7 – Accounting for Insurance Companies

Introduction:

Significant disparities in accounting for life insurance compared to other businesses stem from the long time interval between premium collection and claim payment. This necessitates the use of actuarial estimations of liability to determine life insurance companies’ solvency and profitability.

The terms whole-life, endowment, and maximum investment contracts, including unit-linked policies, annuities, pensions, and permanent health insurance, are all examples of life insurance products. In a for-profit insurance company, both policyholders and stockholders share in the company’s profits. Premiums can be paid as regular or recurring single premium. The actuary must account for mortality, interest, expenditures, and eventualities while determining premium rates, target profit and market competition. Accounting practices are required for premiums, death, maturity, surrender claims (including bonuses), and commissions (including deferred acquisition costs).

7.1 Different Types of Life Insurance Products

There are various sorts of life insurance products, which are detailed in the sub-sections below.

7.1.1 Term Life Insurance

Period insurance is designed to offer pure life cover and will pay out a reward if the policyholder dies during the policy term. The policy can be purchased for any length of time. If the policyholder dies within the policy period, the insurer pays the policyholder’s estate; if she or he survives, she or he receives nothing. Term insurance is a protection product frequently provided in conjunction with repayment mortgages to provide repayment protection.

7.1.2 Whole-Life Coverage

A whole-life policy has no specified term and will always pay a benefit (a contractual amount, adjusted for factors such as policy loans and dividends, if applicable) upon the insured’s death.

Example: Whole-life plans are occasionally used to give a benefit on death that allows beneficiaries to pay the estate’s Inheritance Tax Liability.

7.1.3 Endowment Security

An endowment assurance policy will pay the policyholder a lump sum after a specified time or upon death before the period is completed. In contrast to term and whole life insurance, the policyholder can get the payout. Endowment policies are commonly used as investment or savings vehicles.

Repayment of the principal amount owed on a mortgage is an example. Many whole life and endowment plans are created as ‘with-profit’ policies, which allow policyholders to share in corporate surpluses. In a private corporation, such surpluses are frequently shared 90 percent to policyholders and 10% to shareholders.

7.1.4 Contracts for Maximum Investment

Specific contracts, like unit-like policies, are designed to provide limited life insurance and are primarily investment instruments. Benefits may be paid in the form of a capital sum at maturity that is often partially guaranteed (they are typically subject to market value adjusters so that the return is reduced if the investment return obtained by the life company is insufficient to support the guarantee) or as income throughout the policy period. These products will compete directly with other medium-term deposits, such as building society deposits or unit trusts, as investments.

Policies Associated with Units: A unit-linked policy entails the policyholder purchasing units in a pooled investment fund, allowing them to participate directly in the underlying funds’ investment performance. The value of a specific fund of investments serves as the reference point for determining a unit-linked policy’s return. The contract’s performance is objectively tied to the investment performance of the fund’s investments rather than at the insurer’s discretion, so investment risk is passed on to the policyholder.

A unit-linked policy differs from a traditional policy in that a guaranteed percentage of each premium is allocated to units in the life fund; the capital growth, and frequently the income of the fund, is re-invested in the fund and is reflected in the increased value of the units; and the capital growth, and frequently the income of the fund, is re-invested in the fund, and is reflected in the increased value of the units. The total investment growth and income benefit the policyholder directly.

The basis of the charges levied by the life business is usually established at the commencement of any policy. Companies that only write unit-linked insurance are typically bank subsidiaries (‘bancassurers’).

7.1.5 Annuities

An annuity contract provides payments at regular intervals, beginning on a specific date and usually continuing until the policyholder’s death. The policy specifies the payment amount, which may be constant throughout the annuity period or increase at a predetermined rate.

7.1.6 Pensions

Pension policies entail paying recurring or lump sum premiums to provide a stream of income (beginning at retirement), with the option of paying a capital payment. These plans are essentially savings contracts that result in a deferred annuity and a capital payoff.

For example, premiums paid and investment income earned are tax deductible and tax-exempt.

7.1.7 Lifetime Health Insurance (PHI)

A perpetual health insurance policy provides income payments if the insured becomes ill. The contract determines the amount paid and may be fixed or increased, paid for a set period, or paid indefinitely.

7.1.8 Premiums

A premium is paid to the life office to ensure the benefit stipulated in the policy.

