Objective 5 - Financial Statements

Question 1

Users of financial statements

Answer 1

1. Providers of capital - investment banks, private lenders, individual investors
2. Expert advisors to users of financial statements - attorneys, actuaries, accountants
3. Any parties to any company transactions - policyholders and creditors
4. Independent auditors
5. Stock analysts
6. Rating agencies
7. Rule-making authorities - SEC, FASB

Question 2

Criteria for an item to be included in the financial statement

Answer 2

1. Definition - meets definition of asset, liability, revenue, or expense
2. Measurability - in terms of a relevant attribute
3. Relevance - info consistent, comparable, meaningful to user
4. Reliability - accurate, verifiable, free of bias

Question 3

Organizations responsible for setting GAAP standards

Answer 3

1. American Institute of Certified Public Accountants (AICPA):
   a) Accounting research bulletins
   b) Accounting Principles Board Optinions
   c) Practice bulletins
   d) Industry audit guidelines
2. Financial Accounting Standards Board (FASB):
   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
3. Securities and Exchange Commission (SEC) - has authority to promulgate standards, but generally relies on AICPA and FASB

Question 4

Renewability provisions for health insurance products

Answer 4

1. Guaranteed renewable - insurer cannot cancel policy, but may increase rates
2. Noncancelable - insurer cannot cancel or increase premiums for any reason
3. Collectively renewable - insurer may cancel policies in similar rating classes, but not individual policies
4. Conditionally renewable - may be cancelled if certain specified reasons are met
5. Optionally renewable - can be cancelled at any renewal date
6. Short-term - provides coverage for set term, but may provide 1 or 2 renewals

Question 5

Types of health insurance policies

Answer 5

1. Medical coverages - under and over 65
2. Indemnity policies - set amount per day of hosp confinement
3. Medical savings accounts
4. Disability income
5. Income replacement policies - attempt to reimburse actual econ loss associated with disability
6. Business overhead policies - costs incurred by business while key owner or manager is disabled
7. LTC
8. Medicare supplement

Question 6

Formulas for benefit reserves and deferred acquisition cost reserves

Answer 6

1. Definitions
   a) x = issue age
   b) t = policy duration
   c) p = survival probability
   d) v = 1 / (1 + i) i = valuation interest rate
   e) B = benefits
   f) S = claim cost per unit in force
   g) DE = deferred acquisition expense
2. Benefit net premium (BNP) = Sum_(t=0) v^t * tpx * B_t / Sum_(t=0) v^t * tpx (average benefit weighted on discounted survival probability)
3. Benefit reserve (BV_
   a) Prospective: tBV = Sum [v^t * tpx * S_[x]+t] - Sum [v^t * tpx * BNP]
   Sums all future cash flows beginning at valuation date (t)
   b) Retrospective: tBV = Sum [BNP * (1+i)^t / tpx] - Sum [S_[x]+t * (1+i)^t / tpx]
   Sums from time 0 to time t-1
4. Deferrable acquisition expense net premium (DENP) = Sum [v^t * tpx * DE_t] / Sum [ V^t * tpx]
5. Deferred acquisition cost (DAC) = Sum [DENP * (1+i)^t / tpx] = Sum [DE_t * (1+i)^t / tpx]

Question 7

Types of liabilities for group life and health insurance

Answer 7

1. Active life and unearned premium reserves - group life and health generally don’t have active life, but unearned premiums must be held as liability for active lives
2. Expense capitalization - deferred policy acquisition cost of unearned gross premiums should be established as an asset
3. Claim reserves and claim adjustment expense reserves
4. Premium deficiency reserves - funds any projected losses in advance
5. Reserves for accrued experience refunds
6. Liabilities related to stop-loss reinsurance arrangements
7. Deferred profit liability

Question 8

Primary financial statement exhibits

Answer 8

1. Balance sheet - financial snapshot at point in time of all assets company owns, and all claims against those assets (Assets = Liabilities + SH equity)
2. Income statement - shows revenues and expenses, illustrating how owners’ equity changes over time (Revenue - Expenses = Net Income)
3. Sources and Uses statement - gain a picture of where company got its money (sources) and how it spent it (uses)
4. Cash Flow statement - detailed look at changes in company cash balance over time, separating changes based on if cash flow comes from operating, investing, or financing activities

Question 9

Definitions of types of earnings

Answer 9

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

Question 10

Definitions of types of cash flow

Answer 10

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 = Sum of money today having same value as future stream of cash receipts and disbursements

Question 11

Principle virtues of the cash flow statement

Answer 11

1. Easy to understand
2. Provides more accurate info about some activities than what appears on income statements and balance sheets
3. Highlights the extent to which operations are generating or consuming cash

Question 12

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

Answer 12

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

Question 13

Techniques for forecasting external funding needs

Answer 13

All of these techniques will produce the same estimate of external funding required
1. Pro forma statement - prediction of what the company’s financial statements will look like at the end of the forecast period. Recommended approach for most planning purposes and credit analysis
External funding required = total assets - (liabilities + owners’ equity)
2. Cash flow forecast - forecast of sources and uses of cash. Straightforward and easily understood, but less informative than pro forma statement
External funding required = total uses - total sources
3. Cash budget - forecast of cash receipts and disbursements. 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 14

