Financial and Accounting Concepts for Insurance
Insurers report on two bases. Statutory accounting (SAP) is conservative and creditor-oriented: acquisition costs are expensed as incurred rather than deferred as DAC, and nonadmitted assets (furniture, equipment, overdue receivables) are excluded from surplus. GAAP matches revenue with expense and permits deferred acquisition costs, producing different equity and earnings patterns.
Premium and reserves
Premiums written are billed during the period; premiums earned are recognized over the protection provided. The difference is the unearned premium reserve. Loss reserves include case reserves, IBNR (incurred but not reported), and loss adjustment expense reserves. Inadequate reserving is the classic route to surplus erosion. Policyholders' surplus = admitted assets minus liabilities, the cushion that supports premium growth.
Ratios
- Loss ratio = incurred losses / earned premium
- Expense ratio = underwriting expenses / written premium (trade basis)
- Combined ratio = loss ratio + expense ratio; below 100% is an underwriting profit
- Operating ratio = combined ratio minus investment income ratio
Worked example
Written premium $500, earned premium $480, incurred losses $300, underwriting expenses $150. Loss ratio = 300/480 = 62.5%; expense ratio = 150/500 = 30%; combined = 92.5%, a 7.5-point underwriting gain before investment income.
Traps
Mixing earned and written premiums in one ratio without stating the basis; assuming a combined ratio under 100% guarantees overall profit (investment results matter); overlooking that cash-flow underwriting deliberately accepts an underwriting loss in exchange for investment float.