Premiums must be paid: Contracts with a single premium require the policyholder to pay a lump sum at the start of the contract term.

Contracts for regular premiums: Over the length of the policy, the policyholder is contractually obligated to make payments to the insurer at regular intervals, such as monthly or annually.

Single recurring premium: Neither the timing nor the amount are predetermined. Pension policies are frequently constructed to give the policyholder the most significant amount of freedom in making payments, for example, by referencing the level of his/her income in any given year.

The premium is calculated as follows: Insurance firms must determine a price for coverage that is sufficient to cover:

(a) the cost of any benefits paid to the policyholder,

(b) the commission paid to salespeople or intermediaries,

(c) the costs of running the policy and

(d) the desired profit.

The knowledge of a company’s actuary is required to calculate the premium level for a specific type of policy. When determining the level of premium, the actuary must examine four significant factors:

Mortality: The actuary refers to ‘mortality tables,’ which, based on them, can establish the proper premium to be charged to someone of a given age, gender, and state of health if the policy is sold to a sufficiently large number of policyholders.

For example, women have a higher life expectancy and, on average, pay cheaper premiums for life insurance.

For example, if a 55-year-old needs ‘2,000 coverage for a year, the premium for solely mortality risk may be ’23. However, for a 25-year-old, the required premium may be as little as ‘4. As a result of the growing likelihood of death with age, the 55-year-old policyholder pays a more significant premium.

As a result, if life insurance were purchased annually, premiums would have to rise yearly as the probability of the policyholder dying increased. In practice, such a system would be unworkable because

(a) as the policyholder gets older, the annual increases in premiums grow larger and larger until they become prohibitive and

(b) other factors, such as the policyholder’s general health, would be relevant to assess the life assured’s risk of dying in the next year. As a result, the insurance company would have to force the policyholder to submit to a medical checkup before setting yearly premiums. This would significantly increase the coverage costs, and premiums would have to be raised even more.

Investment Income: Premiums the firm obtains generate income through dividends and interest from the company’s shares and other investments. Further profit may occur from selling the shares at a higher price than originally paid. As a result, the actuary must examine expected future interest rates and account for them in the premium calculation.

Expenses: A margin must cover the life assurance company’s future insurance expenses. These include startup and renewal commissions for agents and brokers, overhead expenses, staff salaries, advertising, etc. The expense loading to a premium is not simply a question of distributing the entire costs to each policyholder because no two policies generate the same types or amounts of expenses. As a result, the expenditure loading must reflect the costs incurred due to the specific type of coverage in an equal manner.

Actuaries are very conservative in their estimates of mortality, interest, and expenses. They incorporate a contingency component to provide a safety margin to meet unexpected results. They also account for the likelihood of policy lapses or early surrenders before the conclusion of the term.

In conclusion, the actuary will consider the following factors in determining premium rates:

1. The sum assured;
2. The age of the policyholder, his/her general health and lifestyle, e.g. Smoker/non-smoker;
3. Future investment returns;
4. Future expense levels in administering the policy;
5. Allowance for contingencies given the uncertainties involved;
6. The target profit;
7. The price at which other companies sell similar products.

7.2 Insurance Accounting

The accounting for insurance is described using the following concepts:

7.2.1 Premiums

Premiums are classified into two types:

Premiums: Ongoing: The following accounting entries would be made to recognise a ’50 renewal premium on regular premium insurance in the month in which the premium is due:

Policyholder/Intermediary Debtor (Balance sheet)              Dr                50

Premiums Written (Technical Account)                                                              50

When the premium is received the following entries will be made:

Cash                                                                         Dr                50

Policyholder/Intermediary Debtor                                                                     50

Suppose a debit balance remains on the policyholder/intermediary debtor account. In that case, this will indicate that a premium has not been received, and either the policy may have lapsed, or the intermediary has not yet settled the account.

Single Premiums and Initial Premiums: Under these cases cash is usually required when the policy proposal is made, and the accounting entry would be:

Cash                                                                         Dr                50

Premiums Written                                                                                   50

 

7.2.2 Claims

The amount of the claim paid to the policyholder is determined by the type of policy signed, whether it is without or with profit. It is paid upon death or the maturity of an endowment policy.

Without-profit Policies: The policyholder’s (or his/her estate’s) only benefit is the payment of the sum promised. The policy’s original provisions set this sum.

