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41 Auditing Insurance Companies 41.1 OVERVIEW OF THE INDUSTRY (a) Structure of the Industry, (b) Reinsurance, (c) Securitization, (d) Industry Code of Conduct, 41.2 REGULATORY ENVIRONMENT (a) State Regulation and the NAIC, (b) Annual Audit Requirements, (c) Statements of Actuarial Opinion, (d) Risk-Based Capital Requirements, (e) Insurance Regulatory Information System Tests (Early Warning Tests), (f) Statutory-Basis Accounting Practices, 41.3 GENERALLY ACCEPTED ACCOUNTING PRINCIPLES (a) Authoritative Accounting Pronouncements, (b) Premium Revenue, (c) Unearned Premiums, (d) Policy Acquisition Costs, (e) Valuation of Investments, (f) Nonadmitted Assets, (g) Realized and Unrealized Investment Gains and Losses, (h) Asset Valuation Reserve and Interest Maintenance Reserve, (i) Investments in Subsidiaries, (j) Income Taxes, (k) Policy Reserve (Future Policy Benefits) Valuation, (l) Loss (or Claim) and Loss (or Claim) Adjustment Expense Reserves, (m) Earned But Unbilled Premiums, 41.4 RISK FACTORS AND AUDIT REACTION 41.5 TYPICAL TRANSACTIONS AND INTERNAL CONTROL (a) Premium Cycle, (i) Policy Writing, (ii) Policy Underwriting, (iii) Recording Premiums, (iv) Collecting Premiums, (b) Claim Cycle, (i) Notification of the Loss, (ii) Verification of the Loss, (iii) Evaluation of the Loss, (iv) Settlement and Recording of the Loss, 41.6 SUBSTANTIVE TESTS (a) Policy Reserves, (b) Reported Losses, (c) Unreported Losses, (d) Deferred Acquisition Costs, (e) Inquiries of Regulators, 41.1 OVERVIEW OF THE INDUSTRY The primary purpose of insurance is to spread risks among people or entities that typically are exposed to similar risks. When an insurance policy is issued, the insured makes a payment in advance of the possible occurrence of an insured event, such as death (life insurance), illness (accident and health insurance), or financial catastrophe (property and liability, also known as property and casualty insurance). Property and liability and accident and health insurance companies generally do not know whether a claim will result if the policy is kept in force, when it will occur, or how much will be paid under the policy. Life insurance companies, in contrast, can be sure a claim will result, if the policy is kept in force, but do not know when it will occur. The fundamental difference between the insurance industry and other industries is that insurance companies accumulate cash first and pay claims and claims settlement costs in the future. In other industries, generally costs are incurred first and cash is received later, after an entity's products have been sold or services performed. The U.S. insurance industry provides financial protection against catastrophic events such as death and property loss, as well as a large share of the nation's health, welfare, and other financial benefits, making it one of the most important financial services industries of the U.S. economy. As a result, the industry receives much attention from lawmakers, industry regulators, the Securities and Exchange Commission (SEC), and the public. (a) Structure of the Industry There are three main types of insurance companies: life, property and liability, and title. Companies are further divided into direct or primary writers and reinsurers. Life insurance companies provide financial assistance at the time of death and also during a person's lifetime in the form of annuity, endowment, and accident and health insurance policies. Premiums are often level, even though the policy benefits and services provided by the insurance company (insurance protection, sales effort, premium collection costs, and claims) are not expected to occur evenly over the contract period. The life insurance industry has changed substantially over the years. Interest-sensitive products such as universal life and investment-type contracts typically promise higher investment returns to policyholders than do traditional products. Premiums on interest-sensitive products are a significant portion of total life premiums and are expected to grow. The profitability of these new products has been challenged by competition, however, including competition from other industries. This competition also has caused life insurers to continually update their insurance offerings. Many companies now offer variable life and annuity products that are indexed to equity markets such as the S&P 500. Health insurers also have undergone major changes. For example, traditional insurance products are being supplemented or replaced with administrative services only (ASO) contracts and managed care programs such as health maintenance organizations (HMOs) and preferred provider organizations (PPOs). These plans attempt to minimize the effects of rising costs by establishing contracts with health care providers to provide reduced rates and incentives for more efficient care. Property and liability insurance companies provide protection against damage to or loss of property caused by various perils, like fire and theft, or legal liability resulting from injuries to other people or damage to their property. Property and liability insurance companies also may issue accident and health insurance contracts. Premiums received on property and liability contracts are intended to cover expected claims costs resulting from insured events that occur during a fixed period of short duration. Life insurance companies and property and liability companies are quite similar in their major operations, underwriting procedures, claims processing, and investment activities. Property and liability insurers, however, undergo what some analysts and other observers have identified as distinct underwriting cycles, which recur every several years. During periods of industry profitability, downward pressure on prices occurs as new companies enter the market and existing companies seek to maintain or expand their market share. This phase of the cycle often is characterized by a pricing and risk acceptance practice referred to as cash flow underwriting. Companies may be inclined to accept additional underwriting risk in profitable times in anticipation of investment earnings on premiums collected. Under the cycle theory, this underwriting trend eventually leads to depressed earnings as lower prices result in higher underwriting losses. Companies react by firming prices and being more selective in accepting risks, thus causing a turn in the cycle. Title insurance companies issue title insurance contracts that indemnify real estate owners, buyers, and mortgage lenders against loss or damage arising from defects in, liens on, or challenges to their title to real estate. Title insurance contracts usually cover an extended period, such as the period of ownership. Similarly, mortgage guaranty insurance companies issue mortgage guaranty insurance contracts that guarantee lenders, such as banks and savings and loan associations, against nonpayment by mortgagors. Most insurance companies are organized as either stock or mutual companies. A stock company is owned by stockholders and earns income for their benefit by performing services for policyholders. A mutual company is owned by the policyholders and operates for their benefit; most mutual policies issued are participating policies under which profits are distributed to the policyholders as policy dividends. Stock companies also may issue participating policies, which entitle policyholders to share in the company's earnings through dividend distributions. Other types of organizations are reciprocal exchanges, which consist of a group of "subscribers" that exchange insurance contracts through an attorney-in-fact, and fraternal benefit societies, which are similar to mutual insurance companies and provide life or health insurance to their members. In the late 1990s, in an effort to attract capital and compete in the marketplace, many mutual companies began the process of demutualization, that is, changing from a mutual company to a stock company. This usually is done by compensating policyholders