According to the American Institute of Certified Public Accountants, “accounting is the art of recording, classifying and summarizing in a significant manner and in terms of money, transactions and events, which are, in part at least, of a financial character and interpreting the result thereof.” Internationally, accounting standards are set by the International Accounting Standards Board. Domestically, accounting standards are set by the Philippine Financial Reporting Standards (PFRS) Council under the oversight of the Board of Accountancy.
Insurance accounting, on the other hand, is governed by special accounting rules known as statutory accounting principles (SAP). It has a special focus on the solvency of insurance companies. The term “statutory” connotes that these accounting rules are governed by a law, or in the case of the Philippines, by regulation of the Insurance Commissioner. In other words, insurance accounting is regulated by the Insurance Commissioner. It is the Commissioner who defines the accounting rules. Conservatism is mandated and paramount, and the interest of the policyholder is given priority. Thus, as observed by Diane Perez: “An insurance company’s annual statement indicates its value as if it were in liquidation rather than continuing in business. This is a more conservative value, as a company cannot include revenue that has not been invoiced. For example, when an insurance company pays a claim, it invoices any coinsurer for partial reimbursement. If the insurance company did not prepare the coinsurer’s invoice before the fiscal year ended, this revenue cannot be included on the annual statement. The insurance company must report the full amount it paid on the claim, without credit for future reimbursement.”
Hence, we can say that GAAP does not apply to insurance companies in its totality. It is also noted that SAP focuses more on the balance sheet, as opposed to the GAAP focusing more on the income statement. A balance sheet presents a picture of a company’s financial position at one moment in time, its assets and its liabilities; while the income statement provides a record of the company’s operating results from the previous period.
The insurance accounting practice is, therefore, a specialist area that requires expertise and an understanding of the insurance sector. It is, perhaps, more important to note that SAP applies only to the insurance industry as all other industries use the GAAP.
Insurance companies report to the Securities and Exchange Commission (SEC) using the GAAP applying the PFRS. On the other hand, they report to the Insurance Commission using the SAP. In other words, there are two reporting frameworks. Insurance accounting is regulated by the Insurance Commissioner through the Financial Reporting Framework (FRF) under Section 189 of the Amended Insurance Code. Hence, as provided under Section 189: “Financial reporting framework means a set of accounting and reporting principles, standards, interpretations and pronouncements that must be adopted in the preparation and submission of the statutory financial statements and reports required by the Commission. This financial reporting framework is not the same as the financial reporting framework used to prepare the financial statements that the Securities and Exchange Commission may require.” Insurance accounting also has variations between the nonlife business (also called general insurance or the property/casualty insurance) and the life business.
Why the difference between SAP and the GAAP?
The underlying peculiarities of the insurance business makes insurance accounting or SAP necessary. The insurance business has many interesting attributes that are not present in other forms of businesses. Notably, an insurance business would have cash premiums paid in advance and claim liabilities that have not yet been discharged. Furthermore, in the life insurance business, policy contracts are issued where a claim may not be made within the next 50 years but a liability should already be reported. Of course, life insurance in 16th century England started out as short term, often as one-year insurance policies. In the nonlife business, the time period when a claim may occur is shorter, but nonetheless, the insurer does not know how many claims will be made, when they will be paid or the final amount to be paid.
Since the supervisory regulator represents the interests of policyholders, the regulator should follow a conservative approach “by taking account of various contingent liabilities as if they were real liabilities.” Furthermore, the GAAP assumes that a company will continue to do business (the Going Concern Concept) whereas the SAP assumes that the insurer may have to be liquidated in the near future (the Liquidation Concept).
To illustrate this on the subject of Asset Valuation, the Insurance Information Institute explains: “Property/casualty companies need to be able to pay predictable claims promptly and also to raise cash quickly to pay for a large number of claims in case of a hurricane or other disaster. Therefore, most of their assets are high quality, income-paying government and corporate bonds that are generally held to maturity. Under SAP, they are valued at amortized cost rather than their current market cost. This produces a relatively stable bond asset value from year to year (and reflects the expected use of the asset.)
“However, when prevailing interest rates are higher than bonds’ coupon rates, amortized cost overstates asset value, producing a higher value than one based on the market. [Under the amortized cost method, the difference between the cost of a bond at the date of purchase and its face value at maturity is accounted for on the balance sheet by gradually changing the bond’s value. This entails increasing its value from the purchase price when the bond was bought at a discount and decreasing it when the bond was bought at a premium.] Under GAAP, bonds may be valued at market price or recorded at amortized cost, depending on whether the insurer plans to hold them to maturity [amortized cost] or make them available for sale or active trading [market value].
“The second-largest asset category for property/casualty companies, preferred and common stocks, is valued at market price. Life insurance companies generally hold a small percentage of their assets in preferred or common stock.
“Some assets are ‘non-admitted’ under SAP and therefore assigned a zero value but are included under GAAP. Examples are premiums overdue by 90 days and office furniture. Real estate and mortgages make up a small fraction of a property/casualty company’s assets because they are relatively illiquid. Life insurance companies, whose liabilities are longer term commitments, have a greater portion of their investments in commercial mortgages.”
Dennis B. Funa is the current insurance commissioner. Funa was appointed by President Duterte as the new insurance commissioner in December 2016. E-mail: email@example.com.