STATISTICS DIRECTORATE

Transcription

1 Room documents 13 STATISTICS DIRECTORATE National Accounts Non-life Insurance Background Material Main author: Fenella Maitland-Smith, OECD OECD MEETING OF NATIONAL ACCOUNTS EXPERTS ChâteaudelaMuette,Paris 8-11 October 2002 Beginning at 9:30 a.m. on the first day

2 TABLE OF CONTENTS Introduction...3 The non-life insurance industry...3 Background on general insurance...3 Underwriting decisions what drives profitability?...5 Recording in the accounts of the 1993 SNA...7 Entries in the accounts...7 Production account...8 Allocation of primary income account...8 Secondary distribution of income account...8 Premiums earned...9 Claims due...9 Premium supplements...10 Changes in technical reserves...10 Technical provisions...10 Unearned premium reserve...11 Outstanding claims reserves...11 Equalisation provisions...11 The boundary between technical provisions and own funds...12 Glossary of Insurance Terms

3 Non-life Insurance Background Material Introduction This room document provides some background material for the discussion of the report of the OECD Task Force on the treatment of non-life insurance in the national accounts and balance of payments. It is in no sense exhaustive, but is an attempt to provide some background to the workings of the non-life insurance industry, and some initial thoughts on a few of the issues yet to be discussed by the Task Force, such as the coverage of premium supplements, and the coverage of technical provisions. Thenon-lifeinsuranceindustry Background on general insurance (Please refer also to the Glossary at the end of the paper). General insurance covers a wide range of activities; examples include accident and theft insurance for motor vehicles and other property, term life insurance 1, professional indemnity, workers compensation, and health insurance. It can also be called property and casualty insurance. General insurance can be contrasted with life insurance (other than term life), where policyholders receive a payment whether or not they suffer a loss. For this reason, in economic terms, life insurance is quite different to general insurance and can be seen as being largely a method of long-term saving similar to pension schemes. (Life insurance is not within the scope of the Task Force). The function of general insurance is to share risk. A textbook 2 definition of insurance goes further by describing insurance services as the pooling of fortuitous losses by transfer of such risks to insurers who agree to indemnify insureds for such losses, to provide other pecuniary benefits on their occurence, or to render services connected with the risk. Pooling is the spreading of losses incurred by the few over the entire group, so that in the process, average loss is substituted for actual loss. Insurers perform various activities in order to fulfil this function. Since their objective is to maintain sufficient funds to compensate policyholders who suffer the insured events, where the funds are made up of pooled premiums, and their investment income, the activities include : Attracting new policyholders Forecasting future claims 1 That is, where benefits are only payable on the death of the insured. 2 Principles of Risk Management and Insurance GeorgeRejda 1992(4 th edn.). 3

4 Setting premium rates appropriately Making investment decisions, and managing the investments Assessing and settling claims Administering all policy details An implication of the pooling of funds by insurers is that the management of these funds is an integral part of the insurance business. These funds are called technical reserves and include provisions for prepaid (unearned) premiums, claims due but not yet paid, and provisions to cover future events for prudential or regulatory reasons. Reserves are invested in real and financial assets that can generate benefits that are available either to meet claims or to provide a return to the insurer s shareholders. So, like other financial intermediation, the value of insurance services includes a component funded by a margin from property income. In its report on the recording of operating results, the OECD suggests 3 that two activities of insurance companies can be distinguished, namely the insurance activity as such and the management of an investment portfolio derived from the investment of premiums and other income held to meet liabilities to policyholders. In many OECD countries the results of the two activities are separately disclosed to enable the user of the financial statements to assess the company s performance for each activity. The Swiss Re goes further still and suggests that non-life insurers are asset managers, although to a lesser extent than life insurers. An insurance company resembles a leveraged investment fund in which debt is raised through the sale of insurance policies rather than via the capital markets. Insurers themselves share risk by reinsurance and retrocession. Reinsurance is the shifting of part or all of the insurance originally written by one insurer to another insurer and is used for several reasons, the most important being: to increase underwriting capacity, i.e. to allow a wider spread to stabilise profits to reduce the level of unearned premium reserve required by law and temporarily raise the policyholders surplus, allowing the insurer to write more business to provide catastrophe protection So, although reinsurance is a vital element of catastrophe protection it is used for other reasons, and for single huge risks (space exploration, liability exposures, industrial/energy risks, etc.). Catastrophe reinsurance generally takes the form of policies which pay out once losses reach a certain level and stop before another threshold (excess-of-loss contracts) or pay a proportion of all losses (quota-share). Reinsurers also reinsure their risk this is called retrocession so that there is often a chain of insurance transactions associated with a single set of risks. 3 Operating Results of Insurance Companies - Current Practices in OECD Countries OECD

