Encyclopedia of actuarial science

1897 Pages·2004·14.369 MB·English

by  Jef L Teugels, Bjørn Sundt

Accident Insurance – Medicalexpenses:Theinsurerwillreimbursethe
insured for each covered expense the insured
incurs in the treatment of a covered accident.
The term accident insurance, also called personal Covered expenses usually include hospital, sur-
accidentinsurance,referstoabroadrangeofindivid- gical, and physicians’ expenses, but some more
ual and group products with the common feature of comprehensiveproductsalsoincludeprescription
providing various types of benefits upon occurrence drugs, treatment by therapists, ambulance ser-
of a covered accident. vices, and aides such as crutches, wheelchair,
Accident benefits are often provided as riders to and so on. This benefit is often provided with
lifeinsurancepolicies.Whilesomeofthefeaturesof a deductible and/or a coinsurance.
thesebenefitsarecommontoboth,inthisarticle,we – Accidentdisabilityincome: The insurer will pro-
concentrate on stand-alone accident insurance plans. vide a specified periodic income benefit to the
insured if he becomes disabled due to a cov-
ered accident. Benefits are provided during the
insured’speriodofdisabilitywithoutexceedinga
Accident
specifieddisabilityperiod.Aneliminationperiod
or waiting period – an amount of time that the
Forpurposesofthiscover,thetermaccidenthasbeen
insured must be disabled before becoming eligi-
definedinmanydifferentways.Thespiritofthevar-
ble to receive policy benefits – is usually also
iousdefinitionsisthat,foranaccidenttobecovered,
applied. Some disability income products mar-
itshouldbeanunintended,unforeseen,and/orviolent
keted as accident insurance – such as hospital
event,and the bodily injuries sufferedby the insured
cash plans, which provide a cash amount for
should be caused directly and independently of all
eachdaytheinsuredspendsinthehospital –also
other causes by the said event.
cover illness.
Limitations and exclusions to this cover also
vary widely but, in the vast majority of cases, the
following accidents are not covered, unless other- Accident Insurance Plans
wise specified
Accidentinsuranceis regardedas a low-costalterna-
– war-related accidents
tive to life insurance. Its advantages and features are
– self-inflicted injuries and suicide
easyfortheinsurertopresentandfortheprospective
– accidents resulting from the insured’s engaging
insured to understand. For this reason, the insurance
in an illegal activity.
markethasdevelopedawidearrayofaccidentinsur-
anceplans,addressingdifferenttypesofneeds.Some
of the most common are the following:
Benefits
– Short-term accident insurance: Provides protec-
Accident insurance provides different types of bene- tionforaperiodshorterthanoneyear.Minimum
fits. The most common are the following: duration is usually three days but can be lower.
These plans are often purchased by travelers or
– Death benefit: If the insured dies as a result of persons who intend to stay for a period of time
an accident, the insurer willpay the sum insured away from their home town. Benefits provided
to the named beneficiary or beneficiaries. areusuallyaccidentaldeath,dismembermentand
– Dismemberment: The insurer will pay a stated medical expenses. Premium rates are calculated
benefit amount if an accident causes the insured as a percent of the yearly rate.
to lose one or more limbs – or the use thereof. – Travel insurance or Travel accident policy:
The partialor totalloss of eyesight,hearing,and Covers only accidents while the insured
speech may also be covered. Benefits are usu- is traveling.
ally described in a benefit schedule, and may be – Student accident insurance: Covers accidents
expressedeitherasaflatamountorasapercent- occurredwhileaninsuredstudentisparticipating
age of the sum insured for the death benefit. in school-related activities.
2 Accident Insurance
– AirtravelinsuranceorAirpassengerinsurance: claimsratecr.Claimsratesareoftencalculatedinan
Covers accidents occurred on a particular flight, empirical or semiempirical manner based on market
usually a commercial carrier. or company statistics and specialized publications,
– Group accident insurance: Covers the members usually undifferentiated by sex and age.
of an insurable group. It is often purchased
as an alternative or as a supplement to group
Deathand Dismemberment
life insurance, providing benefits only in case
of accident.
