State insurance regulators impose financial reporting requirements, based upon statutory accounting principles (SAP), through the NAIC annual statement blanks. Use of SAP is prompted by the regulators’ overriding concerns as to the solvency of the insurance enterprise.

However, there are other interested groups with different needs requiring somewhat different financial information. One such group consists of investors in life insurance companies. Investors are interested in both the current level and prospective growth in the earnings of life insurers in order to value such insurers for investment purposes. In addition, since investments may be made in debt instruments such as bonds and in equity securities such as common or preferred stock, investors are also interested in insurers’ current and future financial strength.

During the 1960s investors began showing increased interest in life insurance companies as suitable vehicles for investment. Concurrently, securities analysts’ frustration mounted as to the financial statements then available which were based upon the conservative-liquidation nature of statutory accounting principles. For example, in a life insurance company’s annual statement based upon SAP, all of the acquisition costs incurred in writing new business are charged against income in the year incurred rather than amortized over the premium paying period of the policy. Since, in most new companies, acquisition costs of individual life insurance policies exceed the first-year premium income, even a well run company most likely would have to report operating losses in its first several years of operations. Such losses not only depleted surpluses of new companies, in some instances surpluses would fall below that required by law, requiring the infusion of additional capital. Similarly, the financial results (income and surplus) of a fast growing established life company can be adversely affected.

A major problem in the promotion of the stock of a new life insurance company was to create a market for the stock of a company whose financial statements showed substantial operating losses. Despite the fact that rapid growth in sales is normally considered to be indicative of a company’s vitality and success, it was difficult for securities advisers to induce prospective investors to purchase securities in even more well established life insurance companies whose earnings were reported in a manner deemed by securities analysts to be artificially depressed. The faster the growth in business, the more negative the income and surplus picture presented.

In response, stock promoters and securities analysts developed various adjustments to the statutory operating statements to derive "adjusted" income as a basis to advise investors on the purchases and sales of life insurance company stock. A commonly used method to offset the impact of the current operating losses, as reported on the statutory accounting basis, was to add projected future earnings on the business already written by means of the so-called adjusted earnings concept. This was said to "normalize" profits. That is, earnings were adjusted to reflect the investment in the unamortized acquisition costs. Adjusted earnings were calculated by adding to the net loss (or gain) from operations the value of the increase of the insurance in force for that year. A rule of thumb approach used to determine adjusted earnings was to value the increase in the insurance in force at, for example, $20 per thousand dollars of ordinary business. Stocks would then be valued in terms of their price/earnings ratio based upon the adjusted earnings regardless of the quality of the increased business and whether it in fact improved or worsened the earnings picture of the company.

In time it became clear to both the SEC and the American Institute of Certified Public Accountants (AICPA) that permitting a variety of unchecked techniques for adjusting life insurance company income statements as a basis for investment recommendations was not healthy. The SEC seeks to ensure that financial statements and accounting rules used by publicly held and traded companies (including stock life insurance companies) offer investors and other users of financial information appropriate and accurate information, both in terms of quantity and quality, to enable them to make informed decisions. Thus, the SEC concluded that investors needed a more controlled standardized flow of information than that which was occurring. The AICPA was requested to develop an accounting structure for life insurance companies more in accord with the Generally Accepted Accounting Practices (GAAP) developed for other types of enterprises. This task was accomplished in the early 1970s.

GAAP seeks to measure a company’s past performance in a manner to provide users information with which to evaluate future performance. The focus is on the income statement and the statement of cash flows. The underlying principle influencing GAAP is to match income and expenses so that profits emerge over the lifetime of a life insurance policy in a manner which is more reasonably related to policy margins than the profits would have been if all costs were charged in the year of sale as is the case under SAP.

The authoritative accounting pronouncements which, when taken as a whole, make up GAAP have been developed and enforced by three bodies. The Federal Accounting Standards Board (FASB), like its predecessors, has been the principal standard-setting body since 1973. The AICPA interprets GAAP through statements of position, accounting and auditing guidelines. And the SEC affects GAAP through its direct and indirect influence over FASB, its own accounting and reporting policies and its case-by-case actions on the accounting practices used by companies seeking approval of their registration statements filed with the SEC. As a consequence, stock insurers have generally come to be subject to SEC GAAP accounting rules.

Insurance accounting practices are reportedly coming under increased scrutiny by the SEC. On several issues, including investments, reinsurance, derivatives, real estate and environmental liability, the SEC is asking insurers to disclose more information and is more aggressively enforcing accounting rules. Insurers may be required to comply with the same disclosure rules regarding mortgage loans and real estate that currently apply to banks and thrift institutions. Such interest presumably stems from the problems several large life insurers recently had with their mortgage loan and real estate portfolios. The SEC is also enforcing the Financial Accounting Standards Board requirement that debt securities be reported at market value unless the insurer can prove that it has the ability and intent to hold the security until maturity. Furthermore, the SEC may more closely examine reinsurance agreements to ensure that there is a legitimate transfer of risk (surplus relief is not recognized under GAAP), may require more disclosure with respect to investments in derivatives, and may ask why reserves are deficient and what the insurer is going to do about it.

For a considerable period of time, mutual insurers were successful in convincing the SEC and other standard-setting organizations that GAAP need not be applied to them since they were not investor owned. However, over the years, mutual companies have increasingly been required to file more financial statements with the SEC because of growing separate account activity and various types of asset based financing and public debt offerings. The difficulty of comparing a mutual insurer’s statutory financial statements and a stock insurer’s GAAP financial statements has given rise to growing SEC concern. Thus, the exemption of mutual companies from GAAP has been under review and the FASB recently adopted a definitive accounting rule (SFAS 120) applicable to financial statements of mutual insurers covering fiscal years beginning after December 31, 1995. This rule denies a "clean" audit opinion to mutual insurance companies that fail to comply with prescribed GAAP accounting standards.

In the past, mutual insurer financial statements could be described as conforming to GAAP even if they were prepared using statutory accounting principles. Under the new FASB standards, mutual insurers may still issue statutory statements, but they will not be able to say that such statements conform to GAAP standards. Under such requirement, auditors would be compelled to report that a mutual company’s statements prepared in accordance with statutory accounting, as required under state insurance regulation, does not conform to GAAP requirements. In effect, this will induce many if not most mutuals to report on the GAAP basis for at least two basic reasons. First, insurers want a clean audit opinion for marketing reasons. Agencies who rate insurance companies may look unfavorably upon insurers not having one. This, in turn, could adversely impact customers’ perception of such insurers, hence the insurers ability to compete for business. Second, there exists the possibility that the SEC will eventually require that only those companies conforming to GAAP requirements will be permitted to sell registered products (for example, variable contracts, mutual funds).

SEC activities in imposing GAAP in general and specific standards in particular on life insurance companies does not constitute a direct federal assault on the imposition of SAP requirements as the basis for the financial statements submitted to the state regulators. But insurers must comply with the financial reporting requirements of both the SEC and the states. Thus, since the 1960s there has emerged dual federal and state regulation of insurer accounting and financial reporting practices.