Objective 5 - Financial Statements

Question 1

Primary financial statement exhibits

Answer 1

1. Balance sheet - a financial snapshot, taken at a point in time, of all the assets the company owns,and all the claims against those asset (Assets = Liabilities + Shareholders’ 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 (sources) and how it spent money (uses)
4. Cash Flow statement - provides a detailed look at changes in the company’s cash balance over time, separating changes based on if the cash flows came from operating, investing, or financing activities

Question 2

Definitions of types of earnings

Answer 2

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
5. EBITDA is earnings before interest, taxes, depreciation, and amortization
6. EIATBS is earnings ignoring all the bad stuff

Question 3

Definitions of types of cash flow

Answer 3

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 4

Principle virtues of the cash flow statement

Answer 4

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 highlights the extent to which operations are generating or consuming cash

Question 5

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

Answer 5

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 6

Techniques for forecasting external funding needs

Answer 6

All of these techniques will 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 recommended approach for most planning purposes and for credit analysis.
External funding required = total assets - (liabilities + owners’ equity)
2. Cash flow forecast - a forecast of sources and uses of cash. Straightforward and easily understood, but less informative than a pro forma statement.
External funding required = total uses - total sources
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 7

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

Answer 7

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 pattens 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 8

Ways to cope with uncertainty in financial forecasts

Answer 8

1. Sensitivity analysis - systematically changing one 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 9

Stages of the financial planning process

Answer 9

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 10

Life cycle of successful companies

Answer 10

1. Startup - the company loses money while developing products 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 reinvest
4. Decline - the company is perhaps marginally profitable, generates excess cash, and suffers declining sales

Question 11

Definition of sustainable growth rate

Answer 11

1. The sustainable growth rate (g*) represent 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 at beginning of period
   ROE(bop) = earnings / equity(bop)
3. Since ROE(bop) = PAT, then g* = PRAT
   P = profit margin
   A = asset turnover rato
   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 12

Growth management strategies for when actual growth exceeds sustainable growth

Answer 12

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 do not pay dividends
4. Prune away marginal activities (“profitable pruning”) - selling off marginal operations and putting that money back into the remaining business
5. Outsource 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 13

Growth management strategies for when sustainable growth exceeds actual growth

Answer 13

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 14

Reasons why US corporations don’t issue more equity

Answer 14

1. Recently, companies in the aggregate have not needed new equity
2. Equity is expensive to issue (costs about 5% to 10% of the amount raised)
3. Many managers consider anything that lowers earnings 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 15

Types of group insurance financial reporting

Answer 15

1. Statutory - the focus is to demonstrate solvency through the balance sheet, so conservative standards are mandated (see separate list)
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 (see separate list)
   a) In the UW, 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 (see separate list)
4. Management reporting - financial reports (usually GAAP) 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 (UW only) - provides information for provider risk sharing arrangements and medical management reporting
7. Assuris (Canada only) - reporting is needed for this consumer protection plan, which indemnifies the policyholders of insolvent life insurers

Question 16

Conservative standards mandated in statutory reporting in the US

Answer 16

1. Certain items (such as agents’ balances) are nonadmitted assets, meaning they are not allowed in determining solvency
2. NAIC prescribes the asset value 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 17

Solvency safeguards in the Canadian Insurance Companies Act

Answer 17

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 CET and CFO matters the actuary believes may have material advsor effects 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 to rectify the matter, the actuary shall send a copy of the report to the Superintendent

Question 18

Major modifications to US statutory reporting to produce GAAP results

Answer 18

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 ACR and IMR

Question 19

Items included in the Canadian annual statement actuarial report

Answer 19

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 20

Modifications to US statutory reporting to produce tax reporting results

Answer 20

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 nay real expense, but is instead a specified percentage of inforce premium.
3. Group carriers must reduce provisions for refunds and unearned premiums by 20%

Question 21

Modifications to Canadian statutory reporting to produce tax reporting results

Answer 21

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

Question 22

Formula for the Gordon Constant Growth Model

Answer 22

1. P/D = 1 / (k-G)
   P = prices
   D = dividends one 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)

Question 23

The components of ROE (the Dupont Formula)

Answer 23

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 requirement of the business.
   b) Net profit margin = Net income / Revenue. This explains what percent on sales become 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 24

