ............................................................................. 21

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1

Insurance AccrualAccounting

Oliver Reichert

Introduction

All companies, no matter which industry they operate in, need toprepare nancial statements consisting o a prot and loss account, a

balance sheet, unds ow statement and notes to the accounts. Teseaccounts must reect a true and air picture o the nancial peror-mance and nancial position o the company. Insurance companiesare no exception, but the nature o insurance is suciently unique thatspecial accounting standards have been developed.

For most industries the period between a products or services saleand subsequent payment by the consumer and delivery by the vendoris relatively short. In the insurance industry, this is not the case: aninsurance policy can be sold with premiums being due and payable(usually annually) or decades aer the contract becomes efective.

Similarly, benets receivable rom owning an insurance policy can alsotake decades to be determined and subsequently settled. Tus oper-ating cycles and nancial and management reporting cycles tend to bevery diferent, leading inevitably to signicant accounting entries atbalance dates representing accrued insurance liabilities and receivables.Accrued insurance liabilities are typically the largest item on a insur-ance entitys balance sheet.

In addition many insurance contracts include embedded optionsavoring the policyholder. Examples include implicit or explicitminimum investment return guarantees, the right to surrender early,

the right to vary the savings and risk components o a Universal Liecontract and the right to renew cover under a yearly renewable term

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Insurance Accrual Accounting2

lie contract. Tese options should be valued and shown as liabilities to

the extent that they cannot be hedged.Accounting or insurance must take these actors into consideration

via accrual accounting methodology. Tis oen involves estimatinguture states o nature and actoring these estimates into complexdiscounted ow calculations.

Unique insurance industry features

Key eatures o the insurance business are:

Policy acquisition: as is the case with all business, the insuranceindustry is sales driven. It is very costly or an insurance companyto acquire, or sell an insurance policy: initial commissions toinsurance agents or brokers are high. Furthermore, expensesrelated to the evaluation process as to whether to accept anindividual policyholder are also high: or example, in the caseo a lie insurance policy, this may involve a doctors examina-tion, including blood tests. Tereore, the cash outow relatedto putting a policy on the books can requently exceed the cash

received or the rst years premium. Tese acquisition costs aregenerally deerred and recovered rom the insurance premiuminow which will take place over the ollowing years.

Premium income: requently, premiums are paid by policyholdersover a number o years. Premiums received or the current yearare accounted or as income. Premiums received/receivableor uture years efectively represent an asset o the insurancecompany. Te quantication o this asset is a complex matter,partially as the duration o the policy cannot be calculated accu-rately: or example, in the case o certain types o policies, the

insurance company does not have the right to cancel a policyonce it has been accepted through the underwriting process. Tepolicyholder, however, may cancel the policy at any stage.

Claims and Benefts payable to policyholders: the cash outowrelating to insured events is uncertain. An insured event or aspecic policy may never take place, such as an auto the, ora building re. Alternatively, an insured event may take placemuch more quickly than contemplated, such as an accidentaldeath o a policyholder who recently purchased a lie insurancepolicy. Claims and benets payable to policyholders need to be

accounted or as a liability o the insurance company, and asnoted it is a complex matter to quantiy this liability.

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Insurance Accrual Accounting 3

Tese eatures usually give rise to large diferences between cash

ow and accounting or prot in any one year. Tus the cash basedaccounting still used in a number o jurisdictions provides a poor, andalmost always overly optimistic, picture o the perormance and nan-cial position o the insurers involved.

In reality, no matter how these cash ows are accounted or, theprot, or loss, on any one policy will be the same over the lie o theinsurance policy. However, insurance companies are legally requiredto produce statements o prots and losses, and balance sheets, at leastannually. As part o the insurance accounting accrual process, theymust thereore estimate, on an annual basis, as accurately as possible:

Te deerral o acquisition costs; Te cash inows rom premiums payable in uture years; and Claims and benets payable to policyholdersincluding those

that have already occurred and are yet to be ully settled andthose that will occur in the uture.

Specialists called actuaries are required to carry out some o thesecalculations. A paper dealing with the work o actuaries is included asmodule 7 o the insurance primer series.

A urther important actor, although by no means unique to theinsurance industry (the banking industry, in particular, has a similarissue) is the importance o matching the duration o investment assetswith the estimated duration o policyholder liabilities, and holdingsucient capital i there is a mismatch. Tis matter is dealt with inurther detail in the section on investment assets.

