Chapter 4: Accounting: Methods and Interpretation

Question 1

2 Distinct methods used by general insurers to present their accounts

Answer 1

• annual (or accident year) accounts

- funded (or underwriting year) accounts

Question 2

Annual (or accident year) accounts

Answer 2

Consider all income earned and outgo incurred in a year

and permit the release of profits at the end of that year.

Question 3

Funded (or underwriting year) accounts

Answer 3

Consider the business written in each year

and do not permit the release of profits until the end of a subsequent year (usually the 3rd year)

Question 4

the term “accident year”

Answer 4

refers to a GROUPING of claims
… according to the year in which the LOSS EVENT ACTUALLY OCCURRED,

… irrespective of when they are reported or paid, and the year in which cover commenced.

Question 5

the term “underwriting year”

Answer 5

refers to a GROUPING of claims
… according to the year in which COVER COMMENCED,

… irrespective of when the loss event occurred, and when the claims are reported or paid.

Question 6

Annual accounting considerations:

Income

Answer 6

• earned premiums
• reinsurance recoveries received
• reinsurance recoveries accrued when the relevant claim has been paid

Question 7

Annual accounting considerations:

Outgo

Answer 7

• claims
• claims handling expenses
• other expenses paid
• reinsurance premiums
• changes in claims outstanding (incl. IBNR) in the accounting period

Question 8

Annual accounting considerations:

Assets

Answer 8

• deferred acquisition costs
• reinsurers’ share of unearned premium reserves
• reinsurers’ share of claims outstanding

Question 9

Annual accounting considerations:

Liabilities

Answer 9

• unearned premium reserve
• additional unexpired risk reserve
• claims outstanding

Question 10

3 components of profit for a given year

Answer 10

profit = money in - money out - increase in reserves

Question 11

4 components of “Money in”

Answer 11

• Gross premiums written
• Reinsurance and other recoveries
• Investment income on insurance funds
• Reinsurance commission received

Question 12

4 Components of “Money out”

Answer 12

• Gross claims paid
• Reinsurance premiums paid
• Expenses paid
• Commission paid

Question 13

3 components of “Increase in reserves”

Answer 13

• Increase in outstanding claims reserves
• Increase in unearned premiums
• Decrease in deferred acquisition costs

Question 14

The conventional format:

Underwriting result

Answer 14

Underwriting result = Premiums - Claims - Expenses + Increase in DAC

Question 15

The conventional format:

Insurance result

Answer 15

Insurance result = Underwriting result + Investment income

Question 16

Net premiums written (2 components)

Answer 16

net premiums written = gross premiums written - reinsurance premiums paid

Question 17

Net premiums earned (3 components)

Answer 17

net premiums earned =
net premiums written
+ unearned premiums brought forward (net of reinsurance)
- unearned premiums carried forward (net of reinsurance)

Question 18

net claims incurred (4 components)

Answer 18

net claims incurred =
gross claims paid
- reinsurance and other recoveries
+ outstanding claim reserve carried forward (net of reinsurance)
- outstanding claim reserve brought forward (net of reinsurance)

Question 19

Expenses (paid) (3 components)

Answer 19

net expenses =
commission paid
+ expenses paid
- reinsurance commission received

Question 20

The profit and loss account:

Profit before taxation

Answer 20

insurance profit
\+   other investment income
\+   profits from other activities
-    interest on loans
=   PROFIT BEFORE TAXATION

Question 21

The profit and loss account:

Retained profits

Answer 21

PROFIT BEFORE TAXATION
-    Taxation
=   PROFIT ATTRIBUTABLE TO SHAREHOLDERS
-    Dividends
=   RETAINED PROFITS

Question 22

The balance sheet:

Total assets

Answer 22

Fixed assets
+ Investments
+ Other current assets

= TOTAL ASSETS

Question 23

The balance sheet:

Shareholders’ net assets

Answer 23

TOTAL ASSETS
-   Current liabilities
-   Deferred taxation
-   Unearned premium reserve
\+  Deferred acquisition costs
-   Outstanding claims reserve
=  SHAREHOLDERS' NET ASSETS

Question 24

The balance sheet:

Shareholders’ funds

Answer 24

Share capital
\+   Share premium account
\+   Profit and loss account
\+   Revaluation reserve
=   SHAREHOLDERS FUNDS

Question 25

How is the revaluation reserve used

Answer 25

The revaluation reserve is increased each year by the net write up for unrealised gains.
If asset values fall sharply, the company might reduce the revaluation reserve.