Claims cost calculation follows the general form
cc=cr·db·il (2)
Pricing
where
The insurance industry has traditionally followed a
straightforward approach to the pricing of accident cr = Claims rate per thousand
insurance, based on claims cost, expense and com- db = Total death benefit in thousands
mission loading, and a number of factors reflecting il = Industryloadingfordeathanddismemberment
the nature and duration of the risk covered.
If the claims rate is related to the overall popu-
The gross premium follows the general form
lation, an industry load may be necessary when the
cc·tc·(1+µ) covered group is deemed to be a substandard risk
GP = (1)
1−(A+C+M) based on its occupation.
where
Disability
cc=Annual claims cost
Claims-cost calculation follows the general form
Claims cost estimation can be manual or expe-
rience based. The main elements to determine the cc=cr·db·il (3)
approach to use are the size of the covered group
where
andtheavailabilityandreliabilityofitsclaimsexpe-
rience.Individualinsuranceisalwaysrated manually. cr = Claims rate per period of indemnity
If the covered group can be experience rated (see db = Total disability benefit per period
Experience-rating),theclaimscostwillbeestimated il = Industry loading for disability
in terms of the group’s claims experience, applying
any necessary adjustments due to changes in the Claimsrateanddisabilitybenefitshouldberelated
size of the covered population and in the conditions to the same period, usually weekly or monthly.
of the coverage, and allowing for claims reporting
time lags (see Reserving in Non-life Insurance). It
MedicalExpenses
is assumed that the claims experience reflects the
group’s occupational risk, so no additional loads
Claims cost calculation follows the general form
should be necessary unless there is an aggravation
of the risk. cc=cr·d·c·mb·mt ·il (4)
Another approach for experience-rated risks is
to calculate an ad hoc claims rate and then apply where
pricingfactorsasshownbelow.Thisprovidesgreater
flexibility to the pricing process. cr = Claims rate
For individualinsuranceandfor groupseithertoo d = Deductible factor
small to experience rate or for which there is no c = Coinsurance factor
reliable claims information, claims cost is estimated mb = Maximum benefit factor
differently for death and dismemberment, medical mt = Medical trend factor
expenses,anddisability.Keytothiscalculationisthe il = Industry loading for medical expenses
Accident Insurance 3
Companiescalculatethesefactorsbasedonmarket While,thisclassificationvarieswidely fromcom-
data and company statistics. panytocompany,itisfundamentaltoconsiderallthe
direct and indirect expenses related to the sale and
tc=Time conversion factor
administration of the product, allowing for a target
minimum profit margin.
This factor is used in two cases:
Itbearsmentioningthataccidentinsurancecomes
1. When the claims rate is specific to a limited in an immense variety of forms. While the general
periodoftimeandthecoverageistobeprovided pricingmodeldescribedaboveaddressesthetypesof
for a longer period. In this case, tc>1. This is insurancecommonlyfoundinthemarket,itdoesnot
commoningroup,experience-ratedpolicies.For necessarily apply to all forms of accident insurance.
example,ifavailablestatisticsforacertaingroup The pricing actuary should carefully examine and
only cover a period of one month, the annual evaluate each risk, and either adapt this model or
claims rate can be estimated by annualizing the develop a new one whenever necessary.
claims rate.
2. When the claims rate is based on annual statis-
Reserving
tics and the coverage is to be provided for a
shorter period. In this case, tc≤1. Most com-
Accidentinsuranceisusuallyreservedonanunearned
panies apply a short-term, nonproportional cov-
premium basis. Other statutory reserves are often
erage factor. For example: if the annual claims
required in most countries, such as IBNR and catas-
rate for a risk is 1% and the period of cover-
trophe reserves. Their nature and methodology for
age is 6months, the company may apply a 0.6
calculation varies from country to country.
short-term factor.
µ=Safety margin Further Reading
A safety margin is often built into the premium
GlossaryofInsuranceTerms,TheRoughNotesCompany,Inc.
calculation. Its size will depend on a number of
(1998). http://www.amityinsurance.com/inswords/index.
factors, such as the quality of the data and mar-
htm.
ket conditions. Jones, H. & Long, D. (1999). Principles of Insurance: Life,
The loading is usually composed of HealthandAnnuities, 2nd Edition, Life Office Manage-
mentAssociation(LOMA),UnitedStates.