with either stock or cash, and raising funds in the capital markets with an initial public offering (IPO). Other mutual companies followed a hybrid approach and formed mutual holding companies (MHCs). In this process, a mutual company creates a holding company to own the insurance operations of its existing business. The rights of ownership attributable to the participating policyholders in the mutual insurance company transfer to the mutual holding company, and the contractual rights of the life insurance contract are held in a newly formed stock insurance company. The MHC then can sell a portion of the stock company in the capital marketplace, usually through an IPO. Not all states allow MHCs, but where they are allowed, the MHC usually is required to own at least 51 percent of the stock insurance company. Insurance companies in the United States are licensed as either life or general insurance companies (property and liability and title companies). Usually companies that do business in both markets are holding companies with separate life and property and liability subsidiaries, or companies licensed in one field with a subsidiary that is licensed in the other. The McCarran Ferguson Act provides certain antitrust immunities to the insurance industry that allow companies, through organizations such as the Insurance Services Office, to obtain industry data in order to prevent inadequate pricing of products. This practice, which often is associated with price fixing in other industries, is considered necessary for the insurance industry since insurers must bill and collect premiums before actual costs are known. Many industry observers speculate that some form of federal oversight of the insurance industry will occur in the future. Areas believed most probable for a federal role are regulation of reinsurance (particularly with foreign reinsurers who assume risks in U.S. markets), prevention and prosecution of illegal acts and fraud, and solvency regulation. In late 1999, Congress passed the Gramm-Leach-Bliley Act (GLBA). The act will likely reshape the financial services industry in the United States and facilitate the creation of global financial conglomerates that will operate across industries and borders. The act eliminates previous restrictions under the Glass-Steagall Act on services that could be offered by different types of financial services companies (banks, insurance companies, securities firms, etc.). A company may now form a financial holding company to own financial service companies that previously were not allowed by the Glass-Steagall Act. The GLBA will result in "functional regulation," that is, insurance commissioners will regulate the business of insurance, and banking regulators the business of banking. The Federal Reserve will serve as the "umbrella" regulator over financial holding companies. (b) Reinsurance Reinsurance is a means by which the original or primary insurer, also known as the ceding company or the reinsured, transfers all or a portion of its risk under an insurance policy or a group of policies to another insurance company, known as the assuming company or the reinsurer. The assuming company may in turn transfer all or part of the risk to one or more other companies. The policyholder continues to hold the original insurance policy and usually does not know that the policy has been reinsured. Company policy regarding reinsurance is based on the desire to limit losses, stabilize underwriting results, and protect surplus. Property and liability companies also use reinsurance to avoid concentration in a single geographical area and thus reduce the possibility of a large number of claims resulting from one event. In transferring all or part of a risk, an insurance company still maintains its liability to the insured. Thus, to the extent that an assuming company might be unable to meet its obligations, a contingent liability exists on the part of the ceding company. (c) Securitization In contrast to the traditional reinsurance company, an SPE may issue securities, the proceeds of which are used to fund the reinsurance. One example of such a securitized insurance risk product is "Act of God" bonds issued to fund catastrophic loss coverage, in which payment of interest (and sometimes repayment of principal) is linked directly to losses arising from catastrophes and natural disasters. Securitized transactions are complex and require careful risk transfer analysis under SFAS No. 113. Further, SFAS No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities (Accounting Standards Section F35), contains guidance on SPE accounting. There are currently two main categories of risk funding products. At one end of the spectrum are catastrophe products that essentially provide statutory capital when a loss occurs and are clearly financing in nature. An example of this is surplus notes, whereby an insurer sets up a "fund" through the sale of notes that are backed by receivables or government securities. The insurer has the ability to access these funds for various purposes, including catastrophic loss coverage. Investors are paid a premium over the treasury bill rate for the use of the funds; they assume the risk of loan default but no real insurance risk. From the insurer's perspective, this type of product provides liquidity and protection and enhancement of regulatory surplus at interest rates, and with higher limits, that are theoretically more competitive than traditional catastrophe reinsurance. At the other end of the spectrum are catastrophe and high excess layer products that provide both statutory capital and underwriting benefit. These securitized products are structured using special purpose entities (SPEs) and reinsurance contracts that meet the risk transfer guidelines in Statement of Financial Accounting Standards (SFAS) No. 113, Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts (Accounting Standards Section In6). In contrast to the traditional reinsurance company, an SPE may issue securities, the proceeds of which are used to fund the reinsurance. One example of such a securitized insurance risk product is "Act of God" bonds issued to fund catastrophic loss coverage, in which payment of interest (and sometimes repayment of principal) is linked directly to losses arising from catastrophes and natural disasters. Securitized transactions are complex and require careful risk transfer analysis under SFAS No. 113. Further, SFAS No. 125, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities (Accounting Standards Section F35), contains guidance on SPE accounting. (d) Industry Code of Conduct In response to a number of highly publicized instances of questionable insurance marketing practices, the American Council of Life Insurers (ACLI) has developed a Code of Life Insurance Ethical Market Conduct (the Code) consisting of six principles to which life insurance companies should adhere. To assess compliance with the Code, a Questionnaire for Assessment of Compliance with the Principles of Ethical Market Conduct (the Questionnaire) has been developed. The Questionnaire is designed to be completed by insurers annually, with a periodic (at least once every three years) certification by independent assessors. This initiative is being led by an organization created by the ACLI known as the Insurance Marketplace Standards Association (IMSA). Reports will be filed with IMSA, which will grant membership to companies meeting certain requirements, including the completion of periodic independent assessments of the Questionnaire. IMSA has issued applications for independent assessors, and will accept reports only from IMSA-approved assessors. Statement of Position (SOP) 98-6, Reporting on Management's Assessment Pursuant to the Life Insurance Ethical Market Conduct Program of the Insurance Marketplace Standards Association, provides guidance on the certification service. 