Policies Concerning Non-profit Organizations: This phrase refers to insurance where policyholders can share any generated surpluses. Thus, the claim amount is determined by the following factors:

1. Investment performance;
2. Expenses;
3. Mortality experience;
4. Rate of policy lapses or surrenders; and

As a result, the policyholder carries the majority of the risk, and any guaranteed sum promised only represents a small percentage of the claim.

Policies Linked to Units: The claim amount is calculated using the value of the chosen fund of investments.

Terminal and reversionary bonuses: In addition to the guaranteed death benefits, assurance companies pay ‘with-profits’ policyholders’ bonuses during the policy duration, which allocates surplus from the life fund. Bonuses are often divided into two types: reversionary bonuses and terminal bonuses. During the policy term, reversionary bonuses are usually declared annually as a percentage of the sum assured (simple reversionary bonuses) or as a percentage of the total promised and previously declared bonuses (combined reversionary bonuses) (compound reversionary bonuses). They boost policyholders’ claim entitlement but are paid only when a claim is made. Terminal bonuses are given in addition to regular reversionary bonuses and are exclusively assigned to policies that become claims due to death or maturity.

Some assurance policies feature ‘guaranteed bonuses,’ which are contractual obligations authorised to set the original premium and are not strictly bonuses.

Surrenders: Because many assurance policies are utilised as a savings vehicle in part or whole, policyholders may desire to discontinue premium payments, so the insurer includes a provision in the contract for its surrender for a cash sum before the conclusion of the policy term. In most cases, the amount payable will be less than the total premiums already paid by the policyholder.

Taking Account of Death Claims: The assurance company will be notified of a policyholder’s death. For example, if the promised sum is £2,000, the insurer will immediately make a provision for this amount.

Claims Paid (Technical Account)                                          Dr                2,000

Claims Outstanding (Balance Sheet)                                                       2,000

The company will then require a death certificate before paying the beneficiaries. Once this is received, the following entries will be made:

Claims Outstanding (Balance Sheet)                                   Dr                2,000

Cash                                                                                             2,000

No accounting entries will usually be made for surrenders or maturity until the payment is authorised. For example, a £1,000 surrender or maturity would be:

Claims Paid (Technical Account)                                          Dr                1,000

Cash                                                                                             1,000

Although the maturity date may have been anticipated, no liability entry is made in the accounts because the amount will already be allowed for in the actuarial estimate of the ‘technical’ provision for the long-term business.

7.2.3 Commissions

Brokers or agents (‘intermediaries’) are given commissions as an incentive to sell policies and maintain and increase the life company’s business. They are usually very high, ranging from 5% to more than 100% of the premiums. As a result, commission can be a significant expense in the life company’s technical account.

There are two kinds of commissions: the first on new policies and the renewal commissions for subsequent periods. The commission provided to the agents is paid as a big upfront payment, but the insurer has the right to recover some of this money if the policy lapses during the time during which the commission is earned.

Accounting Methodology for Initial Commissions: Example: An agent sells insurance, and the policyholder’s monthly premium payments are £25 each month. The agent gets paid a commission of 115 percent of the annual premium value. Because the policyholder pays the first month’s premium, the commission is accounted for as follows:

Deferred Acquisition Costs (Balance Sheet)                        Dr                345

Due to intermediaries (Balance Sheet)                                                   345

The asset for the commission would be written off to the technical account over an appropriate period. The monthly entry required would be:

Acquisition Costs (Technical Account)                                 Dr                28.75

Deferred Acquisition Costs                                                                      28.75

When the agents are paid, the entry is as follows:

Due to intermediaries                                                         Dr                345

Cash                                                                                             345

 

Following the passage of the EU Insurance Accounts Directive, companies are now obligated to delay acquisition expenses throughout the policy, resulting in a more gradual change to the technical account.

7.2.4 Reinsurance

Firms typically ‘lay off’ a portion of the risk by reinsuring with other insurance companies or specialist reinsurance companies. The accounting for reinsurance premiums paid, claims reimbursements received, and commissions paid is nearly identical to the accounting for direct insurance.

