Chapter 6

Question 1

Financial Health

Answer 1

• One of the factors an underwriter must consider when deciding whether to accept a risk.
• Important to ensure they can pay premium.
• Risk must have the financial resources to perform normal behaviours and tasks such as:
• Maintaining and improving equipment and premises
• Implementing loss control measures
• Providing a quality product or service
• Attractive and retaining quality people

Question 2

Financial Information

Answer 2

The numbers tell their story in a financial statement. An experienced observer could be able to tell the following:

• Stability: will tell whether that company will remain in business for a long time, or whether its operating on a minimal budget to make ends meet. Can they pay premium, deductible, is poor financial status a moral hazard.
• Source of revenue: Where’s the risk revenue generated and whether the risk has plans to grow in a particular region. This can change your exposure (usa more litigious)
• Employment: How the risk employees people
• New Operations: Whether the risk has purchase (or is about to purchase) any new operations
• Discontinued Operations: Have any been discontinued and why

Financial information should be current.

Question 3

Financial Information and Underwriting Judgement

Answer 3

• Common sense needed. Ex. new start up
• Location of business - population needed to sustain risk.
• Competition: need to compare the risk to the competitors
• Legislation: Are there any changes that could affect the risks business?
• Analyzing the market: Watch for any business or legislative factors that could be a threat to that market.

Question 4

Sources of Financial Information

Answer 4

• Best: Risk’s annual or quarterly reports to shareholders. Sometimes not possible to obtain.
• Credit Reporting Services - D&B.
• Risks Public Affairs of Public Relations Department: have to exercise judgement in drawing inferences as they are departments that are anxious to publicize good news about the business, and even so, it may not be financial in nature.
• Prospectuses: Used to solicit prospective shareholders. Contain financial information to demonstrate the company’s performance.
• Business plans: Typically only include pro forma financial statements. May not comply with GAAP. May also include SWOT analysis.

Question 5

Pro Forma

Answer 5

Means “for the sake of form”

Are financial statements prepared so as to emphasize either current or projected figures.

Might reflect a proposed change, such as a merger or acquisition.

Question 6

GAAP

Answer 6

“Generally accepted accounting principles”

Refers to a common set of accounting principles and procedures that govern accounting practices in a particular jurisdiction.

Should be cautious when using these in your financial conclusion.

Question 7

SWOT Analysis

Answer 7

Strengths Weaknesses Opportunities Threats.

Question 8

Financial Statements

Answer 8

Every set of financial statements in their titles the name of the business, the name of each particular financial statement within the set, such as the balance sheet or income statement, the date of the statement or the accounting period covered by the statement.

Particular interest to an underwriter:

• Balance sheet
• Income statement
• Statement of cash flow

Need to analyze to identify major sources or revenue and expense.

Question 9

Classes of Financial Statements

Answer 9

Fall into one of three categories:

• Audited statements
• Review statements
• Compilation statements

Question 10

Audited Statements

Answer 10

Expensive, but most reliable.

Either an auditors standard report, or the auditors non-standard report

Question 11

Auditors Standard Report

Answer 11

States the purpose of the audit.

Is in accordance with GAAP.

Question 12

Auditors Non Standard Report

Answer 12

Indicates that there is something to watch for in the financial statements that follow the report.

Expenses one of three kinds of opinion on the part of the auditor:

1. A qualified opinion: attests that financial statements are fairly presented except for a matter in question.
2. An adverse opinion: express the auditors belief that the financial statements are not fairly presented because of a matter in question.
3. A denial of opinion: attests that the auditor is unable to express an opinion whether the financial statements are fairly presented

Question 13

Review Statements

Answer 13

Are financial statements that the auditors have reviewed to determine if they are plausible.

Question 14

Compilation Statements

Answer 14

The least reliable class of financial statements.

Come from an accounting service and are prepared from information supplied by the client.

No guarantee accounting principles were followed.

Question 15

Major Parts of Financial Statements

Answer 15

Audited financial statements have six major parts

1. An independent auditors report
2. A balance sheet
3. An income statement (sometimes called a profit and loss statement)
4. A statement of cash flow
5. A statement of change
6. Notes to the financial statements

Question 16

The Balance Sheet

Answer 16

Shows assets, liabilities and owners equities.

Is prepared for the most recent year and prior year to allow comparison.

Compares what a company owes and what it owns and the difference between those amounts, which is the equity - i.e. what the company is worth.

Assets = Liabilities + Owners Equity

Is similar to an accounting leger

Question 17

Shareholders Equity

Answer 17

The equity on a balance sheet of a publicly traded corporation.

Question 18

Owners Equity

Answer 18

Used when the balance sheet is prepared for an individual, sole proprietorship, a partnership or a corporation.

Question 19

Asset

Answer 19

Is an economic resource.

Real estate, stock, bonds, cash, equipment.

Anything owned by the business that has economic value and this is liquid (cash or a cash equivalent) or can be liquidated (that is, sold for cash)

Question 20

Liability

Answer 20

On a financial statement is a claim on the resources available to a company to satisfy an obligation or debt that the company must pay.