41.2 REGULATORY ENVIRONMENT (a) State Regulation and the NAIC Insurance company operations are significantly affected by state regulatory requirements; consequently, the auditor must know the specific applicable state statutes. Statutes in all states provide for a state insurance department to supervise insurance companies and enforce compliance with the law. In addition, the National Association of Insurance Commissioners (NAIC) promulgates uniform rules and regulations for the industry. The NAIC has no legal status, however, and any rules it adopts must be passed as law in the individual states before they become binding. While statutes vary by state, their main objective is the development and enforcement of measures designed to promote solvency, appropriate premium rates, fair dealing with policyholders, and uniform financial reporting. In the majority of states, insurance companies cannot be organized or sell policies without insurance department authorization. Each state has its own statutory requirements for minimum capitalization, solvency margins, and dividend restrictions. Those requirements also may vary depending on the type of company (life or property and liability, stock company or mutual company) and the type of business conducted (marine or casualty, life or accident and health insurance). Investment restrictions also vary from state to state. Regulations specify how funds may be invested and valued. Values for stocks and bonds are published by the NAIC each January in a manual entitled Valuations of Securities. To promote uniform financial reporting, the statutes provide for annual (and, in some states, quarterly) statements in prescribed form to be filed with the insurance departments, and for insurance companies to be examined by the insurance departments at stated intervals. The annual statement (generally referred to as the "convention blank") includes a balance sheet, summary of operations, surplus statement, statement of cash flows, many supporting exhibits and schedules, and supplemental questionnaires and reports; the data in those statements is extracted from the company's accounting and statistical records. It is essential for auditors to have a working knowledge of the statutory annual statement, since it is usually convenient to use its various schedules and exhibits as a basis for substantive tests of details and analytical procedures. Where applicable, the auditor should make reference to the NAIC's Accounting Practices and Procedures Manuals (life/health and property/casualty). (b) Annual Audit Requirements Before 1986, only a few states required audited financial statements to be filed by insurers. Today, virtually all states have solvency legislation in place that includes a requirement for companies to file audited financial statements annually. NAIC audit rules also require, among other things, that companies file reports received from independent auditors pointing out reportable conditions in their internal control, if any, noted during the audit, as well as material errors in the financial statements and failure by companies to meet minimum capital and surplus requirements. In addition, the NAIC rules mandate rotation of independent CPAs or the partner in charge of the engagement every seven years. In addition, the NAIC has published a "Guide to Compliance with State Audit Requirements." This guide provides summaries and actual text of the individual state and NAIC audit rules, and is an excellent source for keeping track of the audit rules that affect insurance companies and their auditors. 1 The NAIC instructions to the annual statement form for property/casualty insurance companies requires them to instruct their independent auditors to extend the auditing procedures applied to the basic financial statements to include tests of certain loss and loss adjustment expense data contained in Schedule P-Part 1. AICPA Statement of Position (SOP) 92-8, Auditing Property/Casualty Insurance Entities' Statutory Financial Statements-Applying Certain Requirements of the NAIC Annual Statement Instructions, provides guidance for applying such auditing procedures and for issuing reports that may be required. SOP 95-4, Letters for State Insurance Regulators to Comply With the NAIC Model Audit Rule, and a related 1997 AICPA Notice to Practitioners provide guidance on such letters. SOP 95-5, Auditor's Reporting on Statutory Financial Statements of Insurance Enterprises, contains guidance regarding how auditors should apply Statement on Auditing Standards (SAS) Nos. 58 and 62 (AU Sections 508 and 623, respectively) when issuing opinions on statutory financial statements of insurance companies. An interpretation of SAS No. 62 entitled "Evaluation of Appropriateness of Informative Disclosures in StatutoryBasis Financial Statements of Insurance Enterprises" (AU Section 9623) requires that the independent auditor determine whether disclosures similar to those required in financial statements prepared in conformity with generally accepted accounting principles (GAAP) are appropriately included in the audited statutory-basis financial statements of insurance enterprises, including mutual life insurers, for the same or similar types of items, in order to prevent those financial statements from being misleading. (c) Statements of Actuarial Opinion The extensive underwriting losses experienced by property and liability insurers in the mid-1980s raised many questions about the industry's loss reserve practices. States began to require companies to have their loss and loss adjustment expense liabilities examined by qualified loss reserve specialists. In 1990, the NAIC adopted an annual statement instruction requiring certification of loss reserves. Life insurers previously had been required to file statements of actuarial opinion with respect to their reserves and other actuarially determined liabilities. The NAIC annual statement instructions and most state rules currently allow statements of actuarial opinion to be made by qualified loss reserve specialists or actuaries who are employed by or otherwise not independent of the companies whose reserves are being evaluated. Certain states are considering requiring independent certification of reserves, in some cases in addition to the annual certifications currently required. Several states have adopted the NAIC's "valuation actuary" amendments to the Standard Valuation Law for life and health insurers. The amendments require opining actuaries to address in their reports whether a company's reserves, when considered together with assets held to support those reserves, are adequate to meet the company's policy and contract obligations, unless a company meets certain requirements for exemption. An accompanying NAIC model regulation, Actuarial Opinion and Memorandum Regulation, contains additional requirements, including that the actuary be appointed by the authority of the board of directors. A Notice to Practitioners, Auditors' Responsibilities Concerning Statement of Actuarial Opinion Required by Insurance Regulators, provides guidance by the AICPA Insurance Companies Committee in the form of questions and answers concerning an auditor's responsibilities when the actuary rendering an actuarial opinion on the client's reserves (1) assumes responsibility for examination of the underlying data, or (2) states in the actuarial opinion that he or she relied on the auditor for the accuracy of the underlying data. The notice also contains guidance for auditors when providing assistance to independent actuaries in their examination of data underlying reserves and discusses circumstances where the actuary is an employee of the audit firm. It states that an auditor should not consent to actuaries expressing, in their statement of opinion, reliance on the auditor's work regarding the accuracy of data underlying a company's reserves. (d) Risk-Based Capital Requirements The NAIC has adopted risk-based capital (RBC) requirements for both life and property and casualty insurance companies. The concept of risk-based capital was developed to provide a mechanism that can be applied to an individual company to ascertain whether it has a minimum acceptable level of surplus. The RBC requirements