Statutory Accounting Principles
Insurance companies have much in common with other businesses in regard to their finances. Their accounting systems are also very similar. However, states have laws that modify accounting practices of insurance companies domiciled in that state. The statutory accounting system is based on the NAIC Annual Statement Blank, a standardized reporting format developed by the National Association of Insurance Commissioners (NAIC). Each company must file an annual statement both with the state of domicile and in each state in which it is an admitted insurer. There are 2 versions of the Annual Statement Blank: one for property and liability insurers and the other for life insurers. The main purpose of the statutory accounting laws is to ensure the solvency of the insurers by requiring a very conservative valuation of its assets.
The primary purpose of GAAP is to provide investors and lenders with indications of profitability. The primary purpose of statutory accounting principles (SAP) is to provide insurance regulators a clear indication of the solvency of the insurer and the adequacy of its surplus to ensure policyholder protection. Although GAAP and SAP have much in common, there are some differences.
Statutory accounting principles have 3 main objectives: conservativism in valuing assets, consistency in the rules that apply to the accounting of insurers, and recognition of assets when earned and liabilities when incurred, which helps ensure solvency. Since judgment must be used to value many assets, SAP rules require conservative valuations. Since there are many ways to value assets, comparisons between different companies or the same company over time may be misleading due to differences in how assets are valued. Since SAP rules are consistent, insurance companies can be compared over time and with each other. Recognition rules are designed to ensure that assets, liabilities, revenues and expenses are recorded appropriately. Expenses are not permitted to be deferred and must be reported as incurred, because the funds used to pay these expenses can no longer pay future liabilities, which is the main concern of the insurance regulator. For instance, if an asset cannot be used to pay a policyholder benefit, then it is excluded from the balance sheet or from surplus.
Statutory accounting reports and audited statutory financial statements must be received by the state insurance department by a specified time. For insurance companies on a calendar year, statutory accounting reports must be filed by March 1 after the calendar year. Audited statutory financial statements and any required letters must be filed by June 1 following the reported year.
Differences between Statutory Accounting and GAAP
The statutory system combines cash and accrual methods of accounting, but differs in some ways from generally accepted accounting principles (GAAP). There are both commonalities and differences in the statutory accounting requirements for life insurers and property and liability insurers. The 3 main commonalities are what constitutes assets on the balance sheet, how assets are valued, and that expenses are accounted for when they are incurred, but income is only accounted for when it is earned.
Admitted assets are highly liquid and can readily be converted to cash. Only admitted assets can be included in the balance sheet of insurance companies. Nonadmitted assets, including furniture and fixtures, office machines and other illiquid assets, supplies, and premiums at least 90 days past due cannot be listed as assets on the balance sheet.
The valuation of assets is the lower of cost or market value, but the value for debt securities, such as bonds, is their amortized value. Using the amortized value for debt securities was based on the assumption that insurers usually hold debt securities until maturity, so their current market value did not matter. However, insurers did not hold all debt securities until maturity, so the Financial Accounting Standards Board (FASB) issued Statement Number 115, Accounting for Certain Investments and Debt and Equity Securities, requiring insurers to classify their securities as being held to maturity, trading, or available-for-sale. Only debt securities for which the insurer intends to hold to maturity and will be able to hold to maturity can be reported at amortized value, in which case, they are classified as held-to-maturity securities. Trading securities are equity and debt securities that are intended to be sold within a short time. Trading securities must be reported at fair market value, and any unrealized gains or losses must be included in earnings. Available-for-sale securities, which covers all securities not placed in the 1st 2 categories, must also be reported at fair market value, but unrealized gains or losses are excluded from earnings and reported as a separate item of shareholders' equity.
The valuation of stocks is governed by the NAIC Valuation of Securities Task Force, requiring that stocks be listed at their year-end market value. Bonds that are not in in default are carried at their amortized value, but if they are in default, at market value.
