CAS Exam 6

Equation to derive total amount of capital which is subject to the cost of holding capital:

- surplus - equity in the unearned premium reserves - equity in the undiscounted reserves - deferred tax asset (from UEPR and discount) should be subtracted from this amount

2 definitions of surplus

1. Balance sheet definition: surplus = assets - liabilities 2. Income statement definition: surplus = prior years surplus + current year's income

What does Other Surplus Changes consist of in the current year's surplus calculation

1. Change in unrealized capital gains (+) 2. Change in net unrealized foreign exchange capital gains (+) 3. Change in net deferred income tax (+) 4. Change in nonadmitted assets (-) 5. Change in provision for reinsurance (-) 6. Cumulative effect of changes in accounting principles (+) 7. 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 (just reallocation of surplus, total surplus remains constant)

What's included in underwriting & investment expenses:

1. Commission & brokerage expenses 2. Taxes, licenses & fees 3. General & administrative expenses 4. Investment expenses

2 methods to calculate UEPR:

1. Daily pro rata method: based on the number of days of the policy that have expired 2. Monthly pro rata method: assumes that premiums are written evenly through each month

What are some entries that are not part of Other Income, but do impact the overall income

1. Dividends to policyholders 2. Federal & foreign income taxes

The Exhibit of Net Investment Income divides the investment income from bonds into:

1. Interest received during the year 2. Interest due & accrued 3. Current year's amortization/accretion 4. Interest paid for accrued interest on dividends

Examples of nonadmitted assets:

1. Investments in bonds, stocks, mortgage loans or real estate that exceed any state limitations 2. Investments in electronic data processing equipment & software that exceed the set limits 3. Furniture, equipment & supplies 4. Balances from agent from sale of a security, overdue by over 15 days 5. Funds held at a reinsured company that exceed the associated liabilities 6. 10% of deductibles recoverable in excess of collateral

Certain accounting rules can impact many aspects of the actuary's work:

1. Issuing a SAO 2. Pricing/Designing insurance products 3. Determining capital requirements 4. Evaluating risk transfer of reinsurance contracts 5. Assessing the reserve adequacy of non-insurers 6. Assisting in the calculation of taxable income 7. Valuing insurers in M&A transactions

In the U&IE, each category of expenses is broken into:

1. LAE 2. Other underwriting expenses 3. Investment expenses

Two main categories of expenses

1. LAE 2. Underwriting & investment expense

Describe the 6 parts in schedule D

1. Long term bonds and certificates of deposits owned as of 12/31 2. Stocks owned as of 12/31 3. Bonds and stocks acquired during the year and are still owned as of 12/31 4. Bonds and stocks that were owned at the start of the year, but sold (or redeemed) during the year 5. Bonds and stocks acquired and also sold during the year 6. Preferred and common stocks in affiliates (used in R0 calculation)

Two common sources of DTAs:

1. Loss reserves are discounted in tax accounting 2. Carryforward net operating losses

2 accounting methods for nonadmitted assets:

1. Method 1: write off the nonadmitted assets as an expense (in the income statement) 2. Method 2: classify the asset as nonadmitted & charge surplus directly

3 ways to allocate Other Underwriting Expenses

1. NAIC operating expense classification (24 types) 2. Expense categories (LAE; Other Underwriting Expenses; Investment Expenses) 3. Line of business

List some components of Other Income

1. Net gain from agent's or premium balances charged off 2. Finance & service charges not included in premiums 3. Aggregate write-ins for miscellaneous income (gain on sale of equipment, retroactive reinsurance gain, gain on foreign exchange, corporate expenses, fines & penalties)

Two components of investment income in the IS

1. Net investment income earned 2. Net realized capital gain

List some differences between preferred stocks and common stocks:

1. Preferred stocks do not offer voting rights 2. Preferred stocks guarantee dividends 3. Owners of preferred stocks have priority to those of common stocks to receive a return of their investment during a liquidation

Valuation rules of different type of real estate:

1. Properties occupied by the company (>50%): Depreciation - Encumbrances 2. Properties held for the production of income: Depreciated cost - Encumbrances 3. Properties held for sale: min (Depreciated cost, Fair value) - Encumbrances

What should user look out for when using written premium section of the Five-Year Historical Data Exhibit

1. Rapid change in revenue 2. Changes in level of reinsurance protection 3. Increase in exposure to riskier/unprofitable lines 4. Shifts from liability to property lines (increased catastrophe loss) 5. Shifts from property to liability lines (more uncertain reserves)