are used as early warning tools by the NAIC and state insurance departments to identify companies that merit further regulatory action. RBC consists of a series of surplus-related formulas that contain a variety of weighting factors that are applied to financial balances or to levels of activity based on the perceived degree of certain risks, such as asset risk, credit risk, interest rate risk (life insurance companies only), underwriting risk, and other business risks, such as risks related to management, regulatory action, and contingencies. The RBC formulas provide for four different levels of regulatory attention depending on the ratio of a company's total adjusted capital to its RBC. The "company action level" is triggered if a company's total adjusted capital is less than 2.0 times its RBC but greater than or equal to 1.5 times its RBC. At the company action level, a company must submit a plan to the regulatory authority that discusses proposed corrective actions to improve its capital position. The "regulatory action level" is triggered if a company's total adjusted capital is less than 1.5 times but greater than or equal to 1.0 times its RBC. At the regulatory action level, the regulatory authority will perform a special examination of a company and issue an order specifying corrective actions that must be followed. The "authorized control level" is triggered if a company's total adjusted capital is less than 1.0 times but greater than or equal to 0.7 times its RBC. At this level, the regulatory authority may take any action it deems necessary, including placing a company under regulatory control. The "mandatory control level" is triggered if a company's total adjusted capital is less than 0.7 times its RBC, and the regulatory authority is required to place such company under its control. SOP 93-8, The Auditor's Consideration of Regulatory Risk-Based Capital for Life Insurance Enterprises, provides guidance on the auditor's responsibility relating to the RBC requirements for life insurance companies. The scope of SOP 93-8 was effectively extended to all insurance enterprises through revisions made to the AICPA's audit and accounting guide, Audits of Property and Liability Insurance Companies. (e) Insurance Regulatory Information System Tests (Early Warning Tests) Insurance companies' operating results are scrutinized through a series of tests prescribed by the regulatory authorities. These tests consist of a series of separate analytical financial ratios and relationships for both life and property and liability companies and are designed to measure normal levels of financial stability. To the extent that the results of a number of the tests do not fall within acceptable parameters, closer scrutiny may be considered necessary. This information generally is not made public. (f) Statutory-Basis Accounting Practices Statutory financial accounting is required by the state insurance departments and prescribed by the NAIC. Supplemented by minimum capital and surplus requirements of individual states and other financial regulations, these measures serve as one of the primary means by which regulators monitor industry solvency. Statutory accounting practices traditionally have been viewed as conservative. In recent years, however, certain financial regulations and statutory accounting rules-for instance, the use of surplus notes 2 and other transactions entered into by companies solely to increase surplus-have been perceived as loopholes and criticized by regulators and Congress as "accounting gimmicks." In addition, statutory accounting clearly does not provide in all cases for the establishment of economic-based allowances for losses in the value of assets, such as those required by GAAP. In 1999, as a result of its efforts to codify statutory accounting practices for certain insurance enterprises, including life and health companies, property and casualty companies, fraternal benefit organizations, and managed care providers, the NAIC issued a revised Accounting Practices and Procedures Manual (the revised Manual). It will become effective January 1, 2001, for calendar-year and quarterly 2001 financial statements. Currently, the laws and regulations of many states require insurance companies domiciled in those states to comply with the guidance provided in the NAIC Accounting Practices and Procedures Manual. It is expected that some states will automatically adopt the revised Manual when it becomes effective. Other states, however, will be required to take legislative action to adopt the revised Manual. Because the NAIC is considering amendments to the revised Manual that would be effective upon implementation of its provisions, the statutory accounting guidance that follows in this section does not contemplate all of the changes that may occur as a result of the adoption of the revised Manual. In addition to following prescribed accounting policies and procedures, insurance companies can seek permission from state insurance departments for special accounting treatment for certain transactions for statutory reporting purposes. Such treatment is known as permitted accounting practices. Permitted accounting practices include practices not prescribed by state laws, regulations, and general administrative rules applicable to all insurance companies domiciled in a particular state; the NAIC annual statement instructions; the NAIC Accounting Practices and Procedures Manual; the Securities Valuation Manual; NAIC official proceedings; and the NAIC Examiners' Handbook. Permitted accounting practices are generally subject to a "negotiation process" between the regulator and insurer. On occasion, there may be formal communications regarding this negotiation process; sometimes these permitted practices are discussed in the regulatory examination report. Often, however, because of either the passage of time or the limited amount of statutory guidance regarding a topic, it may be difficult for insurers to assess whether an accounting practice is prescribed or permitted. To limit the potential for confusion in this area, insurers should design and implement a process to assist in this assessment. SOP 94-1, Inquiries of State Insurance Regulators, requires the auditor to obtain sufficient competent evidential matter to corroborate management's assertion that permitted statutory accounting practices that are material to an insurance company's financial statements are permitted by the insurance department of the state of domicile. In addition, SOP 94-5, Disclosures of Certain Matters in the Financial Statements of Insurance Enterprises, requires insurance companies to disclose information about permitted statutory accounting practices in their financial statements. One of the main purposes of statutory-basis financial statements is to provide information about the solvency of an insurance company and its ability to pay policyholders' claims. Assets that cannot be used to pay policy claims (like furniture and fixtures, automobiles, prepaid expenses, and agents' balances receivable over 90 days) are irrelevant to that purpose; therefore, they are deducted directly from surplus (i.e., they are "nonadmitted" assets). Statutory accounting starts with "ledger assets," which are account balances arising from cash and premium transactions. The ledger assets are adjusted for accruals and reserves (including unearned premiums and claims or benefit reserves), which are referred to as nonledger assets and liabilities since they are not under general ledger control. These nonledger accounts are controlled by a separate accounting system and are posted to the trial balance for financial reporting purposes. Nonadmitted assets are then deducted to arrive at net admitted assets on a statutory basis. Conservative assumptions generally dominate statutory accounting principles. Statutory accounting practices are considered an other comprehensive basis of accounting as described in SAS No. 62 (AU Section 623). 