Income & Surplus Flashcards
Income Statement & 3 types of income
*contains the revenue, expenses & net income
*3 types of income
Underwriting income
Investment income
Other income
Net Income
Net Income = UW Income + Investment Income + other Income – PH dividends - Tax
Underwriting Income
Underwriting Income = EP – Loss & LAE Incd – Other UW Expenses Incd
Loss & LAE Incd = paid + change in case
if the allocation of other UW expenses (component of prem) is not accurate
subsidies may arise that may cause problems, including:
- distortion of the profitability measures
- inefficient allocation of resources
- anti-selection
Investment Income & 2 components
*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)
Investment Guidelines
Insurers should ensure that the investments conform to their investment guidelines. Guidelines are governed by state investment laws
NAIC Model Investment Law
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
Common elements of Other Income
Net Gain from Agents’ or Premium Balances Charged Off
Finance & Service Charges not included in Premiums
Aggregate Write-ins for Miscellaneous Income
Net Gain from Agents’ or Premium Balances Charged Off
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.
Finance & Service Charges not included in Premiums
includes the service charges that the insurer adds to the prem that is paid in installments
Not part of Other Income, but do impact the overall income
Dividends to policyholders
Federal & Foreign Income Taxes
Capital & Surplus Account
*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
Current Year’s surplus
Current Year’s surplus = Prior Year’s Surplus + Current Year’s Net Income + Other Surplus Changes + Additional Capital Contributions – Stockholder Dividends
Other Surplus Changes
- 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)
2 definitions of surplus
*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
In order to reconcile the income statement definition surplus with the balance sheet definition surplus
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
Double Taxation
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
Atkinson & Dallas Formulae
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
total amount of capital which is subject to this cost of holding capital
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
Amount of tax to invest in bonds vs in insurer
Amount of tax to invest in bonds = Investment * yield * personal tax
Amount of tax to invest in insurer = Investment * yield * (corporate + (1-corporate)*personal)
Money needed to paid by policyholders to compensate investors for cost
Cost of double taxation/[(1-personal tax)*(1-corporate tax)]
if taxes paid mid year -> /(1+yield)^0.5
Revised Cost of Holding Capital ie Atkinson & Dallas
Revised Cost of Holding Capital ie Atkinson & Dallas = Cost of double taxation + Investment *(riskier yield - yield) = Cost of double taxation + cost of constraints
Calculate the Invested Capital and deciding to liquidate
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
