GIM2080 - Accounting framework: general principles of insurance accounting

The Insurance Accounts Directive (“IAD”) does not establish a different set of standards for insurance companies as compared to other undertakings but aims to deal with items specific to insurers. It lays down a standard format for the accounts of insurance companies and specifies the content of items to be disclosed on the balance sheet and in the profit and loss account. Accounts of companies based outside the EU will reflect the home state’s own accounting conventions. The following description is based on UK practice.

Under UK GAAP, general insurance business may be accounted for on two different bases: the annual basis or the funded basis. These bases refer to the way in which profit is recognised:

• Under the annual basis, the profits and losses of business written during the financial year are recognised at the end of that financial year by setting up provisions for outstanding claims, unearned premiums and unexpired risk provisions, and by deferring an appropriate portion of acquisition costs;
• Under the funded basis, the recognition of profits (but not losses) is deferred for up to three years after the end of the financial year in which the business incepts.

In the 1998 ABI SORP, it was recommended that the annual basis be used except where information about premiums or claims for an underwriting year is insufficient for reliable estimates to be made. The 2003 ABI SORP went further and prohibited the use of the funded basis expect in certain circumstances for Lloyd’s corporate capital vehicles. The December 2005 SORP says simply that underwriting results should be determined on an annual basis.

While there are only these two accounting bases under UK GAAP, there are also two methods of measuring the underwriting performance of a general insurance business for regulatory return or other statistical or management purposes - the accident year basis and the underwriting year basis:

• The accident year basis measures performance in relation to the events and earnings of a financial period, irrespective of when the relevant policies incepted
• The underwriting year basis measures performance in relation to the profits arising in respect of policies incepting in a period, irrespective of when the events (premiums, claims and expenses) relating to those policies take place.

A general insurer will therefore have a basis on which it recognises profit (annual or funded) and also have a basis on which it measures underwriting performance (accident year or underwriting year). In theory, on the basis of the perspective taken on the underlying policies, the annual basis of accounting corresponds to the accident year basis and the funded basis of accounting corresponds to the underwriting basis. However, it is possible for a general insurer using the annual basis of accounting to measure underwriting performance on an underwriting year basis. Indeed, provided that technical provisions are established for each underwriting year in accordance with UK GAAP, a technical account produced for business accounted for using annual accounting on an underwriting year basis (i.e. without profit deferral) will look exactly the same as a technical account produced for the same business using annual accounting on an accident year basis.