Shadow Accounting is keeping two sets of accounts or books for strengthening back office activities. Shadow accounting is applied to all those situations where realized gains and losses on investments would influence insurance assets and/or insurance liabilities, and unrealized gains and losses on those investments exist. Where applicable, the adjustment to PVIF (present value of acquired in–force business ), DAC (Deferred acquisition costs ) and the insurance liabilities is recognized in a manner consistent with the recognition of the unrealized gains and losses on the investments.
Shadow Accounting may be defined as – An accounting adjustment to allow for the impact of recognizing unrealized gains or losses on related insurance assets and liabilities, in a consistent manner to the recognition of the unrealized gains or losses on financial assets that have a direct effect on the measurement of the related insurance assets and liabilities. For example, in the income statement or in the statement of changes in equity.
Because it allowed by the extension of local GAAP by IFRS 4 related to CFS (consolidated financial statements) for insurance companies, shadow accounting is a practice of accounting which is applied to account for insurance liabilities for insurance contracts with discretionary participation features. Under this practice, positive or negative valuation differences in the corresponding financial assets which will potentially revert to policyholders are recognized in a Deferred profit sharing reserve.
The deferred profit sharing is being recognized on the liabilities side of the balance sheet under technical reserves of insurance company or on the asset side with an off-setting entry in the income statement or in the valuation reserve, in the same way as unrealized gains and losses on the underlying assets.
The deferred profit sharing is determined in two stages:
1. By allocating unrealized gains and losses on the assets to insurance contracts with participation features on the basis of a three-year historic average;
2. Then by applying to the re-measurements of insurance contracts with participation features a historical distribution key observed over the past three years for redeemable securities and a 100% key for the other financial assets.