A = Administrative expenses
C = Commissions and other acquisition expenses JAIME JEAN
M = Profit margin
Accounting 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
Introduction uses narrowly, may justify more complex informa-
tionrequirementsandstandards.Accountingsystems
This article’s purpose is to give an overview of thatenvisionabroadbodyofusersand/oruseswould
accounting concepts and issues relevant to the actu- tend towards less complexity in published informa-
ary. To do this, it is divided into the following tion and standards.
sections: Thereistypicallythebeliefthat,forinformationto
• Purpose of accounting beunderstandable,informationcontainedinthevari-
• Types of accounting ousfinancialdisclosuresandreportingsmustbetrans-
• Principal financial statements parent(i.e.clearlydisclosedandreadilydiscernable).
• Sources of accounting rules
• Selected accounting concepts
Relevant
• Common accounts for insurance companies.
The information should be relevant to the decision-
making users of the information. It should ‘make a
Purpose of Accounting
difference’ in their decisions. Typically, this means
the information must be
Thepurposeofaccountingisgenerallynottoprovide
the‘answer’or‘decision’fortheuser.Itistoprovide • timely
‘information’ to the user. The user is then free to • have predictive value
perform his own analysis on this information, so as • provide useful feedback on past decisions.
to arrive at his own economic decision based on the
information.
Various accounting standard setters have devel- Reliable
oped criteria for such accounting information. These
criteria vary slightly by standard setting body, but The information should be reliable and dependable.
generally include the concepts listed below. For the This usually includes the concepts of the following:
International Accounting Standards Board (IASB),
such criteria are listed in the Framework for the • Representational faithfulness – The information
Preparation and Presentation of Financial State- represents what it claims to represent. For example,
ments (the IASB Framework). In the United States, if the information is supposed to represent the total
the underlying criteria are found in the Financial amount of ultimate claim payout expected, it should
Accounting Standards Board (FASB) Statements of be that ultimate amount and not an implicitly dis-
Financial Accounting Concepts (SFAC). counted amount. If the reported value of a common
Accounting information should be stockholdingpurportstobethecurrentmarketvalue,
that value should be approximately what the stock
• understandable could be sold for by the company holding it.
• relevant
• reliable • Verifiability –Anotherpersonorentityshouldbe
• comparable and consistent (across time, enti- able to recreate the reported value using the same
information that the reporting entity had.
ties, industries)
• unbiased • Completeness – The reported information should
• cost-benefit effective. not be missing a material fact or consideration that
would make the reported information misleading.
Understandable
The concept of neutrality is sometimes incorpo-
Accounting information should be readily under- rated into the concept of reliability. This article lists
standable to the intended users of the information. neutrality or lack of bias separately.
2 Accounting
Comparable and Consistent but such a value might not be relevant to the user
of the information. Therefore, the choice may be
Foraccountinginformationtobeusable,itmustallow between a very relevant but unreliable value, or a
for comparisons across time and across competing very reliable but irrelevant value.
interests(suchascompetingcompaniesorindustries). This issue also comes up with the valuation of
This leads to a need for some consistency, wherever insurance liabilities that are difficult to estimate.
such comparisons are to be expected. For example, While a value may be estimable by an actuary, how
comparisons of two companies would be very diffi- reliable is that estimate? Could the user depend on
cult and potentially misleading if one discounts all that value, or could the user instead be materially
its liabilities while the other discounts none of its misled by relying on that value? If a range of esti-
liabilities. matescouldbeproduced,butonlythelowendofthe
possiblevaluationrangecouldbereliablydetermined,
Unbiased bookingthelowendoftherangemayproduceareli-
able estimate but how relevant would it be? Would
Information that is biased can be misleading. Biased more disclosure be required to make the information
information is not useful unless the users under- complete – that is, not misleading or lacking mate-
standthebias,anybiasisconsistentlyappliedacross rial facts?
years/firms/industries, and the users can adjust the
reported results to reflect their own desired bias.
