What the heck are reserves?  If one does anything with financial statements for life insurance companies, these seem to be a big deal.  Actuaries spend a lot of time computing these.  The insurance regulators, the IRS, and FASB make up a ton of rules about reserves.  Some accountants are frustrated with reserves, as they have an enormous impact on financial statements, but they are shrouded in mystery.

There are two reasons reserves exist:

• To determine how much money to hold now in order to pay benefits in the future.
• To control the timing of profits.

The second reason seems to be the more important reason.  Insurance commissioners, the IRS, and the FASB all want to control the timing of profits in some fashion through reserving practices.  Most companies produce at least three versions of reserves, which results in three income statements.  One of these statements is handed to state insurance commissioners.  A second is handed to the IRS.  The third and final version is used for financial reporting on Wall Street.

There are three sets of books, all perfectly legal. Like all actuarial work, it’s about the future, and the future is not certain.  Different parties have different viewpoints about how to recognize future events.

Regardless of which version is used, the amount of profits over the life a product does not vary, only the timing.  Three parties who want to control the timing of profits are:

• Insurance Commissioners –One of the goals of income statements produced for insurance commissioners is to delay profits.These statements are referred to as Statutory.   Insurance products are dependent upon many assumptions, and insurance commissioners would like to delay profits just in case they are needed later for unexpected results.
• IRS – The IRS of course wants tax money sooner, so their reserve rules work to accelerate profits.
• Financial Accounting Standards Board – The FASB is one of the parties which set reserve calculation rules for publicly listed companies.  These rules are part of US Generally Accepted Accounting Principles (US GAAP).  They appear to want steady state profits.

Surprisingly enough, all of the rules in use tend to delay profits, even those used by the IRS.  Do insurance companies want to manage profits through reserving?  This topic will be discussed at the end.

*** Warning:  This blog is at a high level. It focuses only on traditional life products.   The full set of rules to compute reserves is quite complex.  This blog only explores concepts at a very general level. ***

The Most Basic Definition of Reserves

Life insurance products are generally very long term, with premium and benefit periods stretching out over several years. For example, a person may purchase a 20-year term life product.  This product consists of 20 years of premium payments, with a death benefit which can be paid at any time during that period. With this the most typical, but not the only, method for determining reserves is:

Projected Benefits & Expenses – Projected Premiums, Fees & Investment Income*

On the surface, this all makes sense.  If benefits and expenses are bigger than premiums, fees and investment income, then one needs to set up something on financial statements.  Then to be safe, any insurance company should have assets larger than reserves.

Then again, let’s think about this.  Most insurance products are priced for profitability.  Premium, fees and investment income should be bigger than benefits and expenses when the product is sold.  Basically, reserves would be negative when the product is sold.  They would represent the future profits of the product.  If one would sell something, all the future profits would be recognized on day one.  Yet this is not how it works in practice.

So, what happens?  For most accounting rules, first, one is not allowed to use full premiums in the above equation.  Second, one may put margins on assumptions used to compute projected benefits.  These two items control the timing of profits. Each accounting regime has different rules on how to handle these.

Why does one want to control profits?

1. If one recognizes all of the profits up front, profits will be spent, or given to someone else.  Then if something goes wrong, there is no money to fix things.
2. Recognition of all future profits at the time of sale was one of the things that led to downfall of Enron.  No, Enron was not an insurance company, but the same basic principles would apply.  They would start a project and recognize all of the profits up front.  And if the profits were not realized, they would simply start up another project.  Enron had other problems as well.
3. Most life insurance products are around for several years.  Many would like to have profits distributed over the life of the products.

* Some people like to write this equation as the Present Value of Benefits and Expenses less the Present Value of Premiums.  The present value is determined using an interest discount rate.  The use of an interest discount rate is equivalent to using projected investment income.

Do Insurance Companies Manage Profits Through Reserves?

It may be possible to manage profits through assumption selection.  There is an incentive to managing profits. Short-term bonuses are often based on profits.  Having said this, such management is unlikely, and it will become even more unlikely in the future.

Actuaries are bound by a Professional Code of Conduct, and there is the Actuarial Board for Counseling and Discipline (ABCD) for enforcement.  Reserve calculations statements are reviewed by both regulator and external auditors.  In about 2 years, new US GAAP rules will require a number of new disclosures related to assumption selection.

While the process is not perfect, there are several safeguards to limit abuse.

Last Thoughts

One of the primary purposes of life insurance reserves is to manage the timing of profits.  There are many ways to manage such profits, with the insurance regulators, the IRS, and FASB all having different goals.  The next blog will provide spreadsheet demonstrations on how this works.

Reserving rules change all of the time.  Perhaps the best way to judge such rules is to determine how such rules will impact the timing of future profits.

Do you have ideas for actuarial blogs?  Send ideas to dmxure@gmail.com