Insurance Accrual Accounting - World Bank...Accounting for insurance must take these factors into...

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Transcript of Insurance Accrual Accounting - World Bank...Accounting for insurance must take these factors into...

  • primer06_cover.indd 1-2 5/20/09 12:17:15

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  • primer06.indb 1

    5/20/09 12:15:50

  • primer06.indb 2

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  • Introduction ...................................................................................................1

    Unique insurance industry features ............................................................2

    The profit and loss statem

    ent .......................................................................3

    The balance sheet ...........................................................................................8

    Accounting for solvency and accounting for profit ................................11

    Insurance accounting for profit .................................................................12

    Insurance accounting for solvency ............................................................15

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

    Should developing countries be encouraged to adopt IFRS or U

    S GA

    AP? ................................................................................................18

    Appendix A: Sim

    plified Non-Life/P&

    C Insurance Profit and Loss U

    sed in Developed C

    ountries ................................................................20

    Appendix B: Simplified Insurance Profit and Loss U

    sed in D

    eveloping Countries .............................................................................21

    primer06.indb 3

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  • All com

    panies, no matter w

    hich industry they operate in, need to prepare financial statem

    ents consisting of a profit and loss account, a balance sheet, funds flow

    statement and notes to the accounts. Th

    ese accounts m

    ust reflect a true and fair picture of the financial perfor-m

    ance and financial position of the company. Insurance com

    panies are no exception, but the nature of insurance is suffi

    ciently unique that special accounting standards have been developed.

    For most industries the period betw

    een a products or services sale and subsequent paym

    ent by the consumer and delivery by the vendor

    is relatively short. In the insurance industry, this is not the case: an insurance policy can be sold w

    ith premium

    s being due and payable (usually annually) for decades after the contract becom

    es effective. Sim

    ilarly, benefits receivable from ow

    ning an insurance policy can also take decades to be determ

    ined and subsequently settled. Thus oper-

    ating cycles and financial and managem

    ent reporting cycles tend to be very different, leading inevitably to significant accounting entries at balance dates representing accrued insurance liabilities and receivables. Accrued insurance liabilities are typically the largest item

    on a insur-ance entity’s balance sheet.

    In addition many insurance contracts include em

    bedded options favoring the policyholder. Exam

    ples include implicit or explicit

    minim

    um investm

    ent return guarantees, the right to surrender early, the right to vary the savings and risk com

    ponents of a Universal Life

    contract and the right to renew cover under a yearly renew

    able term

    primer06.indb 1

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  • life contract. These options should be valued and show

    n as liabilities to the extent that they cannot be hedged.

    Accounting for insurance must take these factors into consideration

    via accrual accounting methodology. Th

    is often involves estimating

    future states of nature and factoring these estimates into com

    plex discounted flow

    calculations.

    Key features of the insurance business are:

    Policy acquisition: as is the case with all business, the insurance

    industry is sales driven. It is very costly for an insurance company

    to acquire, or “sell” an insurance policy: initial comm

    issions to insurance agents or brokers are high. Furtherm

    ore, expenses related to the evaluation process as to w

    hether to accept an individual policyholder are also high: for exam

    ple, in the case of a life insurance policy, this m

    ay involve a doctor’s examina-

    tion, including blood tests. Therefore, the cash outflow

    related to putting a policy on the books can frequently exceed the cash received for the first year’s prem

    ium. Th

    ese acquisition costs are generally deferred and recovered from

    the insurance premium

    inflow

    which w

    ill take place over the following years.

    Premium

    income: frequently, prem

    iums are paid by policyholders

    over a number of years. Prem

    iums received for the current year

    are accounted for as income. Prem

    iums received/receivable

    for future years effectively represent an asset of the insurance com

    pany. The quantification of this asset is a com

    plex matter,

    partially as the duration of the policy cannot be calculated accu-rately: for exam

    ple, in the case of certain types of policies, the insurance com

    pany does not have the right to cancel a policy once it has been accepted through the underw

    riting process. The

    policyholder, however, m

    ay cancel the policy at any stage.Claim

    s and Benefits payable to policyholders: the cash outflow

    relating to insured events is uncertain. An insured event for a

    specific policy may never take place, such as an auto theft, or

    a building fire. Alternatively, an insured event m

    ay take place m

    uch more quickly than contem

    plated, such as an accidental death of a policyholder w

    ho recently purchased a life insurance policy. Claim

    s and benefits payable to policyholders need to be accounted for as a liability of the insurance com

    pany, and as noted it is a com

    plex matter to quantify this liability.

    primer06.indb 2

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  • These features usually give rise to large differences betw

    een cash flow

    and accounting for profit in any one year. Thus the cash based

    accounting still used in a number of jurisdictions provides a poor, and

    almost alw

    ays overly optimistic, picture of the perform

    ance and finan-cial position of the insurers involved.