Situations with Uncertainty
The option for an accounting paradigm, when faced
with uncertainty, is to either require the reporting of
As mentioned earlier, a conflict can arise between
unbiased values accompanied with sufficient disclo-
neutrality and reliability where uncertainty exists.
sure, or require the reporting of biased (‘prudent’ or
Some accounting paradigms require conservatism or
‘conservative’) values with the bias determined in a
prudence in such circumstances. The rationale for
predictable, consistent fashion.
requiring conservatism in the face of uncertainty is
that an uncertain asset, or asset of uncertain value,
Cost-benefitEffective cannot be relied upon. This may lead to the delayed
recognition of some assets until their value is more
Thereisageneralunderstandingthatthedevelopment dependably known or the ability to realize a gain
of accounting information consumes resources. As from their sale is more certain (i.e. the value of the
such, the cost of producing such information should asset is ‘reasonably certain’). Relative to liabilities,
be reasonable in relation to the expected benefit. this would lead to reporting of a high liability value,
This is reflected in many cases through the use of such that a final settlement value greater than the
materiality considerations in accounting paradigms, reported value is unlikely.
such that accounting rules may not have to be fully The danger with such approaches is in the relia-
followed for immaterial items if full compliance bilityandconsistencyoftheirapplication.Giventhat
would result in unwarranted higher costs. uses of information can differ, what is conservatism
to one user may be optimism to another. For exam-
RelevanceversusReliability ple,abuyerofanassetwouldapplyconservatismby
choosingahighestimatewhilethesellerwouldapply
There is a natural trade-off in many cases between conservatismbychoosingalowestimate.Asanother
relevance and reliability. For example, the value of example,ahighestimateofultimatelosseswouldbe
an infrequently traded asset may be very relevant, if conservative when estimating claim (see Reserving
theclearintentistoeventuallysellthatassettomeet inNon-lifeInsurance)liabilitiesbutoptimisticwhen
a liability. But the valuation of such an asset may be estimating agents’ contingent commissions.
difficultorimpossibletoreliablydetermine.Different Also,differentusershavedifferentrisktolerances.
parties may place materially different values on that Hence, any bias in accounting information runs the
asset, such that the reported value is impossible to risk of producing misleading information, unless the
verify by an external party or auditor. The only bias can be quantified or adjusted for by the end
reliable value for the asset may be its original cost, user. As a result, accounting paradigms may opt
Accounting 3
instead for reporting of unbiased estimates when Regulatorsinterestedinsolvencyregulation,how-
facedwithuncertainty,accompaniedbydisclosureof ever, may have more interest in run-off values than
theuncertainty,ratherthanrequiringthereportingof going-concernvalues.Thismayleadthemtodevelop
biased estimates. their own specialized accounting paradigm, such as
the ‘statutory’ accounting rules produced by the
National Association of Insurance Commissioners
Types of Accounting
(NAIC) in the United States. Such rules may place
more emphasis on realizable values for asset sale
The previous section (Purpose of Accounting) dis-
and liability settlement. Hence, they may require
cussed what is necessary for accounting information
a different set of valuation assumptions (possibly
to be usefulto its users.Butthere are differentkinds
including mandatory conservatism or bias), result-
of users with different needs and levels of sophisti-
ing in accounting values materially different from
cation. Therefore, different users may need different
GAAP values.
accounting rules to meet their needs.
Tax authorities may also desire, demand, or be
There are different ways in which users can be
legallyrequiredtousetheirownspecializedaccount-
grouped, each of which could lead to a different set
ingparadigm.Suchaccountingrulesmaybedirected
ofaccountingrules.Ingeneral,however,thegrouping
or influenced by social engineering, public policy,
orpotentialgroupingforinsurancecompanypurposes
political, or verifiability concerns. As such they may
usually includes the following categories:
be materially different from either GAAP or ‘statu-
• Investors, creditors – current and potential tory’ accounting rules.
