Objective 4 (C): Financial Statements Flashcards
Formula for the Gordan Constant Growth Model
P / D = 1 / (k - G); where
- 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 of P / D) is accomplished by maximizing growth (G)
Formula for sustainable growth rate (5)
Represents the limit on a company’s growth if there is no external source of capital
1) Sustainable growth rate = earnings retention rate * ROE
2) Return on equity (ROE) = Net income / Shareholder equity
3) Earnings retention rate = 1 - dividends / earnings
4) The above formulas show that if there are no dividends, then ROE = Sustainable growth rate
5) For the company to grow faster than the ROE, it would need to access external equity, which diminishes the percent of the company owned by existing shareholders
The components of ROE (the Dupont Formula) (2)
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 percent 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
Common income statement ratios for health insurers (4)
1) Administrative expense ratio = administrative expenses / revenue
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); 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 incomes - interest expense - income taxes
Adjustments needed when preparing the same-size income statement (4)
This statement expresses all relevant financial components as a percent 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
Core activities of a health insurer’s operations (4)
1) Premium cycle - The insurer collects premiums from customers in exchange for benefits
2) Investments cycle - The insurer invests excess funds, generating income from those investments
3) Benefits cycle - Policyholders receive benefits
4) Expense cycle - The insurer pays expenses other than the payment of insurance benefits
Ways to classify health insurance contracts by reference to their contractual premiums terms (4)
1) Premium mode - the frequency with which premiums are due
2) Contract length and renewability options - U.S. contracts typically are 12 months and there are various renewability options, such as guaranteed renewable
3) Inflationary vs. non-inflationary benefits - will the cost of benefits be more in the next year due to inflation, for most medical and dental this is the case
4) Premium guarantee period - often 12 months of constant premiums for U.S. health insurance companies
Health insurance products (13) split by four natural benefit liability characteristics
1) Block-level Unpaid Claim Liability (UCL); Policy Reserves
a) Issue-age-rated Medicare Supplement
b) Issue-age-rated supplemental benefits (e.g., cancer, critical illness)
2) Block-level UCL; No Policy Reserves
a) Group medical
b) Medicare Advantage
c) Medicaid managed care
d) Attained-age-rated Medicare Supplement
e) Attained-age-rated supplemental benefits
f) Group dental/vision
g) Group short-term disability
3) Seriatim Disabled Life Reserve (DLR) / In course of Settlement (ICOS), block-level IBNR, Policy Reserves
a) Individual disability income
b) Long-term care
4) Seriatim DLR/ICOS, block-level IBNR, No Policy Reserves
a) Group long-term disability
b) Group term life (DLR for the waiver-of-premium benefit)
The two types of reference through which one can look at non-benefit expenses (8, 5)
Types of insurer expenses, also referred to as administrative expenses
1) Salaries paid to employees
2) Other employee benefits, e.g., health insurance, contributions to benefits
3) Commissions paid to brokers and agents
4) Payments to vendors and consultants
5) Rent on non-owned office space
6) Capital expenditures, e.g., computer systems, furniture, etc.
7) Non-income-based taxes and regulatory fees, e.g., premium taxes
8) Income taxes (this expense is not referred to as an administrative expense)
Functional classification of administrative expenses
1) Policy acquisition expenses - Costs associated with generating new business
2) Claim administration expenses - Costs associated with the adjudication of benefits
3) Other policy maintenance expenses - Costs associated with the ongoing admin of insurance contracts
4) Investment expenses - Costs associated with generating investment income
5) Corporate overhead - Executive officer salaries, branding campaigns, and other marketing costs
Health insurance accounting topics in which actuaries may play some role in measurement (10)
1) Administrative services contracts
2) Partially insured contracts
3) Premium deficiency reserves
4) Quota share reinsurance
5) Excess-of-loss reinsurance
6) Capitation arrangements
7) Provider incentive programs
8) Experience-rated group contracts
9) Risk equalization
10) Risk corridors, rebates and remittances
Ways in which administrative services only (ASO) contracts may lead to balance sheet items of actuarial interest (2)
1) Situations where the insurer has agreed to put a portion of the ASO fees it has received at risk, contingent on certain metrics. Three broad categories:
a) Performance guarantees, which relate to operational customer service measures
b) Discount guarantee, relates to the value realized by the customer from the insurer’s provider network
c) Trend guarantees, relates to the year-over-year growth in the customer’s total benefit costs
2) When the ASO contract ends, the insurer will need to adjudicate the claims runout. This is a future economic sacrifice and, therefore, a liability is appropriate.