The prot and loss statement

Te Prot and Loss Statement consists o the ollowing insurance-specic items:

Revenue

premium income

Te major income source or insurance companies is premiumsreceived. Premiums may be received as a result o:

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single premium contracts where a lump sum is payable up-ront,

such as an auto policy; Regular premium contracts, where the policyholder is contrac-

tually obliged to make payments at regular intervals, such asmonthly, or semi-annually, or annually (in the case o long termlie insurance). An example o a regular premium contract isvoluntary health insurance cover, where premiums are generallypaid monthly; or

Recurring single premium contracts, where the policyholderis able to make payments at irregular intervals. Savings prod-ucts, such as a universal lie contract, may be structured in this

manner.

For Property and Casualty insurers (also known as non lie orgeneral insurers), premiums in the insurance companys nancialstatements have historically usually been calculated on a net earnedbasis as ollows: gross premiums received are adjusted or reinsur-ance payments made, converting them to net premiums. Tese netpremiums are then urther adjusted to take account o the act thatonly those premiums which cover risks arising during the currentnancial year, are taken up as revenue. For example, i a premium o

US$1,200 has been received by an insurance company or a 12 monthcover on May 1, then only US$800 (eight months worth) o that insur-ance revenue can be taken up as revenue in the year ended December31 the remainder o US$400 relates to our months o insurance coveror the ollowing year. Further adjustments or initial expenses, suchas commission may also be made. For example only 80% o the netpremium may be prorated over the nancial year components o thepolicy year.

reinsurance

Some risks underwritten by insurance companies may exceed theirown underwriting capacity as dened by their nancial strength; orexample insuring a US$1 billion industrial complex against re riskwith only US$500 million o net assets to back this contingent liability.Te insurance company thereore lays of that portion o risk whichit cannot cover with a reinsurance company, which does have the nan-cial strength to bear such a large loss, especially aer a urther layingof o risk to other reinsurers (known as retrocession). Module 2 in this

series covers the topic o reinsurance in detail.

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Similarly, claims expenses are ofset by any reinsurance recoveries,

and the net amount is regarded as the claims expense or reportingpurposes.

Tis accounting practice results in reporting premium incomesand claims expenses which reect the net amount o risk which theinsurance company is bearing. A side benet is that it prevents doublecounting o insurance premiums across the industry as direct insur-ance companies can also accept reinsurance premiums rom otherinsurers. Despite this modern accounting and statutory reportingapproaches are now tending to require that gross premium and claimsgures and recoveries are shown separately, but the net approach still

applies in most developing countries.

investment income

Investment Income, generally consisting o interest, dividends andrental income, is also a major revenue item or insurance companies.Te treatment o investment income is exactly the same as it is orother industries: realized gains and losses (ie the diference betweenthe cost o an investment asset, and the amount it is sold or) are

brought to account in the Prot and Loss Statement. Unrealized gainsand losses may either be passed through the Prot and Loss account,or taken up as a reserve on the balance sheet. As this can be a majoritem, care needs to be taken when reading nancial statements as tothe accounting approach in respect o unrealized gains and losseswhich the company has taken. As with banks there may be a distinc-tion between xed interest securities held to maturity and the tradingportolio, with the latter being valued at market and the ormer on anamortized basis (see US GAAP discussion below).

From an accounting perspective, the usual practices apply, whereby

investment income receivable, at the end o the nancial year, isaccrued and thereore allocated to the correct nancial year.

Expenses

claims expense and payments of policyholder benefits

Te major expense incurred by an insurance company is claims paid.For non-lie/P&C companies, this consists o actual claims paid

during the year, and claims accrued prior to the end o the year. Aurther P&C expense needs to be accrued, relating to claims which

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have been incurred towards the end o the nancial year, but have

not been reported as yet. Tese claims are reerred to as incurred butnot reported (IBNR) claims. For example, an auto insurer may havean average o 1,000 claims per month, but or the last month o theyear, only 600 claims have been reported. It is probable that a urther400 auto accidents did occur in that last month, which had not beenreported by December 31. Tese 400 claims need to accrued, as anIBNR claims expense, with the other side o the accounting entry beingan increase to the IBNR liability.

In act, or some specialized product lines, it oen takes manyyears or claims to be reported to the insurance company, such as

asbestos claims. Tis also makes liabilities dicult to estimate andgeneral reserves are sometimes established to cover such contingencies(although they may not be allowable or tax).

