During the past decade, the property and casualty (P&C) insurance industry has encountered a series of challenges and changes, including environmental exposures, the attorney general's antitrust lawsuits, threatened repeal of the McCarran-Ferguson Act, TRA 86 and the junk bond crisis, to name a few. Perhaps the most serious challenge that faced P&C insurers in the '80s, and one that will continue to surface, is consumer-oriented voter initiatives such as California's Proposition 103 (Prop 103).

Additional State Initiatives

As the issue of insurance reform spreads to additional states, the magnitude of these issues will multiply. For example, the following is a partial listing of states that have commenced similar initiatives:

Michigan. In December 1989, Michigan's House of Representatives voted unanimously to roll back auto insurance rates in the state by 30%. The bill, which will likely be changed substantially in the Senate, permits the state insurance commissioner to make exceptions for cases of threatened insolvency.

Nevada. In September 1989, the U.S. District Court in Reno upheld Nevada law requiring insurers to roll back auto liability rates by 15%. Exceptions are permitted for cases of threatened insolvency.

Pennsylvania. In February 1990, the Governor signed into law a bill to roll back auto insurance rates 10% by July 1, 1990, freeze rates for one year, and then roll back rates an additional 12% for drivers who choose a no-fault threshold.

New Jersey. In February 1990, Governor Florio announced a series of measures aimed at reducing auto insurance rates 20%. New Jersey has had the highest average automobile insurance premiums of any state.

Prop 103, a California voter initiative, narrowly passed in November 1988, provided for an overhaul of the state's insurance laws. Among other changes, it required all P&C insurers writing coverage in California other than workers' compensation and assumed reinsurance to immediately reduce rates to an amount 20% below the level in effect on November 8, 1987. The reduced rates were required to remain in effect for one year after the 1988 election, after which time rates charged required the approval of the California Insurance Department.

In addition to the rate reduction, Prop 103 also:

* Mandated the election of the Insurance Commissioner; * Repealed the limited antitrust exemption for insurers; * Authorized banks to sell insurance; and * Provided specific criteria for use in underwriting auto insurance.

After a series of challenges by the P&C industry on grounds of constitutionality, the California Supreme Court reviewed the case and ruled that insurers are entitled to a fair and reasonable rate of return. During the first year of the initiative, the Court ruled that insurers could file for rate relief. Although virtually all insurers filed requests for rate relief, any premiums collected in excess of the rates ultimately approved were subject to refund with interest.

In August 1989, the California Insurance Department initially established 11.2% as a fair and reasonable rate of return on prescribed equity, and tentatively ordered 47 insurance companies to refund nearly $816 million in premiums to consumers. When additional protests were lodged against the Department's prescribed rate, the 11.2% rate was rescinded and hearings were scheduled to establish appropriate criteria for rates of return.

In January 1990, counsel for the California Insurance Department issued a preliminary prayer outlining the calculation of refunds pursuant to Prop 103 as well as the policy of the Department with regard to review and approval of premiums for policies written after November 8, 1989. In May 1990, an administrative law judge ruled that any insurer that had a rate of return less than 13.2% in 1988-89 on all applicable lines of business may be exempted from the 20% rate rollback. In June 1990, the California Insurance Commissioner ruled contrary to the administrative law judge's ruling and once again prescribed 11.2% as the rate of return. As the hearings proceed, further revisions to the calculation and approval process will be made.

The weighted average historical rate of return for the P&C industry over the years 1979 to 1988 has been 11.5%. For comparative purposes, the Standard & Poor's 500(S&P) return for the same period was 14.4%. This same comparison over the previous five years reveals a greater disparity between the returns of P&C insurers, 8.6%, versus the S&P, 14.7%. In particular, the 1988 rate of return on private passenger auto insurance was less than 4%.

Revenue Recognition versus FASB 5 Contingency

Amid this uncertainty, numerous questions have arisen on the proper accounting and disclosure ramifications of Prop 103. The 1988 year-end financial statement was the first period that companies had to address this issue. At that time, because the law had only been in effect less than two months, most companies faced with significant premium writings in California appropriately concluded that the impact on the amount of premiums that had been earned in this seven-week period was immaterial. The only action necessary was to disclose the passage of Prop 103 as a FASB 5 contingency. FASB 5 requires an accrual of a loss contingency if available information indicates the probability that a liability has been incurred and an estimate of the liability can be reasonably made.

During the summer of 1989 the SEC issued a number of comment letters to insurance company registrants. The letters indicated that the SEC viewed Prop 103 as a revenue recognition issue, involving whether a company should recognize premium revenues exceeding the rebate levels and not a FASB 5 issue of accruing a liability. Following SEC guidelines, unless a company believed that it could reasonably estimate and accrue its liability for material rebates, a company should defer the full amount of premiums potentially refundable until such time as the company can determine the amount actually earned.

For 1989 year-end the accounting issues are further complicated because the 20% rollback provision ended on November 8, 1989, and all subsequent premiums rates are required to be approved by the California Insurance Department. Few companies have as yet received such approval from the California Department.

Profit Related Calculations

The potential rebate of premiums affects various other insurance financial statement calculations. FASB 60 defines acquisition costs as those costs that vary with and are primarily related to the acquisition of new and renewal business (e.g., commissions). Acquisition costs are deferred and then charged to expense in proportion to premium revenue recognized. The recoverability of deferred acquisition costs will need to be reviewed, given the possible impact of a premium rebate.

In addition, settlements with agents and reinsurers may require a legal review of the detailed agreements to determine if possible recoveries may exist.

Financial Statement Disclosure

Financial statement disclosure for companies with material exposure to Prop 103 would include the following:

* A general description of the issues arising from Prop 103; * The nature and amount of any deferral; * The amount of any probable, material refunds; and * The amount of any material assessments from the State of California and the reasons for any differences between the assessments and the company's deferral.

Communication and Coordination

Prop 103, and insurance reform in general, pose many complex issues for P&C insurance companies. In the face of these challenges, companies have to communicate the issues externally and coordinate their efforts internally.

Consumers have been critical of insurers for not developing more efficient and innovative methods of controlling costs, even though many of those costs are beyond their control. P&C insurers need to inform policy holders, shareholders and consumers of the increasing costs involved in providing auto insurance coverage. Dynamic claim cost increases are primarily due to uninsured and underinsured motorists, rising medical costs, developments in tort litigation and rising levels of motor vehicle theft and fraud. In many states, rates of return on auto insurance have not been adequate.

In addition to communicating the issues externally, an insurance company has to establish close internal coordination among its accounting, tax, actuarial and legal departments. Good coordination among these departments will help the company to accumulate the necessary information for assessing the impact of Prop 103 and future insurance reform.

Robert J. Coords, CPA, KPMG Peat Marwick