Life insurance accounting requires a few modifications compared with P&C accounting. And although it's gonna try and achieve the same thing, which is to match the premiums and the claims expense, it does need to deal with three areas of complexity. And those are firstly, life insurance policies are typically much longer in duration than P&C policies. And the time value of money becomes much more important. So if a life insurance company expects to pay a claim in say 20 years, how should that claim be recorded today? Secondly, life insurance policies usually require regular premiums to be paid, rather than it's all being paid upfront. Also because the premiums are paid only until the policyholder dies, but the insurance company doesn't really know what the coverage period is, so how should this be dealt with? Finally, the probability of the insured event increases with time as the mortality risk increases. So should an adjustment be made for this? Now, there are two key modifications to the accounting for life insurance. Firstly, the premiums. These are recognized as they are due from the policyholders. Secondly, the reserves. Now, these are calculated on a prospective basis, which means they're based on the present value of future claims less the present value of the future premiums. Also, just note that in life insurance, the claims against policies are usually referred to as benefits. Now, one further thing to note is that IFRS currently doesn't have detailed rules for life insurance accounting and instead allows local GAAP to be used throughout Europe. However, US GAAP does have detailed rules and often European companies look to US GAAP for guidance on the insurance accounting. So we're really gonna focus on US GAAP here. So as mentioned before, life insurance reserves are calculated on a prospective basis, and that's shown here. The present value of the future benefits less the present value of the future premiums is the reserves. Now, clearly, at the start of a policy, the insurance company would expect the present value of future premiums to be greater than the present value of the future benefits. So the reserves will start out at nil. Now, clearly, the insurance company is gonna need to make lots of assumptions when it's calculating the present value of the future benefits and the premiums. And that will include things like the mortality rate of the policyholders, the level of lapses and surrenders and also the discount rate for the present value calculations. And that's based on the investment yield that the insurance company thinks it can achieve on the premiums. Now, all of these estimates are locked into the reserves. So the reserves only change from one year to another as a result of two things. Firstly, the unwinding of the discount on the present value calculations, and secondly, the actual cash flows which occur. That's the premiums received from the policyholders or the benefits being paid out. Now, because all of these estimates are locked in, an additional buffer is included in the calculations and that's referred to as a provision for adverse deviation or sometimes a risk margin. And that buffer reflects the uncertainty in the assumptions. So a higher uncertainty will result in a higher provision. Now, if actual cash flows are as expected, then this provision is gradually released to earnings. Now, you might have noticed that the reserves here are calculated using the net premiums. So what does net premiums mean? Well, if you think of premiums as including both compensation for future benefits and future profits for the insurance company, the net premiums refers only to the proportion of the premiums which relate to future benefit payments and that's referred to as the net premium method. And these formulas here show you how the net premium is calculated. So how is the claims expense calculated from this? Well, the claims expense each year reflects the change in reserves, plus the benefits paid each year. But remember, for life insurance policies, the benefits are typically only paid out at the end of the policy. So for any individual policy throughout its life, the claims expense reflects a change in reserves. But this change in reserves is really just a function of the premiums being received from the policyholders each year. So the claims expense reflects the net premium portion of the premiums received from policyholders each year.
