The Difference Between Statutory Expense Ratio & GAAP Expense Ratio
Statutory expense ratios are calculated under Statutory Accounting Principles (SAP), which are governed by the National Association of Insurance Commissioners (a nonprofit coalition of state insurance agencies). SAP rules are in place to ensure the proper accounting of expenses in insurance premiums when drafting financial statements. Generally Accepted Accounting Principles (GAAP) differ significantly from SAP, in that SAP requires expenses to be recorded immediately, as opposed to being deferred, as is customary under GAAP.
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Defining Statutory Accounting Principles
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SAP is an insurance industry-centric accounting system, which follows more conservative accounting principles, relative to GAAP, for the purpose of generating financial statements. SAP is dictated by state laws, as well as accounting principles established by the Statutory Accounting Principles Working Group. Whereas GAAP is a recognized accounting system for all businesses and is required under Securities and Exchange Commission regulations for public companies, SAP ensures the solvency of the insurance industry predicated on variations in state insurance regulations across the country.
Defining Statutory Expense Ratios
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Statutory expense ratios are calculated on a different basis from GAAP expense ratios. Under SAP, expense ratio accounting requires the insurance company to expense the cost of product development at the time of the product sale. According to A.M. Best, a top insurance ratings company, the expense ratio is determined by matching underwriting expenses to the period when net premiums were written. Underwriting expenses include commissions to brokers; state and local taxes; salaries; employee benefits; marketing and advertising costs; and other operating costs. The expense ratio (measured as a percentage) measures the insurance company's operational efficiency in managing its book of business, and is calculated by dividing underwriting expenses by net premiums written.
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Defining GAAP Expense Ratios
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The insurance industry is unique from an accounting perspective in that the industry uses both SAP and GAAP. For instance, the loss ratio (the ratio relationship between losses and earned income) is calculated on the same basis under both accounting systems. However, under GAAP, the expense ratio is determined by matching underwriting expenses to the period when net premiums were earned. Hence, the earned premium is a pro rata share of a portion of a premium that is applied to an expired period.
Combining SAP and GAAP Within the Insurance Industry
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Insurance companies operate in a highly regulated industry, at both the state and federal level. Each state has its own laws governing insurance companies and the types of policies it allows. The federal government imposes regulations under the U.S. Constitution's "Commerce Clause," which governs interstate commerce. Furthermore, many insurance companies are no longer "mutual" (owned by policy holders) insurance companies, but rather publicly traded entities. This requires insurance companies to file financial reports to state regulators utilizing SAP, while the SEC requires the companies to file financial reports under GAAP rules.
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References
- National Association of Insurance Commissioners; Statutory Accounting Principles Working Group; September 2011
- Securities and Exchange Commission: Exhibit 99 (A)
- Chubb Corporation: Modification of the Presentation of LossesIncurred in the Property and Casualty Underwriting Results
- United Fire Group: Management's Discussion and Analysis
- A.M. Best: Glossary of Insurance Terms
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