Objective 5

Question 1

Users of financial statements

Answer 1

1. Providers of capital
2. Expert advisors to users of financial statements
3. Anyone who is party to any of the company’s transactions
4. Independent auditors
5. Stock analysts
6. Rating agencies
7. Rule-making authorities

Question 2

Criteria for an item to be included in the financial statement

Answer 2

1. Definition - must be an asset, liability, revenue or expense
2. Measurability
3. Relevance
4. Reliability

Question 3

Organizations responsible for setting GAAP standards

Answer 3

1. American Institute of Certified Public Accountants (AICPA) - provides guidance through:
   a. Accounting research bulletins
   b. Accounting Principles Board Opinions
   c. Practice bulletins
   d. Industry audit guides
2. Financial Accounting Standards Board (FASB) - provides guidance through:
   a. Concept statements
   b. Statements of Financial Accounting Standards
   c. FASB interpretations
   d. FASB technical bulletins
   e. FASB Emerging Issues Task Force issues
   f. FASB staff positions
3. Securities and Exchange Commission (SEC) - has authority to promulgate standards, but generally relies on the AICPA and FASB

Question 4

Renewability provisions for health insurance products

Answer 4

1. Guaranteed renewable - insurer cannot cancel the policy but can raise rates
2. Noncancelable - insurer cannot cancel the policy or increase premiums for any reason
3. Collectively renewable - insurer may cancel policies in similar rating classes, but not individual policies
4. Conditionally renewable - policy must be cancelled if certain specified reasons are met
5. Optionally renewable - policy can be cancelled at any renewal date
6. Short-term - provides coverage for a set term, but may provide 1-2 renewals

Question 5

Types of health insurance policies

Answer 5

1. Medical coverages
2. Indemnity policies
3. Medical savings accounts
4. Disability income
5. Income replacement policies
6. Business overhead policies
7. Long-term-care polices
8. Medicare supplement

Question 6

Formulas for benefit reserves and deferred acquisition cost reserves

Answer 6

1. Definitions: x = issue age, t = policy duration, p = survival probability, v = 1 / (1 + i) where i = the valuation interest rate, B = benefits, S = claim cost per unit in force, DE = deferred acquisition expense
2. Benefit net premium (BNP) = SUM(v^t * tpx * B(t)) / SUM(v^t * tpx) both summations over t, starting at 0
3. Benefit reserve (BV):
   a. Prospective: BV(t) = SUM(v^t * tpx * S([x] +t)) - SUM(v^t * tpx * BNP) sums beginning at valuation date t
   b. Retrospective: BV(t) = SUM(BNP * (1 + i)^t /tpx) - SUM(S([x] + t) * (1 + i)^t / tpx) sums from time 0 to t-1 (last period before valuation date)
4. Deferrable acquisition expense net premeium (DENP) = SUM(v^t * tpx * DE(t)) / SUM(v^t * tpx)
5. Deferred acquisition cost (DAC) = SUM(DENP * (1 + i)^t / tpx) - SUM(DE(t) * (1 + i)^t / tpx)

Question 7

Types of liabilities for group life and health insurance

Answer 7

1. Active life and unearned premium reserves
2. Expense capitalization
3. Claim reserves and claim adjustment expense reserves
4. Premium deficiency reserves
5. Reserves for accrued experience refunds
6. Liabilities related to stop-loss reinsurance arrangements
7. Deferred profit liability

Question 8

Primary financial statement exhibits

Answer 8

1. Balance sheet
2. Income statement
3. Sources and Uses statement
4. Cash Flow statement

Question 9

Definitions of types of earnings

Answer 9

1. Net income = total revenue - total expenses
2. Operating earnings = profit from day-to-day operations (excludes taxes, interest income and expense, and extraordinary items)
3. Pro forma earnings = revenue - expenses (after removing items that might cloud perceptions of true earning power of the business)
4. EBIT = earnings before interest and taxes
5. EBITDA = earnings before interest, taxes, depreciation, and amortization
6. EIATBS = earnings ignoring all the bad stuff

Question 10

Definitions of types of cash flow

Answer 10

1. Net cash flow = net income + noncash items
2. Cash flow from operating activities = net cash flow +/- change 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 = sum of money today having the same value as a future stream of cash receipts and disbursements

Question 11

Principle virtues of the cash flow statement

Answer 11

1. Easy to understand
2. Provides more accurate info about some activities than what appears on income statements and balance sheets
3. Highlights the extent to which operations are generating or consuming cash

Question 12

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

Answer 12

1. Financial statements are transaction based - asset’s value on the statements is based on purchase price and depreciation, not 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 13

Techniques for forecasting external funding needs

Answer 13

These will produce the same estimate of external funding needed.

1. Pro forma statement - recommended for most planning purposes and for credit analysis. External funding required = total assets - (liabilities + owners’ equity)
2. Cash flow forecast - straightforward and easily understood, but less informative than pro forma. External funding required = total uses - total sources
3. Cash budget - appropriate for short-term forecasting and cash management. Ending cash = beginning cash + total cash receipts - total cash disbursements. External funding required = minimum desired cash - ending cash

Question 14

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

Answer 14

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 patterns to the newly estimated sales. Items which do not vary with sales will need to be forecast independently
4. Test the sensitivity of results to reasonable variations in sales forecast

