Accounting for Government, Not-for-Profit Entities and Specialized Industries

Hand-out no. 5 – Accounting for Insurance Contracts

INSURANCE CONTRACT
An insurance contract is a contract under which one party (the insurer) accepts significant insurance risks from
another party (the policyholder) by agreeing to compensate the policyholder if a specified uncertain event (the
insured event) adversely affects the policyholder.

Insurance Risk
An insurance risk is a risk, other than financial risk, transferred from the holder of a contract to the issuer.

Insured Event
Insured event is an uncertain future event that is covered by an insurance contract and creates insurance risk.

UNBUNDLING OF COMPONENTS
Unbundling means accounting the components of a contract as if they were separate contracts. Some insurance
contracts contain both an:
(1) Insurance component; and
(2) Deposit component.

In some cases, an insurer is required or permitted to unbundle these components.

 Unbundling is required if both of the following conditions are met:
(1) The insurer can measure the deposit components separately;
(2) The insurer’s accounting policies do not otherwise require it to recognize all obligations and rights
arising from the deposit component.

 Unbundling is permitted, but not required, if the insurer can measure the deposit component separately
but its accounting policies require it to recognize all obligations and rights arising from the deposit
component, regardless of the basis used to measure those rights and obligations.

 Unbundling is prohibited if an insurer cannot measure the deposit component separately.

Once an insurer has unbundled a contract, it shall:

(a) Apply IFRS 4, Insurance Contracts to the insurance component
(b) Apply IFRS 9, Financial Instruments to the deposit component

LIABILITY ADEQUACY TEST

A liability adequacy test is an assessment of whether the carrying amount of an insurance liability needs to be
increased (or the carrying amount of related deferred acquisition costs or related intangible assets decreased), based
on a review of future cash flows.

IFRS 4 par. 15 provides that an insurer shall assess at the end of each reporting period whether the recognized
insurance liabilities are adequate, using current estimates of future cash flows under its insurance contracts. If that
assessment shows that the carrying amount of its insurance liabilities (less related deferred acquisition costs and
related intangible assets) is inadequate in the light of the estimated future cash flows, the entire deficiency shall be
recognized in profit or loss.

The minimum requirements for the liability adequacy test are as follows:
(a) The test considers current estimates of all contractual cash flows, and of related cash flows such as claims
handling costs.
(b) If the test shows that the liability is inadequate, the entire deficiency is recognized in profit or loss.

ACCOUNTING FOR PREMIUMS

Premiums on insurance policies represent the primary source of revenue for an insurance company. A premium
relates to a specified period during which the insurance policy provides financial protection to the insured party from
specified identified risks occurring or discovered within that specified period.

Under accrual basis of accounting, the full amount of the premium is not recognized immediately as income
when received. Instead, the premium is normally regarded as being earned evenly over the period of the policy.

IFRS 4 Insurance Contracts states that premium income shall be recognized from the date of the assumption of risk,
known as the inception date, in relation to each insurance policy because insurers earn premium by assuming
risks on behalf of the insured parties from that date.

Inception date is the date from which an insurer effectively assumes the risk insured in respect of an insurance
policy. Premiums are regarded as being earned evenly over the period of the policy from the inception date.

PRO-FORMA ENTRIES:
Insurance policy is written
Cash (or Premium receivable) XX
Premium revenue XX

BRIAN CHRISTIAN S. VILLALUZ, CPA

LEarning ADvancement Review Center (LEAD)
CPA Reviewer in Advanced Financial Accounting & Reporting (AFAR)
CPA Reviewer in Financial Accounting & Reporting (FAR)
CPA Reviewer in Auditing (Theory & Problems) Page 1 of 3
 Recognition of the unearned portion or the
unexpired period of the insurance policy
Premium revenue XX
Unearned premium reserves XX

Recognition of the earned portion of insurance policy

Unearned premium reserves XX
Premium revenue XX

Problem 1: (Basic Insurance Contract Accounting) Alvarez Insurance, Inc. is an insurer which conducts general
insurance business. During the year ended 2019, its total gross premiums written on motor insurance policies were
P5,000,000. As of the December 31, 2018, the unearned premium reserve was P1,600,000. As of December 31, 2019,
an unearned premium reserve amount of P2,000,000 is considered necessary. How much is the earned premium
revenue for the year ended December 31, 2019?