    In reality, no matter how

    these cash flows are accounted for, the

    profit, or loss, on any one policy will be the sam

    e over the life of the insurance policy. H

    owever, insurance com

    panies are legally required to produce statem

    ents of profits and losses, and balance sheets, at least annually. A

    s part of the insurance accounting accrual process, they m

    ust therefore estimate, on an annual basis, as accurately as possible:

    The deferral of acquisition costs;

    The cash inflow

    s from prem

    iums payable in future years; and

    Claims and benefits payable to policyholders—

    including those that have already occurred and are yet to be fully settled and those that w

    ill occur in the future.

    Specialists called actuaries are required to carry out some of these

    calculations. A paper dealing w

    ith the work of actuaries is included as

    module 7 of the insurance prim

    er series.A

    further important factor, although by no m

    eans unique to the insurance industry (the banking industry, in particular, has a sim

    ilar issue) is the im

    portance of matching the duration of investm

    ent assets w

    ith the estimated duration of policyholder liabilities, and holding

    sufficient capital if there is a m

    ismatch. Th

    is matter is dealt w

    ith in further detail in the section on investm

    ent assets.

    The Profit and Loss Statem

    ent consists of the following insurance-

    specific items:

    The m

    ajor income source for insurance com

    panies is premium

    s received. Prem

    iums m

    ay be received as a result of:

    primer06.indb 3

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  • single premium

    contracts where a lum

    p sum is payable up-front,

    such as an auto policy;Regular prem

    ium contracts, w

    here the policyholder is contrac-tually obliged to m

    ake payments at regular intervals, such as

    monthly, or sem

    i-annually, or annually (in the case of long term

    life insurance). An exam

    ple of a regular premium

    contract is voluntary health insurance cover, w

    here premium

    s are generally paid m

    onthly; orRecurring single prem

    ium contracts, w

    here the policyholder is able to m

    ake payments at irregular intervals. Savings prod-

    ucts, such as a universal life contract, may be structured in this

    manner.

    For Property and Casualty insurers (also known as non life or

    general insurers), premium

    s in the insurance company’s financial

    statements have historically usually been calculated on a “net earned”

    basis as follows: gross prem

    iums received are adjusted for reinsur-

    ance payments m

    ade, converting them to net prem

    iums. Th

    ese net prem

    iums are then further adjusted to take account of the fact that

    only those premium

    s which cover risks arising during the current

    financial year, are taken up as revenue. For example, if a prem

    ium of

    US$1,200 has been received by an insurance com

    pany for a 12 month

    cover on May 1, then only U

    S$800 (eight months’ w

    orth) of that insur-ance revenue can be taken up as revenue in the year ended D

    ecember

    31 – the remainder of U

    S$400 relates to four months of insurance cover

    for the following year. Further adjustm

    ents for initial expenses, such as com

    mission m

    ay also be made. For exam

    ple only 80% of the net

    premium

    may be prorated over the financial year com

    ponents of the policy year.

    Some risks underw

    ritten by insurance companies m

    ay exceed their ow

    n underwriting capacity as defined by their financial strength; for

    example insuring a U

    S$1 billion industrial complex against fire risk

    with only U

    S$500 million of net assets to back this contingent liability.

    The insurance com

    pany therefore “lays off” that portion of risk w

    hich it cannot cover w

    ith a reinsurance company, w

    hich does have the finan-cial strength to bear such a large loss, especially after a further laying off of risk to other reinsurers (know

    n as retrocession). Module 2 in this

    series covers the topic of reinsurance in detail.

    primer06.indb 4

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  • Similarly, claim

    s expenses are offset by any reinsurance recoveries, and the net am

    ount is regarded as the claims expense for reporting

    purposes. Th

    is accounting practice results in reporting premium

    incomes

    and claims expenses w

    hich reflect the net amount of risk w

    hich the insurance com

    pany is bearing. A side benefit is that it prevents double

    counting of insurance premium

    s across the industry – as direct insur-ance com

    panies can also accept reinsurance premium

    s from other

    insurers. Despite this m

    odern accounting and statutory reporting approaches are now

    tending to require that gross premium

    and claims

    figures and recoveries are shown separately, but the net approach still

    applies in most developing countries.

    Investment Incom

    e, generally consisting of interest, dividends and rental incom

    e, is also a major revenue item

    for insurance companies.

    The treatm

    ent of investment incom

    e is exactly the same as it is for

    other industries: realized gains and losses (ie the difference between

    the cost of an investment asset, and the am

    ount it is sold for) are brought to account in the Profit and Loss Statem

    ent. Unrealized gains

    and losses may either be passed through the Profit and Loss account,

    or taken up as a reserve on the balance sheet. As this can be a m

    ajor item

    , care needs to be taken when reading financial statem

    ents as to the accounting approach in respect of unrealized gains and losses w

    hich the company has taken. A

    s with banks there m

    ay be a distinc-tion betw

    een fixed interest securities held to maturity and the trading

    portfolio, with the latter being valued at m

    arket and the former on an

    amortized basis (see U

    S GA

    AP discussion below

    ).From

    an accounting perspective, the usual practices apply, whereby

    investment incom

    e receivable, at the end of the financial year, is accrued and therefore allocated to the correct financial year.

