Haris Ashley
Insurance accounting is a system of recording, analyzing, and reporting an insurance organization's financial status. It involves understanding industry-specific accounting rules and regulations to evaluate an insurer's profitability and operations. The insurance industry is divided into property/casualty (non-life) and life/health segments, with distinct accounting practices due to the nature of their products. Special accounting standards, such as statutory accounting principles (SAP) and generally accepted accounting principles (GAAP), have been developed to ensure fiduciary responsibility and protect policyholders. Insurance companies face challenges in estimating claims-related expenses and must comply with accounting principles like IFRS 17 and ASU 2018-12. The financial statements of insurance companies, including the balance sheet, income statement, and cash flow statement, provide critical financial information for stakeholders. Auditing plays a vital role in enhancing trust and ensuring compliance with financial reporting frameworks.
| Characteristics | Values |
|---|---|
| Purpose | To express an opinion on whether the financial statements are fairly stated and in accordance with the identified financial reporting framework |
| Accounting standards | GAAP, SAP, IFRS, IAS |
| Insurance industry segments | Property/casualty (general insurance or non-life), life/health |
| Statutory accounting | Balance sheet, income statement, Capital and Surplus Account |
| GAAP accounting | Balance sheet, income statement |
| Insurance contract accounting guidance | ASC 944, IFRS 17 |
| Claims | Expenses estimated as Incurred But Not Reported (IBNR) |
| Premiums | Allocated over the policy period, not immediately upon the sale of the policy |
| Underwriting ratio | One minus the combined ratio |
| Financial statements | Balance sheet, income statement, cash flow statement |
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What You'll Learn
Statutory accounting principles and practices (SAP)
Statutory Accounting Principles (SAP) are a set of special accounting rules designed specifically for the insurance industry. SAP provides a general framework for preparing financial statements, which can be modified to meet the specific requirements of certain industries due to sector-specific laws and reporting requirements. SAP focuses on three core values: conservatism, recognition, and consistency.
SAP is constructed under the framework of generally accepted accounting principles (GAAP), but its main emphasis is on recording and maintaining solvency measures. This is to ensure that policyholders, contract holders, and other legal obligations are met when they come due. SAP-prepared books are more useful to insurance regulators than GAAP-prepared accounts and focus primarily on the balance sheet statement.
SAP mandates the reporting of capital flows pertaining to operations, investments, and financing activities. When preparing financial statements using SAP, compliance with legal obligations during audits or regulatory examinations is essential. SAP regulations can be complex and challenging to comprehend, but with the right guidance, they can become a powerful tool for assisting businesses in achieving their financial objectives.
In the United States, insurers submit financial statements to state regulators using SAP. The NAIC Accounting Practices and Procedures Manual (AP&P Manual) details the SAP, but it does not override state legislative and regulatory authority, so state variations may occur. SAP should be applied consistently when evaluating insurance companies so that regulators can compare statements across the board in a meaningful way.
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Generally accepted accounting principles (GAAP)
GAAP is enforced by government institutions, including federal legislative and judicial branches, to ensure compliance with its guidelines. However, the development and updating of GAAP accounting practices are left to private organisations and independent boards. The Financial Accounting Foundation (FAF), founded in 1972, oversees and governs the Financial Accounting Standards Board (FASB) and the Government Accounting Standards Board (GASB). The FASB, established in 1973, serves as the independent body responsible for developing and enhancing financial reporting standards for publicly traded companies.
GAAP-compliant accounting practices are based on various principles, including the separation of an organisation's transactions from those of its owners, standardisation of currency units in reports, and explicit disclosure of the time periods covered by specific reports. Other notable principles include consistency, which ensures the application of consistent standards throughout the financial reporting process, and conservatism, which guides accountants to exercise caution and diligence in verifying data and preparing documents, especially in uncertain situations.
The main objective of GAAP is to provide a standardised system of accounting methods and practices that facilitate accuracy, transparency, and protection for investors. Public companies in the United States must adhere to GAAP when preparing their financial statements, and GAAP compliance is verified through external audits conducted by certified public accounting (CPA) firms. The need for GAAP arose from the financial catastrophe of the Great Depression in 1929, which was attributed to manipulative and faulty reporting practices.
GAAP is primarily used in the United States, while most other countries follow the International Financial Reporting Standards (IFRS). However, GAAP is also utilised by government entities within the United States, including all 50 states and local entities such as counties, cities, towns, and school districts. The equivalent international standard, IFRS, is used in 168 jurisdictions worldwide.
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International Accounting Standards and International Financial Reporting Standards (IFRS)
International Financial Reporting Standards (IFRS) are global accounting standards developed by the International Accounting Standards Board (IASB). The IASB was formed in 2001 with the goal of harmonizing national accounting standards. The new standards were called "International Financial Reporting Standards" (IFRS).
IFRS Standards aim to bring consistency and transparency to financial statements. They are used by companies with high levels of international activities and foreign investments, as they provide a set standard for accounting practices across different countries. The use of IFRS Standards can make entities more attractive to investors, as it provides a level of uniformity in financial reporting that makes it easier to compare and interpret financial data across markets.
