FRA - Multinationals and Financial Institutions Flashcards
Transaction G/L - Big Deal
Current Rate Method Memorize Slide
VIE Characteristics
One or Both:
- At-risk equity insufficient to finance the entity’s activities without additional financial support
- Equity investors that lack any one of the following:
- Decision making rights
- Obligation to absorb losses
- Right to receive residual returns (they get fixed return)
Temporal Method Definition and Treatment
- AKA Remeasurement, monetary/nonmonetary method
- Views overseas operation as an extension of the parent companies activities
- A&L translated at rates that preserve the measurement bases after translation:
- Current value
- historic cost
Solvency Ratios:
Int Coverage Ratio
Fixed Charge Coverage
Debt to Assets
Debt to Capital
Debt to Equity
Financial Leverage
SGR
Effects of Temporal vs. Current Method on Statements
- Temporal:
- Gain / Loss on the Income Statement
- no CTA: plug so that new R/E makes IS work
- Current:
- Balance sheet
- Goes into OCI
- CTA
Basel III
Exchange Rate Defintions
- Current Rate = foreign exchange rate as of balance sheet date
- Average Rate = average fx rate over reporting period
- Historical rate = FX rate that existed when a particular transaction occurred
- not fixed in time
- eg rate when stock was issued
Cash Ratio
Cash + Marketable Securities
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Current Liabilities
Dividend to Policyholders (shareholders) Ratio
and
Combined Ratio after Dividends (CRAD)
Dividends to Policyholders Ratio:
Dividends to Policyholders
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Net Premium Earned
Combined Ratio after Dividends (CRAD:
Combined Ratio + Dividends to Policyholders Ratio
MEMORIZE Temporal vs. Current Rates Used
Insurer Types and Attributes
-
P&C
- protection against adverse events to homes, cars, and commercial activities
- Revenue:
- Premiums
- Investment income earned on float (premiums not paid out in claims)
- Policies:
- Short-term claims lumpier based on unpredictable events
- Protect insureds for losses much greater than amt of premiums
- Act as risk managers as well as investment companies
- Revenue:
- protection against adverse events to homes, cars, and commercial activities
-
L&H (life and health)
- longer term, claims predictable based on actual mortality rates
Comparing Temporal and Current Rate Process
Tier I and Tier II Capital
- Tier I
- Common Equity: common stock, APIC, Retained earnings and OC, less intangibles, and DTA’s
- Subordinated instruments iwth no specified maturity and contractual dividends/interest
- Tier II
- subordinated insturments with original maturity >5 years
Net Profit Margin
NI
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Revenue
Effects of Appreciating and Depreciating currencies on Currency exposure under current and temporal methods (memorization table)
When to use Temporal Vs. Current Rate Methods
Determination onf FUNCTIONAL Currency is paramount
Depends on Level of Integration:
Temporal (Remeasurement):
- Local differs from Functional
- Highly integrated sub
Current Rate (Translation):
- Local = Functional
- indepdendent sub
Current Rate Steps
- Convert the IS - all revenues and expenses are translated at AVERAGE RATE
- Derive closing Retained earnings:
+Opening RE
+ NI (from IS)
- Dividends
Closing RE - Convert the balance sheet - all assets and liabilities are translated at current rate
- BS will not balance! the difference is the translation gain/loss
- Force the BS to balance by including the adjustment in shareholders equity (cumulative translation adjustment)
Note the exchange rate gain or loss for the period is the change in CTA
Basel III Tiers and Approach - DNM Percentages, but know the tiers
Expense Ratio (AKA Underwriting Expense Ratio)
Underwriting Expenses (incl commissions)
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Net Premium Written
- Measures efficiency of operations
- Is a component of Combined ratio
Underwriting Expenses Include:
- Agents’ commissions
- Staff salaries
- Marketing expenses
- Overheads
Temporal / Current Effects on Ratios
Underwriting Loss Ratio
Incurred Losses + Loss Adjustment Expenses
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Net Premium Earned
- Incurred Losses = claims + change of loss reserves*
- Loss Adjustment Expenses = cost of investigating claims*
- Measures quality of underwriting activities
- is a component of Combined Ratio
Current Rate Method Definition and Treatment
- AKA Translation
- Views the overseas operation as an investment
