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Audit and
Accounting Guide
Property and Liability Insurance Entities
September 1, 2018

23574-349

Copyright © 2018 by
American Institute of Certified Public Accountants. All rights reserved.
For information about the procedure for requesting permission to make copies of
any part of this work, please email [email protected] with your request.
Otherwise, requests should be written and mailed to Permissions Department,
220 Leigh Farm Road, Durham, NC 27707-8110.
1 2 3 4 5 6 7 8 9 0 AAP 1 9 8
ISBN 978-1-94549-852-7 QSJOU
*4#/ F1VC

iii

Preface
(Updated as of September 1, 2018)

Prepared by the Insurance Companies Committee.

About AICPA Audit and Accounting Guides
This AICPA Audit and Accounting Guide has been developed by the Property
and Liability Insurance Guide Task Force to assist practitioners in performing
and reporting on their audit engagements, and to assist management of property and liability insurance entities in preparing financial statements in conformity with U.S. generally accepted accounting principles (GAAP) and statutory
accounting principles.
An AICPA Guide containing auditing guidance related to generally accepted
auditing standards (GAAS) is recognized as an interpretive publication as
defined in AU-C section 200, Overall Objectives of the Independent Auditor
and the Conduct of an Audit in Accordance With Generally Accepted Auditing
Standards.1 Interpretive publications are recommendations on the application
of generally accepted auditing standards (GAAS) in specific circumstances, including engagements for entities in specialized industries.
An interpretive publication is issued under the authority of the AICPA Auditing
Standards Board (ASB) after all ASB members have been provided an opportunity to consider and comment on whether the proposed interpretive publication is consistent with GAAS. The members of the ASB have found the auditing
guidance in this guide to be consistent with existing GAAS.
Although interpretive publications are not auditing standards, AU-C section
200 requires the auditor to consider applicable interpretive publications in
planning and performing the audit because interpretive publications are relevant to the proper application of GAAS in specific circumstances. If the auditor
does not apply the auditing guidance in an applicable interpretive publication,
the auditor should document how he or she complied with the requirements of
GAAS in the circumstances addressed by such auditing guidance.
The ASB is the designated senior committee of the AICPA authorized to speak
for the AICPA on all matters related to auditing. Conforming changes made to
the auditing guidance contained in this guide are approved by the ASB Chair
(or his or her designee) and the Director of the AICPA Audit and Attest Standards Staff. Updates made to the auditing guidance in this guide exceeding that
of conforming changes are issued after all ASB members have been provided an
opportunity to consider and comment on whether the guide is consistent with
the Statements on Auditing Standards (SASs).
Any auditing guidance in a guide appendix or exhibit (whether a chapter or
back matter appendix or exhibit), though not authoritative, is considered an
“other auditing publication”. In applying such guidance, the auditor should,
exercising professional judgment, assess the relevance and appropriateness
of such guidance to the circumstances of the audit. Although the auditor
1 All AU-C sections can be found in AICPA Professional Standards.

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determines the relevance of other auditing guidance, auditing guidance in a
guide appendix or exhibit has been reviewed by the AICPA Audit and Attest
Standards staff and the auditor may presume that it is appropriate. The Financial Reporting Executive Committee (FinREC) is the designated senior committee of the AICPA authorized to speak for the AICPA in the areas of financial
accounting and reporting. Conforming changes made to the financial accounting and reporting guidance contained in this guide are approved by the FinREC
Chair (or his or her designee). Updates made to the financial accounting and
reporting guidance in this guide exceeding that of conforming changes are approved by the affirmative vote of at least two-thirds of the members of FinREC.
This guide does the following:

r Identifies certain requirements set forth in the FASB Accounting
Standards Codification® (ASC).

r Describes FinREC’s understanding of prevalent or sole industry
practice concerning certain issues. In addition, this guide may indicate that FinREC expresses a preference for the prevalent or
sole industry practice, or it may indicate that FinREC expresses
a preference for another practice that is not the prevalent or sole
industry practice; alternatively, FinREC may express no view on
the matter.

r Identifies certain other, but not necessarily all, industry prac-

tices concerning certain accounting issues without expressing FinREC’s views on them.

r Provides guidance that has been supported by FinREC on the

accounting, reporting, or disclosure treatment of transactions or
events that are not set forth in FASB ASC.
Accounting guidance for nongovernmental entities included in an AICPA Guide
is a source of nonauthoritative accounting guidance. As discussed later in this
preface, FASB ASC is the authoritative source of U.S. accounting and reporting
standards for nongovernmental entities, in addition to guidance issued by the
SEC.
AICPA Guides may include certain content presented as “Supplement,” “Appendix,” or “Exhibit.” A supplement is a reproduction, in whole or in part, of
authoritative guidance originally issued by a standard setting body (including regulatory bodies) and applicable to entities or engagements within the
purview of that standard setter, independent of the authoritative status of the
applicable AICPA Guide. Both appendixes and exhibits are included for informational purposes and have no authoritative status.

Recognition
2018 Guide Edition
AICPA Senior Committees
Auditing Standards Board
Ilene Kassman, ASB Member
Mike Santay, Chair
Financial Reporting Executive Committee
Michelle Avery, FinREC Member
James Dolinar, Chair

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The AICPA gratefully acknowledges the following individuals who reviewed or
otherwise contributed to the development of this edition of the guide: Stephen
Andrews, Jennifer Austin, Dan Buttke, Will Chan, Alissa Choi, Erica Czajkowski, Katie Frank, Allison Haug, Amanda Hawkins, Christopher Howell,
Jason Jacobs, Margaret Keeley, J Eric Kegler, William Kennedy, Jeff Maffitt,
Brett Maly, Sarah McConnell, Andrea Medley, Brandon Mott, Dave Osborn,
Tiffany Paben, Phillip Pennino, Canita Gunter Peterson, Amanda Poirot, Todd
Ross„ Art Salvadori, Greg Schlaefer, Jie Shen, Christina Siena, Carrie Small,
Catherine Stout, John Szymczyk, Matthew Walker and Jon Zeigler.
AICPA Staff
Ahava Goldman
Associate Director
Audit and Attest Standards
Kim Kushmerick
Associate Director
Accounting Standards
and Staff Liaison to the
AICPA Insurance Expert Panel
2013 Guide Edition
Property and Liability Insurance Entities Audit and Accounting
Guide Overhaul Task Force (2005–2012)
(members when this edition was completed)
Mark Parkin, Chair
Michelle Avery
Keith Bell
Alissa Choi
Maureen Downie
William Ferguson
Daniel Grady
Richard Lynch
Coleman Ross
E. Daniel Thomas
Magali Welch
(former members who contributed to the development of this edition)
Ken Croarkin
Martin John
Scott Lewis
William Lowry
Marc Smith
Ramin Taraz
AICPA Senior Committees
Financial Reporting Executive Committee
(members when this edition was completed)
Richard C. Paul, Chair
Aaron Anderson
Linda Bergen
Adam Brown
Terry Cooper
Lawrence Gray

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Randolph Green
Mary E. Kane
Jack Markey
Joseph D. McGrath
Rebecca Mihalko
Steve Moehrle
Angela Newell
Mark Scoles
Brad Sparks
Dusty Stallings
(former members who contributed to the development of this edition)
Jay Hanson, Former Chair
Benjamin S. Neuhausen, Former Chair
David Alexander
Robert Axel
Rick Arpin
Kimber Bascom
Glenn Bradley
Neri Bukspan
Brett Cohen
Pascal Desroches
James A. Dolinar
L. Charles Evans
Faye Feger
Bruce Johnson
Richard Jones
Carl Kampel
Lisa Kelley
David Morris
Jonathon Nus
Richard Petersen
Roy Rendino
Terry Spidell
Randall Sogoloff
Richard K. Stuart
Enrique Tejerina
Robert Uhl
Dan Weaver
Dan Zwarn
Auditing Standards Board
(members when this edition was completed)
Darrel R. Schubert, Chair
Brian Bluhm
Robert E. Chevalier
Sam K. Cotterell
Jim Dalkin
David Duree
Jennifer Haskell
Ed G. Jolicoeur
Barbara Lewis
Carolyn H. McNerney

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David Morris
Kenneth R. Odom
Don M. Pallais
Brian R. Richson
Mike Santay
Kay W. Tatum
Kim L. Tredinnick
H. Steven Vogel
Kurtis A. Wolff
The AICPA and the Property and Liability Insurance Entities Audit and Accounting Guide Overhaul Task Force gratefully acknowledges the contributions
of Evan Cabat, Jean Connolly, Jennifer Englert, Robert Evans, Danielle Fandrey, Thomas Fekete, Julie Gould, Andy Gray, Linda Healy, Jay Muska, Mary
Saslow, Lisa Slotznick, and Deborah Whitmore.
The AICPA and the Property and Liability Insurance Entities Audit and Accounting Guide Overhaul Task Force gratefully acknowledge those members
of the AICPA Insurance Expert Panel who reviewed or otherwise contributed
to the development of this guide: Jill Butler, Darryl Briley, Kathleen Enright,
Matthew Farney, James Greisch, Kenneth N. Hugendubler, Margie M. Keeley,
Joshua Keene, Rick Sojkowski, Robert Tarnok, Anthony Valoroso, and Jennifer
Yaross. Additionally, the AICPA and the Property and Liability Insurance Entities Audit and Accounting Guide Overhaul Task Force thank those past members of the AICPA Insurance Expert Panel who reviewed or otherwise contributed to the development of this guide but rotated off the Insurance Expert
Panel prior to the guide being completed: Amy Corbin, Elaine Lehnert, Sandra
Peters, and Donald Schwegman.
AICPA Staff
Kim Kushmerick
Senior Technical Manager
Accounting Standards
and Staff Liaison to the
AICPA Insurance Expert Panel
Dan Noll
Director
Accounting Standards

