Accounting Principles – Insurance
Insurance may be defined as a contract whereby, in consideration of a premium paid by one party to another, the former is protected by the latter from loss. Insurance may be of various kinds: Life, fire, accident, health, marine, credit, burglary, fidelity and surety, employers’ liability, etc.
The accountant is little concerned with the nature of the insurance. What does affect him directly is what relation a loss and corresponding settlement bears to the accounting, and in a similar manner what relation the premiums paid bear to the accounting. It is true, of course, that he should have a more or less general idea of the nature and operation of the various kinds of insurance contracts referred to, for which reason they are briefly described here.
Life insurance is not usually involved in the accounts of an organization. It is true that some proprietors may be found who make a practice of merging their private with their business affairs and accounts; however, this is not to be countenanced as good practice. In such cases, of course, instances have been known where sole proprietors either charged the premiums on personal policies to the business as an expense or capitalized them on the books of the business as an asset. This is a matter of bad general practice rather than having anything to do specifically with the matter of insurance. It is mentioned here, however, because of the fact that insurance is one of the items which sole proprietors seem prone to mingle with their business accounts. There has been a custom for some time among copartnerships and corporations to insure its members or officers for the benefit of the copartnership or corporation. The loss of a partner may be very keenly felt by a surviving partner. In the same way the loss of an officer or important employee to a corporation might prove detrimental. It should be borne in mind strictly in these cases that the insurance is taken out by the concern and not by the individual, and that the concern pays the premiums. It means, therefore, that the concern and not the individual should either charge to expense or capitalize the insurance premiums paid. As to capitalization, there can be no well-founded objection to it after the third annual premium, except in the case of straight life, has been paid, since the law requires that such policies shall have a cash surrender value. It is, therefore, perfectly proper to capitalize the premiums at their cash surrender value.
It is doubtful if the accountant would ever come in contact with health insurance in connection with the affairs of a business concern. It is possible, of course, to imagine a case in which a health policy would be carried by the concern on account of some of its officers or employees. This, however, is not apt to be the case, as a health policy is usually taken out by an individual in his own behalf in order that he may be reimbursed for loss of salary and expenses in case of sickness.
It might be interesting to note what would transpire in case of the death of an employee of a given company. To do this the application must be made, of course, to both a copartnership and a corporation, since in each case the situation would be slightly different. In the case of a copartnership, upon receipt of the amount of the policy cash would be charged and profit and loss credited. Thus the surviving partner and the estate of the deceased would participate to the extent in which the partners had previously been interested in the profits. Since the object of the insurance is to protect the surviving partners against loss of capital through the sudden withdrawal by reason of the death of a partner, it sometimes happens that the policies are drawn in favor of the surviving partners. In such a case it usually happens that each partner is equally insured for the benefit of the firm, and while each stands his share of loss through the payment of the premium he takes the risk of failing to survive his partner. Where this situation existed, upon receipt of the cash in settlement of the policy cash would be charged and the respective capital accounts of the surviving partners credited.
While contact with life insurance problems on the part of the accountant is somewhat rare, fire insurance demands his attention in practically every concern with which he comes in contact. In practically every instance it is the question of premiums. Occasionally it is in connection with a fire loss. Since it is the question of premiums that most frequently concerns him, they may perhaps be discussed first.
A premium is paid for protection covering various periods up to three years. The author’s experience leads him to observe that while formerly the three-year period was a popular one such policies are becoming fairly scarce and the year at the present time seems to be the usual period. The pertinent fact in connection with the premium is that it covers a period of time. It is, therefore, evident that the premium, which is to be treated as an expense, should be spread over the period of time covered and not charged to expense in the month or period in which the premium was paid or the expense incurred. It will thus be evident that insurance covering a period running beyond the date upon which the account period closes may be considered as a deferred charge to expense, or, as it has sometimes been called, an asset by courtesy. The problem which confronts the accountant is that of determining the amount of the unexpired insurance. It may be mentioned here, however, that the necessity for this calculation may be avoided by having all policies lapse on the same date, which practice, in case the date coincides with the end of the accounting year, will give rise to a situation in which there is no unexpired insurance involved. Having all new policies written for periods ending on December 31, for example, there would be no unexpired insurance at the end of the year. This will not be true, of course, if the books are closed on June 30, but the unexpired insurance at such time will be one-half the annual premium subject to slight adjustment perhaps on account of new policies which have been written for periods less than a year. This scheme has been advantageously employed in a number of cases which have come under the writer’s observation, and much figuring and bookkeeping has thereby been avoided. Notwithstanding the fact that the practice is a good one, it is not a general one, and the accountant is called upon to value the unexpired insurance. To the end that the procedure may be illustrated by practical application, the following applied theory test is suggested:
London, Liverpool & Globe, No. 705,965, Amount, $10,000. Dated June 17, 1912. One year. Premium, $56.27.
North British and Mercantile, No. 714,837. Amount, $6,000. Dated October 23, 1912. One year. Premium, $31.48.
Scottish Union and National, No. 4,220,876. Amount, $3,000. July 14, 1912. One year. Premium, $18.26.