- All A&L (i.e., net assets are exposed to exchange rate risk)
- Exchange rate gains and losses are unrealized and stored in equity until the overseas operation is disposed of
- CTA realized in income statement on disposal
Reconcilaition of Retained Earnings (need for Temporal Method)
Opening R/E
+ Net Income
- Dividends
Closing R/E
this will be DIFFERENT IN THE INCOME STATEMENT
Force IS Net income to agree with RE net income by adding “gain” or “loss” on IS
Temporal Method Steps
- Produce top of BS (total assets)
- Produce SH/E and Liablities (RE = plug figure to ensure that the BS balances
+ Liabilities (current)
+ Common Stock (historic)
+ RE
+ Liabilities + Equity (same as Total Assets) - Derive net income from reconciliation of R/E
+Opening R/E
+ Net Income
- Dividends
Closing R/E - Produce the income statement. Net Income in the IS will be different from NI in RE
- Force the IS NI to agree to the NI in the RE reconciliation by adding a “gain” or “loss”
Liquidity Coverage Ratio
Available Stable funding / required stable funding
Basel III minimum liquidity standard minimum 100% in a one month stress scenario
Dupont Analysis (Memorize)
Gross Profit Margin
Rev - COGS
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Revenue
ROA
Net Income
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Avg Total Assets
OR
NI + Int(1-t)
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Avg Total Assets
ROE and Return on Common Equity
Net Income
________________
Avg Equity
NI - Pref Dividends
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Avg Common Equity
Temporal / Remeasurement Memorize Slide
Combined Ratio
Total Incurred Losses + Expenses
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Net Premium Earned
- Sum of Underwriting Loss and Expense Ratios
- Soft/Hard Pricing:
- High Ratio = Soft Market
- Low Ratio = Hard Market
- >100% = underwriting loss
CAMELS
-
Capital Adequacy (1 Importance)
- Goal = sufficient capital to absorb potential losses without insolvency
- Based on risk-weighted assets
- More risky assets require higher capital
- Risk weighting by category
- Tier I and Tier II Capital
-
Asset Quality (2 Importance)
- evaluates process of generating and managing assets, as well as risk control
- Evaluation includes existing and potential credit risk
- Management Capabilities
- ability to exploit profitable opportunities while controlling risk
- compliance w laws and regs
- strong corp. governance
- Risk management
- strong internal controls
- quality of reporting
- Earnings
- High quality = ROE > r
- Sustainable, positive trend, unbiased estimates, recurring sources
-
Liquidity (3 Importance)
- Long dated maturities require stble funding. Highly liquid assets dont (assets)
- Long dated deposits are more stable than short term ones (funding sources)
- Deposits from retail customers more stable than similar maturity deposits from other counterparties (ie corporates)
- Sensitivity to Market Risk
- earnings sensitivity to market risks:
- volatility of security prices
- currency values
- interest rate changes
- commodity prices
- liquidity risk
- NOTE: derivative positions create off-BS exposures to market risk
- earnings sensitivity to market risks:
Operating Profit Margin
EBIT (or operating income)
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Revenue
Dupont Analysis Walk
Cash Conversion Cycle
DSO + Days of Inventory on Hand - # days of payables
- DSO = 365 / Receivables Turnover
- Receivables Turnover = Revenue / Avg Receivables
- Days of Payables = 365 / Payables Turnover
- Payables Turnover = Purchases / Avg Payables
- Days Inventory on Hand = 365 / Inventory Turnover
- Inventory Turnover = COGS / Avg Inventory
Net Premium Written vs. Net Premium Earned
- Net Premium Written: Premiums earned over the period of coverage (net of reinsurance)
- Net Premium Earned: Premiums earned over a relevant accounting period
NOTE: UW Loss Ratio and expense ratio have different denominators
GAAP uses Net Premium Earned for both ratios
Transaction Gains / Losses Table
Loss Reserves
- Claims that have not occurred but not yet been paid out
- Based on histprical data
- incorporates estimates of future losses
- Optimistic loss reserves (small) can result in insufficient premiums given the risks borne
- Longer obligation period = harder to estimate loss reserves (changes in the size of court-awarded payouts)
- Constantly Adjusted
- Downward revision = conservative initial estimates
- Upward revision = affressive initial estimates
- Aggressive revision could indicate earnings management
Temporal vs. Current Picture Table
