Objective 5 Flashcards
1
Q
Users of financial statements
A
- Providers of capital
- Expert advisors to users of financial statements
- Anyone who is party to any of the company’s transactions
- Independent auditors
- Stock analysts
- Rating agencies
- Rule-making authorities
2
Q
Criteria for an item to be included in the financial statement
A
- Definition - must be an asset, liability, revenue or expense
- Measurability
- Relevance
- Reliability
3
Q
Organizations responsible for setting GAAP standards
A
- American Institute of Certified Public Accountants (AICPA) - provides guidance through:
a. Accounting research bulletins
b. Accounting Principles Board Opinions
c. Practice bulletins
d. Industry audit guides - Financial Accounting Standards Board (FASB) - provides guidance through:
a. Concept statements
b. Statements of Financial Accounting Standards
c. FASB interpretations
d. FASB technical bulletins
e. FASB Emerging Issues Task Force issues
f. FASB staff positions - Securities and Exchange Commission (SEC) - has authority to promulgate standards, but generally relies on the AICPA and FASB
4
Q
Renewability provisions for health insurance products
A
- Guaranteed renewable - insurer cannot cancel the policy but can raise rates
- Noncancelable - insurer cannot cancel the policy or increase premiums for any reason
- Collectively renewable - insurer may cancel policies in similar rating classes, but not individual policies
- Conditionally renewable - policy must be cancelled if certain specified reasons are met
- Optionally renewable - policy can be cancelled at any renewal date
- Short-term - provides coverage for a set term, but may provide 1-2 renewals
5
Q
Types of health insurance policies
A
- Medical coverages
- Indemnity policies
- Medical savings accounts
- Disability income
- Income replacement policies
- Business overhead policies
- Long-term-care polices
- Medicare supplement
6
Q
Formulas for benefit reserves and deferred acquisition cost reserves
A
- Definitions: x = issue age, t = policy duration, p = survival probability, v = 1 / (1 + i) where i = the valuation interest rate, B = benefits, S = claim cost per unit in force, DE = deferred acquisition expense
- Benefit net premium (BNP) = SUM(v^t * tpx * B(t)) / SUM(v^t * tpx) both summations over t, starting at 0
- Benefit reserve (BV):
a. Prospective: BV(t) = SUM(v^t * tpx * S([x] +t)) - SUM(v^t * tpx * BNP) sums beginning at valuation date t
b. Retrospective: BV(t) = SUM(BNP * (1 + i)^t /tpx) - SUM(S([x] + t) * (1 + i)^t / tpx) sums from time 0 to t-1 (last period before valuation date) - Deferrable acquisition expense net premeium (DENP) = SUM(v^t * tpx * DE(t)) / SUM(v^t * tpx)
- Deferred acquisition cost (DAC) = SUM(DENP * (1 + i)^t / tpx) - SUM(DE(t) * (1 + i)^t / tpx)
7
Q
Types of liabilities for group life and health insurance
A
- Active life and unearned premium reserves
- Expense capitalization
- Claim reserves and claim adjustment expense reserves
- Premium deficiency reserves
- Reserves for accrued experience refunds
- Liabilities related to stop-loss reinsurance arrangements
- Deferred profit liability
8
Q
Primary financial statement exhibits
A
- Balance sheet
- Income statement
- Sources and Uses statement
- Cash Flow statement
9
Q
Definitions of types of earnings
A
- Net income = total revenue - total expenses
- Operating earnings = profit from day-to-day operations (excludes taxes, interest income and expense, and extraordinary items)
- Pro forma earnings = revenue - expenses (after removing items that might cloud perceptions of true earning power of the business)
- EBIT = earnings before interest and taxes
- EBITDA = earnings before interest, taxes, depreciation, and amortization
- EIATBS = earnings ignoring all the bad stuff
10
Q
Definitions of types of cash flow
A
- Net cash flow = net income + noncash items
- Cash flow from operating activities = net cash flow +/- change in current assets and liabilities
- Free cash flow = total cash available for distribution to owners and creditors after funding all worthwhile investment activities
- Discounted cash flow = sum of money today having the same value as a future stream of cash receipts and disbursements
11
Q
Principle virtues of the cash flow statement
A
- Easy to understand
- Provides more accurate info about some activities than what appears on income statements and balance sheets
- Highlights the extent to which operations are generating or consuming cash
12
Q
Primary reasons a company’s book value does not represent the value of the company
A
- Financial statements are transaction based - asset’s value on the statements is based on purchase price and depreciation, not true value
- 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
13
Q
Techniques for forecasting external funding needs
A
These will produce the same estimate of external funding needed.