Unlike GAAP, revenues and expenses are not matched under statutory accounting. Premiums are only recognized when the policy period for that premium has lapsed. Expenses, on the other hand, are recognized when they are incurred. Hence, premiums are treated on the accrual basis, but expenses are treated like cash expenses. This differs from GAAP in that both income and expenses are accrued, with expenses applying to the period when the income is earned.
Policyholder Surplus and Reserves
Policyholder surplus (a.k.a. policyowner surplus) is the excess of admitted assets over liabilities, which is a primary indicator of the insurer's financial strength, and is listed in the equity section of the balance sheet. Reserves are the major liability of insurance companies, funds that are set aside for a specific purpose, to pay future policy benefits and are treated as debts of the insurers to the policyholders. Policyholder surplus can be used to pay claims if reserves prove to be insufficient. Thus, policyholder surplus serves as a cushion that can help prevent insolvency of the insurer.
Statutory Accounting Differences between P&L Insurers and Life Insurers
There are also some differences between the statutory accounting of property and liability insurers (P&L insurers) and life insurers.
Property and Liability Insurers
Under statutory accounting, the premiums received by an insurance company cannot be counted as income until the premium is actually earned, i.e., the policy period corresponding to the premium has elapsed. Because some claims are expected to be filed with the insurance company, the premiums received for the period will be reduced by the amount of losses and related expenses. Until the premiums are earned, the money must be held in an unearned premium reserve as a deferred income account, which is treated as a liability.
Generally, the unearned premium reserve is usually calculated by a formula that accounts for the time distribution of the received premiums, so that as the time elapses, a portion of the unearned premium reserve represented by the elapsed time becomes earned premium. So, for instance, if an insurance company received $100,000 per month, every month for the year, then by year-end, $600,000 will remain in the unearned premium reserve while the remaining $600,000 will be treated as earned premium. This is warranted by the fact that an annual policy in which premiums are paid in January will shortly expire by year-end, so that premium amount can be treated as earned premium, while premiums paid in December will still have almost a year left in the policy, so most of that will be unearned premium. Hence, the average policy term remaining on all of the annual policies issued for that year is 6 months, with 6 months left to run.
Because profits are reported when earned and expenses are reported when incurred, insurance companies may report losses when business is increasing and report profits when business is decreasing.
Example: assume that ABC Insurance Company has written premiums of $1,200,000 for the 1st year, but no written premiums in the 2nd year. As can be seen from the following table, this company will have a large statutory loss in the 1st year and a large profit in the 2nd year.
|Premiums earned in Year 1||$600,000|
|Expenses incurred as a percentage of written premiums||40%|
|Losses incurred (assuming 50% of premiums earned)||$300,000.0|
|Premiums earned in Year 2||$600,000|
|Losses incurred (assuming 50% of premiums earned)||$300,000.0|
Thus, an increase in business can actually result, at least temporarily, in a lower policyholder surplus.
Because there is a certain duration between when a loss occurs and when the insurance company finally pays for the loss, statutory accounting distinguishes losses as 2 types: incurred losses and paid losses. Incurred losses are those that have occurred within a certain policy period, but have not yet been paid. Paid losses are those that have been paid regardless of when the losses occurred. The difference between these 2 accounts is measured by a liability account called loss reserves (a.k.a. claim reserves).
There are also 2 types of loss reserves: a reserve for losses that have been reported but not yet paid and reserves for those losses that have occurred but have not been reported yet. The total for reported losses can be approximated by examining the claims submitted, then adding up expected losses based on the claim information. Because the reporting of losses must necessarily lag the occurrence of those losses, since learning about the loss and filing claims takes a certain amount of time, some losses will have already occurred but have not yet been reported. The total of these losses are usually approximated using the insurance company's history for such types of claims.
Statutory accounting also requires that expenses be recognized when they are incurred. Since most of the expenses of an insurance company is in the acquisition of customers, most of these expenses are paid in the form of commissions to agents and brokers and for other marketing costs. Although these expenses are immediately deducted from revenue, they do not lower the unearned premium reserve, so this reserve will have a surplus equal to the expenses that were not deducted for the policy period.
