Commercial Insurance


Insurers in all states are required to use a special accounting system when filing annual financial reports with state regulators.  This system is known as statutory accounting principles (SAP). SAP accounting is more conservative than generally accepted accounting principles (GAAP), as defined by the Financial Accounting Standards Board, and is designed to ensure that insurers have sufficient capital and surplus to cover all anticipated insurance-related obligations. The two systems differ principally in matters of timing of expenses, tax accounting, the treatment of capital gains and accounting for surplus. Simply put, SAP recognizes liabilities earlier or at a higher value and recognizes assets later or at a lower value. GAAP accounting focuses on a business as a going concern, while SAP accounting treats insurers as if they were about to be liquidated. SAP accounting is defined by state law according to uniform codes established by the National Association of Insurance Commissioners. Insurance companies reporting to the Securities and Exchange Commission must maintain and report another set of figures that meet GAAP standards.


Reserves are liabilities.  They reflect an insurer’s financial obligations with respect to the insurance policies it has issued.  An insurer’s two major liabilities are loss reserves and unearned premium reserves.  Loss reserves are an insurance company’s best estimate of what it will pay in the future for claims.  Unearned premium reserves represent the premiums paid for coverage that has not yet been used because the policy has not expired.  If the policy was cancelled by the policyholder, for example, the insurer would have to return the dollar amount of unused coverage.

Loss reserves are generally the largest liability on an insurer’s balance sheet.  When a claim is filed, a reserve is established for payment of that claim.  Property claims are usually clear-cut and are paid soon after a claim is filed.  But with product liability and other so-called long tail coverages, the total harm caused may not be apparent for some time and the ultimate cost of claims may not be known for years, especially in complex cases that are litigated.  In such cases, claims adjusters and actuaries continuously revaluate costs as new information on the claim becomes available and adjust reserves accordingly based on their experience and judgment.  

Companies pay considerable attention to their loss reserves.  Serious under-reserving may cause an insurer to over-estimate its policyholder surplus (see below), making its financial health appear better than it is.

Investments And Investment Income

Insurers have funds available for investment because coverage is generally prepaid --insurers collect premiums in advance of paying claims on the corresponding policies – and because they are required to have a financial cushion to pay an unexpectedly large number of claims after a disaster such as a major hurricane or the 2001 World Trade Center terrorist attack. They also invest funds set aside as loss reserves and unearned premium reserves. 

Insurers’ investment income is made up of two main items: interest, dividends and other investment earnings; and realized capital gains from selling assets.

The insurance industry does not usually generate profits from its underwriting operations.  Investment income generally offsets underwriting losses. 

One measure of the industry’s profitability is the combined ratio, the percentage of the premium dollar spent on claims and expenses.  The combined ratio does not take into account investment income.  A combined ratio over 100 indicates an underwriting loss and a combined ratio under 100 indicates an underwriting profit.  In periods when interest rates are very high, the industry can still make an overall profit even if the combined ratio is higher than 100, especially in long-tail liability lines where claims may take a long time to settle, because losses on its insurance operations can be offset by investment income.  However, when investment income is low during periods of high stock market volatility and very low interest rates, this source of income cannot be relied on to offset underwriting losses.  In such an environment, a combined ratio of 100 no longer guarantees an adequate return and insurance companies must price their products closer to the actual cost of underwriting and adjusting claims. 
Property/casualty insurers hold a large percentage of their investments in the form of bonds, to protect their assets against precipitous stock market declines, and because they can be more easily liquidated to pay claims in a major disaster than real estate and stocks.  About two-thirds of total investments are in bonds, although this figure has dropped from about 70 percent a decade ago, and less than one-fifth are in common stock. The asset quality of the industry’s investments is high. Bonds in or near default (Class 6) accounted for only 0.1 percent of all bonds

Policyholder Surplus

Insurance companies are required to have a minimum level of capital and policyholder surplus before they can open their doors for business and must maintain certain levels relative to the business they assume.   In a stock company, policyholder surplus consists of retained earnings and capital paid in by shareholders.  In mutual companies, it consists of retained earnings and amounts paid by policyholders and others to meet licensing requirements.  

Policyholder surplus is essentially the amount of money remaining after an insurer’s liabilities are subtracted from its assets.  Policyholder surplus is a financial cushion that protects a company’s policyholders in the event of unexpected or catastrophic losses. In other industries it is known as “net worth” or “owners equity.” It is a measure of underwriting capacity because it reflects the financial resources (capital) that stand behind every policy written by the insurer. A weakened surplus can lead to ratings downgrades and ultimately, if the situation is serious enough, to insolvency.

Policyholder surplus is not fungible; in other words it is not transferable from one segment of the industry as a result of improved underwriting or investment performance to another. A large increase in surplus for auto insurers in one state, for example, cannot be used by commercial lines companies to provide coverage to corporations against terrorism attacks in another.

There is no general measure of capital adequacy for property/casualty insurers. Capital adequacy is linked to the riskiness of an insurer’s business.  All other things being equal, an insurance  company underwriting medical device manufacturers needs a larger cushion of capital than a company covering Main Street businesses, for example, because the potential medical malpractice liability losses are likely to be much higher.