Audit Considerations for Insurance Industries PDF

AUDITING SPECIALIZED INDUSTRIES Handout-01A Auditing Insurance Industries Part 1 EPC PERTINENT TERMINOLOGIES: 1. Contract of insurance – is an agreement whereby one undertake...

AUDITING SPECIALIZED INDUSTRIES Handout-01A Auditing Insurance Industries Part 1 EPC PERTINENT TERMINOLOGIES: 1. Contract of insurance – is an agreement whereby one undertakes for a consideration to indemnify another against loss, damage or liability arising from an unknown or contingent event 2. The Insurance Code – Republic Act No. 10607, an act strengthening the insurance industry, further amending Presidential Decree No. 612, otherwise known as The Insurance Code 3. Insurance Commission – the government body that regulates the operations of insurance industries 4. Insurance Commissioner – shall be appointed by the President of the Republic of the Philippines for a term of six (6) years without reappointment and who shall serve as such until the successor shall have been appointed and qualified. If the Insurance Commissioner is removed before the expiration of his term of office, the reason for the removal must be published. 5. Insurance agent – represents one or more insurance companies and sells their policies for a commission 6. Insurance broker – represents consumers in their search for coverage and can sell policies from several different insurance companies for a commission 7. Required bonds for insurance broker - Pursuant to Republic Act No. 10607 enacted on August 15, 2013, every applicant for insurance broker’s license shall file with the IC and shall thereafter maintain in force while so licensed, a bond in favor of the People of the Republic of the Philippines executed by a Company authorized to become surety upon official recognizances, stipulations, bonds and undertakings. The bond shall be in such amount as may be fixed by the Commissioner but in no case less than P500,000 and shall be conditioned upon full accounting and due payment to the person entitled thereto of funds coming into the broker’s possession through insurance transactions under license. The IC, in the CL, has set the bond requirements for insurance brokers. Every application for issuance of new or renewal of broker’s license, except reinsurance broker, shall be accompanied by a bond in the amount of not less than P1.0 million in favor of the People of the Republic of the Philippines. 8. Required errors and omissions policies for insurance brokers – Insurance brokers or reinsurance brokers must file two Errors and Omissions (Professional Liability or Professional Indemnity) insurance policies issued separately by two insurance companies authorized to do business in the Philippines. 9. Minimum net worth requirement for insurance broker New entrant as an insurance broker or reinsurance broker =20,000,000 P New entrant as an insurance broker and reinsurance broker 50,000,000 Existing insurance or reinsurance broker 10,000,000 Existing insurance and reinsurance broker 25,000,000 10. Insurance company – represents the entity who prepares and issues policies to consumers; shall include all partnerships, associations, cooperatives or corporations, including government-owned or - controlled corporations or entities, engaged as principals in the insurance business, excepting mutual benefit associations 11. Minimum paid-up capital for insurance company – at least one billion pesos 12. Minimum net worth requirement for insurance company Networth Compliance Date =250,000,000 P June 30, 2013 550,000,000 December 31, 2016 900,000,000 December 31, 2019 1,300,000,000 December 31, 2022 On January 13, 2015, the IC issued CL No. 2015-02-A which provides for the clarification of minimum capital requirements under Sections 194, 197, 200 and 289 of The New Insurance Code. 1|P age “Good. Better. Best. Never let it rest. ’Til your good is better and your better is best.” – St. Jerome AUDITING SPECIALIZED INDUSTRIES Handout-01A Auditing Insurance Industries Part 1 EPC 13. Policyholder or insured – a person or an entity that purchase life or non-life insurance policies and pays periodic premiums 14. Insurance policy - the written instrument in which a contract of insurance is set forth 15. Contract of reinsurance - is one by which an insurer procures a third person to insure him against loss or liability by reason of such original insurance 16. Reinsurer – a third person who is procured by the main insurer to insure him against loss or liability by reason of such original insurance 17. Ceding Company – the company which procures a third person to insure him against loss or liability by reason of such original insurance 18. Life Insurance – is insurance on human lives and insurance appertaining thereto or connected therewith 19. Non-Life Insurance Company – is an insurance other than life insurance companies 20. Commission Income – is recognized when services as an insurance broker or agent have been rendered. Service income includes gross inflows of economic benefits received and receivable by the entity on its own account. Amounts collected on behalf of third parties such as sales taxes, goods and service taxes and VAT are not economic benefits which flow to the entity and do not result in increases in equity. The amounts collected on behalf of the principals are not recognized as revenue. 