• Regulators/Supervisors (the term ‘regulator’ is In the United States, the tax accounting rules for
insurance companies are based on statutory account-
common in the United States, while the term
ing,withmodification.Inmanypartsoftheworld,the
‘supervisor’ is common in Europe)
• Tax authorities GAAP, regulatory, and tax accounting rules are the
• Management. same.Oneadvantageofhavingonesetofaccounting
rulesisreducedcostandconfusioninthecreationof
This category grouping for users was chosen the information. One disadvantage is that the needs
becauseofitsclosealignmentwithcommontypesof ofalltheusersarenotthesame,hencecompromises
accounting.Itleavesoutthe‘ratingagency’and‘poli- must be made that are suboptimal to one or more
cyholder’usercategories.Theseotherusers’interests sets of users. For example, a public policy issue that
are typically aligned with regulators/supervisors due drives decisions of tax or regulatory authorities may
to the focus on solvency concerns. result in accounting rules that produce misleading
Accounting rules designed for a broad range of information for investors.
users (including investors, creditors, and owners) The general and two specialized accounting para-
are usually called general purpose accounting rules. digms mentioned above may still not meet the needs
These rules are also typically given the label Gener- ofcompanymanagement.Asaresult,manyorganiza-
ally Accepted Accounting Principles, or GAAP. tionscreateoneormoreadditionalsetsofaccounting
ThefocusofGAAPaccountingistypicallyonthe paradigmswithwhichtobasetheirmanagementdeci-
value or performance of an organization as a going sions. These are generally based on either GAAP or
concern. This is an important point, as many liabil- regulatory accounting rules, with modifications.
ities or assets would have a significantly different For example, the treatment of large claims may
value for a going concern than they would for an require special treatment in evaluating individual
entityinrun-off.Forexample,thevalueofatangible branches of a company. While a constant volume of
asset (such as large machinery or computer equip- large claims may be expected for the total results of
ment) used by a going concern in its business may a company, their incidence may severely distort the
betheasset’sreplacementvalue,butthevaluefora evaluationoftheindividualbusinessunitsthatsuffer
companyinrun-offthatnolongerneedstheassetmay the large claims in the single year being analyzed.
betheasset’sliquidationmarketvalue.GAAP,inthis If each business unit were a separate company, it
instance,wouldbemoreinterestedinthereplacement might have limited its exposure to such a claim (for
value(ordepreciatedcost)thantheliquidation value. example, via reinsurance or coverage restrictions),
4 Accounting
butfor the company as a whole, it mightmake more includes revenue and gains from sales, although it
sensetoretainthatexposure.Therefore,themanage- is not always necessary to distinguish between these
ment may wish to cap any claims to a certain level, two items.
whenlookingatitsinternal‘managementaccounting Some accounting systems differentiate various
basis’ results for individual business units, or may types of income. For example, operating income is
reflect a pro forma reinsurance pool (see Pooling in frequently defined to represent income from ongo-
Insurance) among the business units in its internal ing operations, excluding unusual one-time events
accounting results. or possibly realized capital gains whose realization
As another example, the existing GAAP and/or timingismostlyamanagementdecision.Otherexclu-
regulatory accounting rules may not allow discount- sions from operating income would be the effects
ing of liabilities, possibly due to reliability concerns. of accounting changes, such as a change in how to
Management, however, may feel that such discount- account for taxes or assessments from governmen-
ing is necessary to properly evaluate the financial tal bodies.
results of their business units, and within their oper- In general, net income causes a change to equity,
ation, they feel that any reliability concerns can be but may not be the sole source of changes to equity.
adequately controlled. An accounting system may have certain changes in
valueflowdirectlytoequity,withnoeffectonincome
until they are realized. Examples sometimes include
Principal Financial Reports unrealized gains and losses on invested assets.
The principal statements in financial reports are the
balancesheet,incomestatement,andcashflowstate- CashFlow Statement
ment. These are usually accompanied by selected
other schedules or exhibits, including various ‘notes The cash flow statement reports on the sources and
and disclosures’. uses of cash during the reporting period, and should
reconcile the beginning and ending cash position for
the company.
