Let�s consider the interests and objectives of each of these distinct audiences.

Investors are interested in the current level of and the prospective growth in the earnings of public companies in order to value these companies for investment purposes. Since investments may be made in debt instruments (for example, bonds) and in equity securities (for example, common or preferred stock), investors are also interested in an enterprise�s current and prospective financial strength.

The SEC seeks to ensure that the financial statements and accounting rules used by publicly held companies, including stock life insurance companies, provide investors and other users with the required level of information. Fair and consistent presentation across industries is the norm; however, certain industries, such as insurance, have requirements tailored to their unique characteristics.

State insurance regulators are principally interested in the ability of the life insurance companies that operate in their jurisdictions to meet current and future obligations to policyowners and owners of other contracts with the insurer. This means that the regulators� focus is on the near-term and long-term financial safety and solvency of the company. To this end, they seek to assure that the financial statements filed by life insurance companies are based on conservative accounting principles and practices.

Creditors are interested in the likelihood that the amounts owed to them will be paid. Creditors include bondholders and suppliers of equipment and services to the life insurance company. Creditors whose obligations are due currently need information on the company�s current liquidity position and/or its expected near-term cash flow from operations. This information, however, is rarely available in a timely fashion from the company�s financial statements. Long-term bondholders are interested in assessing the ability of the life insurance company (or its parent company) to pay bond interest and principal due in the future. Although published financial statements can provide some of this information, these creditors usually require additional information not unlike that provided to the rating agencies described below.

Security analysts are an audience with similar but more expansive information requirements than investors. Although large corporate and mutual fund investment managers do their own research using financial statements and other public and private information available about a company, individual investors often rely heavily on the analyses and recommendations of the leading brokerage and investment banking firms� industry analysts.

Rating agencies are another audience for life insurance company financial statements. Their focus is the company�s present financial position and how it may evolve in the future. It is important to these agencies that financial statements of companies in an industry be comparable and provide consistent results over the years. Because the principal agencies (A. M. Best, Standard and Poors, Duff and Phelps, and Moody�s) depend mostly on their own in-depth data-gathering visits and interviews with the company�s senior management, their needs for information do not impose additional requirements on the structure or content of the life insurance company�s published financial statements. Other rating services, which depend almost entirely on published financial statements and other publicly available information, may find their analytical capability and the quality of their ratings limited by the information contained in these sources.

Policyowners and prospective policyowners are primarily concerned with two aspects of a company�s position and performance. One is the company�s ability to meet its benefit guarantees to policyowners; the second is the company�s performance in those areas that will affect future charges to policyowners for insurance coverage. Key performance areas include investment income, mortality costs, expenses, and persistency. Policyowner interest is most acute at the time of purchasing an insurance contract (which often involves comparisons among several companies), but this interest may continue throughout the lifetime of a contract. A life insurance company�s policyowners therefore are interested in financial statements that permit them to assess the company�s safety and solvency and to compare the current levels and trends of the company�s performance in the areas that affect policyowner costs (investment income, mortality, expenses, and persistency) with those of other companies. Businesses, particularly those acting in a fiduciary or quasi-fiduciary capacity as policyowners or sponsors of 401(k) or other benefit plans, have an obligation to deal only with insurance companies with unquestionable positions of safety and solvency.

Members of the insurance company management, as well as the company�s board of directors, are interested in having financial statements that fairly portray the company�s financial position and progress, particularly as they relate to its principal life insurance competitors. The financial statement should not only fairly measure the results of an individual company�s operations but should also ensure comparability among companies. In particular, measurements of current year earnings should neither favor nor disfavor companies that are making investments in capacity or growth for future profits versus companies that are profiting largely from past investments. If financial statements do not recognize the appropriate value of investments in capacity or growth, companies may focus too much on short-term actions to the detriment of long-term performance.

Agents and employees share the interests of company management, policyowners, and in the case of stock companies, shareholders. As representatives of the company, their most immediate concern is that financial statements accurately inform policyowners about operational results and financial strength. Agents, in particular, must advise clients and respond to clients� questions on issues of company safety and solvency and on policy funding adequacy. Very often, the agent�s advice and counsel must be given in competition with other agents and brokers, placing greater intensity and focus on these issues.