Investment income is reported separately from income earned from underwriting. Because insurance companies are generally required to hold investment-grade securities, most investment income consists of interest from bonds, bank deposits, and collateralized lending, and from stock dividends.
Because unsold stocks must be reported at market value, insurance companies will have unrealized capital gains or losses that will be reflected in the gains or losses of the policyholder surplus, but will not affect reported income: only realized capital gains or losses will affect reported income.
Statutory accounting procedures can be misleading. Profits may increase temporarily when business is declining, and losses can increase, again temporarily, while actual business is increasing. To provide a more accurate picture of profitability, the industry has developed a combined ratio that combines a loss ratio and expense ratio over a given period. The loss ratio equals losses for a given period divided by the earned premium for that period. The expense ratio equals expenses divided by the total written premiums for the period. A combined ratio of less than 1 indicates profitability, often referred to as the trade profit, while a combined ratio exceeding 1 indicates losses.
The profitability of an insurance company or industry with respect to premiums collected can be expressed as the combined ratio:
|Combined Ratio||=||Losses + Loss Adjustment Expenses + Underwriting Expenses|
A combined ratio exceeding 1 indicates losses; less than 1, profits, since, then, premiums will exceed losses and expenses.
However, insurance companies will often sell policies even when the combined ratio exceeds 1, if the insurance company is confident that it can make up the losses through profits earned by investing its premiums. This strategy is referred to as cash flow underwriting.
Life Insurance Companies
Because life insurance policies generally have long terms, statutory accounting procedures for life insurance companies not only differs from GAAP, but also differs from property and liability insurers. The longevity of life insurance policies allows life insurance companies to use the less volatile amortized value of bonds and mortgages rather than their market value.
The unearned premium reserves of P&L insurers are equivalent to the policy reserves of life insurers. During the early years of the policy, the policyholder pays a higher premium than what is required for covering potential losses, so this overpayment must be held as a reserve by the insurance company. Additionally, many life insurance policies and annuities have a savings element, where part of the premium will provide a cash value at some maturity date in the future.
The calculations for policy reserves are conservative, using interest rates lower than actual interest earnings and mortality assumptions that are higher than actual experience.
Minimum policy reserves requirements were established by the NAIC Standard Valuation Law, specifying mortality tables and interest rate assumptions that must be used in the formula for calculating the reserves. However, the NAIC has adopted the Standard Valuation Law (SVL) in 2009, creating what is called principle-based reserving (PBR) that is expected to provide a more accurate reserve requirement for increasingly complex life insurance products. The NAIC has agreed to make PBR operative when at least 42 states representing at least 75% of the total premiums written in the United States have adopted SVL, in whole or in part. As of September 2016, the PBR is most likely to be operative by 2017. Although PBR was initially designed for life insurance companies, it will be used to provide reserving requirements for other insurance products as well.
The old formulaic approach required frequent updates as new insurance products were introduced. The old formulas did not change when economic conditions changed or when insurers accumulated actual experience that would suggest more optimal reserve requirements. Hence, in some cases the old formulaic approach was too conservative in calculating reserves, while in other cases, it did not account for additional risks of certain products. PBR obviates the need for frequent updates since reserve requirements would be based on specific principles rather than specific formulas. Hence, the name.
Reserves for Supplementary Contracts
Beneficiaries are not always paid a lump sum. In many cases, they elect to withdraw only interest, or principal plus interest. These payments over time are based on supplementary contracts, requiring the insurer to maintain adequate reserves for their obligation.
Similarly, policyowners may be entitled to dividends. If the insurer allows the insured to reinvest the dividends, then reserves must be maintained to eventually pay these dividends to the policyowner or beneficiary.
Reserves must also be established for unpaid claims, since, as with P&L insurers, life insurance companies receive some claims that were not yet paid. Additionally, some insureds have already died, but were not reported yet.
