GIM2160 - Accounting framework: technical provisions

Technical provisions

Whichever method of accounting is used, an insurer will need to make provision for claims which have not been settled at the date on which the financial statements are finalised. These are normally referred to as “technical provisions”. Such provisions will only hit the technical account under the funded basis if the year has been closed. Otherwise they will be taken to the fund carried forward.

The tax treatment of technical provisions is dealt with in GIM6000+.

The Unearned Premium Provision and the Unexpired Risks Provision have been described in GIM2100 and GIM2130. The main technical provisions in the accounts will be for claims outstanding and for claims which are incurred but not reported (IBNR). Another type of provision which will be encountered is an equalisation reserve. An important aspect of accounting for technical provisions is the question of whether they should be discounted.

Technical provisions: claims outstanding and claims incurred but not reported (IBNR)

The claims outstanding provision is the estimated ultimate cost of all claims and the related claims handling expenses in respect of events up to the accounting date less amounts already paid.

The provision will relate to all events that have occurred up to the accounting date, whether or not the insurer has been notified of the claims in question before the close of the accounting period. This latter category of claims is referred to as Incurred But Not Reported [IBNR] claims.

The amounts involved may be relatively small, as in the case of motor insurance, but in some classes of business the IBNR element will represent a significant proportion of the total claims provision. For example, an insurer may be liable to indemnify an employer for compensation paid in respect of an industrial disease such as asbestosis which takes a long time to manifest itself. If the event that triggers the insurance claim is the original exposure to asbestos fibre, or the (hidden) onset of the disease, the claim may be made years or even decades after the event. Where there is a long delay between the period of cover and the emergence or indeed settlement of claims the business is referred to as “long tail”.

Even with sophisticated mathematical techniques it will obviously be impossible for an insurance company to predict its outstanding claims provisions with 100% accuracy. Yet this item is probably the most significant figure in the accounts. If it is understated the company may distribute assets or otherwise act in a way that could lead to severe financial problems, and possible insolvency, when claims come to be paid. If it is overstated, so that profits are depressed, the company will look unattractive to investors and its tax bill will be reduced. This issue is explored more fully in GIM6000+.