Insurance Accounting Questions Flashcards
An insurance company writes 1-year Premiums of $100 and collects the $100 of Cash from customers midway through the year (June 30th). What happens on the financial statements, assuming the company has not yet recognized any expenses associated with these Premiums?
IS: The company records $50 in Net Earned Premiums (NEP) because it can recognize only 50% of these 1-year Premiums in this current year. Revenue is up by $50, as is Pre-Tax Income, and Net Income is up by $30 at a 40% tax rate. CFS: Net Income is up by $30. However, the Unearned Premium Reserve (UEPR) – similar to Deferred Revenue – also increases by $50 because of the $50 in Premiums set to be recognized in the next year. An increase in a Liability boosts cash flow, so Cash at the bottom is up by $80. BS: Cash is up by $80, so the Assets side is up by $80. On the L&E side, the Unearned Premium Reserve is up by $50, and Equity is up by $30 due to the increased Net Income, so both sides balance. Intuition: The company has collected $100 of Cash, but can only recognize 50% of it as revenue; it pays taxes on just the 50% it can recognize, so its Cash balance increases by $80 rather than $100.
An insurance company writes $100 in Direct Written Premiums. It also reinsures $50 in Premiums from other insurance companies, and it cedes 30% of its Direct Written Premiums to other companies. What is the company’s Net Written Premiums (NWP) for the year, and what appears as revenue on its Income Statement?
Net Written Premiums = Direct Written Premiums + Assumed Premiums – Ceded Premiums, so $100 + $50 – 30% * $100 = $120. Only Net Earned Premiums appear as revenue on the Income Statement, so some number less than $120 shows up there. We don’t have enough information to determine this number because we don’t know the percentage of Premiums the company earned this year.
Let’s take the same scenario and say that, on average, 50% of the company’s Written Premiums are earned in a given year. What appears on the Income Statement as revenue?
If it’s a simple 50%, you can multiply $120 by 50%, which produces $60 as the Net Earned Premiums (NEP) number that appears as revenue on the Income Statement. If the earning percentages differed for each category of Premiums, you would multiply the numbers above by the relevant percentages and add them up.
When an insurance company reinsures policies from other companies, what is the difference between Quota Share (QS) and Excess of Loss (XOL) agreements?
A Quota Share agreement is based on simple percentages for both Premiums and Claims. For example, another company cedes 30% of its Premiums to your company, so the other company pays 70% of the Claims, and your company pays 30% of the Claims. With Excess of Loss, by contrast, the Premium and Claim sharing is not proportional. For example, the other company might cede 5% of its Premiums to your company, but then the other company might pay for up to $1 million in Claims rather than 95% of all Claims. Then, your company might pay for Claims between $1 million and $5 million, and the other company might pay for Claims above $5 million. These policies affect financial models because you make different expense assumptions depending on the type of reinsurance.
Why do insurance companies have complex reinsurance policies? For example, why do they cede their Premiums and assume Premiums from other companies?
They do it for risk management and diversification. For example, if 100% of a company’s policies were from one geography, and a hurricane suddenly passed through, this company would take massive losses as it pays out Claims to all its customers. But if this company had distributed risk by ceding some of its policies and assuming policies from other companies in different regions, the potential for massive losses would have been much lower.
What’s the purpose of the Loss & Loss Adjustment Expense (LAE) Reserve, otherwise known as the Claim and Claim Adjustment Expense Reserve?
It’s similar to Accrued Expenses for normal companies. It reflects that insurance companies must record expenses to match Net Earned Premiums because of the matching principle of accounting, but that companies don’t necessarily pay out these same expenses in Cash in the periods shown. For example, if a company has $120 in Net Written Premiums and $60 in Net Earned Premiums, with a 60% Loss & LAE Ratio, there are $36 in Claims on the Income Statement in the first year. But the Cash payout of these Claims may be very different because customers could get into accidents and file Claims over several years – not all in Year 1. So, if the company only pays $20 in Cash Claims in Year 1, the Loss & LAE Reserve increases by $16. If it then pays $8 in Cash Claims in Year 2 (vs. $0 in Claims on the Income Statement), the Loss & LAE Reserve decreases by $8.
What is the “Loss Triangle” for insurance companies?
This term refers to how an insurance company incurs Loss & LAE Expenses each year and then pays them out in Cash over time. Over many years, this pattern creates a “triangle,” as shown below:
What are Ceded Unearned Premiums and Reinsurance Recoverables on an insurance company’s Balance Sheet?
These are both line items on the Assets side of an insurance company’s Balance Sheet.
“Ceded Unearned Premiums” is like the Unearned Premium Reserve, but for reinsurers instead. When the company cedes Premiums to other companies, Unearned Premiums for those ceded policies will increase this item. Then, when the company earns those Premiums, this item will decrease.
“Reinsurance Recoverables” is like the Loss & LAE Reserve, but for reinsurers instead. This item changes based on the difference between Losses Incurred and Losses Paid in Cash for Ceded Premiums.
What is the Deferred Acquisition Costs (DAC) Asset?
