Financial Accounting in          Insurance Companies                                                      Basic ConceptsRe...
Basic Terms                                              Accounting: A system or set of rules and methods for collecting, ...
Financial Statements                                              Balance sheet (Account form)                    Balance ...
User of Accounting informationFinancial Accounting in Insurance Companies                                                 ...
Accounting Equation                                                  Asset (A)                    Liability (L)           ...
Chart of Accounts                                              An account is a tool that a company uses to record, group, ...
Double Entry Accounting                                                  1.  Every business transaction has at least one d...
Accounting Cycle                                                Journalisation (making journal                            ...
Accounting Entries                                              Accounting entry or journal entry is a record of a busines...
Types of Accounting Entries                                              Closing Entry is an accounting entry that a compa...
Normal Balances                                              Account balance is the monetary amount (Debit minus Credit) i...
Accounting Principles and Concepts                                              Two Financial Statement Concepts:         ...
Realization and Matching principle                                              Realization principle states that a compan...
Account Bases – Accrual and                                                             Cash basis                        ...
Asset Accounting                                              Some definitions                                            ...
Asset Accounting…Cont.                                              Accounting for asset (A) purchaseFinancial Accounting ...
Asset Accounting…Cont.                                              Accounting for asset (A) SaleFinancial Accounting in I...
Asset Accounting…Cont.                                              Some Complex Asset Accounting EntriesFinancial Account...
Asset Accounting…Cont.                                              Some Complex Asset Accounting Entries                 ...
Asset Accounting…Cont.                                              Some Complex Asset Accounting Entries                 ...
Asset Accounting…Cont.                                              Some Complex Asset Accounting Entries                 ...
Reserve (Liabilities) Accounting                                              Reserve are estimates of the amount of money...
Reserve (Liabilities) Accounting…cont.                                                 Recording and paying policy owner d...
Reserve (Liabilities) Accounting…cont.                                              Waiver of premium accounting          ...
Capital and Surplus Accounting                                              Preferred Stock                               ...
Revenue and Expense Accounting                                              Premium Income                                ...
Revenue and Expense Accounting…cont.                                              Producer Commission                     ...
Revenue and Expense Accounting…cont.                                              Reinsurance Allowances and Premiums     ...
Responsibility Accounting                                              The area, function or organizational unit that a sp...
Insurance company responsibility                                                                 centers organization     ...
Cost Accounting                                              Cost Classification by description                           ...
Cost Accounting…cont.                                              Cost Classification by behavior                        ...
Cost Accounting…cont.                                              Cost Classification by measurement                     ...
Cost Accounting…cont.                                              Cost Accumulation                                      ...
Auditing                                              An audit is the examination and evaluation of company accounting rec...
Accounting Regulation (US)                                              Generally Accepted Accounting Principles (GAAP) is...
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Accounting in insurance companies basic concepts

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This is a primer on accounting in insurance companies.

