Part 3.1 (Odomirok 8-9) (***)

Question 1

Statements required to calculate Income and Surplus

Answer 1

Income Statement, and the Capital & Surplus Account

Question 2

Income Statement

Answer 2

Revenue and expense components used to calculate net income

3 Types of Income
- Underwriting Income
- Investment Income
- Other Income

Question 3

Capital & Surplus Account

Answer 3

Details on the changes in Surplus during the year

Question 4

Underwriting Income (1st major category of Income in Income Statement)

Answer 4

UW Income = Earned Prem - Incurred LAE - Incurred Other Underwriting Expenses

Question 5

Expenses (LAE & Other Underwiring Expenses)

Answer 5

Allocated in 3 different ways in the annual Statement

NAIC operating expense classifications
- Includes 24 types of expenses
- Rows of U&IE, Part 3

Expense Categories
- Grouped by operational function
- LAE, Other UW Expenses, Investment Expenses

Line of Business
- IEE segments the expenses into the lines of business listed in the U&IE, part 2A

Question 6

Subsidies

Answer 6

Happen if allocation is not accurate

Distortion of profitability measures
Inefficient allocation of resources
anti-selection

Question 7

Net Investment Gain

Answer 7

Shown in the Income Statement and divided into two components

Net Investment Income Earned
- Segments the investment income from the different asset classes
- Lists deductions required to convert gross investment income to net investment income
> Mainly from interest and dividends
> Net of investment expenses
> Gross of taxes
> Recorded on an accrual basis

Net Realized Capital Gains
- Also segments by asset class
- Distinguishes between gain/losses realized on sale of the asset and losses due to impairment and foreign exchange (second column)

Question 8

Net Investment Income Earned

Answer 8

• Segments the investment income from the different asset classes
• Lists deductions required to convert gross investment income to net investment income
  > Mainly from interest and dividends
  > Net of investment expenses
  > Gross of taxes
  > Recorded on an accrual basis

Question 9

Exhibit of Net Investment Income

Answer 9

• Also segments by asset class
• Distinguishes between gain/losses realized on sale of the asset and losses due to impairment and foreign exchange (second column)

Question 10

Exhibit of Capital Gains

Answer 10

Bonds
Stocks
Cash, Cash Equivalents, and Short Term Investments
Derivatives

Question 11

Bonds (Largest Asset Held by Insurer) and the Net Investment Income Earned

Answer 11

Exhibit of Net Investment Income shows the Net Investment income based on:

> Interest received during the year
- On a cash flow basis, so needs to be added to the change in interest due & accrued in order to calculate income

> Interest due & accrued

> Current year’s amortization/accretion
- When purchase price of bond is different to face value
- Ie when Coupon rate different to the market interest rate at time bond bought
- Amortized cost equal to the face value at maturity since prem or discount is amortized over the life of the bond

> Interest paid for accrued interest on dividends
- Required whenever an insurer purchases a bond between coupon payments
- A portion of the coupon was “earned” by seller so purchaser should reimburse this amount

Question 12

Bonds (Largest Asset Held by Insurer) and the Capital Gains

Answer 12

Total gain shown in Exhibit of Capital Gain by:

> Realized gain on sale/maturity (Col 1)

> Other Realized Adjustments (Col 2)
- Foreign exchange gain on disposal
- Other than temporary impairments

Question 13

Bond Capital Gains Calculation

Answer 13

1. Find value of bond
   - When bond is purchased, it is recorded at actual cost, which includes brokerage and other fees
   - After purchase, it is valued at adjusted carrying value

Adjusted Carrying Value
> NAIC Class 1-2 (higher grade) = Amortized Cost (updated annually)
> NAIC Class 3-4 (lower grade) = Min(Amortized Cost, Fair Value)

Question 14

Valuation Rules for Bonds

Answer 14

> If adjusted to the fair value, the adjustment is treated as an unrealized loss

> When sold, the realized gain is the difference between the amount received and the adjusted carrying value

> If a bond is valued at amortized cost (higher grade) because held till maturity, no capital gain/loss occurs over the life of the bond

> Foreign currency bonds are impacted by changes in the exchange rates. This impact is included in the adjusted carrying value, but is not realized until the bond is sold.

> “Other than temp Impairments” occur when an insurer won’t collect all the amounts due. Treat the amount of the impairment as a realized capital loss.