    The m

    ajor expense incurred by an insurance company is claim

    s paid. For non-life/P&

    C companies, this consists of actual claim

    s paid during the year, and claim

    s accrued prior to the end of the year. A

    further P&C expense needs to be accrued, relating to claim

    s which

    primer06.indb 5

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  • have been incurred towards the end of the financial year, but have

    not been reported as yet. These claim

    s are referred to as incurred but not reported (“IBN

    R”) claims. For exam

    ple, an auto insurer may have

    an average of 1,000 claims per m

    onth, but for the last month of the

    year, only 600 claims have been reported. It is probable that a further

    400 auto accidents did occur in that last month, w

    hich had not been reported by D

    ecember 31. Th

    ese 400 claims need to accrued, as an

    IBNR claim

    s expense, with the other side of the accounting entry being

    an increase to the IBNR liability.

    In fact, for some specialized product lines, it often takes m

    any years for claim

    s to be reported to the insurance company, such as

    asbestos claims. Th

    is also makes liabilities diffi

    cult to estimate and

    general reserves are sometim

    es established to cover such contingencies (although they m

    ay not be allowable for tax).

    Payments of policyholder benefits generally relate to life insurance.

    Benefits to be paid could be discretionary (non guaranteed) dividends or bonuses payable annually to policyholders of life policies w

    ith a savings elem

    ent, or terminal bonuses payable on m

    aturity of the policy or death of the policyholder.

    Claims expenses and paym

    ents of policyholder benefits need to be disclosed net of reinsurance recoveries.

    This expense category consists of com

    missions paid or payable and

    other expenses which relate to the cost of acquiring policies. Th

    ese “expenses” are generally initially recognized as an asset, and then am

    or-tized each year over the life of the insurance policy.

    This expense category relates to the expenses incurred in the day-

    to-day running of the insurance company. Investm

    ent managem

    ent expenses are included in this category.

    Changes in Policyholder Liabilities are in fact an adjustment to the

    largest liability a life or a long term non-life/P&

    C insurance company

    has. Changes to the value of this liability are generally taken through

    primer06.indb 6

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  • the profit and loss account. This item

    can have a significant impact on

    the profit or loss of an insurance company.

    It needs to be noted that changes in Policyholder Liabilities can either be an increase (in w

    hich case it is an expense), or a decrease (in w

    hich case it is a contributor to profit). By way of exam

    ple, other things being equal, the actuary has determ

    ined that in the light of recent expe-rience, m

    ortality has been too conservatively calculated in the past. As

    a result, mortality assum

    ptions are changed to reflect that policyholders live longer. Th

    erefore death claims are deferred by som

    e years, and this change in assum

    ptions results in an improvem

    ent in profit. This

    example applies to the application of international standards, rather

    than US G

    AA

    P.

    There are three key ratios calculated for non-life/P&

    C insurance com

    panies:

    1. Th

    e claims ratio, or loss ratio: Th

    is is calculated by dividing total claim

    s expense by net earned premium

    s. This ratio generally

    represents the amount paid to policyholders, from

    every dollar of prem

    ium received. W

    hilst this ratio varies by type of busi-ness, developed countries generally have an average claim

    s ratio of around 60%

    to 70%, ie in total insurance com

    panies pay out, to policyholders, around 60–70 cents for each dollar of prem

    ium

    received.

    2. Expense ratio: This is calculated by dividing operating expenses

    by net earned premium

    s. This ratio is a m

    easure of efficiency, and

    also a measure of the level of service supplied to policyholders.

    Developed countries have an average expense ratio of around

    20% to 30%

    .

    3. Combined ratio: Th

    is ratio is arithmetically the addition of the

    claims ratio and the expense ratio. A

    combined ratio of less than

    100% represents an underw

    riting profit; a ratio of more than

    100% represents an underw

    riting loss. Insurers generally aim for

    a combined ratio of 90%

    to 95%, thus m

    aking an underwriting

    profit of 5% to 10%

    . It needs to be noted that investment incom

    e is excluded from

    this ratio, and hence insurance companies can

    still make an overall profit even if they have m

    ade an under-w

    riting loss.

    primer06.indb 7

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  • Life insurance companies w

    hich only sell risk products are also able to use these ratios. H

    owever, life insurance com

    panies that also sell investm

    ent products, or “bundled” products which contain both

    risk and savings elements (for exam

    ple, whole life policies) cannot be

    analyzed using such ratios.

