Learning Objective 5 - Financial Statements

Question 1

2 basic accounting principles

Answer 1

1. Financial statements are an important window into reality. There is a strong link between a company’s operations and its finances.
2. Profits do not equal cash flow. A company could be profitable and still have cash flow problems that lead to insolvency.

Question 2

assets =

Answer 2

liabilities + shareholders’ equity

Question 3

Net income =

Answer 3

revenue - expenses

Question 4

Many companies keep 2 separate sets of financial records for the purposes of:

Answer 4

1 for managing the company, 1 for tax purposes

Question 5

international accounting standards adopted by more than 100 countries, the U.S. not being one

Answer 5

IFRS

International Financial Reporting Standards

Question 6

Primary financial statement exhibits

Answer 6

1. Balance sheet - a financial snapshot, taken at one point in time of all the assets the company owns, and all the claims against those assets (assets = liabilities + equity)
2. Income statement - shows revenues and expenses, illustrating how owners’ equity changes over time (revenue - expenses = net income)
3. Sources and uses statement - is used to gain a picture of where a company got its money and how it spent money. Is prepared by comparing successive balance sheets and segregating the changes in accounts between:
   a. Sources - changes that generated cash, such as a reduction in an asset or an increase in a liability
   b. Uses - changes that consumed cash, such as an increase in an asset or a reduction in a liability
4. Cash flow statement - provides a detailed look at changes in the company’s cash balance over time. Is prepared by expanding and rearranging the sources and uses statement, placing each source or use into one of 3 categories: cash flows from operating, investing, and financing activities

Question 7

Definitions of types of earnings

Answer 7

1. Net income - total revenue less total expenses
2. Operating earnings - profit realized from day-to-day operations (excludes taxes, interest income and expense, and extraordinary items)
3. Pro forma earnings - revenue less expenses after omitting items the company believes might cloud perceptions of the true earning power of the business.
   4 EBIT is earnings before interest and taxes
4. EBITDA is earnings before interest, taxes, depreciation, and amortization.
5. EIATBS is earnings ignoring all the bad stuff

Question 8

Principle virtues of the cash flow statement

Answer 8

1. It is easy to understand
2. It provides more accurate information about some activities than what appears on income statements and balance sheets
3. It casts light on cash generation and solvency

Question 9

Definitions of types of cash flow

Answer 9

1. Net cash flow - net income + noncash items
2. Cash flow from operating activities = net cash flow plus or minus changes in current assets and liabilities
3. Free cash flow - total cash available for distribution to owners and creditors after funding all worthwhile investment activities
4. Discounted cash flow = a sum of money today having the same value as a future stream of cash receipts and disbursements

Question 10

Primary reasons why a company’s book value does not represent the value of the company

Answer 10

1. Financial statements are transactions based - so an asset’s value on the statements is based on the purchase price and depreciation, not its true value.
2. Investors buy shares of a company based on the future income they hope to receive, not based on the value of the company’s assets.

Question 11

Techniques for forecasting external funding needs

Answer 11

All of these techniques produce the same estimate of external funding required
1. Pro forma statement - a prediction of what the company’s financial statements will look like at the end of the forecast period. Is the reommended approach for most planning purposes and for credit analysis.
External funding required = total assets - (liabilities + shareholders’ equity)
2. Cash flow forecast - a forecat of sources and uses of cash. Straightforward and easily understood, but less informative than a pro forma statement.
External funding required = total uses - total sourcdes
3. Cash budget - a forecast of cash receipts and disbursements. Is appropriate for short-term forecasting and the management of cash.
Ending cash = beginning cash + total cash receipts - total cash disbursements
External funding required = minimum desired cash - ending cash

Question 12

Steps in the % of sales approach for creating pro forma statements

Answer 12

1. Examine historical data to determine which financial statement items have varied in proportion to sales in the past.
2. Estimate future sales as accurately as possible
3. Estimate statement items by extrapolating historical patterns to the newly estimated sales. Some items will not vary with sales, and will therefore need to be forecasted independently
4. Test the sensitivity of the results to reasonable variations in the sales forecast.