In addition to the different perspectives of the several audiences described above, the structure of life insurance company financial statements is shaped by the nature of the business the company conducts. Most contracts issued by life insurance companies involve long-term commitments. Policy accumulations are invested for long periods of time, and many contracts remain in force for decades. Because the company�s actual financial results for each block of contracts can be determined only after it has run its full course, measuring financial results on in-force contracts often depends as much on the assumptions and accounting conventions used as it does on cash receipts and payments (premiums received, investment income received, death claims and surrender values paid, and expenses paid). This factor shapes life insurance company financial statements as much or more than the goals and objectives of the various audiences for these statements.

The remainder of this chapter describes the structure and content of life insurance companies� published financial statements. It will become clear that these statements largely, but not fully, satisfy the objectives of certain of these audiences and leave others largely unfulfilled. Despite the significant expansion in the amount of information provided in financial statements in recent years, no statement (or set of statements) can economically meet all needs. As indicated above, the shortfalls in the ability of financial statements to meet the objectives of a particular audience can sometimes be bridged by additional information or in-depth visits, but this is not always practical.

Financial statements are a primary means for a life insurance company, or for that matter any enterprise, to communicate information to the audiences described earlier. In one of its financial accounting concepts statements, the Financial Accounting Standards Board (FASB) identified three objectives of financial reporting. These are paraphrased below:

The statement of financial position, more commonly called the balance sheet, lists the company�s assets, liabilities, and its equity position at the end of the fiscal period. Comparable numbers are also shown for one or 2 prior years. (For life insurance companies, the calendar year is the fiscal year; the statement date is December 31 of that year.)

Assets are economic resources that the company owns or controls. Assets include cash, investments (stocks, bonds, mortgages, and real estate), real property used in the business (buildings, parking lots, and so on), and premiums and other amounts receivable from customers. There are events or transactions that can cause a change in the value of an asset that a life insurance company holds. For example, the market price of a common stock can go up (or down) and can increase (or decrease) the value of the company�s investment in that stock relative to its original cost. Similarly, in the case of the investment-income-receivable asset, experience has shown that the amount due and accrued will not always be collected, particularly if the business is behind in its payments. Therefore total investment income due and accrued will be reduced by an estimate of the amount that will not be received to determine the appropriate asset value.

Certain assets, such as buildings, furniture, computers, and equipment, are usually worth less as they age. For financial reporting purposes, a useful life is determined for each such asset or asset class and the cost of the asset is written off or depreciated over its productive years. Depreciation is an expense in the income statement and a reduction in the asset�s carrying value. Over time, the cumulative amount of depreciation for an asset grows until, at the end of its useful life, the statement or book value of the asset is reduced to zero (or some residual or salvage value if resale is possible). When applied to intangible assets such as goodwill, the term amortization is used to describe a similar process.

Liabilities, on the other hand, are obligations to transfer assets or to provide services to others: policyowners and contract owners, creditors, employees, suppliers, or taxing authorities. Liabilities include such items as policyowners� account balances and future benefits payable, short- and long-term debt, dividends not yet paid to policyowners and/or shareholders, and taxes payable.

In the insurance industry, the terms liability and reserve are often used interchangeably. However, these terms have distinctly different meanings in other accounting contexts and for other industries. For example, policy reserves (discussed in detail in chapter 16) are liabilities. The allowances for uncollectible investment income mentioned above are often called reserves, but they are classified with and used to reduce assets.

Equity is, very simply, the difference between assets and liabilities. A company�s equity is the book measurement of the ownership interest. The insurer�s own common and nonredeemable preferred stock, the related paid-in capital, and its retained earnings/surplus are typical components of equity.

Equity is increased when the owners of a business make additional investments in the company or when a company�s net earnings are retained in the business instead of being returned to the owners as dividends. Equity is decreased when a company has a net loss from operations, pays dividends to shareholders, or otherwise returns assets to its owners.