5 Underwriting decisions what drives profitability? 4 To analyse the drivers of profitability, it is useful to decompose returns on equity (ROE) into its main components. Profits are first determined by underwriting performance, i.e. losses and expenses, which are themselves influenced by pricing, risk selection, claims management, marketing and administrative expenses. The other main driver is investment performance, which is a function of asset allocation and management, and asset leverage. ROE is additionally affected by tax strategies and solvency. So, the price or underwriting cycle and investment performance are the two most important factors shaping profitability. Box 1 shows a table comparing the five-year average performance ratios of the major non-life markets, based on statutory data. It shows that losses plus expenses exceed premiums, giving negative underwriting results, in all countries except Germany and Japan. Net investment results often turn these negative results into positive pre-tax profits. Box 1: Profitability of the major non-life markets Five year averages as % of net premiums (except *) USA Canada UK Germany France Italy Japan a Loss ratio b Expense ratio c Underwriting result d Investment yield* e Asset leverage d*e = f Net investment result g Other expenses/earnings c+f+g = h Pre-tax profit margin j Tax rate* h*(100-j) = k Post-tax profit margin m Solvency n.a. n.a. k/m = n ROE* n.a. n.a. Source: Swiss Re. Statutory data have the benefit of wider market coverage (including non-public stock companies and mutuals), but the disadvantage of less economic significance, particularly with regard to measuring profits and capital funds. Data are also not fully comparable across countries, due to different accounting systems and regulations. Ratios are given net of reinsurance for the USA, Canada and the UK, but are for direct business (prior to cessions to reinsurers) for Germany, France, Italy and Japan. Note: The loss ratio (a) and expense ratio (b) have different denominators (NPE and NPW) so cannot be summed 4 This section is largely taken from a study prepared by the Swiss Reinsurance Company just prior to September 11, 2001, which addressed profitability trends in the non-life insurance markets of the G7 countries Profitability of the non-life insurance industry : it s back-to-basics time. SIGMA 5/

