Charles S. Di Lullo

The financial statements for life insurance companies differ substantially from those of other businesses. The reason for such differences is due to the application of statutory accounting principles (SAP) in the preparation of life insurance financial statements versus generally accepted accounting principles (GAAP) that are applied to the financial statements of other types of businesses.

Differences also exist within life insurance companies themselves. These differences are found in whether a particular life insurance company is a stock company or a mutual company. A stock company has stockholders to whom the board of directors and management must account, whereas a mutual company must account to its policyholders who are in fact the owners of the company. (See figure 15-1.) Different presentation approaches exist in support of these two different types of accountabilities.

FIGURE 15-1 Stock versus Mutual Life Insurance Companies

The objectives, audiences, and structure associated with the formation and dissemination of GAAP versus SAP are also substantially different. (See figure 15-2.)

GAAP is concerned with the measurement of economic activities, the time when such measurements are made and recorded, the proper disclosures surrounding these economic activities, and the preparation and presentation of summarized economic activities in financial statements. The resulting financial statements are prepared and presented in published or unpublished reports issued by a company along with other pertinent information, and/or they are reflected in financial reports audited and issued with a related opinion by an external CPA—either an individual or a firm. The audiences that GAAP-prepared financial statements generally serve are investors, creditors, prospective investors, security and exchange commission, company management and board, company employees, and various financial and security analysts.

SAP is concerned with the methods and measurements of reflecting the degree of solvency or the amount of asset coverage that a life insurance company must have to meet the present and future claims on such assets. In addition to the reports issued by a company and/or the related audited CPA report as issued under GAAP, a life insurance company under SAP must submit to the state a statutory financial report. The audiences that SAP-prepared financial statements serve, in addition to those served by GAAP, are state insurance regulators, rating agencies, prospective policyowners, and company agents. SAP has the additional requirement over GAAP of satisfying within its financial statements the state regulatory authorities.

The evolution of GAAP over the years has been from a number of different sources, such as industry practices, professional opinions and pronouncements, and professional publications. Currently, the primary body that oversees existing principles and issues new or revised principles is the Financial Accounting Standards Board (FASB). It is the successor of the old Accounting Principles Board (APB) that came into existence in 1959 and issued its first opinion in 1962. The APB consisted exclusively of CPAs who provided their time and efforts on a voluntary basis. The FASB has a wider and more diversified financial disciplines representation of its members, and they are compensated for their responsibilities.

SAP had its origin in 1875 when the first annual statement was adopted by the National Association of Insurance Commissioners (NAIC). This statement, commonly referred to—even today—as the blank or blue blank statutory report, must be filed in each state where an insurance company is licensed to do business. The reporting requirements for SAP, unlike GAAP, are established by each state’s legislature. The state’s insurance department interprets and enforces the state’s statutory requirements. The NAIC, which consists of membership from various state insurance departments, has as one of its objectives the fostering of uniformity in the recording requirements among the various states.

In the early 1970s, both the Security and Exchange Commission (SEC) and the American Institute of Certified Public Accountants (AICPA) had concerns relative to the different recording requirements being established by the various states. This resulted in the AICPA developing GAAP requirements for insurance companies. These requirements were restricted to those insurance companies who were stock companies, since they were similar to other types of corporations. They did not address mutual life insurance companies. Supposedly, the formulation of GAAP requirements for mutual life insurance companies is currently being deliberated. Stock companies issue two reports, a SAP report for the state and a GAAP report for all other purposes; mutual companies issue only a SAP report.

The principles supporting GAAP versus SAP requirements are totally different. GAAP’s objective is the reporting of a company’s financial status and results of operations for a specified period. SAP’s objective is to reflect the degree of solvency and asset coverage needed to meet a company’s current and future liabilities. (See figure 15-3.)

