Chapter 4: Accounting: methods and interpretation Flashcards
Distinct methods used by general insurers to present their financial accounts
- annual (accident year) accounts
- funded (underwriting year) accounts
Annual (or accident year) accounts
Consider all income earned and outgo incurred in a year and permit the release of profits at the end of that year.
Based on the cover provided during the accounting period, regardless of when the contracts of insurance start or end.
Funded (underwriting year) accounts
Consider the business written in each year and do not permit the release of profits until the end of a subsequent year (usually the third year).
Based on the contracts starting during the accounting period, regardless of the periods of cover provided.
Accident year
Refers to grouping of claims according to the year in which the loss event actually occured, irrespective of when they are reported or paid or the year in which cover commenced.
Under funded accounting, we considered the business written in each year and could not release profits until the end of three years for:
- Llyod’s when we calculate the RITC and released profits to Llyod’s Names
- companies when we calculate the emerging profit
- underwriting and reserve risk, which may be reduced to reflect investment income that’ll be earned on assets held against reserves and on premiums received in relation to the proposed and prior underwriting years.
Underwriting year
Refers to grouping of claims according to the year in which cover commenced, irrespective of when the loss event occured and when the claims are reported/paid
Annual accounting considerations
Income
- eaned premiums
- reinsurance recoveries received
- reinsurance recoveries accrued when the relevant claim has been paid
Annual accounting considerations
Outgo
- claims
- claims handling expenses
- other expenses paid
- changes in claims outstanding (incl. IBNR) in the accounting period
- reinsurance premiums
Annual accounting considerations
Assets
- deferred acquisition costs
- reinsurer’s share of unearned premium reserve
- reinsurer’s share of claims outstanding
Annual accounting considerations
Liabilities
- uearned premium reserve
- additional unexpired risk reserve
- claims outstanding
Annual accounting considerations
Debtor and creditor balances
- reflect outstanding payments due to or from policyholders, brokers and reinsurers
Technical account
AKA revenue account
Shows the basic trading profit from writing insurance business for a given period.
Components of profit for a given year
profit = money in - money out - increase in reserves
Main components of “Money in”
- gross premiums written
- reinsurance and other recoveries
- investment income on insurance funds
- reinsurance commission received
Main components of “Money out”
- gross claims paid
- reinsurance premiums paid
- expenses paid
- commission paid
Main components of “Increase in reserve”
- increase in outstanding claims reserve
- increase in unearned premiums
- decrease in deferred aquisition costs
Conventional format
Underwriting result
Underwriting result = Premiums - Claims - Expenses + Increase in DAC
Conventional format
Insurance result
Insurance result = Underwriting result + Investment income
Net premiums written
net written premiums =
gross premiums written
- reinsurance premiums paid
Net premiums earned
net premiums earned =
net premiums written
+ unearned premiums brought forward (net of reinsurance)
- unearned premiums carried forward (net of reinsurance)
net claims incurred
net claims incurred =
gross claims paid
- reinsurance and other recoveries
+ outstanding claim reserve carried forward (net of reinsurance)
- outstading claim reserve brought forward (net of reinsurance)
Net expenses
Net expenses =
commission paid
+ expenses paid
- reinsurance commission received
Profit and loss account
Profit before tax
insurance profit
+ other investment income
+ profts from other activities
- interest on loan
= PROFIT BEFORE TAXATION
Profit and loss account
Retained profits
PROFIT BEFORE TAXATION
- taxation
= PROFIT ATTRIBUTABLE TO SHAREHOLDERS
- dividends
= RETAINED PROFITS
Profit and loss account
Important note on investment income
The treatment of investment income gives rise to inconsistencies between different companies - consider it investment income on the insurer’s free reserves.
Investment income on technical reserves has already been included in the insurance profit
Balance sheet
Total assets
fixed assets
+ investments
+ other current assets
= TOTAL ASSETS
Balance sheet
Shareholder’s net assets
TOTAL ASSETS
- current liabilities
- deferred taxation
- unearned premium reserve
+ deferred aquisition cost
- outstanding claims reserve
= SHAREHOLDERS’ NET ASSETS
Balance sheet
Shareholders’ funds
share capital
+ share premium account
+ profit and loss account
+ revaluation reserve
= SHAREHOLDERS’ FUNDS
How is the revaluation reserve used
AKA investment reserve
It is increased each year by the net write up for unrealised gains. If asset values fall sharply, the company might reduce the revaluation reserve
Share capital
The number of shares multiplied by the par value of each share
Share premium account
The aggregate of the excess paid for the shares (when issued) above the share’s par value
Fixed assets
Include basic items the company needs to operate, such as offices, vehicles and computer equipment.
What problems may arise if assets are value at full market value in the balance sheet?