Question 13

Ways to cope with uncertainty in financial forecasts

Answer 13

1. Sensitivity analysis - systematically changing 1 assumption at a time and observing how the forecast responds
2. Scenario analysis - looks at how a number of assumptions might change in unison in response to a particular economic event. Generates a separate forecast for each scenario
3. Simulation - assign probability distributions to a number of uncertain inputs and use a computer to generate a distribution of possible outcomes

Question 14

Stages of the financial planning process

Answer 14

1. Corporate executives develop a corporate strategy, including development of performance goals for the different divisions.
2. Division managers determine the activities needed for achieving the goals defined in stage 1
3. Department personnel develop quantitative plans and budgets based on the activities defined in stage 2

Question 15

Life cycle of successful companies

Answer 15

1. Startup - the company loses money while developing products or services and establishing market foothold
2. Rapid growth - the company is profitable but Is growing so rapidly that it needs regular infusions of outside financing
3. Maturity - growth declines and the company switches from absorbing outside financing to generating more cash than it can profitably invest
4. Decline - the company is perhaps marginally profitable, generates excess cash, and suffers declining sales.

Question 16

Definition of sustainable growth rate

Answer 16

1. The sustainable growth rate (g*) represents the limit on a company’s growth if there is no external source of capital.
2. g* = change in equity / equity (bop) = R * ROE(bop)
   R = earnings retention rate = 1 - dividends/ earnings
   Equity(bop) - equity @ beginning of period
   ROE(bop) = earnings / equity(bop)
3. Since ROE(bop) = PAT, then g* = PRAT
   P = profit margin = net income/ sales
   A = asset turnover ratio = sales/ assets
   T = financial leverage = assets-to-equity ratio (using beginning of period equity) Therefore, to increase g*, one of P, R, A, or T must increase
4. Since ROA = profit margin * asset turnover ratio, then g* = RT` * ROA

Question 17

Growth management strategies for when actual growth exceeds sustainable growth

Answer 17

1. Sell new equity - many companies are unable or unwilling to do this
2. Increase financial leverage by increasing debt
3. Reduce the dividend payout - not possible for most companies since they don’t pay dividends
4. Prune away marginal activities (“profitable pruning”) - selling off marginal operations and putting that money back into the remaining business
5. Outsoucre some or all of production - outsource activities that are not core competencies
6. Increase prices - this will slow actual growth and could also lead to higher profit margins
7. Merge with a “cash cow” - look for a partner with deep pockets

Question 18

Growth management strategies for when sustainable growth exceeds actual growth

Answer 18

1. Look within the firm to remove internal constraints on company growth.
2. Ignore the problem - continue to invest in the core business despite poor returns, or sit on idle resources. This may lead investors or the board of directors to force a management change.
3. Return the money to shareholders - done by increasing dividends or repurchasing shares
4. Buy growth - acquire an existing business or start a new product line from scratch
5. Reduce financial leverage
6. Cut prices

Question 19

Reasons why US corporations don’t issue more equity

Answer 19

1. Recently, companies in the aggregate have not needed new equity
2. Equity is expensive to issue (costs about 5-10% of the amount raised)
3. Many mangers consider anything that lowers earning per share (EPS) as bad, and issuing new equity will initially lower EPS.
4. Most companies feel their stock prices are undervalued, so they choose to not sell new stock at what they think is too low a price.
5. Many managers view the stock market as an unreliable funding source, so they build funding strategies that do not rely on the stock market.