Payments o policyholder benets generally relate to lie insurance.Benets to be paid could be discretionary (non guaranteed) dividendsor bonuses payable annually to policyholders o lie policies with asavings element, or terminal bonuses payable on maturity o the policyor death o the policyholder.

Claims expenses and payments o policyholder benets need to bedisclosed net o reinsurance recoveries.

operating expensesnew business

Tis expense category consists o commissions paid or payable andother expenses which relate to the cost o acquiring policies. Teseexpenses are generally initially recognized as an asset, and then amor-tized each year over the lie o the insurance policy.

operating expensesother

Tis expense category relates to the expenses incurred in the day-to-day running o the insurance company. Investment managementexpenses are included in this category.

Changes in policyholder liabilities

Changes in Policyholder Liabilities are in act an adjustment to the

largest liability a lie or a long term non-lie/P&C insurance companyhas. Changes to the value o this liability are generally taken through

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the prot and loss account. Tis item can have a signicant impact on

the prot or loss o an insurance company.It needs to be noted that changes in Policyholder Liabilities can

either be an increase (in which case it is an expense), or a decrease (inwhich case it is a contributor to prot). By way o example, other thingsbeing equal, the actuary has determined that in the light o recent expe-rience, mortality has been too conservatively calculated in the past. Asa result, mortality assumptions are changed to reect that policyholderslive longer. Tereore death claims are deerred by some years, andthis change in assumptions results in an improvement in prot. Tisexample applies to the application o international standards, rather

than US GAAP.

Ratio analysis

Tere are three key ratios calculated or non-lie/P&C insurancecompanies:

1. Te claims ratio, or loss ratio: Tis is calculated by dividing totalclaims expense by net earned premiums. Tis ratio generally

represents the amount paid to policyholders, rom every dollaro premium received. Whilst this ratio varies by type o busi-ness, developed countries generally have an average claims ratioo around 60% to 70%, ie in total insurance companies pay out,to policyholders, around 6070 cents or each dollar o premiumreceived.

2. Expense ratio: Tis is calculated by dividing operating expensesby net earned premiums. Tis ratio is a measure o eciency, andalso a measure o the level o service supplied to policyholders.Developed countries have an average expense ratio o around

20% to 30%.3. Combined ratio: Tis ratio is arithmetically the addition o the

claims ratio and the expense ratio. A combined ratio o less than100% represents an underwriting prot; a ratio o more than100% represents an underwriting loss. Insurers generally aim ora combined ratio o 90% to 95%, thus making an underwritingprot o 5% to 10%. It needs to be noted that investment incomeis excluded rom this ratio, and hence insurance companies canstill make an overall prot even i they have made an under-writing loss.

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Lie insurance companies which only sell risk products are also

able to use these ratios. However, lie insurance companies that alsosell investment products, or bundled products which contain bothrisk and savings elements (or example, whole lie policies) cannot beanalyzed using such ratios.

The balance sheet

Tere are three key items on the balance sheet o insurance companieswhich warrant comment. Specically, these are:

Investment Assets; Deerred Acquisition Costs; and Policyholder Liabilities

Te remainder o assets and liabilities are in line with balance sheetso companies rom other industries.

Investment assets

Investment Assets are usually the largest asset on the balance sheeto an insurance company (i they are not this is normally a red ag).Investment Assets requently represent in excess o 80% o total assetso an insurance company. Tese assets are mainly required to be ableto be drawn upon to meet the payment o policyholder liabilities (seebelow) as and when these all due. It is thereore imperative that insur-ance companies attempt to match the duration o their investmentassets with the anticipated uture payments o policyholder liabilities.Consequently, insurance companies who sell short tail insurance

products, such as auto insurance and householders insurance, holdpredominantly investment assets which can be readily converted intocash at relatively short notice with comparatively little price uctuationor credit risk, such as bank deposits and government bonds.

Te quality o investment assets to be held by insurance companiesis generally legally prescribed, and may be linked to investment qualitygrading introduced by independent ratings agencies such as Standard& Poor or Moodys. Investment assets held by insurance companiestend to be o high quality, with many being AAA rated. Insurancecompanies generally disclose the quality o their investment assets in

their nancial statements. By way o example, Allianz disclosed in itsnancial statements or the year ended 31 December 2007 that 56% o

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its assets were AAA rated by Standard & Poor, 32% were AA rated

and 11% were A ratedonly 0.7% percent o investment assets wereunrated or had an investment grading lower than A.

