Accounting Concepts for the Actuary

By Ralph S. Blanchard III, FCAS, MAAA

June 2003

CAS Study Note

 Introduction

This article’s purpose is to give an overview of accounting concepts and issues relevant to
the actuary. To do this, it is divided into the following sections:
• Purpose of accounting
• Types of accounting
• Principal financial statements
• Sources of accounting rules
• Selected accounting concepts
• Common accounts for insurance companies

I. Purpose of Accounting

The purpose of accounting is generally not to provide the “answer” or “decision” for the
user. It is to provide “information” to the user. The user is then free to perform their own
analysis on this information, so as to arrive at their own economic decision based on the
information.

Various accounting standard setters have developed criteria for such accounting informa-
tion1 . These criteria vary slightly by standard setting body, but generally include the con-
cepts listed below.

Accounting information should be:

• Understandable
• Relevant
• Reliable
• Comparable and Consistent (across time, entities, industries)
• Unbiased
• Cost-benefit effective

Understandable
Accounting information should be readily understandable to the intended users of the in-
formation. Note that this is a function of both the intended users and the intended uses of
the information. Accounting systems that define either the users or uses narrowly may jus-
tify more complex information requirements and standards. Accounting systems that envi-
sion a broad body of users and/or uses would tend towards less complexity in published
information and standards.

1
For the International Accounting Standards Board (IASB), such criteria are listed in the Framework for the
Preparation and Presentation of Financial Statements (the IASB Framework). In the United States, the
underlying criteria are found in the Financial Accounting Standards Board (FASB) Statements of Financial
Accounting Concepts (SFAC).

1
There is typically the belief that, for information to be understandable, information con-
tained in the various financial disclosures and reportings must be transparent (i.e., clearly
disclosed and readily discernable).

Relevant
The information should be relevant to the decision-making users of the information. It
should “make a difference” in their decisions. Typically, this means the information must
be:
• Timely
• Have predictive value
• Provide useful feedback on past decisions

Reliable
The information should be reliable and dependable. This usually includes the concepts of:
• Representational faithfulness - the information represents what it claims to represent.
For example, if the information is supposed to represent the total amount of ultimate
claim payout expected, it should be that ultimate amount and not an implicitly dis-
counted amount. If the reported value of a common stock holding purports to be the
current market value, that value should be approximately what the stock could be sold
for by the company holding it.
• Verifiability – another person or entity should be able to recreate the reported value
using the same information that the reporting entity had.
• Completeness – the reported information should not be missing a material fact or con-
sideration that would make the reported information misleading.

The concept of neutrality is sometimes incorporated into the concept of reliability. This
article lists neutrality, or lack of bias, separately.

Comparable and Consistent

For accounting information to be usable, it must allow for comparisons across time and
across competing interests (such as competing companies or industries). This leads to a
need for some consistency, wherever such comparisons are to be expected. For example,
comparisons of two companies would be very difficult and potentially misleading if one
discounts all its liabilities while the other discounts none of its liabilities.

Unbiased
Information that is biased can be misleading. Biased information is not useful unless the
users understand the bias, any bias is consistently applied across years/firms/industries, and
the users can adjust the reported results to reflect their own desired bias. The option for an
accounting paradigm, when faced with uncertainty, is to either requiring reporting of unbi-
ased values accompanied with sufficient disclosure, or require the reporting of biased
(“prudent” or “conservative”) values with the bias determined in a predictable, consistent
fashion.

2
Cost-Benefit effective
There is a general understanding that the development of accounting information consumes
resources. As such, the cost of producing such information should be reasonable in rela-
tion to the expected benefit. This is reflected in many cases through the use of materiality
considerations in accounting paradigms, such that accounting rules may not have to be
fully followed for immaterial items if full compliance would result in unwarranted higher
costs.

Relevance versus reliability

There is a natural tradeoff in many cases between relevance and reliability. For example,
the value of an infrequently traded asset may be very relevant, if the clear intent is to even-
tually sell that asset to meet a liability. But the valuation of such an asset may be difficult
or impossible to reliably determine. Different parties may place materially different values
on that asset, such that the reported value is impossible to verify by an external party or
auditor. The only reliable value for the asset may be its original cost, but such a value
might not be relevant to the user of the information. Therefore the choice may be between
a very relevant but unreliable value, or a very reliable but irrelevant value.