41.3 GENERALLY ACCEPTED ACCOUNTING PRINCIPLES The purpose of GAAP for insurance companies is the same as for any other type of entity, but differs from the purpose of statutory accounting. GAAP-basis financial statements include assets that are not admitted for statutory accounting purposes, and they are based on more realistic assumptions regarding accounting estimates. This section of the chapter describes the major accounts that are unique to insurance companies and the differences between statutory and GAAP-basis accounting. First, however, it discusses the principal sources of GAAP that are unique to insurance companies. (a) Authoritative Accounting Pronouncements Specific pronouncements related to the insurance industry have been issued by the Financial Accounting Standards Board (FASB) in: SFAS No. 60, Accounting and Reporting by Insurance Enterprises (Accounting Standards Section In6) SFAS No. 61, Accounting for Title Plant (Accounting Standards Section Ti7) SFAS No. 97, Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments (Accounting Standards Section In6) SFAS No. 113, Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts (Accounting Standards Section In6) SFAS No. 120, Accounting and Reporting by Mutual Life Insurance Enterprises and by Insurance Enterprises for Certain Long-Duration Participating Contracts (Accounting Standards Section In6) SOP 92-5, Accounting for Foreign Property and Liability Reinsurance, provides guidance on accounting for reinsurance assumed from foreign companies. SOP 98-7, Deposit Accounting: Accounting for Insurance and Reinsurance Contracts That Do Not Transfer Insurance Risk, provides guidance on how to account for insurance and reinsurance contracts that do not transfer insurance risk. It is effective for financial statements for fiscal years beginning after December 15, 1999. SOP 92-5, Accounting for Foreign Property and Liability Reinsurance, provides guidance on accounting for reinsurance assumed from foreign companies. In 1997, the Deposit Accounting Task Force of the Insurance Companies Committee of the AICPA exposed for comment a proposed SOP, Deposit Accounting: Accounting for Insurance and Reinsurance Contracts That Do Not Transfer Insurance Risk. The proposed SOP would provide guidance on how to account for insurance and reinsurance contracts that do not transfer insurance risk and would be effective for financial statements for fiscal years beginning after December 15, 1998. Mutual life insurance companies are subject to the provisions of FASB Interpretation No. 40, Application of Generally Accepted Accounting Principles to Mutual Life Insurance and Other Enterprises (Accounting Standards Section In6), as amended by SFAS No. 120. These pronouncements remove the exemption for mutual life insurance companies from SFAS Nos. 60, 97, and 113, thus precluding statutory accounting practices from being considered GAAP for such insurers. SOP 95-1, Accounting for Certain Insurance Activities of Mutual Life Insurance Enterprises, also addresses accounting and reporting by mutual life insurance enterprises. In April 2000, the AICPA issued an exposure draft of an SOP, Accounting by Insurance Enterprises for Demutualizations and Formations of Mutual Insurance Holding Companies and for Certain Long-Duration Participating Contracts. The proposed SOP provides guidance on accounting by insurance enterprises for demutualizations and the formation of mutual insurance holding companies and also applies to stock insurance companies that apply SOP 95-1 to account for certain participating policies. The proposed SOP would be effective for financial statements for years beginning after December 15, 2000. The FASB has published a special report, A Primer on Accounting Models for Long-Duration Life Insurance Contacts under U.S. GAAP. The special report illustrates and explains the operation of the accounting models for long-duration contracts underlying SFAS Nos. 60 and 97 and SOP 95-1. The AICPA insurance industry audit and accounting guides, Audits of Life Insurance Companies and Audits of Property and Liability Insurance Companies, contain specialized accounting principles and practices. In addition, SOP 97-3, Accounting by Insurance and Other Enterprises for Guaranty-Fund and Certain Other InsuranceRelated Assessments, provides guidance to insurance and other enterprises on accounting for guaranty-fund and certain other insurance-related assessments. The FASB Emerging Issues Task Force (EITF) has discussed six issues specifically relating to the insurance industry: EITF Issue 92-9, Accounting for the Present Value of Future Profits Resulting from the Acquisition of a Life Insurance Company, Issue 93-6, Accounting for Multiple-Year Retrospectively Rated Contracts by Ceding and Assuming Enterprises, Issue 93-14, Accounting for Multiple-Year Retrospectively Rated Insurance Contracts by Insurance Enterprises and Other Enterprises, Issue 99-12, Accounting for Weather Derivatives, Issue 99-4, Accounting for Stock Received from the Demutualization of a Mutual Insurance Company, and Topic D-54, Accounting by the Purchaser for a Seller's Guarantee of the Adequacy of Liabilities for Losses and Loss Adjustment Expenses of an Insurance Enterprise Acquired in a Purchase Business Combination. The form and content of financial statements of insurance companies subject to SEC regulation are governed by Article 7 of Regulation S-X. (b) Premium Revenue Premiums are consideration received from an insured in exchange for the insurance company's contractual obligation to assume risk, and are a major source of an insurance company's income. Premiums are considered to be of short or long duration, depending on the terms of the insurance contract. SFAS No. 60 (Accounting Standards Section In6.107) defines these terms as follows: Short-Duration Contract. The contract provides insurance protection for a fixed period of short duration and enables the insurer to cancel the contract or to adjust the provisions of the contract at the end of any contract period, such as adjusting the amount of premiums charged or coverage provided. Long-Duration Contract. The contract generally is not subject to unilateral changes in its provisions, such as a noncancelable or guaranteed renewable contract, and requires the performance of various functions and services (including insurance protection) for an extended period. As stated in Accounting Standards Section In6.108, examples of short-duration contracts include most property and liability insurance contracts, most accident and health insurance contracts, and certain term life insurance contracts, like credit life insurance. Examples of long-duration contracts are whole-life contracts, guaranteed renewable term life contracts, endowment contracts, annuity contracts, universal life type contracts, and title insurance contracts. Revenue recognition for short-duration contracts is generally the same for GAAP and statutory purposes. Premiums should be recognized as revenue over the period of the contract in proportion to the amount of insurance protection provided. Under GAAP, premiums from long-duration contracts should be recognized as revenue when they are due, unless the product has been classified as an investment contract, limited-payment contract, or universal life contract as defined in SFAS No. 97, which sets forth the accounting treatment for products meeting those definitions. Investment contracts that do not contain significant mortality or morbidity risk are not accounted for as insurance contracts but as interest-bearing financial instruments. Gross premiums in excess of net premiums on limited-payment contracts must be deferred and recognized over the benefit period. SFAS No. 97 requires use of the retrospective deposit method for universal life-type products. Under that method, premiums are not reported as income; instead, they are credited to policyholder accounts, which are charged periodically for mortality and administrative and other expenses. For statutory purposes, premiums from longduration contracts are recognized as gross revenue on the annual anniversary date. (c) Unearned Premiums Unearned