The underlying concepts supporting GAAP fall into nine basic principles. Each represents a component of the building blocks applicable to accomplishing the overall objective of GAAP. (See figure 15-4.) Those concepts are

• Relevancy: reflection of the useful data on financial statements that affects or is directly associated with the process of making pertinent financial decisions

• Uniformity: consistency in the accounting practices within and across different businesses for enhanced understanding and for viable comparative analysis
• Consistency: application within a business of similar accounting practices over time for appropriate comparative analysis of performance in one year as compared with another
• Accrual: recognition of revenues and expenses in the accounting period when earned or incurred versus the period received or paid
• Cost: conservation of the initial exchange price for an asset, liability, or capital, and maintaining such price as the historic cost basis
• Conservatism: if necessary, understating rather than overstating net income or net assets; in other words, never anticipate profits and always provide for losses
• Materiality: disclosure of events that are of relative importance to a business’s performance and for understanding its financial statements
• Monetary Unit: reflection of only those transactions of economic activities or occurrences that can be measured in monetary terms
• Going Concern: assumption that a business will remain in existence indefinitely

Under SAP the underlying principle is liquidity. All financial data is recorded on a cash basis. All transactions are reflected on a liquidation value basis (current market value).

The critical differences between GAAP and SAP are found in their underlying principles. GAAP concentrates on matching revenues and expenses (accrual concept); SAP utilizes cash-base accounting. GAAP focuses primarily on the income and cash-flow statements; SAP focuses on the balance sheet and emphasizes solvency. (See figure 15-5.)

Under SAP accounting, both admitted and nonadmitted asset accounts and ledger and nonledger accounts exist. (See figure 15-6.) Conversely, under GAAP accounting no such difference exists.

Admitted assets are reflected on an insurance company’s annual statement. These assets concern themselves with both revenue and expense accounts that are directly associated with a company’s product premiums, investments, and related product benefit cost. Nonadmitted assets are not reflected on the annual statement. They fall into two categories: those partially admitted and those entirely nonadmitted. Partially admitted assets, as an example, include investments that have a lower market value than their current book value. Entirely nonadmitted assets are those acquired in carrying out the normal process of doing business, such as furniture, most equipment (computer equipment is classified as an admitted asset), and amounts advanced to agents against future commissions.

SAP also has ledger and nonledger accounts, a difference that does not exist under GAAP. The ledger accounts are those that are maintained on a cash-basis accounting system. The nonledger accounts are those that are not on the cash-basis system but are maintained on a separate worksheet and are not part of the general ledger. Unlike the nonadmitted assets, the nonledger accounts are reflected on the annual statement. To keep the ledger and nonledger accounts in balance on the general ledger, a balancing account is maintained as a ledger account, which could be considered a composite total of all of a company’s nonledger accounts.

The application of the underlying principles supporting both GAAP and SAP to their related financial statements affects the "what, how, and why" of those statements. To find and properly interpret the critical information in those statements, it is important to understand what they reflect, how they can be used to help a business attain its objectives (financial and other), how the underlying principles impact various methods of data presentation, and what tools and techniques are available to extract information needed to understand the why of what occurred, which will help any decision process and related action plan.

FIGURE 15-6 SAP Type of Accounts

The preparation of financial statements is an art. Many different methods of presenting financial data are both available and legitimate. The art must be understood so that proper interpretation of such data can be made.

The objectives supporting the preparation of financial statements can have a dramatic impact on the "what, how, and why" of the information presented. Statements can be prepared for different audiences, under different bases, utilizing different methods, or with different goals. (See figure 15-7.)

• Different audiences (such as external audited statements for investors and creditors versus internal detailed statements for management to utilize in evaluating a business plan)
• Different bases (such as GAAP versus SAP statements)
• Different methods (such as the accrual method for business purposes versus the cash method for tax purposes)
• Different goals (such as the presentation of a company’s financial status and results of operations under a going concern concept versus personal financial statements that are based on current market value)

The basic financial statements applicable to both GAAP and SAP are the balance sheet, the income statement, and the cash-flow statement. (See figure 15-8.)