Investment income is equal to income from dividends and interest plus realized gains minus realized losses from sales plus or minus unrealized gains or losses from changes in the fair market value of held securities minus investment expenses.
Life insurers must maintain certain reserves to protect against the volatility of financial markets. Since 1951, the Mandatory Security Evaluation Reserve was used to determine the reserve requirements for stock and bond holdings. However, the Asset Valuation Reserve (AVR) and the Interest Maintenance Reserve (IMR) replaced the older reserve requirements in 1992 that apply to all investments.
AVR is counter cyclical, to smooth any effect on surplus due to changing valuation of assets. AVR is based on a default component, if the underlying security is a bond, mortgage, or other fixed-income asset, and an equity component for common stocks, real estate, or other equity assets.
The declining value of debt securities may be temporary if it is related to changes in interest rates, but only if the insurer can hold the security long enough to expect recovery or until the security matures. On the other hand, declines in value because of the impairment of the debt issuer should not be considered temporary since the issuer may never recover, so the value of the securities may decline to a fraction of their original worth, or may even become worthless. Equity securities, on the other hand, have no maturation date, so their value cannot be guaranteed at any time in the future.
There is a formula for calculating unrealized capital gains or losses due to changes in interest rates and another formula for determining changes in price because of changes in creditworthiness of the issuer. The equity and default components are combined to form the total AVR. As unrealized gains or losses, increases or decreases are reported as direct adjustments to surplus, not income.
The IMR accumulates realized capital gains and losses. Gains and losses are amortized and reported as an adjustment to the net investment income over the remaining life of the sold assets. This treatment is designed to prevent gaming of the system, where insurers may be motivated to sell securities at certain times to artificially satisfy the reserve requirements.
Because life insurance policies generally have much longer terms than property and liability insurance policies, the surplus of life insurers typically is much less than those of P&L insurers: less than 10% as opposed to 35 to 50% of total assets. Some states, such as New York, have legal limits to the surplus.
Income and Deductions
Life insurers calculate income differently from P&L insurers, in that all premiums that were collected or were due is treated as income, even if the premiums were for future benefits. However, part of the premium must be used to increase legal reserves that will cover future benefits, so this part of the premium is deducted from income. This net income is the income from collected premiums or premiums that were due in the current period that applied to the policy period that has elapsed during the reported duration. Hence, the net income of life insurers corresponds to the earned premium of P&L insurers.
A claim under a life insurance policy or endowment policy is deducted from income, even if the claim is not yet paid or if the beneficiary decides to receive payment over an extended duration rather than receiving it as a lump-sum. The amount left with the insurer under a supplementary contract is treated as a premium; reinvested dividends are treated similarly. Payable dividends are deducted from income even if the beneficiary elects to have it reinvested, but the deferred dividend is treated as income from dividends on deposit.
Investment income is reported as both gross income and net income. Gross income is simply all investment income before subtracting expenses: net income is what remains after subtracting expenses. Life insurers earn the same type of income as P&L insurers: interest earned on bank deposits, bonds, mortgages, and collateralized loans; stock dividends; and real estate income.
The primary deduction of life insurers is the benefits paid to policyholders: death and disability benefits, dividends, and cash surrender values. The 2nd largest deduction is the increase in legal reserves that will be used to pay future benefits. Operating expenses are another major deduction, which includes general and administrative expenses and commissions paid to sales agents and brokers.
As with P&L insurers, life insurers must report expenses as they are incurred. Since life insurance agents often earn commissions exceeding the 1st year premium on life insurance policies, increasing sales of life insurance policies would reduce the income or cause losses for the life insurer. The increase in legal reserves for the written policies would further reduce income or increase losses. To mitigate the negative effect that new policies have on the income of life insurers, and recognizing that most of the expense of selling a new policy comes in the 1st year and that life insurance policies have longer terms than P&L policies, states have allowed the deferral of the 1st year reserve.