    There are three key item

    s on the balance sheet of insurance companies

    which w

    arrant comm

    ent. Specifically, these are:

    Investment A

    ssets;D

    eferred Acquisition Costs; and

    Policyholder Liabilities

    The rem

    ainder of assets and liabilities are in line with balance sheets

    of companies from

    other industries.

    Investment A

    ssets are usually the largest asset on the balance sheet of an insurance com

    pany (if they are not this is normally a red flag).

    Investment A

    ssets frequently represent in excess of 80% of total assets

    of an insurance company. Th

    ese assets are mainly required to be able

    to be drawn upon to m

    eet the payment of policyholder liabilities (see

    below) as and w

    hen these fall due. It is therefore imperative that insur-

    ance companies attem

    pt to match the duration of their investm

    ent assets w

    ith the anticipated future payments of policyholder liabilities.

    Consequently, insurance com

    panies who sell “short tail” insurance

    products, such as auto insurance and householders’ insurance, hold predom

    inantly investment assets w

    hich can be readily converted into cash at relatively short notice w

    ith comparatively little price fluctuation

    or credit risk, such as bank deposits and government bonds.

    The quality of investm

    ent assets to be held by insurance companies

    is generally legally prescribed, and may be linked to investm

    ent quality grading introduced by independent ratings agencies such as Standard &

    Poor or Moodys. Investm

    ent assets held by insurance companies

    tend to be of high quality, with m

    any being “AA

    A” rated. Insurance com

    panies generally disclose the quality of their investment assets in

    their financial statements. By w

    ay of example, A

    llianz disclosed in its financial statem

    ents for the year ended 31 Decem

    ber 2007 that 56% of

    primer06.indb 8

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  • its assets were “A

    AA” rated by Standard &

    Poor, 32% w

    ere “AA” rated

    and 11% w

    ere “A” rated—only 0.7%

    percent of investment assets w

    ere unrated or had an investm

    ent grading lower than “A

    .”Investm

    ent assets are generally marked to m

    arket. Unrealized gains

    and losses are generally held in a balance sheet reserve established for this purpose; they are not taken through the Profit and Loss Statem

    ent.

    Costs relating to the acquisition of longer term

    insurance policies are generally capitalized and taken up as an asset on the balance sheet. Th

    e D

    AC asset is then amortized over the expected duration of the insur-

    ance contracts (or such shorter period as prudence or regulation may

    specify), in order to match the future revenue stream

    of incoming

    premium

    s with the expensing of the costs of bringing these policies

    onto the books of the insurance company.

    The raison d’etre for insurance com

    panies is to pay claims and bene-

    fits to policyholders—and hence the provision for such paym

    ents is the largest liability on the balance sheet of insurance com

    panies. Frequently, in excess of 90%

    of all insurance company liabilities is

    represented by this single item.

    The total policyholder liabilities—

    claims and benefits payable to

    policyholders—effectively consist of:

    Technical reserves; andFuture benefits payable to policyholders.

    These reserves relate prim

    arily to non-life/P&C insurance com

    panies but can also be relevant to life insurers. Th

    ey consist of the following

    key items:

    Unearned Premium

    Reserve: this reserve relates to that portion of prem

    ium received w

    hich has not been earned as yet. For exam

    ple, if a premium

    of US$1,200 has been received by an

    insurance company for a 12 m

    onth cover on May 1, then only

    primer06.indb 9

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  • US$800 (eight m

    onths’ worth) of that insurance revenue is

    taken up as revenue in the year ended Decem

    ber 31 – the rem

    ainder of US$400 relates to four m

    onths of insurance cover for the follow

    ing year, and this amount is taken up as a liability

    (“Unearned Prem

    ium Reserve”) in the accounts at 31 D

    ecember.

    The exam

    ple represents the balance sheet entry of the example

    used previously above.O

    utstanding Claims Reserve: claim

    s which have been lodged

    with the insurance com

    pany, but have not been paid as yet. The

    calculation of this reserve is based on “open claims file m

    ethod-ology”: A

    n estimate as to the total cost of each reported claim

    is prepared, and the total of all claim

    s payable, less the amount

    already paid on outstanding claims, is aggregated into the total

    outstanding claims reserve; and

    Incurred But Not Reported (“IBNR”) Claim

    s: claims incurred at

    the end of the financial year which have not been reported as yet.

    For example, an auto insurer m

    ay have an average of 1,000 claims

    per month, but for the last m

    onth of the year, only 600 claims

    have been reported. It is probable that a further 400 auto acci-dents did occur in that last m

    onth, and these 400 claims need to

    taken up as a liability, the “IBNR Reserve.”

    The calculations for O

    utstanding Claims Reserves and IBN

    R claims

    can be quite complex for long term

    non-life/P&C business. Actuaries

    are generally required to calculate the more com

    plex elements of these

    reserves.