21. Premiums – are payments made by the policyholder or insured to the insurer. An insurer is entitled to payment of the premium as soon as the thing insured is exposed to the peril insured against. Notwithstanding any agreement to the contrary, no policy or contract of insurance issued by an insurance company is valid and binding unless and until the premium thereof has been paid. 22. Financial reporting framework - means a set of accounting and reporting principles, standards, interpretations and pronouncements that must be adopted in the preparation and submission of the statutory financial statements and reports required by the Commission 2|P age “Good. Better. Best. Never let it rest. ’Til your good is better and your better is best.” – St. Jerome  AUDITING SPECIALIZED INDUSTRIES Handout-01A Auditing Insurance Industries Part 1 EPC KEY AUDIT CONSIDERATIONS Pre-Audit Engagement The consideration whether to accept an insurance client or not should take into considerations the following: 1. Competence – accountants should not portray themselves of an expertise they do not actually possess  The firm should ensure that it has personnel that possess significant competence in the field of insurance industry.  Competence can be attained when the audit team has sufficient knowledge in terms of a) the nature of insurance industry (agency, brokerage or company); b) the regulatory requirements and compliance with the specific government agency where the company reports (Bureau of Internal Revenue (BIR), Securities and Exchange Commission (SEC) and Insurance Commission (IC)); c) accounting implications particular to the company; and d) the latest trends in the insurance industry.  Further, it is important to attend on seminars and trainings in connection with the latest IC circulars and other pronouncements and updates in accounting standards related with the insurance entity. 2. Independence – consider any threats that may impair independence and objectivity  In practice, the audit team member is required to signify an independence checklist to ensure that there are no threats to independence. 3. Ability to service the client properly – no acceptance of an audit engagement if there are no qualified personnel to conduct the audit  For insurance industries, the audit partner must be duly accredited with the IC. This is a requirement before the audit partner can do the actual audit and sign an opinion regarding the financial statements.  Audit manager and senior associate should have enough experience in handling the insurance clients. It is important that they understand the specific concepts about the industry to properly identify key audit risk areas. These key audit risk areas are crucial in the identification of audit findings. Further, they should have enough time and patience to supervise the work of the audit associate and lead the latter to the correct execution of auditing procedures.  An audit associate or audit staff may be inexperienced in terms of handling insurance clients. This is true as the audit associate may be a newly-passed certified public accountant. An audit associate is tasked mainly to understand the entity and its environment, including internal controls, document the understanding in terms of narrative or flowcharts, conduct test of controls, if necessary, and do the detailed audit procedures to address the management assertions on the financial statements. Before sending an audit associate to the actual fieldwork, he or she must be properly oriented with what to do. Also, he or she must undergo preliminary trainings, particularly with the practical application of the auditing theory concepts. 4. Integrity of management – not associating with clients who lack integrity  Conduct interviews with appropriate parties such as the legal counsel of the client to obtain information about the reputation of the client  Send letter to predecessor auditor  Prior to this, the auditor should seek permission from the client to conduct an interview with the predecessor auditor.  Once permitted, the auditor will send the letter to the predecessor auditor and wait for the response of the latter as to where and when is the interview.  Matters that should be taken into consideration when consulting the predecessor auditor include:  Predecessor auditor’s understanding as to the reasons for change in auditors  Any disagreement between the predecessor auditor and the client  Any fact that may have bearing on the integrity of the prospective client’s management  Retention of existing client  There should be an evaluation at least once a year whether to retain the existing client or not. In connection with this, there must be an assessment of occurrence of major events such as change 3|P age “Good. Better. Best. Never let it rest. ’Til your good is better and your better is best.” – St. Jerome AUDITING SPECIALIZED INDUSTRIES Handout-01A Auditing Insurance Industries Part 1 EPC in management, directors, nature of business or other changes which may affect the scope of the examination.  Engagement Letter – written contract between an auditor and an audit client usually prepared after accepting an audit engagement. This sets forth the following:  Objective of the audit of financial statements  Management’s responsibility  Scope of the audit  Forms or any reports or other communicates that the auditor are expected to issue  For insurance entities, in addition to the opinion on the financial statements, the following reports are expected to be provided: a. Report of independent auditors to accompany financial statements for filing with the BIR – signed by the audit partner which indicates that no partner of our Firm is related by consanguinity or affinity to the president, manager or principal stockholders of the Company b. Report of independent auditors to accompany financial statements for filing with the SEC – signed by the audit partner which states the number of stockholder of the company owning 100 shares or more c. Report of independent auditors on supplementary schedules for filing with the insurance commission – includes attachment to the statement of business operations which is the responsibility of the management and is not part of the basic financial statements d. Supplementary schedule of financial soundness indicators under Revised Securities Regulation Code Rule 68 (for insurance brokers) – this composes of the following financial ratios for the comparative periods presented in the financial statements: i. Current ratio/Acid test ratio ii. Solvency ratio iii. Debt-to-equity ratio iv. Asset-to-equity ratio v. Interest rate coverage ratio vi. Return on assets ratio vii. Return on equity ratio viii. Net profit margin  Due to the limitations of the audit, there are unavoidable risk that material misstatements may remain undetected  After the conduct of substantive procedures, the aggregate of passed adjustments should be evaluated whether it exceeds the overall materiality set in the financial statements as a whole.  