This issue also comes up with the valuation of difficult to estimate insurance liabilities.
While a value may be estimable by an actuary, how reliable is that estimate? Can the user
depend on that value, or could the user instead be materially misled by relying on that
value? If a range of estimates could be produced, but only the low end of the possible
valuation range could be reliably determined, booking the low end of the range may pro-
duce a reliable estimate but how relevant would it be? Would more disclosure be required
to make the information complete – i.e., not misleading or lacking material facts?

Situations with uncertainty

As mentioned earlier, a conflict can arise between neutrality and reliability where uncer-
tainty exists. Some accounting paradigms require conservatism or prudence in such cir-
cumstances. The rationale for requiring conservatism in the face of uncertainty is that an
uncertain asset, or asset of uncertain value, cannot be relied upon. This may lead to the
delayed recognition of some assets until their value is more dependably known or the abil-
ity to realize a gain from their sale is more certain (i.e., the value of the asset is “reasonably
certain”). Relative to liabilities, this would lead to reporting of a high liability value, such
that a final settlement value greater than the reported value is unlikely.

The danger with such approaches is in the reliability and consistency of their application.
Given that uses of information can differ, what is conservatism to one user may be opti-
mism to another. For example, a buyer of an asset would apply conservatism by choosing
a high estimate while the seller would apply conservatism by choosing a low estimate2 .
Also, different users have different risk tolerances. Hence, any bias in accounting informa-
tion runs the risk of producing misleading information, unless the bias can be quantified or
adjusted for by the end user. As a result, accounting paradigms may opt instead for report-

2
As another example, a high estimate of ultimate losses would be conservative when estimating claim liabili-
ties but optimistic when estimating agents’ contingent commissions.

3
ing of unbiased estimates when faced with uncertainty, accompanied by disclosure of the
uncertainty, rather than requiring the reporting of biased estimates.

II. Types of Accounting

The previous section discussed what is necessary for accounting information to be useful
to its users. But there are different kinds of users with different needs and levels of sophis-
tication. Therefore, different users may need different accounting rules to meet their
needs.

There are different ways users can be grouped, each of which could lead to a different set
of accounting rules. In general, however, the grouping or potential grouping for insurance
company purposes usually includes the following categories3 :

• Investors, creditors – current and potential

• Regulators/Supervisors4
• Tax authorities
• Management

Accounting rules designed for a broad range of users (including investors, creditors and
owners) are usually called general purpose accounting rules. These rules are also typically
given the label Generally Accepted Accounting Principles, or GAAP.

The focus of GAAP accounting is typically on the value or performance of an organization

as a going concern. This is an important point, as many liabilities or assets would have a
significantly different value for a going-concern than they would for an entity in runoff.
For example, the value of a tangible asset (such as large machinery or computer equip-
ment) used by a going concern in its business may be the asset’s replacement value, but the
value for a company in runoff that no longer needs the asset may be the asset’s liquidation
market value. GAAP in this instance would be more interested in the replacement value
(or depreciated cost) than the liquidation value.

Regulators interested in solvency regulation, however, may have more interest in runoff
values than going concern values. This may lead them to develop their own specialized
accounting paradigm, such as the “statutory” accounting rules produced by the National
Association of Insurance Commissioners (NAIC) in the United States. Such rules may
place more emphasis on realizable values for asset sale and liability settlement. Hence they
may require a different set of valuation assumptions (possibly including mandatory con-
servatism or bias), resulting in accounting values materially different from GAAP values.

Tax authorities may also desire, demand, or be legally required to use their own specialized
accounting paradigm. Such accounting rules may be directed or influenced by social engi-

3
This category grouping for users was chosen due to its close alignment with common types of accounting.
It leaves out the “rating agency” and “policyholder” user categories. These other users’ interests are typically
aligned with regulators/supervisors due to the focus on solvency concerns.
4
The term “regulator” is common in the U.S., while the term “supervisor” is common in Europe.

