Chapter 4: Accounting: Methods and Interpretation Flashcards
2 Distinct methods used by general insurers to present their accounts
- annual (or accident year) accounts
- funded (or 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.
Funded (or 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 3rd year)
the term “accident year”
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.
the term “underwriting year”
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.
Annual accounting considerations:
Income
- earned 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
- reinsurance premiums
- changes in claims outstanding (incl. IBNR) in the accounting period
Annual accounting considerations:
Assets
- deferred acquisition costs
- reinsurers’ share of unearned premium reserves
- reinsurers’ share of claims outstanding
Annual accounting considerations:
Liabilities
- unearned premium reserve
- additional unexpired risk reserve
- claims outstanding
3 components of profit for a given year
profit = money in - money out - increase in reserves
4 components of “Money in”
- Gross premiums written
- Reinsurance and other recoveries
- Investment income on insurance funds
- Reinsurance commission received
4 Components of “Money out”
- Gross claims paid
- Reinsurance premiums paid
- Expenses paid
- Commission paid
3 components of “Increase in reserves”
- Increase in outstanding claims reserves
- Increase in unearned premiums
- Decrease in deferred acquisition costs
The conventional format:
Underwriting result
Underwriting result = Premiums - Claims - Expenses + Increase in DAC
The conventional format:
Insurance result
Insurance result = Underwriting result + Investment income
Net premiums written (2 components)
net premiums written = gross premiums written - reinsurance premiums paid
Net premiums earned (3 components)
net premiums earned =
net premiums written
+ unearned premiums brought forward (net of reinsurance)
- unearned premiums carried forward (net of reinsurance)
net claims incurred (4 components)
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)
Expenses (paid) (3 components)
net expenses =
commission paid
+ expenses paid
- reinsurance commission received
The profit and loss account:
Profit before taxation
insurance profit \+ other investment income \+ profits from other activities - interest on loans = PROFIT BEFORE TAXATION
The profit and loss account:
Retained profits
PROFIT BEFORE TAXATION - Taxation = PROFIT ATTRIBUTABLE TO SHAREHOLDERS - Dividends = RETAINED PROFITS
The balance sheet:
Total assets
Fixed assets
+ Investments
+ Other current assets
= TOTAL ASSETS
The balance sheet:
Shareholders’ net assets
TOTAL ASSETS - Current liabilities - Deferred taxation - Unearned premium reserve \+ Deferred acquisition costs - Outstanding claims reserve = SHAREHOLDERS' NET ASSETS
The balance sheet:
Shareholders’ funds
Share capital \+ Share premium account \+ Profit and loss account \+ Revaluation reserve = SHAREHOLDERS FUNDS
How is the revaluation reserve used
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.
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
The basic items the company needs to operate, such as offices, vehicles and computer equipment.
What problems might arise if assets are valued at full market market value in the balance sheet?
- 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”
2 Key reasons why three-year accounting might be preferred to one-year accounting
- areas where underwriting years are fundamentally important (e.g. reinsurance / Lloyds)
- delays in premium and claims settlement
Accounting principles:
Going concern
The enterprise will continue in operational existence for the foreseeable future.
Accounting principles:
Accruals basis
Revenue and costs are recognised as they are earned or incurred, not as money is received or paid.
Accounting principles:
Consistency
There is consistency of accounting treatment of like items within each accounting period and from one period to the next.
Accounting principles:
Prudence and realisation
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.
Accounting principles:
Separate valuation of assets and liabilities
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.
“Prudence”
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.
Underwriting profit (from the revenue account)
The excess of earned premiums over incurred claims and expenses.
Insurance profit (from the profit and loss or revenue account)
The underwriting profit plus the investment income earned on the technical reserves.
The insurance profit represents the profit achieved through writing insurance business.
Profit before tax (from the profit and loss account)
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.
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 the company.
Claim ratio
incurred claims /
earned premiums
Expense ratio
expenses paid /
written premiums
Commission rate
commission paid /
written premiums
Combined ratio
Expense ratio + Claim ratio
a.k.a. operating or underwriting ratio
Proportion reinsured
NET written premiums /
GROSS written premiums
(or alternatively, its compliment)
Investment performance ratio
investment return /
average asset value during the year
Return on capital
post-tax profit /
free reserves at the start of the year
Solvency ratio
free reserves /
net written premiums
Profit margin
Insurance profit /
net earned premium
4 Key widely-used accounting concepts
- Consistency
- Going-concern
- Prudence and realisation
- Accruals basis
- Separate valuation of assets and liabilities
Reports on accounting:
General point
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.
Reports on accounting:
Points to include
- 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