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  • Less accounting for Insurance company but more of General Basic Accounting Concepts applicable to all 'profit-making' entities
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Accounting in insurance companies basic concepts

  1. 1. Financial Accounting in Insurance Companies Basic ConceptsReference:1.  LOMA 361(Accounting and Financial Reporting in Life Insurance Companies) Course Material Prepared by Avik Saha (mail@aviksaha.com)2.  Essentials of Financial Accounting by Asish K, Bhattacharyya
  2. 2. Basic Terms Accounting: A system or set of rules and methods for collecting, categorizing, measuring, recording, summarizing, reporting, analyzing and monitoring financial information about the financial condition and performance of a company as a whole,Financial Accounting in Insurance Companies as well as of segments, product lines or divisions within the company. Financial Reporting: The process of presenting financial data about a company’s financial position, the company’s operating performance, and the flow of funds for an accounting period. Business Transaction: A transaction to which a company must assign an objective monetary value, whether the impact on the company is large or small, actual or expected. Solvency: Company’s ability to meet its financial obligation on time and with available cash. Profitability: Degree to which a company is successful in consistently generating money for its owners. Prepared by Avik Saha 3
  3. 3. Financial Statements Balance sheet (Account form) Balance sheet (Report form) Assets Liabilities Assets Owners’ Equity Liabilities Owners’ EquityFinancial Accounting in Insurance Companies Income Statement Revenues (-) Expenses Earning Before Interest and Tax (EBIT) (-) Interest Expense Earning Before Tax (EBT) (-) Income Tax Net Income Cash Flow Statement Cash Flow from operating activities (+) Cash Flow from Investing activities (+) Cash Flow from Financing activities Net Increase (Decrease) in Cash (+) Beginning Period Cash Balance Ending Cash Balance Prepared by Avik Saha 4
  4. 4. User of Accounting informationFinancial Accounting in Insurance Companies External Users Internal Users •  Individual Policy Owners •  Employees •  Group Policy Owners •  Directors •  Beneficiaries •  Officers Direct Interest •  Insureds •  Stockholders •  Producers •  Creditors •  Competing Companies •  External Auditors •  Insurance Commissioners Indirect Interest •  Independent Rating Agencies •  Tax Authorities Prepared by Avik Saha 5
  5. 5. Accounting Equation Asset (A) Liability (L) Owner’s equity (E)Financial Accounting in Insurance Companies Items of value owned by Monetary value of a Owner investment in the the company company’s current and company future obligations •  Cash •  Contractual reserves •  Common Stocks outstanding •  Investments (stocks, bonds) •  Commissions payable •  Preferred Stock outstanding •  Premium due and receivable •  Accrued Expense •  Additional Paid-in capital •  Accrued Income •  Retained Earnings •  Equipment •  Real Estate etc Prepared by Avik Saha 6
  6. 6. Chart of Accounts An account is a tool that a company uses to record, group, and summarize similar type of business transactions which typically involve Assets, Liabilities, Owner’sFinancial Accounting in Insurance Companies Equity, Revenues and Expenses. Chart of Accounts is a numbered or an alphabetical list of all the company’s account names. Example: 1000 Assets Permanent Account is a balance sheet 1001 Bonds account that has a balance at the 1002 Common Stocks 1003 Mortgages beginning of each accounting period. 2000 Liabilities E.g. Asset, Liability and Owner’s Equity 2001 Contractual Reserves Accounts 2002 Other Liabilities 3000 Owner’s Equity 3001 Capital Temporary Account or a nominal account is 3002 Surplus an account that is closed out to a 4000 Revenues permanent account on the balance sheet 4001 Premium Income 4002 Investment Income at the end of each accounting period. 5000 Expenses E.g. Revenue and Expense accounts. At 5001 Contractual benefits the beginning of each account period 5002 Operating Expenses temporary accounts have zero balance Prepared by Avik Saha 7
  7. 7. Double Entry Accounting 1.  Every business transaction has at least one debit and one credit 2.  The total monetary amount of debits must equal that of the credits for that transaction 3.  Each accounting entry maintain the balance of the basic accounting equation (A=L+E)Financial Accounting in Insurance Companies Debit (Dr.)/Credit (Cr.): Specified change made to the monetary value of an account Debit increases values of Asset and Expense accounts; decreases values of Liability, Owner’s Equity and Revenue Accounts Credit decreases values of Asset and Expense accounts; increases values of Liability, Owner’s Equity and Revenue Accounts Dr. Cr. Asset = Liabilities + Owner’s Equity + + - - Cr. Expense Revenue Dr. Prepared by Avik Saha 8