4
neering, public policy, political, or verifiability concerns. As such they may be materially
different from either GAAP or “statutory” accounting rules.

In the U.S., the tax accounting rules for insurance companies are based on statutory ac-
counting, with modification. In many parts of the world, the GAAP, regulatory and tax
accounting rules are the same. One advantage to having one set of accounting rules is re-
duced cost and confusion in the creation of the information. One disadvantage is that the
needs of all the users are not the same, hence compromises must be made that are sub-
optimal to one or more sets of users. For example, a public policy issue that drives deci-
sions of tax or regulatory authorities may result in accounting rules that produce mislead-
ing information for investors.

The general and two specialized accounting paradigms mentioned above may still not meet
the needs of company management. As a result, many organizations create one or more
additional sets of accounting paradigms with which to base their management decisions.
These are generally based on either GAAP or regulatory accounting rules, with modifica-
tions.

For example, the treatment of large claims may require special treatment in evaluating in-
dividual branches of a company. While a constant volume of large claims may be ex-
pected for the total results of a company, their incidence may severely distort the
evaluation of the individual business units that suffer the large claims in the single year
being analyzed. If each business unit were a separate company, it might have limited its
exposure to such a claim (for example, via reinsurance or coverage restrictions), but for the
company as a whole it might make more sense to retain that exposure. Therefore, man-
agement may wish to cap any claims to a certain level, when looking at its internal “man-
agement accounting basis” results for individual business units, or may reflect a pro forma
reinsurance pool among the business units in its internal accounting results.

As another example, the existing GAAP and/or regulatory accounting rules may not allow
discounting of liabilities, possibly due to reliability concerns. Management, however, may
feel that such discounting is necessary to properly evaluate the financial results of their
business units, and within their operation they feel that any reliability concerns can be ade-
quately controlled.

III. Principal Financial Reports

The principal statements in financial reports are the balance sheet, income statement and
cash flow statement. These are usually accompanied by selected other schedules or exhib-
its, including various “notes and disclosures”.

Balance Sheet
The balance sheet lists the assets and liabilities of the company, with the difference be-
tween the assets and liabilities being equity (sometimes referred to as “net assets”, “capi-
tal” or “surplus”). This statement gives a snapshot of the current value of the company as
of the statement or reporting date.

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Note that some assets may not be required or allowed to be reported, due to concerns by
the accounting standard setters with reliable valuation. Examples can include various
types of “intangible” assets such as royalties, brand name or franchise value. Similarly,
certain liabilities may not be reported due to reliability concerns. (See later discussion of
“Recognition and Measurement”, and the discussion in this section on “Notes and Disclo-
sures”.)

Income Statement
The income statement reports on the income and expenses of the firm during the reporting
period, with the difference being net income or earnings. Income includes revenue and
gains from sales, although it is not always necessary to distinguish between these two
items.

Some accounting systems differentiate various types of income. For example, operating
income is frequently defined to represent income from ongoing operations, excluding un-
usual one-time events or possibly realized capital gains whose realization timing is mostly
a management decision. Other exclusions from operating income would be the effects of
accounting changes, such as a change in how to account for taxes or assessments from
governmental bodies.

In general, net income causes a change to equity, but may not be the sole source of changes
to equity. An accounting system may have certain changes in value flow directly to equity,
with no affect on income until they are realized. Examples sometimes include unrealized
gains and losses on invested assets.

Cash Flow Statement

The cash flow statement reports on the sources and uses of cash during the reporting pe-
riod, and should reconcile the beginning and ending cash position for the company.

