🏦Financial Services Reporting Unit 5 – Insurance Company Financial Reporting

Key Concepts and Terminology

• Insurance companies prepare financial statements to provide information about their financial position, performance, and cash flows
• Key financial statements include the balance sheet, income statement, statement of comprehensive income, statement of changes in equity, and statement of cash flows
• Insurance contracts are agreements where the insurer accepts significant insurance risk from the policyholder by agreeing to compensate them if a specified uncertain future event adversely affects the policyholder
• Premiums are the amounts charged by insurance companies for providing insurance coverage
  • Premiums are recognized as revenue over the period of the insurance contract
• Claims are the amounts paid or payable by the insurer to the policyholder for covered losses or events
• Reserves are liabilities established by insurers to cover future obligations arising from insurance contracts (unearned premiums, claims incurred but not reported)
• Reinsurance is a risk management tool where an insurer transfers a portion of its risk to another insurer (reinsurer) to reduce exposure and manage capital
• Solvency refers to an insurer's ability to meet its long-term financial obligations and is a key focus of insurance regulation

Regulatory Framework for Insurance Reporting

• Insurance companies are subject to extensive regulation to ensure financial stability, protect policyholders, and maintain market confidence
• Regulatory bodies (National Association of Insurance Commissioners in the US) establish accounting and reporting standards for insurers
• Solvency regulation focuses on ensuring insurers maintain sufficient capital to meet their obligations and withstand adverse events
  • Risk-based capital (RBC) requirements are used to assess an insurer's capital adequacy relative to its risk profile
• Statutory accounting principles (SAP) are accounting rules prescribed by insurance regulators that emphasize solvency and policyholder protection
  • SAP differs from generally accepted accounting principles (GAAP) used by non-insurance companies
• Insurers are required to file periodic financial statements (annual statements, quarterly statements) with regulators to demonstrate compliance and financial health
• Regulatory examinations and audits are conducted to verify the accuracy and completeness of insurance financial reporting

Financial Statement Components

• The balance sheet presents an insurer's financial position at a specific point in time, showing assets, liabilities, and equity
  • Assets include investments (bonds, stocks, real estate), premiums receivable, and reinsurance recoverables
  • Liabilities include reserves for unpaid claims, unearned premiums, and policyholder dividends
• The income statement reports an insurer's financial performance over a period, presenting revenues, expenses, and net income
  • Revenues include premiums earned, investment income, and realized capital gains
  • Expenses include claims incurred, policy acquisition costs, and general administrative expenses
• The statement of comprehensive income includes net income and other comprehensive income items (unrealized investment gains/losses, foreign currency translation adjustments)
• The statement of changes in equity shows the changes in an insurer's equity during a period, including net income, dividends, and other equity transactions
• The statement of cash flows presents the inflows and outflows of cash and cash equivalents, categorized into operating, investing, and financing activities

Accounting for Insurance Contracts

• Insurance contracts are accounted for differently than other financial instruments due to their unique characteristics and risks
• Short-duration contracts (property and casualty insurance) are accounted for using the deferral and matching approach
  • Premiums are recognized as revenue over the coverage period, and claims are expensed when incurred
  • Unearned premium reserves are established for the portion of premiums related to future coverage periods
• Long-duration contracts (life insurance, annuities) are accounted for using the long-term actuarial approach
  • Assumptions about mortality, morbidity, investment returns, and expenses are used to calculate reserves and premiums
  • Premiums are recognized as revenue when due, and benefits and expenses are matched with premiums
• Claim reserves are established for both reported claims and incurred but not reported (IBNR) claims based on actuarial estimates
• Deferred acquisition costs (DAC) are capitalized and amortized over the life of the insurance contracts, representing the costs of acquiring new business

Valuation of Assets and Liabilities

• Insurers' assets and liabilities are valued using methods that reflect their unique characteristics and risks
• Investments are typically valued at fair value, with changes in fair value recognized in the income statement or other comprehensive income
  • Bonds are valued using market prices or discounted cash flow models
  • Stocks are valued at market prices
  • Real estate is valued using appraisal techniques
• Reserves for unpaid claims are estimated using actuarial methods that consider historical claim experience, trends, and other relevant factors
  • Claim development triangles are used to analyze the pattern of claim payments over time
  • Discounting is applied to reserves for long-tail lines of business to reflect the time value of money
• Reserves for life insurance and annuity contracts are calculated using actuarial models that incorporate assumptions about mortality, morbidity, interest rates, and expenses
• Reinsurance recoverables are valued based on the terms of the reinsurance contracts and the financial strength of the reinsurers

Revenue Recognition and Expense Allocation

• Insurers recognize revenue and allocate expenses in a manner that reflects the earning process and the matching of revenues and expenses
• Premiums are recognized as revenue over the coverage period of the insurance contracts
  • Unearned premiums are deferred and recognized as revenue as the coverage is provided
• Investment income is recognized as earned, with realized capital gains and losses recognized when investments are sold
• Claim expenses are recognized when incurred, including estimates for IBNR claims
• Policy acquisition costs (commissions, underwriting expenses) are deferred and amortized over the life of the contracts as DAC
• General and administrative expenses are expensed as incurred and allocated to various business segments and products based on appropriate methodologies (premium volume, claim counts)

Reinsurance and Its Impact on Reporting

• Reinsurance transactions impact an insurer's financial statements by transferring risk and altering the recognition of revenues, expenses, assets, and liabilities
• Ceded reinsurance premiums are treated as a reduction of revenue, while ceded claims are treated as a reduction of expenses
• Reinsurance recoverables are recorded as assets, representing amounts due from reinsurers for their share of claims and expenses
• Ceded unearned premiums and ceded claim reserves are recorded as reductions to the corresponding liability accounts
• Commissions received from reinsurers (ceding commissions) are recorded as a reduction of DAC or as income, depending on the terms of the reinsurance contract
• The effectiveness of reinsurance in transferring risk is evaluated to determine the appropriate accounting treatment (prospective or retroactive reinsurance)

Analysis and Interpretation of Insurance Financial Statements

• Analysis of insurance financial statements involves assessing an insurer's financial strength, profitability, liquidity, and risk management practices
• Key ratios used in insurance financial analysis include:
  • Loss ratio: claims incurred divided by premiums earned, measuring underwriting profitability
  • Expense ratio: expenses divided by premiums written, measuring operational efficiency
  • Combined ratio: loss ratio plus expense ratio, measuring overall underwriting profitability
  • Investment yield: investment income divided by average invested assets, measuring investment performance
  • Return on equity (ROE): net income divided by average equity, measuring overall profitability
• Trend analysis involves comparing an insurer's financial results over time to identify improvements or deterioration in performance
• Comparative analysis involves comparing an insurer's financial results to industry benchmarks or peer companies to assess relative performance
• Liquidity analysis assesses an insurer's ability to meet short-term obligations by examining cash flows, liquid assets, and access to funding sources
• Solvency analysis evaluates an insurer's ability to meet long-term obligations by examining capital adequacy, reserve adequacy, and asset quality