- Pro forma statement - recommended for most planning purposes and for credit analysis. External funding required = total assets - (liabilities + owners’ equity)
- Cash flow forecast - straightforward and easily understood, but less informative than pro forma. External funding required = total uses - total sources
- Cash budget - appropriate for short-term forecasting and cash management. Ending cash = beginning cash + total cash receipts - total cash disbursements. External funding required = minimum desired cash - ending cash
14
Q
Steps in the percent-of-sales approach for creating pro forma statements
A
- Examine historical data to determine which financial statement items have varied in proportion to sales in the past
- Estimate future sales as accurately as possible
- Estimate statement items by extrapolating historical patterns to the newly estimated sales. Items which do not vary with sales will need to be forecast independently
- Test the sensitivity of results to reasonable variations in sales forecast
15
Q
Ways to cope with uncertainty in financial forecasts
A
- Sensitivity analysis
- Scenario analysis
- Simulation
16
Q
Stages of the financial planning process
A
- Corporate executives develop a corporate strategy, including development of performance goals for the different divisions
- Division managers determine the activities needed for achieving the goals defined in stage 1
- Department personnel develop quantitative plans and budgets based on the activities defined in stage 2
17
Q
Life cycle of successful companies
A
- Startup
- Rapid growth
- Maturity
- Decline
18
Q
Definition of sustainable growth rate
A
- The sustainable growth rate (g*) represents the limit on a company’s growth if there is no external source of capital
- g* = R * ROE(bop), where R = earnings retention rate = 1 - dividends / earnings, ROE(bop) = earnings / equity at beginning of period
- Since ROE(bop) = PAT, then g* = PRAT, where P = profit margin, A = asset turnover ration, T = financial leverage = assets-to-equity ratio (using beginning of period equity)
- Since ROA = profit margin * asset turnover ratio, g* = RT * ROA
19
Q
Growth management strategies for when actual growth exceeds sustainable growth
A
- Sell new equity
- Increase financial leverage by increasing debt
- Reduce the dividend payout
- Prune away marginal activities “profitable pruning”
- Outsource some or all of production
- Increase prices
- Merge with a “cash cow”
20
Q
Growth management strategy for when sustainable growth exceeds actual growth
A
- Look within the firm to remove internal constraints on company growth
- Ignore the problem
- Return the money to shareholders
- Buy growth
- Reduce financial leverage
- Cut prices
21
Q
Reasons US corporations don’t issue more equity
A
- Recently, companies in the aggregate have not needed new equity
- Equity is expensive to issue
- Managers consider anything that lowers earnings per share as bad and issuing new equity will initially lower EPS
- Companies feel their stock prices are undervalued, so they choose not to sell new stock at what they think is too low a price
- Managers view the stock market as an unreliable funding source
22
Q
Types of group insurance financial reporting
A
- Statutory - focus is on solvency, so conservative standards are mandated
- GAAP - attempts to accurately reflect earnings during a reporting period:
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 - Tax - statutory reports are the starting point, with adjustments to reserve items
- Managerial reporting - GAAP reports are modified to provide a more accurate picture of the impact of management decisions
- Policyholder reporting - provides info for risk-sharing arrangements, for gov’t reporting, and for policyholders to complete their own financial reports
- Provider reporting (US only) - provides info for provider risk sharing arrangements and medical management reporting
- Assuirs (Canada only) - reporting is needed for this consumer protection plan, which indemnifies the policyholders of insolvent life insurers
23
Q
Conservative standards mandated in statutory reporting in the US
A
- Certain items are nonadmitted assets (not allowed in determining solvency; ex: agents’ balances)
- NAIC prescribes the asset values to be used
- Deferred acquisition costs are not allowed
- Recognition of expense allowances in reserves is limited
- Only in specific circumstances can lapses be assumed in policy reserve calculations
- Minimum morbidity and mortality tables are required when determining reserves
- Maximum interest rates to be used in setting reserves are specified
- Asset Valuation Reserves (AVR) and Interest Maintenance Reserves (IMR) are required in order to provide a cushion against investment losses and interest rate fluctuations
24
Q
Solvency safeguards in the Canadian Insurance Companies Act
A
- The actuary is required to examine the current and future solvency position of the company