Notes and Disclosures

The notes and disclosures sections of financial reports allow for additional information be-
yond the three statements mentioned above, including a description of the accounting poli-
cies used in preparing the financial statements and discussion of values that may not be
reliably estimable. Such disclosures may include discussion of the risks and uncertainty
associated with the insurance liability estimates found in the balance sheet and income
statement (in some cases referred to as “management discussion and analysis”). They may
also include “forward-looking information”, concerning estimates of future financial earn-
ings or events that have yet to occur by the financial report publication date. Note that
these are different from “subsequent events” that may be disclosed, which are events that
occurred after the statement or valuation date but before the publication date of the finan-
cial report.5

5
For example, a catastrophe that occurred after the statement date but before the publication date would be a
subsequent event, not included in the reported equity or income. In contrast, a discussion of future exp osure
to catastrophes for the coming year would be a “forward-looking” statement.

6
 IV. Sources of Accounting Rules

Within any given accounting paradigm there are typically several different sources of
rules. Where the rules for a given paradigm potentially conflict, a pre-defined hierarchy
must be followed. Rules from a source higher on the hierarchy supercede or overrule those
from a source lower on the hierarchy.

GAAP
The top of the GAAP hierarchy is generally the organization in charge of securities regula-
tion for a particular jurisdiction. They may defer the rule setting to a specified accounting
standard setter, such as the IASB, but they generally have the authority to add additional
requirements or rules. They may also retain veto power over the designated accounting
standard setter’s proposed new rules6 . A list of such organizations can be found on the
web site of the International Organization of Securities Commissions (IOSCO).

Next in the hierarchy are the standards set by the specified accounting standard setter for
that jurisdiction. The European Union has identified the International Financial Reporting
Standards (IFRS) produced by the IASB as the accounting standards for companies with
publicly traded securities. In the United States, the Securities and Exchange Commission
(SEC) has designed the Financial Accounting Standards Board (FASB) as the accounting
standard setter under the SEC. Note that these standards would be at the top of the hierar-
chy for companies that are not subject to public-traded securities rules (for example, a pri-
vately owned firm).

These standards may be supplemented by industry-specific guidance. In the United States,

some industry-specific guidance in the form of Statements of Position (SOPs) came from a
separate organization of accounting professionals called the American Institute of Certified
Professional Accountants (AICPA). The U.S.’s FASB retained effective veto power over
AICPA-issued guidance7 .

Last on the hierarchy would be interpretations, such as those issued by the IASB’s Interna-
tional Financial Reporting Interpretations Committee. Interpretations are produced when
timely guidance is needed, as they can be produced much faster than official accounting
standards. This is due to the much shorter period for due process in the production of an
official interpretation.

Regulatory/Supervisory Accounting
Regulatory accounting rules can consist of a totally separate set of standards, produced by
or with the approval of the regulator, or can consist solely of additional specialized ac-
counting schedules, filed in additional to the normal GAAP financial reports. Worldwide,
it appears to be more common for the regulators to rely on GAAP financial statements. In

6
This describes the situation in the U.S., where the SEC retains veto power over new FASB standards.
7
The FASB decided in 2002 to eliminate this role for the AICPA in the future. Except for certain projects in
process and not yet completed at that date, the FASB will no longer look to the AICIPA to create SOPs.
(FASB newsletter The FASB Report, November 27, 2002.)

7
the U.S., regulators have developed a complete set of accounting rules, combining ele-
ments of both liquidation accounting and going concern accounting.

Tax Accounting (for Federal Income Tax purposes)

Tax accounting rules can be based on GAAP accounting rules, statutory accounting rules,
or determined on a totally separate basis. This determination is generally based on tax law
or regulation for the jurisdiction in question. Some countries rely on GAAP accounting
reports to determine taxable income, while at least one relies on statutory accounting re-
ports with modifications.

V. Selected Accounting Concepts

This section defines and discusses the following accounting concepts:

• Fair Value versus Historical Cost

• Recognition versus Measurement
• Deferral-Matching versus Asset-Liability
• Impairment
• Revenue Recognition
• Reporting Segment
• Liquidation versus Going Concern
• Change in Accounting Principle versus Change in Accounting Estimate
• Principle-based versus Rule-based

Fair Value versus Historical Cost

According to the IASB, “Fair value is the amount for which an asset could be exchanged
or a liability settled between knowledgeable, willing parties in an arm’s length
transaction.”8 It is meant to represent market value given a sufficiently robust and effi-
cient market. Where no such market exists, the fair value conceptually would be esti-
mated. When the fair value estimate is based on a model rather than an actually observed
market value, it is called “marked to model” rather than “marked to market”.

