Objective 4 - Financial Statements Flashcards
Formula for the Gordon Constant Growth Model
1. 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 price-earnings ratio, or P / D) is accomplished by maximizing growth (G)
Skwire Ch. 41, Page 728
Formula for Sustainable Growth Rate
Represents the limit on a company’s growth if there is no external source of capital
- Sustainable Growth Rate = Earnings Retention Rate * ROE
- ROE = Net Income / Shareholder Equity
- Earnings Retention Rate = 1 - dividends / earnings
- The above formula shows that if there are no dividends, then ROE = sustainable growth rate
- For the company to grow faster than the ROE, it would need to access external equity, which diminishes the % of the company owned by existing shareholders
Skwire Ch. 41, Page 729
The Components of ROE (Dupont Formula)
- Return on Assets (ROA) = Total Asset Turnover * Net Profit Margin
a) This explains what return on all invested assets can be earned by the company
b) Total Asset Turnover = Revenue / Total Assets
- -> This explains how much total investment is required to meet requirements of the business
c) Net Profit Margin = Net Income / Revenue.
- -> This explains what % of sales become profit - Return on Equity = Return on Assets * 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 people’s money
Skwire Ch. 41, Page 730
Common Income Statement Ratios for Health Insurers
- Administrative expense ratio = administrative expenses / revenues
- Health Benefit Ratio (or loss ratio) = health benefit expenses / premium revenues
- 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 = Admin Expense Ratio - Net Margin = Net Income / Revenues
a) Net Income = Operating Profits + Investment Income - Interest Expense - Income Taxes
Skwire Ch. 41, Page 737
Adjustments needed when preparing the same-size income statement
(this statement expresses all relevant financial components as a % of revenue)
- Reinsurance - should could reinsurance recoveries as offsets to health care costs
- Commissions - count as an administrative expense
- Investment Income - count as non-operating income
- ASO products - look at financial reports separately for each product type
Skwire Ch. 41, Page 740
Core Activities of a Health Insurer’s Operations
- Premium Cycle - The Insurer Collects Premiums from customers in exchange for benefits
- Investments Cycle - The Insurer invests the excess funds, generating income from those investments
- Benefits Cycle - Policyholders receive benefits
- Expense Cycle - The insurer pays expenses other than the payment of insurance benefits
GHFV-109-19, Page 10
Ways to classify health insurance contracts by reference to their contractual premiums terms
- Premium (M)ode - the Frequency with which premiums are due
- Contract Length and (R)enewability Options - U.S. Contracts typically are 12 months and there are various renewability options, such as guaranteed renewable
- (I)nflationary 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
- Premium (G)uarantee period - often 12 months of constant premiums for U.S. Health insurance companies
contract looks GRIM
GHFV-109-19, Page 10
Health Insurance Products Split by Four Natural Benefit Liability Characteristics
Policy Res ; Block-Level UCL*
- Issue-Age Rated Medicare Supplement
- Issue-Age Rated Supplemental Benefits
No Policy Res ; Block-Level UCL*
- Group Medical
- MA
- Medicaid Managed Care
- Attained-Age Rated Medicare Supplement
- Attained-Age Rated Supplemental Benefits
- Group Dental/Vision
- Group STD
Policy Res ; Seriatim DLR/ICOS, Block-Level IBNR
- Individual Disability Income
- Long Term-Care
No Policy Res ; Seriatim DLR/ICOS, Block-Level IBNR
- Group LTD
- Group Term Life (DLR for WoP benefit)
GHFV-109-19, Page 29
The Two Frames of Reference Through Which one Can Look at Non-Benefit Expenses
- Type and Function
- Types of Insurer Expenses, also referred to as administrative expenses, include:
a) Salaries paid to employees
b) Other EE benefits, e.g., health insurance, contributions to benefits
c) Commissions paid to brokers and agents
d) Payments to vendors and consultants
e) Rent on non-owned office space
f) Capital Expenditures, e.g., computer systems, furniture, etc.
g) Non-income-based taxes and regulatory fees, e.g., premium taxes
h) Income taxes (this expense is not referred to as an administrative expense) - Functional Classification of Administrative expenses might look like this:
a) Policy Acquisition Expenses - Costs associated with generating new business
b) Claim Administration expenses - Costs associated with the adjudication of benefits
c) Other Policy Maintenance expenses - Costs associated with the ongoing admin of insurance contracts
d) Investment expenses - Costs associated with generating investment income
e) Corporate Overhead - Executive officer salaries, branding campaigns, and other marketing costs
GHFV-109-19, Page 31
Health Insurance Accounting Topics in Which Actuaries May Play Some Role in Measurement
- Administrative Services Contracts
- Partially Insured Contracts
- Premium Deficiency Reserves
- Quota Share Reinsurance
- Excess-of-loss Reinsurance
- Capitation Arrangements
- Provider Incentive Programs
- Experience-rated Group Contracts
- Risk Equalization
- Risk Corridors, Rebates, and Remittances
GHFV-109-19, Page 36
Ways in which Administrative Services Only (ASO) Contracts may lead to balance sheet items of Actuarial Interest
- 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 - 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.