6 Investment performance has increased in importance, with net investment results rising from about 15% of net premiums written in 1985 to about 18% in 1999 and The main reason for the increasing importance of the investment result is the trend to a higher asset leverage, which makes more assets per premium available for investments. There are two main sources of assets to invest: technical reserves generated out of underwriting activity, and shareholders funds which are kept as risk capital. Technical reserves are made up of loss reserves, loss adjustment reserves, and unearned premiums. The reserve ratio (technical reserves as % of net premiums written NPW) has risen in all major markets along with the increasing importance of liability lines of business, higher inflation for indeminified services, such as medical care, and mounting litigation costs. There are three things that affect total investment returns bond yields, dividend income and capital gains. Since most insurers invest heavily in bonds, interest rates are most important in determining insurers investment returns, although insurers total investment yields have shown an increasing trend in excess of yields on government bonds since On occasion, capital gains can be very important, particularly to smooth investment returns when interest rates are low. Underwriting results and investment yields are highly interdependent. Over history, they have been negatively correlated strong investment results increase capital funds, softening (lowering) prices. To the extent that insurers use regular forecasts of interest rates in their pricing decisions, premium rates fall when interest rates rise. Equilibrium premium rates are supposed to reflect the present value of expected future loss payments, plus loadings for expenses and capital costs. Thus the higher the interest rate, the stronger the discount effect and the lower the premium rate. Aggressive pricing during periods of high investment returns is commonly called cash-flow underwriting. On the other hand, when investments slump insurers must improve their underwriting results to survive. Similarly, to smooth earnings when underwriting results deteriorate, particularly following a catastrophe, insurers will realise capital gains. Expense ratios have remained fairly constant over the past 25 years. The absence of efficiency gains from the use of technology could be due to enhanced customer service, but is more likely to be due to intensified competition, which has resulted in increased advertisement expenses and higher commissions. There is a clear upwards trend in solvency ratios, corresponding to the increasing riskiness of the insurance business which itself stems from: Growing exposure to natural disasters High-severity lines of business such as liability, political risk, credit risk, etc. Higher reserves leverage of premium volume (reserves risk) Increased importance of asset management and thus financial risk. Underwriting results follow a cyclical pattern, caused by external factors affecting capacity, such as catastrophic events and investment performance. In addition, internal factors such as insurers striving for market share during times of robust investment results, contribute to the cycle. The cycles average about six years in length and are synchronised across countries and to some extent across lines of business. The phenomenon of the underwriting cycle has been analysed extensively in the economic and financial literature, and is best explained by a combination of two hypotheses the rational markets with imperfect foresight and capital constraints hypotheses. Important external features/events which can cause a shock or can delay a response to a shock include: 6

7 Entry and/or exit costs Regulatory constraints Accounting characteristics, including data and information lags Catastrophic events Unexpected changes in claims costs or loss distributions Unexpected changes in interest rates and equity values. Insurance pricing, by virtue of its backward-looking nature, cannot immediately respond to changing market conditions, i.e. there is market stickiness. This lag results in a tendency to overshoot the price necessary to equilibrate the market, which is later followed by an undershoot, creating a price cycle until the next major shock. The rational markets with imperfect foresight hypothesis can best explain underwriting cycles in Germany, France and Italy. The capacity constraint model implies that cycles are caused by impediments to capital flows, creating alternating periods of excessive and insufficient capital. Exogeneous shocks to the capital funds of insurers result in a capacity shortage causing price increases. Shocks can arise either from the asset side of the liability (loss) side. This provides a very plausible explanation for the recent hard markets in the USA and the UK, i.e. that they have been the result of liability losses in the mid-80s and natural catastrophes in the early 90s. Recording in the accounts of the 1993 SNA 5 Entries in the accounts The following discussion deals with the case of direct insurance. From the insurers point of view, the 1993 SNA treatment breaks down general insurance into separate economic processes which belong in different accounts. These flows are : the service provided (output) the (imputed) income flows in the form of income on reserves attributed to policyholders the current transfers of claims and net premiums and the changes in technical reserves These appear in the 1993 SNA accounts 6 as follows: output in the production account 7 ; 5 Much of this section is taken from Rob Dippelsman s draft paper The Statistical Treatment of General Insurance. 6 Annex IV of the 1993 SNA gives an overview of insurance, including the accounts for insurance. 7 paras and Annex IV, paras.14-18, 39 7

8 income on reserves attributed to policyholders in the allocation of primary income account 8 ; current transfers of claims and net premiums in the secondary distribution of income account 9 : changes in technical reserves in the financial account 10. Production account The output of insurance activity, which represents the service provided to policyholders, is calculated seperately for life and non-life insurance as 11 : total actual premiums earned; plus total premium or contribution supplements, i.e. income from investment of insurance technical reserves; less claims due, i.e. claims payable during the period plus changes in reserves against outstanding claims; Allocation of primary income account The 1993 SNA recognizes the role of income on insurance technical reserves in funding insurance services. In order to better show the underlying economic reality, the income is attributed to policyholders and an equal payment is imputed from the policyholders back to the insurance companies. The income payment is called property income attributed to policyholders and the offsetting payment back to the insurers is called premium supplements (in the production account). Property income is allocated between the policyholding sectors in proportion to their shares of earned premium. Secondary distribution of income account Net premiums and claims paid are recorded in the secondary income account as current transfers. Net premiums are premiums earned plus premium supplements less the service charge. Because of the way the service charge is defined in the 1993 SNA, claims paid always equal net premiums (at least for the insurer as a whole; the 1993 SNA does not explicitly discuss the allocation to policyholders). An important issue for the insurance industry, and consequently for statisticians, is the uncertainty of measurement. In both insurers own accounts and national statistics, initial estimates of claims due during the reference period are used, rather than claims paid or claims accepted. Claims due include estimates of claims that have been reported but not finalized, incurred but not reported, and claims inadequately 8 paras and Annex IV, paras , 40 9 paras and Annex IV, paras , para and Annex IV, para The formula appears in 1993 SNA para and Annex IV, para 18. Unfortunately, in para , the subtraction entries are incorrectly shown as additions. 8