Historical cost is the amount (price) at which the asset or liability was originally obtained.
Where the historical cost is expected to be different from the final value when the item is
no longer on the balance sheet, some amortization or depreciation of the value may be
called for. This can result in an amortized cost or depreciated cost value. These values are
generally more reliably determinable, but less relevant than fair value.

Recognition versus Measurement

Accounting rules distinguish the decision or rule to recognize an asset or liability in finan-
cial reports from the rule establishing how to measure that liability once recognized. For
example, the rule for when to record an asset may be to wait until the financial benefit
from it is virtually certain, but the rule for measuring it at initial recognition may be to re-

8
From the IASB’s Draft Statement of Principles for Insurance Contracts, paragraph 3.4, released November
2001.

8
cord its most likely value. Hence the probability standard for recognition may vary from
the probability standard for measurement.

There may also be multiple recognition triggers and measurement rules. For example, the
rule for initial recognition may differ from the rule for the triggering of subsequent re-
measurement. The rule for initial recognition of an asset may be based on “reasonable cer-
tainty” of economic value. The measurement basis may then be its fair value, which
implicitly includes a discounting of future cash flows. This initial measurement value
would then be included in subsequent financial reports (i.e., “locked-in”) until the remeas-
urement is triggered, ignoring the change in assumptions and facts since the original meas-
urement. The rule for the triggering of subsequent remeasurement may be whether the
undiscounted flows are likely to be less than the current value.

Deferral/matching versus asset/liability

Two major classes of accounting paradigms are deferral/matching and asset/liability.

Under a deferral/matching approach the focus is to coordinate the timing of income and
expense recognition so that both occur at the same time, when the triggering event that is
the focus of the contract occurs. For example, under a deferral/matching approach the
premium is not recognized when received but is instead recognized (“earned”) over the
policy term during the period the insurance protection is provided. Likewise, the related
expenses and incurred losses are not recognized when paid or committed to but are instead
recognized over the same period as the premium. This may lead to the deferral of some
up-front expenses, and the accrual of some losses that may take decades to pay. The defer-
ral/matching approach requires the establishment of certain assets and liabilities to defer
or accelerate recognition of revenue, expense or loss, in order to obtain the desired income
statement effect9 . Hence the focus is on the income statement more than the balance sheet.

Under an asset/liability approach, the focus is on the value of assets or liabilities that exist
as of the balance sheet date. An asset is booked if a right to a future stream of cash flows
(or to an item that could be converted to future cash flows) existed at the reporting date.
Likewise, a liability is booked if the entity was committed to an obligation at the balance
sheet date that would result in the payment of future cash flows or other assets. Such an
approach would not recognize a “deferred acquisition cost” as an asset if it cannot be trans-
ferred or translated as cash. It would also not recognize an unearned premium liability be-
yond that needed for future losses, expenses or returned premiums associated with that
contract. In general, the income statement is whatever falls out of the correct statement of
the assets and liabilities, hence the focus on the balance sheet over the income statement.

Proponents of a deferral/matching approach have commonly focused on the timing of

profit emergence. Absent changes in estimates, under a deferral/matching approach the
profit emerges in a steady pattern over the insurance policy term.

9
The two most common balance sheet accounts resulting from this approach for insurance companies are
Deferred Acquisition Cost (DAC) assets, used to defer the impact of certain up-front expenses on the income
statement, and Unearned Premium liabilities, used to defer the reflection of revenue.

9
Proponents of an asset/liability approach have commonly stressed the importance of reli-
able measures of value at the reporting date. They typically favor the booking of only
those assets that have intrinsic value10 , and the immediate reflection of liabilities once they
meet recognition criteria, rather than (what some consider) an arbitrary deferral to smooth
out reported earnings.