7.3 Accounting for Insurance

Certain fundamental insurance accounting principles include: Loss and loss adjustment expenditure accounting fundamentals, Reinsurance accounting fundamentals, Deposit accounting fundamentals

7.3.1 Accounting for Losses and Loss Adjustment Expenses

The phrases “loss” and “claim” are used interchangeably throughout the following, as are “liability” and “reserve.” The author knows that language differs by jurisdiction, company within a jurisdiction, and even within the same company. As a result, the student should confirm using this terminology in their corporate context. This debate also focuses solely on losses rather than losses and loss adjustment charges, though much of it also applies to loss adjustment expenses.

Accounts for losses: The following are the basic accounting transactions involving losses:

• Claims payment
• Claims reserves can be increased or decreased.

These two items have an impact on the income statement because of incurred losses, which equal paid claims (or “losses”) plus the change in loss reserves, or Paid losses minus incurred losses equals total losses (ending loss reserves – beginning loss reserves)

A company’s ledger may contain many loss reserve accounts. As several jurisdictions require that these amounts be disclosed separately in annual financial reports, all companies’ ledgers will generally include the categories of case reserve (the estimate of unpaid claims established by a claim adjuster or the claim system) and IBNR (the reserve for “Incurred but Not Reported” claims).

Bulk Reserve: This reserve represents the estimated deficiency in the aggregate of case reserves for known claims. If forced to choose between case reserves and IBNR reserves, some will choose case reserves because they represent reserves for claims that have already been reported. Others will attribute it to IBNR since it represents an aggregate calculation above claim adjuster estimates that cannot be appropriately assigned to a single claim.

Additional Case Reserve: This is an additional reserve for an individual claim put up in addition to the level set up by the claim adjuster. It is most commonly used for claims under assumed reinsurance contracts, where the case reserve is provided directly by the ceding company because it allows the assuming company to record a different estimate for the value of a claim than the ceding business.

Companies may or may not build up loss reserve accounts for reopened claims, anticipated subrogation or salvage recoveries, deductible recoveries (where the insurer pays the full loss and then bills the insured for the deductible), expected legal defence costs, and so on.

It should be noted that the amounts listed above could be positive or negative. Bulk reserves, for example, could be harmful if case reserves are expected to be redundant in aggregate. Case reserves for a claim may be detrimental if it is assumed that the amount paid-to-date on a claim is more than the final value and that some future recovery of paid amounts is envisaged.

The Loss Cycle: In most cases, incurred losses are presented in financial statements in two parts: the initial estimate of incurred losses for the most recent exposure period and modifications in the estimate of incurred losses for past periods. In summation, this can be translated into:

• Losses incurred for the current accident year
• Estimated incurred loss changes for previous accident years.

There are also two broad methods for initial recognition of losses for the current accident year: those based on actual claim activity and those based on accrual of estimated incurred losses based on earned exposure level. The graph below depicts the life-cycle of incurred claims for each technique, first when initial reserves are based on actual claim activity and subsequently when initial reserves are estimated based on estimated earned exposure.

Claim activity in the field: The incurred losses for the most recent exposure period are set initially based on actual claim activity, with possible additional loss reserves built to account for IBNR claims or any predicted deficiency/redundancy in claim adjuster reserves. Changes in claim adjuster estimates immediately affect incurred losses in succeeding valuations of the same group of claims, and aggregate reserves such as bulk and IBNR reserves are run off over time based on historical data studies or other actuarial studies.

The following chart shows the accounting entries for claims for a fictional company/line of business during January 2011, from initial valuation through final payment.

In the following example, the following (oversimplified) assumptions were made:

• All claims are reported within four months of the occurrence of the loss.
• The total premium earned for the month is ‘100.
• Each claim is worth ’10, with half paid in the reporting month and the other half paid in the following month.
• The initial IBNR is set at 30% of the earned premium and is deducted evenly over the next three months.
• There is no need for a bulk reserve (beyond that which may be implicit in the IBNR calculation).

Example 1: When reserving is based on actual claim activity from the outset.

Assume

• All claims are reported within four months of the occurrence of the loss.
• The total premium earned for the month is ‘100.
• Each claim is valued at ’10, with half paid in the month of reporting and half paid in the following month. Case reserves are set at ’10 after the claim is recorded.
• The initial IBNR is set at 30% of the earned premium and is deducted evenly over the next three months.
• There is no need for a bulk reserve (beyond that which may be implicit in the IBNR calculation).

Setting initial reserves for an exposure period based on actual activity is common, where most claims are recorded and settled very rapidly, such as for particular property lines in many jurisdictions. Such a strategy is not feasible if claims are reported slowly and/or initial claim adjuster estimates are not sufficiently trustworthy predictors of the final payout.