9 reported. For types of insurance involving a long time to payment (called long-tail business), there is considerable initial uncertainty. Accordingly, actuarial estimation is required, not only for setting premiums in advance, but also for measuring past performance for recent periods. The transactions used to estimate values of the flows in these accounts are: premiums earned claims due premium supplements changes in technical reserves Premiums earned The part of the premium for which the protection of the policy has already been given. For example, an insurance company is considered to have earned 75% of an annual premium after a period of nine months of an annual term has elapsed. Premiums are usually paid in advance of the cover (service) being provided, and thus these flows must be converted to an accruals basis by removing the portion of premiums paid which are for cover provided outside the period in question. Thus, only premiums earned during the period are recorded. Claims due Claims due means that claims are measured on the basis of the time when the insured eventuality occurs 12. That is, claims relating to events that took place during that period, regardless of which period they are paid, with the result that claims due includes some claims that are not due for payment until some time later (e.g., claims that involve litigation, or a stream of income payments). The term claims incurred is used in some countries and emphasizes more clearly that timing relates to the event, rather than when payment is due to be paid (for example, a claim for personal injury may take the form of an annuity over many years; the correct 1993 SNA treatment is to treat the present value as the claim due, with the amounts to be paid in future years shown as a liability of the insurer). The words premiums and claims are sometimes used without qualification in the 1993 SNA, but that is for reasons of brevity, not because the timing is unimportant. Claims due should exclude claim settlement expenses. A problem is presented by some long-tail business such as the US casualty (workers compensation) policies written on a losses occurring basis in the 1960s which gave rise to the huge asbestosis losses of the 1980s. Losses occurring means that the event takes place within the policy period, but there is no restriction on when the claim is made. In the case of asbestosis, people who had worked with asbestos in the 1960s started to file claims in the 1970s and 1980s when the disease manifested itself. The courts ruled that the event triggering liability was the original exposure to asbestos, and that the insurers in the 1960s were liable, not those providing workers compensation (employers liability) cover at the date of manifestation. Such business is now more often written on a claims made basis, i.e. the insurer is liable for claims made during the policy period, so that the business is extremely short-tail. 12 para , Annex IV, para. 16 9