The distinction between liabilities and equity is not always clear. For example, redeemable preferred stock has characteristics of both debt and equity. The asset valuation reserve (AVR) is reported as a liability in the annual statements filed with state regulators, but it is often treated as equity. (The AVR will be discussed more fully later in this chapter.)

Unlike the statement of financial position, which presents the company�s position on the date of the statement, the income statement (which is also referred to as the statement of operations, or statement of earnings) presents the company�s revenues, expenses, and earnings (losses) for the accounting period specified (a fiscal year or a fraction thereof). Earnings serve to build the company�s equity and, in the case of stock companies, to provide the funds for distribution as dividends to shareholders. Year-to-year trends in a company�s earnings, which are usually expressed as earnings per share of stock outstanding, are a principal factor affecting the stock market�s evaluation of the value (price) of the company�s stock.

Revenues are inflows of cash or other assets that result from an enterprise�s business operations. In the case of a life insurance company, major sources of revenue include premiums and other contract charges and income from its investments. Expenses, on the other hand, are outflows or other uses of assets (or incurred liabilities) required to provide products and services to a company�s clients. Benefits paid to policyowners or contract owners, salaries, commissions, employee benefits, and taxes are a few of the more significant expenses life insurers report in the income statement.

In financial reports a distinction is drawn between revenues and expenses from the insurance company�s normal ongoing business activities and its gains and losses. One distinguishing characteristic of gains and losses is that they are usually the direct result of specific management actions. For example, when an investment is sold, the difference between the amount the company receives and the current carrying value of the investment represents a gain or loss. Similarly, the discontinuance or sale of a business may produce a gain or loss. Security analysts tend to treat gains and losses differently from (and place less importance on) income from regular business operations in evaluating a company�s economic performance.

In addition to the balance sheet and income statement, a life insurance company�s financial statement contains a cash flow statement and supplementary material that provides additional details regarding the balance sheet and income statements. The cash flow statement and the supplementary material will be discussed in greater detail in a later section of this chapter.

Although the goals and objectives of the several audiences for life insurance company financial statements are now well understood, this was not always the case. Life insurance company statements have evolved in form and content as these audiences have grown in influence and their requirements have become more clearly defined and articulated.

Until the 1960s, state regulators were the only group with a substantial interest in life insurance companies� published financial statements. There were few major stock life insurance companies and limited investor interest in such companies. The Accounting Principles Board, the predecessor of today�s Financial Accounting Standards Board, had just come into being in September 1959 and would not issue its first opinion until 1962. There had been no major life insurance company insolvencies since the Great Depression, and most individual life insurance was sold in situations in which there was little policyowner concern about insurer safety and solvency and, given the relatively low level of price competition, whether the company�s illustrations of future policy performance would be realized.

In this environment the state insurance departments defined the contents of the only published financial statements for life insurance companies. The statutory financial statements they prescribe, commonly called the NAIC blank or the "blue blank" (because of the color of its cover), must be filed by life insurance companies in each state in which they are licensed to do business. The statutory statement places primary emphasis on solvency and stability. As a result, this statement focuses principally on the balance sheet. The statutory accounting practices (SAP) are a form of liquidation-basis accounting�that is, accounting as if the insurer is expected to cease operations in an orderly fashion in the near future. SAP tends to value both assets and liabilities conservatively. Some of the traditional statutory accounting practices include immediately charging furniture and equipment purchases directly against surplus, immediately expensing all costs (including policy and contract acquisition costs), and computing policy reserves on the basis of conservative (low) interest rates. The effect of this emphasis on the balance sheet is to lessen the value of the income statement as a source of information and dependable trends.

Statutory accounting and reporting requirements are established by each state�s legislature, which enacts the insurance laws and authorizes the regulations that govern insurance companies in that state. The state insurance department, headed by an insurance commissioner, interprets and enforces the prescribed statutory requirements. A life insurance company must comply with the requirements in each state in which it does business. Even though each state independently enacts its individual body of law, much similarity exists because of the influence of the National Association of Insurance Commissioners (NAIC), an organization made up of state insurance department regulators.

