Chapter 26: Accounting Methods

[Qayanaat]

Hi,

In the core notes on page 3 of Chapter 26, it says "profit is crystallized in the year premium is earned" - that is not entirely true is it?

Agreed that as and when we are earning premiums, profits are being realized but only part of the profits should be realized, isn't it (and that too assuming business earned is profitable)? Because even if all premiums have been earned (at which point we have no UPR, assume profitable, so no AURR) , we would still be holding claims reserves (IBNR & o/s, claims handling reserves, etc.).

Hence it's only when all reserves relating to the premiums earned & unearned are exhausted, that the entire profit related to it will be realized.

I would appreciate some help on this, thank you.

 

[GemmaHayes]

Hi,

In the core notes on page 3 of Chapter 26, it says "profit is crystallized in the year the premium is earned" - that is not entirely true is it?

Agreed that as and when we are earning premiums, profits are being realized but only part of the profits should be realized, isn't it (and that too assuming business earned is profitable)? Because even if all premiums have been earned (at which point we have no UPR, assume profitable, so no AURR) , we would still be holding claims reserves (IBNR & o/s, claims handling reserves, etc.).

Hence it's only when all reserves relating to the premiums earned & unearned are exhausted, that the entire profit related to it will be realized.

I would appreciate some help on this, thank you.

I think the key point here is about declaring of profit on the book of business. The actual profit is only ever known when all the cash items are known (premiums minus all claims, expenses etc). The reserves have no impact on the actual/real profit but have a secondary impact on investment returns etc. It's only talking about declaring of profit here I'd guess. My profit is crystallised for a given year means that I pay taxes etc on that year of declared profit when it was earned. If my reserves estimates were wrong in terms of IBNR/OSLR etc it will just affect the following year of declared profits so that if I under reserved in the past it will have an impact on the following year of declared profit.

Hopefully this helps but let me know if it's unclear.

Thanks

 

[Darren Michaels]

Don't forget that reserving strength can delay / accelerate the emergence of profit too. For example, if an insurer sets very prudent reserves, then the claims incurred will be higher initially, leading to lower profits in the short term. As the claims come in over time and the reserves are released, then further profit will be released as the margins are released from the prudence in the reserves.

Of course the tax authorities may not allow you to set excessively prudent reserves as that will delay the emergence of profit and hence the payment of tax.

Going back to Qayanaat's original point, if the insurer's reserves are precisely equal to the future claims that are paid out in respect of a given tranche of business, then all of the profit is earned in that year, since the future paid claims will be precisely offset by the reduction in the outstanding claims reserves and so the claims incurred for that tranche will be zero in future time periods. So subject to any over or under reserving the profit is crystallised in the year the premium is earned.

 

[CapitalActuary]

This doesn't directly address the question, but I saw a good post on LinkedIn recently, which included a visualisation of insurance accounting basics. https://www.linkedin.com/posts/pete...on-insurtech-ugcPost-6780445120618622976-1usx

It might help you out, or perhaps others.

If you're struggling to see what the animation shows: first it shows you what happens if an insurer were to recognise profit in line with cashflows (i.e. no UPR, case reserves, IBNR or DAC). Then it adds in these items one by one and the animation repeats each time, showing the impact on how profit is recognised and the chart heading states (more or less) the purpose and/or impact of each item.

I like it, anyway!