Guidance Considered in This Edition
This edition of the guide has been modified by the AICPA staff to include certain changes necessary due to the issuance of authoritative guidance since the
guide was originally issued, and other revisions as deemed appropriate. Relevant guidance issued through September 1, 2018, has been considered in the
development of this edition of the guide. However, this guide does not include
all audit, accounting, reporting, and other requirements applicable to an entity
or a particular engagement. This guide is intended to be used in conjunction
with all applicable sources of authoritative guidance.
Authoritative guidance that is issued and effective on or before September 1,
2018, is incorporated directly in the text of this guide. Authoritative guidance
issued but not yet effective as of September 1, 2018, but becoming effective

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on or before December 31, 2018, is also presented directly in the text of the
guide, but shaded gray and accompanied by a footnote indicating the effective
date of the new guidance. The distinct presentation of this content is intended
to aid the reader in differentiating content that may not be effective for the
reader’s purposes (as part of the guide’s dual guidance treatment of applicable
new guidance).
Relevant guidance issued but not yet effective as of the date of the guide and not
becoming effective until after December 31, 2018, is referenced in a guidance
update box; that is, a box that contains summary information on the guidance
issued but not yet effective.
In updating this guide, all guidance issued up to and including the following
was considered, but not necessarily incorporated, as determined based on applicability:

r FASB Accounting Standards Update (ASU) No. 2018-15, Intangibles—Goodwill and Other—Internal-Use Software (Subtopic 35040): Customer’s Accounting for Implementation Costs Incurred in
a Cloud Computing Arrangement That Is a Service Contract (a
consensus of the FASB Emerging Issues Task Force)

r SAS No. 133, Auditor Involvement With Exempt Offering Documents (AU-C sec. 945)

r National Association of Insurance Commissioners Statement of
Statutory Accounting Principles No. 107, Accounting for the RiskSharing Provisions of the Affordable Care Act

r National Association of Insurance Commissioners, Statutory Ac-

counting Principles Working Group, INT 18-03: Additional Elements Under the Tax Cuts and Jobs Act

r PCAOB Staff Guidance Changes to the Auditor’s Report Effective
for Audits of Fiscal Years Ending on or After December 15, 2017
(PCAOB sec. 300.04)2
Users of this guide should consider guidance issued subsequent to those items
listed previously to determine their effect on entities covered by this guide.
In determining the applicability of recently issued guidance, its effective date
should also be considered.
The changes made to this edition of the guide are identified in the Schedule
of Changes appendix. The changes do not include all those that might be considered necessary if the guide were subjected to a comprehensive review and
revision.
PCAOB quoted content is from PCAOB Auditing Standards and PCAOB Staff
Audit Practice Alerts, ©2017, Public Company Accounting Oversight Board. All
rights reserved. Used by permission.
FASB standards quoted are from the FASB Accounting Standards Codification ©2017, Financial Accounting Foundation. All rights reserved. Used by permission.

2 All PCAOB Staff Guidance can be found in PCAOB Standards and Related Rules.

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FASB ASC Pending Content
Presentation of Pending Content in FASB ASC
Amendments to FASB ASC (issued in the form of ASUs) are initially incorporated into FASB ASC in “pending content” boxes below the paragraphs being
amended with links to the transition information. The pending content boxes
are meant to provide users with information about how the guidance in a paragraph will change as a result of the new guidance.
Pending content applies to different entities at different times due to varying
fiscal year-ends, and because certain guidance may be effective on different
dates for public and nonpublic entities. As such, FASB maintains amended
guidance in pending content boxes within FASB ASC until the roll-off date.
Generally, the roll-off date is six months following the latest fiscal year end for
which the original guidance being amended could still be applied.

Presentation of FASB ASC Pending Content in AICPA Audit and
Accounting Guides
Amended FASB ASC guidance that is included in pending content boxes in
FASB ASC on September 1, 2018, is referenced as “pending content” in this
guide. Readers should be aware that pending content referenced in this guide
will eventually be subjected to FASB’s roll-off process and no longer be labeled
as “pending content” in FASB ASC (as discussed in the previous paragraph).

Terms Used to Deﬁne Professional Requirements in This
AICPA Audit and Accounting Guide
Any requirements described in this guide are normally referenced to the applicable standards or regulations from which they are derived. Generally, the
terms used in this guide describing the professional requirements of the referenced standard setter (for example, the ASB) are the same as those used in the
applicable standards or regulations (for example, must or should). However,
where the accounting requirements are derived from FASB ASC, this guide
uses should, whereas FASB uses shall. In its resource document “About the
Codification” that accompanies FASB ASC, FASB states that it considers the
terms should and shall to be comparable terms and to represent the same concept — the requirement to apply a standard.
Readers should refer to the applicable standards and regulations for more information on the requirements imposed by the use of the various terms used
to define professional requirements in the context of the standards and regulations in which they appear.
Certain exceptions apply to these general rules, particularly in those circumstances where the guide describes prevailing or preferred industry practices for
the application of a standard or regulation. In these circumstances, the applicable senior committee responsible for reviewing the guide’s content believes
the guidance contained herein is appropriate for the circumstances.

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Applicability of Generally Accepted Auditing Standards
and PCAOB Standards
Appendix A, “Council Resolution Designating Bodies to Promulgate Technical
Standards,” of the AICPA Code of Professional Conduct recognizes both the
ASB and the PCAOB as standard setting bodies designated to promulgate auditing, attestation, and quality control standards. Paragraph .01 of the “Compliance With Standards Rule” (ET sec. 1.310.001 and 2.310.001)3 requires an
AICPA member who performs an audit to comply with the applicable standards.
Audits of the financial statements of those entities subject to the oversight authority of the PCAOB (that is, those audit reports within the PCAOB’s jurisdiction as defined by the Sarbanes-Oxley Act of 2002, as amended) are to be
conducted in accordance with standards established by the PCAOB, a private
sector, nonprofit corporation created by the Sarbanes-Oxley Act of 2002. The
SEC has oversight authority over the PCAOB, including the approval of its
rules, standards, and budget. In citing the auditing standards of the PCAOB,
references generally use section numbers within the reorganized PCAOB auditing standards and not the original standard number, as appropriate.
Audits of the financial statements of those entities not subject to the oversight
authority of the PCAOB (that is, those entities whose audits are not within the
PCAOB’s jurisdiction — hereinafter referred to as nonissuers) are to be conducted in accordance with GAAS as issued by the ASB. The ASB develops and
issues standards in the form of SASs through a due process that includes deliberation in meetings open to the public, public exposure of proposed SASs, and a
formal vote. The SASs and their related interpretations are codified in AICPA
Professional Standards. In citing GAAS and their related interpretations, references generally use section numbers within the codification of currently effective SASs and not the original statement number, as appropriate.
The auditing content in this guide primarily discusses GAAS issued by the
ASB and is applicable to audits of nonissuers. Users of this guide may find the
tool developed by the PCAOB’s Office of the Chief Auditor helpful in identifying comparable PCAOB Standards. The tool is available at
standards/auditing/pages/findanalogousstandards.aspx.
Considerations for audits of issuers in accordance with PCAOB standards may
also be discussed within this guide’s chapter text. When such discussion is provided, the related paragraphs are designated with the following title: Considerations for Audits Performed in Accordance With PCAOB Standards. PCAOB
guidance included in an AICPA guide has not been reviewed, approved, disapproved, or otherwise acted upon by the PCAOB and has no official or authoritative status.

Applicability of Quality Control Standards
QC section 10, A Firm’s System of Quality Control,4 addresses a CPA firm’s responsibilities for its system of quality control for its accounting and auditing
practice. A system of quality control consists of policies that a firm establishes
and maintains to provide it with reasonable assurance that the firm and its
3 All ET sections can be found in AICPA Professional Standards.
4 All QC sections can be found in AICPA Professional Standards.

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personnel comply with professional standards, as well as applicable legal and
regulatory requirements. The policies also provide the firm with reasonable assurance that reports issued by the firm are appropriate in the circumstances.
This section applies to all CPA firms with respect to engagements in their accounting and auditing practice.
QC section 10 applies to all CPA firms with respect to engagements in their accounting and auditing practice. In paragraph .13 of QC section 10, an accounting and auditing practice is defined as “a practice that performs engagements
covered by this section, which are audit, attestation, compilation, review, and
any other services for which standards have been promulgated by the AICPA
ASB or the AICPA Accounting and Review Services Committee (ARSC) under the “General Standards Rule” (ET sec. 1.300.001) or the “Compliance With
Standards Rule” (ET sec. 1.310.001) of the AICPA Code of Professional Conduct. Although standards for other engagements may be promulgated by other
AICPA technical committees, engagements performed in accordance with those
standards are not encompassed in the definition of an accounting and auditing
practice.”
In addition to the provisions of QC section 10, readers should be aware of other
sections within AICPA Professional Standards that address quality control considerations, including the following provisions that address engagement level
quality control matters for various types of engagements that an accounting
and auditing practice might perform:

r AU-C section 220, Quality Control for an Engagement Conducted
in Accordance With Generally Accepted Auditing Standards
r AT-C section 105, Concepts Common to All Attestation Engagements
r AR-C section 60, General Principles for Engagements Performed
5

in Accordance With Statements on Standards for Accounting and
Review Services6
Because of the importance of engagement quality, this guide includes an appendix, “Overview of Statements on Quality Control Standards.” This appendix
summarizes key aspects of the quality control standard. This summarization
should be read in conjunction with QC section 10, AU-C section 220, AT-C
section 105, AR-C section 60, and the quality control standards issued by the
PCAOB, as applicable.