Question 15

Schedules for Bonds

Answer 15

Schedule D, Part 1 - Long term bonds owned
Schedule D, Part 2 - Long term bonds sold, redeemed, disposed of
Schedule DA, Part 1 - Bonds with 1 year or less maturity

Question 16

Valuation of Common Stock

Answer 16

When being held valued at fair value.

Changes in fair value are recorded as unrealized valuation changes.
- Fair value obtained from a stock exchange
- If not publicly traded, value is determined by NAIC’s (Security Valuation Office) SVO

Question 17

Common Stock investment gain

Answer 17

Investment income earned
- Dividends received
- Change in accrual for dividends decreased but unpaid

Realized Capital gains
- Amount received - Original Cost including commission and tax

Question 18

Preferred Stock 2 types

Answer 18

Redeemable
- The issuer has the option to redeem for a preset price at a specified maturity date, or after a specified period of notice

Perpetual
- Cannot be redeemed

Question 19

Valuation of Preferred Stocks

Answer 19

Highest two rated redeemable preferred
- Valuation = Amortized Cost

Highest two rated perpetual preferred
- Valuation = Fair Value

Lower rated bonds & Lower rated Preferred stocks
- Valuation = Min(Amortized Cost, Fair Value)

Question 20

Cash, Cash Equivalents, & Short Term Investments

Answer 20

Assets immediately convertible to cash & have an original maturity of a year or less

> Any premium or discount when the asset is purchased is amortized over its life
Not receiving premium (impairment) is possible, but not common since short duration

Question 21

Derivatives

Answer 21

Contract between two parties where the value depends on the value of a particular asset or variable

Used to hedge exposure to a risk

High profile, can cause failure of insurance group in financial crises

Question 22

Accounting of a derivative

Answer 22

Highly effective Hedge
- If it can be demonstrated the derivative has significantly reduced a particular risk exposure
- Derivative receives same accounting treatment as the hedged asset (used to offset asset)

Mark-To-Market
- If not the case above

Question 23

Schedules for Derivatives

Answer 23

Schedule DB, Part 1 - Derivatives owned
Schedule DB, Part 2 - Derivatives written (sold)
Schedule DB, Part 3 - Derivates terminated during the year

Question 24

Schedule DB

Answer 24

• lists info about counterparties for all derivatives that are open at year end.
• number of contracts for each derivative
• notional amount (number of units of the underlying asset involved)
• dates of purchase and maturity
• transaction price
• current price
• type of risk being hedged

Question 25

Investment Guidlines

Answer 25

Governed by State investment laws

NAIC Model Investment Law

Question 26

NAIC Model Investment Law

Answer 26

Two types of guidelines

> Defined Limits - established quantitative limits that the insurer has to follow

> Prudent Person - Principles based approach, enables the insurer to develop its own guidelines
- need to strive for protection of the policyholder
- consider the investment expertise and resources available

Question 27

Measuring Investment Performance

Answer 27

Consider, but not solely:
- Size of Investable assets
- Risks
- Taxes

Ratio of income to average invested assets
- Common
- Does not reflect the risk

Investment performance between companies
- Income statement presents the “net realized capital gains” after capital gains tax, so differences may be due to tax rates

Question 28

Other Income (3rd major category of Income in Income Statement)

Answer 28

> Net gain from agents or premium balances charged off

> Finance and service charges not included in premiums

> Aggregate write-ins in miscellaneous income
- Input on a new line since uncommon

> Dividends to policyholders in cash (Not actually other)
- That have been paid
- Change in dividends that have been declared but not yet paid

> Federal & Foreign Income Taxes
- Excluders any portion deferred to future years

Question 29

Current Year Surplus

Answer 29

Prior Year Surplus + Current Year Net Income + Direct Surplus Changes

Question 30

How to get Net Income

Answer 30

Taken from Income Statement

Question 31

How to get Direct Surplus Changes

Answer 31

Change in:
- Unrealized Capital Gains
- Net Unrealized Foreign Exchange capital gains
- Net Deferred Income Tax
- Nonadmitted Assets
- Provision for Reinsurance

Cumulative Effect of Changes in Accounting Principles
- e.g. impact from changing recording gross of to net of

Capital Changes & Surplus Adjustments

Dividends to stockholders (paid out as cash)
- only paid from unassigned surplus (not assigned to the par value of stock etc)

Question 32

Capital Changes & Surplus Adjustments

Answer 32

Changes in capital due to issuance of stock
- Paid in capital is the amount collected associated with the par value
- Paid in surplus is the excess

Changes due to return of capital

Impact of Stock dividends (do not impact total surplus balance, but reallocation of surplus to capital)
- Paid out as stock