American of Newark, No. 1427,832. Amount, $7,000. Dated February 22, 1912. One year. Premium, $47.82.
Aetna Insurance, No. 528,789. Amount, $5,000. Dated February 28, 1912. One year. Premium, $322.13.
Compute the unexpired insurance December 31, 1912.
It is probably the custom in computing unexpired insurance to divide the annual premium by 365 or 366 days, as the case may be, and after thus ascertaining the rate per day multiply the said rate by the number of days unexpired. A computation of this kind is, of course, accurate, but the process somewhat laborious. In cases where extreme accuracy is not necessary it suffices many times to take the unexpired period as so many twelfths of a year, depending upon the proximity of the expiration date to the end of the month. For example: A policy expiring on the third of May would be treated as four-twelfths expired.
The difficulty involved in setting up unexpired insurance is sometimes overcome by having an insurance register. This is a book which provides for the name, number, amount, date, period and premium of each policy and has twelve columns, corresponding to the months of the year, over which each premium is distributed. It thus becomes an easy matter to determine by footing the column corresponding to a given month what the charge to expense for that month should be. When the insurance registered does not obtain, the method of treatment in closing the books will be to charge insurance unexpired and credit insurance. But where the register is used, the procedure will be the reverse, namely: having charged all premiums to an unexpired insurance account, in closing the books insurance will be charged and unexpired insurance credited in the amount shown by the footing of the corresponding month in the insurance register.
An important question arises frequently in connection with unexpired insurance. As is probably known, if a policy is canceled the assured will not receive back the proportion of the premium corresponding to the unelapsed time. For example: If a policy on which the premium is $60 per year is canceled on the 30th of September, the assured will not receive as a return premium $15, but approximately $12.75. This is due to the fact that the fire insurance companies make use of what is known as the short rate basis. It is considered by the companies that it costs them more to carry a risk for a short time than a longer time. There must also be some provision for the expense of securing the business, such as the agent’s commissions, etc. For this reason the companies make use of a short rate table in New York. For example, such as is prescribed by the New York Fire Insurance Exchange, which has the effect of reducing the value of the unexpired insurance. The question which now arises is, Shall the unexpired insurance be figured on the basis of the unexpired time or on the short rate basis? The argument in favor of the latter is that the amount so determined would be all that could be obtained on the premium were it to be canceled. Against this there is the contention that it is not expected that the policy will be canceled and that, therefore, to a going concern the premium has its full value and it may be with propriety pro-rated over the period which it covers. It is, therefore, thought that a logical answer to the question as to the basis upon which unexpired insurance should be computed consists in saying that in the case of a going concern it may be pro-rated, whereas, in the case of a concern about to go into bankruptcy, or in making up a statement of affairs, unexpired insurance should be figured on the short rate basis.
A question frequently arises with regard to fire losses as to the relation of the insured to the company and the rights of each party to the contract. The settlement of a fire loss will depend usually on whether or not the policy is a “valued” one and whether or not the property is insured under what is known as the 80 per cent. clause. Many States have what are called “valued policy laws,” under which the insured receives the amount stated in his policy in case of a total loss. There is an exception to this rule in some States in that allowance is made for depreciation. The person insured for $10,000 and having a total loss would in some States receive the full $10,000, whereas in others he would receive $10,000 less an estimated amount for depreciation. The rates of valued policies are naturally higher than on other kinds. In the majority of cases the policy stipulates that:
“This company shall not be liable beyond the actual cash value of the property at the time any loss or damage occurs, and the loss or damage shall be ascertained or estimated according to such actual cash value, with proper deduction for depreciation however caused, and shall in no event exceed what it would then cost the insured to repair or replace the same with material of like kind and quality; said ascertainment or estimate shall be made by the insured and this company, or, if they differ, then by appraisers, as hereinbefore provided; and, the amount of loss or damage having been thus determined, the sum for which this company is liable pursuant to this policy shall be payable sixty days after due notice, ascertainment, estimate and satisfactory proof of the loss have been received by this company in accordance with the terms of this policy. It shall be optional, however, with this company to take all, or any part, of the articles at such ascertained or appraised value, and also to repair, rebuild or replace the property loss or damage with other of like kind and quality within a reasonable time on giving notice, within thirty days after the receipt of the proof herein required, of its intention so to do; but there can be no abandonment to this company of the property described.”
There would appear from an accounting point of view to be some contradiction of terms in the above paragraph. For example: “actual cash value, with proper deductions for depreciation.” It is understood that by this is meant what the accountant looks upon as book value, namely, cost less depreciation. It will thus be seen that under contracts of this kind the insured will, in case of a total loss, receive, not the amount stated in the policy, but an amount corresponding to the value of the property destroyed. This would be true as a rule, except in cases where the insured becomes a co-insurer under the 80 per cent. clause. This clause requires that the property shall be insured for at least 80 per cent. of its value. In the case of failure to do this the insured becomes proportionately liable for the loss to the extent of the difference between what the property is insured for and 80 per cent. of its value. Assume, for example, that the value of a certain manufacturing plant is $100,000; that the insurance carried thereon is $50,000; that the loss through fire is fixed at $40,000. The insured will, upon settlement in such a case, receive not $40,000, the amount of the loss, but $25,000, or five-eighths of the loss. The insured will have become a co-insurer with the company to the extent of three-eighths and the loss will be borne by the company and the insured in the proportions of five-eighths and three-eights respectively.