    Insurance companies m

    ust provide for benefits payable in the future, allow

    ing for any options embedded in the contracts (w

    hich can signifi-cantly change the apparent duration of the contract and hence optim

    al investm

    ent policy). The type of benefit to be provided for depends on

    the type of policy which has been sold. By w

    ay of example, a life insur-

    ance whole of life policy provides for a large lum

    p sum paym

    ent in the event of the death of the policyholder or, typically, once an advanced age (say 85) has been reached. A

    liability must be calculated for all

    whole of life policies taking into account such factors as the age of poli-

    cyholders, whether they are m

    ale or female (fem

    ales live an average of 7 years longer than m

    ales), whether they are sm

    okers or non-smokers

    (that is, the consequent mortality statistics), future investm

    ent earning rate and future discontinuance rates . A

    nother example m

    ay be an

    primer06.indb 10

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  • income insurance policy, w

    here future policyholder benefits are based on such statistics as m

    orbidity by employm

    ent category. Typically a prospective approach is used, w

    hereby the reserve (often called the m

    athematical reserve) is defined as the present value of future benefits

    and expenses less the present value of future premium

    s. Th

    e reserving approach also depends on whether risk capital

    needs to be maintained. M

    odern accounting and regulatory doctrine norm

    ally requires that most risks are carried by capital, w

    ith a modest

    resilience level being built into technical and mathem

    atical reserves.Th

    e estimation of future benefits to policyholders is the m

    ost com

    plex calculation in the balance sheet of insurance companies,

    particularly for life insurers. Actuaries are required to perform this

    calculation.

    In almost all jurisdictions, insurance com

    panies need to prepare their financial accounts in tw

    o separate ways:

    For ordinary readers of financial statements, financial accounts

    consisting of balance sheets, profit and loss statements and notes

    to the accounts need to be completed. Th

    ese accounts are used by stakeholders such as potential investors, shareholders, bankers, stock exchanges (m

    ost insurance companies are publicly listed)

    and industry observers.Th

    ere are two m

    ajor accounting methodologies applied in the

    developed world for norm

    al ‘going concern’ reporting:

    – Generally Accepted Accounting Principles used in the

    United States (U

    S GA

    AP); and

    – International Financial Reporting Standards (IFRS).

    Th

    ese two m

    ethodologies are expanded upon below.Separate financial statem

    ents need to be prepared for insurance industry regulators. Th

    ese are more in the nature of conservative

    ‘wind up’ cash forecasts.

    primer06.indb 11

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  • The first accounting m

    ethodology specifically designed for insur-ance com

    panies was established in the U

    nited States and is part of the reporting fram

    ework w

    hich is comm

    only referred to as US G

    AA

    P. The

    first US G

    AA

    P insurance standard, FAS 060, w

    as published in 1982. O

    ther accounting standards specifically applicable to the insurance industry are FA

    S 097, FAS 120 and FA

    S 144.Th

    ese US G

    AA

    P standards deal with all m

    atters relating to insur-ance com

    panies: life insurance, non life insurance, reinsurance and also investm

    ent products sold by insurance companies.

    The U

    S GA

    AP approach is prescriptive, and m

    any specific rules apply as to how

    the profit on a book of insurance business is to be calculated. U

    S GA

    AP generally requires that assum

    ptions be set in the year in w

    hich a group of similar insurance policies is sold: this includes

    the quantum of deferred acquisition costs relating specifically to this

    book of business, and assumptions relevant to estim

    ating future policy cash flow

    s. These assum

    ptions are then maintained throughout the

    life of those policies. Consequently, U

    S GA

    AP determ

    ines profit in future years by locking in assum

    ptions, rather than adjusting assump-

    tions based on emerging experience. Th

    is is generally regarded as being a conservative approach, and the tendency tow

    ards “back end profit recognition” is com

    pounded by US G

    AA

    P deferring only variable acquisition costs.

    In order to harmonize accounting across the w

    orld, and thereby prom

    ote comparability of financial results, international accounting

    standards (“IFRS”) have been developed over the past decade. Alm

    ost all developed countries, w

    ith the exception of the United States, have

    decided to fully adopt the IFRS standards.Th

    e specific standard pertaining to insurance is “IFRS 4 Insurance C

    ontracts.” The standard w

    as developed in 2001, and applied from

    2006. IFRS 4 is regarded as an interim standard, as the International

    Accounting Standards Board has requested further public input, and expects to put in place a revised standard in 2010.

