Insurance Accounting Overview WAMIC Director Seminar November 16, 2016

Goals Understand key concepts in insurance accounting Obtain a better understanding of financial statements Use ratios to assess your Company’s overall financial condition

What makes insurance accounting unique? Premiums = Income Losses = Cost of goods sold Surplus = Equity …it’s just different terminology!

Key concepts-Premiums Written premium Earned premium Unearned premium Deferred premium Premiums received in advance Cancellations

Premiums

Key concepts-Premiums Written premium The total premium charged to the policyholder for the effective period of the contract Recorded as of the effective date of the contract When written premium is recorded, a liability for unearned premium is established to reflect the amount of premium for the portion of the insurance coverage that has not yet expired

Key concepts-Premiums Earned premium The portion of written premium that has been fully earned as of a date. Example: Insurance policy written December 1st for a one year term. Premium is $1,250, of which $50 in policy fees is fully earned when the policy is written. Remaining $1,200 will be earned (and recognized as income) equally throughout the year. How much of the $1,200 is earned through December 31st? How much total is earned through December 31st?

Key concepts-Premiums Unearned premium A liability or future obligation representing the portion of premium that will be earned in future periods. Example: Insurance policy written December 1st for a one year term. Premium is $1,250, of which $50 in policy fees is fully earned when the policy is written. How much of the $1,200 is unearned through December 31st?

Key concepts-Premiums Deferred premium An asset or future benefit representing the portion of premium that will be received in future periods. Example: $1,250 insurance policy written December 1st for a one year term, payable in quarterly installments. Policyholder paid $312.50 in December 1st. How much is deferred premium as of December 31st? $1,250 - $312.50 already paid = $937.50 deferred – represents the remaining that will be collected.

Key concepts-Premiums Premiums received in advance A liability that represents cash that is received before the policy’s effective date. Example: $1,250 insurance policy written December 1st for a one year term, paid amount in full on November 28th. $1,250 would be treated as premiums received in advance (a liability) until its December 1 effective date.

Key concepts-Premiums Cancellations A complete termination of any existing policy before expiration, may be requested by the insured or occur by reason of nonpayment of premium. If, at the time of cancellation, the insured has paid more premium than has been earned, the insured will receive a return of premium. $1,250 premium paid in full November 28, and the policyholder cancels policy on January 31. How much would be return premium? $1,250 - $50 (fully earned) – $200 (earned in December and January) = $1,000

Reserves

Key concepts-Reserves Reserves are the liability established for unpaid losses and loss adjustment expenses. Reserves are recorded when insured events occur based on the estimated costs of settling the claims.

Key concepts-Reserves Reserves are management’s best estimate of those amount incurred yet unpaid. They are reduced for estimated salvage and subrogation recoveries.

Key concepts-Reserves Claim Notification Claim Estimation Claim Settlement Reinsurance Receivable Salvage and Subrogation

Financial Statements

Balance sheet - Assets What your Company owns Cash and investments Real estate Deferred premium

Balance sheet - Liabilities What your Company owes to others Reserves Commissions payable Unearned premiums Reinsurance payable

Balance sheet - Surplus Assets – Liabilities = Surplus Looked at by regulators to assess overall financial condition. A Company’s surplus provides a cushion for absorbing above average losses. Surplus will increase when you have underwriting profit/net income. Surplus is also affected by changes in unrealized gains/losses in investments.

Illustrative Balance Sheet

Income Statement Underwriting profit is the measurement of how well a company is doing from its insurance operations. Net income includes underwriting profit, investment income, other income and income taxes. From an analysis standpoint, use historical trend of underwriting income to determine if Company is doing well.

Illustrative Income Statement

Financial Ratios

Financial Ratios Compile historical data and calculate financial ratios to assess a Company’s financial condition and evaluate trends Obtain your Company’s Annual Statement which shows many of the key financial ratios

Financial Ratios Gross premiums written to surplus ratio Measures how strong of a cushion a Company has for above-average losses The higher the ratio, the more risk (and weaker) a Company bears Gross premium/policyholders’ surplus Example: Gross written premium $2,275,000; Policyholders’ surplus $3,943,500 Gross premiums written to surplus ratio 57.7% Flip it: for every $1 in premium written, there is $1.73 in surplus.

Financial Ratios Change in net writings Example: Major increases or decreases in net premiums written indicate a lack of stability. Moderate change between 1-5%. Don’t want too much growth too fast. Example: Net premium written previous year: $2,200,000 Net premium written current year: $2,275,000 Change in net writings$75,000 $75,000/$2,200,000 = 3.4%

Financial Ratios Change in policyholders’ surplus Example: The ultimate measure of the improvement or deterioration of the Company’s financial condition during the year Measured as the change in policyholders’ surplus divided by beginning surplus. Prefer not to see greater than 10% decline. Example: Policyholders’ surplus prior year: $3,501,500 Policyholders’ surplus current year: $3,943,500 Change in policyholders’ surplus $442,000 $442,000/$3,501,500 = 12.6%

Financial Ratios Reinsurance ratio Example: Measures reinsurance costs as a percentage of premiums written. The lower the number, the less reinsurance you’re paying proportionately. Town mutual range of 25-45%. Example: Reinsurance ceded $900,000 Gross premiums written $2,275,000 Reinsurance ratio 39.56% (900,000/2,275,000)

Financial Ratios LOOK at the trends Ask your Manager to compile 10 year historical data showing financial ratios and underwriting profit Trend data may help identify needs to evaluate underwriting, raise rates

Questions? Margo Rosen, CPA Partner Carlson Highland & Co., LLP margor@carlsonhighlandcpa.com 715-268-7999