The responsibility of the management to provide an unrestricted access to the company’s records, documentation, and other information that the auditor may determine as necessary for the conduct of audit.  Billing arrangements  Expectation of receiving management representation letter and management letter  Arrangement concerning the involvement of experts. Example:  Some insurance companies would hire a qualified independent appraiser for the appraisal of its fixed assets. This is done to revalue the fixed assets to realize revaluation surplus which is an addition to the minimum net worth requirement.  For postemployment benefits, insurance companies may outsource the service of an actuary for computation of the net retirement liability or net plan assets at the end of the reporting period.  Request for the client to confirm the terms of the engagement 4|P age “Good. Better. Best. Never let it rest. ’Til your good is better and your better is best.” – St. Jerome  AUDITING SPECIALIZED INDUSTRIES Handout-01A Auditing Insurance Industries Part 1 EPC Audit Planning The auditor should plan the audit work so that the audit will be performed in an effective and efficient manner. The extent of planning is based on the size of the entity, the complexity of the audit and the auditor’s experience with the entity and knowledge of the business. Importance of adequate planning: 1. Helps ensure that appropriate attention is devoted to important areas of the audit 2. Identification of potential problems 3. Allows work to be completed expeditiously 4. Assists in the proper assignment and coordination of work 5. Helps ensure that audit is conducted efficiently and effectively The important aspects that the auditor should observe during the planning stage of the audit are as follows: 1. Understanding of the entity and its environment  The auditor should have sufficient understanding of the entity and its environment, including its internal control in order to identify events, transactions and practices that may have significant impact in the audit of the financial statements.  The following are the sources of information: i. Review of prior year working paper – for recurring audits ii. Tour on client’s facilities iii. Interview with the process owners iv. Reading books, periodicals and other publications related to the entity’s industry v. Reading corporate documents and financial reports  Considerations for new audit engagements 1. It must be noted that for initial audit engagements, the auditor should ensure that appropriate procedure is done to verify the opening balance of the balance sheet accounts. This is commonly called as Test of Beginning Balance. In addition, the auditor should obtain sufficient evidence that: a) the prior year’s ending balances in the statement of financial position have been correctly brought forward to the beginning balance of the current year’s financial statements b) appropriate accounting policies have been implemented and consistently observed 2. Understanding internal control a) Together with the understanding of the entity and its environment, the auditor should have sufficient understanding of the accounting and internal control system of the company. This is to help plan the audit and to develop effective audit approach. b) The auditor should consider the following significant classes of transactions (SCOTs) in understanding the accounting and internal control systems: SCOTs Insurance Agency Insurance Broker Insurance Company Purchases to Applicable Applicable Applicable disbursements Revenue to collection Applicable* Applicable* Applicable** Inventory management Not Applicable*** Not Applicable Not Applicable Payroll Applicable Applicable Applicable Fixed asset Applicable Applicable Applicable management * For insurance agency and broker, the main revenue stream is commission income **For insurance company, the main revenue stream is the premiums earned from policyholders. ***Inventory management is not applicable as these companies are service-oriented and do not have merchandise inventory. c) After understanding the SCOTs, the auditor should conduct test of one complete transaction and walkthrough. This is to confirm if the understanding of the auditor as represented by the process owners are really evident in terms of actual documents. d) In addition to the SCOTs, the auditor should also conduct interview regarding the financial statement closing process (FSCP) of the entity. 