10 However, the SNA93 states that valid claims accepted by insurance enterprises are considered due for payment when the eventuality or accident that gives rise to the claim occurs however long it takes to settle disputed claims. Thus SNA93 does not appear to recognise the possibility of non-life risk being unexpired over more than a single period, and does not explicitly include provision for unexpired risk in the technical reserves for non-life insurance. Does this imply that national accounts for the 1960s should be revised in the light of asbestosis losses? Premium supplements In the 1993 SNA, premium supplements are defined as the income from the investment of technical reserves. This item is used in deriving the value of insurance services and also appears in the allocation of primary income account as property income on technical reserves attributed 13 to policyholders. It is equal to the sum of dividends, interest, and operating surplus from the investment of technical reserves and is all classified as property income because it is an imputed payment from the insurer to policyholders, not a direct payment of dividends, interest, and operating surplus. Holding gains are excluded. There are several issues connected with the scope of premium supplements that need clarifying in the context of SNA93 and BPM5. Firstly, the scope of technical reserves themselves, secondly whether the scope should be widened to include income on all reserves, and then whether or not holding gains on reserves should be included in the income. Changes in technical reserves The net change in technical reserves due to the net increase in prepaid premiums and incurred but unpaid claims, is recorded as an adjustment item in the financial account and balance sheets, as a liability of the insurer [and asset of the policyholders?]. Technical provisions Technical provisions, or reserves 14, are amounts which must be adequate to meet fully the commitments of the insurer to policyholders. They are treated as liabilities of the insurer and assets of the policyholders. For non-life business, accountants recognise technical reserves as being comprised of provisions for: unearned premiums unexpired risks claims equalisation outstanding claims, including claims incurred but not reported (IBNR) 13 The 1993 SNA uses both attributed and attributable, but no difference seems to have been intended. 14 The practice among accountants is to apply the term provisions to the amounts set aside to provide for liabilities assumed to exist at the accounting date, and to apply the term reserves to amount available to meet liabilities that may arise after that date. Among actuaries and among practitioners of general insurance it has been widespread practice to apply the term reserve to both categories. 10

11 Technical reserves as defined by the 1993 SNA, on the other hand, do not cover all reserves, but are limited to: unearned premiums, called prepaid premiums in the 1993 SNA; and outstanding claims, called unpaid claims. Unearned premium reserve The unearned premium reserve is a liability reserve representing the unearned portion of gross premiums on all outstanding policies at the time of valuation. It is only after policies expire that a premium is fully earned. The 1993 SNA discusses the prepayment of premiums in terms of the fact that the policy period does not usually coincide with the accounting period therefore, at the end of the accounting period, parts of the premiums paid, and thus appearing in the balance sheet, are in fact intended to cover exposure in the subsequent period.. premiums earned [are] those parts of the premiums that are paid in the current period or the preceding period and that are intended to cover risks outstanding during the current period. For most classes of non-life business it is true that risks do remain outstanding only as far as the following period. But for some classes such as casualty business written on a losses occurring basis, the insurer remains exposed to risk for many years after the policy has expired. In theory, the policyholder continues to receive a service and a portion of the premium remains unearned until all of the risk has expired, but it can be very difficult to assign ratios of earned to unearned premiums for these policies over such a long period. As a result, companies usually deal with unexpired risk in one of two ways any provision for unexpired risk may be simply included in the unearned premium reserve, or a separate reserve for unexpired risk may be identified (where unexpired refers to a period longer than the average policy period). Outstanding claims reserves Outstanding claims reserves can also be called claim reserves or loss reserves. Claims are identified and recorded in the SNA93 at the time of the insured event, even though the settlement of the claim may not occur until much later. For long-tail business, such as medical malpractice or workers compensation or when lengthy litigation is involved, the lag to payout on claims can be long and so the technical reserves are relatively large. Reserves for claims outstanding cover the total estimated ultimate cost to an insurer of settling all claims arising from events which have occurred, whether reported or not (i.e., including estimates for losses incurred but not reported IBNR), less amounts already paid in respect of such claims. Reserves for IBNR are sometimes identified separately, but the SNA does not explicitly include IBNR reserves against outstanding claims are reserves that insurance enterprises hold in order to cover the amounts they expect to pay out in respect of claims that are not yet settled or claims that may be disputed, and the present value of the amounts expected to be paid out in settlement of claims, including disputed claims. Equalisation provisions Equalisation provisions are amounts set aside in compliance with legal or administrative requirements to equalise fluctuations in loss ratios in future years, or to provide for special risks. These would be particularly relevant in connection with catastrophe business. In many countries and in ESA 1995, but not the 1993 SNA, they are included in technical reserves. 11