    IFRS 4 applies to all insurance contracts which carry insurance

    risk. The standard does not apply to other assets and liabilities, such

    as financial assets and financial liabilities – “IFRS 39 Financial Instru-

    primer06.indb 12

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  • ments” deals w

    ith these matters for all types of financial service com

    pa-nies, not solely insurance com

    panies.Th

    e IFRS approach is to measure the value of policyholder assets

    and liabilities using a “mark to m

    arket,” or “fair value” approach, and hence assum

    ptions in valuing assets and liabilities are changed each year: for exam

    ple, if interest rates rise during the year, the interest rate assum

    ption for discounting purposes is changed. A change in

    this assumption alone has a m

    ajor impact on those insurers w

    ith long term

    liabilities: by way of exam

    ple, the value of policyholder liabilities increases significantly w

    hen the discount rate is decreased. At the same

    time, w

    ith a decrease of the discount rate, the value of investment assets

    will increase significantly as w

    ell, and therefore if there is a perfect asset–liability m

    atch, there will be no im

    pact on profit.Th

    e IFRS philosophy is to cover the issues in principle, rather than using a prescriptive approach. It then stipulates that com

    panies explain their financial statem

    ents with extensive use of notes attached to the

    financial accounts. By way of exam

    ple, companies are required to

    disclose the key assumptions used in valuing policyholder liabilities. A

    sensitivity analysis on the effect of changes to key assum

    ptions is also required.

    Both IFRS and US G

    AA

    P have the same objective: to disclose the

    financial performance (profit and loss) and the financial position

    (balance sheet) of insurance companies in a realistic m

    anner. How

    ever, the philosophies applying to those tw

    o methodologies are distinctly

    different, and therefore they can produce quite different financial results:Th

    e “lock in assumptions” approach for both future policyholder

    liabilities and deferred acquisition costs produces a reasonably predictable profit picture, year after year, under U

    S GA

    AP. A

    s IFRS assum

    ptions are changed each year in order to apply the m

    ost relevant assumptions, the value of liabilities w

    ill fluctuate m

    ore under IFRS. U

    nder IFRS, investment “prem

    iums” and “claim

    s” under policies such as savings plans, are treated in a sim

    ilar manner to bank

    deposits and withdraw

    als, and are thus excluded from prem

    ium

    revenue and claims expenses. U

    nder US G

    AA

    P, all policyholder revenue, including revenue received on savings and investm

    ent policies, is included as prem

    ium revenue.

    primer06.indb 13

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  • In terms of investm

    ent asset revaluations, both US G

    AA

    P and IFRS use a “m

    ark to market” approach. IFRS uses this approach

    for all investment assets, w

    hereas US G

    AA

    P requires insurers to hold investm

    ent bond assets, a major asset class for insurance

    companies, at book value if they are intended to hold these assets

    to maturity. Th

    ere will therefore be greater fluctuations in the

    value of investment assets under IFRS.

    In summ

    ary, financial statements are likely to be m

    ore “accurate” under IFRS, because changes to underlying assum

    ptions reflect the m

    ost recent information. U

    S GA

    AP, on the other hand, in applying the

    “locked in” principles, largely relies on assumptions w

    hich were appli-

    cable a number of years ago, w

    hen each block of business was sold.

    How

    ever, changing key assumptions every year results in greater vola-

    tility of financial results from year to year under IFRS. C

    onsequently, reported profit results for insurance com

    panies are far more predictable

    under US G

    AA

    P methodology than they are using the IFRS approach.

    A concern w

    ith using IFRS methodology is that it is diffi

    cult, if not im

    possible to mark liabilities (paym

    ent of future policy benefits) to m

    arket. Given that the IFRS approach has only been im

    plemented

    since 2006, and at any event it is regarded as being an interim standard

    only, it is difficult to determ

    ine as yet just how volatile the financial

    results will be over the years.

    A concern w

    ith US G

    AA

    P is its relative inflexibility: it is a complex

    framew

    ork for simple insurance products, and yet it seem

    s too rigid to cope w

    ith complex product designs.

    Many life insurance com

    panies have converted from m

    utual to share-holders structures in the last 40 years. A

    s standard accounting prac-tice can m

    ask high profitability for life insurers (particularly when

    they are growing rapidly and have heavy front end costs) an approach

    was developed w

    hereby the ‘true’ value of the insurer is shown in the

    notes to the accounts to properly inform the m

    arket and forestall take-overs. Th

    is involves disclosing the embedded value w

    hich consist of the adjusted net assets of the life insurer plus the present value of profits em

    erging from the policies on the books of the insurer (the in force)

    at the balance date. Where a life insurer is being taken over appraisal

    values are employed. Th

    ese consist of the embedded value plus the esti-

    mated present value of the future business that w

    ill be produced by the current distribution system

    .

    primer06.indb 14

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  • Insurance regulators are important stakeholders w

    ho are primarily

    concerned with an insurance com

    pany’s solvency, and therefore its ability to pay claim

    s and benefits to policyholders as and when they fall

    due. In carrying out their duty, insurance regulators take into account that:

    a number of assets disclosed in the balance sheet cannot be

    converted into cash (such as computer softw

    are, office fittings

    and deferred acquisition costs);Various classes of investm

    ent assets have different risk profiles attached to them

    : for example, the investm

    ent categories cash and governm

    ent bonds are far more likely to retain their value than

    stocks, shares and real estate; Investm

    ent assets may be w

    orth a great deal less than their present value on the balance sheets (for exam

    ple, due to a stock m

    arket crash or a real estate market dow

    nturn); andFuture claim

    s and benefits payable to policyholders may be

    significantly higher than the reported liabilities and future prem

    iums payable. Insured catastrophes and disasters such as

    Katrina and September 11 do occur—

    that, after all, is the purpose of policyholders purchasing insurance products.