Question 26

Share capital

Answer 26

The number of shares multiplied by the par value of each share

Question 27

Share premium account

Answer 27

The aggregate of the excess paid for the shares (when issued) above the share’s par value.

Question 28

Fixed assets

Answer 28

The basic items the company needs to operate, such as offices, vehicles and computer equipment.

Question 29

What problems might arise if assets are valued at full market market value in the balance sheet?

Answer 29

• The apparent financial strength would be very volatile (reflecting the volatility of market values)
• The financial strength would be overstated if the market values were on a “high”

Question 30

2 Key reasons why three-year accounting might be preferred to one-year accounting

Answer 30

• areas where underwriting years are fundamentally important (e.g. reinsurance / Lloyds)
• delays in premium and claims settlement

Question 31

Accounting principles:

Going concern

Answer 31

The enterprise will continue in operational existence for the foreseeable future.

Question 32

Accounting principles:

Accruals basis

Answer 32

Revenue and costs are recognised as they are earned or incurred, not as money is received or paid.

Question 33

Accounting principles:

Consistency

Answer 33

There is consistency of accounting treatment of like items within each accounting period and from one period to the next.

Question 34

Accounting principles:

Prudence and realisation

Answer 34

Revenue and profits are not anticipated (that is, they must be realised),

and provision is made for all known liabilities,

• whether the amount of these is known with certainty
• or is a best estimate in the light of the information available.

Question 35

Accounting principles:

Separate valuation of assets and liabilities

Answer 35

When determining the aggregate amount of any item,

the enterprise must determine separately the amount of each individual asset or liability that makes up that item.

Question 36

“Prudence”

Answer 36

The inclusion of a degree of caution in the exercise of the judgements needed in making the estimates required under conditions of uncertainty, such that gains or assets are not overstated and losses or liabilities are not understated.

Question 37

Underwriting profit (from the revenue account)

Answer 37

The excess of earned premiums over incurred claims and expenses.

Question 38

Insurance profit (from the profit and loss or revenue account)

Answer 38

The underwriting profit plus the investment income earned on the technical reserves.
The insurance profit represents the profit achieved through writing insurance business.

Question 39

Profit before tax (from the profit and loss account)

Answer 39

This is the insurance profit plus investment income from other assets (ie the free reserves).
This is the total profit earned by the shareholders’funds.

Question 40

Retained profit (from the profit and loss account)

Answer 40

This is the profit remaining after payment of tax and dividends.

Question 41

Total shareholders’ funds (from the balance sheet)

Answer 41

This is the excess of assets over liabilities. It is a measure of the financial strength of the company.

Question 42

Claim ratio

Answer 42

incurred claims /

earned premiums

Question 43

Expense ratio

Answer 43

expenses paid /

written premiums

Question 44

Commission rate

Answer 44

commission paid /

written premiums

Question 45

Combined ratio

Answer 45

Expense ratio + Claim ratio

a.k.a. operating or underwriting ratio

Question 46

Proportion reinsured

Answer 46

NET written premiums /
GROSS written premiums

(or alternatively, its compliment)

Question 47

Investment performance ratio

Answer 47

investment return /

average asset value during the year

Question 48

Return on capital

Answer 48

post-tax profit /

free reserves at the start of the year

Question 49

Solvency ratio

Answer 49

free reserves /

net written premiums

Question 50

Profit margin

Answer 50

Insurance profit /

net earned premium

Question 51

4 Key widely-used accounting concepts

Answer 51

• Consistency
• Going-concern
• Prudence and realisation
• Accruals basis
• Separate valuation of assets and liabilities

Question 52

Reports on accounting:

General point

Answer 52

These ratios are based upon published accounts. So the figures will be distorted due to the strength of the reserving basis and other accounting conventions, such as the treatment of depreciation and DAC.

For a sale and purchase we would need to consider accounts prepared on a realistic basis.

Question 53

Reports on accounting:

Points to include

Answer 53

• General point
• Growth in premium income
• Claim ratio
• Expense ratio
• Solvency ratio
• Asset/Liability ratio
• Return on capital employed
• Indication of the length of tail
• Investment return
• Taxation
• Dividends