I. Overview of the Insurance industry Insurance companies play a major role in today’s financial industries. While the banking industry is creating assets and wealth, the insurance industry is protecting that wealth. The primary business purpose of an insurance company is to spread risk among people or entities that are exposed to similar risks. The insurance industry thrives in marketing uncertainties, selling promises, and making more money by cycling their revenues back into the nation’s building process. Insurance companies are global by design massive in numbers. The insurance industry, like many other industries, have changed dramatically over the years and is constantly being reshaped by factors such as changing interest rates, tightening legislation, growing competition, and even medical advancements. However, the major difference between the insurance industry and all other industries is that the insurance industry accumulates cash first and pay claims costs in the future. In fact, the insurance company does not even know if a claim will occur, when a claim will occur, and how much the claim will cost.
II. Insurance Industry Structure
Basic Classifications There are three main types of insurance companies: life, property and liability, and title insurance companies. Companies are further divided into primary policy writing and reinsurance. Primary writing is when insurance companies issue new insurance policies and maintain those policies throughout the policy term. Reinsurance is when a primary insurance company transfers all or a portion of its risk from an insurance policy to another insurance company. Companies reinsure policies as a means of managing risk, limiting potential loses, stabilizing underwriting results, and protecting surplus revenue. For example, property and liability companies use reinsurance to avoid a heavy concentration of policies in one geographical location. This prevents the company from having a large intake of claims resulting from one event. The procedures for auditing reinsurance will not be covered in this paper because reinsurance is a highly technical area.
II. Preliminary Engagement Activities
Audit Team Requirements The insurance industry is a highly specialized field. An industry that is so unique and important cannot be audited causally. Specialization is an everyday requirement for the insurance industry. Therefore, auditors working in the insurance industry need to develop a domain expertise in insurance. Financial concepts such as bottom lines estimations, statutory limitations, capitalization, risk bearing procedures, and protection of policyholder’s interests need to be understood by the auditor. Providing assurance services to the people who are in the business of assuring others comes with a lot of responsibility and is a serious matter. Auditors involved in auditing insurance companies provide comfort to the stakeholders, regulators, reinsurers, tax authorities, and policyholders. Depending on state requirements, there are qualification courses an auditor is required to take about insurance auditing outside of an auditor’s general training.
Compliance with Ethics and Independence An audit engagement team must also meet ethical and independence requirements. The Statements on Quality Control Standards states that a public accounting firm needs to develop procedures to ensure that all team members meet the profession’s ethical requirements and are fully independent of the company being audited. Depending on state requirements, insurance auditors are required a certain number of years of relevant experience before moving up the ranks of an insurance audit team.
III. Planning Audit Strategy and Risk Assessment Procedures The type of audit conducted for the insurance industry is known as a company evaluation audit. This type of audit determines the stability of an insurance company. It examines the company’s investments or holding obtained through policies and reinsurance. Claim systems are also examined to determine if an insurance company can pay future claims occurring under outstanding policies. During the company’s audit, a variety of methods are used to gauge the company’s performance and evaluate the company’s organizational structure. Planning an audit includes gaining an understanding of the insurance industry environment and assessing the need for assistance from specialists.
Insurance Industry Environment To formulate an audit strategy for an insurance company, the auditor must gain an understanding of the environment in which the company operates. The insurance industry environment includes the nature of the entity, industry regulations, and business strategies.
Nature of the Entity The basic organizational structures were discussed earlier in this paper; however, there are a few more factors that affect the nature of the entity. An insurance company is unique in the fact that it collects money first and pays claims later. The company then invests that money back into the economy to earn investment interest that is later used to pay claims. For example, one of the most significant assets of an insurance company is its portfolio of bonds. Bonds are reflected in the financial statement at an amortized cost. If interest rates are high, there is risk the market values will be lower then the amortized value. The auditor needs to assess the companies’ ability and intent to hold on to the bonds up through maturity. The other key factors an auditor must understand include sources of funding, operating characteristics, sources of entity’s earnings, key suppliers, and customer relationships. However, due to the generic nature of this paper, those topics will not be discussed in detail.