The balance sheet reflects a business’s financial status at a point in time, that is, on a particular date such as December 31. Included within the statement are all business assets, liabilities, and equity. The strength of the financial status will depend on the type and related funding of the business’s assets. Such funding is either by debt or by equity.

The income statement reflects the results of operations for a period of time, such as January 1 through December 31. The statement accounts for all revenues earned and expenses incurred during the period being measured. The results of operations (a business’s profit or loss) will depend on whether revenues exceed expenses, which is a profit, or expenses exceed revenues, which is a loss.

The cash-flow statement reflects, by using both the balance sheet and income statement, a business’s overall increase or decrease in cash over a specified period of time. The statement accounts for the sources and uses of cash from three different perspectives. The first perspective is from operations, which is extracted from the income statement and the working capital (current assets minus current liabilities) found on the balance sheet. The next perspective is from investments, the acquisition and/or disposal of long-term assets found on the balance sheet. The final perspective is from financing, which includes both long-term debt and equity transactions also found on the balance sheet. The statement is an excellent management evaluation tool. It reflects a cash basis, the sources of cash available to an organization, and, through the uses of such cash, the direction management is taking.

The structure of the financial statements for GAAP versus SAP differs according to the type of accounts that are reflected on each statement. The balance sheet under GAAP generally is divided between current assets (cash, marketable securities, accounts receivables, and inventory) and long-term assets (property, plant, and equipment) whereas SAP assets, in addition to cash and marketable securities, are reflected mainly as invested assets, other admitted assets, deferred due, accrued income, and separate account assets. Invested assets are those assets that produce income in the form of interest, rent, dividends, and capital gains. Other admitted assets include electronic data-processing equipment, reinsurance ceded, federal income tax recoverable, and other items that can be established as necessary by the insured. Deferred, due, and accrued income consist of investment income due and accrued, and deferred and uncollected premiums on policies in force. Separate account assets are those assets that are maintained apart from a company’s general accounts. They are usually invested in nonguaranteed insurance products and/or employee benefit plans.

Liabilities under GAAP are generally segregated by current accounts payable, taxes payable, accrued liabilities, and long-term debt payable. SAP liabilities include nonledger accounts for policies currently in force or policies that have terminated with a remaining liability, policy reserves, amounts on deposit, claims incurred but not yet paid, dividend liabilities, accrued expense other than claims, unearned income, and amounts temporarily held for disposition.

Equity under GAAP usually consists of capital stock, retained earnings, and any capital surplus or paid-in capital accounts. Under SAP there is capital stock for stock companies and surplus for both stock and mutual companies. Surplus usually consists of contributed surplus for the excess over par value on issued capital stock, special surplus for reserves applicable to general contingencies, and unassigned surplus, which represents accumulated operating and other earnings.

The income statement under GAAP reflects the revenues and related costs associated with a company’s operating and other activities. Similarly SAP reflects the revenues or income from insurance contracts and/or net income from investments, and expenses for policy benefits, policy reserves costs, commissions, general expenses, taxes, and policy dividends.

Financial statements can be evaluated for a number of reasons that include but are not limited to evaluation of performance, evaluation of stability, evaluation for identifying funding sources, evaluation for identifying debt collateral, evaluation for investment, and evaluation for determination of a business’s worth. (See figure 15-9.)

A number of different evaluation tools are available to analyze and understand GAAP-prepared financial statements. Such tools as common-size analysis, trend analysis, ratio analysis, break-even analysis, and even a number of external publications are available. (See figure 15-10.)

Common-size analysis is a tool that converts dollars to percentages and relates the components of total assets to the individual asset accounts, total liabilities and equity to the individual liabilities and equity accounts, and net sales to the individual revenue and expense accounts. Its advantages are that percentages are easier to work with than absolute dollars, and that it eliminates any differences in overall dollar size of two companies that are being compared.