Much discussion has occurred in accounting circles with regard to the position into which the insured puts himself by providing for depreciation of his property and showing same on his books and balance sheets. The question of the matter of insurance has very often arisen in connection with the manner of stating the property and reserves for depreciation accounts on the balance sheet. It has been claimed by some that the reason for showing the reserves broad instead of deducting them from the asset accounts was to avoid having fixed any book value on the assets whereby the insured could be bound by the company in case of a fire loss. It was argued that writing the asset down and showing it net on the balance sheet, or showing the cost and deducting the reserve on the balance sheet, was an admission of the depreciation value of the property, whereas showing the asset at its cost and placing the reserve on the liability side gave the same effect to the proprietor’s net worth, at the same time the proprietor did not admit publicly that the reserve was anything more than his estimate of the depreciation. The absurdity of this contention will be apparent from the following quotation, taken from the standard form of policy:
“The insured, as often as required, shall exhibit to any person designated by this company all that remains of any property herein described, and submit to examinations under oath by any person named by this company, and subscribe the same; and, as often as required, shall produce for examination all books of account, bills, invoices, and other vouchers or certified copies thereof if originals are lost, at such reasonable place as may be designated by this company or its representatives, and shall permit extracts and copies thereof to be made.”
It would appear from the above as though this were an excellent argument as to why proprietors should exercise care in computing depreciation and should proceed with such computations scientifically.
The treatment of fire losses in the accounts presents an interesting topic for discussion. As to the procedure, it may be said that there are two forms. The first and more logical one, since it follows the facts historically, would consist in relieving the property account and charging the company at the time the loss is determined. The other consists in deferring any entry until such time as the cash is received, when the property account is relieved. The principle is the same in either case, regardless of whether the policy is a valued one or the property is or is not insured under the 80 per cent. clause. The only difference in any of these variations would be the extent of the loss. Assume, for example, the cost of a certain piece of property to be $100,000; reserves having been set up to the extent of $20,000; a fire occurs and the loss is fixed at $60,000. Under the first procedure the reserve will first be closed out against the asset account, making the balance $80,000. The company will then be charged on the books with $60,000, profit and loss will be charged with $20,000, and the property account will be credited with $80,000, thereby closing it out. At the time the settlement is actually made cash will be charged with $60,000 and the company credited. This procedure shows all the steps in the transactions and is to be preferred. The second form of procedure consists in deferring the entries until such time as the settlement is made, when the reserve will first be closed out to the property account, leaving a balance of $80,000, while cash will be charged in the amount of $60,000, profit and loss in the amount of $20,000, and the property credited with the amount of $80,000. In so far as profit and loss is concerned the reverse of the above would be true if the amount of the loss were fixed at a figure higher than the book value of the property. The entries, as outlined above, would operate on the same principles in the case of other forms of insurance, such as marine, burglary and fidelity. In all cases the property lost would be replaced by the amount recovered from the insurance company and the difference debited or credited to profit and loss in accordance with the relation which the settlement bore to the book value of the property. Credit insurance works out practically the same way. The company bases its risk on the ratio of sales to losses of the insured in past years. In the case of loss the amount received from the company takes the place of that which was not received from the debtor, and the difference is charged to profit and loss. A well organized and efficient credit department is very often cheaper than credit insurance.
Employer’s liability insurance is somewhat different from any of the above mentioned. On May 30, 1908, the President of the United States approved an act of Congress “granting to certain employees of the United States the right to receive from it compensation for injuries sustained in the course of their employment.” Similar laws have been passed by various States, among the most prominent of which are Massachusetts and New York. Thus it will be seen that business concerns in the various States where these laws exist have become liable for damages for injuries sustained by employees in the pursuit of their work. A very natural consequence of these laws was the springing up of employers’ liability insurance companies to take the place of and relieve employers from the obligation of having to settle with employees in cases of accident. When an accident occurs the employer turns the case over immediately to the insurance company, which either makes an immediate settlement with the injured workman or defends the suit in case litigation ensues. For this reason the insurance company charges a premium which, presumably for the want of a better or more logical basis, is computed on the amount of the yearly payroll. Since the amount for the current year cannot be determined in advance, it is the custom in computing the premium to base it on the payroll of the previous year. The premium is then paid. At the end of the year a report is made to the company, showing the exact amount of the premium for the current year and the correct premium is then computed, the difference between the previous premium and the correct one being adjusted either by a payment to or rebate by the insurance company. Here the matter of adjustments of asset accounts does not enter in. There is nothing actually lost and there is nothing to be replaced, for the reason that no settlement is made by the company to the insured. All that the company does is to relieve the insured of the risk of having to stand damage suits, and for this insurance the insured pays a premium which is charged to expense. It should be noted that in this case, as well as other forms of insurance above mentioned, where premiums are paid in advance, it is perfectly proper to set up the proportion corresponding to the unexpired time when the books are closed.
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