One peculiar aspect of the insurance industry is the great lapse of time between the revenues on the one hand and the related expenses on the other--in other words, between the receipt of premiums from policyholders and the payment of claims. This gap makes actuarial estrimates (of the expected longevity of the insured, for example, in the case of life insurance) a crucial factor in determining the profitability, even the solvency, of a firm.
Loss and Loss Adjustments
At the heart of the insurance industry are two accounting transactions unique to that market: paying claims on the one hand, and increasing or decreasing claims reserves on the other. Both transactions combine to make up "incurred losses." The net change in reserves over an accounting period, plus paid claims, equals the incurred losses.
There are also recoverables, or cash offsets, such as salvage and subrogation, that are recorded as negative paid losses.
For example, an insurance company may reserve a "right of subrogation" after a loss. The company will pay the insured its claim and then step into the position of its insured as a possible plaintiff against a third party who may have caused the damage.
Insurance companies often contract out a portion of their risk by entering into their own contracts with reinsurance companies. The accounting procedures for reinsurance are, as a report from the London School of Economics put it in 1996, a "mirror image of the accounting for the direct insurance."
The Standard Setters
The International Accounting Standards Board (IASB), in London, produces the International Financial Reporting Standards (IFRS), the standards accepted by most of the financial accounting world outside of the United States. The Financial Accounting Standards Board (FASB), in Norwalk, Connecticut, is its counterpart for accountants within the U.S.
The two bodies are engaged in a joint project, developing what they call a "measurement approach" to insurance. This addresses the time gap between revenue and expense by requiring a present value assessment of a given contract, with three elements: the explicit probability-weighted average of future cash flows expected to arise given insurer fulfillment of the contract; the effect of the time value of money; and the elimination of gains from the mere inception of the contract.
The Discount Rate
The provision for the effect of the time value of money that will be allowed in the emerging standards is also known as the discount rate.
This rate, the two boards have agreed, "shall reflect the characteristics of the contracts, rather than the characteristics of assets actually held to back the contracts, unless the contracts share those characteristics."
Specifically, if the insurance contract-related cash flows do not themselves reflect the productivity of specific assets, then the discount rate will simply be the risk-free rate with an adjustment for illiquidity. On the other hand, if the productivity of specific contract-backing assets does play a part in determining the cash flow, the discount rate will be adjusted to reflect as much,