Alternatives Within U.S. Generally Accepted
Accounting Principles
The Private Company Council (PCC), established by the Financial Accounting
Foundation’s Board of Trustees in 2012, and FASB, working jointly, will mutually agree on a set of criteria to decide whether and when alternatives within
U.S. GAAP are warranted for private companies. Based on those criteria, the
PCC reviews and proposes alternatives within U.S. GAAP to address the needs
of users of private company financial statements. These U.S. GAAP alternatives
may be applied to those entities that are not public business entities, not-forprofits, or employee benefit plans.
5 All AT-C sections can be found in AICPA Professional Standards.
6 All AR-C sections can be found in AICPA Professional Standards.

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The FASB ASC glossary defines a public business entity as follows:
A public business entity is a business entity meeting any one of the
criteria below. Neither a not-for-profit entity nor an employee benefit
plan is a business entity.
a. It is required by the U.S. Securities and Exchange Commission (SEC) to file or furnish financial statements, or
does file or furnish financial statements (including voluntary filers), with the SEC (including other entities whose
financial statements or financial information are required
to be or are included in a filing).
b. It is required by the Securities Exchange Act of 1934 (the
Act), as amended, or rules or regulations promulgated under the Act, to file or furnish financial statements with a
regulatory agency other than the SEC.
c. It is required to file or furnish financial statements with
a foreign or domestic regulatory agency in preparation for
the sale of or for purposes of issuing securities that are not
subject to contractual restrictions on transfer.
d. It has issued, or is a conduit bond obligor for, securities that
are traded, listed, or quoted on an exchange or an over-thecounter market.
e. It has one or more securities that are not subject to contractual restrictions on transfer, and it is required by law,
contract, or regulation to prepare U.S. GAAP financial
statements (including footnotes) and make them publicly
available on a periodic basis (for example, interim or annual periods). An entity must meet both of these conditions
to meet this criterion.
An entity may meet the definition of a public business entity solely because
its financial statements or financial information is included in another entity’s
filing with the SEC. In that case, the entity is only a public business entity for
purposes of financial statements that are filed or furnished with the SEC.
Readers should refer to Technical Questions and Answers (Q&A) section
7100.15, “Insurance Companies and the Definition of Public Business Entity,”7
for additional information related to applying the definition of a public business
entity to insurance entities.
Considerations related to alternatives for private companies may be discussed
within this guide’s chapter text. When such discussion is provided, the related
paragraphs are designated with the following title: Considerations for Private
Companies That Elect to Use Standards as Issued by the Private Company
Council.

AICPA.org Website
The AICPA encourages you to visit the website at aicpa.org and the Financial
Reporting Center at www.aicpa.org/frc. The Financial Reporting Center supports members in the execution of high quality financial reporting. Whether
you are a financial statement preparer or a member in public practice, this
7 All Q&A sections can be found in Technical Questions and Answers.

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center provides exclusive member-only resources for the entire financial reporting process. The Financial Reporting Center also provides timely and relevant news, guidance, and examples supporting the financial reporting process,
including accounting, preparing financial statements, and performing compilation, review, audit, attest or assurance, and advisory engagements. Certain
content on the AICPA’s website referenced in this guide may be restricted to
AICPA members only.

Select Recent Developments Signiﬁcant to This Guide
Insurance Contracts Project
IASB Activities
The International Accounting Standards Board (IASB) split its insurance contract project into two phases so that some components of the project were completed by 2005 without delaying the rest of the project. Phase I addresses
the application of the existing International Financial Reporting Standards
(IFRSs) to entities that issue insurance contracts. The issuance of IFRS 4, Insurance Contracts, along with Basis for Conclusions on IFRS 4 and Implementation Guidance to IFRS 4, brought Phase I of the international insurance project
to a close.
Phase II, initiated in September 2004, was a comprehensive project on accounting for insurance contracts.
In September 2016, the IASB issued amendments to IFRS 4 to address concerns
arising from implementing the new financial instruments standard, IFRS 9,
Financial Instruments, before implementing the replacement standard that the
board was developing for IFRS 4. These concerns included temporary volatility
in reported results. IFRS 9 is effective for annual periods beginning on or after
January 1, 2018, with early application permitted.
The amendments introduce two approaches: an overlay approach and a deferral
approach. The amended standard will

r give all companies that issue insurance contracts the option to rec-

ognize in other comprehensive income, rather than profit or loss,
the volatility that could arise when IFRS 9 is applied before the
issuance of the new insurance contracts standard; and

r give companies whose activities are predominantly connected

with insurance an optional temporary exemption from applying
IFRS 9 until 2021. The entities that defer the application of
IFRS 9 will continue to apply the existing financial instruments
standard, IAS No. 39, Financial Instruments: Recognition and
Measurement.
The amendments to IFRS 4 supplement existing options in the standard that
can already be used to address the temporary volatility.
In May 2017, the IASB issued IFRS 17, Insurance Contracts, replacing IFRS
4. IFRS 17 has an effective date of January 1, 2021, but early application is
permitted provided that IFRS 9 and IFRS 15 are also applied. IFRS 17 is the
first comprehensive and truly international IFRS standard establishing the
accounting for insurance contracts.

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IFRS 17 requires a company that issues insurance contracts to report insurance
contracts on the balance sheet as the total of
a. the fulfilment cash flows — the current estimates of amounts that
the insurer expects to collect from premiums and pay out for claims,
benefits and expenses, including an adjustment for the timing and
risk of those cash flows; and
b. the contractual service margin — the expected profit for providing
future insurance coverage (that is, unearned profit).
The measurement of the fulfilment cash flows reflects the current value of any
interest-rate guarantees and financial options included in the insurance contracts.
To better reflect changes in insurance obligations and risks, IFRS 17 requires a
company to update the fulfilment cash flows at each reporting date, using current estimates that are consistent with relevant market information. Changes
in insurance obligations due to changes in the economic environment (such
as changes in interest rates) will be reflected in an insurer’s financial statements in a timely way. IFRS 17 will therefore provide current updated information about the effect of insurance contracts on a company’s financial position
and risk exposure, as well as transparent reporting of changes in insurance
obligations.

FASB Activities
On August 2, 2007, FASB issued an invitation to comment on An FASB Agenda
Proposal: Accounting for Insurance Contracts by Insurers and Policyholders, Including the IASB Discussion Paper, Preliminary Views on Insurance Contracts.
That invitation to comment included a discussion paper issued by IASB, Preliminary Views on Insurance Contracts, which set forth its preliminary views
on the main components of an accounting model for an issuer’s rights and obligations (assets and liabilities) under an insurance contract. FASB issued the
invitation to comment to gather information from its constituents to help decide whether there was a need for a comprehensive project on accounting for
insurance contracts and whether FASB should undertake such a project jointly
with IASB.
In October 2008, FASB decided to join IASB’s insurance contract project.
On September 17, 2010, FASB issued, for public comment, the discussion paper
Preliminary Views on Insurance Contracts.
In June 2013, FASB issued the exposure draft, Insurance Contracts. The guidance in the FASB exposure draft would require an entity to measure its insurance contracts under one of two measurement models, referred to as the
building block approach and the premium allocation approach.
At the February 19, 2014, meeting, FASB decided to change the scope and direction of the insurance contract project as follows:

r Scope. Limit the scope to insurance entities as described in exist-

ing U.S. GAAP (instead of continuing to include all entities that issue insurance contracts or purchase reinsurance contracts as proposed in the June 2013 exposure draft).

r Direction of the project. The project should focus on making targeted improvements to existing U.S. GAAP.

