Odomirok 8-9 Flashcards
Income Statement contains
revenue, expenses & net income
There are 3 types of income
Underwriting income
Investment income
Other income
Capital & Surplus Account
provides details on the changes in surplus during the year
Underwriting Income
Earned Premium – Loss & LAE Incurred – Other Underwriting Expenses Incurred
Expenses (LAE & Other Underwriting Expenses) are allocated in 3 different ways in the Annual Statement
NAIC operating expense classifications: includes 24 types of expenses, listed in the rows of U&IE, Part 3
Expense categories: grouped by operational function: LAE/ Other Underwriting Expenses/ Investment Expenses. These are listed in the columns of the U&IE, Part 3
Line of business: The IEE (discussed later) uses the lines of business listed in the U&IE, Part 2A
Each expense will need to be allocated to
expense classification, expense category & line of business
If the allocation is not accurate, subsidies may arise that may cause problems, including:
- distortion of the profitability measures
- inefficient allocation of resources
- anti-selection
Insurers have an opportunity to earn investment income because
there is a delay between the time that the premium is collected and when the losses are paid out
2 components of investment income in the income statement
Net investment income earned: -mainly from interest & dividends -recorded net of investment expenses -recorded gross of taxes -accrual basis
Net realized capital gain: -adjusted for amortization of premiums/ accretion of discounts -realized losses can also be caused by impairment
Exhibit of Net Investment Income
contains details by asset class. In addition, it:
Differentiates between income earned & income collected
Contains the deductions for investment expenses & other costs
Exhibit of Capital Gains
contains details of net realized capital gain by asset class. It distinguishes between the gains/ losses realized on sale of the asset; and losses due to impairment.
major investment asset classes
Bonds, Stocks
Cash
Cash Equivalents & Short Term Investments
Derivatives
Bonds
largest asset held by insurers
they are divided into 4 categories: US government bonds Bonds exempt from US tax Other bonds (unaffiliated) Bonds of affiliates
Exhibit of Net Investment Income shows net investment income earned from bonds, which is based on
Interest received during the year
Interest due & accrued
Current year’s amortization/ accretion
Interest paid for accrued interest on dividends:
Amortization or accretion
arises when the purchase price of the bond is different to the face value. This difference arises because the coupon rate is different to the market interest rate at the time the bond is purchased. This premium or discount is amortized over the life of the bond. This will produce an amortized cost equal to the face value at maturity
also earn realized capital gains (or losses) from bonds. The total gain
is derived in the Exhibit of Capital Gains.
It consists of:
Realized gain on sale/ maturity (Col 1)
Other Realized Adjustments (Col 2)
To calculate the capital gains, the value of the bond first needs to be derived
When the bond is purchased, it is recorded at actual cost. This includes the brokerage and other fees
After purchase, it is valued at adjusted carrying value
adjusted carrying value of bonds
- NAIC Class 1 & 2 (higher grade bonds): amortized cost: updated annually to reflect amortization/ accretion of premium/ discount
- NAIC Class 3-6 (lower grade bonds): min (amortized cost, fair value)
Impairments occur
when the insurer believes that it won’t collect all the amounts due. In this case, the insurer has to treat the amount of the impairment as a realized capital loss (even if it is still holding the bond)
investment income from common stocks consists of
investment income earned (dividends received; change in accrual for dividends declared but unpaid)
realized capital gains
To calculate the capital gains, the value of common stocks needs to be derived
When common stocks are purchased, they are valued at the initial carrying value: actual cost plus commissions and taxes.
After purchase, they are valued at fair value. Changes in fair value are recorded as unrealized valuation changes.
value of preferred stocks
valued at the initial carrying value when purchased
Value after purchase depends on whether they are redeemable (the issuer has the option to redeem for a preset price at a specified maturity date or after a specified period of notice) or perpetual (cannot be redeemed)
preferred stocks value after purchase
The highest 2 ratings of redeemable preferred stock: original purchase price + acquisition costs
The highest 2 ratings of perpetual preferred stock: fair value
Lower rated redeemable & perpetual: min (book value, fair value)
When a stock is sold, the difference between the amount received & the original cost is recorded as
realized gain/ loss
Cash, Cash Equivalents & Short Term Investments valuation
Any premium or discount when the asset is purchased is amortized over its life. Impairment is also possible, but is not common given the short duration
If the insurer can demonstrate that a derivative has significantly reduced a particular risk exposure, it may qualify for hedge accounting
valuation using this accounting
the derivative receives the same accounting treatment as the hedged asset
this allows changes in the value of the hedged asset to be offset by changes in the value of the derivative
If the derivative does not/ no longer qualifies for hedge accounting
mark-to-market accounting should be used in which case any changes in fair value are recorded as unrealized gains.
NAIC Model Investment Law allows the insurer to adopt either of the following 2 types of investment guidelines:
Defined Limits: quantitative limits
Prudent Person: a principles based approach, which enables the insurer to develop its own guidelines. The insurer should:
- strive for the protection of the policyholder
- consider the investment expertise and resources available
It is often difficult to measure investment performance, including making comparisons between companies. Analysts need to consider:
Size of investable assets
Risk
Taxes
common metric used to compare companies for investment performance and problem
ratio of income to average invested assets. The problem with this metric is that this does not reflect the risk
OTHER INCOME: common elements
Net Gain from Agents’ or Premium Balances Charged Off: If the insurer believes that the balances won’t be collected, it needs to recognize them as a loss. This particular component includes any balances that had previously been written off and later collected.
Finance & Service Charges not included in Premiums: This includes the service charges that the insurer adds to the premium that is paid in installments.
Aggregate Write-ins for Miscellaneous Income: including gain on sale of equipment, retroactive reinsurance, gain on foreign exchange, corporate expenses, etc
what are not part of Other Income, but do impact the overall income
Dividends to policyholders: this includes: -dividends that have been paid -change in dividends that have been declared but not yet paid
Federal & Foreign Income Taxes: This excludes any portion deferred to future years
Current Year’s surplus
= Prior Year’s Surplus + Current Year’s Net Income + Other Surplus Changes + Additional Capital Contributions – Stockholder Dividends
Net income taken from income statement
Other surplus changes: change in unrealized capital gains, nonadmitted assets, provision for reinsurance