Steps in the percent-of-sales approach for creating pro forma statements

Answer 14

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 sensitivity of results to reasonable variations in sales forecast

Question 15

Ways to cope with uncertainty in financial forecasts

Answer 15

1. Sensitivity analysis - how forecast responds to change in one assump at a time
2. Scenario analysis - how assumps might change in unison in response to a particular economic event. separate forecast for each scenario
3. Simulation - probability distributions for number of uncertain inputs, computer generate distribution of possible outcomes

Question 16

Stages of the financial planning process

Answer 16

1. Corporate executives develop corporate strategy, including performance goals for different divisions
2. Division managers determine activities needed to achieve goals from stage 1
3. Department personnel develop quant plans and budgets based on activities from stage 2

Question 17

Life cycle of successful companies

Answer 17

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

Question 18

Definition of sustainable growth rate

Answer 18

1. Sustainable growth rate (g*) represents limit on company growth if there is no external source of capital
2. g* = R * ROE_bop
   R = earnings retention rate = 1 - dividends/earnings
   ROE_bop = earnings / equity at beginning of period
3. Since ROE_bop = PAT, then g* = PRAT
   P = profit margin
   A = asset turnover ratio
   T = financial leverage = assets-to-equity ration (using BOP equity)
   Therefore, to increase g*, one of P, R, A or T must increase
4. Since ROA = profit margin * asset turnover ratio, g* = RT * ROA

Question 19

Growth management strategies for when actual growth exceeds sustainable growth

Answer 19

1. Sell new equity - many companies are unwilling or unable
2. Increase financial leverage by increasing debt
3. Reduce dividend payout - not possible for most companies as they do not pay dividends
4. Prune away marginal activities (“profitable pruning”) - sell off marginal operations, put money back into remaining business
5. Outsource some/all production - those that are not core competencies
6. Increase prices - will slow actual growth, could lead to higher profit margins
7. Merge with “cash cow” - look for partner with deep pockets

Question 20

Growth management strategies for when sustainable growth exceeds actual growth

Answer 20

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

Question 21

Reasons why US companies don’t issue more equity

Answer 21

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

Question 22

Types of group insurance financial reporting

Answer 22

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

Question 23

Conservative standards mandated in statutory reporting in the US

Answer 23

1. Certain items (such as agents’ balances) are nonadmitted assets, so not allowed in determining solvency
2. NAIC prescribes asset values to be used (no 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. AVR and IMR are required in order to provide a cushion against investment losses and interest rate fluctuations

Question 24

Solvency safeguards in the Canadian Insurance Companies Act

Answer 24

1. Actuary is required to examine the current and future solvency position of the company
2. Actuary is required to report to CEO and CFO matters the actuary believes may have material adverse effects on financial position of company, require rectification
3. Copy of this report is to be provided to the directors
4. If actuary believes suitable action is not being taken, actuary shall send a copy of the report to the Superintendent

Question 25

Major modifications to US statutory reporting to produce GAAP results

Answer 25

1. Removal of some of conservatism in reserving assumptions
2. Recognition of deferred taxes
3. Recognition of 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 AVR and IMR

Question 26

Items included in the Canadian annual statement actuarial report

Answer 26

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

Question 27

Modifications to US statutory reporting to produce tax reporting results

Answer 27

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

Question 28

Modifications to Canadian statutory reporting to produce tax reporting results

Answer 28

1. Changes in actuarial reserves
2. Reserves for incurred but not reported claims
3. Provisions for deferred policy acquisition costs
4. Provisions for experience rating refunds

Question 29

Formula for the Gordon Constant Growth Model

Answer 29

1. P / D = 1 / (k - G)
   P = price
   D = dividends in 1 year
   k = required rate of return or discount rate
   G = growth rate of dividends
2. Formula shows that maximizing value (price-to-earnings ratio, P / D) is accomplished by maximizing growth (G)

Question 30

Components of ROE (the Dupont Formula)

Answer 30

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

Question 31

Common income statement ratios for health insurers

Answer 31

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

Question 32

Adjustments needed when preparing the same-size-income statement

Answer 32

Statement expresses all relevant financial components as a percent of revenue

1. Reinsurance - should count reins premiums as health expenses, and reins recoveries as offsets to health costs
2. Commissions - count as admin expense
3. Investment income - counts as non-operating income
4. ASO products - look at financial reports separately for each product type

Question 33

FAS 60 accounting requirements

Answer 33

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 estimated future net premiums. Shall be accrued as premium revenue is recognized
4. Costs related to investments, general admin, 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 (list)
7. Reinsurance - in 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 amount to be paid

Question 34

FAS accounting for premium deficiencies

Answer 34

For short-duration contracts:
1. Deficiency exists if sum of expected claims, claim adj expenses, dividends, unamortized acquisition costs, and maintenance costs exceed unearned premium
2. Deficiency is first offset by reducing unamortized acquisition costs to extent needed
3. If deficiency is greater than unamortized acquisition costs, liability shall be accrued for the difference
For long-duration contracts
1. Premium deficiency calculated using revised assumptions based on experience. Equals:
a) PV of future benefits and expenses using revised assumptions
b) Minus PV of future gross premiums using revised assumptions
c) Minus liability for future policy benefits
d) Plus unamortized acquisition costs
2. Shall be recognized by a charge to income and reduction of unamortized acquisition costs or increase in liability for future policy benefits