Broadly speaking, two major types of insured events could give rise to losses covered by insurance contracts:

Events that actuarial analysis could assess and predict with a high level of accuracy across a large number of contracts (for example, events covered by automobile insurance). Catastrophes, which were generally adverse natural events such as earthquakes and hurricanes, but which could also be human-induced events such as terrorist attacks. Catastrophes were considered low probabilityhigh consequence events. They were uncertain and very difficult to predict in terms of timing and extent of damage.

For the coming year, the company had estimated that expected losses across all its automobile insurance contracts would amount to 70% of premiums. (Exhibit 1 shows historical data on losses incurred by Tokyo AFM in automobile insurance and catastrophe insurance.) With respect to catastrophes, Matsumoto had concluded that the average expected losses would be 12% of premiums, but that any scenario between 4% and 20% was equally likely.

Question What accounting treatment would you choose for expected losses (a) associated with automobile contracts and (b) associated with catastrophes? From a shareholders perspective, what concerns do you think could arise with respect to the accounting treatment of expected losses?

Exhibit 1 Damages Historical Loss Ratioa for Automobile Insurance and Catastrophe-related 80.0% 70.0% 60.0% 50.0% 40.0% 30.0% 20.0% 10.0% 0.0% -Automobile Catastrophes Source: Casewriter a The loss ratio is equal to total claims settled by insurance companies divided by total premiums collected from policyholders