premiums represent deferred income from policies written. Normally, unearned premiums are computed from a file of policies currently in effect, known as a premium in force file, based on either a monthly or daily proration. A monthly proration assumes that all policies with an effective date in a certain month are written evenly throughout the month. When the daily pro rata method is used, the unearned premium is calculated by multiplying premiums in force by the unexpired number of days divided by the total number of days for which the policy is effective. Unearned premiums are calculated for both statutory and GAAP accounting purposes. The calculation applies mainly to property and liability insurance companies, although group accident and health policies issued by life insurance companies also typically have unearned premiums. (d) Policy Acquisition Costs Policy acquisition costs represent costs incurred by the insurance company during periods when insurance and investment contracts are written and certain costs incurred when products are renewed. For statutory accounting purposes, these costs are expensed as incurred. Under GAAP, certain of these costs are deferred and amortized as expenses in future periods. SFAS No. 60 defines those costs as "costs that vary with and are primarily related to the acquisition of new and renewal contracts" (e.g., commissions, underwriting and issue expenses, and inspection reports). For short-duration insurance products accounted for under SFAS No. 60, the entire premium is not earned when the policy acquisition costs are expended. Therefore, deferred acquisition expenses are amortized over the policy life in proportion to premium revenue recognition for GAAP reporting purposes. For universal life-type products and certain participating life insurance products, deferred policy acquisition costs should be amortized at a constant rate based on the present value of the estimated gross profit over the life of the book of business for GAAP reporting purposes. The estimated gross profit includes estimates of interest margin, mortality margin, expense margin, and surrender charges. Deferred acquisition costs for investment contracts accounted for under SFAS No. 97 generally are amortized using an effective yield method. In June 1999, the AICPA issued a discussion paper entitled Accounting by Life Insurance Enterprises for Deferred Acquisition Costs on Internal Replacements Other Than Those Covered by FASB Statement No. 97. After reviewing comments received on the paper, the AICPA will decide whether accounting guidance is needed on this topic and, if so, whether it should be in the form of an SOP or Practice Bulletin to be approved by AcSEC. (e) Valuation of Investments For statutory reporting purposes, investments are carried at values specified by the NAIC. Generally, common stocks are carried at market value, preferred stocks at cost for life insurance companies and at market for property and liability companies, and bonds at amortized cost. For GAAP purposes, SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities (Accounting Standards Section I80), has a significant effect on insurance company GAAP-basis financial statements. It addresses accounting for and reporting on investments in debt securities and in equity securities that have a readily determinable fair value. Under SFAS No. 115, investment securities that are classified as "held-to-maturity" are carried at amortized cost only if the reporting entity has the positive ability and intent to hold the securities to maturity. "Trading" securities are bought principally for the purpose of selling them in the near term and are carried at fair value. Unrealized gains and losses on trading securities are included in earnings. "Available-for-sale" securities are those that are classified as neither trading nor held to maturity, and are reported at fair value. Unrealized gains and losses on availablefor-sale securities are excluded from earnings and shown, net of income taxes, as a separate component of shareholders' equity. The majority of securities currently held by insurance companies are categorized as available-for-sale. Investments in policy loans and mortgage loans are reported at the outstanding principal balance, and investments in real estate are stated at cost less accumulated depreciation. If a decline in the value of an investment carried at cost or amortized cost is considered to be other than temporary, the investment should be reduced to its net realizable value. SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, established accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts (collectively referred to as derivatives), and for hedging activities. It requires that an entity recognize all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value. Generally, contracts of the type that are within the scope of SFAS No. 60, No. 97, and No. 113 are not subject to the requirements of SFAS No. 133, regardless of whether they are written by insurance companies. Other contracts entered into by insurance enterprises, however, may be subject to the provisions of SFAS No. 133 (e.g., indexed annuity contracts, variable life insurance contracts, and property and casualty contracts that combine traditional insurance coverage with foreign currency options). Such contracts may contain embedded derivative instruments that might require separate accounting pursuant to SFAS No. 133. Furthermore, the FASB's Derivative Implementation Group has discussed several insurance-specific issues and the FASB did not object to the inclusion of these issues in an FASB staff-authored implementation guide. At the time of this writing, the AICPA is working on projects related to nontraditional life and annuity contracts and separate accounts. The projects are intended to provide interpretive guidance under SFAS No. 60 and No. 97 on the valuation and presentation of nontraditional life and annuity insurance contract obligations excluded from SFAS No. 133 and on the valuation, presentation, and disclosure of separate accounts. (f) Nonadmitted Assets For statutory reporting purposes, nonadmitted assets include all assets recognized under GAAP that are not permitted to be reported as admitted assets in the statutory-basis annual statement and are charged directly to surplus. Nonadmitted assets, including receivables outstanding for more than 90 days, prepaid expenses, goodwill, and certain property, plant, and equipment, are restored to the balance sheet for GAAP purposes. The auditor should review receivables outstanding for more than 90 days for collectibility and evaluate the need for an allowance for uncollectible accounts. The auditor also should review prepaid expenses, goodwill, and property, plant, and equipment for propriety of capitalization. (g) Realized and Unrealized Investment Gains and Losses Realized investment gains or losses are recognized in determining net income for GAAP reporting and for statutory reporting by property and liability companies. Realized gains and losses are reported in the income statement as a component of other income on a pretax basis. Life insurance companies record realized gains or losses directly in surplus for statutory purposes. Unrealized gains and losses associated with trading securities are recognized in income both for statutory reporting purposes and under GAAP. (h) Asset Valuation Reserve and Interest Maintenance Reserve The NAIC requires life insurance companies to maintain an Asset Valuation Reserve (AVR). The AVR is computed in accordance with a prescribed formula and represents a provision for possible fluctuations in the value of bonds, equity securities, mortgage loans, real estate, and other investments. The AVR is recorded as a liability and charged directly to surplus. Similarly, changes in AVR are included in surplus. The NAIC also requires life insurance companies to establish an Interest Maintenance Reserve (IMR), which represents realized capital gains and losses on fixed income investments, principally bonds and mortgage