It is typical to base the initial incurred loss estimate on an “a priori” estimate of loss exposure for the period for product lines with delayed reporting and/or payment patterns or if the initial case reserves are less accurate at initial valuation. The following is an example of such a method: the initial estimate of incurred losses is based on an expected loss ratio multiplied by the earned premium.

Estimated incurred losses are accrued based on the level of earned exposure. In the following example, the following (oversimplified) assumptions were made:

• Claim activity is tracked, and reserves are established based on the year of the accident.
• The earned premium for the 2012 calendar year is’1,000 per month.
• Based on examining pricing and loss patterns and planned underwriting, management anticipates a 60 percent loss ratio for the 2012 accident year.
• Case and IBNR are the only two loss reserve accounts that are kept.

These two reserve accounts are further divided into two AY buckets, the current AY (in this case, 2012) and all preceding.

In this example, management calculates the incurred losses for the current AY based on the earned premium for the period. It conducts frequent reserve checks to assess whether earlier accident year projections should be revised. In the picture, the estimate for previous years has changed.

Example 2: Setting a reserve in June 2012.

Step 1 – Determine Incurred Losses
AY 2012
June 2012 earned premium	1,000	a
Expected loss ratio	60%	b

Incurred losses	600			c	Source
All prior years
Change in prior estimate of ultimate incurred losses	500			d
Step 2 – Determine IBNR reserves
	AY 2012	All prior	Total
May 31, 2012 case reserves	500	4,800	5,300	e	ledger
May 31, 2012 IBNR	900	5,300	6,200	f	ledger
May 31, 2012 total reserves	1,400	10,100	11,500	g	(e) + (f)
–   paid losses in June 2012	100	400	500	h	ledger
+  incurred losses in June 2012	600	500	1,100	i	(c) and (d)
June 30, 2012 total reserves	1,900	10,200	12,100	j	(g) – (h) + (i)
June 30, 2012 case reserves	700	4,750	5,450	k	ledger
June 30, 2012 IBNR reserves	1,200	5,450	6,650	l	(j) – (k)

 

It is feasible for an insurer to utilise one of the aforementioned approaches for sure of its lines of business while using the other strategy for others. It may employ both approaches on the same line, reserving based on a loss ratio times earned premium early in an accident year and then shifting to reserving based on real claim experience after the actual claim data becomes more reliable. It may also choose to utilise one strategy for specific loss kinds and another for others for the same product line. Unless applicable accounting standards and/or insurance laws/regulations require a particular estimation of reserve method, the choice is usually open to the insurer.

Discounted reserves must be accounted for: The use of discounted reserves raises its challenges when developing an accounting system because the ultimate paid losses will be reported at nominal value, which is more than the recorded discounted loss reserves. As a result, the accounting system must decide how to treat the rise in the reserve owing to discount amortisation.

In many countries, the current practice is to report the increase due to discount amortisation as incurred losses. If not accompanied by sufficient disclosure, this may appear as reserve strengthening in some reports.

The income statement impact of rising loss reserves due to discount amortisation can be recorded as interest expenditure, an alternative option (not extensively used in insurance loss accounting). If interest expense is reported with interest revenue, incurred losses will remain at the initial discounted value unless incurred loss estimations alter. It would also result in lower investment income than is currently achieved in many insurance accounting systems.

7.3.2 Reinsurance Accounting Fundamentals

It contains the following ideas:

Assumed Accounting for reinsurance: Generally, the accounting requirements for insurers who write direct insurance contracts also apply to those who write assumed reinsurance contracts. However, there may be changes from time to time, such as various risk transfer procedures and different definitions of loss versus loss expense.

Expense for loss adjustment: Legal defence costs are commonly covered in reinsurance contracts covering tort liability insurance risks. These are usually categorised as loss adjustment expenses and are frequently reported separately from ceding company losses. On the other hand, the assuming corporation may record such charges as assumed losses on its books.

Accounting for ceded reinsurance: There are now two general approaches to ceded reinsurance accounting:

1. Treating ceded reinsurance entries as negatives of direct or assumed reinsurance entries, or
2. Treating reinsurance purchase as an asset purchase.

These methodologies may be blended into a single accounting system at times.

