Confirming permitted statutory accounting practices of insurance enterprises.

Insurance companies prepare their statutory financial statements using accounting practices "prescribed or permitted by the insurance department of the state of domicile" (see the sidebar, page 108). Though that basis of accounting is expected to be replaced with statutory accounting practices codified by the National Association of Insurance Commissioners, the change will not occur until 1996 at the earliest.

PERMITTED STATUTORY ACCOUNTING PRACTICES

Insurance companies currently prepare their statutory financial statements in accordance with accounting principles and practices prescribed or permitted by the insurance department of their states of domicile. The National Association of Insurance Commissioners (NAIC) currently has a project under way to codify statutory accounting practices through a complete revision of its Accounting Practices and Procedures Manuals, which, when complete, are expected to replace prescribed and permitted accounting practices as the statutory basis of accounting for insurance enterprises. Accordingly, though permitted accounting practices could exist both before and after codification, codification is likely to result in changes to what is considered a prescribed versus permitted statutory accounting practice. Furthermore, postcodification permitted statutory accounting practices will be exceptions to the statutory basis of accounting.

Current prescribed statutory accounting practices include state laws, regulations and general administrative rules applicable to all insurance enterprises domiciled in a particular state, NAIC Annual Statement Instructions, the NAIC Accounting Practices and Procedures Manuals, the Securities Valuation Manual (published by the NAIC Securities Valuation Office), NAIC official proceedings and the NAIC Examiners' Handbook.

Permitted statutory accounting practices include practices not prescribed above but implicitly or explicitly allowed by the domiciliary state insurance department. Insurance enterprises may request permission from the domiciliary state insurance department to use a specific accounting practice in the preparation of their statutory financial statements (1) when the enterprise wishes to depart from the prescribed statutory accounting practices or (2) when prescribed statutory accounting practices do not address the accounting for the transaction(s). Furthermore, permitted statutory accounting practices may have been allowed through the regulatory examination process.

In the meantime, American Institute of CPAs Statement of Position no. 94-1, Inquiries of State Insurance Regulators (which is effective for audits of insurance companies' 1994 statutory financial statements), requires auditors to obtain competent evidential matter from domiciliary state insurance regulators that statutory accounting practices that management asserts are permitted indeed have been permitted by the insurance department. Written confirmation is only one of three types of corroborating evidence identified in the SOP, and it is a matter of auditor judgment as to whether confirmation is necessary. Nevertheless, positive confirmations provide the best audit evidence and, accordingly, should be used whenever practicable.

This requirement appears straightforward; however, permitted accounting practices generally have not been confirmed in the past, so the SOP stakes out new territory for insurance companies, auditors and state insurance regulators. As a result, the anxiety level about the process is high. No one is sure just how many "permitted accounting practices" there are or how responsive regulators will be to requests for confirmation or clarification.

Nevertheless, with planning, cooperation and understanding the process can run smoothly. This column should help auditors and their insurance company clients meet the challenge the confirmation process will present.

GETTING STARTED

Affected parties should start planning now. The following five steps for auditors should be done as soon as possible:

1. Review with your client what needs to be done and why. Auditors are asking clients to assist them in obtaining from state insurance departments confirmations of permitted statutory accounting practices because obtaining competent evidential matter is required by generally accepted auditing standards. Auditors are reporting on what is prescribed or permitted by the state; state insurance regulators are the only parties who can provide audit evidence that a permitted accounting practice is indeed permitted.

2. Obtain an inventory of permitted statutory accounting practices. Auditors may assist their clients in this process, which should be directed toward providing as much detail about the permitted accounting practices as possible. When prescribed statutory accounting practices do not cover the accounting for a transaction, insurance enterprises sometimes use generally accepted accounting principles to account for the transaction. Such a practice is considered "prescribed" if the state of domicile has a law or regulation stating that GAAP should be used in the absence of a prescribed statutory practice. However, such a practice is considered "permitted" if no such law or regulation exists, and SOP no. 94-1 should be applied. Some questions to ask include: What are the financial statement effects? How long has this practice been used? Is there any documentation regarding regulator permission? The auditor should be satisfied that the inventory is accurate and complete.