Balance Sheet
Thebalancesheetliststheassetsandliabilitiesofthe
Notesand Disclosures
company, with the difference between the assets and
liabilities beingequity (sometimesreferredto as‘net Thenotesanddisclosuressectionsoffinancialreports
assets’,‘capital’or ‘surplus’).This statementgives a allow for additional information beyond the three
snapshot of the current value of the company as of statements mentioned above, including a description
the statement or reporting date. oftheaccountingpoliciesusedinpreparingthefinan-
Note that some assets may not be required or cialstatementsanddiscussionofvaluesthatmaynot
allowed to be reported, due to concerns by the be reliably estimable. Such disclosures may include
accounting standard setters with reliable valuation. discussionoftherisksanduncertaintyassociatedwith
Examples can include various types of ‘intangi- the insurance liability estimates found in the balance
ble’ assets such as royalties, brand name or fran- sheetandincomestatement(insomecasesreferredto
chise value. Similarly, certain liabilities may not be as‘managementdiscussionandanalysis’).Theymay
reported because of reliability concerns. (See later also include ‘forward-looking information’, concern-
discussion of ‘Recognition and Measurement’, and ing estimates of future financial earnings or events
the discussion in this section on ‘Notes and Disclo- thathaveyettooccurbythefinancialreportpublica-
sures’.) tion date. Note that these are different from ‘subse-
quentevents’thatmaybedisclosed,whichareevents
IncomeStatement thatoccurredafterthestatementorvaluationdatebut
beforethepublicationdateofthefinancialreport.For
The income statement reports on the income and example, a catastrophe that occurred after the state-
expensesofthefirmduringthereportingperiod,with mentdate butbefore thepublicationdate wouldbe a
the difference being net income or earnings. Income subsequentevent,notincludedinthereportedequity
Accounting 5
or income. In contrast, a discussion of future expo- this role for the AICPA in the future. Except for
sure to catastrophes for the coming year would be a certain projects in process and not yet completed at
‘forward-looking’ statement. thatdate,theFASBwillnolongerlooktotheAICIPA
tocreateSOPs.(FASBnewsletterTheFASBReport,
November 27, 2002.)
Sources of Accounting Rules Last on the hierarchy would be interpretations,
such as those issued by the IASB’s International
Withinanygivenaccountingparadigmtherearetyp- FinancialReportingInterpretationsCommittee.Inter-
ically several different sources of rules. Where the pretations are produced when timely guidance is
rulesforagivenparadigmpotentiallyconflict,apre- needed, as they can be produced much faster than
defined hierarchy must be followed. Rules from a officialaccountingstandards.Thisisduetothemuch
source higher on the hierarchy supercede or overrule shorterperiodfordueprocessintheproductionofan
those from a source lower on the hierarchy. official interpretation.
GAAP Regulatory/Supervisory Accounting
The top of the GAAP hierarchy is generally the Regulatory accounting rules can consist of a totally
organization in charge of securities regulation for separate set of standards, produced by or with the
a particular jurisdiction. They may defer the rule approval of the regulator, or can consist solely of
settingtoaspecifiedaccountingstandardsetter,such additional specialized accounting schedules, filed in
as the IASB, but they generally have the authority additional to the normal GAAP financial reports.
to add additional requirements or rules. They may Worldwide, it appears to be more common for the
alsoretainvetopoweroverthedesignatedaccounting regulators to rely on GAAP financial statements.
standard setter’s proposed new rules. (This describes In the United States, regulators have developed a
the situation in the U.S., where the SEC (Securities complete set of accounting rules, combining ele-
and Exchange Commission) retains veto power over ments of both liquidation accounting and going con-
new FASB standards.) A list of such organizations cern accounting.
can be found on the web site of the International
Organization of Securities Commissions (IOSCO).
Tax Accounting (forFederal IncomeTax
Next in the hierarchy are the standards set by the
Purposes)
specified accounting standard setter for that jurisdic-
tion. The European Union has identified the Inter-
TaxaccountingrulescanbebasedonGAAPaccount-
national Financial Reporting Standards (IFRS) pro-
ingrules,statutoryaccountingrules,ordeterminedon
duced by the IASB as the accounting standards for
a totally separate basis. This determination is gener-
companies with publicly traded securities. In the
allybasedontaxlaworregulationforthejurisdiction
United States, the SEC has designed the Financial
in question. Some countries rely on GAAP account-
Accounting Standards Board (FASB) as the account-
ingreportstodeterminetaxableincome,whileatleast
ing standard setter under the SEC. Note that these
one relies on statutory accounting reports with mod-
standards would be at the top of the hierarchy for
ifications.
companies thatare not subject to public-traded secu-
rities rules (for example, a privately owned firm).
