8-1

Statutory Accounting

1. NAIC Annual Statement Blank

2. Differences between Statutory Accounting and GAAP

• admitted and non-admitted assets

• valuation of assets (stocks, bonds)

• matching of revenues and expenses

8-2

Terminology

Policyholders’ Surplus

• excess of assets over liabilities

• for capital stock insurers, capital and surplus

• for mutual insurers, surplus

Reserves

• synonymous with liability in insurance company accounting

8-3

NAIC Codification Project

1. Statutory accounting system has come under criticism by public accountants (AICPA).

2. In 1993, the AICPA announced it would not issue unqualified opinions on statutory accounting statements after 1994.

3. AICPA argues that statutory accounting principles are not clearly articulated: they are not generally codified by state laws and differences exist across states.

4. NAIC responded with a project to more clearly define principles of statutory accounting and seek state codification of these principles.

8-4

Property and Liability Insurers

1. Earned premiums

2. Unearned premium reserve

3. Incurred losses/loss reserves

4. Incurred expenses

5. Summary of operations

6. Investment results

7. The combined ratio

8-5

Property and Liability Insurer Surplus Drain

Premiums Written $100,000

Premiums Earned 50,000Expenses Incurred -40,000Incurred Losses -25,000Net Operating Loss -15,000

Statutory operating loss is an illusion that stems from mis-matching revenues and expenses.

8-6

Property and Liability Insurer Surplus Drain

1. Incurred expenses must be charged before income is earned.

2. Premiums earned on existing policies could offset the statutory underwriting loss.

3. When premiums are increasing, statutory profit is understated.

4. When premiums are decreasing, statutory profit is overstated.

8-7

Life Insurers

1. Life insurer assets

2. Life insurers liabilities

3. Life insurers policyholders surplus

4. Life insurer summary of operations

5. Surplus drain in life insurance

8-8

Reinsurance

1. Nature of reinsurance

2. General approaches• facultative • treaty

3. Types of treaties• facultative• automatic

8-9

Reinsurance in Property & Liability Insurance

1. Proportional reinsurance

• quota share

• surplus line

2. Excess loss reinsurance

8-10

Reinsurance in Life Insurance

1. Term insurance approach

2. Coinsurance approach (quota share)

8-11

Functions of Reinsurance

1. Spreading of risk

2. Financing function - surplus relief

8-12

Risk Financing Alternatives to Reinsurance

Insurance Derivatives - Securitization of Insurance Risk

• Derivatives are financial instruments that embody futures or options in a security, commodity, and financial markets.

• Price is derived from the value of commodity prices, interest rates, stock market prices, and now insurance indexes.

• Like reinsurance, insurance derivatives are designed to transfer a part of an insurer’s underwriting risk to another party.

8-13

Risk Financing Alternatives to Reinsurance

Derivatives differ from reinsurance in risk financing by securitizing insurance risk--that is, linking it to securities.

• Instead of transferring specific risks, insurer makes a side bet with a speculator.

• Side-bets have been manifest in two ways:

»CBOT catastrophe insurance futures options

» catastrophe bonds (act of God bonds).

8-14

Catastrophe Futures and Options

A futures contract is a binding contract providing for the delivery of a specified quantity of some commodity or financial instrument at some future specified date

An option contract is a contract in which one of the parties pays for the right to purchase a commodity at a specified price (called the exercise price or strike price) at some time during a specified option period.

8-15

Catastrophe Futures and Options

In 1995, CBOT began trading catastrophe insurance futures options, based on a benchmark of catastrophe estimates, provided by Property Claim Services, known as PCS options.

• For PCS options, the “commodity” is an amount of dollars indicated by an index of catastrophe losses.

• By acquiring call options—the right to buy futures contracts whose price is pegged to disaster losses—an insurer can earn a profit and arrange a future source of funds to pay claims for catastrophe losses.

8-16

Catastrophe Bonds (also called cat bonds of act of God bonds)

Issued by an insurer with the repayment terms linked to company's losses from disasters.

• Loss exceeding a certain size automatically produces changes in the bonds' structure designed to protect insurer's capital base.

• Some or all of the principal is forgiven or subject to deferred payment in the event the issuing insurer suffers a catastrophe loss.

• For stock insurers, the bonds may also provide for automatic conversion of the cat bonds into stock in the insurer.

8-17

Future of Insurance Derivatives

Future of insurance derivatives remains to be seen.

• Initially, the industry has been indifferent.

• Some reluctance is a philosophic predisposition.

• Some uncertainty regarding regulatory response.

• Illinois, New York, and California approved use of futures but most states have not addressed issue.

• Reinsurance is well understood, while insurance derivatives are new and untested.

• Transactions thus far do not offer any economies over traditional reinsurance.

8-18

Taxation of Insurance Companies

1. State premium taxes

• sales tax on all premiums sold in state

• varies from 2% to 4%

• some states tax domestic insurers at a lower rate

8-19

Taxation of Insurance Companies

2. Federal income taxes

• same tax rates as other corporations

• computation of taxable income is different to reflect effect of reserves and prepaid expenses

8-20

Taxation of Life Insurers

Special I.R.C. provisions for life insurers

1. Small Company deduction - 60% of first $3 million in life insurance company taxable income (LICTI)

2. Mutual insurers’ deduction for policyholders dividends is reduced by a “differential earnings” amount (an imputed return on equity)

3. Policy acquisition expense must be capitalized and amortized.

8-21

Taxation of Property & Liability Insurers

Tax Reform Act of 1986

1. Only 80% of increase in unearned premium reserve is deductible.

2. Loss reserves are subject to statutory discounting.

3. 15% of tax exempt interest and dividends is disallowed.