Investment assets are generally marked to market. Unrealized gainsand losses are generally held in a balance sheet reserve established orthis purpose; they are not taken through the Prot and Loss Statement.

Deferred acquisition costs (DAC)

Costs relating to the acquisition o longer term insurance policies are

generally capitalized and taken up as an asset on the balance sheet. TeDAC asset is then amortized over the expected duration o the insur-ance contracts (or such shorter period as prudence or regulation mayspeciy), in order to match the uture revenue stream o incomingpremiums with the expensing o the costs o bringing these policiesonto the books o the insurance company.

Policyholder liabilities

Te raison detre or insurance companies is to pay claims and bene-ts to policyholdersand hence the provision or such paymentsis the largest liability on the balance sheet o insurance companies.Frequently, in excess o 90% o all insurance company liabilities isrepresented by this single item.

Te total policyholder liabilitiesclaims and benets payable topolicyholdersefectively consist o:

echnical reserves; and Future benets payable to policyholders.

technical reserves

Tese reserves relate primarily to non-lie/P&C insurance companiesbut can also be relevant to lie insurers. Tey consist o the ollowingkey items:

Unearned Premium Reserve: this reserve relates to that portiono premium received which has not been earned as yet. For

example, i a premium o US$1,200 has been received by aninsurance company or a 12 month cover on May 1, then only

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US$800 (eight months worth) o that insurance revenue is

taken up as revenue in the year ended December 31 theremainder o US$400 relates to our months o insurance coveror the ollowing year, and this amount is taken up as a liability(Unearned Premium Reserve) in the accounts at 31 December.Te example represents the balance sheet entry o the exampleused previously above.

Outstanding Claims Reserve: claims which have been lodgedwith the insurance company, but have not been paid as yet. Tecalculation o this reserve is based on open claims le method-ology: An estimate as to the total cost o each reported claim

is prepared, and the total o all claims payable, less the amountalready paid on outstanding claims, is aggregated into the totaloutstanding claims reserve; and

Incurred But Not Reported (IBNR) Claims: claims incurred atthe end o the nancial year which have not been reported as yet.For example, an auto insurer may have an average o 1,000 claimsper month, but or the last month o the year, only 600 claimshave been reported. It is probable that a urther 400 auto acci-dents did occur in that last month, and these 400 claims need totaken up as a liability, the IBNR Reserve.

Te calculations or Outstanding Claims Reserves and IBNR claimscan be quite complex or long term non-lie/P&C business. Actuariesare generally required to calculate the more complex elements o thesereserves.

future benefits payable to policyholders

Insurance companies must provide or benets payable in the uture,

allowing or any options embedded in the contracts (which can signi-cantly change the apparent duration o the contract and hence optimalinvestment policy). Te type o benet to be provided or depends onthe type o policy which has been sold. By way o example, a lie insur-ance whole o lie policy provides or a large lump sum payment in theevent o the death o the policyholder or, typically, once an advancedage (say 85) has been reached. A liability must be calculated or allwhole o lie policies taking into account such actors as the age o poli-cyholders, whether they are male or emale (emales live an average o7 years longer than males), whether they are smokers or non-smokers

(that is, the consequent mortality statistics), uture investment earningrate and uture discontinuance rates . Another example may be an

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income insurance policy, where uture policyholder benets are based

on such statistics as morbidity by employment category. ypically aprospective approach is used, whereby the reserve (oen called themathematical reserve) is dened as the present value o uture benetsand expenses less the present value o uture premiums.

Te reserving approach also depends on whether risk capitalneeds to be maintained. Modern accounting and regulatory doctrinenormally requires that most risks are carried by capital, with a modestresilience level being built into technical and mathematical reserves.

Te estimation o uture benets to policyholders is the mostcomplex calculation in the balance sheet o insurance companies,

particularly or lie insurers. Actuaries are required to perorm thiscalculation.

Accounting for solvency and accounting for prot

In almost all jurisdictions, insurance companies need to prepare theirnancial accounts in two separate ways:

For ordinary readers o nancial statements, nancial accounts

consisting o balance sheets, prot and loss statements and notesto the accounts need to be completed. Tese accounts are used bystakeholders such as potential investors, shareholders, bankers,stock exchanges (most insurance companies are publicly listed)and industry observers.