Trend analysis is also a percentage statement. It identifies a base year as 100 percent and relates each successive year’s percentages as a relationship of each account to the base year. Its advantage is that it reflects the impact of inflation and other external factors on profitability and growth. Ratio analysis provides a series of specific ratios that measures different components of a business for comparison with prior performance, other businesses, or industry averages. Such ratios can measure liquidity, capital structure, returns on investment, asset utilization, and market performance. Break-even analysis is another tool that can assist in determining the break-even point for proposed products or projected courses of action.

Risk Based Capital

The evaluation methods available for financial statements prepared under GAAP are also available for those prepared under SAP. In addition, under SAP the concept of risk based capital can be applied. The risk based capital concept and related formula and performance levels provide a vehicle to assist the management of companies, the state regulators, and the general public in maintaining good business practices. It provides the necessary early warning signals to allow sufficient time for corrective action, and it will help, along with other good management, product and investment objectives and related performances to enhance consumer confidence in the industry.

The National Association of Insurance Commissioners (NAIC) adopted the Risk Based Capital for Life and Health Insurance Model Act on December 6, 1992. The act established higher minimum capital requirements in support of continued financial stability. It has as its overall objective the strengthening of companies that are undercapitalized. It identifies early warning signals of companies with unstable capital, which can be rectified through improving their capital structure. Finally, it strengthens the authority of state regulators over life companies experiencing capital structure problems. (See figure 15-11.)

Under the act every company must submit to the NAIC—and to the state in which it does business upon written request from the state—on or before the filing date a risk based capital report reflecting its risk based capital levels as of the end of the previous calendar year. The risk based capital levels fall into one of four event categories: company action level, regulatory action level, authorized control level, or mandatory control level.

A strong capital structure within a company assists in providing the necessary protection from investment and insurance risk. Such risks are associated with unforeseen events that can have a substantial negative impact and/or drain on a company’s assets and reserves.

The amount of capital that is set aside to minimize risk exposure should be reflective of the type of risk that exists. The higher the risk, the higher the required capital support. The lower the risk, the lower the required capital support. With the use of a risk based capital formula, assistance is provided in quantifying the funds that a company should set aside for the various risks taken in its business operations.

The concept of utilizing various formulas to measure appropriate capital is not new. Over the years, both rating agencies and companies have been using internally developed formulas to accomplish this objective. The rating agencies still use their formula to establish levels of capital that they want to maintain, which are referred to by various surplus names such as required, target, or benchmark surplus. In comparing actual capital to a target, a company can plan courses of action to follow either with excess capital or with capital to enhance product line, or formulate steps with capital deficiencies to reduce capital needs or increase the capital base.

Internally developed formulas are sometimes utilized for other financial and operating purposes, such as allocating capital by profit centers and evaluating performance by the return on capital invested in each center, which assists management in determining the most productive use of capital.

The risk based capital concept provides a means of establishing regulatory capital standards for overall business operations relative to the size and risk profile of various companies.

The four major risks associated with the risk profile that are involved in the calculation of a risk based capital formula are

• asset risk: the risk of asset default
• insurance risk: the risk of adverse mortality and morbidity experience
• interest rate risk: the disintermediation risk of policyholders withdrawing funds
• general business risk: the normal business and management risk (See figure 15-12.)

The risk based capital for a particular company is determined or calculated by applying established factors to various asset, premium, and reserve balances. Such factors are higher for those account items with greater underlying risk, and lower for those accounts items that are less risky. The following are examples of the accounts and other items to which factors are applied:

• asset risk accounts: bonds, mortgages, preferred and common stocks, separated accounts, real estate and other long-term assets, miscellaneous and reinsurance accounts, and off-balance sheet items
• insurance risk accounts: medical insurance premiums, disability income premiums, claim reserves, various life insurance premiums, and premium stabilization reserves
• interest rate risk accounts: low risk category accounts and medium and high risk category accounts
• general business risk accounts: life and annuity premiums and health premiums

The risk based capital standards are used by regulators to assist in determining appropriate actions relating to companies who, as a result of applying a formula, reflect signs of deteriorating financial conditions. The risk based capital standards also provide an additional standard for measuring minimum capital requirements; companies that fall below this standard would be placed under regulatory control.