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— For short-duration contracts, the targeted improvements
will be limited to enhancing disclosures (not including
measurement and recognition).
— For long-duration contracts, decisions reached by IASB
in its 2013 exposure draft, Insurance Contracts, should
be considered when contemplating improvements to existing U.S. GAAP.
In May 2015, FASB issued ASU No. 2015-09, Financial Services—Insurance
(Topic 944): Disclosures about Short-Duration Contracts, that requires additional disclosures about the liability for unpaid claims and claim adjustment
expenses for all insurance entities that issue short-duration contracts as defined in FASB ASC 944, Financial Services—Insurance.
FASB ASU No. 2015-09 was effective for public business entities for annual
periods beginning after December 15, 2015, and interim periods within annual
periods beginning after December 15, 2016. For all other entities, FASB ASU
No. 2015-09 is effective for annual periods beginning after December 15, 2016,
and interim periods within annual periods beginning after December 15, 2017.
In September 2016, FASB issued proposed ASU Financial Services—Insurance
(Topic 944): Targeted Improvements to the Accounting for Long-Duration Contracts.
In August 2018, FASB issued ASU No. 2018-12, Financial Services—Insurance
(Topic 944): Targeted Improvements to the Accounting for Long-Duration Contracts, that will result in the following improvements:
1. Requires updated assumptions for liability measurement. Assumptions used to measure the liability for traditional insurance contracts, which are typically determined at contract inception, will
now be reviewed — and, if there is a change, updated — at least
annually, with the effect recorded in net income.
2. Standardizes the liability discount rate. The liability discount rate
will be a standardized, market-observable discount rate (uppermedium grade fixed-income instrument yield), with the effect of
rate changes recorded in other comprehensive income.
3. Provides greater consistency in measurement of market risk benefits. The two previous measurement models have been reduced
to one measurement model (fair value), resulting in greater uniformity across similar market-based benefits and better alignment
with the fair value measurement of derivatives used to hedge capital market risk.
4. Simplifies amortization of deferred acquisition costs. Previous
earnings-based amortization methods have been replaced with a
more level amortization basis.
5. Requires enhanced disclosures. They include rollforwards and information about significant assumptions and the effects of changes
in those assumptions.
For calendar-year public business entities, the changes in FASB ASU No. 201812 are effective at the beginning of 2021. For all other calendar-year entities,
the changes in FASB ASU No. 2018-12 are effective at the end of 2022. Early
application is permitted.

AAG-PLI

xvi

The New Revenue Recognition Standard: FASB ASC 606
FASB ASU No. 2014-09, Revenue from Contracts with Customers (Topic 606),
and subsequent amendments (FASB ASU No. 2016-08, Revenue from Contracts
with Customers (Topic 606): Principal versus Agent Considerations (Reporting
Revenue Gross versus Net); ASU No. 2016-10, Revenue from Contracts with Customers (Topic 606): Identifying Performance Obligations and Licensing; ASU
No. 2016-12, Revenue from Contracts with Customers (Topic 606): NarrowScope Improvements and Practical Expedients; and ASU No. 2016-20, Technical
Corrections and Improvements to Topic 606, Revenue from Contracts with Customers, was effective for annual reporting periods of public business entities,
certain not-for-profits and certain employee benefit plans, beginning after December 15, 2017, including interim periods within that reporting period. Earlier
application would be permitted only as of annual reporting periods beginning
after December 15, 2016, including interim reporting periods within that reporting period.
All other entities, will apply the guidance in FASB ASU No. 2014-09 to annual reporting periods beginning after December 15, 2018, and interim periods
within annual periods beginning after December 15, 2019. Application would be
permitted earlier only as of an annual reporting period beginning after December 15, 2016, including interim reporting periods within that reporting period,
or an annual reporting period beginning after December 15, 2016, and interim
reporting periods within annual reporting periods beginning one year after the
annual reporting period in which an entity first applies the guidance in ASU
No. 2014-09.
Appendix C, “The New Revenue Recognition Standard: FASB ASC 606,” of this
guide provides an overview of the guidance. The AICPA has formed 16 industry
task forces to assist in developing a new accounting guide on revenue recognition that will provide helpful hints and illustrative examples for how to apply the new standard. Revenue recognition implementation issues identified
will be available for informal comment, after review by the AICPA FinREC, at
www.aicpa.org/revenuerecognition.
In this guide, revenue recognition implementation issues developed by the insurance revenue recognition task force are directly referenced from the insurance entities chapter in the AICPA Audit and Accounting Guide Revenue
Recognition.

AAG-PLI

Table of Contents

xvii

TABLE OF CONTENTS
Chapter

Paragraph

Nature, Conduct, and Regulation of the Business
.01-.113
General Nature of the Business . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
.01-.03
Kinds of Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
.04-.08
Legal Forms of Organization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
.09
Methods of Producing Business . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
.10-.17
Major Transaction Cycles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
.18-.41
Underwriting of Risks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
.18-.27
Pooling, Captives, and Syndicates . . . . . . . . . . . . . . . . . . . . . . . .
.28-.30
Processing and Payment of Claims . . . . . . . . . . . . . . . . . . . . . . . .
.31-.32
Investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
.33-.36
Deﬁnition of Public Business Entity . . . . . . . . . . . . . . . . . . . . . . . . .
.37-.41
Revenue Recognition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
.42
Accounting Practices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .43-.113
State Insurance Regulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
.43-.51
National Association of Insurance Commissioners . . . . . . . . .
.52-.53
Federal Regulation — Securities and Exchange
Commission . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
.54-.59
Federal Regulation — The Dodd-Frank Wall Street
Reform and Consumer Protection Act . . . . . . . . . . . . . . . . . . .
.60-.70
Federal Regulation — Terrorism . . . . . . . . . . . . . . . . . . . . . . . . . . .
.71-.75
Industry Associations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
.76
Statutory Accounting Practices . . . . . . . . . . . . . . . . . . . . . . . . . . . .
.77-.104
Generally Accepted Accounting Principles . . . . . . . . . . . . . . . . . .105-.112
Comparison of SAP and GAAP . . . . . . . . . . . . . . . . . . . . . . . . . . .
.113

Audit Considerations
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Scope of the Audit Engagement . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
General Considerations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Integrated Audit of Financial Statements and Internal
Control Over Financial Reporting . . . . . . . . . . . . . . . . . . . . . .
Additional PCAOB Audit Standards . . . . . . . . . . . . . . . . . . . . . . .
Planning and Other Auditing Considerations . . . . . . . . . . . . . . . .
Audit Planning . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Audit Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Risk Assessment Procedures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Understanding the Entity, Its Environment, and Its Internal
Control . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Common Industry Ratios and Performance Metrics . . . . . . . . .
Identifying and Assessing the Risks of Material
Misstatement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

.01-.188
.01
.02-.15
.02-.04
.05-.10
.11-.15
.16-.75
.17-.18
.19-.23
.24-.29
.30-.49
.50-.62
.63-.66

Contents

xviii

Table of Contents

Chapter
2

Contents

Paragraph
Audit Considerations — continued
Performing Audit Procedures in Response to Assessed
Risks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Use of Assertions in Obtaining Audit Evidence . . . . . . . . . . . .
Other Risk Assessment Activities and Considerations . . . . . . . . .
Planning Materiality . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Performance Materiality and Tolerable Misstatement . . . . . . .
Consideration of Fraud in a Financial Statement Audit . . . . . . .
Insurance Industry — Fraud Risk Factors . . . . . . . . . . . . . . . . . . . . .
The Importance of Exercising Professional Skepticism . . . . . .
Discussion Among Engagement Personnel Regarding the
Risks of Material Misstatement Due to Fraud . . . . . . . . . . . .
Obtaining the Information Needed to Identify the Risks of
Material Misstatement Due to Fraud . . . . . . . . . . . . . . . . . . . .
Identifying Risks That May Result in a Material
Misstatement Due to Fraud . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Assessing the Identiﬁed Risks After Taking an Evaluation
of the Entity’s Programs and Controls That Address the
Risks Into Account . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Responding to the Results of the Assessment . . . . . . . . . . . . . . .
Evaluating Audit Evidence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Responding to Misstatements That May Be the Result of
Fraud . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Communicating About Possible Fraud to Management,
Those Charged With Governance, and Others . . . . . . . . .
Documentation and Guidance . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Use of Information Technology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Going Concern Considerations . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Evaluating Misstatements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Audit Documentation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Consideration of the Work of Internal Auditors . . . . . . . . . . . .
Communication of Matters Related to Internal Control . . . . . . . .
Identiﬁcation of Deﬁciencies in Internal Control . . . . . . . . . . . .
Communication of Deﬁciencies in Internal Control . . . . . . . . .
Communication of Other Matters With Those Charged With
Governance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Matters to Be Communicated . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Communications by Successor Auditors . . . . . . . . . . . . . . . . . . . . . .
Auditor Independence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Auditing Fair Value Measurements and Disclosures . . . . . . . . . .
Considerations for Auditors to Comply With the NAIC
Model Audit Rule . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Awareness . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Change in Auditor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Auditor’s Letter of Qualiﬁcations . . . . . . . . . . . . . . . . . . . . . . . . . .
Qualiﬁcations of the Auditor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

.67-.73
.74-.75
.76-.80
.76-.78
.79-.80
.81-.82
.83-.105
.85
.86-.89
.90-.91
.92-.96

.97-.98
.99
.100
.101-.102
.103-.104
.105
.106-.109
.110-.118
.119-.122
.123-.131
.130-.131
.132-.139
.133-.134
.135-.139
.140-.144
.142-.144
.145
.146-.147
.148-.150
.151-.172
.152-.153
.154
.155
.156