Question 20

ASOP #7

Answer 20

describes the items an actuary should consider when testing both liability and asset cash flows

Question 21

ASOP #22

Answer 21

mentions cash flow testing under moderately adverse scenarios as the most common method for forming an actuarial opinion on asset adequacy, but allows for other methods

Question 22

ASOP #28

Answer 22

instructs the actuary to consider specific policy and contract provisions affecting liabilities and assets, and to make sufficient provision for adverse deviation from reasonable assumptions

Question 23

Types of group insurance financial reporting

Answer 23

1. Statutory - the focus is to demonstrate solvency throug hthe balance sheet, so convserative standards are mandated
2. GAAP - attempts to accurately reflect the earnings during a reporting period, so it focuses on the income statement. Therefore, much of the conservatism in statutory reporting is removed.
   a. In the US, publicly-traded companies and mutual companies must prepare GAAP reports
   b. In Canada, insurers can only publish statements that are based on statutory accounting.
3. Tax - in general, statutory financial reports are the starting point, with certain adjustments to reserve items
4. Managerial reporting - usually GAAP reports are modified to provide a more accurate picture of the impact of management decisions
5. Policyholder reporting - provides information for risk-sharing arrangements, for government reporting, and for policyholders to complete their own financial reports
6. Provider reporting (in US) - provides information for provider risk sharing arrangements and medical management reporting
7. Assuris (in Canada) - reporting is needed for this consumer protection plan, which indemnifies policyholders of insolvent life insurers

Question 24

Conservative standards mandated in statutory reporting in the US

Answer 24

1. Certain items (such as agents’ balances) are nonadmitted assets, meaning they are not allowed in determining solvency.
2. NAIC prescribes the asset values to be used (does not allow flexibility)
3. Deferred acquisition costs are not allowed
4. Recognition of expense allowances in reserves is limited
5. Only in specific circumstances can lapses be assumed in policy reserve calculations
6. Minimum morbidity and mortality tables are required when determining reserves
7. Maximum interest rates to be used in setting reserves are specified
8. Asset Valuation Reserves (AVR) and Interest Maintenance Reserves (IMR) are required in order to provide a cushion against investment losses and interest rate fluctuations

Question 25

Solvency safeguards in the Canadian Insurance Companies Act

Answer 25

1. The actuary is required to examine the current and future solvency position of the company.
2. The actuary is required to report to the CEO and CFO matters the actuary believes may have material adverse effect on the financial position of the company and require rectification
3. A copy of this report is to be provided to the directors
4. If the actuary believes suitable action is not being take n to rectify the matter, the actuary must send a copy of the report to the Superintendent.

Question 26

Major modifications to US statutory reporting to produce GAAP results

Answer 26

1. Removal of some of the conservatism in reserving assumptions
2. Recognition of deferred taxes
3. Recognition of the market value of most assets
4. Recognition of lapses in reserves
5. Capitalization of deferred acquisition costs
6. Recognition of all receivables and allowances
7. Removal of the AVR and IMR

Question 27

Items included in the Canadian annual statement actuarial report

Answer 27

1. a description and justification for all assumptions
2. A description of any approximations used
3. Any changes in the assumptions and the effect thereof
4. A signed statement affirming compliance with Canadian actuarial standards of practice
5. A description of how the actuary is compensated and a signed statement that the actuary has performed his duties without regard to personal considerations
6. A signed copy of the opinion of the actuary
7. Any other information that the Superintendent may require.

Question 28

Modifications to US statutory reporting to produce tax reporting results

Answer 28

1. Use of minimum interest rates for tax reserves
2. Use of the DAC tax to delay recognition of certain expenses. This tax is not related to any real expense, but is instead a specified % of inforce premium
3. Group carriers must reduce provisions for refunds and unearned premiums by 20%

Question 29

Modifications to Canadian statutory reporting to produce tax reporting results

Answer 29

1. Changes in actuarial reserves
2. Reserves for incurred but unreported claims
3. Provisions for deferred policy acquisition costs
4. Provisions for experience rating refunds

Question 30

Formula for the Gordon Constant Growth Model

Answer 30

P/ D = 1 / (k-G)

P = price
D = dividends one year from now
k= required rate of return, or discount rate
G = growth rate of dividends

This formula shows that maximizing value (represented by the price-to-earnings ratio, or P / D) is accomplished by maximizing growth (G0

Question 31

The components of ROE (Dupont Formula)

Answer 31

1. Return on assets (ROA) = Total asset turnover * Net profit margin.
   This explains what return on all invested assets can be earned by the company.
   a. Total asset turnover = Revenue / Total Assets
   This explains how much total investment is required to meet the requirements of the business
   b. Net profit Margin = Net income / Revenue
   This explains what % on sales becomes profit.
2. Return on Equity (ROE) = ROA * Total leverage ratio = Net Income / Shareholder Equity
   a. Total leverage ratio = Total Assets/ Shareholder equity.
   This explains to what degree the business can be operated by leveraging other peoples’ money.