Tere are two major accounting methodologies applied in thedeveloped world or normal going concern reporting:

Generally Accepted Accounting Principles used in theUnited States (US GAAP); and

International Financial Reporting Standards (IFRS).

Tese two methodologies are expanded upon below. Separate nancial statements need to be prepared or insurance

industry regulators. Tese are more in the nature o conservativewind up cash orecasts.

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Insurance accounting for prot

US GAAP

Te rst accounting methodology specically designed or insur-ance companies was established in the United States and is part o thereporting ramework which is commonly reerred to as US GAAP. Terst US GAAP insurance standard, FAS 060, was published in 1982.Other accounting standards specically applicable to the insuranceindustry are FAS 097, FAS 120 and FAS 144.

Tese US GAAP standards deal with all matters relating to insur-

ance companies: lie insurance, non lie insurance, reinsurance and alsoinvestment products sold by insurance companies.

Te US GAAP approach is prescriptive, and many specic rulesapply as to how the prot on a book o insurance business is to becalculated. US GAAP generally requires that assumptions be set in theyear in which a group o similar insurance policies is sold: this includesthe quantum o deerred acquisition costs relating specically to thisbook o business, and assumptions relevant to estimating uture policycash ows. Tese assumptions are then maintained throughout thelie o those policies. Consequently, US GAAP determines prot in

uture years by locking in assumptions, rather than adjusting assump-tions based on emerging experience. Tis is generally regarded as beinga conservative approach, and the tendency towards back end protrecognition is compounded by US GAAP deerring only variableacquisition costs.

International Financial Reporting Standards (IFRS)

In order to harmonize accounting across the world, and thereby

promote comparability o nancial results, international accountingstandards (IFRS) have been developed over the past decade. Almostall developed countries, with the exception o the United States, havedecided to ully adopt the IFRS standards.

Te specic standard pertaining to insurance is IFRS 4 InsuranceContracts. Te standard was developed in 2001, and applied rom2006. IFRS 4 is regarded as an interim standard, as the InternationalAccounting Standards Board has requested urther public input, andexpects to put in place a revised standard in 2010.

IFRS 4 applies to all insurance contracts which carry insurance

risk. Te standard does not apply to other assets and liabilities, suchas nancial assets and nancial liabilities IFRS 39 Financial Instru-

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ments deals with these matters or all types o nancial service compa-

nies, not solely insurance companies.Te IFRS approach is to measure the value o policyholder assets

and liabilities using a mark to market, or air value approach, andhence assumptions in valuing assets and liabilities are changed eachyear: or example, i interest rates rise during the year, the interestrate assumption or discounting purposes is changed. A change inthis assumption alone has a major impact on those insurers with longterm liabilities: by way o example, the value o policyholder liabilitiesincreases signicantly when the discount rate is decreased. At the sametime, with a decrease o the discount rate, the value o investment assets

will increase signicantly as well, and thereore i there is a perectassetliability match, there will be no impact on prot.

Te IFRS philosophy is to cover the issues in principle, rather thanusing a prescriptive approach. It then stipulates that companies explaintheir nancial statements with extensive use o notes attached to thenancial accounts. By way o example, companies are required todisclose the key assumptions used in valuing policyholder liabilities. Asensitivity analysis on the efect o changes to key assumptions is alsorequired.

Comparison between the US GAAP approach and the IFRS approach

Both IFRS and US GAAP have the same objective: to disclose thenancial perormance (prot and loss) and the nancial position(balance sheet) o insurance companies in a realistic manner. However,the philosophies applying to those two methodologies are distinctlydiferent, and thereore they can produce quite diferent nancialresults:

Te lock in assumptions approach or both uture policyholderliabilities and deerred acquisition costs produces a reasonablypredictable prot picture, year aer year, under US GAAP. AsIFRS assumptions are changed each year in order to apply themost relevant assumptions, the value o liabilities will uctuatemore under IFRS.

Under IFRS, investment premiums and claims under policiessuch as savings plans, are treated in a similar manner to bankdeposits and withdrawals, and are thus excluded rom premiumrevenue and claims expenses. Under US GAAP, all policyholder

revenue, including revenue received on savings and investmentpolicies, is included as premium revenue.