  8. 8. Accounting Cycle Journalisation (making journal entry) of transactions and business eventsFinancial Accounting in Insurance Companies General Ledger posting and balancing Preparation of Trial Balance Preparation of final accounts (Balance Sheet, Income Statements, Cash Flow Statements) Prepared by Avik Saha 9
  9. 9. Accounting Entries Accounting entry or journal entry is a record of a business transaction that includes at least one debit and one credit and shows the monetary transactions in balance on a specified dateFinancial Accounting in Insurance Companies Simple Accounting Entry Insurer A receives $2000 annual premium on a life insurance policy: Cash…………..2000 Dr. Premium Income………..2000 Cr. Compound Accounting Entry Insurer A paid a claim of $10000 plus interest of $100 to a beneficiary: Death Claim Paid………10000 Dr. Interest Expense………..100 Dr. Cash…………………………10100 Cr. Prepared by Avik Saha 10
  10. 10. Types of Accounting Entries Closing Entry is an accounting entry that a company makes at the end of each accounting period to start the next accounting period with zero balance in the temporary accounts. E.g. Suppose in an accounting period Insurer A has $3000 of Revenue and $2000 of Expense. As Revenue and Expense accounts are temporary, their balances will be $0 at the beginning of the nextFinancial Accounting in Insurance Companies accounting period. So a closing entry is made to transfer the net income of $1000 to the Retained Earnings or Surplus account (permanent Owner’s Equity account). Adjusting Entry is an accounting entry that a company makes to record accruals for revenues and expenses, unearned revenues and prepaid expenses. Other adjusting entries include depreciation, changes made to reserve accounts and corrections to previous accounting periods. Accruals refers to expense incurred but not yet paid or revenue earned but not yet received. Unearned revenues refers to the income e.g. unearned premium which has been collected in one accounting period but coverage to be provided in the next period but before policy anniversary date. Prepaid expense are those expenditures, remitted in advance, that the insurer expects will provide a future value of benefits The adjusting entry for salary earned by the producer but not yet paid: Accrued Salaries Expense……….XXX Dr. Salaries Payable………………………….XXX Cr. When salary is paid to the producer: Salaries Payable…………………..XXX Dr. Cash………………………………………XXX Cr. Prepared by Avik Saha 11
  11. 11. Normal Balances Account balance is the monetary amount (Debit minus Credit) in an account on a particular date. If Debit > Credit, the account has normal debit balanceFinancial Accounting in Insurance Companies If Credit > Debit, the account has normal credit balance Normal balance is the side of the account, whether debit or credit, to which increases to the account is recorded. Normal Debit Balance Normal Credit Balance Asset Liability Expenses Owner’s Equity Revenue If an account shows opposite of its normal balance, that account is subject to manager review. For example, if Cash account which has a normal debit balance, shows credit balance i.e. the cash balance is below zero, it needs investigation. Prepared by Avik Saha 12
  12. 12. Accounting Principles and Concepts Two Financial Statement Concepts: Entity Concept states that a company must account separately for the business activities of each entity, business unit or economic unit. An entity is the basic business unit for which a company keeps separate business records and prepareFinancial Accounting in Insurance Companies reports, e.g. a person, a partnership, a corporation , an organization, a business or a portion of a business. The Going Concern concept states that a company should maintain its accounting records with the assumption that the company would continue to operate indefinitely i.e. it is not facing liquidation. Liquidation is the process of selling all company assets for cash and using that cash to pay the company’s debts; any remaining funds are distributed to the company’s owners. Insurers should disclose all material or significant information in the financial statements. The accounting information should be : Relevant i.e. useful and timely to affect an user’s decision about the company Reliable i.e. accurate, objective and free from bias and misrepresentation Comparable i.e. statements for different accounting periods and different companies can be compared Consistent i.e. company follows same accounting principles in different periods (unless there is a sound reason to change) Conservative i.e. prudent reaction; understating asset and revenue, overstating liabilities and expenses Prepared by Avik Saha 13