Industry Regulations The insurance industry is dominated and controlled by state regulations. The National Association of Insurance Commissioners (NAIC) was formed in an attempt to establish uniform rules and regulations among the different states. Their main objectives are to develop and enforce measures designed to promote solvency, appropriate premiums, fair dealing with policyholders, and uniform financial reporting. In general, all auditors must ensure the entity’s financial statements and accounting practices are in compliance with the generally accepted accounting principles (GAAP). However, the insurance industry is also regulated by the statutory accounting principles (SAP). The SAP is a set of accounting rules for insurance companies set forth by the NAIC. The SAP is used to prepare the statutory financial statements of insurance companies. There are, however, minor state-by-state variations. Nonetheless, overall the SAP is the basis for regulation among the insurance industry throughout the United States. The SAP focuses on the balance sheet and solvency analysis and differs from the GAAP. For example, SAP requires certain loss reserves to be calculated by using a conservative formula instead of the insurer’s own estimates. The SAP also requires the insurance entity to immediately recognize expenses associated with the writing of new policies rather then amortizing them over time. Lastly, the SAP does not allow the inclusion of certain non-admitted assets to be included on the balance sheet. It is obvious why it is so important for an auditor to have adequate training and specialized knowledge. The insurance industry is controlled by an expanse of regulations, and each state and jurisdiction has the authority to alter and change those higher regulations. Insurance audits require keeping up-to-date on new regulations. It is also extremely important for an auditor to have an understanding of all these specific requirements because an insurance company is subject to periodic audits by the state, and the company’s operating results are scrutinized through a series of Insurance Regulatory Information System Tests (Early Warning Tests). These test consist of financial ratios and relationship analyses. The tests are designed to measure levels of financial stability. The state and regulatory audits can help in the development of an overall audit strategy, and the auditor should utilize all of the information generated by the insurance company to conduct the audit.
Business Objectives and Strategies The auditor should obtain an understanding of management’s objectives and methods of controlling the business. Many insurance companies have sophisticated management decision-making systems. An auditor can use these systems to assess inherent and control risks associated with the insurance industry and its products. The insurance industry is also highly competitive. For example, in the 1980’s high interest rates led to the need for interest-sensitive products. These conditions lead to the development of universal life and single-premium deferred annuities. These products now hold a dominant position in the insurance industry. It is important to realize that new products and a competitive environment lead to the need for new regulations. The auditor is faced with the challenge of evaluating the impact of new products on changing procedures and regulation.
Assess the Need for Specialists Since the insurance industry is extremely complex and requires a lot of specialization, an external auditor is strongly advised to have the assistance of an insurance actuary. An insurance actuary complies and analyzes statistics and uses them to calculate insurance risks and premiums.
III. Internal Controls If a company has handled a product line for a considerable time, it usually has effective controls the auditor can test. Test of controls are efficient because of the massive amounts of data processed by insurance companies. Frequent reviews by management allow the auditor to have a greater reliance on internal controls and allows for efficient testing.
Typical Transactions and internal Control Structure Policies and Procedures The basic flow of operations for a general insurance companies involves three main transaction cycles.
The Premium Cycle The premium cycle is unique to the insurance industry. The premium cycle starts with the premium recognition process for an application and ends with the expiration of the policy. The first phase of the premium cycle is policy writing. Policy writing consists of writing and insuring a client under an insurance policy. The major control objectives for policy writing includes prompt, complete, and accurate reporting of all policy transactions to the home insurance company. This objective is achieved by controlling blank policies issued to agents. If the auditor can assess control risk at low, the audit strategy will include test of control relating to the policy writing function. The second phase in the premium cycle is policy underwriting. Underwriting is the assumption of risks in exchange for a premium. This phase includes evaluating the acceptability of risk, assessing the company’s ability to assume the entire risk, and determining the premium if the risk is accepted. The quality of underwriting is hard to determine until a significant period of time had passed. The major control objectives in underwriting is the prompt, accurate, and complete recording of all risks that have been accepted and proper documenting of all underwriting transactions. The auditor should consider whether premium, commission, and reinsurance rates are valued at proper amounts. It is also important to make sure that all underwriting of polices can be covered by the insurance company’s retention limit. Documents should also show evidence of review by the appropriate supervisor in the underwriting department. The third phase in the premium cycle is recording premiums. When a premium is received the amount is credited to a premium income account or a policyholder account. When statutory-financial statements are prepared, uncollected premiums and deferred premiums must be calculated. The main control objective for recording premiums is maintaining accurate records. Auditing procedures must ensure input is complete and accurate. An auditor may check policy numbers, issue dates, term of plan, premium amounts, or face value amount of insurance policies. The auditor can also test the company’s control procedure over recording risks by numerical sequencing of policies and sampling. The fourth phase of the premium cycle is collecting premiums. Premium collecting includes billing policyholders, receiving cash, applying the receipts to agents’ balances, and paying commission. An unpaid premium file is kept to record all premiums due. The major control objectives for collecting premiums include prompt billing, control of cash receipts, investigating and resolving differences between company records and agent records, and accurately calculating receivables, commission, and related accounts. Test of controls are mostly performed on premium billing and the collection system. However, substantive tests such as the confirmation of receivables and review of subsequent cash receipts are also performed. Auditor will often select a sample of transactions performed throughout the period and compare and observe the relating record keeping procedures.