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In terms o investment asset revaluations, both US GAAP and

IFRS use a mark to market approach. IFRS uses this approachor all investment assets, whereas US GAAP requires insurers tohold investment bond assets, a major asset class or insurancecompanies, at book value i they are intended to hold these assetsto maturity. Tere will thereore be greater uctuations in thevalue o investment assets under IFRS.

In summary, nancial statements are likely to be more accurateunder IFRS, because changes to underlying assumptions reect themost recent inormation. US GAAP, on the other hand, in applying the

locked in principles, largely relies on assumptions which were appli-cable a number o years ago, when each block o business was sold.However, changing key assumptions every year results in greater vola-tility o nancial results rom year to year under IFRS. Consequently,reported prot results or insurance companies are ar more predictableunder US GAAP methodology than they are using the IFRS approach.

A concern with using IFRS methodology is that it is dicult, inot impossible to mark liabilities (payment o uture policy benets)to market. Given that the IFRS approach has only been implementedsince 2006, and at any event it is regarded as being an interim standard

only, it is dicult to determine as yet just how volatile the nancialresults will be over the years.

A concern with US GAAP is its relative inexibility: it is a complexramework or simple insurance products, and yet it seems too rigid tocope with complex product designs.

Embedded value

Many lie insurance companies have converted rom mutual to share-

holders structures in the last 40 years. As standard accounting prac-tice can mask high protability or lie insurers (particularly whenthey are growing rapidly and have heavy ront end costs) an approachwas developed whereby the true value o the insurer is shown in thenotes to the accounts to properly inorm the market and orestall take-overs. Tis involves disclosing the embedded value which consist o theadjusted net assets o the lie insurer plus the present value o protsemerging rom the policies on the books o the insurer (the in orce)at the balance date. Where a lie insurer is being taken over appraisalvalues are employed. Tese consist o the embedded value plus the esti-

mated present value o the uture business that will be produced by thecurrent distribution system.

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Insurance accounting for solvency

Insurance regulators are important stakeholders who are primarilyconcerned with an insurance companys solvency, and thereore itsability to pay claims and benets to policyholders as and when they alldue. In carrying out their duty, insurance regulators take into accountthat:

a number o assets disclosed in the balance sheet cannot beconverted into cash (such as computer soware, oce ttingsand deerred acquisition costs);

Various classes o investment assets have diferent risk prolesattached to them: or example, the investment categories cash andgovernment bonds are ar more likely to retain their value thanstocks, shares and real estate;

Investment assets may be worth a great deal less than theirpresent value on the balance sheets (or example, due to a stockmarket crash or a real estate market downturn); and

Future claims and benets payable to policyholders may besignicantly higher than the reported liabilities and uturepremiums payable. Insured catastrophes and disasters such as

Katrina and September 11 do occurthat, aer all, is the purposeo policyholders purchasing insurance products.

As a result o the risks attached to the above actors, insurance regu-lators require insurance companies to adjust their accounts in such amanner that they can prove that they have sucient capital and invest-ment assets to pay or claims as and when they all due under potentialadverse circumstances. Regulators examine solvency in detail, whichincludes the demonstration by insurance companies that they havesignicant nancial bufers in place, to cover or such actors as invest-

ment market turmoil. Te methodologies used by regulators o devel-oped countries vary signicantly.

As a result, the adjusted accounts, requently reerred to as statutoryaccounts, which insurance companies need to submit to their regulators,set out a companys nancial position on a conservative basis.

Insurance accounting in developing countries

Most developing countries use neither IFRS nor US GAAP as a basis

or preparing nancial statements or insurance companies. Teirnancial reporting methodology is requently based on European

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solvency approaches rom the 1960s and 1970s. Te elements generally

are as ollows:

Key prot and loss items

Revenue rom premiums received: many developing countries accountor premium revenue on a gross premium received basis, rather thancalculating, in detail, an earned premium. Statistics kept by regulatorsrelate only to gross premiums written. Tere is thereore a danger thatsome premiums are double counted or the industry, particularly in

circumstances where insurance companies reinsure with each other. Inthose developing countries where a net earned approach applies, theamount calculated as the Unearned Premium Reserve is usually basedon a percentage o gross premiums.