- The actuary is required to report to the CEO and CFO matters he/she believes may have material adverse effects on the financial position of the company and require rectification
- A copy of this report is to be provided to the directors
- If the actuary believes suitable action is not being taken to rectify the matter, the actuary shall send a copy of the report to the Superintendent
25
Major modifications to US statutory reporting to produce GAAP results
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
26
Items included in the Canadian annual statement actuarial report
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
27
Modifications to US statutory reporting to produce tax reporting results
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 percentage of inforce premium
3. Group carriers must reduce provisions for refunds and unearned premiums by 20%
28
Modifications to Canadian statutory reporting to produce tax reporting results
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
29
Formula for the Gordon Constant Growth Model
1. P / D = 1 / (k - G), where P = price, D = dividends 1 year from now, k = required rate of return, or discount rate, G = growth rate of dividends
2. This formula shows that maximizing value (represented by the price to earnings ratio, or P / D) is accomplished by maximizing growth (G)
30
The components of ROE (the Dupont Formula)
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
31
Common income statement ratios for health insurers
1. Administrative expense ratio = admin expenses / revenues
2. Health benefit ratio (or loss ratio) = health benefit expenses / premium revenues
3. For simple insured business:
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
32
Adjustments needed when preparing the same-size-income statement
This statement expresses all relevant financial components as a percent of revenue.
1. Reinsurance - count reinsurance premiums as paid health expenses, and reinsurance recoveries as offsets to health care costs
2. Commissions - count as an admin expense
3. Investment income - count as non-operating income
4. ASO products - look at financial reports separately for each product type
33
FAS 60 accounting requirements
1. Premiums:
a. For short-duration contracts, premiums are recognized as revenue over the period in proportion to 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 = PV of estimated future policy benefits and related expenses - PV of estimate future net premiums. They shall be accrued as premium revenue is recognized
4. Costs related to investments, general administration, and policy maintenance - shall be charged to expense as they are incurred
5. Acquisition costs - shall be capitalized and charged to expense in proportion to premium revenue recognized
6. Premium deficiencies
7. Reinsurance - in the income statement, claims recoveries, ceded premiums, and unearned premiums shall be netted against incurred claims, premiums, and unearned premiums
8. Policyholder dividends - shall be accrued using an estimate of the amount to be paid
34
FAS 60 accounting for premium deficiencies
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 first offset by reducing the unamortized acquisition costs to the extent 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 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
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
35
(Added) Sarbanes-Oxley Requirements
1. Company management must assess internal controls over financial reporting and report its conclusion in its annual report
2. Auditor must assess management's assessment and report its own conclusion
3. Actuaries are part of the management team/auditor team providing this assessment
36
(Added) Recoverability and loss recognition
1. Recoverability tests at issue determine whether DAC asset is recoverable:
a. Gross premium valuation
b. Net-to-gross premium ratio using valuation assumptions: if net prem > gross prem, remove PAD; if net prem still > gross prem, reduce deferred acquisition expense; if net prem still > gross prem, establish a premium deficiency reserve
2. Loss recognition test after issue on a group of policies - approximate gross premium valuation using valuation assumptions
3. Once DAC is eliminated, it cannot be re-established
37
(Added) Categories of assets for FAS 115 purposes
1. Held to maturity - held at amortized value
2. Available for sale - reported at fair value in 2 parts: book value and difference between market value and book value
3. Trading - held at fair value
38
(Added) Shadow adjustments
1. Definition - collatoral effects of FAS 115 on DAC, value of business acquired, and unearned revenue liability based on change to value as if assets were sold and gains (losses) recognized; the difference between primary balance and shadow balance
2. Needed because categorizing assets as required by FAS 115 impacts equity as though assets were sold on last day of accounting period