It is possible for both approaches to produce comparable income statement results11 , and
one would generally expect both to produce comparable equity values, but the actual data
available to the user may vary significantly between the two approaches12 . It is also possi-
ble for a single accounting paradigm to combine elements of both these approaches.13

Revenue Recognition
A key question in some accounting situations is when to recognize revenue. This is par-
ticularly important for those industries where revenue growth is a key performance meas-
ure.

Under a deferral/matching approach, revenue would be recognized only as service is ren-

dered. In the insurance context, revenue would be recognized under the deferral/matching
approach over the policy period in proportion to the covered insurance risk. Under an as-
set/liability approach, revenue would be recognized up front, once the insurer gained con-
trol of the asset resulting from the revenue. Therefore, the timing of revenue recognition is
a function of the chosen accounting paradigm.

Impairment
It is possible to reflect one paradigm for income statement purposes and another for bal-
ance sheet purposes. This sometimes leads to the use of “impairment” tests and rules, to
prevent inconsistencies between the two valuations from growing too large or problematic.
(An asset may be considered impaired if it is no longer expected to produce the economic
benefits expected when first acquired.)

For example, consider an accounting paradigm that requires an asset to be reported at its
fair value with regular remeasurement for balance sheet purposes, but at locked-in histori-
cal cost valuation for income statement purposes. A risk under such an approach is that the
two could become significantly out of sync, such as when the fair value of assets have
dropped significantly below their historical cost. This risk can be alleviated through re-
quired regular testing of any such shortfall, to determine whether such a shortfall is perma-
nent (i.e., whether a “permanent” impairment exists). When this happens, the extent of

10
In contrast to certain assets that can exist under a deferral/matching approach that have no intrinsic value,
such as a deferred acquisition cost asset. For example, it is impossible to sell a deferred acquisition cost asset
due to its lack of intrinsic value.
11
For insurance contracts, a principal determinant of how similar the income statements would be under the
two approaches is the treatment of risk when valuing assets and liabilities. For example, the asset or liability
risk margin under an asset/liability approach could be set such that profit is recognized evenly over the cov-
erage period. This could recreate the same profit emergence pattern found under a deferral/matching system.
12
A deferral/matching paradigm is used by the IASB for accounting for service contracts, while the IASB
endorsed in 2003 an asset/liability paradigm for insurance contracts.
13
This is sometimes called a “mixed attribute” paradigm.

10
permanent impairment would be reflected in the income statement. The result would be a
reduction in the discrepancy between the cumulative income statements and cumulative
balance sheet changes, without bringing the income statement to a fair value basis.

Reporting Segment
GAAP financial statements are typically produced on a consolidated basis for the reporting
entity. The consolidation may include the combined impact of multiple legal corporations
or other entities with the same ultimate parent company or owner.

Regulatory financial statements may be required on a non-consolidated basis, separately

for each legal entity, matching the legal authority of the regulator to intervene.

GAAP accounting rules also require reporting at the Reporting Segment level, generally
defined as the level at which operations are managed and performance measured by senior
management.14 Reporting segments may be defined by product, by geography, by cus-
tomer or other similar criteria, alone or in combination with other factors. The reporting
segment selection is based on they way a particular company operates. For example, a
company producing one product but in multiple regions, with somewhat autonomous man-
agement and functions by region, may be required to define its reporting segments by geo-
graphic region. A company with multiple products in one geographic market, with
generally autonomous management by product unit, may define its reporting segments by
product.

Where the accounting standard defines reporting segment requirements, it typically also
includes a list of required items to be reported by reporting segment. Note that not all
items are required to be reported by reporting segment. For example, income statements
may have to be disclosed by reporting segment, but not balance sheets.

Liquidation versus Going Concern

Many GAAP paradigms focus on the assumption that the business is a “going concern”
when valuing an asset or liability. This is in contrast with a runoff or liquidation assump-
tion. For example, the value of a factory in use to produce a profitable product may be
much greater than the value the factory could be sold for in a liquidation scenario. A run-
off assumption may be more appropriate for regulatory accounting purposes, where a sol-
vency focus exists.