Mortgage, bank debt, loan, bond.

Only objective value liabilities are show on a balance sheet - i.e. tangible assets.

Question 21

Tangible Assets

Answer 21

Cash, machinery, land.

All have a physical existence.

Question 22

Intangible Assets

Answer 22

Copyright, trademarks, patents.

No physical existence.

Question 23

Surplus

Answer 23

Owners equity, or the policyholder surplus.

The value of the company if all assets and liabilities were liquidated.

Question 24

The Income Statement

Answer 24

Sometimes referred to as the profit and loss statement, or P and I.

Is a summary of a company’s transactions during a specified accounting period, listing sales or revenues, cost of goods sold, expenses, capital gains and losses, net profit and loss before income tax.

Can be used to:

• Measure progress of company.
• Record of the companies operating activities
• Took to forecast how the company might do in the future

Question 25

Net Income (or loss)

Answer 25

Is the difference between the sum of the revenues and the sum of the cost of goods sold and the expenses on an income statement. Revenues - Cost of Goods Sold - Expenses = Net Income (or Loss) Is the companies bottom line.

Question 26

Revenues

Answer 26

Are the monies a company generates from selling goods, services or both.

Question 27

Cost of Goods Sold

Answer 27

Is the sum of the costs incurred specifically to sell the goods or services that generate revenue for the company. Sometimes called the cost of sales.

Question 28

Expenses

Answer 28

Are monies that the company pays out - sales, supplies, rent - in order to continue operations and generate revenues.

Question 29

Loss Ratio

Answer 29

Is the ratio of the insurer's incurred claims to its earned premiums over a specified period.

Question 30

Expense Ratio

Answer 30

The ratio of the insurer's acquisition costs and other expenses to its earned premiums over a specified period.

Question 31

Combined Ratio

Answer 31

Is the sum of its loss ratio and expense ratio. When it exceeds the it's earned premium have been less than costs incurred. If it is less than 100, earned premiums are greater than those incurred and the insurer's surplus increased by the difference.

Question 32

The Statement of Cash Flow

Answer 32

Looks a the sources and use of funds. Answers the question of how much money the business generated, where the money came from, and where it went. Three main sections: 1. Operating activities 2. Investing activities 3. Financing (borrowing) activities Will tell if they have sufficient funds to pay bills, and if they are in a timely manner.

Question 33

The Statement of Change

Answer 33

Supplies any information that is missing from the financial statements discussed thus far. Provides items such as a summary of major cash sources and dispositions, how the business generated funds, how its cash resources have been used over the reporting period. Evaluates liquidity on solvency.

Question 34

Notes to Financial Statements

Answer 34

Narratives that are used to explain important financial statements that cannot be adequately quantified or even otherwise shown.

Question 35

Indicators of Potential Problems

Answer 35

- Signs of a poor risk: cash strapped, debts rising, quality suffering. - Bad risks not obvious: difference in how items are booked? - Too few sources of revenue or supplies - Future viability of risk - Change in auditor - refusal of ethical reasons to do audit - Similarity of business and personal finances

Question 36

Accrual Basis

Answer 36

Revenue is recorded when the item or service is sold, even though the cash may not have been received.

Question 37

Financial Ratio Analysis

Answer 37

- On reports by D&B - Tools to evaluate both the performance of a company over time and the condition of a company at a given time - Underwriter should look at the corresponding financial ratios for the industry as a whole

Question 38

Liquidity Ratios

Answer 38

Reveal how liquid the business is. Measure the business' ability to pay its liabilities.

Question 39

Liquidity

Answer 39

The measure of how readily an asset can be converted to cash.

Question 40

Current Ratio

Answer 40

Most commonly used liquidity ratio Current Assets ----------------------- Current Liabilities = Current ratio

Question 41

Working Capital

Answer 41

The difference between current assets and current liabilities

Question 42

The Quick Ratio

Answer 42

How quickly it could find cash if it needs its Cash + Marketable Securities + Current Receivables ------------------------------------- Current liabilities = Quick ratio

Question 43

Activity Ratio

Answer 43

Measure how well a company has been using its available resources

Question 44

Accounts Receivable Ratio

Answer 44

Is an activity ratio Sales --------------------- Average Accounts Receivable = Accounts Receivable Turnover Ratio

Question 45

Average Collection Period

Answer 45

Activity Ratio Average Accounts Receivable --------------------------------- Sales x365 days = average collection period

Question 46

Inventory Ratio

Answer 46

Cost of goods sold ---------------------- average inventory = inventory turnover

Question 47

Financial Leverage Ratios

Answer 47

Compare the amounts made available by the creditors with the amount of funds made available by the owners. Ex. Debt Ratio Total Liabilities --------------- Total Assets = Debt Ratio

Question 48

Profitability Ratios

Answer 48

Measure the overall effectiveness of a companies management Ex. Return on Assets Net Income ----------- Total Assets = Return on Assets Ex. Return on Equity Net Income ------------ Owners Equity = Return on Equity