Federal government subsidies paid to insurers under Medicare Part D (2)
This is an example of a partial insured contract
1) The direct subsidy covers most of the premiums for Part D coverage
2) The other subsidies are based on the standard structure of the benefit plan which can change year to year
a) Reinsurance subsidy - “Catastrophic” claims are paid by government subsidy (80%), insurer (15%), and member (5%)
b) Low-income cost-sharing (LICS) subsidy - Cost share subsidies for certain low-income individuals paid for by the insurer but covered by the government
c) These subsidies are paid to insurers monthly and later, after claims run-out, the insurer settles up with the government
The generally accepted accounting model for Part D (5)
1) Premiums received from the government and/or insureds are considered revenue
2) The portion of benefit payment to pharmacies that relate to risks borne by the insurer are considered expense
3) The other regular monthly inflows to the insurer, such as reinsurance subsidies and LICS subsidies do not impact the insurer’s income statement. When the insurer receives these amounts, it debits cash and credits balance sheet accounts.
4) The portion of benefit payments to pharmacies that relate to risks retained by the government are not supposed to impact the insurer’s income statement
5) The insurer may not be able to compute portions of payment in real time that represent the government’s risk, so in practice:
a) All payments made to pharmacies get debited to insured expense
b) On a monthly basis, analysis is performed to move amounts off the income statement as appropriate
c) Crediting claims expense and debiting balance sheet accounts
Methods to estimate experience-rated refund reserves during the middle of a contract year (2)
1) Year-to-date method: The insurer records a liability based solely on actual year-to-date experience under the contract, as if the contract were to terminate as of the financial statement date
2) Prorated ultimate method: The insurer computes the amount owed to the employer for the full contract period, based on actual experience for the partial contract period and projected experience for the remainder of the contract period, and then prorates that amount
The main ways the loss ratio (LR) for ACA rebate purposes differs from the LR appearing in the insurer’s financial statements (5)
1) The financial statement LR reflects an “accounting view”, in which incurred claims represent all claims paid plus the change in reserve, over a given period of time
2) The LR computed for rebate determination purposes reflects an “actuarial view” of the experience:
a) Claims both incurred and paid in the given period of time; plus
b) Claims that were incurred in the given year and paid during the specified runout period; plus
c) The estimated UCL as of the end of the specified runout for claims incurred in the period
3) The claims and premiums used for rebate purposes are gross of reinsurance (except for ACA transitional reinsurance), whereas a financial statement LR would normally be net of reinsurance
4) For rebate purposes, the LR numerator includes insurer expenses that meet a regulatory definition of quality-improvement activities (QIA)
a) Pre-ACA, these expenses would often be reported as part of admin expenses rather than claims
b) The insurer’s inclusion of QIA in the rebate LR calculation makes it easier for insurers to reach the MLR thresholds
5) Statutory language indicates that the LR denominator for rebate purposes shall exclude federal and state taxes and fees, which has required health insurers to develop methodologies for allocating income taxes down to the state/market level
Basic formula for the ACA definition of “loss ratio” to determine ACA rebates
Prior to the credibility adjustment, the LR takes this form:
[Incurred Claims (actuarial view, gross of reinsurance) + QIA expenses] / [Earned premiums (actuarial view, gross of reinsurance, net of risk equalization) - Taxes & Fees]
General principles captured in the income statement (2)
The income statement is the net effect of all the financial transactions recognized during that period:
1) For a revenue item, the amount recognized in the period is equal to the cash directly posted to revenue (e.g., paid premiums), plus the change in the period in any associated asset balance (e.g., due & unpaid premiums), less the change in the period in any associated liability balance (e.g., unearned premium)
2) For an expense item, the amount recognized in the period is equal to the cash directly posted to expense (e.g., paid salaries), plus the change in the period in any associated liability balance (e.g., accrued salaries), less the change in the period in any associated asset balance (e.g., DAC)
Important points to emphasize about the “accounting view” of the income statement (2)
1) After an accounting period has closed, the amount of revenue and expense that accountants attribute to that period never changes
2) The amount of revenue and expense that accountants attribute to a given accounting period is a mixture of several different types of items:
a) Known cash flows relating to insurance coverage provided for the given period
b) End-of-period estimates relating to insurance coverage provided for the given period
c) The difference, if any, between the beginning-of-period estimates relating to insurance coverage provided prior to the given period, and the sum of:
i) Known cash flows occurring in the given period, but relating to insurance coverage provided prior to the given period
ii) End-of-period estimates relating to insurance coverage provided prior to the given period