Table of Contents

Chapter
2

xix
Paragraph

Audit Considerations — continued
Indemniﬁcation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Partner Rotation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Prohibited Services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Consideration of Internal Controls in a Financial Statement
Audit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Notiﬁcation of Adverse Financial Condition . . . . . . . . . . . . . . .
Report on Internal Controls . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Working Papers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Communications to Audit Committees . . . . . . . . . . . . . . . . . . . . .
Management’s Report on Internal Controls Over Financial
Reporting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Auditor’s Consideration of State Regulatory Examinations . . . .
Auditor’s Consideration of Permitted Statutory Accounting
Practices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
SEC Requirements for Management’s Report on Internal
Control Over Financial Reporting . . . . . . . . . . . . . . . . . . . . . . . .
Premiums
Background . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Types of Premiums Adjustments . . . . . . . . . . . . . . . . . . . . . . . . . . .
Summary of Premium Transaction Flow . . . . . . . . . . . . . . . . . . . .
Involuntary Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Accounting for Premiums and Acquisition Cost . . . . . . . . . . . . . . .
Premium Revenue and Premium Adjustments . . . . . . . . . . . . . . .
Premium Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Acquisition Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Premium Deﬁciencies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Medicare Part D . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Accounting for Contracts That Do Not Transfer Insurance
Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Disclosure Considerations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Auditing Premiums and Acquisition Costs . . . . . . . . . . . . . . . . . . . .
Audit Planning . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Consideration of Fraud in a Financial Statement Audit . . . . .
Audit Risk Factors — Premiums and DAC . . . . . . . . . . . . . . . . . .
Management Estimates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Risk of Material Misstatement — Inherent Risk Factors . . . . .
Internal Control . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Control Environment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Risk Assessment Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Control Activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Audit Procedures Responsive to the Assessed Risks of
Material Misstatement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Audit Consideration Chart . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

.157
.158
.159-.161
.162
.163-.164
.165-.167
.168
.169
.170-.172
.173-.177
.178-.182
.183-.188
.01-.132
.01-.29
.04
.05-.26
.27-.29
.30-.110
.30-.49
.50-.55
.56-.83
.84-.97
.98-.102
.103-.104
.105-.110
.111-.132
.111
.112
.113-.116
.117-.119
.120-.121
.122-.124
.125-.126
.127-.128
.129
.130-.131
.132

Contents

Table of Contents

Chapter
4

Contents

Paragraph
The Loss Reserving and Claims Cycle
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Types of Businesses and Their Effect on the Estimation
Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Policy Duration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Type of Coverage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Kind of Insurance Underwritten: Line of Business or
Type of Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
The Transaction Cycle . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Claim Acceptance and Processing . . . . . . . . . . . . . . . . . . . . . . . .
Claim Adjustment and Estimation . . . . . . . . . . . . . . . . . . . . . . . . .
Claim Settlement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Reinsurance Recoverable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Salvage and Subrogation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Components of Loss Reserves . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Estimating Methods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Illustrative Projection Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
LAE Reserves . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
DCC Reserve Calculation Approaches . . . . . . . . . . . . . . . . . . . .
AO Reserve Calculation Approaches . . . . . . . . . . . . . . . . . . . . . .
Changes in the Environment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Critical Accounting Policies and Estimates Disclosure . . . . . . . . .
Use of Specialists by Management in Determining Loss
Reserves . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Guaranty Fund and Other Assessments . . . . . . . . . . . . . . . . . . . . . .
Accounting Principles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
GAAP Accounting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Discounting Loss Reserves . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Structured Settlements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Reinsurance Recoverables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Liability for Unpaid Claims and Claim Adjustment
Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Statutory Accounting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Disclosures of Certain Matters in the Financial Statements
of Insurance Enterprises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Applicability to Statutory Financial Statements . . . . . . . . . . . . .
Relationship to Other Pronouncements . . . . . . . . . . . . . . . . . . . . .
Auditing Loss Reserves . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Planning Considerations — Overview . . . . . . . . . . . . . . . . . . . . .
Consideration of Fraud in a Financial Statement Audit . . . . .
Risk of Material Misstatement — Inherent Risk Factors . . . . .
Internal Control . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Control Environment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
The Entity’s Risk Assessment Process . . . . . . . . . . . . . . . . . . . . . . .
Information Systems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

.01-.204
.01-.02
.03-.14
.04
.05
.06-.14
.15-.32
.16-.18
.19-.24
.25-.28
.29-.30
.31-.32
.33
.34-.53
.44-.53
.54-.62
.56-.59
.60-.62
.63-.66
.67-.68
.69-.71
.72
.73-.95
.73-.74
.75-.82
.83-.85
.86
.87-.88
.89-.95
.96-.112
.96
.97-.112
.113-.204
.113-.118
.119-.121
.122
.123-.125
.126
.127-.128
.129

Table of Contents

Chapter
4

xxi
Paragraph

The Loss Reserving and Claims Cycle — continued
Control Activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Identifying and Assessing the Risks of Material
Misstatement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Audit Procedures Responsive to the Assessed Risks of
Material Misstatement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Use of Loss Reserve Specialists . . . . . . . . . . . . . . . . . . . . . . . . . . .
Loss Reserve Specialists Engaged by the Auditor . . . . . . . . . .
Use of Management Specialists by Auditors in Evaluating
Loss Reserves . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Auditor’s Response to Management’s Use or Non-Use of a
Loss Reserve Specialist . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Evaluating the Reasonableness of the Estimates . . . . . . . . . . . .
Analytical Procedures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Testing the Data, Assumptions, and Selection of the
Estimate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Auditing the Underlying Data Used in the Loss Reserving
Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Develop a Point Estimate or Range to Evaluate
Management’s Estimate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Loss Reserve Ranges . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Factors That Could Affect a Range of Reasonably Possible
Outcomes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Evaluating the Financial Effect of a Reserve Range . . . . . . . . .
Auditor Uncertainty About the Reasonableness of
Management’s Estimate and Reporting Implications . . . . .
Evaluating the Reasonableness of Loss Adjustment Expense
Reserves . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Ceded Reinsurance Recoverable . . . . . . . . . . . . . . . . . . . . . . . . . .
Understanding the Impacts of Foreign Exchange . . . . . . . . . . .
Audit Consideration Chart . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Investments and Fair Value Considerations
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Investment Evaluation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Recordkeeping and Key Performance Indicators . . . . . . . . . . .
The Transaction Cycle . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Safekeeping . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Regulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Statutory Limitations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
FASB Accounting Standards Codiﬁcation 820 and 825 . . . . . .
Deﬁnition of Fair Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Application to Liabilities and Instruments Classiﬁed in a
Reporting Entity’s Shareholders’ Equity . . . . . . . . . . . . . . . . .
The Fair Value Hierarchy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Fair Value Determination When the Volume or Level of
Activity Has Signiﬁcantly Decreased . . . . . . . . . . . . . . . . . . .

.130-.131
.132
.133-.141
.142
.143-.145
.146-.148
.149
.150
.151-.156
.157-.161
.162-.167
.168-.169
.170-.176
.177-.183
.184-.192
.193-.194
.195-.196
.197-.202
.203
.204
.01-.251
.01-.08
.01
.02-.03
.04-.05
.06-.07
.08
.09-.14
.10-.14
.15-.40
.16-.22
.23-.25
.26-.30
.31-.33

Contents

xxii

Table of Contents

Chapter
5

Contents

Paragraph
Investments and Fair Value Considerations — continued
Disclosures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Fair Value Option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Statutory Accounting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Accounting Practices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Signiﬁcant Differences Between GAAP and Statutory
Accounting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Cash and Cash Equivalents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Debt and Equity Securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Mortgage Loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Troubled Debt Restructurings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Real Estate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Derivatives, Including Futures, Options, and Similar
Financial Instruments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Joint Ventures and Partnerships . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Investments in SCA Entities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Investment Income Due and Accrued . . . . . . . . . . . . . . . . . . . . . .
Asset Transfers and Extinguishments of Liabilities . . . . . . . . . .
Repurchase Agreements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Securities Lending . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Other Information . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Auditing Investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Audit Planning . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Consideration of Fraud in a Financial Statement Audit . . . . .
Audit Risk Factors — Investments . . . . . . . . . . . . . . . . . . . . . . . . . .
Risk of Material Misstatement — Inherent Risk . . . . . . . . . . . . .
Internal Control . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Control Environment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Risk Assessment Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Information System . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Control Activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Service Organizations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Audit Procedures Responsive to the Assessed Risks of
Material Misstatement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Group Audit Considerations for Investments in Alternative
Investments and Subsidiary, Controlled and Afﬁliated
Entities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Audit Consideration Chart and Procedures . . . . . . . . . . . . . . . .
Reinsurance
Types of Reinsurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Reinsurance Contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Bases of Reinsurance Transactions . . . . . . . . . . . . . . . . . . . . . . . .
Frequently Used Terms in Reinsurance Contracts . . . . . . . . . . .
Accounting Practices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

.34-.35
.36-.38
.39-.40
.41-.224
.42
.43-.50
.51-.99
.100-.114
.115-.123
.124-.134
.135-.149
.150-.166
.167-.182
.183-.188
.189-.202
.203-.215
.216-.223
.224
.225-.251
.225
.226
.227-.230
.231-.233
.234-.236
.237
.238-.239
.240-.241
.242
.243-.246
.247-.248