5|P age “Good. Better. Best. Never let it rest. ’Til your good is better and your better is best.” – St. Jerome AUDITING SPECIALIZED INDUSTRIES Handout-01A Auditing Insurance Industries Part 1 EPC 3. Developing an overall audit strategy a) In developing the overall audit strategy, the auditor should take into consideration the approach that results in the most efficient audit – that is, an effective audit performed at the least cost. Further, the audit is not unlimited as to the duration of the performance because reports are expected to meet the pertinent regulatory deadlines. With this, the audit should be devoted more into key risk areas which requires significant attention. The most common audit approach is the risk-based approach. For insurance industries, these are some of the key-risk areas that may require significant audit consideration and attention (these are not all-inclusive): Insurance Agency Insurance Broker Insurance Company  Reconciliation of cash in  Reconciliation of cash in  Reconciliation of cash in bank balance per books and bank balance per books and bank balance per books and per bank per bank per bank  Realizability of commission  Realizability of commission  Realizability of commission receivable (in connection receivable (in connection receivable (in connection with ECL assessment) with ECL assessment) with ECL assessment)  Significant fixed assets  Significant fixed assets  Significant fixed assets acquisition, including acquisition, including acquisition, including subsequent measurement of subsequent measurement of subsequent measurement of property, plant and property, plant and property, plant and equipment equipment equipment  Existence of investments and  Existence of investments and  Existence of investments and reasonableness of reasonableness of reasonableness of investment income investment income investment income  Revenue recognition  Revenue recognition  Revenue recognition (commission) and (commission) and (premiums) and completeness of revenue completeness of revenue completeness of revenue  Reasonableness of  Reasonableness of  Reasonableness of commission expense commission expense commission expense  Reasonableness of employee  Reasonableness of employee  Reasonableness of employee benefit expense benefit expense benefit expense  PFRS 16 assessment  PFRS 16 assessment  PFRS 16 assessment  Other directly attributable  Other directly attributable  Other directly attributable cost to match the revenue cost to match the revenue cost to match the revenue  Other significant contracts  Other significant contracts  Other significant contracts entered into entered into entered into  Impact of changes in tax  Impact of changes in tax  Impact of changes in tax rates and other tax rates and other tax rates and other tax considerations considerations considerations  Minimum net worth  Minimum net worth requirement, including requirement, including considerations for admitted considerations for admitted and non-admitted assets and non-admitted assets b) In addition, an audit plan should be made regarding: a) How much evidence to accumulate b) How and when this should be done c) Finally, the auditor should carefully consider the appropriate levels of materiality and audit risk. Materiality– should be viewed as: The largest amount of misstatement that the auditor could tolerate in the financial statements, or The smallest aggregate amount that could misstate the financial statements a) Materiality at planning stage – to determine the scope of the audit procedures b) Materiality at completion stage – evaluate effects of the misstatements 6|P age “Good. Better. Best. Never let it rest. ’Til your good is better and your better is best.” – St. Jerome AUDITING SPECIALIZED INDUSTRIES Handout-01A Auditing Insurance Industries Part 1 EPC How to set-up materiality? 1. Determine a benchmark that is applicable to the audit – if the client is profit-oriented, the appropriate benchmark is the pre-tax net income. If the client is not profit-oriented such as non-profit organizations, the appropriate benchmark is the total assets. 2. Set the overall materiality based on the benchmark – the amount of misstatement that can be material to the financial statements as a whole. If the overall materiality is set too high, the auditor may not detect material misstatements and vice versa. 3. Determine the tolerable misstatements at account balance level or performance materiality – this can be expressed as a percentage of the overall materiality 4. Compute for clearly trivial threshold – this can be expressed also as a percentage of the overall materiality and can be considered as the maximum misstatement that can be ignored for adjustments Audit Risk – the auditor should use professional judgment to assess audit risk and to design audit procedures to reduce the audit risk to an acceptably low level Audit risk = inherent risk * control risk * detection risk Relationship between materiality, audit risk and planned audit procedures: Planning Materiality Audit Risk Planned Audit Procedures LOW HIGH More extensive HIGH LOW Less extensive 4. Risk assessment procedures – this includes: a) Inquiries of management and others within the entity; b) Analytical procedures; and c) Observation and inspection Steps in performing preliminary analytical review: a) Develop expectations regarding financial statements b) Compare expectations with the financial statements under audit c) Investigate significant differences Use of analytical procedures in an audit Stage of Audit Objective Planning the audit  To understand the client’s business  To identify areas that may represent specific risks Substantive tests  To obtain evidence to confirm individual account balances Overall review  To identify unusual fluctuations that were not identified in the planning and testing phases of the audit  To confirm conclusions reached with respect to the fairness of the financial statements 5. Documenting the audit plan a) Audit plan – an overview of the expected scope and conduct of the audit; sets out in broad terms the nature, timing and extent of the audit procedures to be performed b) Audit program – sets out in detail the audit procedures to be performed in each segment of the audit; should include the detailed audit procedures to address the specific management assertions per account in the financial statements c) Time budget – an estimate of the time that will be sent in executing the audit procedures listed in the audit program; provides the basis of estimating audit fees and assists auditor in assessing the efficiency of the assistants 7|P age “Good. Better. Best. Never let it rest. ’Til your good is better and your better is best.” – St. Jerome