When an insurance company sells a new policy, it must pay a Cash commission to the broker that referred the sale based on the policy’s entire value, even if it only recognizes part of it as revenue in a given year.
For example, if it’s a 3-year policy for $1,000 of Premiums each year, the total value is $3,000. Initially, the insurance company might pay a 5% commission to the broker for $150 in Cash.
On the Income Statement, however, the insurance company can record only the portion of that $150 that matches the Net Earned Premiums for the year.
So, if the company earns $1,000 in Premiums for this year, it can record only $50 in commissions.
On the Balance Sheet, the DAC Asset tracks this difference between Commissions Incurred on the Income Statement and Cash Commissions Paid.
It’s similar to the Prepaid Expenses item for normal companies because they both represent Cash payments made before the expenses have been recognized.
In Year 1, an insurance company records $100 in Net Written Premiums and $50 in Net Earned Premiums and pays Commissions of 10%.
What happens on the financial statements? Ignore Claims for now.
The company must pay Cash Commissions of 10% * $100 = $10, but it can only recognize 50% of that, or $5, on its Income Statement:
- IS: Revenue is up by $50, and there are $5 in Commission Expenses, so Pre-Tax Income is up by
$45. At a 40% tax rate, Net Income is up by $27.
- CFS: Net Income is up by $27, and the Unearned Premium Reserve is up by $50, so cash flow is up by $77 so far. The Deferred Acquisition Costs Asset increases by $5, and, therefore, reduces cash flow by $5. Cash at the bottom is up by $72.
- BS: Cash is up by $72 on the Assets Side, and the DAC Asset is up by $5, so the Assets side is up by $77 total. On the other side, the Unearned Premium Reserve is up by $50, and Equity is up by $27 due to the increased Net Income, so both sides are up by $77 and balance.
Intuition: The firm collects $100 in Cash, pays taxes on less than half that amount, and also pays additional Cash Commissions, so its Cash increases by significantly less than $100.
Walk me through what happens in Year 2, when the remaining $50 in Net Earned Premiums gets recognized. Assume there are no expenses other than Commissions, and that the company writes and earns no new Premiums.
- IS: Revenue is up by $50, and the company records the remaining $5 in Commission Expenses, so Pre-Tax Income is up by $45. At a 40% tax rate, Net Income is up by $27.
- CFS: Net Income is up by $27, but the Unearned Premium Reserve falls by $50 because the company recognizes the remaining Premiums. So far, the company’s cash flow is down by $23. The DAC Asset decreases by $5 because the company recognizes the remaining $5 in Commissions, which boosts cash flow by $5. Altogether, Cash at the bottom is down by $18.
- BS: Cash on the Assets side is down by $18, and the DAC Asset is down by $5, so the Assets side is down by $23. On the L&E side, the Unearned Premium Reserve is down by $50, but Equity is up by $27 due to the increased Net Income, so that side is down by $23, and the Balance Sheet balances.
Intuition: Cash decreases because the company must now pay taxes on some portion of the Premiums it collected in Cash in a previous period. It realizes some tax savings because of the deduction for the Commission Expenses, but not enough to offset the additional taxes on Net Earned Premiums.
Why do you link the Loss & LAE Ratio to Net Earned Premiums rather than Net Written Premiums?
This ratio is defined as the Loss and Loss Adjustment Expense (LAE) on the Income Statement divided by the Net Earned Premiums.
It’s defined this way because the Losses or Claims follow Earned Premiums more closely than Written Premiums.
For example, if a customer buys a 2-year auto insurance policy, he or she can get in accidents and file Claims over that entire 2-year period. But the company records Net Written Premiums for this policy only in the first year in which it is sold.
How do you calculate the Expense Ratio, and what does it mean?
This ratio is defined as (Net Commission Expense + Underwriting Expense) / Net Written Premiums – so you ignore the Loss & LAE Expense.
You divide by Net Written Premiums because both Commissions and Underwriting Expenses, such as employee salaries, trend with Written Premiums more than Earned Premiums since most of the work takes place when the company first sells the policy.
This ratio tells you how profitable the underwriting business of an insurance company is.
The Combined Ratio is defined as the Expense Ratio + the Loss & LAE Ratio. But how is that possible? These ratios use different denominators!
There is no real, official reason other than “It is a quirk of the insurance industry, and it has been calculated that way for decades.”
It doesn’t make much sense mathematically, but the argument for it is that Losses or Claims
correspond to Net Earned Premiums, but many other expense match Net Written Premiums.
It’s useful for getting a sense of the company’s underwriting profitability, but you should not take it as a literal measure of the firm’s exact profit margin.
What are the typical ranges for these ratios? And what do they tell you about the insurance firm?
All these ratios measure the firm’s profitability and operational efficiency, and lower ratios mean the firm is more profitable or “efficient.”
The Combined Ratio is usually in the 90-105% range, the Expense Ratio might be in the 20-25% range, and the Loss & LAE Ratio might be in the 70-80% range.
These numbers vary based on the type of insurance and geography, but a Combined Ratio of 50% or 150% would be highly unusual.
Remember that many insurance companies lose money on their underwriting activities and only become profitable via interest and investment income.