.249
.250-.251
.01-.119
.07-.08
.09-.19
.15-.18
.19
.20-.81

Table of Contents

Chapter
6

xxiii
Paragraph

Reinsurance — continued
Generally Accepted Accounting Principles Accounting
Practices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Statutory Accounting Principles . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Special Risk Considerations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Auditing Reinsurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Audit Planning . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Consideration of Fraud in a Financial Statement Audit . . . . .
Audit Risk Factors — Reinsurance . . . . . . . . . . . . . . . . . . . . . . . . .
Risk of Material Misstatement — Inherent Risk . . . . . . . . . . . . .
Internal Control . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Control Environment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Risk Assessment Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Information and Communication . . . . . . . . . . . . . . . . . . . . . . . . . .
Control Activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Audit Procedures Responsive to the Assessed Risks of
Material Misstatement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Internal Control of the Ceding Entity . . . . . . . . . . . . . . . . . . . . . . .
Internal Control of the Reinsurer . . . . . . . . . . . . . . . . . . . . . . . . . .
Auditing Procedures for the Ceding Entity . . . . . . . . . . . . . . . . .
Auditing Procedures for the Assuming Entity . . . . . . . . . . . . . . .
Pools, Associations, and Syndicates . . . . . . . . . . . . . . . . . . . . . . .
Reinsurance Intermediaries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Audit Consideration Chart . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Income Taxes
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
GAAP Accounting for Income Taxes . . . . . . . . . . . . . . . . . . . . . . . . .
Basic Principles of GAAP Accounting for Income Taxes . . . .
Disclosure Requirements Contained in GAAP Literature . . . .
Statutory Accounting for Income Taxes . . . . . . . . . . . . . . . . . . . . . . .
Disclosure Requirements Contained in Statutory
Literature . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Changes in Tax Law . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Auditing Income Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Audit Planning . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Consideration of Fraud in a Financial Statement Audit . . . . .
Audit Risk Factors — Income Taxes . . . . . . . . . . . . . . . . . . . . . . .
Risk of Material Misstatement — Inherent Risk . . . . . . . . . . . .
Internal Control . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Control Environment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Risk Assessment Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Control Activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Audit Procedures Responsive to the Assessed Risks of
Material Misstatement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Audit Consideration Chart . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

.20-.75
.76-.81
.82-.86
.87-.119
.87
.88
.89-.91
.92
.93-.94
.95
.96-.97
.98-.99
.100
.101-.102
.103-.104
.105-.106
.107-.109
.110-.113
.114
.115-.118
.119
.01-.67
.01-.02
.03-.42
.05-.26
.27-.42
.43-.51
.51
.52
.53-.67
.53
.54
.55-.57
.58
.59-.60
.61
.62-.63
.64
.65-.66
.67

Contents

xxiv
Chapter
8

Contents

Table of Contents

Insurance-Related Expenses, Taxes, and Assessments
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Premium and State Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Guaranty Fund and Other Assessments . . . . . . . . . . . . . . . . . . . . . .
Generally Accepted Accounting Principles . . . . . . . . . . . . . . . . .
Statutory Accounting Principles . . . . . . . . . . . . . . . . . . . . . . . . . . . .
The Patient Protection and Affordable Care Act . . . . . . . . . . . .
Capitalized Costs and Certain Nonadmitted Assets . . . . . . . . . .
Pensions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Audit Considerations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Audit Planning . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Consideration of Fraud in a Financial Statement Audit . . . . .
Audit Risk Factors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Internal Control . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Audit Procedures Responsive to the Assessed Risks
of Material Misstatement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Paragraph
.01-.93
.01-.05
.06-.12
.13-.66
.19-.22
.23-.30
.31-.66
.67-.71
.72-.75
.76-.93
.76
.77
.78-.80
.81-.83
.84-.93

Captive Insurance Entities
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Types of Captive Organizations . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Captive Operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Speciﬁc Transaction Considerations and Accounting
Principles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Audit Considerations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Audit Planning . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Consideration of Fraud in a Financial Statement Audit . . . . .
Audit Risk Factors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Internal Control . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Audit Procedures Responsive to the Assessed Risks of
Material Misstatement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

.01-.41
.01-.06
.07-.26
.27-.29

Reports on Audited Financial Statements
Reports on Financial Statements . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Unmodiﬁed Opinions on GAAP Financial Statements . . . . . . . .
Modiﬁed Opinions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Qualiﬁed Opinion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Disclaimer of Opinion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Adverse Opinion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Emphasis-of-Matter Paragraphs . . . . . . . . . . . . . . . . . . . . . . . . . . .
Evaluating Consistency of Financial Statements . . . . . . . . . . . .
Additional Guidance When Performing Integrated Audits
of Financial Statements and Internal Control Over
Financial Reporting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Integrated Audits Performed in Accordance With GAAS . . .

.01-.82
.01-.02
.03-.05
.06-.26
.10-.11
.12-.14
.15-.17
.18-.25
.26

.30-.33
.33
.34-.41
.34
.35
.36-.38
.39-.40
.41

.27-.31
.27

Table of Contents

Chapter
10

xxv
Paragraph

Reports on Audited Financial Statements — continued
Considerations for Audits Performed in Accordance
With PCAOB Standards . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Reporting on Whether a Previously Reported Material
Weakness Continues to Exist . . . . . . . . . . . . . . . . . . . . . . . . . . .
Auditors’ Reports on Statutory Financial Statements of
Insurance Entities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
NAIC — Codiﬁed Statutory Accounting . . . . . . . . . . . . . . . . . .
Regulatory Basis Financial Statements Intended for
General Use . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Regulatory Basis Financial Statements Intended for
Limited Use . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Regulatory Basis Financial Statements — Other Issues . . . . .
Correction of Error . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Correction of an Error — Regulatory Basis Financial
Statements Intended for General Use . . . . . . . . . . . . . . . . . . .
Correction of an Error — Regulatory Basis Financial
Statements Intended for Limited Use . . . . . . . . . . . . . . . . . . . .
Opinion on Supplemental Schedules . . . . . . . . . . . . . . . . . . . . . . . .
Other Reports . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Accountant’s Awareness Letter . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Change in Auditor Letter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Notiﬁcation of Adverse Financial Condition Letter . . . . . . . . .
Auditor Reports for Communicating Unremediated
Material Weaknesses in Internal Control to
Insurance Regulators . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Accountant’s Letter of Qualiﬁcations . . . . . . . . . . . . . . . . . . . . . . .

.28-.30
.31
.32-.51
.33-.35
.36-.40
.41-.45
.46-.51
.52-.57
.56
.57
.58-.64
.65-.82
.66-.68
.69-.72
.73-.76

.77-.80
.81-.82

Appendix
A

Accounting for Financial Instruments

The New Leases Standard: FASB ASC 842

The New Revenue Recognition Standard: FASB ASC 606

Overview of Statements on Quality Control Standards

Property and Liability Insurance Entity Speciﬁc Disclosures

Examples of Development Data

List of Industry Trade and Professional Associations, Publications, and
Information Resources

Schedule of Changes Made to the Text From the Previous Edition

Glossary
Index of Pronouncements and Other Technical Guidance
Subject Index

Contents

Nature, Conduct, and Regulation of the Business

Chapter 1

Nature, Conduct, and Regulation
of the Business

General Nature of the Business
1.01 The primary purpose of the property and liability insurance business
is the spreading of risks. The term risk1 generally has two meanings in insurance — it can mean either a peril insured against (for example, fire is a risk to
which most property is exposed) or a person or property protected (for example,
a home or an automobile). For a payment known as a premium, insurance entities agree to relieve the policyholder of all or part of a risk and to spread the
total cost of similar risks among large groups of policyholders.
1.02 The functions of the property and liability insurance business include marketing, underwriting (that is, determining the acceptability of risks
and the amount of the premiums), billing and collecting premiums, investing and managing assets, investigating and settling claims made under policies, and paying expenses associated with these functions.
1.03 In conducting its business, an insurance entity accumulates a significant amount of investable assets. In addition to funds raised as equity and
funds retained as undistributed earnings, funds accumulate from the following:

r Premiums collected
r Sums held for the payment of claims in the process of investigation, adjustment, or litigation

r Sums held for payment of future claims settlement expenses
The accumulation of these funds, their investment, and the generation of investment income are major activities of insurance entities.

Kinds of Insurance
1.04 Kinds of insurance, generally referred to as lines of insurance, represent the perils that are insured by property and liability insurance entities.
Some of the more major lines of insurance offered by property and liability insurance entities include the following:

r Accident and health covers loss by sickness or accidental bodily

injury. It also includes forms of insurance that provide lump-sum
or periodic payments in the event of loss by sickness or accident,
such as disability income insurance and accidental death and dismemberment insurance.

1 This definition differs from the definition of insurance risk stated in the FASB Accounting
Standards Codification (ASC) glossary, which describes insurance risk as the risk arising from uncertainties about both underwriting risk and timing risk. Actual or imputed investment returns are not
an element of insurance risk. Insurance risk is fortuitous; the possibility of adverse events occurring
is outside the control of the insured. It is the definition in the FASB ASC glossary that determines
the proper accounting when considering risk transfer. See chapter 6, “Reinsurance.”

