Odomirok 8 to 9 Flashcards
Income Statement
contains revenue, expenses, & net income
Three 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
Three ways expenses allocated in Annual Statement
- NAIC operating expense classification: 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
- Line of business: The IEE uses the lines of business listed in the U&IE, Part 2A
Why should actuary have basic understanding of the topic of other underwriting expenses?
- The expenses are a component of premium
- 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
Two components of Net Investment Gain
- 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 and income collected
- contains deductions for investment expenses and other costs
Exhibit of Capital Gains
Contains details of net realized capital gain by asset class. It distinguishes between the gains/losses realized on a sale of the asset; and losses due to impairment.
Investment Asset Classes: Bonds
- US Government Bonds
- Bonds exempt from US tax
- Other bonds (unaffiliated)
- Bonds of affiliates
Four ways to earn investment income from bonds
- Interest received during the year: in order to calculate income, this needs to be modified to an accrual basis, by adding it to the change in the interest due & accrued
- Interest due and accrued
- Current year’s amortization/accretion
- Interest paid for accrued interest on dividends: required whenever an insurer purchases a bond between coupon payments. The insurer needs to pay the seller for the coupons that were earned while they owned the bond.
Amortization/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.
Realized capital gains 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) \+Foreign exchange gain on disposal \+Other than temporary impairments
Actual cost of the bond
When the bond is purchased it is recorded at actual cost, which includes the brokerage and other fees
Adjusted carrying value of the bond
After purchase, it is valued at adjusted carrying value:
- 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)
Valuation rules for bonds
- The fair value is published in the NAIC Valuation of Securities Manual
- Schedule D, Part 1 contains the NAIC designation, actual cost, fair value, par value, book/adjusted carrying value of the bonds
- If the bond valuation is adjusted to the fair value, the adjustment is treated as an unrealized loss.
- When the bond is sold, the realized gain is the difference between the amount received and the amortized cost (note the text says adjusted carrying value; not amortized cost)
- Most bonds held by insurers are NAIC 1 or 2, and are also held till maturity. As a result, there is no capital gain/loss over the life of the bond.
Bonds denominated in foreign currency
Impacted by changes in the exchange rates. The impact is included in the adjusted carrying value, but is unrealized until the bond is sold.
Impairments of bonds
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
- investment income earned (dividends received; change in accrual for dividends declared but unpaid)
- realized capital gains
To calculate 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.
If the common stock is not publicly traded, it’s value:
will be determined from the NAIC’s Security Valuation Office
Value of preferred stocks at purchase
Initial carrying value
Value of preferred stocks 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):
- 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)
Stock is subject to impairment charges
Occur if there is a reduction in fair value that is “other than temporary”
When stock is sold…
The difference between the amount received and the original cost is recorded as a realized gain/loss. Details in Exhibit of Capital Gains
Investment income from cash, cash equivalents, and short-term investments
- Any premium or discount when the asset is purchased is amortized over its life.
- Impairment is possible, but not common given the short duration
Derivative
A contract between two parties where the value depends on the value of a particular asset of variable. They are often used to hedge exposure to risk.
“Highly effective” hedge
A derivative has significantly reduced a particular risk exposure. Required to qualify for hedge accounting
Hedge 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
Mark-to-market accounting
If derivative does not/no longer qualifies for hedge accounting; any changes in fair value are recorded as unrealized gains
Schedule DB
Contains details about the derivatives
Part 1: includes derivatives owned
Part 2: includes derivatives sold
Part 3: includes derivatives terminated during the year
Schedule DB lists:
- The number of contracts for each derivative
- The notional amount (the number of units of the underlying asset that are involved)
- The original trade date & the maturity/expiration date
- Transaction price (price insurer agreed at which to buy/sell)
- Current price
- Information about the item hedged (if applicable) & type of risk being hedged
Schedule E
Lists information about the counterparties for all derivatives that are open at year end. This can be used to investigate whether there is too much exposure to an individual counterparty.
NAIC Model Investment Law
Allows insurers to adopt either of the 2 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
Measuring investment performance
Analysts need to consider:
- Size of investable assets
- Risk
- Taxes
Ratio of income to average invested assets
Common metric used to compare companies, but is flawed because it does not reflect risk
Problem that arises when comparing investment performance of different companies
Net realized capital gains/losses are presented after capital gains tax. Numbers may vary between companies due to different tax rates.
Net Gain from Agent’s or Premium Balances Charged Off
A component of Other Income; includes any balances that had previously been written off and later collected.
Finance & Service Charges not included in Premiums
A component of Other Income; Includes the service charges that the insurer adds to the premium that is paid in installments.
Aggregate Write-ins for Miscellaneous Income
A component of Other Income;
- Gain on sale of equipment: when sale price is different to depreciated cost
- Retroactive Reinsurance: gained if the reinsurance premium is different to the liabilities that had been transferred
- Gain on foreign exchange: If the payments are made/received in a foreign currency, the ultimate settlement may be at a different exchange rate than at which the payment was originally recorded.
- Corporate expenses
- Fines & penalties of regulatory activities
Dividends to policyholders
A component of Other Income; includes:
- dividends that have been paid
- change in dividends that have been declared but not yet paid
Federal & Foreign Income taxes
A component of Other Income; Excludes any portion deferred to future years
Current Year’s surplus (line 39) of Capital & Surplus Account section on income statement
= Prior year's surplus (line 21) \+ Current year's net income (line 22) \+ Other surplus changes (lines 24 - 31) \+ Additional Capital Contributions (lines 32 & 33) - Stockholder dividends (line 35)
Other surplus changes
- Change in unrealized capital gains
- Change in Net unrealized Foreign Exchange Capital Gains
- Change in Net Deferred Income Tax
- Change in Nonadmitted Assets
- Change in Provision for Reinsurance
- Cumulative effect of changes in accounting principles: the impact of the changes on the beginning surplus
- Capital Changes & Surplus Adjustments:
+changes in capital due to issuance of stock
+changes due to return of capital
+transfers from surplus to capital when stock dividends issued
When stocks are issued:- the amount collected associated with the par value is recorded as paid in capital
- the excess is paid in surplus
-Dividends to stockholders: this may only be paid from unassigned suplus
