Explore essential insurance accounting concepts, including claim reserves, premium recognition approaches, and the significance of the combined ratio under IFRS 17 and US GAAP.
Let’s dig into one of the most critical topics in analyzing insurance companies: the interplay between claim reserves, premium recognition, and, of course, the combined ratio. When you read insurers’ financial statements, especially in property and casualty (P&C) or life segments, these three areas often serve as the barometer of underwriting success or failure. Anyway, I recall an early insurance seminar I attended where the speaker said, “If you want to understand an insurer, look at how they handle reserves, how they book premium, and how their combined ratio looks over time.” That casual tip ended up being an entire blueprint for analyzing an insurer.
Claim reserves usually represent the single largest liability item on an insurer’s balance sheet. The moment a policy covers risk, the insurer anticipates potential claims. Some will be reported quickly, others will occur but won’t be reported until later, and a fraction may never happen. So calibrating these reserves with accuracy is no small feat. Under-reserving might make the company’s performance look rosy in the short run, but it often leads to dreaded “reserve strengthening” in future years—essentially a fancy way of saying the insurer didn’t hold enough money aside to cover obligations.
Under IFRS 17, the future cash flows related to incurred claims—both reported and IBNR—get lumped into the Liability for Incurred Claims (LIC). Changes in these future cash flow assumptions, like mortality rates or discount rates, can shift the LIC. Some adjustments feed directly into profit or loss; others might adjust the Contractual Service Margin (CSM) if they relate to future service. It can be a bit tricky, so keep an eye on disclosure notes to see how the insurer’s assumptions evolve over time.
Think of a typical auto insurance policy that covers you for six months. In these short-duration settings, premiums are typically recognized as earned over the coverage period. If, say, the total premium for your policy is $600, the insurer might recognize $100 each month. This accrual-based approach aligns revenue recognition with the period during which the insurer is on the hook for claims.
Life insurance can be a bit mind-boggling because you might pay premiums over decades. That means there’s a long tail of potential claims. In accounting terms, it’s not as simple as spreading the premium evenly over a couple of months. Actuaries help break down the expected cash flows—things like mortality rates, lapses, surrenders, and investment returns—so that premiums are recognized in sync with how liabilities build up over time. Under IFRS 17, the liability for remaining coverage (LRC) covers the unexpired risk portion of these long-duration contracts, while the contractual service margin (CSM) captures the unearned profit to be released as the insurer provides coverage.
Once upon a time, some insurers used a direct method, effectively recognizing premiums when received, and claims as they were paid. But modern standards, both IFRS and US GAAP, generally require accrual accounting. This means the timing of premium recognition should match coverage periods. The direct method might look simpler, but it seldom paints an accurate picture. If you’re analyzing insurance statements and see references to “cash-based” or “direct” measures, dig deeper to see if that’s just additional disclosure or the method they use in practice (which is rare these days).
Among the many ratios you’ll encounter, the combined ratio is often called the “quick test” of underwriting profitability for P&C insurers. Essentially, it’s:
Combined Ratio = Loss Ratio + Expense Ratio
• Loss Ratio = (Claims + Adjustments) / Net Earned Premium
• Expense Ratio = Underwriting Expenses / Net Earned Premium
If the combined ratio is under 100%, the insurer generated an underwriting profit. Above 100%, there’s an underwriting loss. You know, people sometimes get confused here: an underwriting loss doesn’t necessarily mean the insurer lost money overall. Insurers invest premium cash flows in securities, which can ring up investment income. In a low interest rate environment, it has historically been harder for many insurers to make up for underwriting losses with investment returns—but that strategy of “collect now, invest at a profit, pay claims later” is still pretty typical.
Investment income can be a saving grace. A P&C insurer could have a combined ratio of 105%, meaning it’s losing on pure underwriting. However, if it invests the premium payments in relatively high-yield assets, that investment return can offset the underwriting deficits. This dynamic is one reason analyzing an insurer’s asset portfolio and its risk profile matters just as much as analyzing its liability side.
Under IFRS 17, the recognition of premiums and related liabilities has become more transparent, aiming to ensure that insurers don’t mask profitability or shortfall issues by mixing different lines of business. The standard separates the Liability for Remaining Coverage (LRC) from the Liability for Incurred Claims (LIC). The release of the CSM (Contractual Service Margin) to net income theoretically spreads out the profit margin over the coverage period, preventing frontloading or backloading of profits.