Question 32

Common income statement ratios for health insurers

Answer 32

1. Administrative expense ratio = administrative expenses / revenues
2. Health benefit ratio (or loss ratio) = health benefit expenses / premium revenues
3. For simple insured business (i.e., no non-premium revenues such as ASO fees):
   a. Operating profit margin = operating profits / revenues = 1 - health benefit ratio - administrative expense ratio
4. Net margin = net income / revenues
   a. Net income = operating profits + investment income - interest expense - income taxes

Question 33

Adjustments needed when preparing the same-size-income statement & PMPM analysis

Answer 33

Same-sized-income statement expresses all relevant financial components as a % of revenue

1. Reinsurance - should count reinsurance recoveries as offsets to health care costs
2. Commissions - count as an administrative expense
3. Investment Income - count as non-operating income
4. ASO products - look at financial reports separately for each product type

Question 34

Effects of ACA provisions on health insurer financial statements

Answer 34

1. Increased level of uncertainty in financial statements - due to the need to estimate the impact of risk-adjustment provisions, reinsurance benefits, and the seasonal pattern of incurred claims in light of significant plan design changes.
2. Issues with year-to-year comparability of the balance sheet - due to a # of large new assets or liabilities, such as the reinsurance and risk-adjustment programs receivables and payables
3. Issues with year-to-year comparability of the income statement - some provisions (such as the health insurance providers fee and reinsurance program contributions ) may result in year-to-year mismatches between revenue and expense
4. Issues with issuer-to-issuer comparability - due to a few provisions for which the issuer has flexibility with regard to accounting policy or timing of payment.

Question 35

the ACA could affect Premium Deficiency Reserve (PDR) calculations in the 3 following ways:

Answer 35

1. If an insurer overestimated its risk adjustment receivables for this year and future years, then it may have underestimated its future losses and resulting PDR.
2. Enhance reviews of rate increase filings could result in needed rate increases being denied, which could result in the need for a PDR
3. Changes in the marketplace beginning in 2014 could lead to changes in how insurers define their blocks of business for PDR testing purposes (ex. on exchange and off exchange products may be considered separate blocks of business)

Question 36

Premium stabilization programs in the ACA

Answer 36

1. Risk adjustment - permanent program that began in 2014
   a. designed to allow a health insurer to price products without factoring in the health status of the individuals purchasing these products
   b. insurers whose pools have lower-than-average risk scores will transfer funds to those whose pools have higher-than-average risk scores
   c. Applies to individual and SG products
2. Reinsurance - will be in effect from 2014-2016
   a. Applies to individual insurance only
   b. Is funded by assessment paid by commercial insurers and self-funded plans.
   c. The 2014 benefit will be 80% of claims between $60K-$250K for a given individual
3. Risk Corridor - will be in effect from 2014-2016
   a. designed to provide some protection against variability in claims cost
   b. applies to Ind and SG products
   c. The insurer pays HHS if actual experience is more than 3% below the target amount. And HHS pays the insurer if actual experience is more than 3% above the target.
   d. The payment amount is 50% of the amount +/- 3% of the target and +/- 8% of the amount of the target, and 80% of the amount that is +/- 8% of the target
   e. the calculation is done after accounting for amounts transferred as a result of the risk-adjustment and reinsurance programs

Question 37

Differences between the ACA and Medicare Advantage risk-adjustment programs

Answer 37

1. ACA risk adjustment uses a concurrent model (current year data is used to develop risk scores). But MA risk adjustment is based on a retrospective model (prior year data is used instead), which makes risk scores far more predictable as of the financial reporting due.
2. MA risk adj is performed as a single national program, which makes it much simpler than the ACA approach, which is by state, market, and risk pool
3. MA plans have relatively stable membership. Ind and SG plans will be far less stable, which will make it harder to estimate risk-adjustment amounts.
4. The payment process used for MA risk adj allows insurers to develop relatively accurate estimates of their ultimate settlement amounts.