Example 3: Under US GAAP, ceded reinsurance premiums and losses are treated as negative premiums and losses on the income statement, but ceded loss reserves are treated as an asset rather than as an offset to a liability on the balance sheet.

The example below assumes that the relative entries in an account are combined to obtain a total. For instance, if a corporation writes $100 in direct premium and later cedes $10 in premium, the premium entries are +’100 and –’10. These numbers are then ADDED to obtain the net value of ’90. Some accounting systems record ceded entries as positive values and always deduct ceded values when calculating account totals. The premium entries in such a system would be + ‘100 and + ’10, and the information user would need to know how to SUBTRACT ceded amounts from direct and assumed amounts.

Example 4: The impact of ceded reinsurance on the income statement, assuming it is treated as adverse insurance.

Assume the corporation has (and has always maintained) quota shares of the ceded reinsurance contract with a ceding commission of 30% for all direct insurance.

Assume the direct business loss ratio is 65% and the sole direct expense is a 30% commission.

Assume the direct earned premium for the year is $100, and the direct loss reserve is $200 at the end of the year.

Income Statement

Direct Earned Premium	$100
Ceded Earned Premium	-20
Net Earned Premium	80
Direct Incurred Losses	$ 65
Ceded Incurred Losses	-13
Net Incurred Losses	$ 52
Direct Commissions	$ 30
Ceded Commissions	-6
Net Commissions	24
Net underwriting income	$ 4
Balance Sheet
Direct Loss Reserve	$200
Ceded Loss Reserve	-40
Net Loss Reserve	160

 

If the accounting requires separate reporting of the impact of ceded reinsurance, it may be necessary to treat it as a net expense in the computation of underwriting income. In the preceding case, the net cost of ceded reinsurance would be (equivalent to an earned premium cost of 20, with fewer recoveries of 13 for losses and expenditures).

Example 5: For balance-sheet purposes, treat ceded reinsurance as a purchase of an asset (such as under U.S. GAAP)

Consider the same facts as in Example 4 but with a different balance-sheet treatment. The Balance Sheet

Assets                               Liabilities

Ceded Loss Reserve         $40     Direct Loss Reserve          $200

Reinsurance reporting lags: Reinsurance treaties include wording requiring the ceding firm to report to the assuming business. These reports fulfil several functions. One is to carry out the contractually required paid transactions by the policy terms, such as ceded premiums and losses. Another goal is to provide the assuming firm with enough information to conduct its reserve analysis (either for the specific contract or contract claims or the assuming company’s portfolio of contracts or claims). A third goal is for the assuming firm to be able to meet its accounting obligations.

These reinsurance reports might be filed and received with severe delays. The lags could be caused by the time the ceding firm takes to collect the data that needs to be reported. They could also result from the requirement to coordinate input from numerous parties, such as when the ceding company is a pool, and the pool administrators must first collect necessary data from all pool members before sending reports to the pool reinsurers. Numerous handoffs and consolidations can also cause delays, as in some retrocession contracts where ceding firms must first report to their reinsurers, who must then process the data before sending their report to retrocession Aires (with multiple layers of retrocession Aires being possible). Higher-level retrocession contracts involving parties from different countries and/or continents have been subject to multi-year delays.

Some accounting paradigms require the assuming company to record anticipated transactions with significant lags and money amounts. Based on anticipated or previous experience, this may entail documenting estimated premiums, losses, and expenses (including estimated “paid” losses). Once the actual numbers are known or improved estimates are obtained, these estimations can be trued up.

7.3.3 Accounting for Deposits

A contract’s deposit accounting follows typically the following rules:

• Even if the resulting contract-by-contract amounts are disclosed in financial reports on a summary basis, the accounting is done on an individual contract-by-contract basis, not on a portfolio basis.
• The amount(s) received for a contract is recorded as a deposit liability, with no impact on revenue or expense (and therefore no impact on income).
• Fresh receipts and, in most cases, investment income credits increase the deposit liability, while payments diminish it.
• As a result, the deposit represents the present value of future payment commitments.
• Under the following scenarios, deposit accounting may be required by the accounting paradigm for what would otherwise be an insurance (or reinsurance) contract:
• There is no risk transfer.

Only timing risk is transferred, but no amount of risk is transferred – that is, the amount to be paid until the contract is fixed or subject to low uncertainty. Still, there is uncertainty about the timing of the payment.