  13. 13. Realization and Matching principle Realization principle states that a company should recognize revenue when it isFinancial Accounting in Insurance Companies earned, regardless of when the company receives the actual payment (insurance premium or annuity consideration for example), so long as a legal and reasonable expectation exists that the customer will remit payment in full. Recognition refers to the process of classifying an item in a financial statement as an asset, liability, owner’s equity, revenue or expense. Matching Principle states that a company should recognize expenses as the company earns the revenue related to those expenses, regardless of when the company receives payment for the revenues earned and regardless of when the company actually paid the expenses. Realization Principle and Matching Principle work in tandem. Prepared by Avik Saha 14
  14. 14. Account Bases – Accrual and Cash basis Accrual basis Accounting is an accounting system under which a company records revenues when they are earned and expenses when they are incurred, even if theFinancial Accounting in Insurance Companies company has not yet received the revenues or paid the expenses. Cash basis Accounting is an accounting system under which a company records revenues and expenses only when it receives cash or disburses cash. Only accrual basis accounting follows realization and matching principles. Example: On 31st Dec, 2010, Insurance company ABC bought $5000 of furniture on account from XYZ. XYZ delivered it same day. ABC remits the payment in full on Jan 10, 2011. Cash Basis Accrual Basis Furniture…….$5000 Dr. December 31, 2010 No Accounting entry Accounts Payable…......$5000 Cr. January 10, 2010 Furniture…….$5000 Dr. Cash…......$5000 Cr. Accounts Payable …….$5000 Dr. Cash…......$5000 Cr. Note: All subsequent examples follow accrual basis accounting. Prepared by Avik Saha 15
  15. 15. Asset Accounting Some definitions Valuation is the process of calculating monetary value of an assetFinancial Accounting in Insurance Companies Historical Cost is the original price paid for the asset Book value is the value at which the company records the asset in its accounting records and reports the asset on the balance sheet. On date of purchase, asset’s historical cost equals book value. Amortization is the periodic and systematic increase or decrease of the original cost of an investment to its ultimate value at maturity Depreciation is the allocation (spreading) of the cost of an asset over the asset’s estimated useful life. Total amount of depreciation allocated to an asset as of a specified date is called Accumulated Depreciation. Fair value is the price that an asset would obtain if the seller sells the asset to the buyer in the absence of a required liquidation (in case of bankruptcy) or other condition that would force the asset’s sale by the seller. Fair value accounting is reporting a company’s assets on the balance sheet at fair value. Bond, Stock, Mortgages are some of the investment vehicles of insurance companies. These are invested assets. Prepared by Avik Saha 16
  16. 16. Asset Accounting…Cont. Accounting for asset (A) purchaseFinancial Accounting in Insurance Companies Purchase on Cash Asset A ……. $$$ Dr. (Asset) Cash….$$$ Cr. (Asset) Purchase on Account Asset A ……. $$$ Dr. (Asset) Accounts Payable ….. $$$ Cr. (Liability) Purchase on Account with a cash down payment Asset A ……. $$$ Dr. (Asset) Cash….$ Cr. (Asset) Accounts Payable ….. $$ Cr. (Liability) Prepared by Avik Saha 17
  17. 17. Asset Accounting…Cont. Accounting for asset (A) SaleFinancial Accounting in Insurance Companies Sale for Cash Cash….$$$ Dr. (Asset) Asset A ……. $$$ Cr. (Asset) Sale on Account Accounts Receivable - Asset A ….$$$ Dr. (Asset) Asset A ……. $$$ Cr. (Asset) Sale on Account with a cash down payment Accounts Receivable - Asset A ….$$ Dr. (Asset) Cash…………………………………$ Dr. (Asset) Asset A ……. $$$ Cr. (Asset) Prepared by Avik Saha 18