These standards may be supplemented by
Selected Accounting Concepts
industry-specific guidance. In the United States,
some industry-specific guidance in the form of This section defines and discusses the following
Statements of Position (SOPs) came from a separate accounting concepts:
organization of accounting professionals called
the American Institute of Certified Professional • Fair value versus historical cost
Accountants (AICPA). The United States’ FASB • Recognition versus measurement
retained effective veto power over AICPA-issued • Deferral-matching versus asset–liability
guidance. The FASB decided in 2002 to eliminate • Impairment
6 Accounting
• Revenue recognition includes a discounting of future cash flows. This ini-
• Reporting segment tial measurement value would then be included in
• Liquidation versus going concern subsequent financial reports (i.e. ‘locked-in’) until
• Change in accounting principle versus change in the remeasurement is triggered, ignoring the change
accounting estimate in assumptions and facts since the original measure-
• Principle-based versus rule-based. ment.Theruleforthetriggeringofsubsequentremea-
surementmaybewhethertheundiscountedflowsare
likely to be less than the current value.
Fair Value versusHistorical Cost
According to the IASB, ‘Fair value is the amount
Deferral/Matching versusAsset/Liability
for which an asset could be exchanged or a liabil-
ity settled between knowledgeable, willing parties in Twomajorclassesofaccountingparadigmsaredefer-
anarm’slengthtransaction’.(FromtheIASB’sDraft ral/matching and asset/liability.
StatementofPrinciplesforInsuranceContracts,para- Under a deferral/matching approach, the focus
graph 3.4, released November 2001.) It is meant to is to coordinate the timing of income and expense
representmarketvaluegivenasufficientlyrobustand recognitionsothatbothoccuratthesametime,when
efficientmarket.Wherenosuchmarketexists,thefair the triggering event that is the focus of the con-
valueconceptuallywouldbeestimated.Whenthefair tract occurs. For example, under a deferral/matching
value estimate is based on a model rather than an approach,thepremiumisnotrecognizedwhenrecei-
actually observed market value, it is called ‘marked ved but is instead recognized (‘earned’) over the
to model’ rather than ‘marked to market’. policy term during the period the insurance pro-
Historical cost is the amount (price) at which the tection is provided. Likewise, the related expenses
asset or liability was originally obtained. Where the and incurred losses are not recognized when paid
historical cost is expected to be different from the or committed to but are instead recognized over
finalvaluewhentheitemisnolongeronthebalance the same period as the premium. This may lead
sheet,someamortizationordepreciationofthevalue to the deferral of some up-front expenses, and the
maybecalledfor.Thiscanresultinanamortizedcost accrualof some losses thatmay take decadesto pay.
or depreciated costvalue. These values are generally The deferral/matching approach requires the estab-
more reliably determinable, but less relevant than lishment of certain assets and liabilities to defer or
fair value. acceleraterecognitionofrevenue,expenseorloss,in
order to obtain the desired income statement effect.
Recognition versusMeasurement Hence, the focus is on the income statement more
than the balance sheet. The two most common bal-
Accounting rules distinguish the decision or rule to ance sheet accounts resulting from this approach
recognizeanassetorliabilityinfinancialreportsfrom for insurance companies are Deferred Acquisition
the rule establishing how to measure that liability Cost (DAC) assets, used to defer the impact of
once recognized. For example, the rule for when to certain up-front expenses on the income statement,
record an asset may be to wait until the financial and unearned premium liabilities (see Reserving in
benefit from it is virtually certain, but the rule for Non-life Insurance), used to defer the reflection of
measuringitatinitialrecognitionmaybetorecordits revenue.
mostlikelyvalue.Hence,theprobabilitystandardfor Under an asset/liability approach, the focus is on
recognition may vary from the probability standard the value of assets or liabilities that exist as of the
for measurement. balance sheet date. An asset is booked if a right to
There may also be multiple recognition triggers a future stream of cash flows (or to an item that
and measurement rules. For example, the rule for could be converted to future cash flows) existed at
initial recognition may differ from the rule for the the reporting date. Likewise, a liability is booked if
triggeringofsubsequentremeasurement.Therulefor the entity was committed to an obligation at the bal-
initial recognition of an asset may be based on ‘rea- ance sheet date that would result in the payment of
sonable certainty’ of economic value. The measure- future cash flows or other assets. Such an approach
mentbasismaythenbeitsfairvalue,whichimplicitly would not recognize a ‘deferred acquisition cost’ as
Accounting 7
an asset if it cannot be transferred or translated as for those industries where revenue growth is a key
cash. It would also not recognize an unearned pre- performance measure.