Established risk based capital factors exist for each category as well as the levels of risk within each category of a company’s accounts. These factors are applied to the values reflected in a company’s annual statement. Within the asset risk accounts, factors exist for

• different categories and sizes of government bonds
• mortgages in good standing versus mortgages that are 90 days overdue or are overdue with unpaid taxes or are in foreclosure
• different risk categories of preferred stock
• affiliated and unaffiliated common stock
• separate accounts
• occupied real estate, real estate investments, or foreclosed real estate
• other long-term assets
• miscellaneous assets such as policy loans and short-term investments
• various categories of reinsurance
• off-balance sheet accounts such as noncontrolled accounts and contingent liabilities

Within the insurance risk accounts, factors exist for different categories and amounts for individuals and group major medical, disability, and other coverages with limited benefits and with claim reserves; for different categories and amounts applied to net amount at risk for ordinary and group life in force; and for premium stabilization reserves.

Within the interest rate risk accounts, factors exist for various types of low-, medium-, and high-risk annuities, GICs, and life insurance reserves.

The product of the application of the factors to the various accounts provides the basis for determining the various individual risk exposures, that is, asset, insurance, interest, and general business risks.

The total risk based capital of a company estimates the capital required to deal with losses caused by catastrophic financial events. The chances that all of the various individual risks will occur simultaneously is remote. In fact, some of the risks are mutually exclusive. Therefore adding all of the individual risks together to determine a company’s total risk based capital would overstate the total risk and not be appropriate. To deal with this problem, the individual risks are modified within a formula to compute the total risk based capital. The formula takes into consideration what is referred to as the covariance adjustment and is as follows:

Total Risk Based Capital   

  Equals

Ö [(Asset Risk + Interest Rate Risk)² + (Insurance Risk)²] + Business Risk

The total risk based capital results represent the foundation for computing the various risk based capital levels that are compared with a company’s total adjusted capital. This comparison determines the extent, if any, to which state regulators become involved in a company and its operations.

Total adjusted capital is determined by modifying a company’s capital and surplus to include asset valuation and voluntary investment reserves and to also include 50 percent of the company’s dividend liability.

The risk based capital is compared with the total adjusted capital for determining the risk based capital level. As indicated earlier, the risk based capital level falls into one of four event categories. They consist of a company action level event, a regulatory action level event, an authorized control level event, and a mandatory control level event. Each requires a different action by a company. (See figure 15-13.)

A company action level event exists when the filing of a risk based capital report indicates that the total adjusted capital is greater than or equal to the regulatory action level but less than its company action level; or that the total adjusted capital is greater than or equal to the company action level but less than the product of the authorized control level and 2.5.

If such an event occurs, a company must submit a comprehensive financial plan that identifies the condition for the existence of the event, a proposal of corrective actions, projected financial results for the current year and at least the next 4 years—giving consideration to what would occur with or without the corrective actions, and an explanation of the major assumptions affecting the projections and the sensitivity of the projections to the assumptions.

The comprehensive financial plan must be submitted within 45 days after the year-end in which the company action level event occurred. Then, within 60 days after its submission the company will receive feedback relative to the acceptance, modification, or rejection of the plan. Hearing procedures exist for situations in which the feedback decision is challenged.

