Income & Surplus

Question 1

Income Statement & 3 types of income

Answer 1

*contains the revenue, expenses & net income

*3 types of income

Underwriting income

Investment income

Other income

Question 2

Net Income

Answer 2

Net Income = UW Income + Investment Income + other Income – PH dividends - Tax

Question 3

Underwriting Income

Answer 3

Underwriting Income = EP – Loss & LAE Incd – Other UW Expenses Incd

Loss & LAE Incd = paid + change in case

Question 4

if the allocation of other UW expenses (component of prem) is not accurate

Answer 4

subsidies may arise that may cause problems, including:

• distortion of the profitability measures
• inefficient allocation of resources
• anti-selection

Question 5

Investment Income & 2 components

Answer 5

*Insurers have an opportunity to earn investment income because there is a delay between time that the prem is collected and when the losses are paid

*2 components of investment income in the income statement:

Net investment income earned

Net realized capital gain (position is closed for a profit)

Question 6

Investment Guidelines

Answer 6

Insurers should ensure that the investments conform to their investment guidelines. Guidelines are governed by state investment laws

Question 7

NAIC Model Investment Law

Answer 7

allows the insurer to adopt either of the following 2 types of investment guidelines:

Defined Limits: quantitative limits

Prudent Person: a principles based approach, which enables the insurer to develop its own guidelines. The insurer should strive for the protection of the PH and consider the investment expertise and resources available

Question 8

Common elements of Other Income

Answer 8

Net Gain from Agents’ or Premium Balances Charged Off

Finance & Service Charges not included in Premiums

Aggregate Write-ins for Miscellaneous Income

Question 9

Net Gain from Agents’ or Premium Balances Charged Off

Answer 9

If the insurer believes that the balances won’t be collected, it needs to recognize them as a loss. This particular component includes any balances that had previously been written off and later collected.

Question 10

Finance & Service Charges not included in Premiums

Answer 10

includes the service charges that the insurer adds to the prem that is paid in installments

Question 11

Not part of Other Income, but do impact the overall income

Answer 11

Dividends to policyholders

Federal & Foreign Income Taxes

Question 12

Capital & Surplus Account

Answer 12

*provides sources of the surplus change in addition to those reflected in the income statement

*can be used to reconcile the beginning to the ending surplus

Question 13

Current Year’s surplus

Answer 13

Current Year’s surplus = Prior Year’s Surplus + Current Year’s Net Income + Other Surplus Changes + Additional Capital Contributions – Stockholder Dividends

Question 14

Other Surplus Changes

Answer 14

• Change in Unrealized Capital Gains (profitable position that has yet to be sold in return for cash)
• Change in Net Unrealized Foreign Exchange Capital Gains
• Change in Net Deferred Income Tax
• Change in Nonadmitted Assets
• Change in Provision for Reinsurance
• Cumulative Effect of Changes in Accounting Principles
• Capital Changes & Surplus Adjustments
• Capital paid in
• Surplus paid in

*need to include reduction of Deferred Tax Liability for the reduction in unrealized gains (ie + 35%*DTL)

Question 15

2 definitions of surplus

Answer 15

*Balance Sheet definition: surplus = assets – liabilities

*Income Statement definition: surplus = prior years surplus + current year’s income

*These 2 definitions would equivalent if all balance sheet transactions also flow through the income statement

Question 16

In order to reconcile the income statement definition surplus with the balance sheet definition surplus

Answer 16

it is necessary to adjust the income statement definition surplus for transactions that do not flow through the income statement. These are either:

Direct credits (increases) to surplus

Direct charges (reductions) to surplus

*Exhibits from the Annual Statement will account for the difference: Exhibit of Non-Admitted Asset; or Capital and Surplus account

Question 17

Double Taxation

Answer 17

By investing in insurance companies, investors incur double taxation

*Cost of Double Taxation = indirect taxes - direct taxes = investment yield *corporate tax rate *(1-personal tax rate)

*cost of double taxation is an additional amount that investors need to pay by investing in securities via the insurer. To encourage investors to invest in the insurer, this lost yield needs to be paid by the PHs

*paid through premiums (as the profit margin component), since there are no direct transactions between the PHs and the investors. Since it is paid through the profit margin in the premiums (which is taxed as underwriting income), there is another layer of tax involved

Question 18

Atkinson & Dallas Formulae

Answer 18

reflect the additional cost that arises because of the investment constraints of insurers.

Cost of the insurer investing in the safer investments. This is equal to the difference between what the insurer could earn had they invested in the higher yielding equity, and what they are currently earning

Question 19

total amount of capital which is subject to this cost of holding capital

Answer 19

to the sum of:

• surplus
• equity in the unearned premium reserves (UEPR * acquisition cost %)
• equity in the undiscounted reserves (undiscounted reserve * discount rate)
• Deferred Tax Asset should be subtracted from this amount

Question 20

Amount of tax to invest in bonds vs in insurer

Answer 20

Amount of tax to invest in bonds = Investment * yield * personal tax

Amount of tax to invest in insurer = Investment * yield * (corporate + (1-corporate)*personal)

Question 21

Money needed to paid by policyholders to compensate investors for cost

Answer 21

Cost of double taxation/[(1-personal tax)*(1-corporate tax)]

if taxes paid mid year -> /(1+yield)^0.5

Question 22

Revised Cost of Holding Capital ie Atkinson & Dallas

Answer 22

Revised Cost of Holding Capital ie Atkinson & Dallas = Cost of double taxation + Investment *(riskier yield - yield) = Cost of double taxation + cost of constraints

Question 23

Calculate the Invested Capital and deciding to liquidate

Answer 23

Equity in UEPR = UEPR*acquisition %

Equity in undiscounted reserve = discounted reserve/closing IRS discount factor – discounted reserves

DTA from UEPR = UEPR*tax*(1-closing IRS discount factor)

DTA from discount = Equity in undiscounted reserve*tax*%paid during yr

Invested capital = surplus+equity in UEPR+equity in undiscounted reserve – DTA

Insurer is profitable if PV after tax income > invested capital

If insurer is not profitable, should liquidate if cost of liquidation is less than invested capital – PV of after tax income

PV after tax income = earnings*(1-tax)/cost of equity capital