AAG-PLI 1.04

Property and Liability Insurance Entities

r Automobile covers personal injury or automobile damage sustained by the insured and liability to third parties for losses
caused by the insured.

r Fidelity bonds cover employers against dishonest acts by employees. Blanket fidelity bonds cover groups of employees.

r Fire and allied lines includes coverage for fire, windstorm, hail,
and water damage (but not floods).

r Home insurance provides coverage for damage or destruction of
the policyholder’s home. In some geographical areas, the policy
may exclude certain types of risks, such as flood or earthquake,
and require additional coverage.

r Inland marine covers property being transported other than

transocean. (It also includes floaters, which are policies that cover
movable property, such as a tourist’s personal property.)

r Miscellaneous liability covers most other physical and property
damages not included under workers’ compensation, automobile
liability, and multiple peril policies. Damages include death, cost
of care, and loss of services resulting from bodily injury, as well as
loss of use of property.

r Multiple peril, a package coverage, includes most property and li-

ability coverage except workers’ compensation, automobile insurance, and surety bonds.

r Ocean marine includes coverage for ships and their equipment,
cargos, freight, and liability to third parties for damages.

r Professional liability covers physicians, surgeons, dentists, hospitals, engineers, architects, accountants, attorneys, and other professionals from liability arising from error or misconduct in providing or failing to provide professional service.

r Surety bonds provide for monetary compensation to third parties for failure by the insured to perform specifically covered acts
within a stated period. (Most surety bonds are issued for persons
doing contract construction, persons connected with court actions,
and persons seeking licenses and permits.)

r Workers’ compensation compensates employees for injuries or illness sustained in the course of their employment.
1.05 In addition to these lines, insurance is provided by excess and surplus
lines:

r Excess liability covers the insured against loss in excess of a stated

amount, but only for losses as covered and defined in an underlying policy. The underlying amount is usually insured by another
policy but can be retained by the insured.

r Surplus lines include coverage for risks that do not fit normal un-

derwriting patterns, risks that are not commensurate with standard rates, or risks that will not be written by standard carriers
because of general market conditions. These kinds of policies may
be written by carriers not licensed in the jurisdiction where the
risk is located and generally are not subject to regulations governing premium rates or policy language.

AAG-PLI 1.05

Nature, Conduct, and Regulation of the Business

1.06 The lines and premium volume that may be written by an entity are
generally restricted by state insurance regulations. States also use risk-based
capital standards for regulating solvency and capacity and also monitor the
amount of premium written as a ratio of the entity’s surplus.
1.07 Insurance written by property and liability insurance entities may
be broadly classified as personal lines, which consist of insurance policies issued to individuals, and commercial lines, which consist of policies issued to
business enterprises. Personal lines generally consist of large numbers of relatively standard policies with relatively small premiums per policy. Examples
are homeowner and individual automobile policies. Commercial lines involve
policies with relatively large premiums that may also be retroactively adjusted
based on claims experience. The initial premium is often only an estimate because it may be related to payroll or other variables. Examples are workers’
compensation and general liability. Many large insurance entities have separate accounting, underwriting, and claim-processing procedures for these two
categories.
1.08 Insurance is generally available to the individual as a means of protection against loss. There are instances, however, in which a person cannot
obtain insurance in the voluntary insurance market. States have established
programs to provide insurance to those with high risks who otherwise would be
excluded from obtaining coverage. The following are some of the more common
programs that provide the necessary coverage:

r Involuntary automobile insurance. States have a variety of meth-

ods for apportioning involuntary automobile insurance. The most
widely used approach is the Automobile Insurance Plan (formerly
called the Assigned Risk Plan). Under this plan, all entities writing automobile insurance in a state are allocated a share of the
involuntary business on an equitable basis. Each automobile insurer operating in the state accepts a share of the undesirable
drivers, based on the percent of the state’s total auto insurance
that it writes. For example, an entity that writes 5 percent of the
voluntary business in a state may be assigned 5 percent of the involuntary applicants. It is then responsible for collecting the premiums and paying the claims on the policies issued to these applicants. Other states use a reinsurance plan under which each
insurer accepts all applicants but may place high-risk drivers in
a reinsurance pool, with premiums paid to and losses absorbed
by the pool. Still another approach is a joint underwriting association, in which one or more servicing entities are designated to
handle high-risk drivers. States may require insurers to participate in the underwriting results.

r Fair Access to Insurance Requirements (FAIR) plans. FAIR plans

are state-supervised programs established to provide coverage for
property in high-risk areas. Entities that operate in the state are
required to participate in the premiums, losses, expenses, and
other operations of the FAIR plan.

r Medical malpractice pools. These pools were established when

healthcare professionals and institutions were experiencing difficulty in obtaining liability insurance in the voluntary insurance
market. The pools were established by law and currently exist
in the majority of states. All insurers writing related liability

AAG-PLI 1.08

Property and Liability Insurance Entities

insurance in such states are considered mandatory participants
in the pools as a condition for their continuing authority to transact business in such states.

r Workers’ compensation pools. These pools are similar to FAIR

plans. As with FAIR plans, companies operating in a given state
are assessed a proportionate share, based on direct writings, of the
underwriting results of the pool.

Legal Forms of Organization
1.09 The principal kinds of property and liability insurance organizations
are
a. stock companies, which are corporations organized for profit with
ownership and control of operations vested in the stockholders.
Generally, the stockholders are not liable in case of bankruptcy or
impairment of capital.
b. mutual companies, which are organizations in which the ownership
and control of operations are vested in the policyholders. On the expiration of their policies, policyholders lose their rights and interests in the entity. Many states require the net assets of a mutual
insurance entity in liquidation to be distributed among the current
policyholders of the entity, and the prior policyholders have no claim
against the assets. Most major mutual entities issue nonassessable
policies as provided under state laws. If a mutual entity is not qualified to issue such policies, however, each policyholder is liable for
an assessment equal to at least one annual premium in the event of
bankruptcy or impairment of minimum equity requirements. Many
mutual insurance entities are seeking enhanced financial flexibility
and access to capital to support long-term growth and other strategic initiatives. Because of many economic and regulatory factors,
as well as increased competition, some mutual insurance entities
have chosen to demutualize or to form mutual insurance holding
entities.
c. reciprocal or interinsurance exchanges, which are composed of a
group of persons, firms, or corporations, commonly termed subscribers, who exchange contracts of insurance through the medium
of an attorney-in-fact. Each subscriber executes an identical agreement empowering the attorney-in-fact to assume, on the subscriber’s behalf, an underwriting liability on policies covering the
risks of the other subscribers. The subscriber assumes no liability
as an underwriter on policies covering his or her own risk; the subscriber’s liability is limited by the terms of the subscriber’s agreement. Customarily, the attorney-in-fact is paid a percentage of premium income, from which he or she pays most operating expenses,
but some exchanges pay his or her own operating expenses and
compensate the attorney-in-fact at a lower percentage of premiums
or by some other method.
d. public entity risk pools, which are cooperative groups of governmental entities joining together to finance exposures, liabilities, or risks.
Risk may include property and liability, workers’ compensation, employee health care, and so forth. A pool may be a stand-alone entity

AAG-PLI 1.09

Nature, Conduct, and Regulation of the Business

or be included as part of a larger governmental entity that acts as
the pool’s sponsor. Stand-alone pools are sometimes organized or
sponsored by municipal leagues, school associations, or other kinds
of associations of governmental entities. A stand-alone pool is frequently operated by a board that has as its membership one member from each participating government. It typically has no publicly
elected officials or power to tax. Public entity risk pools normally
should be distinguished from private pools, which are organized
under the Risk Retention Act of 1986. These private pools, or risk
retention groups, can provide only liability coverage, whereas public entity risk pools organized under individual state statutes can
provide several kinds of coverage. The four basic kinds of public
entity risk pools are
i. risk-sharing pools, which are arrangements by which governments pool risks and funds and share in the cost of
losses.
ii. insurance-purchasing pools, which are arrangements by
which governments pool funds or resources to purchase
commercial insurance products. These arrangements are
also called risk-purchasing groups.
iii. banking pools, which are arrangements by which money is
made available for pool members in the event of loss on a
loan basis.
iv. claims-servicing or account pools, which are arrangements
by which pools manage separate accounts for each pool
member from which the losses of that member are paid.
A pool can serve one or several of those functions. Pools that act only
as banking or claims-servicing pools do not represent transfer of risk.
Those pools are not considered insurers and do not need to report as
such.
e. private pools. Because of the unavailability and unaffordability of
commercial liability insurance, Congress enacted the Risk Retention Act of 1986. This act allows the organization of private pools
for the purpose of obtaining general liability insurance coverage.
Two basic types of private pools are allowed:
i. Risk retention groups. An insurance entity formed by the
members of the private pool primarily to provide commercial liability insurance to the members.
ii. Purchasing groups. Members of a private pool purchase
commercial liability insurance on a group basis.