In developing countries, the total claims expense taken up in ayear consists o claims paid, plus claims not as yet paid and thereoreaccrued, plus an estimate or IBNR-claims which have been Incurredbut Not Reported. In developing countries, claims paid during theyear are generally correctly recorded, so these amounts are regardedas providing the most reliable (or least unreliable) basis or estimating

outstanding claims. Te amount taken up or claims which have notbeen paid as yet is generally calculated as a ratio o premiums received.Similarly, IBNR claims are estimated as a percentage o premiumsreceived, rather than being based on open claims le methodology.Te legal ramework o developing countries generally stipulates thepercentage which is to be applied to premiums received, in order tocalculate the outstanding claims reserve. Tis approach makes it easyor regulators to check that the ratio calculation (premiums to claimsreserves) has been complied with, but leads to inaccurate nancialresults as outstanding claims may be much higher or lower than the

legally decreed ratio.

Prot ratios

claims ratios

In developing countries, claims ratios or non-lie/P&C insurancecompanies are generally quite lowaround 25% (that is, in total, poli-cyholders receive 25 cents in each premium dollar paid), but they can

be as low as 10%. Tis could imply that policyholders do not receivevalue or money on their insurance products. Tis can be due to

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a number o reasons: in recently opened markets, policyholders

requently believe that their insurance premium is a taxparticularlyor compulsory products such as motor insurance, and thereore theydo not realize that they can make a claim on an insurance company. Alow claims ratio can also result rom overpricing o the insurance cover,or as a result o insurance companies reusing to pay claims.

In the longer term, insurance companies in developed countriesgenerally use a benchmark whereby they pay back to policyholders anaverage, or the company as a whole across all lines o business, o atleast 60 cents o each premium dollar received.

expense ratios

Expense ratios in developing countries are usually high: over 30%, andup to 60% o every premium dollar received. Tese ratios are high,generally due to either market ineciencies, such as the sector havingdeveloped only recently, and hence there is a high level o initial invest-ment, or corporate ineciencies, such as the insurance company havinginecient/ manual systems and procedures, and/or the insurancecompanies being too small to take advantage o any economies o scale.

In developed countries, expense ratio benchmarks are around25 cents o each premium dollar received. Tis benchmark can varyconsiderably.

combined ratios

In total, many developing countries have combined ratios similarto those o developed countries. However, as observed above, theelements o the combined ratio are diferent: insurance companies in

developing countries generally spend ar more on their administration,and generally ar less money is returned to policyholders in the orm obenets and/or claims paid.

Balance sheet

Many jurisdictions o developing countries still stipulate that invest-ment assets need to be held at historical cost rather than being markedto market. In addition, the legislation o many developing countries

stipulates that investment assets must be situated in their countrythey are not permitted to invest outside their own country. In some

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developing countries, the purchase o international investment assets

is permitted, but to a limited degree (say, 10% o the total investmentportolio). Te impact o the prohibition to purchase internationalassets is signicant or the insurance industry: investment assets witha long duration cannot be purchased (because this asset class does notexist in many developing countries) and hence long term lie insur-ance products cannot be ofered. For example, in Vietnam in the past,the only investment grade assets purchased by insurance companieswere Government bonds, which generally had a duration o 5 years.Lie insurance companies could thereore only ofer ve year endow-ment policies. Whilst the industry would have preerred to sell whole-

o-lie policies, it could not do so because the asset/liability durationmismatch (a ve year asset compared to potentially a 50 year liability)represented a ar too great nancial risk or the insurance company.

Te key liabilities are accrued claims and benets payable, at sometime in the uture, to policyholders. In developing countries, non-lie/P&C claims liabilities, or technical reserves, are generally calcu-lated as a ratio o premium income. Tis leads to inaccurate nancialresults, as such ratios are unlikely to reect an accurate corporate nan-cial position.

Te legislative rameworks o many developing countries stipulate

that catastrophe reserves, usually also expressed as a percentage opremium income, be held. Such reserves are regarded as being totallysubjective, and are thereore specically disallowed by IFRS 4.

Balance Sheet disclosure, via notes to the accounts, is generallylow by insurance companies in developing countries. Notes to nan-cial accounts should be extensive, and explain as ully as is reasonablypossible the nancial position o the company, and provide urtherdetail on individual prot and loss items, and balance sheet items.Most indigenous insurers in developing countries do not provide muchinormation above the raw minimum amount required by law. Tere

are notable exceptions, such as Nigeria, where insurance companiestend to provide detailed explanatory notes to nancial statements.

Should developing countries be encouraged to adopt IFRS orUS GAAP?