  18. 18. Asset Accounting…Cont. Some Complex Asset Accounting EntriesFinancial Accounting in Insurance Companies Bonds …………………………………...$1000 Dr. Investment Income Due and Accrued …..$20 Dr. Cash …………………………………$1020 Cr. (To record the cash purchase of a bond with face value $1000 and accrued interest of $20) Cash Dividend income due and accrued ………$200 Dr. Dividend Income - Common Stock……….$200 Cr. (To record (on ex-dividend date) the cash dividend income due and accrued on 200 held shares at the rate of $1/share) Note: Ex-Dividend Date is the date used to determine whether a stockholder is eligible to receive a declared cash dividend. Bonds pay interest (and return of capital). Stocks pay dividend (and capital gain or increase in stock price) Prepared by Avik Saha 19
  19. 19. Asset Accounting…Cont. Some Complex Asset Accounting Entries AT&T stock ………..$9500 Dr.Financial Accounting in Insurance Companies Cash………………..$9500 Cr. (To record purchase of 100 shares of AT&T at $95/share) Cash……………………………….$8000 Dr. Loss on sale of AT&T stock……..$1500 Dr. AT&T stock…………………….$9500 Cr. (To record sale of those 100 AT&T shares at $80/share (at a loss)) Cash……………………………….$12000 Dr. AT&T stock…………………….$9500 Cr. Gain on sale of AT&T stock…..$2500 Cr. (To record sale of those 100 AT&T shares at $120/share (at a gain)) Prepared by Avik Saha 20
  20. 20. Asset Accounting…Cont. Some Complex Asset Accounting Entries Purchase and sale of real estateFinancial Accounting in Insurance Companies Insurance company A purchases Axis Building for $1,000,000. Depreciation on the building is $10,000 per year. Accounting entry for recording this depreciation is as follows: Depreciation expense - Axis Building….$10,000 Dr. Accumulated Depreciation – Axis Building….$10,000 Cr. Accumulated Depreciation is a contra account . Contra Account accompanies a specified ‘companion’ account – typically an asset account, that has a normal balance which is opposite of the companion account. The amount in contra account usually reduces the balance in its companion account. Insurer A sells Axis Building for $1,500,000 (gain). Depreciation on the building to date is $20,000. Cash……………………………………………..$1,500,000 Dr. Accumulated Depreciation - Axis Building…..$20,000 Dr. Axis Building……………………………………….$1,000,000 Cr. (disposing the asset) Gain on sale of Axis Building……………………..$70,000 Cr If Insurer sells the building for $900,000 (loss), the following accounting entry is made: Cash…………………………………………….$900,000 Dr. Accumulated Depreciation - Axis Building….$20,000 Dr. Loss on sale of Axis Building………………….$80,000 Dr. Axis Building……………………………………….$1,000,000 Cr. (disposing the asset) Prepared by Avik Saha 21
  21. 21. Asset Accounting…Cont. Some Complex Asset Accounting Entries Reinsurance TransactionsFinancial Accounting in Insurance Companies Life Insurance company XYZ issued an individual life insurance policy with a $300, 000 death benefit. XYZ reinsured $50,000 of the risk. While policy was in force, claim was made for the policy and XYZ determined that the beneficiary would receive the full amount i.e. $300,000. The following accounting entry is made: Death Claims Paid…………………$300,000 Dr. (Expense account) Cash……………………………….$300,000 Cr. (to record payment to beneficiary) Amount recoverable from reinsurer……..$50,000 Dr. (Asset account) Death Claims Paid……………………..$50,000 Cr. (to record amount recoverable from reinsurer) Cash…………………….$50,000 Dr. Amount recoverable from reinsurer……..$50,000 Cr. (when the amount received from insurer) Prepared by Avik Saha 22
  22. 22. Reserve (Liabilities) Accounting Reserve are estimates of the amount of money an insurer needs to pay future contract obligations. Reserve make up significant portion of insurer’s liabilitiesFinancial Accounting in Insurance Companies Cash…XX Dr. Invested Assets …XX Dr. Change in reserves…XX Dr. Premium Income…XX Cr. Cash…XX Cr. Contractual reserves…XX Cr. To record premium income To record purchase of invested To record the establishment of received from sales of new life assets to generate income and reserves for the new life insurance insurance products dividends product Cash…XX Dr. Death Claim paid…XX Dr. Invested Assets…XX Cr. Cash…XX Cr. Claims are incurred and reported against the new block of policies To record sale of invested To record payment of and are approved for payment assets to provide cash for the approved life policy claims payment of policy claims Contractual reserves…XX Dr. Actuaries provide an updated Change in reserves…XX Cr. reserve amount for the product on the valuation date To record the reserves released from the settlement of claim Prepared by Avik Saha 23