Methods of Producing Business
1.10 The marketing department of an insurance entity is responsible for
sales promotion, supervision of the agency or sales force, and sales training.
Property and liability insurance entities may produce business through a network of agents (agency companies) or through an employee sales force (direct
writing companies), or they may acquire business through insurance brokers
or through direct solicitation. A combination of methods may also be used. The

AAG-PLI 1.10

Property and Liability Insurance Entities

distinctions among an agent, a broker, and a salesperson are based on their
relationships with the insurance entity.
1.11 Agents. Insurance agents act as independent contractors who represent one insurance entity (exclusive agents) or more than one entity (independent agents) with express authority to act for the entity in dealing with
insureds.
1.12 General agents have exclusive territories in which to produce business. They agree to promote the entity’s interest, pay their own expenses, maintain a satisfactory agency force, and secure subagents. They may perform a significant portion of the underwriting. They may also perform other services in
connection with the issuance of policies and the adjustment of claims, including
negotiating reinsurance on behalf of the insurer, which neither local agents nor
brokers are authorized or expected to do.
1.13 Local and regional agents are authorized to underwrite and issue
policies but are not usually given exclusive territories. They usually report either to entity branch offices or directly to the entity’s home offices. Agents are
generally compensated by commissions based on percentages of the premiums
they produce. Because of their greater authority and duties, general agents
usually receive higher percentages than local or regional agents.
1.14 Agents have the power to bind the entity, which means that the insurance is effective immediately, regardless of whether money is received or a
policy is issued. Generally, agents are considered to have vested rights in the
renewal of policies sold for insurance entities. The entity cannot, however, compel independent agents to renew policies, and the agents may place renewals
with other entities.
1.15 Brokers. Insurance brokers represent the insured. As a result, brokers do not have the power to bind the entity. Brokers solicit business and submit it for acceptance or rejection with one or more insurance entities. Brokers
may submit business directly to an entity, through general or local agents, or
through other brokers. Brokers are compensated by commissions paid by insurance entities, normally percentages of the premiums on policies placed with the
entities, or through fees paid by the insured. Some large brokers have fee agreements, wherein commissions are either not accepted from the respective insurer
or commissions received from the insurer by the broker are offset against the
fees to be paid by the insured.
1.16 Direct writing. Direct writing entities sell policies directly to the public, usually through salespeople or Internet sales, thus bypassing agents and
brokers. Direct writing may be done from the entity’s home office or through
branch sales offices. Underwriting and policy issuance may also be done from
the home office or branches. The salespeople may be paid commissions, straight
salaries, or a commission incentive with a base salary. Salespeople generally
have the power to bind the entity; however, the entity retains the right to cancel the policy, generally for up to 60 days.
1.17 Direct response advertising or mass marketing is also used for producing business. This results in sales to many people simultaneously, with single programs to insure a number of people or businesses. Such methods use
direct billing techniques that may also permit individuals to pay premiums by
salary deductions, credit cards, or as a direct draft against a checking account.

AAG-PLI 1.11

Nature, Conduct, and Regulation of the Business

Major Transaction Cycles
Underwriting of Risks
1.18 Underwriting includes evaluating the acceptability of the risk, determining the premium, and evaluating the entity’s capacity to assume the entire
risk.
1.19 Evaluating risks. Evaluating risks and their acceptance or rejection
involves (a) a review of exposure and potential loss based on both the review
of policies, past claims experience, and the endorsements to existing policies
and (b) an investigation of risks in accordance with procedures established by
entity policy and state statutes. For example, applicants for automobile insurance may be checked by reference to reports on driving records issued by a state
department of motor vehicles. A commercial enterprise wanting to purchase
property insurance coverage may need to provide certain types of information
when applying for coverage, for example, claims history, an engineering survey,
a fire hazard survey, or similar investigations. In addition, an entity’s underwriting policy may establish certain predetermined criteria for accepting risks.
Such criteria often specify the lines of insurance that will be written as well as
prohibited exposures, the amount of coverage to be permitted on various kinds
of exposure, the areas of the country in which each line will be written, and
similar restrictions.
1.20 Setting premium rates. Establishing prices for insurance coverage is
known as the rate-making process, and the resultant rates that are applied to
some measure of exposure (for example, payroll or number of cars) are referred
to as premiums. Determining premiums is one of the most difficult tasks in
the insurance business. The total amount of claims is not known at the time
the insurance policies are issued and, for many liability policies, is not known
until years later. Determining proper premium rates is further complicated by
the fact that no two insurable risks are exactly alike. The intensity of competition among hundreds of property and liability insurance entities in the United
States is also significant in setting premiums.
1.21 Premium rates may be established by one of three methods:
a. Manual rating, which results in standard rates for large groups of
similar risks and is used, for example, in many personal lines such
as automobile insurance
b. Judgment rating, which depends on the skill and experience of the
rate-maker and, generally, is used for large or unusual risks such
as ocean marine insurance
c. Merit rating, which begins with an assumed standard or “manual”
rate that is adjusted based on an evaluation of the risk or the insured’s experience in past or current periods and is used in many
commercial lines such as workers’ compensation
1.22 The transaction cycle for premiums is described in detail in chapter
3, “Premiums.”
1.23 Reinsurance. Insurance entities collect amounts from many risks
subject to insurable hazards; it is expected that these amounts will be sufficient
in the aggregate to pay all losses sustained by the risks in the group. To do so,

AAG-PLI 1.23

Property and Liability Insurance Entities

the number of risks insured needs to be large enough for the law of averages
to operate.2 However, insurance entities are often offered, or may be compelled
to accept, insurance of a class for which they do not have enough volume in the
aggregate to permit the law of averages to operate. Further, entities often write
policies on risks for amounts beyond their financial capacities to absorb. An entity also may write a heavy concentration of policies in one geographic area that
exposes the entity to catastrophes beyond its financial capabilities. Ordinarily,
all or part of such risks are passed on to other insurance or reinsurance entities.
1.24 Spreading of risks among insurance entities is called reinsurance.
The entity transferring the risk is called the ceding entity and the entity to
which the risk is transferred is called the assuming entity, or the reinsurer. Although a ceding entity may transfer its risk to another entity through reinsurance, it does not discharge its primary liability to its policyholders. The ceding
entity remains liable for claims under the policy; however, through reinsurance, the ceding entity reduces its maximum exposure in the event of loss by
obtaining the right to reimbursement from the assuming entity for the reinsured portion of the loss. The ceding entity is also exposed to the possibility
that the reinsurer will not be able to reimburse the ceding entity.
1.25 The term portfolio reinsurance is applied to the sale of all or a block
of an entity’s insurance in force to another entity. This kind of reinsurance is
frequently used when an entity wishes to withdraw from a particular line, territory, or agency. In portfolio reinsurance, the assuming entity generally undertakes responsibility for servicing the policies — collecting the premiums, settling the claims, and so on — and the policyholder subsequently deals directly
with the assuming entity.
1.26 Fronting. Fronting is a form of an indemnity reinsurance arrangement between two or more insurers whereby the fronting entity will issue contracts and then cede all or substantially all of the risk through a reinsurance
agreement to the other insurer(s) (the fronted entity) for a ceding commission.
Such arrangements must comply with any regulatory requirements applicable
to fronting to ensure avoidance of any illegal acts. As with other reinsurance
contracts, the fronting entity remains primarily liable on the insurance contract with the insured. Fronting arrangements usually are initiated by fronted
companies that are not authorized to write insurance in particular states.
1.27 The principal kinds of reinsurance agreements and the mechanics of
reinsurance are discussed in detail in chapter 6, “Reinsurance.”

Pooling, Captives, and Syndicates
1.28 Pooling. The term pooling is often used to describe the practice of
sharing all, or portions of, business of an affiliated group of insurance entities among the members of the group. Each premium written by the affiliated
companies is customarily ceded to one entity; after allowing for any business
reinsured outside the group, the premiums are in turn ceded back in agreedupon ratios. Claims, claim adjustment expenses, commissions, and other underwriting and operating expenses are similarly apportioned. Each member of the
group shares pro rata in the total business of the group, and all achieve similar
underwriting results. Another kind of pooling involving sharing of risks among
governmental entities is discussed in paragraph 1.09d.
2 That is, the statistical tendency of expected losses over a large population of risks.

AAG-PLI 1.24

Nature, Conduct, and Regulation of the Business

1.29 Underwriting pools, associations, and syndicates. Underwriting pools,
associations, or syndicates are formed by several independent entities or groups
of entities in joint ventures to underwrite specialized kinds of insurance or to
write in specialized areas. These groups are often operated as separate organizations having distinctive names and their own staff of employees. The pools,
associations, or syndicates may issue individual or syndicate policies on behalf
of the member entities, which share in all such policies in accordance with an
agreement, or policies may be issued directly by the member entities and then
reinsured among the members in accordance with the agreement. The agreement stipulates the group’s manner of operation and the sharing of premiums,
claims, and expenses. Such groups customarily handle all functions in connection with the specialized business that would otherwise have to be handled by
specific departments in each of the member companies. This kind of arrangement usually is more economical in handling the business for the members.
1.30 Captives. Noninsurance businesses3 try to use various methods to
minimize their cost of insurance. Other than retaining the risk (that is, selfinsurance), perhaps the most conventional method is the use of captive insurers. Captive insurers may be wholly owned subsidiaries or organized by a group
of entities created to provide insurance to those entities. Captives were originally formed because no tax deductions are allowed if risks are not transferred,
whereas premiums paid to insurers are tax deductible. Captives domiciled in
the United States continue to expand as states continue to pass legislation to
facilitate the formation of domestic captives. The growth in the capital that captives control is also on the rise. Captives are discussed in detail in chapter 9,
“Captive Insurance Entities.”

Processing and Payment of Claims
1.31 An insurance entity’s claim department accepts, investigates, adjusts, and settles claims. Although specific procedures vary from entity to entity,
a common pattern exists to the flow of transactions through the claims cycle,
which consists of the following major functions: claim acceptance and processing, claim adjustment and estimation, and claim settlement.
1.32 The transaction cycle for claims, including a claims process flowchart,
is discussed in more detail in chapter 4, “The Loss Reserving and Claims Cycle.”

Investments
1.33 A property and liability insurance entity collects funds from those
who desire protection from insured losses and disburses funds to those who incur such losses. During the time between receiving premiums and the payment
of losses, the entity invests the funds. These investments consist …
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