ACCOUNTING FOR UNEARNED PREMIUM RESERVES

Time apportionment method
There are various time apportionment methods being used. Two most common methods are the following:
1. The 365th method – known as the daily method.
2. The 24th method – known as the monthly method.
 This method represents a practical simplification of the time apportionment method but can only
be applied for insurance policies which have a term of one year.
 This method assesses total monthly premiums by assuming that the average date of issue of all
policies written during any one month is the middle of that month.

Problem 2: (365th method) Totoy Insurance issued two, one-year motor insurance policies for a premium of P30,000
for each policy during the year 2019:
 Motor Insurance Policy #01223 – dated August 1, 2019.
 Motor Insurance Policy #01367 – dated November 30, 2019.

How much is the total unearned premium reserves on December 31, 2019 assuming the company uses
the 365th method?

Problem 3: (24th method) The following relates to fire insurance premiums written by Bibo Insurance Company for
the year ended December 31, 2019:

Premiums
written:
January P30,000
February 25,000
March 20,000
April 15,000
May 20,000
June 15,000
July 25,000
August 35,000
September 35,000
October 30,000
November 40,000
December 35,000
TOTAL PREMIUMS WRITTEN 325,000

As of January 1, 2019, the unearned premium reserve balance amounted to P90,000.

1. Prepare the journal entry to record the receipt of premiums.

2. How much is the premium revenue for the year ended 2019?
3. How much is the unearned premium reserves on December 31, 2019?
4. Prepare the journal entry to adjust the unearned premium reserve account.

ACCOUNTING FOR REINSURANCE

Reinsurance is an arrangement whereby the reinsurer, in consideration of a premium, agrees to indemnify the
principal ceding insurer against the loss, which the latter may sustain under the policy or policies that the insurer
has written. Reinsurance is a means whereby insurance companies spread their exposures to losses from claims by
ceding and accepting premiums amongst themselves.

A “ceding insurer” is an insurer that reinsures part or the whole of a risk with one or more reinsurers. The risk
reinsured is referred to as an outward reinsurance.

A “reinsurer” is an insurer which accepts part of a risk from ceding insurer by way of reinsurance. The risk
accepted is referred to as an inward reinsurance.

Retrocession is a process wherein a reinsurer may, in turn, reinsure part of the risk which it has accepted to
another reinsurer.

BRIAN CHRISTIAN S. VILLALUZ, CPA

LEarning ADvancement Review Center (LEAD)
CPA Reviewer in Advanced Financial Accounting & Reporting (AFAR)
CPA Reviewer in Financial Accounting & Reporting (FAR)
CPA Reviewer in Auditing (Theory & Problems) Page 2 of 3
Problem 4: (Accounting for Insurance and Reinsurance) During April 2019, Nene Insurance Co. writes fire
insurance policies for a total premium of P144,000. During the same period, total premiums of P48,000 were ceded to
reinsurers.

1. How much is the premium earned by the Cedant for the year ended 2019?
2. How much is the premium earned by the Reinsurer for the year ended 2019?
3. How much is the Insurance Contract Liability or unearned premium reserves on December 31,
2019?

END

BRIAN CHRISTIAN S. VILLALUZ, CPA

LEarning ADvancement Review Center (LEAD)
CPA Reviewer in Advanced Financial Accounting & Reporting (AFAR)
CPA Reviewer in Financial Accounting & Reporting (FAR)
CPA Reviewer in Auditing (Theory & Problems) Page 3 of 3