    As a result of the risks attached to the above factors, insurance regu-

    lators require insurance companies to adjust their accounts in such a

    manner that they can prove that they have suffi

    cient capital and invest-m

    ent assets to pay for claims as and w

    hen they fall due under potential adverse circum

    stances. Regulators examine solvency in detail, w

    hich includes the dem

    onstration by insurance companies that they have

    significant financial buffers in place, to cover for such factors as invest-m

    ent market turm

    oil. The m

    ethodologies used by regulators of devel-oped countries vary significantly.

    As a result, the adjusted accounts, frequently referred to as “statutory accounts,” w

    hich insurance companies need to subm

    it to their regulators, set out a com

    pany’s financial position on a conservative basis.

    Most developing countries use neither IFRS nor U

    S GA

    AP as a basis

    for preparing financial statements for insurance com

    panies. Their

    financial reporting methodology is frequently based on European

    primer06.indb 15

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  • solvency approaches from the 1960s and 1970s. Th

    e elements generally

    are as follows:

    Revenue from prem

    iums received: m

    any developing countries account for prem

    ium revenue on a “gross prem

    ium received” basis, rather than

    calculating, in detail, an “earned” premium

    . Statistics kept by regulators relate only to gross prem

    iums w

    ritten. There is therefore a danger that

    some prem

    iums are double counted for the industry, particularly in

    circumstances w

    here insurance companies reinsure w

    ith each other. In those developing countries w

    here a “net earned” approach applies, the am

    ount calculated as the Unearned Prem

    ium Reserve is usually based

    on a percentage of gross premium

    s.In developing countries, the total claim

    s expense taken up in a year consists of claim

    s paid, plus claims not as yet paid and therefore

    accrued, plus an estimate for IBN

    R-claims w

    hich have been Incurred but N

    ot Reported. In developing countries, claims paid during the

    year are generally correctly recorded, so these amounts are regarded

    as providing the most reliable (or least unreliable) basis for estim

    ating outstanding claim

    s. The am

    ount taken up for claims w

    hich have not been paid as yet is generally calculated as a ratio of prem

    iums received.

    Similarly, IBN

    R claims are estim

    ated as a percentage of premium

    s received, rather than being based on open claim

    s file methodology.

    The legal fram

    ework of developing countries generally stipulates the

    percentage which is to be applied to prem

    iums received, in order to

    calculate the outstanding claims reserve. Th

    is approach makes it easy

    for regulators to check that the ratio calculation (premium

    s to claims

    reserves) has been complied w

    ith, but leads to inaccurate financial results – as outstanding claim

    s may be m

    uch higher or lower than the

    legally decreed ratio.

    In developing countries, claims ratios for non-life/P&

    C insurance com

    panies are generally quite low—

    around 25% (that is, in total, poli-

    cyholders receive 25 cents in each premium

    dollar paid), but they can be as low

    as 10%. Th

    is could imply that policyholders do not receive

    “value for money” on their insurance products. Th

    is can be due to

    primer06.indb 16

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  • a number of reasons: in recently opened m

    arkets, policyholders frequently believe that their insurance prem

    ium is a tax—

    particularly for com

    pulsory products such as motor insurance, and therefore they

    do not realize that they can make a claim

    on an insurance company. A

    low

    claims ratio can also result from

    overpricing of the insurance cover, or as a result of insurance com

    panies refusing to pay claims.

    In the longer term, insurance com

    panies in developed countries generally use a benchm

    ark whereby they pay back to policyholders an

    average, for the company as a w

    hole across all lines of business, of at least 60 cents of each prem

    ium dollar received.

    Expense ratios in developing countries are usually high: over 30%, and

    up to 60% of every prem

    ium dollar received. Th

    ese ratios are high, generally due to either m

    arket inefficiencies, such as the sector having

    developed only recently, and hence there is a high level of initial invest-m

    ent, or corporate inefficiencies, such as the insurance com

    pany having ineffi

    cient/ manual system

    s and procedures, and/or the insurance com

    panies being too small to take advantage of any econom

    ies of scale.In developed countries, expense ratio benchm

    arks are around 25 cents of each prem

    ium dollar received. Th

    is benchmark can vary

    considerably.