IFRS 17, effective for annual reporting periods beginning on or after 1 January 2023, specifically addresses insurance contracts. Insurance contracts have features of both financial instruments and service contracts, often generating cash flows with substantial variability over long periods. IFRS 17 provides guidance on recognizing and measuring these unique characteristics. It combines the current measurement of future cash flows with the recognition of profit over the period that services are provided. It also requires the separate presentation of insurance service results and insurance finance income or expenses.
IFRS 17 includes an optional simplified measurement approach, known as the premium allocation approach, for simpler insurance contracts. This approach was previously introduced in IFRS 4, which was an interim standard that allowed for a wide variety of accounting practices for insurance contracts, subject to specified disclosures. IFRS 4 was replaced by IFRS 17 in May 2017, with the latter providing more comprehensive principles for the recognition, measurement, presentation, and disclosure of insurance contracts. Amendments to IFRS 17 were issued in June 2020 to assist entities in implementing the standard effectively.
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Balance sheets and income statements
A balance sheet is a financial statement that provides a snapshot of a company's financial health at a specific point in time. It includes information on a company's assets, liabilities, and shareholders' equity. Assets refer to what the company owns, including cash, inventory, investments, debts owed, and intellectual property. Liabilities refer to what the company owes, such as loans, accounts payable, and accrued expenses. Shareholders' equity represents the remaining amount if all the assets were liquidated and all the liabilities were paid off. The balance sheet is useful for understanding a company's financial position and whether it has a positive net worth. It is also used by lenders and creditors to assess the company's creditworthiness.
An income statement, on the other hand, focuses on the company's financial performance over a specific period, typically a fiscal quarter or year. It includes information on the company's revenue, expenses, gains, and losses. The income statement is used to evaluate the company's profitability by comparing the total revenue and gains with the total expenses and losses. If the revenue is greater than the expenses, the company made a profit; if the expenses are greater, the company incurred a loss. The income statement is important for investors and lenders as it indicates the company's ability to generate profits and meet its financial obligations.
Both the balance sheet and the income statement are essential components of financial reporting and analysis. They provide different but complementary perspectives on a company's financial health. The balance sheet offers a static view of the company's finances at a particular moment, while the income statement provides a dynamic perspective on the company's financial performance over a defined period. Together, they enable stakeholders, including investors, lenders, and company management, to make informed decisions and assess the company's financial stability and potential.
In the context of insurance accounting, the balance sheet and income statement play a crucial role in assessing the financial health and performance of insurance companies. Insurance companies have unique accounting considerations due to the long-term nature of their contracts and the potential impact of uncertain events, such as volatile markets, natural catastrophes, and changes in regulations. The balance sheet helps insurance companies evaluate their solvency, ensuring they have sufficient assets to meet their liabilities and policy obligations. It also enables regulators and stakeholders to assess the financial stability of the insurance company.
The income statement, in contrast, provides insights into the profitability of the insurance company over a specific period. It helps identify trends in revenue and expenses, allowing insurance companies to make data-driven decisions to improve their financial performance. Additionally, the income statement assists insurance companies in allocating resources effectively and determining the pricing and profitability of their insurance products. By analyzing the income statement, insurance companies can identify areas of strength and weakness, adjust their business strategies, and make informed decisions about their product offerings.
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Claims and expenses
Liability claims are another type of insurance claim that arises when a business is held responsible for causing harm to a third party, including bodily injury, property damage, or other losses. These claims often involve complex legal and financial considerations, requiring meticulous record-keeping of the incident, claim process, and any settlements. Proper accounting for liability claims helps manage risk and maintain financial stability by accurately reflecting associated expenses and potential liabilities in the company's financial statements. Recognising the insurance receivable, which is the amount expected to be recovered from the insurance company, is the first step in this process.
The cost of investigating and settling claims can vary significantly for insurance companies. Natural disasters, man-made disasters, and accidents can result in a high volume of claims. Loss reserves, also known as loss adjustment reserves, are crucial in this context as they represent the funds set aside by insurance companies to settle claims. These reserves cover expenses associated with claims adjusters, legal assistance, investigators, and other costs related to claim settlement. Property and casualty insurers typically establish claim reserves for accidents and events that have already occurred, but some claims, such as workers' compensation, may be settled long after the policy has expired.
In the context of insurance accounting, it is essential to recognise acquisition expenses before premium income is fully earned. This approach reduces the surplus available at the inception of a policy, necessitating a larger safety margin in policyholder surplus levels to fulfil obligations to policyholders. Additionally, the premium for each policy is calculated based on historical data from similar policies and is paid in advance. However, the actual cost of each policy to the insurer is not known until the end of the policy period or even later, depending on the specific insurance product.
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Frequently asked questions
Accounting is a system of recording, analyzing, and reporting an organization’s financial status. For insurance companies, it is a vital tool as it provides a framework for recording and analyzing financial information, including revenue, claims, expenses, and investments. It also enables insurers to compare their performance to industry benchmarks and assess the effectiveness of their investments.
The main financial statements for insurance companies are the balance sheet, the income statement, and the cash flow statement. The balance sheet presents the company’s financial position at a given time, listing its assets and liabilities. The income statement records the company’s operating results from the previous period, including revenue from premiums and claims paid out.
Insurance companies rely on accounting principles and the analysis of market data to determine rates for policies. By taking into account financial information and market trends, insurance companies can set rates that accurately reflect the risk associated with a particular policy.