Question 38

Elements of ACA risk adjustment that may lead to uncertainty in an inusurer’s financial statments

Answer 38

1. Uncertainty as to the insurer’s risk score - because risk adjustment is based on concurrent analysis, the insurer will not have complete data by year end for calculating risk score.
2. Uncertainty as to other insurer’s risk scores - the insurer’s payment will depend on its risk score relative to others in the market, so the insurer will need to estimate the average risk score of other insurers
3. Uncertainty as to member exposure - determining yearend membership is difficult because the ACA require insurers to use a 90-day premium grace period provision for any member receiving a premium subsidy
4. Granularity of the calculation - ACA RA requires insurers to do a separate calculation for various risk adjustment cells, which complicates the modeling required to estimate risk adjustment balances.
5. Implications of data reviews - data validation reviews could lead to payment adjustments if data is later found to contain errors.

Question 39

Aspects of the ACA reinsurance program that can increase uncertainty in financial statements

Answer 39

1. Accrual for reinsurance on unpaid claims - insurers may need to estimate recoveries on claims that have yet to be paid. It will be difficult to accurately estimate these recoveries.
2. Magnitude of the reinsurance recovery accrual - since there will not be interim settlements, the full year’s reinsurance recovery will need to be accrue at yearend. This will result in a relatively large accrual.
3. Potential valuation allowance on reinsurance recoverable - reinsurance benefits are limited to available funds in the reinsurance pool, so benefits may be reduced for all insurers. Insurers need to consider whether to reduce the recoverable amount by a valuation allowance.
4. Potential for denied reinsurance claims - a review process may lead to some claims being denied, but this will not occur until after yearend statements are filed. So insurers may way to apply a probability of claim denial to their estimated recoverables.

Question 40

New health insurance taxes and fees due to the ACA

Answer 40

1. Health insurance provider fee (HIPF) - a new non-deductible excise tax assessed to insurers based on prior year market share of premiums in eligible lines of business (insured major medical, dental/ vision, MA, Part D, & Medicaid). Companies not subject federal income tax only count 1/2 of their premiums. Amount assessed will be 8 billion in 2014, 11.3 billion in both 2015 & 2016, increasing thereafter.
2. Reinsurance contribution - the ACA reinsurance benefits will be funded by this assessment charged to health insurers and sponsors of self-funded health plans. Contribution rate was $5.25 PMPM in 2014.
3. Patient Centered Outcomes Research Institute (PCORI) fee - for plan years ending between October 2012 & Septmeber 2019. Was $1 PMPY for the first plan year, $2 PMPY for the 2nd year, and indexed for inflation for future years.
4. Risk adjustment user fee - applies to issuers of plans to which the ACA risk-adjustment program applies. Was $0.96 PMPY in 2014.
5. Federally-facilitated exchange user fee - applies to issuer of plans offered through a federally-facilitated exchange. Was 3.5% of premium in 2014.
6. Excise tax for high-cost health plans (beginning in 2018)
7. Limitations to tax-favored allowances for FSAs
8. New taxes on certain medical devices

Question 41

Impact of ACA on actuarial liabilities

Answer 41

1. Claim liabilities - claim payment patterns and PMPM claim cost levels will change at the beginning of 2014 due to required plan design changes, the addition to the risk pool of many individuals who were previously uninsured, changes in claim operations, and other effects of the ACA. This will make it challenging to set reserves using the typical reserving methods.
2. Contract reserves - some insurers have held contract reserves in the individual market to account for the effect of underwriting wear-off. These will no longer be appropriate beginning in 2014 because underwriting will not be allowed.
3. Due and unpaid premium asset - this asset will be affected by the 90-day premium grace period provision that must be given to those who receive premium subsidies through the exchanges.
4. Premium Deficiency reserve - enhanced reviews of rate increase filing could result in needed rate increases being denied, which could result in the need for a PDR. Also, insurers will need to decide whether to treat exchange products as separate blocks of business for PDR purposes.