One tricky area—maybe the trickiest—under IFRS 17 is the effect of assumption changes (mortality, discount rate, expense inflation, etc.). If the revision relates to future service, it adjusts the CSM rather than hitting the profit or loss in the current period. If it’s attributed to past coverage, it typically impacts the profit or loss immediately. This can create fluctuations in an insurer’s bottom line, so it pays to read the disclosures. Also, repeated adjustments to prior period claims—“reserve strengthening”—might be a red flag that management has historically been too optimistic in setting reserves.
Imagine a small P&C insurer, RiverGate Insurance. The numbers for 2024:
• Net Earned Premium = $1,000,000
• Claims (including IBNR estimates) = $550,000
• Underwriting Expenses = $250,000
Loss Ratio = $550,000 / $1,000,000 = 55%
Expense Ratio = $250,000 / $1,000,000 = 25%
Combined Ratio = 55% + 25% = 80%
Because the combined ratio is below 100%, RiverGate has an underwriting profit. Let’s say it invests some of those premiums in short-term fixed income and picks up an additional $20,000 in net investment income. The bottom line looks even better.
Below is a simple Mermaid flowchart to illustrate the path from premium collection to claims reserving. Of course, IFRS 17 complexities can add more layers, but this is a decent overview:
flowchart LR
A["Premium Collection <br/> (Net Written Premium)"] --> B["Coverage and Underwriting"];
B --> C["Claims <br/> (Reported & IBNR)"];
C --> D["Reserve Estimation <br/> (LIC & Other Reserves)"];
D --> E["Recognized in Financials <br/> (Income Statement, Balance Sheet)"];
This linear progression helps remind us how the premium the insurer collects eventually becomes recognized as earned revenue, while the claims form into liability reserves on the balance sheet. Any mismatch between timing or magnitude can distort the insurer’s reported profit.
• Study the footnotes thoroughly. Insurers usually provide detail about changes in assumptions and methodologies.
• Keep an eye on discount rate changes, especially in a volatile interest rate environment. They can substantially swing the present value of future claims.
• Don’t rely on a single ratio. Yes, the combined ratio is crucial, but also look at the insurer’s return on equity, solvency ratios, and growth in reserves.
• Cross-check industry data. If an insurer’s claims patterns differ too wildly from the rest of the market, it might be pricing risk too aggressively or not making accurate assumptions.
I once chatted with a senior claims manager who said something like, “We’re always nervous about IBNR. It kind of feels like waiting for the other shoe to drop.” This notion captures the reality that insurers must guess a little when booking these reserves. The better their data and models, the better their guess. But sometimes an unexpected event—like a surprise hailstorm or court ruling—blows the estimates out of the water. That’s why repeated underestimation of IBNR is such a big red flag.
When it comes to analyzing insurers, ensure you truly understand how they handle reserves and premium recognition. Don’t overlook IFRS 17 nuances: how they separate out the LRC, LIC, and measure the CSM. And absolutely keep your eye on the combined ratio if you’re dealing with P&C underwriting. In the exam’s vignette-style questions, you might see a scenario with a sudden reserve strengthening or a discussion of how a shift in discount rates triggered a jump in incurred claims. Focus on toggling between IFRS 17 terms (LRC, LIC) and US GAAP equivalents, and make sure you can interpret the combined ratio quickly.
• Read the entire vignette carefully. Sometimes the exam puts hidden clues in the footnotes.
• Watch for changes in assumptions that drive differences between earned premium and recognized claims.
• Memorize the components of the combined ratio and understand how it ties back to underwriting performance.
• Practice with real data from insurance company filings—this is an excellent way to see how IFRS 17 disclosures are structured.
Remember, the exam is as much about application as pure theory. If you see a question about “reserve adequacy,” suspect that they want you to identify potential under-reserving or to see if an insurer needs future reserve strengthening. Good luck, and keep your eyes on the footnotes!
• CFA Institute curriculum readings on insurance accounting under IFRS and US GAAP.
• IFRS 17 Insurance Contracts Implementation Guidance: https://www.ifrs.org
• National Association of Insurance Commissioners (NAIC) RBC and Regulatory Disclosures: https://content.naic.org
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