What Is Deposit Accounting?
Deposit accounting refers to an insurance and reinsurance company recognizing and measuring an asset or liability for short-term and multi-year contracts. The consideration earned or charged, minus any premiums or fees retained, is used to calculate the said deposit asset or liability.
Insurance companies transfer contracts to lessen the burden of claims filed and manage the amount of risk. In deposit accounting, the contracts requiring no transfer of underwriting risks must be accounted for under the US Generally Accepted Accounting Principles (GAAP) guidelines. It also defines rules for reinsurance contracts that do not compensate or protect the insurer from losses.
- Deposit accounting definition implies a method of accounting used to journal the transfer of assets or liabilities with reinsurance contracts.
- The reinsurance contracts with limited or underwriting risks must account for under the US Generally Accepted Accounting Principles (GAAP) rules.
- Reinsurance contracts help insurance companies to diversify risksDiversify RisksA diversifiable risk refers to the firm-specific uncertainty that impacts an individual stock price rather than affecting the whole industry or sector in which the firm operates. Such risk can be mitigated or reduced by adopting diversification strategies to ensure that the returns are not affected. and lessen the burden of claims filed. If an insurance company were to experience any significant claims, these risks spread out over multiple insurance companies.
- There are three different forms of deposit accounting, including bank, prospective, and retrospective deposit.
Is Policyholders Deposit An Asset Or A Liability?
People purchase insurance policies when they seek protection from losses or liabilitiesLiabilitiesLiability is a financial obligation as a result of any past event which is a legal binding. Settling of a liability requires an outflow of an economic resource mostly money, and these are shown in the balance of the company. that may occur in situations like:
- Automobile accidents
- Medical emergencies
- Loss of loved ones
- Workplace injuries
- Stolen identity
- Damaged possessions
In exchange for protection from these risks, they will have to pay premiums to the insurance company. The premium payments will typically be made on an annual or monthly basis by the policyholder.
The insurance company can then save the premium payments and collect them to have enough capital to pay if they receive a claim. The funds must be in cash or other liquid assetsLiquid AssetsLiquid Assets are the business assets that can be converted into cash within a short period, such as cash, marketable securities, and money market instruments. They are recorded on the asset side of the company's balance sheet. for the insurance company to have the ability to convert them to cash quickly.
If the insurance company collects more in premium than what they are required to pay in claims, they will be profitable. If the insurer is paying more in the claims, it will raise premiums. Traditionally, when the company has a surplus of premium payments, it will be considered the insurers’ assets. And the companies liabilities will be the amount owed to policyholders.
When Deposit Accounting is Helpful?
The deposit accounting method may be helpful in cases involving insurance and reinsurance contracts, such as:
- No transfer of underwriting risk
- Transfer of timing risk only
- Prospective reinsurance
Deposit accounting will require these contracts to be measured individually as opposed to a portfolio. The deposit money will be reported as a deposit liability rather than an asset. The amount paid is known as deposit in deposit accounting and can be accounted for as an asset by the ceding party.
p.s. – Insurance companies will often purchase insurance from other insurers to diversify their risk in the event of a significant claim – a process known as reinsuranceReinsuranceReinsurance is a tool used by the insurance companies to reduce their claim liability by getting some of it insured by another company. It helps prevent insurance companies from insolvency. The company insuring the claims is called the ‘Reinsurer’ and the company getting insured is called the ‘Ceding company’..
Types of Deposit Accounting
There are different forms of deposit accounting, including:
#1 – Bank Deposit
- The bank deposit form will allow the deposit to grow and earn interest on the initial investment.
- The interest rate will typically be a pre-determined number but can also be at a variable rate where the current market rate will determine it.
- It is the most straightforward type of deposit accounting.
#2 – Prospective
- In the prospective form, the deposit will depend on the value of the payment to be made in the future, not the initial investment.
- The interest rate will be dependent on the current market rate. However, it can be calculated at a rate that does not adjust over time or is locked into a specific interest rate.
- The deposit value does change over time as interest is paid.
#3 – Retrospective
- The deposit will be determined by the original, previous, and potential payment in the retrospective method.
- The interest rate will be dependent on the money flowing in and out of the contract. It could be beneficial, but it can also produce negative rates when more money is flowing out of the contract rather than into it
- It is a different concept based on the flow of money in the past and the present.
Accounting Journal Entries of Deposit
For deposit accounting entry, let us take an example of insurance company A looking to enter into a reinsurance contract with insurance company B that does not transfer risk.
According to the American Institute of Certified Public Accountants, arrangements that do not transfer risks must be accounted for under the Generally Accepted Accounting PrinciplesGenerally Accepted Accounting PrinciplesGenerally accepted accounting principles (GAAP) are the minimum standards and uniform guidelines for the accounting and reporting. These standards prohibit firms from engaging in unethical business activities and enable for a more accurate comparison of financial reports to investors. (GAAP) deposit accounting rules. It means that both insurance companies A and B will have to account for the asset or liability that comes with the contract.
The ceding company, in this case, insurance company A, would be transferring liabilities to insurance company B. Any changes in the timing of payments should be noted by insurance company A.
Here are the steps involved in the process to better understand how to do an accounting journal entryAccounting Journal EntryAccounting journal, often known as the book of original entry, is first used to record the company's accounting record whenever a financial transaction occurs. It's difficult to comprehend, yet it's crucial in business operations and accounting.:
- Insurance company A must pay $10 million to insurance company B over ten years, with equal payments due at the end of each year.
- It would imply that $1 million in dues will be paid per year.
- Insurance company A agrees to pay $8 million at the beginning of the contract.
- Insurance firm B will refund any portion of the initial deposit that has not yet been repaid after ten years.
- If the timing of these payments changes for some reason, all insurance firms would have to alter their asset and liability balance sheets. For example, if the cash flow changes, the deposit money will also need to be changed.
- If the deposits are increased by insurance company A, the present valuePresent ValuePresent Value (PV) is the today's value of money you expect to get from future income. It is computed as the sum of future investment returns discounted at a certain rate of return expectation. of the assets will also increase.
This has been a guide to What is Deposit Accounting & its Definition. Here we discuss how does deposit accounting work along with its types and journal entries. You may also have a look at the following articles to learn more –