The NAIC helps to promote uniformity among the states. Model laws and regulations are developed by the NAIC that each state is then encouraged to pass. The NAIC has also codified statutory accounting practices into policy manuals and produces an annual statement guide that covers the information to be included in every report, schedule, and exhibit that make up the NAIC blanks.

Until the advent of generally accepted accounting practices (GAAP), many life insurance companies also published a condensed version of the statutory financial statement to include in the company�s annual report. Mutual life companies produce such statutory statements to this day. This condensed statement, while still compiled in accordance with statutory accounting practices, more closely resembled the traditional financial statement found in the annual reports of noninsurance enterprises. However, while the balance sheets and income statements of life insurance companies looked similar to those of noninsurance enterprises, the numbers were based on two separate and distinct accounting methodologies. Uniformity in the underlying accounting policies and procedures used by insurers was needed to achieve comparable financial statements.

During the 1960s, investors showed an increased interest in life insurance companies as potential investments. At the same time, analysts� frustration with the statutory financial statements was growing. The accounting practice that required acquisition costs to be written off immediately tended to tint the income statements of fast-growing companies negatively. As a result, security analysts developed several different rule-of-thumb adjustments to the statutory operating statements and used the "adjusted" income to advise investors in purchases and sales of life insurance company stock.

It soon became clear to the SEC and the American Institute of Certified Public Accountants (AICPA) that an environment in which state insurance regulators established accounting rules for life insurance companies and analysts developed different techniques for adjusting the resulting income statements for investment recommendations was not healthy. Investors needed a more controlled, standardized information flow. The AICPA was asked to develop an accounting structure for life insurance companies that would be in accord with the set of GAAP developed for other types of enterprises. This effort was completed in the early 1970s.

The GAAP statement seeks the best possible measure of a company�s past performance to provide users (investors, creditors, company managements, rating agencies, and so forth) with information to evaluate potential future performance. The focus of GAAP reporting is on the income statement and the statement of cash flows and on making the results of operations between periods easy to compare.

The underlying accounting principle influencing GAAP is to match income and expense so that profits emerge over the lifetime of a life insurance policy in a pattern that is more reasonably related to the policy margins than the profits would have been if all costs had been charged off in the year of sale, as they are under SAP. (Some FASB and SEC actions in the early 1990s diluted the focus on the income statement to some degree but did not disturb the essential nature of GAAP for life insurance companies.)

GAAP accounting standards usually apply to all United States business enterprises and to foreign operations that have United States filing requirements. In some instances, special guidance is developed on an industry-wide basis; the insurance industry is a case in point.

The authoritative accounting pronouncements that, taken as a whole, make up GAAP have been developed and enforced by three bodies. Like its predecessors, FASB has been the principal GAAP-standard-setting body since 1973. The AICPA, through its statements of position, accounting and auditing guides, and similar technical services, interprets existing GAAP. Finally, the SEC continues to affect GAAP through its direct and indirect influence on FASB, its own codified accounting and reporting policies, and case-by-case actions on the accounting practices used by companies seeking approval of registration statements.

During the development of the GAAP accounting structure for life insurers, there was a split between the mutual and stock segments of the industry. The mutual segment argued that GAAP accounting was not required for mutual companies, which were not investor-owned, and that the proposed GAAP treatment of policy dividends as a policy benefit was not in accord with mutual company dividend practices.

The mutual companies were successful in convincing the SEC and the other standard-setting organizations that the new GAAP structure should not be applied to them. As a result, stock companies have prepared both statutory and GAAP financial statements since 1973, while mutual companies have issued only statutory financial statements.

Over the years, mutual companies have been required to file more financial statements with the SEC, frequently because of an increasing amount of separate account activity and various kinds of asset-based financings and public debt offerings. The noncomparability of the mutual company�s statutory financial statements and the stock company�s GAAP financial statements is, in the view of the SEC, a growing concern.

Therefore the exemption for mutual insurers is being examined and FASB has been asked to develop and implement a GAAP structure for mutual life insurance companies which still had not been implemented in early 1998.