Accounting for insurance loss reserves
For accountants in the insurance industry, reporting loss reserves presents something of a dilemma. The issue is this: When an insurer incurs a claim it won't have to pay for many years, such as benefit claims tied up in litigation, current accounting standards require that the loss be recorded at "nominal value," the actual dollar amount. However, insurers would prefer reporting it as a discounted "present value" loss, which reflects the fact that the insurer will earn years of interest on the money, thereby reducing its liability.
Even though the practice runs contrary to accepted accounting standards, it makes eminent sense to Karen Nelson, assistant professor of accounting. She suggests that discounting loss reserves to present value is well worth considering. Her recent research, based on the accounting practices of 755 insurers between 1989 and 1993, has revealed that property-casualty insurers are already discounting their loss reserves in order to make their balance sheets look better.
The issue is especially relevant to the insurance industry, but present valuebased measurement in financial reporting also has been broadly debated by the Financial Accounting Standards Board. "When we have cash flow streams that won't be paid for a number of years, should we report those at the undiscounted value or should we take into account the time value of money? An obligation to be paid in the future won't be as costly as an obligation paid today," Nelson says.
Nelson chose the property-casualty industry for her study because many of its claims are not paid for 10 years or more. Such
claims include personal auto liability, homeowners, commercial auto, medical malpractice and commercial multiple peril claims.
Until the last decade or so, there typically wasn't a long waiting period for insurance claims. Usually claims were paid within a year or two, so discounting was simply not an issue. In addition, lower interest rates took away any urgency. Historically, regulators obsessed with the solvency of insurance companies required insurers to record higher liabilities. That meant they had to maintain higher surpluses. But now that the insurance environment has changed, firms are trying to adapt.
Required methods of reporting insurance loss reserves register higher liabilities, lower stockholders' equity and lower income, Nelson says. She found that the pressure on the insurers' financial statements was such that it made it undesirable to report losses at nominal value. "If you imagine an insurance com-pany that wants to expand, it's difficult for it to look good in this situation," Nelson says. "Discounting its claims liability not only makes the company look better, but it is also more in line with the economically correct thing to do."
Furthermore, the economies that are achieved by using present value on the balance sheet seem to be accurately reflected in customer premiums, so insurers were not using the time value of money to hike rates, Nelson found.
Overall, allowing insurers to discount loss reserves gives them needed flexibility as they try to manage and grow in a changing environment, Nelson says.
"The Discretionary Use of Present Value-Based Measurements by Property-Casualty Insurers," Karen K. Nelson, GSB Research Paper #1428, January 1997.