GIM2140 - Accounting framework: funded accounting: general and the transition to annual accounting

The use of funded accounting is not permitted in financial statements for accounting periods beginning on or after 1 January 2005 (paragraph 82 of the 2005 SORP requires the annual basis to be used).

Funded accounting may however still be encountered in the accounts prepared by some non- UK insurers. The IAD requires that a balance of profit be struck, at the latest, 3 years after the end of the underwriting year. Some captive insurance companies (see GIM11000+) located in tax havens do not strike the balance of profit for many years.

Funded accounting was originally used where basic information about premiums and claims took a long time to reach the insurer. The difficulties that companies may face in making sensible estimates at the accounting date of claims incurred (or even of premiums earned) are particularly acute in some types of business. These may include marine insurance or non- proportional reinsurance where the reinsurer’s potential liability may not emerge until the direct insurer is nearing settlement of the claims incurred.

It used to be argued that this basis was superior to the basis used in annual accounting, because it recognises the nature of the insurance contract as one of indemnity. The insurer performs the service of providing the indemnity, and earns the whole premium, on the day on which the contract comes into being (“incepts”). Claims are then matched with premiums in a logical way.

Transition from funded accounting to annual accounting

The change from funded accounting to annual accounting is generally reflected in a single prior period adjustment the accounts. Because the typical fund will be three years, this will reflect two re-statements: one of a year that would otherwise be at its 24 month point and one of a year that would otherwise be at its 12 month point.

There is no legislation that makes clear how the transition should be reflected for tax purposes. The principle is though that over time the funded and annual bases would give the same result. With this in mind, any solution that ensures that the prior period adjustment is fully reflected for tax purposes will generally be acceptable.

One solution is to treat the fund that is at its 24 month point as a two-year fund, and the fund that is at the 12 month point as a one-year fund; that is to close both at the end of the year prior to the year that annual accounting is adopted.