Accounting framework: technical provisions
Whichever method of accounting is used, an insurer will need to make full provision for claims which have not been settled at the date on which the financial statements are finalised. The accounting Regulations (SI2008/410) emphasise a prudent approach - regulation 49 provides that technical provisions must at all times be sufficient to cover any liabilities arising out of insurance contracts so far as can reasonably be foreseen. Technical provisions include, in addition to unpaid claims, provisions for unearned premiums (UPP), unexpired risks (URP) and, sometimes, equalisation reserves. GIM2150 gives more details in the context of funded accounting.
UPP was described at GIM2100 and URP at GIM2130. The main technical provisions in the accounts will be for unpaid claims outstanding and for claims which have been incurred but not reported (IBNR). Equalisation reserves are discussed at GIM2170 and their tax treatment at GIM7000+.
Technical provisions: claims outstanding and claims incurred but not reported (IBNR)
The provision for claims outstanding is the estimated ultimate cost of settling claims together with the related claims handling expenses for events up to the accounting date, less amounts already paid. This is irrespective of whether the insurer has been notified of the claims before the close of the accounting period. The unreported category is referred to as Incurred But Not Reported (IBNR).
The amounts of IBNR may be relatively small, as is the case for motor insurance, or substantial, as for liability insurance. An extreme example is employers’ liability covering workers’ exposure to asbestos, where the claim for compensation may be made years or even decades after the event. Where there is a long delay between the period of cover and the emergence or indeed settlement of claims, the business is referred to as ‘long tail’.
Even with sophisticated mathematical techniques it is difficult for an insurance company to predict its outstanding claims provisions with a high degree of accuracy. Yet this item is probably the most significant figure in the accounts. If it is understated the company may distribute assets or otherwise act in a way that could lead to severe financial problems, and possible insolvency, when claims come to be paid. If it is overstated, so that profits are depressed, the company will look unattractive to investors but its tax bill may be reduced. This issue is explored more fully at GIM6000+.