Permitted practices in insurance accounting, how they work and why they help

Abstract

In a perfect market, a firm should not be able to improve the financial condition observed by other market participants by switching to a different accounting standard, unless they also improve their real financial condition. We show that firms increase the capital observed by other market participants without changing their fundamentals. In our setup, some US life insurers use exceptions to general accounting principles called permitted practices (PPs) to increase regulatory capital without changing their operations. We believe insurers use PPs to comply with regulatory standards during tough financial times. Consistent with this view we observe a substantially larger number of PPs being used during the 2008 Great Financial Crisis compared with other years. In addition to helping comply with regulatory standards, PPs can also boost insurers’ credit ratings if rating agencies are unaware of these PPs or learn about them with a lag.