mium liability beyond that needed for future losses, Under a deferral/matching approach, revenue
expenses or returned premiums associated with that would be recognized only as service is rendered. In
contract. In general, the income statement is what- the insurance context, revenue would be recognized
ever falls out of the correct statement of the assets underthedeferral/matchingapproachoverthepolicy
and liabilities, hence the focus on the balance sheet period in proportion to the covered insurance risk.
over the income statement. Under an asset/liability approach, revenue would be
Proponents of a deferral/matching approach recognized up front, once the insurer gained control
have commonly focused on the timing of profit of the asset resulting from the revenue. Therefore,
emergence. Except for changes in estimates, under thetimingofrevenuerecognitionisafunctionofthe
a deferral/matchingapproach,the profitemergesin a chosen accounting paradigm.
steady pattern over the insurance policy term.
Proponents of an asset/liability approach have
Impairment
commonly stressed the importance of reliable mea-
sures of value at the reporting date. They typically It is possible to reflect one paradigm for income
favor the booking of only those assets that have statement purposes and another for balance sheet
intrinsicvalue,andtheimmediatereflectionofliabil- purposes.Thissometimesleadstotheuseof‘impair-
ities once they meet recognition criteria, rather than ment’ tests and rules, to prevent inconsistencies
(what some consider) an arbitrary deferralto smooth betweenthetwovaluationsfromgrowingtoolargeor
outreportedearnings.(Anexampleofanassetunder problematic. (An asset may be considered impaired
a deferral/matching approach with no intrinsic value
if it is no longer expected to produce the economic
is a deferred acquisition cost asset. One indication
benefits expected when first acquired.)
thatithasnointrinsicvalueisthatitisimpossibleto
For example, consider an accounting paradigm
sell it for cash.)
that requires an asset to be reported at its fair value
Itispossibleforbothapproachestoproducecom-
with regular remeasurement for balance sheet pur-
parable income statement results, and one would
poses, but at locked-in historical cost valuation for
generally expect both to produce comparable equity
income-statement purposes. A risk under such an
values, but the actual data available to the user may
approach is that the two could become significantly
vary significantly between the two approaches. For
outofsync,suchaswhenthefairvalueofassetshave
insurance contracts, a principal determinant of how
droppedsignificantlybelowtheirhistoricalcost.This
similar the income statements would be under the
risk can be alleviated through required regular test-
twoapproachesisthetreatmentofriskwhenvaluing
ing of any such shortfall, to determine whether such
assets and liabilities. For example, the asset or lia-
a shortfall is permanent (i.e. whether a ‘permanent’
bility risk margin under an asset/liability approach
impairment exists). When this happens, the extent
could be set such that profit is recognized evenly
of permanent impairment would be reflected in the
over the coverage period. This could recreate the
incomestatement.Theresultwouldbeareductionin
same profit emergence pattern found under a defer-
thediscrepancybetweenthecumulativeincomestate-
ral/matching system.
mentsandcumulativebalancesheetchanges,without
Itisalsopossibleforasingleaccountingparadigm
bringing the income statement to a fair value basis.
to combine elements of both these approaches. This
is sometimes called a ‘mixed attribute’ paradigm.
A deferral/matching paradigm is used by the Reporting Segment
IASB for accounting for service contracts, while it
GAAP financial statements are typically produced
endorsedin2003anasset/liabilityparadigmforinsur-
on a consolidated basis for the reporting entity. The
ance contracts.
consolidation may include the combined impact of
multiple legal corporations or other entities with the
RevenueRecognition
same ultimate parent company or owner.
Akeyquestioninsomeaccountingsituationsiswhen Regulatory financial statements may be required
to recognize revenue. This is particularly important on a nonconsolidated basis, separately for each legal