    In total, many developing countries have com

    bined ratios similar

    to those of developed countries. How

    ever, as observed above, the elem

    ents of the combined ratio are different: insurance com

    panies in developing countries generally spend far m

    ore on their administration,

    and generally far less money is returned to policyholders in the form

    of benefits and/or claim

    s paid.

    Many jurisdictions of developing countries still stipulate that invest-

    ment assets need to be held at historical cost rather than being m

    arked to m

    arket. In addition, the legislation of many developing countries

    stipulates that investment assets m

    ust be situated in their country—they are not perm

    itted to invest outside their own country. In som

    e

    primer06.indb 17

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  • developing countries, the purchase of international investment assets

    is permitted, but to a lim

    ited degree (say, 10% of the total investm

    ent portfolio). Th

    e impact of the prohibition to purchase international

    assets is significant for the insurance industry: investment assets w

    ith a long duration cannot be purchased (because this asset class does not exist in m

    any developing countries) and hence long term life insur-

    ance products cannot be offered. For example, in Vietnam

    in the past, the only investm

    ent grade assets purchased by insurance companies

    were G

    overnment bonds, w

    hich generally had a duration of 5 years. Life insurance com

    panies could therefore only offer five year endow-

    ment policies. W

    hilst the industry would have preferred to sell w

    hole-of-life policies, it could not do so because the asset/liability duration m

    ismatch (a five year asset com

    pared to potentially a 50 year liability) represented a far too great financial risk for the insurance com

    pany. Th

    e key liabilities are accrued claims and benefits payable, at som

    e tim

    e in the future, to policyholders. In developing countries, non-life/P&

    C claims liabilities, or “technical reserves,” are generally calcu-

    lated as a ratio of premium

    income. Th

    is leads to inaccurate financial results, as such ratios are unlikely to reflect an accurate corporate finan-cial position.

    The legislative fram

    eworks of m

    any developing countries stipulate that “catastrophe reserves,” usually also expressed as a percentage of prem

    ium incom

    e, be held. Such reserves are regarded as being totally subjective, and are therefore specifically disallow

    ed by IFRS 4.Balance Sheet disclosure, via notes to the accounts, is generally

    low by insurance com

    panies in developing countries. Notes to finan-

    cial accounts should be extensive, and explain as fully as is reasonably possible the financial position of the com

    pany, and provide further detail on individual profit and loss item

    s, and balance sheet items.

    Most indigenous insurers in developing countries do not provide m

    uch inform

    ation above the raw m

    inimum

    amount required by law. Th

    ere are notable exceptions, such as N

    igeria, where insurance com

    panies tend to provide detailed explanatory notes to financial statem

    ents.

    Both US G

    AA

    P and IFRS represent insurance accounting at an advanced stage, and therefore require infrastructure in place w

    hich is sim

    ply not available in developing countries. This infrastructure

    consists of:

    primer06.indb 18

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  • A legal and regulatory fram

    ework w

    hich permits the im

    plemen-

    tation of IFRS and/or US G

    AA

    P. Surprisingly, many legal fram

    e-w

    orks stipulate concepts which are expressly forbidden by both

    US G

    AA

    P and IFRS, such as the holding of catastrophe reserves;Education: detailed know

    ledge of IFRS or US G

    AA

    P, and how to

    apply the complex accounting concepts;

    The availability of technical expertise to perform

    the complex

    calculations required for insurance companies;

    A corporate governance regim

    e which prom

    otes the use of either U

    S GA

    AP or IFRS m

    ethodologies; andA

    skilled insurance regulator and/or corporate regulator possessing the technical expertise required to ensure that insur-ance com

    panies comply w

    ith US G

    AA

    P or IFRS rules.

    Alm

    ost all developing countries simply do not have the above

    infrastructure in place. Therefore, insistence that developing countries

    implem

    ent imm

    ediately either IFRS or US G

    AA

    P achieves relatively little: the insurance com

    panies generally cannot comply w

    ith such a directive. In addition the insurance regulator usually does not have the requisite skill and expertise available (such as fully qualified in-house actuaries) even in cases w

    here some insurance com

    panies can comply

    (for example, large local insurers or subsidiaries of international

    insurers). In the longer term

    , all countries will need to com

    ply with interna-

    tional accounting standards. Each country should have a “road map”

    in place which outlines m

    ilestones as to how to achieve this objective,

    and stipulate a time fram

    e. The road m

    ap will vary from

    country to country, as it w

    ill depend on such factors as the current level of market

    development, current levels of expertise and the size of the m

    arket. Th

    us, developing countries such as India and China are much closer to

    complying (w

    ith IFRS) already: both these countries have high levels of expertise, good legal fram

    eworks and, in IRD

    A and CIRC, strong and

    effective regulators.

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