• Subject to exclusions, retroactive reinsurance is available.
• Bank deposit methods, prospective approaches, and retrospective approaches are the three general types of deposit accounting that can currently be observed.

Bank Deposit Method: This is the most basic of the three deposit accounting methods to be described. Under this technique, the initial deposit grows with credited interest at a predetermined rate (and possibly with further deposits depending on the contract terms) and decreases with withdrawals. The defining feature is that the beginning balance exclusively determines the ending deposit for a reporting period, the period’s credited rate, and any deposits or withdrawals made during the period. The credited rate might be fixed or variable, based on market rates or non-market events or rates, but the calculation mechanism is usually predetermined.

Prospective Strategy: This approach’s distinguishing feature is that the current value of the deposit is set equal to the present value of future payments, regardless of the initial deposit or previous payments. The interest rate is typically a market rate, which may be based on risk-free rates and may be fixed at the outset so that it does not alter over time. (A prospective technique may theoretically employ a market rate adjusted for each reporting period.)

The deposit value will change as interest is amortised, and estimated future losses will alter under this approach (and with a change in the discount rate if the accounting paradigm does not lock in the rate).

The defining feature of the retrospective approach is that the deposit is a function of the initial deposit, all past payments, and the present estimate of all future payments. The interest rate used in this strategy is the rate at which the discounted value of previous and expected future payments equals the initial deposit. The interest rate can change anytime the contract’s expected cash flows change. If used in a contract, this strategy could produce a negative rate where the expected outflows no longer exceed the initial inflows. Whereas the prospective approach is only concerned with the future (except an interest rate lock-in in the past), the retrospective approach is concerned with all flows since inception, both past and future.

The deposit value and discount rate are subject to alteration under this technique if the predicted cash flows since inception vary.

Illustration 1

XYZ Insurance Company

Impact of Large Line Capacity Treaty

Balance Sheet		Without	With
Assets
Bonds		2,575	2,663
Cash		75	113
Agents Balances		100	140
Total		2,750	2,915
Liabilities
Loss Reserves	Gross	750	1,125
	Cede	0	300
	Net	750	825
Unearned Premium	Gross	500	700
	Cede	0	150
	Net	500	550
Ceded Agts. Balances		0	30
Total		1,250	1,405
Surplus		1,500	1,510
Income Statement (net of reinsurance)
Earned Premium		1,000	1,100
Incurred Losses		750	825
Expenses		200	220
Underwriting Income		50	55
Investment Income		133	139
Total income		183	194
Other Financial Statistics
Written Premium               Gross		1,000	1,400
Cede		0	300
Net		1,000	1,100

 

Gross WP/Surplus	67%	93%
Net WP/Surplus	67%	73%
Gross Loss Res./Surpl.	50%	75%
Net Loss Res./Surpl.	50%	55%
Ceded balances/Surplus	0%	30%

 

Illustration 2: ABC I insurance Company Impact of Catastrophe Protection Treaty

	No Cat. event		Yes Cat. Event
Balance Sheet	Without	With	Without	With
Assets
Bonds	2,575	2,525	2,480	2,430
Cash	75	75	120	120
Agents Balances	100	100	100	100
Total	2,750	2,700	2,700	2,650
Liabilities
Loss Reserves       Gross	750	750	1,200	1,200
Cede	0	0	0	400
Net	750	750	1,200	800
Unearned Premium                              Gross	500	500	500	500
Cede	0	0	0	0
Net	500	500	500	500
Ceded Agts. Balances	0	0	0	20
Total	1,250	1,250	1,700	1,320
Surplus	1,500	1,450	1,000	1,330
Income Statement (net of reinsurance)
Earned Premium	1,000	950	1,000	930
Incurred Losses	750	750	1,250	850
Expenses	200	200	200	200
Underwriting Income	50	0	-450	-120
Investment Income	133	130	130	128
Total income	183	130	-320	8
Other Financial Statistics
Written Premium    Gross	1,000	1,000	1,000	1,000
Cede	0	50	0	70
Net	1,000	950	1,000	930
Gross WP/Surplus	67%	69%	100%	75%
Net WP/Surplus	67%	66%	100%	70%
Gross Loss Res./Surpl.	50%	52%	120%	90%
Net Loss Res./Surpl.	50%	52%	120%	60%
Ceded balances/Surplus	0%	0%	0%	30%