Principles and Criteria of Insurance Accounting: Practice Questions and Solutions

Some of the questions here ask for short written answers. This is meant to give the student practice in answering questions of the format that will appear on Exam 6. Students are encouraged to type their own answers first and then to compare these answers with the solutions given here. Please note that the solutions provided here are not necessarily the only possible ones.

Source:

Blanchard, R.S., "Accounting Concepts for the Actuary," CAS Study Note, June 2003.

Original Problems and Solutions from The Actuary's Free Study Guide

Problem S6-53-1. (a) Identify and briefly describe the six criteria for accounting information discussed by Blanchard in "Accounting Concepts for the Actuary", pp. 1-4.

(b) Discuss a possible tradeoff that might exist between two of these criteria.

(c) Why might application of the principle of conservatism be difficult in some circumstances?

Solution S6-53-1. (a) The six criteria for accounting information discussed by Blanchard are as follows:

1. Relevance: The information should be timely, should have predictive value, and should provide useful feedback on past decisions of the users of the information.
2. Reliability: The information should represent what it claims to represent, be independently verifiable, and contain all relevant material facts that assure its completeness.
3. Comparability and Consistency: The information must allow comparisons over time and competing interests. For instance, an accounting paradigm should enable comparisons of performance between a company and its competitor in the same industry.
4. Lack of Bias: Either there is no bias or the bias is clearly disclosed, and users with a different bias can adjust the information accordingly. Also, a "prudent" or "conservative" bias is possible.
5. Cost-Benefit Effectiveness: The value of the information should exceed the cost in producing it.
6. Understandability: The intended users of the information should be able to readily comprehend it.

(b) There may be a tradeoff between relevance and reliability. For relevant information, there may be too much uncertainty to determine exact values or reliable predictions. Reliable, easily estimated figures may not be relevant to future events or the user's decisions.

(c) It may be difficult to apply the principle of conservatism when overstating or understating a particular estimate could both inflate and deflate the company's results, depending on the situation. For instance, a overstating a claim liability might be conservative when predicting future paid claims, but not conservative when predicting future reinsurance receivables.

Problem S6-53-2. Identify (a) three distinct broad accounting paradigms and (b) four broad categories of users of accounting information. (See Blanchard, "Accounting Concepts for the Actuary", pp. 4-5.)

Solution S6-53-2. (a) Three distinct broad accounting paradigms are (1) Generally Accepted Accounting Principles (GAAP), (2) Statutory Accounting Principles (SAP), and (3) specialized tax accounting paradigms.

(b) Four broad categories of users of accounting information are (1) current and potential investors and creditors, (2) insurance regulators and supervisors, (3) management, and (4) tax authorities.

Problem S6-53-3. Describe the GAAP hierarchy of accounting rules. (See Blanchard, "Accounting Concepts for the Actuary", p. 7.)

Solution S6-53-3. In the GAAP hierarchy of accounting rules, the highest authority is the securities regulator of the given jurisdiction, which has the power to add rules and requirements and to veto designated standard setters' rules.

The next-highest authorities are the organizations specified as the accounting standard-setters - such as the International Accounting Standards Board (IASB) in the European Union and the Financial Accounting Standards Board (FASB) in the United States . For privately owned firms, these organizations are at the top of the hierarchy of accounting rules.

Lower on the hierarchy are interpretations of accounting standards, which are not themselves accounting standards. These are issued by the standard-setting organizations when prompt clarification and guidance are needed.

Problem S6-53-4. Briefly describe each of the key issues in each following concepts and/or distinctions discussed by Blanchard, "Accounting Concepts for the Actuary", pp. 8-12:

(a) Fair Value versus Historical Cost

(b) Recognition versus Measurement

(c) Deferral/Matching versus Asset/Liability

(d) Impairment

(e) Revenue Recognition

(f) Reporting Segment

(g) Liquidation versus Going Concern

(h) Change in Accounting Principle versus Change in Accounting Estimate

(i) Principle-based versus Rule-based

Solution S6-53-4. (a) Fair Value versus Historical Cost: Is the asset/liability valued at the price for which it was originally obtained (historical cost) or at the amount for which it could be exchanged today between knowledgeable, willing parties in an arm's length transaction (fair value)?

(b) Recognition versus Measurement: When does an asset or liability first get recorded (recognition) and what amount is assigned to it once it is recorded (measurement)?

(c) Deferral/Matching versus Asset/Liability: Are expenses and revenues recognized as occurring at the same time (deferral-matching) with a focus on the income statement, or are they recognized at the time they occur, without a necessary matching and with a focus on the balance sheet?

(d) Impairment: An impaired asset is one that no longer produces the economic benefits expected upon its acquisition. If one paradigm is used for the income statement and another is used for the balance sheet, the differences may result in impaired assets.

(e) Revenue Recognition: When should revenue be recognized - as a service is rendered (deferral/matching paradigm) or when the control of the asset representing the revenue is obtained (asset/liability paradigm)?

(f) Reporting Segment: Are the financial statements to be produced for the entire consolidated reporting entity, or separately for each legal entity comprising the reporting entity?

(g) Liquidation versus Going Concern: Is it being assumed that the company is going to continue operating and creating value (going concern), or is the focus on what the assets and liabilities would be if the company were sold off by its components today (liquidation)?

(h) Change in Accounting Principle versus Change in Accounting Estimate: Is a fundamental assumption about the accounting rules being changed (change in accounting principle) or is there simply a revision in a particular value, without a change in the underlying analytical framework (change in accounting estimate)?

(i) Principle-based versus Rule-based: Does the accounting standard rely on interpretation and judgment to be implemented (principle-based), or is flexibility limited and the use of the standard defined in detail in advance (rule-based)?

Problem S6-53-5. (a) Sometimes a distinction is made between reinsurance recoverables and reinsurance receivables. Explain the difference.

(b) Define deferred acquisition costs and state whether they are used under a deferral/matching paradigm or an asset/liability paradigm.

(c) Broadly describe three options for discounting a liability.

(See Blanchard, "Accounting Concepts for the Actuary", pp. 12-14.)

Solution S6-53-5. (a) Reinsurance recoverables are contra-liabilities representing amounts expected to be due from reinsurers as a result of incurred but currently not paid losses. Reinsurance receivables are assets representing amounts already billed to and due from reinsurers as a result of ceded losses that have already been paid by the primary insurer.

(b) Deferred acquisition costs can be an asset under the deferral/matching accounting paradigm, used to enable expenses to be recognized at the same time as revenues. Instead of being recognized immediately as expenses, acquisition costs are expensed over time, and the portion that has not yet been expensed is part of the deferred acquisition cost asset.

(c) Blanchard, on p. 14, describes the following three options for discounting a liability:

1. Treat the discount as an asset and report the liability on an undiscounted basis.
2. Report the liability with the discount built in.
3. Report the undiscounted liability and report the discount as a contra-liability (i.e., a negative entry under liabilities).

See other sections of The Actuary's Free Study Guide for Exam 6.