12 According to the 1993 SNA, they should not be recognized as transfers or liabilities to policyholders because there is no liability to pay the policyholders until an uncertain future event occurs, i.e. they are contingent liabilities. Contingent assets and liabilities are excluded from the 1993 SNA framework 15 and internal accounting entries do not qualify as transactions 16. Although this is an argument for not recording equalisation reserves as liabilities on insurers balance sheets, it could be argued that the income on these reserves should be included in premium supplements. Similarly, there may be arguments for including them in the calculation of insurance services (see later under Estimation of Expected Claims). The 1993 SNA approach of not treating equalization provisions as technical reserves means that when reserves are built up, insurers will be shown as saving, when they are used for claims, they will appear as a run-down of insurance saving and transfer to policyholders. Under ESA 1995, increases in provisions are shown in the allocation of primary income account as current transfers to policyholders, and subsequent saving by policyholders. When the provisions are reduced due to claims being incurred, no transfers of claims to policyholders are recorded. If an insurer were able to reduce equalization provisions due to lower than expected claims or going out of that line of business, there would need to be a non-premium transfer back to the insurer The boundary between technical provisions and own funds The Task Force has recognised several outstanding questions relating to the boundary between technical provisions and own funds. Although these questions have yet to be addressed by the Task Force, the following paragraphs are the initial thoughts of some Task Force members and will form the basis for discussions at the next meeting. a. Rob Dippelsman Besides technical reserves, all insurers have free reserves or own funds, which include all the excess of the insurer s assets over liabilities, and which are all potentially available to meet future claims. These are clearly not liabilities to policyholders and so should not be part of technical reserves on the 1993 SNA balance sheet. But they are not fully at the disposal of the insurer either since they are available to meet claims they are an integral part of being an insurer. Thus the associated investments are not necessarily treated separately from those for technical reserves by the insurers. So, is there a case for taking income on other reserves into the scope of premium supplements, even if there are no recognized liabilities to third parties associated with them? If insurers were found to have consistently low values of operating surplus in the national accounts, it would suggest that the scope of premium supplements may need to be widened to better reflect the way premiums are set. There is also a practical problem associated with restricting premium supplements to the income on reserves for unearned premiums and claims outstanding. While different types of reserves may be reported as separate categories on the liabilities side of the insurer s balance sheet, the corresponding assets and income are not necessarily associated with any particular category of reserves. Thus the income on technical reserves needs to be separated from other income, either by identifying the assets that match the technical reserves, or otherwise by prorating. John Walton points out that prorating tends to understate premium supplements, to the extent that insurers own funds tend to be invested in low-yielding assets such as own premises. ESA 1995 suggests prorating (para 4.68) SNA paras SNA Chapter III, Part C,

13 b. Anne Harrison The SNA has a narrower scope of technical provisions than those appearing in the company accounts of insurance companies. This is because of the insistence in the SNA that income arising from lending "own funds" is not output but simply a redistributive process within the economy. The case for this can be clearly seen in the case of households with money on deposit in a bank; it would be difficult to describe them as undertaking a production process by simply paying money into a bank account. In the case of banks lending their own funds, a distinction could be made between a service charge associated with lending money and the interest arising in respect of this loan. Treating the first as indicative of a production activity need not necessarily imply that the second is also production. This subject is discussed in detail in the report of the task fore on financial services. The question of interest here is whether the insurance company has any own funds and if so, how the income from them should be recorded in the accounts. The position of the 1993 SNA is that some of the reserves of the insurance company are regularly used to generate income which is used, along with actual premiums received, to meet current costs including the payments of a normal level of claims. These are the reserves recognised in the SNA as technical provisions and they are treated as belonging to the policy holders and generating property income which should be attributed to those policy holders. However, it is clear that the insurance company has some other reserves which would not normally be used to meet current expenses and normal claims. These reserves are treated by the SNA as "own funds" and property income in respect of them is excluded from the measure of insurance output. If these funds were indeed completely independent from the regular business of the insurance company, it would seem prudent for the company to separate them out into another institution where the reserves could not be called on in the case of an emergency; as long as they are listed as assets of the company, they must ultimately be used to meet liabilities of the company if the need arises. Claims under long-tail business (and perhaps some point in time catastrophes) would seem to represent such unforeseen circumstances where emergency reserves are called upon. Thus it seems that the present SNA guidelines, which work more or less well for insurance business where claims are predictable on a year by year basis, may have two deficiencies for less predictable risks. The first is the level of claims which may suddenly exceed expected claims or retrospectively increase claims already agreed for past periods. Allowing for these claims when they become liable for payment causes counter-intuitive changes in the level of output for insurance or may invoke the need for revisions to historically distant accounts. The other deficiency concerns the income on those reserves which the SNA treats as own funds. Perhaps in the long run, these reserves also should be regarded as giving rise to premium supplements in respect of exceptional claims so that again these premium supplements and exceptional claims offset each other but over a long time scale, not on a year to year basis. Question: Does an insurance company really possess inalienable "own funds" or are these funds effectively the long term reserves for infrequent but large claims? Note that this view of "own funds" is consistent with the suggestion above (para 65) from John Walton that in some cases exceptional claims may only be met by the injection of additions to "own funds". If the level of insurance output were to be increased by the property income on reserves previously regarded as "own funds", the increase in property income would presumably by attributed to policy holders and add to the level of premium supplements. In most years, there would be an excess of premiums plus premium supplements over claims, and this would lead to saving on the part of insurance companies, reflected in the financial account by an increase in these technical provisions. 13