GHFV-109-19, Page 41
Federal Government Subsidies Paid to Insurers under Medicare Part D
This is an example of a partial insured contract
- The direct subsidy covers most of the premiums for Part D coverage
- 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 : 80% govt subsidy, 15% insurer; 5% member
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
GHFV-109-19, Page 42
Generally accepted accounting model for Part D
- Premiums received from the government and/or insureds are considered Revenue
- The portion of benefit payment to pharmacies that relate to risks borne by the insurer are considered expense
- 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
- 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
- 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
GHFV-109-19, Page 44
Methods to Estimate Experience-Rated Refund (ERR) Reserves During the Middle of a Contract Year
- 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
- Pro-rated 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
GHFV-109-19, Page 64
The Main Ways the Loss Ratio (LR) for ACA Rebate Purposes Differs from the LR Appearing in the Insurer’s Financial Statements
- The financial statement LR reflects and “accounting view,” in which incurred claims represent:
a) All claims paid plus the change in reserve, over a given period of time - The LR computed for rebate determination purposes reflects and “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 - The claims and premiums used for rebate purposes are gross reinsurance (except for ACA transitional reinsurance), whereas a financial statement LR would normally be net of reinsurance
- 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 - 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
GHFV-109-19, Page 76
Basic Formula for the ACA Definition of “Loss Ratio” to Determine ACA Rebates
Prior to the credibility adjustment, the LR takes this form:
[EP (actuarial view, gross of reins, net of risk equalization) - Taxes & fees]
GHFV-109-19, Page 77
General principles captured in the income statement
Income Statement is the new effect of all the financial transactions recognized during that period:
- For a revenue item, the amount recognized in the period is equal to the cash directly posted to revenue (e.g., paid premiums0, 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)
- 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 associate liability balance (e.g., accrued salaries), less the change in the period in any associated asset balance (e.g., DAC)
GHFV-109-19, Page 82
Important Points to Emphasize about the “Accounting View” of the Income Statement
- After an accounting period has closed, the amount of revenue and expense that accountants attribute to that period never changes
- The amount of revenue and expenses that accountants attribute to a given 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
GHFV-109-19, Page 83
Reasons an Actuary Would Not Want to Work with the Revenue and Claims are Reported by the Insurer’s Accountant
- Those amounts are potentially distorted by prior-period effects
- Those amounts included end-of-period estimates of quantities that become more certain with time
GHFV-109-19, Page 84
Statutory Financial Reports Required for Insurers Regulated by the NAIC
- The annual statement blank
- The quarterly statement blank
- The annual risk-based capital (RBC) report
- The annual audited financial statement
- The annual actuarial opinion
- The annual actuarial opinion memorandum (AOM)
GHFV-109-19, Page 92
Conceptual differences between SAP and GAAP financial reporting for Insurers
- The parent company is usually regulated by the SEC (use GAAP), and the subsidiary company that’s selling the insurance is regulated by the state (use SAP)
- SAP focus is on financial solvency and GAAP focuses on the future earnings potential
- Statement blanks used for statutory reporting are completely pre-formatted, thus consistent across insurers
- Greater detail is required by insurers in statutory financial statements than provided in SEC filings
- A prescribed statement of actuarial opinion does not exist for GAAP nor is it required on the consolidated GAAP reserves of the parent company
GHFV-109-19, Page 93
Key Characteristics used to distinguish short-duration contracts verses long-duration contracts under GAAP
- Key Characteristics of short-duration contracts include:
a) short-duration contracts specify that insurance protection is provided “for a fixed period of short duration”
b) The insurer has the right “to cancel the contract or adjust the provisions of the contract at the end of any contract period, such as adjusting the amount of premiums charged or coverage provided” - Long-duration contracts specify that “the contract generally is not subject to unilateral changes in its provisions,” and that “the contract requires the performance of various functions and services (including insurance protection) for an extended period”
GHFV-109-19, Page 103
Financial Accounting for Premium Deficiencies
Original FAS 60, now ASC 944
For Short-Duration Contracts:
- A deficiency exists if the sum of expected claims, claim adjustment expenses, dividends, unamortized acquisition costs, and maintenance costs exceed unearned premium
- The deficiency is first offset by reducing the unamortized acquisition costs to the extent needed
- If the deficiency is greater than unamortized acquisition costs, a liability shall be accrued for the difference
For Long-Duration Contracts:
- Premium deficiency is calculated using revised assumptions based on experience. It equals:
a) PV of future benefits and expenses 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 unamortized acquisition costs
* *Items a & b together are also referred to as the Gross Premium Reserve
* *Items c & c together are also referred to as the locked-in net GAAP liability - 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
GHFV-109-19, Pages 108 and 110
Accounting Concepts That Have Influenced the Development of NAIC SAP Guidance
The Preamble to the Accounting Practices and Procedures Manual (APPM) lays out three main concepts that have influenced the development of NAIC SAP Guidance:
- Conservatism - Statutory-basis financial statements’ primary interests are protecting the interests of policyholders. GAAP financial reporting emphasis is on helping providers of capital assess the entity’s prospects for future net cash inflows.
- Consistency - Regulators benefit from having consistency across all the insurers they regulate, as seen in the pre-formatted financial statement blanks discussed earlier
- Recognition - in Accounting, “recognition” refers to the determination of whether or not a particular event ought to be included within the financial statements
GHFV-109-19, Page 117