Change in Accounting Principle versus Change in Accounting Estimate

Accounting paradigms may have drastically different reporting requirements for a change
in accounting principle versus a change in accounting estimate. A change in accounting
principle may require special disclosure of the change, with recalculation of prior period

14
The IASB standard in reporting segments, IAS 14, defines reporting segments as follows: “Segments are
organisational units for which information is reported to the board of directors and CEO unless those organ-
isational units are not along product/service or geographical lines, in which case use the next lower level of
internal segmentation that reports product and geographical information.” (quoted from a summary of IAS 14
found on the IASB website www.iasb.org.uk).

11
 results15 , while a change in accounting estimate would generally involve no prior period
recalculation and impact only the latest reporting period.

For example, a change from undiscounted liability estimates to present value estimates
would typically be described as a change in accounting principle, possibly requiring recal-
culation of prior period results. A change in the estimated amount of undiscounted liabili-
ties would be a change in accounting estimate, requiring no prior period recalculation and
only impacting the reporting period where the estimate was changed16 .

Where the change in accounting principle is due to a change in accounting standard, the
new standard itself will usually provide the preparer with specific implementation guid-
ance.

Principle-based versus Rule-based

Accounting standards may take the form of general principles, relying on interpretation
and judgment by the financial statement preparers before they can be implemented. Al-
ternatively, standards may take the form of a series of rules, limiting the flexibility and use
of judgment allowed in their implementation. This is a natural tradeoff, with advantages
and disadvantages to each approach.

Principle-based standards are potentially very flexible with regard to new and changing
products and environments. As such, they should also require less maintenance. But they
do have certain disadvantages, such as being more difficult to audit relative to compliance,
and concern over consistent and reliable interpretations across entities. To the extent that
they rely on individual judgment to interpret and implement the standards, there is a dan-
ger that they can be used to manipulate financial results.

Rule-based standards are generally considered easier to audit for compliance purposes,
and may produce more consistent and comparable financial reports across entities. Disad-
vantages may include a lack of flexibility with regard to changing conditions and new
products, hence requiring almost continual maintenance at times. A concern also exists
that rule-based standards are frequently easier to “game”, as entities may search for loop-
holes that meet the literal wording of the standard but violate the intent of the standard.

VI. Common Accounts for Insurance Companies

The following are some common accounts used by insurance companies in conjunction
with insurance contracts sold. Note that this list excludes accounts that are not directly in-
surance related, such as those for invested assets.

15
When recalculation is required it would generally impact only the results for prior periods required to be
shown in the financial statement at the time the accounting principle is changed. A cumulative effective ad-
justment may also be required for the oldest period shown, equaling the adjustment required to bring the
beginning balances in compliance with the new accounting principle being implemented.
16
Additional disclosure may be required when the change in estimate is material to the interpretation of the
financial reports.

12
Balance Sheet Accounts - Assets
Premiums Receivable (or Premium Balances or Agents Balances or something similar) –
premiums due on policies, either from agents if the agent bills the policyholder or from
the policyholder if billed directly.

Reinsurance recoverables – amounts due from reinsurers due to ceded losses. In some
accounting paradigms, the amounts billed and due as a result of ceded paid losses are re-
corded as an asset (and sometimes called reinsurance receivables), while the amounts to
be ceded and billed in the future as a result of incurred but unpaid losses are recorded as a
contra-liability (and called reinsurance recoverables).

Deferred acquisition costs – expense payments that are deferred for income statement
purposes under a deferral-matching accounting paradigm. They are deferred so that they
can be recognized in the income statement at the same time as the corresponding revenue.

Balance Sheet Accounts - Liabilities

Policy liabilities (or Provision for Unexpired Policies or something similar) – a liability
established for in-force insurance policies for future events, for which a liability exists due
to a contract being established. There is no policy liability for policies that have yet to be
written, however a policy liability may exist for events covered by the renewal of existing
policies, under certain situations. For example, a policy liability would exist for level
premium renewable term life insurance, but not for possible renewals of property insur-
ance contracts where the pricing is not guaranteed and either party can decide to non-
renew.