14 The addition to "exceptional reserves" would arise in the current account. If exceptional claims were shown in the current account, the saving of insurance companies would decrease as would be reflected in their own accounts. On the other hand, the receipts of claims would also have to be shown as current receipts and the saving of the recipients would increase in a way NOT consistent with their own accounts. If exceptional claims are shown as capital transfers, the accounts for the recipients are consistent with their own accounts but those for insurance companies are not. Further, this introduces a type of capital transfer which always flows in one direction, from insurance companies to policy holders, with no matching capital inflow, the inflow being recorded in the current account. In short, therefore, we are back to the perpetual accounting conundrum of how to record a transfer which should be recorded in the current account of one party and the capital account of the other. Question: transfers? What are the relevant merits of treating exceptional claims as capital rather than current 14

15 GLOSSARY OF INSURANCE TERMS asset leverage average invested assets as % of NPW, i.e. technical reserves + own funds assets all funds, property, goods, securities, rights of action, or resources of any kind owned by an insurance company. Statutory accounting, however, excludes non-admitted assets, such as deferred or overdue premiums, that would be considered assets under generally accepted accounting principles (GAAP). capacity the amount of capital available to an insurance company or to the industry as a whole for underwriting general insurance coverage or coverage for specific perils. capital shareholder s equity (for publicly-traded insurance companies) and retained earnings (for mutual insurance companies. There is no general measure of capital adequacy for property/casualty insurers. casualty insurance insurance concerned with the insured's legal liability for injuries to others or damage to other persons' property. catastrophe event which causes a loss of extraordinary magnitude, such as a hurricane or tornado. cede to transfer all or part of a risk written by an insurer (the ceding, or primary company) to a reinsurer. claims incurred claims paid during the policy year plus the claim reserves as of the end of the policy year, minus the corresponding reserves as of the beginning of the policy year. claims incurred but not reported (IBNR) losses that are liabilities of a plan or an insurer but that have not been reported to or recorded by the plan or insurer. IBNR reserves provide for claims in respect of events that have occurred before the accounting date but had still to be reported to the insurer by that date. In the case of a reinsurer, the reserve needs to provide for claims that, although already known to the cedant, have not yet been reported to the reinsurer as being liable to involve the reinsurer. combined ratio the sum of the loss ratio plus the expense ratio plus the policyholder dividend ratio. A ratio above 100 means that for every premium dollar taken in, more than a dollar went for losses, expenses, and commissions. contingency reserve reserve for losses in excess of those that are expected. An insurer generally contributes up to 50% of premiums earned in any year to this reserve, and amounts contributed are to remain there for 10 years, subject to transfer to the surplus account either at the end of that period or before to the extent that the loss ratio exceeds 35% in any given year. Federal income taxes on amounts in the contingency reserve are deferred as long as the funds remain allocated there and are paid when they are transferred to surplus. direct insurance premiums written (less return premiums), without any allowance for premiums for assumed or ceded reinsurance. Direct or primary insurance involves an insurer and the policyholder. In 15