Examples of other long term assets

1. Real estate not directly owned by the insurer 2. Joint ventures 3. Partnership interests 4. Surplus debentures

Two components of the total gain from bonds

1. Realized gain on sale/maturity 2. Other realized adjustments - Foreign exchange gain on disposal - Other than temporary impairments

When comparing companies' investment performance, what do analysts need to consider:

1. Size of investable assets 2. Risk 3. Taxes

Describe accounting treatment when stocks are issued

1. The amount collected associated with the par value is recorded as paid in capital 2. The excess is paid-in surplus

2 reasons that insurers should not have large investments in mortgages:

1. They are not part of the core business strategy 2. They are illiquid

Financial reports help stakeholders & regulators:

1. Track the company's financial performance 2. Compare the company's performance 3. Make informed financial decisions

4 categories that bonds are divided into

1. US government bonds 2. Bonds exempt from US tax 3. Other bonds (unaffiliated) 4. Bonds of affiliates

How is the value of preferred stocks drived

1. When common stocks are purchased, they are value at the initial carrying value 2. 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)

How is the value of common stocks derived

1. When common stocks are purchased, they are valued at the initial carrying value: actual cost + commission and taxes 2. After purchase, they are valued at fair value. Changes in fair value are recorded as unrealized valuation changes.

How to calculate the value of the bonds

1. When the bond is purchased, it's recorded at actual cost (incl. brokerage and other fees) 2. After purchase, it is valued at adjusted carrying value: - NAIC 1&2: amortized cost - NAIC 3-6: min (amortized cost, fair value)

List some problems that may arise if expenses are not accurately allocated:

1. distorted profitability measures 2. inefficient allocation of resources 3. anti-selection

2 components of investment income from common stocks

1. investment income earned (dividends received; change in accrual for dividends declared but unpaid) 2. realized capital gains

Non admitted portion of Accrued Retrospective Premium:

10% of the unsecured Accrued Retrospective Premium is non admited

Equation to derive current year's surplus from prior value:

= Prior year's surplus + current year's net income + other surplus changes + additional capital contributions + stockholder dividends

Define derivative

A contract between two parties where the value depends on the value of a particular asset of variable

Define premium deficiency reserve

A separate liability that the insurer needs to create if the premium is insufficient to cover losses, expenses & other costs

How is Dividends to Stockholders derived

Actual amount paid during the year + change in amount of dividends declared but unpaid during the year

Formula to derive realized gain when bond is sold:

Amount received - adjusted carrying value

Deferred premiums

Balances due after the financial statement date

Uncollected premiums & agents' balances

Balances due before the financial statement date

Margin needed to compensate the lost of yield as a percentage of premium (assuming premium is paid at inception and taxes are paid midyear)

Capital x [investment yield x corporate tax rate / (1 - corporate tax rate)] / [premium x (1 + investment yield)^0.5]

Purpose of financial reporting

Communicate financial results to the stakeholders

2 types of investment guidelines that are permitted by the NAIC Model Investment Law:

Defined Limits: quantitative limits Prudent Person: a principles based approach, which enables the insurer to develop its own guidelines

Schedule D of A.S. describes:

Details about stocks and bonds

Underwriting Income formula:

Earned Premium - L&LAE Incurred - Other Underwriting Expense Incurred

Actuary's major role in income statement

Estimate the amount and timing of payments

List an advantage of Fair Value & one for Historical Cost

Fair value: more accurate (consistent with actual market value) Historical cost: more reliable (objectively verifiable)

Compare Fair Value to Historical Cost:

Fair value: value it can be traded at in the open market Historical cost: purchase price - depreciation

Define deferred tax asset (DTA)

Future tax benefits that arise due to temporary differences in income recognition between tax and statutory accounting

Role of the actuary in the preparation of the balance sheet

Help value the reserves - uncertainty associated with the reserves

How can a derivative qualify to be a "highly effective" hedge:

If the insurer can demonstrate that a derivative has significantly reduced a particular risk exposure

Schedule BA of A.S. describes:

Information about other long term assets owned by the insurer

Non admitted portion of Interest Due & Accrued:

Interest Due & Accrued over 90 days overdue is a non admitted asset

Needed margin as a percentage of capital

Investment yield x corporate tax rate / (1 - corporate tax rate)] / [(1 + investment yield)^0.5]

Equation for the cost of double taxation (after tax):

Investment yield x corporate tax rate x (1 - personal tax rate)

Primary users of Generally Accepted Accounting Principles (GAAP):

Investors

How is the DTL arising out of the unrealized capital gains treated

It is a direct charge to surplus

How is unrealized capital gains treated in BS and IS

It is direct credit to surplus, as there is no impact on the income statement.