Both US GAAP and IFRS represent insurance accounting at anadvanced stage, and thereore require inrastructure in place whichis simply not available in developing countries. Tis inrastructure

consists o:

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A legal and regulatory ramework which permits the implemen-

tation o IFRS and/or US GAAP. Surprisingly, many legal rame-works stipulate concepts which are expressly orbidden by bothUS GAAP and IFRS, such as the holding o catastrophe reserves;

Education: detailed knowledge o IFRS or US GAAP, and how toapply the complex accounting concepts;

Te availability o technical expertise to perorm the complexcalculations required or insurance companies;

A corporate governance regime which promotes the use o eitherUS GAAP or IFRS methodologies; and

A skilled insurance regulator and/or corporate regulator

possessing the technical expertise required to ensure that insur-ance companies comply with US GAAP or IFRS rules.

Almost all developing countries simply do not have the aboveinrastructure in place. Tereore, insistence that developing countriesimplement immediately either IFRS or US GAAP achieves relativelylittle: the insurance companies generally cannot comply with such adirective. In addition the insurance regulator usually does not have therequisite skill and expertise available (such as ully qualied in-houseactuaries) even in cases where some insurance companies can comply

(or example, large local insurers or subsidiaries o internationalinsurers).

In the longer term, all countries will need to comply with interna-tional accounting standards. Each country should have a road mapin place which outlines milestones as to how to achieve this objective,and stipulate a time rame. Te road map will vary rom country tocountry, as it will depend on such actors as the current level o marketdevelopment, current levels o expertise and the size o the market.Tus, developing countries such as India and China are much closer tocomplying (with IFRS) already: both these countries have high levels o

expertise, good legal rameworks and, in IRDA and CIRC, strong andefective regulators.

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Appendix A:

Simplied Non-Life/P&C Insurance Protand Loss Used in Developed Countries

Premium Revenue

Less: Outwards Reinsurance Expense

Net Premium Revenue

Change in net U.E Premiums

Earned Premium

Gross claims incurred*

Less: Accrued reinsurance and other recoveries*

Net claims incurred

Selling Expenses

General Business Expenses

Other Underwriting Expenses

57,000

(8,000)

49,000

2,000

47,000

37,000

(5,000)

32,000

6,000

4,000

10,000

Net Underwriting Result 5,000

Investment revenueLess: Other (investment and non insurance) expenses

Operating Prot before Tax

Tax

16,000(3000)

18,000

(4,000)

Operating Prot after Tax 14,000

Ratio Analysis:

Claims Ratio: net claims/net earned premiums

Expense Ratio: expenses/net earned premiums

Combined Ratio: (net claims + expenses)/net earned premiums

* After allowing for changes in technical reserves

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Appendix B:

Simplied Insurance Prot and Loss Usedin Developing Countries

Item Amount Comments

Premium Revenue 3,200 Premium revenue is frequently calculated on agross received basis, not on a net earned basis.In times of high growth, this leads to overstate-ment of revenue

Less: OutwardsReinsurance Expense

50

Change in Provision forpolicy liability

2,100 There seem to be two legislative approaches:either this calculation is highly prescriptive, or it iscompletely open, saying this amount needs to beactuarially calculated.

Net revenue frominsurance activities

1,050

Claims Expenses 300 Claims expenses are generally calculated as cashoutlays accrued claims (claims not as yet paidand IBNR claims) are calculated as a percentageof premium income. This can result in a highlydistorted claims expense gure which in a stronglygrowing market understates the expense

Commission Expenses 330 Generally, deferral of these expenses, and treat-ment of them as deferred acquisition costs, is notpermitted.

Gross Prot frominsurance activities

420

Selling Expenses 410 Deferral of selling expenses is generally notpermitted.

Administration Expenses 320 These expenses are generally dened in detail.

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Item Amount Comments

Prot before Tax 90

Income Tax 20 Generally, only cash items are tax deductible.

Net Prot/(Loss) after Tax 70 The prot calculated is generally much closer toa cash ow statement than a calculation of protusing accrual principles.

Notes:

1. The above format is based on an East Asian countrys accounting and regulatoryrequirements.

2. The above format, and comments, is used for illustrative purposes, and the commentsapply to many developing countries. However, it is difcult to put all developing coun-

tries into the same category: for example, India, with a relatively low GDP per capita is welladvanced and does not fall into this category.

3. In developing countries, the same form is almost always used for life insurers as it is fornon-life/P&C insurers.

Insurance Accrual Accounting

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