16 contrast, reinsurance involves two insurers, with one ceding risks undertaken as a direct insurer to another insurer earned premium the portion of a premium which is the property of an insurance company, based on the period for which protection of the policy has already been given (the expired period). For example, an insurance company is considered to have earned 75% of an annual premium after a period of nine months of an annual term has elapsed. expected claim cost contracts the expected value of the loss distribution for a particular group of insurance expected value the sum of losses divided by the number of exposures; the average. expense ratio the ratio of a company's operating expenses to premiums. The sum of general insurance expenses, direct commissions, and net commissions and expense allowances on reinsurance assumed and ceded, as a percentage of net premiums written (NPW). gross premium the premium paid by the policyholder. investment yield net investment return (including realised capital gains) as % of average invested assets loss ratio claims as a % of premiums. May be calculated in several different ways, using paid premiums (NPW) or earned premiums (NPE), and using paid claims with or without changes in claim reserves and with or without changes in active reserves. net premium usually, total written premium or earned premium less provision for ceded reinsurance premiums and, on occasion, certain expenses such as commissions. The portion of the premium rate which is designed to cover benefits of the policy, but not expenses, contingencies, or profit. Net premium has a different meaning in the 1993 SNA. net written premiums (NPW) premium income retained by insurance companies, directly or through reinsurance, after payments (premiums ceded) made for reinsurance. non-technical results results deriving mainly from investments premiums earned, gross the amount of premiums received for in advance that are earned by virtue of the expiration of risk. premiums earned, net gross premiums earned less premiums earned on business ceded to reinsurers premiums written, gross total premiums received from all sources including reinsurance assumed from other insurers. premiums written, net gross premiums written less premiums ceded to reinsurers. property / casualty property insurance covers damage to or loss of the policyholder's property. Casualty covers the policyholder's legal liability for damages and injuries caused to others. property insurance insurance providing financial protection against the loss of, or damage to, real and personal property caused by such perils as fire, theft, windstorm, hail, explosion, riot, aircraft, motor vehicles, vandalism, malicious mischief, riot and civil commotion, and smoke. 16

17 provisions the practice among accountants is to apply the term provisions to the amounts set aside to provide for liabilities assumed to exist at the accounting date, and to apply the term reserves to amount available to meet liabilities that may arise after that date. Among actuaries and among practitioners of general insurance it has been widespread practice to apply the term reserve to both categories. reinsurance the acceptance (assumption) by one or more insurers, called reinsurers, of a portion of the risk underwritten by another insurer who has contracted for the entire coverage. The purchase of insurance by an insurance company from another insurance company (reinsurer) to provide it protection against large losses on cases it has already insured. reserve The amount required to be carried as a liability in the financial statement of an insurer to provide for future commitments under policies outstanding. Note that a reserve is usually a liability and not an extra fund. It is an amount allocated for a special purpose. retention the net amount of risk retained by an insurance company for its own account or that of specified others, as opposed to the amount it insures (or reinsures) with another. retrocession the process by which a reinsurer obtains reinsurance from another company. return on assets (ROA) net operating income as a percentage of average general account assets for the year. Average assets are calculated based on reported assets at the end of the current and prior fiscal years. Excludes capital gains/losses. return on statutory capital (ROE) net operating income as a percentage of average statutory capital outstanding for the year. Average capital is calculated based on reported capital at the end of the current and prior fiscal years. Excludes capital gains/losses solvency average capital funds (own funds) as % of NPW technical provisions amounts, which must be adequate to meet fully the commitments of the insurer to policyholders and beneficiaries of contracts. They are treated as liabilities of the insurer and assets of the policyholders. Technical provisions include: provisions for unearned premiums, unexpired risks (life only, or long-tail casualty too?), outstanding claims, claims equalisations reserve, IBNR technical results results deriving from pure insurance activities written premiums the amount of premium for which cover commenced in an accounting period, either net or gross of reinsurance. 17