Question 42

Users of financial statements

Answer 42

1. Providers of capital - such as investment banks, private leaders, and individual investors
2. Expert advisors to users of financial statements - this includes attorneys, actuaries, and accountants
3. Anyone who is party to any of the company’s transactions - includes policyholders & creditors
4. Independent auditors
5. Stock analysts
6. Rating agencies
7. Rule-making authorities - such as the SEC & FASB

Question 43

Criteria for an item to be included in the financial statement

Answer 43

1. Definition - item needs to meet the definition of an asset, liability, revenue, or an expense
2. Measurability - an item must be measurable in terms of a relevant attribute
3. Relevance - information about the item needs to be consistent, comparable, and meaningful to the user
4. Reliability - the information must be accurate, verifiable, and free of bias

Question 44

FAS 60 accounting requirements

Answer 44

1. Premiums:
   a. For short-duration contracts, premiums are recognized as revenue over the period in proportion t the amount of insurance protection provided.
   b. For long-duration contracts, premiums shall be recognized as revenue when due from policyholders
2. Liabilities for unpaid claims and claim adjustment expenses - shall be accrued when insured events occur
3. Liabilities for future policy benefits for long-duration contracts = PV of estimated future policy benefits and related expenses - PV of estimated future net premiums. Accrued as premium is recognized.
4. Costs related to investments, general administration, and policy maintenance - shall be charge to expense as they are incurred.
   5 Acquisition costs - shall be capitalized and charged to expense in proportion of premium revenue recognized
5. Premium deficiencies
6. Reinsurance - in the income statement, claims recoveries, ceded premiums, and unearned premiums shall be netted against incurred claims, premiums, and unearned premiums.
7. Policyholder dividends - shall be accrued using an estimate of the amount to be paid.

Question 45

FAS 60 accounting for premium deficiencies

Answer 45

For short-duration contracts:

1. A deficiency exists if the sum of expected claims, claim adjustment expenses, dividends, unamortized acquisition costs, and maintenance costs exceed unearned premium
2. The deficiency is 1st offset by reducing the unamortized acquisition costs to the extend needed.
3. If the deficiency is greater than unamortized acquisition costs, a liability shall be accrued for the difference

For long-duration contracts:
1. Premium deficiency is calculated using revised assumptions based on experience . It equals:
a. PV of future benefits and expense using the revised assumptions
b. Minus PV of future gross premiums using the revised assumptions
c Minus the liability for future policy benefits
d. Plus unamotirzed acquisition costs
2. Shall be recognized by a charge to income and a reduction of unamortized acquisition costs or an increase in the liability for future policy benefits.

Question 46

Recommended actuarial practice when working on financial audits, reviews, and examinations

Answer 46

1. Scope & planning- the reviewing actuary should assist with the planning for an audit and should understand the relevant aspects of the scope of the audit.
2. Discussion between responding actuary and entity - the responding actuary should discuss hi or her responses with the entity being audited
3. The reviewing actuary should disclose to the auditor any relationships with the entity (or its affiliates) that is being audited.
4. Communication from responding actuary - the responding actuary should be appropriately responsive to request from the auditor, examiner, or reviewing actuary.
5. Requests for information - the reviewing actuary and responding actuary should cooperate when compiling the needed information
   a. The reviewing actuary should communicate, preferably in writing, what information is requested and within what time frame
   b. The responding actuary should consider whether the information requested is readily available, and if not, what other information that would meet the auditor’s needs is available or can reasonably be produced.
   c. The responding actuary should be prepared to discuss the data, assumptions, methods, and models used by the entity
   d. The responding actuary should be prepared to discuss circumstances that had or may have a significant effect on items being audited (e.g., changes i the operating environment or trends in experience)
6. Documentation - the reviewing actuary’s documentation should include a summary of the items subject to the audit and the results of the review. The responding actuary should document what information was provided to the auditor.