loans, attributable to interest rate changes. Such gains and losses are deferred and amortized to income over the remaining period to maturity of the investments sold. The IMR is recorded as a liability and charged directly to surplus. Similarly, changes in IMR are included in surplus. Such reserves are not required in the statutory-basis financial statements of property and liability insurance companies. They also are not appropriate for GAAP-basis financial statements of insurance companies. (i) Investments in Subsidiaries GAAP-basis financial statements for insurance companies should follow the requirements of SFAS No. 94, Consolidation of All Majority-Owned Subsidiaries (Accounting Standards Section C51), regarding the inclusion of subsidiaries for consolidation purposes. Investments in subsidiaries may not be consolidated under statutorybasis reporting requirements but must be accounted for, as prescribed by the NAIC, using methods similar to those for investments in common or preferred stocks. Generally, the carrying value of common stock of subsidiaries is established by the company based on the book value or equity of the subsidiary at the balance sheet date. (j) Income Taxes The Tax Reform Act of 1984 established a single-base tax structure for life insurance companies. This structure embodies the tax rules applicable to corporations in general while retaining provisions that reflect the unique nature of the life insurance industry and its products. The Tax Reform Act of 1986 (TRA 86) had a significant impact on property and casualty companies. TRA 86 required property and casualty and health insurers to recompute loss reserves and loss adjustment expense reserves for tax purposes as of January 1, 1987. In addition, the Revenue Reconciliation Act of 1990 required property and casualty insurers to accrue estimated salvage and subrogation recoverables. Since 1990, life insurance companies have been required to capitalize and amortize policy acquisition expenses for purposes of determining taxable income. The amount to be capitalized is determined using a "proxy method," which specifies percentages of net premiums to be considered as policy acquisition expenses. The capitalized amounts are amortized over a 120-month period (60-month period for small companies). GAAP-basis financial statements for insurance companies should follow the requirements of SFAS No. 109, Accounting for Income Taxes. Under GAAP, companies must record deferred income taxes for specified differences between GAAP income and taxable income. For statutory reporting purposes, insurance companies do not provide for deferred income taxes. (k) Policy Reserve (Future Policy Benefits) Valuation Policy reserves represent the future guaranteed benefits of life insurance policies payable under the contract provisions of the policies. Policy reserves are actuarially computed to show the present value of future benefits reduced by the present value of future net premiums. Policy reserves are the largest liability on a life insurance company's balance sheet. Statutory reserves for life insurance companies are calculated assuming conservative estimates for interest earned on premium revenue that is collected and invested and for mortality (probability of death or proportion of persons expected to die at particular ages per thousand persons). Published actuarial tables, sometimes modified to reflect a company's experience, are used by life insurance companies; approval of a state insurance department is required if the tables are modified. Morbidity tables that indicate the probability of incidence, by age, of becoming mentally or physically diseased or of becoming physically impaired are used for accident and health insurance. No assumption for withdrawals in the form of lapsed (or, for cash value life insurance policies, surrendered) policies is made in statutory reserve calculations, since statutory reserves usually are expected to equal or exceed cash surrender values. Statutory reserves are subject to limitations and methods prescribed or permitted by regulatory authorities that are at variance with GAAP. Under GAAP, the interest assumption should reflect the current investment return, the mortality or morbidity assumptions should reflect recent experience, and a withdrawal assumption should be included. Other assumptions relating to guaranteed contract benefits and conversion privileges also should be considered. In addition, the assumptions should include a provision for adverse deviation in light of the long-term nature of life insurance and the inherent inability to predict the future with certainty. GAAP require that the original assumptions made at the time the product was sold continue to be used (i.e., to be "locked in") as long as reserves are sufficient to provide for future benefits and expenses. If a deficiency occurs, the assumptions are revised for loss recognition purposes, as discussed later. Revised assumptions may be applied to new sales as necessary. In accordance with SFAS No. 97, the benefit liability for universal life-type contracts that contain contract or account balances is equal to the sum of (a) the contract holder's account balance at the valuation date, plus (b) any amounts assessed against the contract holder that are accounted for as unearned revenue at the valuation date, plus (c) any amounts previously assessed against the contract holder that are refundable upon termination of the contract, plus (d) any probable loss (premium deficiency). Amounts that may be assessed against the contract holder in future periods, such as surrender charges, are not anticipated in the liability. In the absence of a contractholder account balance or implicit or explicit contract value, the account balance element of the benefit liability is the cash value at the valuation date that could be realized by the contract holder if the contract were surrendered on that date. Benefit liabilities for universal life-type contracts do not contain provisions for adverse deviation or withdrawal assumptions. (l) Loss (or Claim) and Loss (or Claim) Adjustment Expense Reserves Under both statutory and GAAP accounting practices, loss and claim reserves of property and casualty companies are recognized when incurred. Estimated liabilities are established for losses that have been reported, and additional estimates are made for losses that have been incurred but have not yet been reported (IBNR). SFAS No. 60 (Accounting Standards Section In6) neither prohibits nor requires discounting of estimated liabilities. In establishing the estimated IBNR liability, a company accumulates its past reported losses by line of business and attempts to project the ultimate cost of settling all losses for a given year. Other factors that should be considered include changes in inflation rates, reinsurance programs, and lines or volume of business written. Statutory and GAAP accounting methods also provide that costs associated with settling losses (loss adjustment expenses) should be accrued in the period when the related losses were incurred. These costs include amounts paid for outside services like claims adjusters and attorneys, and direct and indirect internal costs associated with settling claims. Under GAAP, estimates of recoveries on unsettled claims for salvage (an amount received by an insurance company from the sale of property on which a total loss has been paid to the insured) and subrogation (the statutory or legal right of an insurance company to recover amounts from a third party that is wholly or partially responsible for a loss the insurance company paid) should be deducted from the liability for unpaid claims. Under statutory accounting practices, netting of salvage and subrogation in loss reserves is permitted by most, but not all, states. Consequently, permission must be sought from the state insurance department if such a practice is followed in a state where it is not explicitly permitted. SOP 94-5, Disclosures of Certain Matters in the Financial Statements of Insurance Enterprises, prescribes disclosures relating to the liability for unpaid claims and claim adjustment expenses. In addition, insurance companies are required to disclose the reasons for the change in the provision for incurred claims and claim adjustment expenses attributable to insured events of prior fiscal years. (m) Earned But Unbilled Premiums Some property and liability companies write a significant volume of business, such as workers' compensation, for which the initial payment is in the form of a deposit premium. After part or all of the policy period has passed, the insured's reported payroll is audited and a billing made to adjust the premium. When a company writes this type of business, the amount of additional premium receivable at the financial statement date should be estimated and recorded. Statutory accounting for earned but unbilled premiums varies by state. 