Statutory Accounting

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

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

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.

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

5. Property and Liability Insurer Surplus Drain • Premiums Written $100,000 • Premiums Earned 50,000 • Expenses Incurred -40,000 • Incurred Losses -25,000 • Net Operating Loss -15,000 • Statutory operating loss is an illusion that stems from mis-matching revenues and expenses.

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.

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. Reinsurance • 1. Nature of reinsurance • 2. General approaches • facultative • treaty • 3. Types of treaties • facultative • automatic

9. Reinsurance in Property & Liability Insurance • 1. Proportional reinsurance • quota share • surplus line • 2. Excess loss reinsurance

10. Reinsurance in Life Insurance • 1. Term insurance approach • 2. Coinsurance approach (quota share)

11. Functions of Reinsurance • 1. Spreading of risk • 2. Financing function - surplus relief

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.

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).

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.

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.

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.

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.

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

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

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.

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.