3. Identify potential problems. It is possible that a state insurance department will be unaware of certain permitted statutory accounting practices that an insurance company believes are permitted. When questions arise about whether a nonprescribed practice is permitted, an audit can be significantly delayed; such questions should be resolved with the insurance company and the regulator as soon as possible.

4. Identify the parties in the state insurance department to whom confirmations should be directed and alert them accordingly. Finding someone in the state insurance department who is knowledgeable and has authority to confirm permitted practices is an important step. Auditors may wish to write to state insurance commissioners telling them about the confirmation process and asking who is authorized to respond to the confirmation requests. As soon as the insurance department contact is known, he or she should be alerted about what to expect from the confirmation process.

5. Select the permitted statutory accounting practices for confirmation. SOP no. 94-1 requires corroboration of permitted statutory accounting practices that are material to an insurance enterprise's financial statements. Auditors are likely to make judgements about the materiality of permitted accounting practices, individually and in the aggregate, in relation to an insurance enterprise's statutory capital.

6. Prepare confirmation requests. Confirmation requests should be designed in a way that helps regulators respond readily. Auditors should consider including a brief explanation of the purpose of the confirmation and sufficiently detailed information about the permitted statutory accounting practices.

NO NEWS IS BAD NEWS

When an auditor gets no response or confirmations were not sent, SOP no. 94-1 allows for two alternative types of evidential matter:

1. Written acknowledgment from the regulator. Examples of this kind of audit evidence include (a) a letter from the state regulator to the insurance company and (b) a statement in a regulatory report of examination. The auditor may have to obtain additional evidence in some cases to make sure the written acknowledgment reflects the regulators' current position.

2. Oral confirmation from the regulator. Examples of this kind of audit evidence include (a) a meeting of the auditor, the client and the regulator and (b) a phone call from the auditor (with the client present) to the regulator. Such discussions always should be followed up with a written memo to the regulator prepared by the auditor or the insurance company.

When an auditor can't get a response to a confirmation request regarding a permitted practice that is material and he or she isn't satisfied with the evidence other procedures provide, there is a limitation on the scope of the audit of the statutory financial statements. The auditor must either qualify his or her opinion on the statutory financial statements or issue a disclaimer. Deciding whether to qualify or disclaim requires significant professional judgment, and Statement on Auditing Standards no. 58, Reports on Audited Financial Statements, should be consulted. If the client won't allow the auditor to confirm the permitted practice or otherwise obtain sufficient audit evidence, this client-imposed scope restriction generally should result in a disclaimer of opinion.

If the auditor also is reporting on financial statements in accordance with GAAP, he or she faces a scope limitation if the inability to get sufficient evidence about the permitted practices is material to the required disclosure of regulatory total authorized capital.

EXECUTIVE SUMMARY

* AMERICAN INSTITUTE of CPAs Statement of Position no. 94-1, Inquiries of State Insurance Regulators, requires auditors to obtain audit evidence from state insurance regulators that statutory accounting practices have been permitted by the domiciliary state insurance department. Many auditors will need to send confirmation requests to regulators.

* THE CONFIRMATION process will be smoother if CPAs with insurance enterprise clients take these steps early on:

1. Review with the client what the confirmation process involves and why it is necessary.

2. Obtain an inventory of permitted statutory accounting practices.

3. Identify potential problems.

4. Identify the parties in the state insurance department to whom confirmations should be directed and alert them accordingly.

5. Select the permitted statutory accounting practices for confirmation.

6. Prepare clear confirmation requests.

* IF THERE IS NO RESPONSE to a confirmation request, or no confirmations were sent, two alternative types of evidential matter may be obtained:

1. A written acknowledgment from the regulator to the insurance company.

2. An oral confirmation from the regulator.