Stanford University
Graduate School of Business
June, 1997
For information, contact Janet Zich, [email protected], or 415/723-9193
Accounting for Insurance Loss Reserves
STANFORD -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 at
the Stanford Businss School. Nelson 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
value-based measurement in financial reporting has also 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," says Nelson.
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, says Nelson.
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," says Nelson. "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, says
Nelson.
by Barbara Buell
-30-
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