Unearned Premium Liability – a liability caused by the deferral of premium revenue under
a deferral-matching accounting paradigm. The amount of unearned premium liability
generally represents the portion of policy premium for the unexpired portion of the policy.
In an asset/liability paradigm this would be replaced by a policy reserve.

Claim liabilities – a liability for claims on policies for events that have already occurred.
This would typically include amounts for both reported claims and for Incurred But Not
Reported (IBNR) claims. It would also include amounts for Incurred But Not Enough
Reported (IBNER), sometimes called supplemental or bulk reserves, for when the sum of
individual claim estimates for reported claims are estimated to be too low in the aggregate.
In some cases, IBNR is used to refer both of the last two amounts.

Claim expense liabilities – the liability for the cost of settling or defending claims on poli-
cies for events that have already occurred. This includes the cost of defending the policy-
holder (for liability policies). It can also include the cost of disputing coverage with the
policyholder. It sometimes is included in the Claim liability value discussed above.

Insurance expense liabilities – the liability for expenses incurred but unpaid in conjunc-
tion with the insurance policy, other than the claim expenses discussed above. Typical
subcategories include commission liabilities (sometimes split into regular and contingent
commission liabilities) and premium tax liabilities (where applicable).

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Income statement accounts
Premiums – in an asset-liability paradigm, this may equal written premiums, while in a
deferral-matching premium, this would equal earned premiums. Earned premiums equal
the written premiums less the change in unearned premium liabilities. They represent the
portion of the charged premium for coverage under the reporting period.

Losses – Claims incurred during the reporting period. They represent the amount paid for
claims plus the change in claim liabilities.

Loss expenses – Claim expenses incurred on claims resulting from events during the re-
porting period. Note that a claim expense can be incurred on a non-covered claim due to
the necessary cost to dispute non-covered filed claims. These amounts are sometimes in-
cluded in Losses.

Underwriting expenses – Expenses incurred that directly relate to the insurance operation.
They include commission expenses, other acquisition expenses, general expenses and
overhead related to the insurance operation, and various fees and taxes related to the in-
surance operation.

Underwriting income – Premium revenue less losses, loss expenses and underwriting ex-
penses.

Policyholder dividends – Dividends to policyholders incurred during the reporting period.

In some accounting paradigms these amounts are legally incurred only when declared. In
others, an estimate of historical dividends relating to the policy coverage provided during
the reporting period must be made and allocated to that reporting period. These amounts
are generally included in underwriting income, but may not be for some purposes. It is
possible for them to be subtracted from revenue under some accounting paradigms.

Discounting treatment
There are several ways discounting can be handled by an accounting paradigm. When
discounting a liability, the amount of the discount could be treated as an asset with the li-
ability reported on an undiscounted basis. Alternatively, the liability could be established
on a discounted basis directly. Other options may exist, such as including the discount as
a contra-liability in a separate liability account.

The establishment of any present value estimates will require the reporting of the unwind-
ing of discount over time, somewhere in the income statement. One approach for an ac-
counting paradigm is to report the unwinding as an interest expense. Another approach is
to report the unwinding as a change in liability estimate, perhaps with separate disclosure
so it can be distinguished from other sources of changes in estimates.

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Resources:
• CAS Task Force on Fair Value Liabilities - White Paper on Fair Valuing Prop-
erty/Casualty Insurance Liabilities (fall 2000)
• IASB Draft Statement of Principles (DSOP) on Insurance (fall 2001)
• International Accounting Standards: Framework for the Preparation and Presentation
of Financial Statements (1989)
• Introduction to Accounting, second edition (1991), published by the American Insti-
tute for Property and Liability Underwriters (on the CPCU 8th exam at that time).
• FASB website, at www.fasb.org
• IASB website, at www.iasb.org.uk

Also recommended is the following paper, discussing the work on developing a new IASB
insurance accounting standard up to the paper’s publication date in 2003: “The Search for
an International Accounting Standard for Insurance: Report to the Accountancy Task Force
of the Geneva Association,” by Gerry Dickinson.

The author of this article would like to thank the following people for numerous helpful
comments as the article was drafted: Keith Bell, Sam Gutterman, and Gary Venter.

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