GAAP

Study guides: Exam 6U, Exam CP-321, Exam CP-341, Exam GH-201U, Exam GI-302, Exam ILA-101, Exam ILA-201U

GAAP (U.S. Generally Accepted Accounting Principles) is the accounting framework set by the Financial Accounting Standards Board (FASB) and codified in its Accounting Standards Codification (ASC), under which SEC-registered U.S. insurers report to investors; insurance guidance sits mainly in ASC 944. Where SAP asks whether the insurer could meet its policyholder obligations, GAAP asks what the business is earning as a going concern — so it matches expenses to the revenue they produce.

$\text{Acquisition expense}_{\text{GAAP}} = \text{Costs incurred} - \Delta\text{DAC}$

Deferred acquisition costs (DAC) are the signature difference. GAAP capitalises the incremental costs of successfully acquiring contracts — commissions, premium taxes — and amortises them in proportion to premium earned; SAP expenses them as incurred. GAAP therefore recognises the "equity in the unearned premium" that SAP withholds, and a growing insurer looks better on GAAP than on SAP.
The other SAP-to-GAAP differences a candidate should be able to list:
- Nonadmitted assets (overdue premiums, furniture and equipment, part of the deferred tax asset) are restored, net of allowances.
- Reinsurance is grossed up: recoverables on unpaid losses and prepaid reinsurance premiums are assets, not reductions of liabilities, and the statutory provision for reinsurance (Schedule F) gives way to an allowance for credit losses under the CECL model (ASC 326).
- Available-for-sale bonds are at fair value, with unrealised gains in other comprehensive income (SAP: amortised cost for investment grade); fair-value changes on equity securities run through net income.
- Surplus notes are debt, not surplus; changes in deferred tax run through tax expense, not directly to surplus.
- A gain on retroactive reinsurance is deferred and amortised, rather than booked to restricted special surplus.
What largely does not differ: P&C claim liabilities are carried undiscounted under both, with no explicit risk margin, and both require a premium deficiency reserve when unearned premium will not cover future losses and expenses.
Statements and disclosure. Balance sheet, income and comprehensive income, changes in shareholders' equity, cash flows, and notes — which for short-duration contracts include accident-year incurred and paid claims development tables, GAAP's counterpart to Schedule P. See Financial Statements and Accounting Standards for the three-way comparison with SAP and IFRS.

Growth Strain: SAP Loss, GAAP Profit A new insurer writes $\$1{,}200$ of annual policies uniformly through its first year. Acquisition costs (commission and premium tax) are $20\%$ of written premium; other, non-deferrable expenses are $\$30$ . Losses and LAE are $65\%$ of earned premium.

Compute first-year underwriting income on each basis.
Answer Uniform writing of annual policies earns half the year's writings, so earned premium is $\$600$ and unearned premium is $\$600$ .
 $\begin{align*} \text{Losses and LAE} &= 0.65 \times 600 \\ &= 390 \\ \text{Acquisition costs} &= 0.20 \times 1{,}200 \\ &= 240 \end{align*}$ 
SAP expenses all $\$240$ ; GAAP defers the part relating to unearned premium, $0.20 \times 600 = \$120$ , and amortises the other $\$120$ :
 $\begin{align*} \text{UW income}_{\text{SAP}} &= 600 - 390 - 240 - 30 \\ &= -60 \\ \text{UW income}_{\text{GAAP}} &= 600 - 390 - 120 - 30 \\ &= 60 \end{align*}$ 
The $\$120$ gap is exactly the DAC asset. The business runs at a $90\%$ GAAP combined ratio, yet statutory surplus falls by $\$60$ in the year it is written — the growth strain that makes a fast-growing insurer need capital even when its pricing is sound.

Bridging Statutory Surplus to GAAP Equity An insurer reports statutory surplus of $\$400$ M. It has $\$60$ M of acquisition costs GAAP would defer; $\$15$ M of nonadmitted assets, which GAAP would carry net of a $\$3$ M credit-loss allowance; an $\$8$ M provision for reinsurance, against which GAAP would hold a $\$2$ M CECL allowance; available-for-sale bonds whose fair value exceeds amortised cost by $\$10$ M; and $\$25$ M of surplus notes. Apply $21\%$ deferred tax to the DAC and the unrealised gain only.

Estimate GAAP shareholders' equity.
Answer
 $\begin{align*} \text{Equity} &= 400 + 60 + (15 - 3) + (8 - 2) \\ &\quad + 10 - 25 - 0.21(60 + 10) \\ &= 400 + 60 + 12 + 6 + 10 - 25 - 14.7 \\ &= 448.3 \end{align*}$ 
GAAP equity is $\$448.3$ M, $\$48.3$ M above statutory surplus even after the surplus notes move to debt. Each step reverses one piece of statutory conservatism: DAC restores the equity in the unearned premium, nonadmitted assets return at realisable value, the Schedule F penalty gives way to an estimate of what is actually uncollectible, and bonds move to market value.