  23. 23. Reserve (Liabilities) Accounting…cont. Recording and paying policy owner dividends (for different payment options) Board approves dividend and sets the date for policy owner dividend paymentFinancial Accounting in Insurance Companies Actuaries determine and recommend dividend to board of directors Policy owner dividend…..XX Dr. Policy owner dividend payable…..XX Cr. Insurers update policy owner dividend record for policy owner dividend payment option CASH PURCHASE ADDITIONAL INSURANCE Policy owner dividend paid….XX Dr. Dividends to purchase Paid-Up Addition…..XX Dr. Cash…………………………….XX Cr. Single premiums for Paid-Up Addition ……………XX Cr. Or REDUCE PRIMIUM Policy owner dividend applied to Dividends to purchase one year term insurance…….XX Dr. premium……….XX Dr. Single premium for one year term insurance ……………….XX Cr. Premium Income…….XX Cr. ACCUMULATE AT INTEREST Policy owner dividend applied to dividend accumulations……….XX Dr. Dividend Accumulations..…….XX Cr. Prepared by Avik Saha 24
  24. 24. Reserve (Liabilities) Accounting…cont. Waiver of premium accounting Waiver of premium contract provision provides premium payments to keep a life insurance policy in force if the insured suffers a qualifying disability.Financial Accounting in Insurance Companies Waiver of premium benefits – ordinary……XX Dr. Premium Income……………………..XX Cr. (to record the payment of a waived premium) Premium Suspense Account Suspense account is an account that is used to record transactions that can not be posted immediately to a specified account. Premium Suspense is the liability account used to record transactions that are intended as premiums, but that the insurer cannot accept as income until a particular event occurs. Insurers typically use premium suspense accounts for premium payment amounts that are a) renewal premiums b) different from the amounts in the insurer’s records or c) lacking critical information such as policy number. Cash…………………XXX Dr. Premium Suspense …………..XXX Cr. (to record receipt of premium payment that cannot be immediately recorded to a premium income account) Premium Suspense …………..XXX Dr. Premium Income……………..XXX Cr. (To record the application of a suspended premium as an actual premium – after the particular event occurs) Prepared by Avik Saha 25
  25. 25. Capital and Surplus Accounting Preferred Stock Preferred stock is a type of equity security that represents ownership in a corporation and usually provides for the payment of fixed periodic dividend which is paid before any dividends can be paid on the corporation’s common stocks.Financial Accounting in Insurance Companies Cash………………..XXX Dr. Insurer’s Preferred Stock……………….XXX Cr. (to record issue and sale of Insurer preferred stock at par value) Additional Paid-In Capital Cash………………..XXX Dr. Insurer’s Preferred Stock…………………XX Cr. Additional Paid-in capital………………….X Cr. (to record the sale of Insurer preferred stock at greater than par value) Unrealized gains and losses Unrealized Loss on Bonds…………..XXX Dr. Market Value adjustment – Bonds………….XXX Cr. (to decrease the value of a bond temporarily as the bond’s current value is less than the value recorded in the accounting records ) Realized Loss on Bonds…………..XXX Dr. Bonds……………...………….XXX Cr. (to write down the value of a permanently impaired bond) Prepared by Avik Saha 26
  26. 26. Revenue and Expense Accounting Premium Income Cash…………………XXX Dr. Premium Income………..XXX Cr. (to record premium income on policy sale)Financial Accounting in Insurance Companies Investment Income Cash…………………XXX Dr. Interest Income - Bonds………..XXX Cr. (to record interest income received on bonds owned by the insurer) Cash…………………XXX Dr. Interest Income - Mortgages………..XXX Cr. (to record interest income received on mortgages owned by the insurer) Cash…………………XXX Dr. Rental Income - Real Estate………..XXX Cr. (to record rental income received on real estate owned by the insurer) Cash…………………XXX Dr. Dividend Income – Common Stock………..XXX Cr. (to record dividend income received for the common stock owned by the insurer) Prepared by Avik Saha 27
  27. 27. Revenue and Expense Accounting…cont. Producer Commission Commission expense…………….XXX Dr. Producers Ledger Control…………XXX Cr. (to record incurred producer commission expense)Financial Accounting in Insurance Companies Producer Ledger Control………..XXX Dr. Cash…………………………………XXX Cr. (to record the payment of producer commissions) Producer Salaries Salaries Expense……………………………$1000 Dr. Federal Income Taxes Payable………………...$100 Cr. Social Security and Medicare Taxes Payable…..$80 Cr. State Income taxes payable……………………...$20 Cr. Salaries Payable………………………………...$800 Cr. (to record the establishment of a liability for a producer’s salary and appropriate tax withholdings) Salaries Payable…………………………….$800 Dr. Cash……………………………………$800 Cr. (to record the payment of a producer’s salary) State Income taxes payable…………………$20 Dr. Cash…………………………………….$20 Cr. (to record payment of state income taxes withheld from a producer’s salary) Prepared by Avik Saha 28