Define net investment income earned

It is mainly from interest & dividends; net of investment income expenses; gross of taxes; accrual basis

What is Schedule B

It lists the mortgage loans (secured by real estate) owned by the insurer

What is Schedule A

It provides details about real estate directly owned by the insurer

Amounts recoverable from reinsurers includes:

Just the balances due for the losses that have been paid (the ceding company recognizes recoverables on it unpaid losses by holding the loss reserves net of recoveries)

What is reinsurance payable on losses & LAE

Liabilities for amounts owed to reinsured, for losses that they have already paid

List a party that would take a "liquidation" view of insurer & one that would take a "going concern" view:

Liquidation: Regulators Going concern: Investors

Describe the Capital & Surplus exhibit

Lists those transactions that impact surplus, but which are not included in the income statement

Main reason that SAP rules are conservative

Main focus of the regulators is to ensure that the policyholders will be protected

How are derivatives that do not qualify for hedge accounting treated:

Market-to-market accounting (any changes in fair value are recorded as unrealized gains)

Why are nonadmitted assets not included in the surplus calculation

Non admitted assets are not easily convertible to cash to satisfy the insurers liabilities

Define common capital stock

Par value of the insurers stock that is issued & outstanding

Define redeemable preferred stock:

Preferred stock that is redeemable at the option of the issuer at a specified maturity date, or after a specified period of notice, for a specified price

Define perpetual preferred stock:

Preferred stock with no maturity date (i.e. can not be redeemed by the issuer)

Portion of agents balances that is nonadmitted

Premium that is over 90 days overdue is nonadmitted

List some factors that can be used to allocated expenses:

Premium, claim count or headcount

Main objective of GAAP:

Present results that closely measure the financial performance during a period (by matching revenues and expenses)

Compare principles to rules, including their respective advantages:

Principle: a general accounting approach that the users need to interpret Rule: specific guidance that users need to follow The rules are easier to interpret, but the principles are more adaptable to changes

Describe Notes to the Financial Statements

Quantitative & qualitative disclosures elaborating on elements from the statements

Common metric to compare companies' investment performance

Ratio of income to average invested assets (does not reflect risk)

Describe interest paid for accrued interest on dividends

Required whenever an insurer purchases a bond between coupon payments. It needs to pay the seller for the coupons that were earned while they owned the bond

Define unassigned funds

Results from the contribution of retained earnings to surplus

Different net/gross basis for SAP & GAAP

SAP: net basis GAAP: gross basis

Describe the Balance Sheet

Shows the assets and liabilities as of a certain point in time

Describe the Cash Flow Statement

Shows the cash flows into and out of the firm

Describe the Income Statement

Shows the financial results (income) earned during a period

Accounting principles prescribed by the State Regulators

Statutory Accounting Principles (SAP)

What is unassigned surplus

Surplus that is not assigned to the par value of stock, special surplus funds, surplus notes, or treasury stock

Why is amortization or accretion of bonds required

The coupon rate is different to the market interest rate at the time the bond is purchased. The amortization produces an amortized cost equal to the face value at maturity.

Define hedge accounting treatment

The derivative receives the same accounting treatment as the hedged asset

Define double taxation

The difference between the indirect amount of tax paid (via investing through the insurer) and the direct amount of tax paid (investing directly) is the cost of double taxation

How should reserves be booked if management has a range of estimates, and no point within the range is more likely

The midpoint should be booked

Define par value

The minimum amount set by the insurer at which the stock can trade at its initial offering

Non admitted portion of Real Estate:

The permanent excess of book over the market value is a nonadmitted asset

Why should users be concerned if there are large receivables from parent, subsidiary of affiliates

They are usually not as liquid as other assets

Define gross pad in & contributed surplus

This is generated when the insurer issues stock. It equals the excess of the sale price of stock over its par value

What is Atkinson & Dallas Formulae

To reflect the additional cost that arises because of the investment constraints of insurers

One and two year loss development section of the Five-Year Historical Data Exhibit

Users may be concerned if the development is significant relevant to surplus IRS and investors may be concerned if there is a favorable development

Bond face value

amount to be paid in the final single payment

Preferred stocks are valued:

similar to bonds (i.e. NAIC 1-6)

Upon purchase of the bond, record:

the bond at actual cost

Upon purchase of the common stocks, record:

the bond at cost + brokerage fees

After purchase of the common stocks, record:

the bond at fair value