Insurance Accounting Basics

Okay, One peculiar aspect of the insurance industry is the great lapse of time between the revenues on the one hand and the related expenses on the other--in other words, between the receipt of premiums from policyholders and the payment of claims. This gap makes actuarial estrimates (of the expected longevity of the insured, for example, in the case of life insurance) a crucial factor in determining the profitability, even the solvency, of a firm.

Loss and Loss Adjustments

At the heart of the insurance industry are two accounting transactions unique to that market: paying claims on the one hand, and increasing or decreasing claims reserves on the other. Both transactions combine to make up "incurred losses." The net change in reserves over an accounting period, plus paid claims, equals the incurred losses.

There are also recoverables, or cash offsets, such as salvage and subrogation, that are recorded as negative paid losses.

For example, an insurance company may reserve a "right of subrogation" after a loss. The company will pay the insured its claim and then step into the position of its insured as a possible plaintiff against a third party who may have caused the damage.

Reinsurance
Insurance companies often contract out a portion of their risk by entering into their own contracts with reinsurance companies. The accounting procedures for reinsurance are, as a report from the London School of Economics put it in 1996, a "mirror image of the accounting for the direct insurance."

The Standard Setters
The International Accounting Standards Board (IASB), in London, produces the International Financial Reporting Standards (IFRS), the standards accepted by most of the financial accounting world outside of the United States. The Financial Accounting Standards Board (FASB), in Norwalk, Connecticut, is its counterpart for accountants within the U.S.

The two bodies are engaged in a joint project, developing what they call a "measurement approach" to insurance. This addresses the time gap between revenue and expense by requiring a present value assessment of a given contract, with three elements: the explicit probability-weighted average of future cash flows expected to arise given insurer fulfillment of the contract; the effect of the time value of money; and the elimination of gains from the mere inception of the contract.

The Discount Rate
The provision for the effect of the time value of money that will be allowed in the emerging standards is also known as the discount rate.

This rate, the two boards have agreed, "shall reflect the characteristics of the contracts, rather than the characteristics of assets actually held to back the contracts, unless the contracts share those characteristics."

Specifically, if the insurance contract-related cash flows do not themselves reflect the productivity of specific assets, then the discount rate will simply be the risk-free rate with an adjustment for illiquidity. On the other hand, if the productivity of specific contract-backing assets does play a part in determining the cash flow, the discount rate will be adjusted to reflect as much.

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Tips, Do You Really Need Life Insurance?

Whether you need life insurance depends on your family circumstances and your personal financial status. No pat answer covers every individual situation. Evaluating the family financial condition as objectively as possible can help you determine if you need life insurance. An honest in-depth assessment of what life would be like for your family without you, both now and in the future, is a good place to start in gathering information to make the decision.

Look at the Larger Picture
Looking at present circumstances helps determine if you need life insurance. If you have a hefty mortgage and your spouse or partner would be liable for the remainder without your income to rely on, this consideration should factor into your decision. Other debts, such as auto loans, student loans and credit card balances, need to be taken into account as well. Whether your family depends on your income for day-to-day living expenses is another factor. In addition, current resources play a significant role in determining if you need life insurance. Assets to consider are balances in emergency savings, investments and retirement accounts. You should also calculate how long these funds would last if contributions stopped today.

Analyze Your Daily Expenses
Awareness of where your money is spent on a day-to-day basis makes it easier to determine your dependents' future needs. A list of your present expenses shows where your family's income goes. Looking back over the past two years of monthly expenses provides an even broader view. Checkbook registers and filed copies of monthly bills offer insight into regular and expected expenses, and unusual and one-time payments. Your consideration here is whether your survivors could pay all these expenses and maintain their lifestyle if your income were suddenly gone with no possibility for replacing it. Life insurance can fill in that gap.

Peer Into the Future
Analyzing potential future expenses is important in determining if you need life insurance. Consider where the money will come from if you have children who will require financial help with college. Another factor is whether you wish to protect your assets and how much you want to leave for your children and grandchildren. Immediate expenses your family would incur in the event of your early death include funeral expenses and, in some jurisdictions and situations, estate taxes. In addition, you might be leaving your survivors with unpaid medical bills.

Doing Without Life Insurance
Not everyone needs life insurance. Perhaps your mortgage is paid and you have no outstanding personal loans. If your children are grown and college is behind them, or you have no children at all, your need for life insurance may be greatly diminished. You might be without a spouse or partner, or your spouse or partner does not depend on your income to meet living expenses. If your savings and investments will leave a comfortable income for your survivors in addition to covering funeral expenses and any medical bills left behind, then life insurance may be an extraneous expense.

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