Question 15

Ways to cope with uncertainty in financial forecasts

Answer 15

1. Sensitivity analysis
2. Scenario analysis
3. Simulation

Question 16

Stages of the financial planning process

Answer 16

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 17

Life cycle of successful companies

Answer 17

1. Startup
2. Rapid growth
3. Maturity
4. Decline

Question 18

Definition of sustainable growth rate

Answer 18

1. The sustainable growth rate (g*) represents the limit on a company’s growth if there is no external source of capital
2. g* = R * ROE(bop), where R = earnings retention rate = 1 - dividends / earnings, ROE(bop) = earnings / equity at beginning of period
3. Since ROE(bop) = PAT, then g* = PRAT, where P = profit margin, A = asset turnover ration, T = financial leverage = assets-to-equity ratio (using beginning of period equity)
4. Since ROA = profit margin * asset turnover ratio, g* = RT * ROA

Question 19

Growth management strategies for when actual growth exceeds sustainable growth

Answer 19

1. Sell new equity
2. Increase financial leverage by increasing debt
3. Reduce the dividend payout
4. Prune away marginal activities “profitable pruning”
5. Outsource some or all of production
6. Increase prices
7. Merge with a “cash cow”

Question 20

Growth management strategy for when sustainable growth exceeds actual growth

Answer 20

1. Look within the firm to remove internal constraints on company growth
2. Ignore the problem
3. Return the money to shareholders
4. Buy growth
5. Reduce financial leverage
6. Cut prices

Question 21

Reasons US corporations don’t issue more equity

Answer 21

1. Recently, companies in the aggregate have not needed new equity
2. Equity is expensive to issue
3. Managers consider anything that lowers earnings per share as bad and issuing new equity will initially lower EPS
4. Companies feel their stock prices are undervalued, so they choose not to sell new stock at what they think is too low a price
5. Managers view the stock market as an unreliable funding source

Question 22

Types of group insurance financial reporting

Answer 22

1. Statutory - focus is on solvency, so conservative standards are mandated
2. GAAP - attempts to accurately reflect earnings during a reporting period:
   a. In the US, 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 - statutory reports are the starting point, with adjustments to reserve items
4. Managerial reporting - GAAP reports are modified to provide a more accurate picture of the impact of management decisions
5. Policyholder reporting - provides info for risk-sharing arrangements, for gov’t reporting, and for policyholders to complete their own financial reports
6. Provider reporting (US only) - provides info for provider risk sharing arrangements and medical management reporting
7. Assuirs (Canada only) - reporting is needed for this consumer protection plan, which indemnifies the policyholders of insolvent life insurers

Question 23

Conservative standards mandated in statutory reporting in the US

Answer 23

1. Certain items are nonadmitted assets (not allowed in determining solvency; ex: agents’ balances)
2. NAIC prescribes the asset values to be used
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 24

Solvency safeguards in the Canadian Insurance Companies Act

Answer 24

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 CEO and CFO matters he/she believes may have material adverse 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 taken to rectify the matter, the actuary shall send a copy of the report to the Superintendent

Question 25

Major modifications to US statutory reporting to produce GAAP results

Answer 25

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 AVR and IMR

Question 26

Items included in the Canadian annual statement actuarial report

Answer 26

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 27

Modifications to US statutory reporting to produce tax reporting results

Answer 27

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 any 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 28

Modifications to Canadian statutory reporting to produce tax reporting results

Answer 28

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

Question 29

Formula for the Gordon Constant Growth Model

Answer 29

1. P / D = 1 / (k - G), where P = price, D = dividends 1 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 30

The components of ROE (the Dupont Formula)

Answer 30

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 requirements of the business b. Net profit margin = net income / revenue. This explains what percent on sales becomes 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 31

Common income statement ratios for health insurers

Answer 31

1. Administrative expense ratio = admin expenses / revenues 2. Health benefit ratio (or loss ratio) = health benefit expenses / premium revenues 3. For simple insured business: 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 32

Adjustments needed when preparing the same-size-income statement

Answer 32

This statement expresses all relevant financial components as a percent of revenue. 1. Reinsurance - count reinsurance premiums as paid health expenses, and reinsurance recoveries as offsets to health care costs 2. Commissions - count as an admin expense 3. Investment income - count as non-operating income 4. ASO products - look at financial reports separately for each product type

Question 33

FAS 60 accounting requirements

Answer 33

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, premiums 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 = PV of estimated future policy benefits and related expenses - PV of estimate future net premiums. They shall be accrued as premium revenue 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 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 dividends - shall be accrued using an estimate of the amount to be paid

Question 34

FAS 60 accounting for premium deficiencies

Answer 34

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

Question 35

(Added) Sarbanes-Oxley Requirements

Answer 35

1. Company management must assess internal controls over financial reporting and report its conclusion in its annual report 2. Auditor must assess management's assessment and report its own conclusion 3. Actuaries are part of the management team/auditor team providing this assessment

Question 36

(Added) Recoverability and loss recognition

Answer 36

1. Recoverability tests at issue determine whether DAC asset is recoverable: a. Gross premium valuation b. Net-to-gross premium ratio using valuation assumptions: if net prem > gross prem, remove PAD; if net prem still > gross prem, reduce deferred acquisition expense; if net prem still > gross prem, establish a premium deficiency reserve 2. Loss recognition test after issue on a group of policies - approximate gross premium valuation using valuation assumptions 3. Once DAC is eliminated, it cannot be re-established

Question 37

(Added) Categories of assets for FAS 115 purposes

Answer 37

1. Held to maturity - held at amortized value 2. Available for sale - reported at fair value in 2 parts: book value and difference between market value and book value 3. Trading - held at fair value

Question 38

(Added) Shadow adjustments

Answer 38

1. Definition - collatoral effects of FAS 115 on DAC, value of business acquired, and unearned revenue liability based on change to value as if assets were sold and gains (losses) recognized; the difference between primary balance and shadow balance 2. Needed because categorizing assets as required by FAS 115 impacts equity as though assets were sold on last day of accounting period