41.4 RISK FACTORS AND AUDIT REACTION To formulate the audit strategy for an insurance company, the auditor must understand the environment in which the company operates, including the products it offers and how long it has been involved in specific product lines; its underwriting policies and procedures; and its loss experience by product. In addition, the auditor should be aware of the regulatory constraints of the individual states where the company does business. If a company has handled certain product lines for a considerable time, it usually has effective controls that the auditor can test. Tests of controls are often efficient because of the massive amounts of data typically processed by insurance companies. In addition, in many companies management reviews profit and loss analyses by line of business or product as a basis for reacting to decreases in premium revenue or increases in claims or benefit payments, which may call for changing product pricing, underwriting standards, or reinsurance. If such reviews are made, the auditor may consider it efficient to test them. In developing the overall audit strategy, the auditor should fully utilize the statutory information the insurance company generates to comply with state regulations. Information like annual statements, RBC calculations, Early Warning Test results, and state examination reports are invaluable tools for assessing a company's financial position and operating results. Specifically, the auditor should understand the company's statutory minimum capital and surplus requirements, which depend on the types of business written and the state of domicile. In addition, many insurance companies have sophisticated management decision-making systems for assessing profitability and monitoring progress in meeting budgets and business plans. The auditor should obtain an understanding of management's objectives and methods of controlling the business as a basis for identifying the inherent risks associated with the company and its products and assessing control risk. One of the most significant assets of an insurance company is its portfolio of bonds. If interest rates are high, there is a risk that the market value of bonds classified as held to maturity may be significantly lower than their amortized cost. If a company is faced with the prospect of a negative cash flow, this may affect its ability to hold the bonds to maturity. Accordingly, the auditor should assess the company's ability and intent to hold the bonds to maturity and consider the possibility that the carrying value of the bonds may have to be adjusted to market. In addition, the auditor, in conjunction with the actuaries, should assess the company's efforts to match asset and liability maturities. In some instances, duration mismatches may signal cash flow, liquidity, or valuation exposures. Most companies rely heavily on reinsurance. Accordingly, the ceding company must assess and monitor the financial stability of its reinsurers. To the extent that procedures for accomplishing this are not in place, the auditor should consider the possibility of contingent liabilities from reinsurer failures. In addition, special consideration should be given to ensuring that reinsurance contracts meet the transfer of risk criteria in SFAS No. 113 and Chapters 22 and 24 of the NAIC Accounting Practices and Procedures Manual. Assessing the adequacy of loss reserves is critical for an auditor of a property and liability company. The company establishes its loss reserves based on reported claim data and historical information plus considerations such as changes in its underwriting philosophy and mix of business, reductions or increases in retention for its own account (use of reinsurers), unusually large or nonrecurring losses, and dramatic increases in either inflation rates or current awards by juries or judges in liability cases. It is important for the auditor to assess the company's experience in these areas in light of the planned audit strategy. 41.5 TYPICAL TRANSACTIONS AND INTERNAL CONTROL The flow of operations of a typical insurance company is as follows: 1. The company determines the appropriate premium, bills the insured, and collects the premium. 2. Some of the premium is used to pay immediate expenses, like commissions and operating costs. 3. Most of the premium is invested to pay claims in the future. 4. Investment income and proceeds from sales of investments are used to pay claims as incurred. 5. Profits, if any, are returned in part to the stockholders or policyholders as dividends. Those operations may be viewed as falling into three major transaction cycles: The premium cycle The claim cycle The investment cycle The investment cycle includes buying and selling investments and receiving investment income, net of related investment expenses. Auditing an insurance company's investment cycle is the same as in other businesses that maintain investment portfolios; thus it is not described in this chapter. The other two cycles, which are unique to the insurance industry, are discussed below. (a) Premium Cycle The premium cycle includes all phases of premium recognition, from application to expiration of the policy. They can be divided into four functions: Policy writing Policy underwriting Recording premiums Collecting premiums The accounts related to the premium cycle are premium income, reinsurance ceded, commission expense, premiums receivable, ceded premiums payable, future policy benefits (policy reserves), and unearned premiums. (i) Policy Writing. The policy writing function consists of writing and issuing insurance policies. A policy is a contract between the insurer and the insured and contains all the terms and conditions agreed to. In a life insurance company, policies generally are prepared at the home office; a number is assigned to each policy. The initial premium usually is paid when the policy is delivered, although many companies encourage payment with the application. Close control must be kept over policies delivered but not paid for. As soon as a policy is issued, an in-force file is created; this is probably the most important file used by a life insurance company. It is a perpetual inventory of all policies issued and in force at a given time and is the source for preparing or calculating premium billings, commission payments, premium taxes, policyholder dividends, and the actuarial reserve liability. Once a policy has been issued, all information on the application, including age, gender, premium, and limits of coverage, is entered on this file. The policy is the source document for the master file. In a property and liability insurance company, policy writing may be done by agents, at a branch, or at the home office. It may be completed before or after risk underwriting, depending on who writes the policy. If an agent writes a policy, the home or branch office underwrites the policy after it has been written, based on a copy or abstract of the policy called a "daily." An agent is a person who has a relationship with a particular insurance company and has the authority to bind the company on the coverage for the insured. In contrast, a broker has a relationship with various insurers