  28. 28. Revenue and Expense Accounting…cont. Reinsurance Allowances and Premiums Ceding Company is the insurer which purchases reinsurance Assuming Company is the reinsurer Ceding company pays periodic premiums to assuming company Reinsurance Allowance is the commission that reinsurer pays to the ceding company (like the insurer pays commission to producers)Financial Accounting in Insurance Companies E.g. For a reinsurance contract reinsurance premium is $800, reinsurance allowance is $600. Following is the accounting entry made by the insurer for reinsurance premium payment: Reinsurance ceded – first year premium expense…………………$800 Dr. Reinsurance Allowance – ceded……………………………..$600 Cr. Cash……………………………………………………………$200 Cr. (to record payment of reinsurance premium; the insurer basically pays $200 to the reinsurer) The accounting entry made by the reinsurer is as follows: Reinsurance Allowance – assumed……………………$600 Dr. (Expense account) Cash…………………………………………………….$200 Dr. (Asset account) Reinsurance assumed – first year premium income……$800 Cr. (Income account) Premium Taxes Premium taxes are taxes on the paid premium income an insurer receives within a particular jurisdiction. Premium Tax expense………………..XXX Dr. Premium Taxes Payable…………….XXX Cr. (to record incurred premium taxes) Premium Taxes Payable……………...XXX Dr. Cash…………………………………..XXX Cr. (to record payment of premium taxes) Prepared by Avik Saha 29
  29. 29. Responsibility Accounting The area, function or organizational unit that a specified manager controls is called a Responsibility Center. The said manager is called the Responsibility Manager.Financial Accounting in Insurance Companies Cost Center is a department or division to which costs (expenses) can be traced. E.g. accounting department, legal department and the claims department of an insurance company. Profit Center is a department or other business segments to which both costs (expenses) and revenues can be traced. E.g. companies’ lines of businesses – individual life insurance, annuities, health insurance, and group life insurance. Investment Center is a department or other business segments to which both costs (expenses), revenues and capital or investment funds can be traced. E.g. lines of businesses, investment division. Responsibility Accounting is a management accounting (i.e. for internal use as against financial accounting which is particularly prepared for external users) system of policies and procedures that allow for revenues, expenses and investments to be assigned to the specific employee or organizational level that is accountable for those revenues, expenses and investments. Prepared by Avik Saha 30
  30. 30. Insurance company responsibility centers organization Investment Centers Profit Centers Cost Centers Claims Administration Life Insurance Line UnderwritingFinancial Accounting in Insurance Companies Policy Owner Service Individual Insurance Division Claims Administration Health Insurance Line Underwriting Policy Owner Service Insurance Company Home Office Claims Administration Life Insurance Line Underwriting Policy Owner Service Group Insurance Division Claims Administration Health Insurance Line Underwriting Policy Owner Service Prepared by Avik Saha 31
  31. 31. Cost Accounting Cost Classification by description Cost Classification Definition ExampleFinancial Accounting in Insurance Companies Direct cost A cost that is identified with a specific cost To the group life line of business, the salary of object the division manager of group life insurance Indirect Cost A cost that is not identified specifically with a To the group life line of business, the salary of single cost object the vice president in charge of all group insurance Controllable cost A cost over which a responsibility manager has To a line of business, the cost of its supplies, decision making authority travel and employee overtime Non-controllable cost A cost over which a responsibility manager has To a line of business, home office rent and no decision making authority depreciation on equipment Differential Cost The difference in cost between two alternative To the group insurance division, the difference in choices costs if a new line of business is added, and if the line is not