Common income statement ratios for health insurers

Answer 24

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 25

Adjustments needed when preparing the same-size-income statement

Answer 25

(this statement expresses all relevant financial components as a percent of revenue)

1. Reinsurance - should count reinsurance premiums paid as health expenses, and 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 26

Effects of ACA provisions on health insurer financial statements

Answer 26

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 number of large new assets or liabilities, such as the reinsurance and risk-adjustment program 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 insurer-to-insurer comparability - due to a few provision for which the issuer has flexibility with regard to accounting policy or timing of payment

Question 27

Premium stabilization programs in the ACA

Answer 27

These are referred to as the 3 Rs

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 small group 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 $60,000 and $250,000 for a given individual
3. Risk corridor - will be in effect from 2014-2016
   a) Designed to provide some protection against variability in claims costs
   b) Allies to individual and small group 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 between +/- 3% of the target and +/- 8% 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 28

Differences between the ACA and Medicare Advantage risk-adjustment programs

Answer 28

1. ACA risk adjustment uses a concurrent model (current year data is used to develop risk scores). But Medicare Advantage 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 date.
2. Medicare Advantage risk adjustment 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. Medicare Advantage plans have relatively stable membership. Individual and small group plans will be far less stable, which will make it harder to estimate risk-adjustment amounts.
4. The payment process used for Medicare Advantage risk adjustment allows insurers to develop relatively accurate estimates of their ultimate settlement amounts

Question 29

Elements of ACA risk adjustment that may lead to uncertainty in an insurer’s financial statements

Answer 29

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 its risk score
2. Uncertainty as to other insurers’ risk scores - the insurers’ 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 requires insurers to use a 90-day premium grace period provision for any member receiving a premium subsidy
4. Granularity of the calculation - ACA risk adjustment 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 30

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

Answer 30

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 accrued at year-end. 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 year-end statements are filed. SO insurers may want to apply a probability of claim denial to their estimated recoverables.

Question 31

New health insurance taxes and fees due to the ACA

Answer 31

1. Health insurance providers fee - 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, Medicare Advantage, Medicare Part D, and Medicaid). Companies not subject to federal income tax only count 1/2 of their premiums. Amount assessed will be $8 billion in 2014, $11.3 billion in both 2015 and 2016, and 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 fee - for plan years ending between October 2012 and September 2019. Was $1 PMPY in the first plan year, $2 PMPY for the second year, and indexed for inflation in future years.
4. Risk adjustment user fee - applies to issuers of plans to which the ACA adjustment program applies. Was $0.96 PMPY in $2014.
5. Federally-facilitated exchange user fee - applies to issuers of plans offered through a federally-facilitated exchange. Was 3.5% of premium in 2014.

Question 32

Impact of the ACA on actuarial liabilities

Answer 32

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 of 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 to 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 filings 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 33

Users of financial statements

Answer 33

1. Providers of capital - such as investment banks, private lenders, 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 - this includes policyholders and creditors
4. Independent auditors
5. Stock analysts
6. Rating agencies
7. Rule-making authorities - such as the SEC and FASB

Question 34

Criteria for an item to be included in the financial statement

Answer 34

1. Definition - the 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 35

FAS 60 accounting requirements

Answer 35

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, premium 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 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 (see sparate list)
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 dividend -shall be accrued using an estimate of the amount to be paid

Question 36

FAS 60 accounting for premium deficiencies

Answer 36

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 in income and a reduction of unamortized acquisition costs or an increase in the liability of future policy benefits

Question 37

Responsibilities of actuaries related to audits or examinations of financial statements

Answer 37

1. Responsibilities of the responding actuary - reply to reasonable requests, which may include:
   a) Discussion of the data used, the source of prescribed assumptions (if any), the methods used, and the basis for assumptions that are not prescribed
   b) Discussion of environmental considerations that affected the preparation of the financial statement (such as changes in operations or in the entity’s methods, policies, or procedures)
   c) Requests for data and sample calculations
2. Responsibilities of the reviewing actuary:
   a) Planning - discuss the project’s scope with the auditor, inform the responding actuary about the expected timing, and request the information needed
   b) Documentation of the procedures planned and followed, the items subject to review, and the results of the review
   c) Preserve the confidentiality of any information received
3. Both actuaries should disclose any relationships with the entity whose financial statement is being audited
4. Both actuaries should comply with ASOP #41 in communicating findings and documenting work