- The company’s apparent financial strength would be very volatile - reflect volatility of market values
- The company’s financial strength would be overstated if the market values were on a “high” - not prudent
Funded (three-year) accounting
Closing an account year
The convention at Lloyd’s is to pay a premium to another account to pass on (or reinsure) these liabilities. Called reinsure to close (RITC)
Key reasons why three-year accounting might be preferred to one-year accounting
- fundamentally important underwriting years
- delays in premium and claim settlement
Converting underwriting year records into annual accounts
Claims outstanding calculated by underwriting year include amounts from incidents already reported and amounts in respect of claims on events that will occur in future accounting periods
Should reduce estimated claims outstanding so that only cover events up until the end of the accounting period
Need to set up a UPR in respect of claims yet to occur on policies that have been written but not yet fully earned
Usually do this in proportion to earned premiiums - may need to adjust for abnormal loss experience that aren’t expected to occur in future
Need to add in claims arising from incidents occuring in the year in question but in respect of policies written in earlier years.
Why are apparent profits and underlying profits not the same?
- factors determining true profitability are unknown when accounts are put together. Apparent profit disclosed is highly dependent on estimates of future claim payments, expenses, etc.
- profits declared are a function of the particular accounting basis used. True underlying profitability of business is not directly affected by the accounting basis
Going concern
Accounting principle
The enterprise will continue in operational existence for the foreseeable future
Accrual basis
Accounting principle
Revenue and costs are recognised as they are earned or incurred, not as money is received or paid.
Consistency
Accounting principle
There is consistency of accounting treatment of like items within each accounting period and from one period to the next.
Prudence and realisation
Accounting principle
Revenue and profits are not anticipated (that is, 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.
Seperate valuation of assets and liabilities
Accounting principle
When determining the aggregate amount of any item the enterprise must determine seperately the amount of each individual asset or liability that makes up the item
“Prudence”
Includes a reference to best etimate and doesn’t refer to including a margin. Estimates need to be free from deliberate or systematic bias.
Gains of assets aren’t overstated and losses or liailities are not understated
Underwriting profit (from the revenue account)
This is the excess of earned premiums over incurred claims and expenses. A crude measure of trading profit.
Insurance profit (from profit and loss or revenue account)
This is the underwriting profit plus the investment income earned on the technical reserves. It represents the profit achieved through writing insurance business.
Profit before tax (from profit and loss account)
This is the insurance profit plus investment income from other assets (i.e. the free reserves). This is the total profit earned by the shareholders’ funds.
Retained profit (from the profit and loss account)
This is the profit remaining after payment of tax and dividends.
Total shareholders’ funds (from the balance sheet)
This is the excess of assets over liabilities. It is a measure of the financial strength of a company.
Claims ratio
AKA loss ratio
= incurred claims/earned premiums
- basic measure of claims level
- high level may indicate inadequate premiums, poor underwriting standards, poor claims control or strong reserving basis
Expense ratio
= expenses paid/written premiums
- proportion of premiums taken up by expenses
- expenses net of reinsurance commission received and premiums net of outward reinsurance premiums
Commission rate
= commission paid/written premiums
Combined ratio
= claims ratio + expense ratio
- AKA operating ratio/underwriting ratio
Proportion reinsured
= net written premiums/gross written premiums
- determines extent to which company relies on reinsurance
OR
= 1- net written premiums/gross written premiums
- shows amount of business ceded to reinsurance
OR
= net claims incurred/gross claims incurred
- indicates the value for money of reinsurance, but one-off events or a year of poor claims experience may distort it
Investment performance
= investment return/average asset value
- dependent on how company treats realised and unrealised capital gains and if unrealised gains aren’t included, the balance of the investment policy between seeking income and capital gains
- distorted if large amount of nil bearing assets (only tangible assets should be included)
Return on capital
= post-tax profit/free reserves at start of year
Solvency ratio
= free reserves/net written premiums
Profit margin
= insurance profit/net earned premium
- how much the company has made for every R1 of premium earned
- could include investment income on free reserves - not generated by writing insurance business = less comparable
Claims settlement pattern
= total outstanding claims reserve/claims paid
- higher ratio = longer the average tail of business written
Reporting delays
= notified and incurred claims OR IBNR/total claim reserve
Processing delays
= claims paid/reserve for reported outstanding claims
Analysing financial accounts
Things to remeber
- strength of the reserving basis is subject to many factors which potentially require a subjective view. Differences in reserving bases between companies can distort the comparison of profitability and strength between companies
- strong reserving bases increase the size of the reserves and defer the emergence of profit
- differences in the basis for valuing assets makes it difficult to compare values and ratios of different companies
- changes in the mix of business from one year to the next or unusual events may have a distorting impact on the picture from the accounts
Accounting ratios to calculate from the accounts
- claim ration (loss ratio)
- expense ratio
- commission rate
- combined ratio (operating/underwriting ratio)
- proportion reinsured
- investment return
- profit margin
- return on capital
- solvency ratio
- assets to liabilities
- claims settlement pattern
