However, accrual accounting–in which earnings and expenses are recorded as they occur or are incurred, without regard to the actual date of collection or payment–provides a clearer picture of the underlying economics of the industry.

The cash-flow bar graph on this page shows data on net income after taxes and cash flow for the p-c insurance industry in 2000 and 2001.

As noted by many analysts, the industrys after-tax loss was $7.9 billion–well down from a profit of $20.6 billion in 2000. According to the Insurance Services Office Inc., this is the industry's first-ever annual loss.

Despite the disastrous net income figures, we find that cash flow was positive in 2001–that is, the industry had more money at year-end 2001 than at year-end 2000. And the cash inflow was stronger in 2001 than in 2000!

What is going on?

Let us first define cash flow. Following A.M. Best's characterization, cash flow is defined as premiums collected less expenses paid, less losses paid, plus investment income on a cash basis. There are other variants on this definition, but the use of another definition does not change the basic conclusions.

The primary contributor to increased cash flow in 2001 was premiums collected. As insurers raised prices, collected premiums increased by 8.1 percent. This was a much higher rate than the 6.1 percent increase in earned premiums.

Students of insurance accounting know that when prices increase, written and collected premiums initially show higher gains than earned premiums. The increase in prices is immediately recorded in the cash-flow items, but the increase has to be earned over the year to be included in accrued earned premiums.

While this factor explains some of the difference between the accrual and cash data, we need to look further to explain the 2001 net loss, as opposed to the cash flow increase.

The answer lies in the massive increase in reserves for 2001. An increase in reserves is recorded as a loss in accrual accounting, but has no direct impact on cash flow.

As shown in the other graph accompanying this column, the industry posted a massive increase of $16 billion in loss reserves in 2001, following a number of years of minor changes in loss reserves.

The increase in 2001 is partly explained by increased reserves arising out of Sept. 11 claims. In addition, a number of companies raised reserves to cover future asbestos claim payouts, where there is increasing evidence of a ratcheting up in claim activity.

From this brief overview, it is clear that looking at cash flow can add to our understanding of the industrys financial underpinnings. But confining the review only to the shoebox view would provide a very misleading picture of the industrys financial health.

Enron scandal or not, there is no compelling logic to even consider abandoning statutory accrual accounting.

Sean F. Mooney, CPCU, is senior vice president, research director and economist at Guy Carpenter & Company in New York.

Reproduced from National Underwriter Property & Casualty/Risk & Benefits Management Edition, June 24, 2002. Copyright 2002 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.