A regulatory action level event exists when the filing of a risk based capital report indicates that the total adjusted capital is greater than or equal to its authorized control level but less than its regulatory action level. If such an event occurs, the state regulators may require an examination and analysis (either internally and/or by a third-party consultant for which all costs and fees would be borne by the company) of the risk based capital plan and of the company’s assets, liabilities, and operations. Such an examination and analysis results in an order, referred to as the Corrective Order, specifying whatever corrective actions the state regulator requires. Within 45 days after the year-end in which the regulatory action level event occurred, the company must submit a comprehensive financial plan. Hearing procedures exist for situations in which any corrective order is challenged.

An authorized control level event exists when the filing of a risk based capital report indicates that the total adjusted capital is greater than or equal to the mandatory control level but less than the authorized control level.

As under the regulatory action level event, if such an event occurs the state regulators may require an examination and analysis (either internally and/or by a third-party consultant for which all costs and fees would be borne by the company) of the risk based capital plan and of the company’s assets, liabilities, and operations.

If deemed to be in the best interest of policyholders, creditors, and the general public, the state regulators will take such action to cause a company to be placed under regulatory control. The event is deemed sufficient grounds for the regulatory control action to take place. Hearing procedures exist for situations in which any corrective order and/or regulatory control is challenged.

A mandatory control level event exists when the filing of a risk based capital report indicates that the total adjusted capital is less than the mandatory control level.

As under the authorized control level event, if it is deemed to be in the best interest of policyholders, creditors, and the general public, such action can be taken to cause a company to be placed under regulatory control. The event is deemed sufficient grounds for the regulatory control action to take place. Hearing procedures exist for situations in which the regulatory control is challenged.

The Risk Based Capital for Life and Health Insurance Model Act increased the state regulator’s ability to evaluate a company and also increased the regulator’s authority over a company whose financial condition has deteriorated. The act requires that each year every life insurance company calculate its minimum capital requirement using the risk based capital formula. The results of the formula are compared with the company’s actual total adjusted capital balance, and, if the company’s capital balance falls below the formula, the state regulator will take some form of action depending on the severity of the deficiency. The act requires the determination of the four event levels that are used to determine if regulatory action is necessary. (See table 15-1.)

The initial base level, which represents 50 percent of the risk based capital formula calculation, is referred to as the 100 percent authorized control level. If the total adjusted capital of a company falls below the authorized capital control level but equals or exceeds the mandatory control level, the company must file a corrective plan and submit to an examination, and the company may, as a result of the examination, be placed under regulatory control.

The mandatory control level represents 70 percent of the authorized control level. If the total adjusted capital of a company falls below the mandatory control level, the company must be put under regulatory control.

The regulatory action level represents 150 percent of the authorized control level. If the total adjusted capital of a company falls below the regulatory action level but equals or exceeds the authorized control level, the company must file a corrective plan, submit to an examination, and follow any orders for corrective action.

The company action level represents 200 percent of the authorized control level. If the total adjusted capital of a company is between 200 percent and 250 percent of the authorized control level, the company is required to prepare a trend test. If the total adjusted capital is below the company action level but above the regulatory action level, the company must submit within 45 days a financial plan that identifies the cause of the capital problem and the proposed course of action to correct it.

A trend test calculates the greater of the decrease in the margin between the current year’s authorized control level and the prior year, and the average of the past 3 years. It also assumes that the decrease in the authorized control level could occur again in the coming year. Any company that trends below 1.9 times its authorized control level would trigger regulatory action. (See table 15-2.)

Under a sensitivity test, a company, depending on certain considerations, recalculates its risk based capital or total adjusted capital using a specific alternative for a particular factor in the formula and reports to the state regulator the recalculated amount.

Every company has the opportunity to prepare and submit to the state regulator a written report and analysis of its risk based capital results that could also include any other appropriate comments.

As indicated at the outside, the financial statements for life insurance companies differ substantially from those of other businesses. With a better understanding of the underlying concepts of GAAP and SAP and their differences in principles, objectives, and audiences, a clearer base for interpreting and analyzing such statements should occur.

Chapter 14

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Appendix