Appendix 5

A Starting Point:

The Insurance Industry

 

"When you come to a fork in the road – take it."

Yogi Berra

It is not necessary or desirable for accounting to immediately leave one path and start on another. Accounting can and should explore its options. Some diversification may be prudent. One option is to phase in AFTF for a single industry and delay implementation for other industries. The insurance industry is an ideal starting point for many reasons. 

Insurance systems, in particular, involve the long-term future. Life insurance and annuity contracts often last many decades. An accounting system, which fails to fully recognize the long-term nature of insurance, fails to the same degree. The insurance industry, more than any other industry would benefit from a prospective accounting system. In fact, the insurance industry already has crude prospective accounting in the form of reserves. A reserve (statutory, GAAP, or tax) is the present value of policy benefits less the present value of net premiums, which is similar in theory to the present values of negative and positive expected cash flows of AFTF. Unfortunately the reserve mechanisms are too crude and too conservative to produce meaningful or useful accounting. For example, with statutory and GAAP accounting the issuance of a profitable insurance policy produces an accounting loss. Hence financial reporting to shareholders or management sends a backward message; shareholder value has been increased, but is reported as a decrease. 

AFTF would provide a single accounting system meeting the essential needs of all insurance accounting systems. This would be very useful to the insurance industry, which has three separate financial reporting systems (statutory, GAAP, and tax) as well as other accounting systems. The insurance industry needs unified systems. We have already generally explored how AFTF satisfies the essential purposes of various types of accounting, but I will touch on two such purposes. 

First, statutory regulatory accounting’s essential purpose purports to be the solvency of the insurance company and the protection of the policyholder. AFTF would essentially eliminate insolvencies. Insolvencies arise from several causes. Major causes of insolvencies include: inadequate pricing, inadequate reserves, concentrated (un-diversified) investments, inadequate capital, and too rapid growth. All of these causes result from a failure to carefully account for the future. AFTF is designed to conserve or maximize shareholder value. Since the policyholders have first claim on company assets, shareholder value provides a shield for the policyholder. This shield will be effective if the shareholder is informed about the company value. The shield won’t be needed if management is properly informed about the future. AFTF provides information about future cash flows and their present value. The best way to protect the policyholder to give the shareholder the information he needs to protect himself. 

Second, GAAP financial reporting’s essential purpose to provide the shareholder with relevant, decision-useful information. In Chapter 3 we outlined many of the problems of traditional (GAAP) accounting. In Chapters 9, 10 and 11 we saw how AFTF corrects those problems. For the life insurance industry those deficiencies are severe because of the long-term nature of insurance. Insurance requires a much longer reporting period. AFTF recognizes the long-term future and provides appropriate current measures. AFTF satisfies the essential purposes of GAAP accounting much better than GAAP accounting itself does. AFTF not only corrects the problems of traditional accounting, it goes far beyond. AFTF makes financial reporting much more useful; it improves all types of accounting. 

AFTF is easiest to implement for the insurance industry. There are several reasons for this. 

The insurance industry is already partially oriented to the future. The reserve concept is prospective. Insurance pricing and gross premium valuations are essentially AFTF valuation technology. 

The insurance industry has, for several years, been required by statutory accounting to analyze asset adequacy and to submit a formal Actuarial Memorandum summarizing the results. This analysis requires a company to project cash flows for all assets and liabilities. This is Cash Flow Testing (CFT). Unlike the Canadian Dynamic Solvency Testing (DST) it does not require that new business be projected or modeled, but CFT can be fairly easily extended to DST. The projected cash flows of CFT or DST are the expected cash flows of AFTF. The essential ingredients of AFTF expected cash flows are already in place in the insurance industry. 

The insurance industry has the information technologies required for AFTF already in place. Very sophisticated and refined CFT and DST software are available and widely used. Two leading programs are PTS by Chalke Associates and TAS by Tillinghast. Insurance companies have powerful computers on which cash flow models can be run. The insurance industry has generally maintained the data and performed the experience studies needed for modeling purposes. Mortality, lapse, and expense studies are a normal feature of insurance operations. 

The insurance industry has a foundation of experienced personnel needed for AFTF. Insurance company management is generally experienced and capable enough to fulfill their limited AFTF role (see Chapter 13). If they are not, AFTF will encourage their capabilities. Insurance company accountants and auditors are generally experienced and skilled enough to understand and assume their AFTF roles. As suggested, the accountant’s role is quite limited and fairly traditional. The accounting profession would naturally have general control over AFTF and would have control over additional educational requirements. The modeler is the potential weak link. In the case of the insurance industry, the actuary, especially the valuation actuary, provides an acceptable level of expertise to oversee the modeling of cash flows. The valuation actuary is generally highly trained, meeting rigorous and relevant educational standards (including continuing educational requirements, which might be customized to AFTF). The valuation actuary is also experienced in modeling cash flows due to the CFT or DST requirements and by reason of his general training. 

An insurance company is generally well diversified. Typically assets are well diversified, investment quality bonds, mortgages, and other prudent instruments. An insurance company typically has several lines of business, many products, and myriads of individual policyholders. This prudent diversification creates great stability in future asset and liability cash flows so that predictability is high for insurance companies. The insurance industry is diversified enough to produce a high degree of AFTF reliability. 

Insurance industry accounting is a mess and nobody likes it. The NAIC is not satisfied with its own reporting requirements and has called for proposals. They have gradually shifted from an earnings concept to cash flows. They appear to be heading toward a DST approach. The accounting profession is looking for new models and is considering a "much more forward-looking information, prospective-type reporting". Accountants have never been comfortable with reserves, not even GAAP reserves. 

Insurance companies are not happy with maintaining multiple sets of books (cash, statutory, GAAP, and tax accounting), especially since these systems do not accomplish their essential purposes. There is general dissatisfaction with insurance accounting systems, which could motivate a desire for change.

AFTF requires a multi-disciplinary approach. There is the possibility of a new cooperative relationship between the accounting and actuarial professions. This relationship would be needed on an informal basis for AFTF for the life insurance industry, but it might be strengthened in a broader setting. Actuaries may be helpful to the accounting profession in different aspects of AFTF, not just as insurance company modelers. For example, actuaries could contribute to the development and implementation of AFTF principles and practices. 

 

Conclusions 

The insurance industry is an ideal starting point for AFTF. Insurance accounting could be simplified and improved by a disciplined value-added accounting model. AFTF would satisfy both regulatory and GAAP reporting purposes better. The insurance industry is experienced with the future and with cash flows projections; it has the personnel and technologies required for implementation. The insurance industry is not happy with the multiplicity of systems now in use and would benefit substantially from a prospective accounting system.

  

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