State insurance regulators require insurance companies to keep their accounting records for filing annual financial reports in accordance with statutory accounting principles (SAP). The Internal Revenue Service requires insurers to report their financial statements and tax returns in accordance with generally accepted accounting principles (GAAP). The primary difference between SAP and GAAP is in the way they record sales costs, unearned income, loss reserves, recoverable reinsurance payments, fixed assets,capital gains, bond recognition and accounting for surpluses. Under SAP, insurers report their income, expense, liabilities and net worth as if the company is about to be liquidated. Under GAAP, the IRS treats the company as a going concern. Here's how to convert SAP reporting to GAAP reporting.
Reclassify sales costs and unearned income. Under SAP, insurers expense sales costs immediately upon the sale of a policy. GAAP requires sales costs to be amortized over the life of the policy. State regulators require insurers to report and pay state taxes on a portion of their unearned income (premium payments for future periods). GAAP reporting does not require income to be reported or taxed until it is earned.
Add back loss reserve discounts. Loss reserves are the funds insurance companies must set aside to pay claims to policyholders. SAP requires insurers to discount (reduce) these reserves for state tax purposes, resulting in higher taxable income. GAAP allows reporting 100 percent of the loss reserves as a liability. This may result in a lower taxable income for federal tax reporting purposes.
Recognize reinsurance recoverables and nonadmitted assets as a part of net worth under GAAP. SAP reporting excludes potentially unrecoverable reinsurance payments (payments insurance companies make to other insurers to reduce their risk). SAP also excludes the costs of an insurer's fixed assets, such as furniture and equipment. This has the effect of decreasing an insurer's net worth. GAAP allows 100 percent of reinsurance recoverables and fixed asset costs as assets. This has the effect of increasing the insurer's net worth.
Exclude deferred tax assets on unrealized capital gains from net worth for GAAP reporting. For federal tax purposes, only realized gains and the taxes associated with them are reportable. SAP reporting allows these deferred taxes to be included in net worth.
Restate bonds at their fair market value for GAAP reporting. This treatment reflects the true current value of a bond. SAP reporting requires a bond to be reported at its amortized value. In other words, SAP requires the bond to reflect the discount taken or premium paid over the life of the bond to its maturity date.
Report surplus notes as liabilities under GAAP. A surplus note is a highly subordinated form of debt. This means that the note holder can only be repaid after all other operational debts have been satisfied. Because a surplus note holder is in a relatively weak position, SAP reporting allows these notes to be included as a part of the value of policyholders' policy value. GAAP requires these surplus notes to be classified as debt like any other long-term debt on the balance sheet.