Insurance companies provide two types of services. One is an identified contract service—mortality protection or loss protection. The second is investment management service.
There are basically four types of insurance organizations:
The regulation of insurance companies started at the state level. Beginning in 1828, the state of New York required that annual reports be filed with the state controller. Subsequently, other states followed this precedent, and all 50 states have insurance departments that require annual statements of insurance companies. The reports are filed with the state insurance departments in accordance with statutory accounting practices (SAP). The National Association of Insurance Commissioners (NAIC), a voluntary association, has succeeded in achieving near uniformity among the states, so there are no significant differences in SAP among the states.
Statutory accounting emphasizes the balance sheet. In its concern for protecting policy holders, statutory accounting focuses on the financial solvency of the insurance corporation.
After the annual reports are filed with the individual state insurance departments, a testing process is conducted by the NAIC. This process is based on ratio calculations concerning the financial position of a company. If a company’s ratio is outside the prescribed limit, the NAIC brings that to the attention of the state insurance department.
A.M. Best Company publishes Best’s Insurance Reports, which are issued separately for life-health companies and property - casualty companies. Best’s Insurance Reports evaluate the financial condition of more than 3,000 insurance companies. The majority of companies are assigned a Best’s Rating, ranging from A+ (Superior) to C−(Fair). The other companies are classified as “Not Assigned.” The “Not Assigned” category has ten classifications to identify why a company has not been assigned a Best’s Rating.
Some of the items included in Best’s data include a balance sheet, summary of operations, operating ratios, profitability ratios, leverage ratios, and liquidity ratios. Most of the ratios are industry - specific. It is not practical to describe and explain them in this book. It should be noted that the financial data, including the ratios, are based on the data submitted to the state insurance departments and are thus based on SAP. Generally accepted accounting principles (GAAP) for insurance companies developed much later than SAP.
The annual reports of insurance companies are based on GAAP.
The 1934 Securities and Exchange Act established national government regulation, in addition to the state regulation of insurance companies. Stock insurance companies with assets of $1 million and at least 500 stockholders must register with the SEC and file the required forms, such as the annual Form 10-K. Reports filed with the SEC must conform with GAAP.
Figure contains the income statement and balance sheet from the 1998 annual report of The Chubb Corporation. These statements were prepared using GAAP. Review them to observe the unique nature of insurance company financial statements.
Balance Sheet Under GAAP
The balance sheet for an insurance company is not classified by current assets and current liabilities (nonclassified balance sheet). Instead, its basic sections are assets, liabilities, and shareholders’ equity.
The asset section starts with investments, a classification where most insurance companies maintain the majority of their assets. Many of the investments have a high degree of liquidity, so that prompt payment can be assured in the event of a catastrophic loss. The majority of the investments are typically in bonds, with stock investments being much lower. Real estate investments are usually present for both property - casualty insurance companies and for life insurance companies. Because liabilities are relatively short term for property casualty companies, the investment in real estate for these companies is usually immaterial.
THE CHUBB CORPORATION
For life insurance companies, the investment in real estate may be much greater than for property - casualty companies because of the generally longer - term nature and predictability of their liabilities.
For debt and equity investments, review the disclosure to determine if there are significant differences between the fair value and the cost or amortized cost. Also review the stockholders’ equity section of the balance sheet to determine if there is significant unrealized appreciation of investments (gains or losses).
Assets—Other than Investments
A number of asset accounts other than investments may be on an insurance company’s balance sheet. Some of the typical accounts are described in the paragraphs that follow.
Real estate used in operations is reported at cost, less accumulated depreciation. Under SAP, real estate used in operations is expensed.
Deferred policy acquisition costs represent the cost of obtaining policies. Under GAAP, these costs are deferred and charged to expense over the premium - paying period. This is one of the major differences between GAAP reporting and SAP reporting. Under SAP reporting, these costs are charged to expense as they are incurred. Goodwill is an intangible account resulting from acquiring other companies. The same account can be found on the balance sheet of companies other than insurance companies.
Under GAAP, the goodwill account is accounted for as an asset and subsequently amortized to expense. Under SAP, neither the goodwill account nor other intangibles are recognized.
Generally, the largest liability is for loss reserves. Reserving for losses involves estimating the ultimate value, considering the present value of the commitments. The quantification process is subject to a number of subjective estimates, including inflation, interest rates, and judicial interpretations. Mortality estimates are also important for life insurance companies. These reserve accounts should be adequate to pay policy claims under the terms of the insurance policies.
Another liability account found on an insurance company’s balance sheet is policy and contract claims. This account represents claims that have accrued as of the balance sheet date. These claims are reported net of any portion that can be recovered.
Many other liability accounts, such as notes payable and income taxes payable, are found on an insurance company’s balance sheet. These are typically reported in the same manner as other industries report them, except there is no current liability classification.
The stockholders’ equity section usually resembles the stockholders’ equity section for companies in other industries. The account net unrealized gains (losses) on securities can be particularly large for insurance companies because of the expanded use of this account as a result of standards for insurance companies and the material amount of investments that an insurance company may have. Pay close attention to changes in this account, since the seunrealized gains or losses have not been recognized on the income statement.
Income Statement Under GAAP
The manner of recognizing revenue on insurance contracts is unique for the insurance industry. In general, the duration of the contract governs the revenue recognition. For contracts of short duration, revenue is ordinarily recognized over the period of the contract in proportion to the amount of insurance protection provided. When the risk differs significantly from the contract period, revenue is recognized over the period of risk in proportion to the amount of insurance protection.
Policies relating to loss protection typically fall under the short-duration contract. An example would be casualty insurance in which the insurance company retains the right to cancel the contract at the end of the policy term.
For long-duration contracts, revenue is recognized when the premium is due from the policyholder. Examples would be whole-life contracts and single-premium life contracts.
Likewise, acquisition costs are capitalized and expensed in proportion to premium revenue. Long-duration contracts that do not subject the insurance enterprise to significant risks arising from policyholder mortality or morbidity are referred to as investment contracts.
Amounts received on these contracts are not to be reported as revenues but rather as liabilities and accounted for in the same way as interest-bearing instruments. The contracts are regarded as investment contracts since they do not incorporate significant insurance risk.
Interestingly, many of the life insurance policies currently being written are of this type. With the investment contracts, premium payments are credited to the policyholder balance. The insurance company assesses charges against this balance for contract services.
As previously indicated, many of the ratios relating to insurance companies are industry specific. An explanation of industry - specific ratios is beyond the scope of this book. The industry - specific ratios are frequently based on SAP financial reporting to the states, rather than the GAAP financial reporting that is used for the annual report and SEC requirements.
Ratios computed from the GAAP - based financial statements are often profitability - and investor - related. Examples of such ratios are return on common equity, price / earnings ratio, dividend payout, and dividend yield. These ratios are explained in other sections of this book.
Insurance companies tend to have a stock market price at a discount to the average market price (price / earnings ratio). This discount is typically 10% to 20%, but at times it is much more. There are likely many reasons for this relatively low market value. Insurance is a highly regulated industry that some perceive as having low growth prospects. It is also an industry with substantial competition. The regulation and the competition put pressure on the premiums that can be charged. The accounting environment likely also contributes to the relatively low market price for insurance company stocks. The existence of two sets of accounting principles, SAP and GAAP, contributes to the lack of understanding of insurance companies’ financial statements. Also, many of the accounting standards are complex and industry-specific.
The nature of the insurance industry leads to standards that allow much subjectivity and possible manipulation of reported profit. For example, insurance companies are perceived to under - reserve during tough years and over-reserve during good years.
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