added, to the division Marginal Cost The additional cost of producing an additional To a life insurer, the additional cost of processing unit of an existing product or service one more policy application per hour Sunk cost A cost that is already incurred and does not To a line of business, existing salary cost that change as a result of a future decision will not change as a result of the decision to undertake a specified project Unit cost A cost attributable to a single measured amount To a life insurer, the cost per $1000 of insurance of work underwritten Discretionary Cost A cost that result from periodic management To a life insurer, the costs of product advertising, decision that changes as conditions change promotional campaigns, and employee training Prepared by Avik Saha 32
  32. 32. Cost Accounting…cont. Cost Classification by behavior A fixed cost is a cost that remains constant for all levels of production or operatingFinancial Accounting in Insurance Companies activity, e.g., fire insurance for home office facility, which remains same notwithstanding sales volume. A variable cost is a cost that changes in amount in direct proportion to changes in the level of operating activity, e.g. agent commission, which increases with sales volume. A semi variable cost has a fixed cost component and a variable cost component, e.g. cost of electricity which involves a basic monthly service charge and the rest depending on usage. Prepared by Avik Saha 33
  33. 33. Cost Accounting…cont. Cost Classification by measurement An opportunity cost is the benefit forfeited as a result of choosing one decisionFinancial Accounting in Insurance Companies alternative over other, e.g., if an insurer is considering introduction of a new universal life product requiring an out-of-pocket cost of $1 million, the opportunity cost in this case will be what other things the insurer could have done with $1 million like purchasing asset that would have generated investment income. Marginal cost and Unit cost, which are described under cost classification by description also fall under classification by measurement. Prepared by Avik Saha 34
  34. 34. Cost Accounting…cont. Cost Accumulation Cost accumulation is the process of capturing all company costs and categorizingFinancial Accounting in Insurance Companies them in meaningful ways. Four methods of accumulating cost data: 1)  Type of cost – e.g. cost relating to salary 2)  Line of business – e.g. cost attributable to/allocated to a line of business 3)  Department or cost center – e.g. accumulating all claim cost under claims dept. 4)  Function – e.g. cost of policy maintenance function of insurer Cost Allocation Base Allocation base is used to ensure equitable allocation of indirect costs to cost centers, e.g. amount of square footage, number of employees, percentage of direct costs etc Prepared by Avik Saha 35
  35. 35. Auditing An audit is the examination and evaluation of company accounting records and procedures to ensure that 1) the financial information, financial statements and source documents comply with accounting standards and are fair and consistent depiction of the company’s financial condition and performance 2) qualityFinancial Accounting in Insurance Companies assurance is maintained and 3) operation procedures and policies are effective. Internal audit is a financial audit performed by company employees. External audit is a financial audit performed by external auditors, who are employees of public accounting firms, insurance regulators or reinsurers. Audit trail is a chronological, sequential set of accounting records and reports from the beginning to the end of a business transaction. Prepared by Avik Saha 36
  36. 36. Accounting Regulation (US) Generally Accepted Accounting Principles (GAAP) is followed by stock insurers. Mutual and Fraternal insurers those sell variable products comply with US GAAP. Financial Statement is prepared based on GAAPFinancial Accounting in Insurance Companies Statutory Accounting is followed by all life insurers in US when preparing Annual Statement that they submit to insurance regulators. US Regulatory Agencies and Organizations •  Securities and Exchange commission (SEC) •  Financial Industry Regulatory Authority (FINRA) •  Financial Accounting Standards Board (FASB) •  National Association of Insurance Commissioners (NAIC) •  Internal Revenue Service (IRS) Countries are moving to International Financial Reporting Standards (IFRS) for accounting and financial reporting. Prepared by Avik Saha 37

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