The Claims Cycle The claims cycle is unique to the insurance industry. The claims cycle can be broken down into four phases. The first phase of the claims cycle is notification of loss. A loss or claim report is made by a policyholder to notify the insurance company of a loss occurrence covered under an active policy. The primary control objective is the prompt, accurate, and complete recording of all claims. This is very important because claim records are the basis for determining the insurance companies’ liability. This objective is achieved by promptly creating a claims file, matching all related paperwork to the appropriate claims file, and following up on claims that have been open for awhile. Audit tests should be conducted to determine if there are any abnormal delays between the reporting dates, the date claims are filed, and the date claims are received at the home office. The second phase of the claims cycle is verifying losses. The insurance company verifies a claim by obtaining evidence of the loss and that the loss is actually covered under the policy. The main objective for verifying losses is to ensure that only valid claims are included in the company’s claim liability. Specific tests should include examining documents that verify the policy was in effect, that reinsurance existed, and that the claims were properly authorized. The third phase of the claims cycle is evaluating losses. The liability of an insurance company may be specifically stated in a policy or may require calculations and estimations based on the details of the claim. There is often a long wait between the reporting of a claim and the reporting of the estimated claim valuation due to difficulties in determining the loss. The major control objective of evaluating losses is the prompt establishment of claims and proper adjustments to the claims reserve as a result of accepted claims. Test for this control include determining the insurance companies’ procedure for documenting losses, ensuring adjusters are adequately supervised to ensure losses are estimated properly, ensuring reserves are revised properly, and checking to make sure open claims files are reviewed periodically. The fourth phase in the claims cycle is settling and recording losses. A claim is settled by an insurance companies’ decision to pay or not to pay the claim. The major control objectives are prompt payment of accepted claims, proper authorization for disbursements, and accurate recording of payments made. These can be achieved by establishing procedures to authorize disbursements, to record disbursements, and to follow up on claims that have been open for a long time. Test for this control include testing to see if documents are approved before processed and tests to see how posting to non-ledger and ledger accounts occurs. Tests can also be done to compare and reconcile accounting data with statistical data.
The Investment Cycle The investment cycle includes buying and selling investments and receiving interest income. The auditing of investment cycle is similar to all other industries that maintain investment portfolios. Thus, it is not described in this paper due to large scoop of the topic and the complexity involved in conducting a proper audit.
IV. Substantive Test of Account Details, Balances, and Disclosures An auditor should test account balances when an insurance company’s control environment is considered to be unreliable or ineffective. An example of testing account balances is when an auditor reviews an insurance company’s premiums receivable account balance to assess whether the amounts are computed properly. An auditor should test account details to ensure individual account balances agree with the balances presented in the financial statements. An example of testing account details is when an auditor reviews individual policyholder’s accounts to verify that the sum of these accounts matches the amounts reported in the company’s balance sheet. An auditor should test account disclosures to ensure that an insurance company is disclosing accounts completely and accurately. An auditor would also test account disclosures to make sure an insurance company is classifying accounts correctly, the transactions have actually occurred, and transactions are actually a liability of the company. An example of an auditor testing account disclosures is when an auditor checks an insurance companies reported losses account to make sure that the company has recorded the correct amount of liability due to the possible that some of the loss is covered by reinsurance.
V. Substantive Analytical Procedures The following section will take a look at accounts that are unique to the insurance industry and how an auditor would audit the accounts.
Policy Reserves This account is similar to a perpetual inventory and is computed based on policies in effect. An auditor needs to be able to understand the table of rates the company used to compute the policy reserve account. Therefore, an insurance actuary should assist the auditor. Tests for this account are directed at completeness and accuracy. The auditor accomplishes this by conducting substantive tests on the procedures used to update the master file of policies. This includes comparing a selected sample of policies with the master policy file. The auditor should also recalculate reserve factors and trace them back to appropriate factor tables. The number of policies and the face values of those policies should be compared to the annual statements and master file.
Reported Losses The auditor should test reported losses for mathematical accuracy and trace the totals to the financial statements. Claims need to be reviewed to make sure that it is consistent with prior years and that the current year has an appropriate cutoff date. The auditor should also review the methods used to determine loss estimates and review the company’s reported loss statistics from past years. An auditor needs to be aware of the difficulty of accurately estimating the cost of settling outstanding claims due to inflation and changing legislation.
Unreported Losses Unreported losses are losses occurring in one period but reported in a later period. Auditing this account requires that the auditor understands the company’s approach to estimating losses. The auditor should ensure that the methods are consistent from years and that the loss reserve analyses agree with actual experiences. A review of the data an insurance company uses in the developing percentages and ratios should be conducted. The auditor should use all statistical data considered reliable to determine the reasonableness of the loss reserve. It is important to remember that such factors such as catastrophes, inflation, or changing reserving policies can influence the reliability of past statistics. Overall, the auditor should be satisfied that methods used for unreported losses are reliable and valid.
VI. Complete the Audit At this stage the auditor should complete all final analytical procedures, evaluate the entity’s ability to continue as a going concern, review working papers, conduct final evaluation of audit results, evaluate the financial statements presentation and disclosure, and chose the appropriate audit report to issue.

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