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SOA Health Core Exam - Objective 5
SOA Health Core Exam - Objective 5

Additional Insurance Flashcards




Users of financial statements (3)
1. Providers of capital - such as investment banks, private lenders, and individual investors
2. Expert advisors to users of financial statements - this includes attorneys, actuaries, and accountants
3. Anyone who is party to any of the company's transactions - this includes policyholders and creditors
4. Independent auditors
5. Stock analysts
6. Rating agencies
7. Rule-making authorities - such as the SEC and FASB
Criteria for an item to be included in the financial statement (8)
1. Definition - the item needs to meet the definition of an asset, liability, revenue, or an expense
2. Measurability - an item must be measurable in terms of a relevant attribute
3. Relevance - information about the item needs to be consistent, comparable, and meaningful to the user
4. Reliability - the information must be accurate, verifiable, and free of bias
Organizations responsible for setting GAAP standards (18)
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
Renewability provisions for health insurance products (321)
1. Guaranteed renewable - insurer cannot cancel the policy, but may increase 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 cannot cancel individual policies
4. Conditionally renewable - the policy may be cancelled if certain specified reasons are met
5. Optionally renewable - the policy can be cancelled at any renewal date
6. Short-term (such as short-term medical) - this type of policy only provides coverage for a set term, but it may provide one or two renewals
Types of health insurance policies (325)
1. Medical coverages - for two markets: under age 65 and over age 65
2. Indemnity policies - such as a set amount per day of hospital confinement
3. Medical savings accounts
4. Disability income
5. Income replacement policies - attempt to reimburse actual economic losses associated with a disability
6. Business overhead policies - cover costs incurred by a business while the key owner or manager is disabled
7. Long-term-care policies
8. Medicare supplement - fills the gaps in coverage provided by Medicare
Formulas for benefit reserves and deferred acquisition cost reserves (335)
1. Definitions
a) x = issue age
b) t = policy duration
c) p = survival probability
d) v = 1 / (1 + i) where i = the valuation interest rate
e) B = benefits
f) S = claim cost per unit in force
g) DE = deferred acquisition expense

2. Benefit net premium (BNP) = I v' * tpx * Bt / S v* * ,px
3. Benefit reserve (BV)

a) Prospective: ,BV = £ H> V* * ,px * S w +, -1 H, v1 * ,px * BNP
b) Retrospective: ,BV = E « BNP * (1 + i)' / ,px -1 H> S [X] +, * (1 + i)' / tpx

4. Deferrable acquisition expense net premium (DENP) = S ^0 v1 * tpx * DE, / £ ,=o v1 * ,px
5. Deferred acquisition cost (DAC) = I« DENP * (1 + i)' / ,px -1 H, DE, * (1 + i)' / ,px
Types of liabilities for group life and health insurance (384)
1. Active life and unearned premium reserves - group life and health contracts generally do not have active
life reserves, but unearned premiums must be held as a liability for active lives in a group
2. Expense capitalization - a deferred policy acquisition cost of unearned gross premiums should be established as an asset
3. Claim reserves and claim adjustment expense reserves
4. Premium deficiency reserves - this reserve funds any projected losses in advance
5. Reserves for accrued experience refunds
6. Liabilities related to stop-loss reinsurance arrangements
7. Deferred profit liability
Primary financial statement exhibits (6)
1. Balance sheet - a financial snapshot, taken at a point in time, of all the assets the company owns, and all the claims against those assets (Assets = Liabilities + Shareholders' equity)
2. Income statement - shows revenues and expenses, illustrating how owners' equity changes over time (Revenue - Expenses = Net income)
3. Sources and Uses statement - is used to gain a picture of where a company got its money (sources) and how it spent money (uses)
4. Cash Flow statement - provides a detailed look at changes in the company's cash balance over time, separating changes based on if the cash flows came from operating, investing, or financing activities
Definitions of types of earnings (15)
1. Net income - total revenue less total expenses
2. Operating earnings - profit realized from day-to-day operations (excludes taxes, interest income and expense, and extraordinary items)
3. Pro forma earnings - revenue less expenses after omitting items the company believes might cloud perceptions of the true earning power of the business
4. EBIT is earnings before interest and taxes
5. EBITDA is earnings before interest, taxes, depreciation, and amortization
6. EIATBS is earnings ignoring all the bad stuff
Definitions of types of cash flow (22)
1. Net cash flow = Net income + Noncash items
2. Cash flow from operating activities = Net cash flow plus or minus changes 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 = A sum of money today having the same value as a future stream of cash receipts and disbursements
Principle virtues of the cash flow statement (23)
1. It is easy to understand
2. It provides more accurate information about some activities than what appears on income statements and balance sheets
3. It highlights the extent to which operations are generating or consuming cash
Primary reasons why a company's book value does not represent the value of the company (23)
1. Financial statements are transactions based - so an asset's value on the statements is based on the purchase price and depreciation, not its 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
Techniques for forecasting external funding needs (89, 106)
All of these techniques will produce the same estimate of external funding required
1. Pro forma statement - a prediction of what the company's financial statements will look like at the end of
the forecast period. Is the recommended approach for most planning purposes and for credit analysis.
External funding required = total assets - (liabilities + owners' equity)
2. Cash flow forecast - a forecast of sources and uses of cash. Straightforward and easily understood, but
less informative than a pro forma statement.
External funding required = total uses - total sources
3. Cash budget - a forecast of cash receipts and disbursements. Is appropriate for short-term forecasting and
the management of cash.
Ending cash = beginning cash + total cash receipts - total cash disbursements External funding required = minimum desired cash - ending cash
Steps in the percent-of-sales approach for creating pro forma statements (90)
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. Some items will not vary with sales, and will therefore need to be forecasted independently.
4. Test the sensitivity of the results to reasonable variations in the sales forecast
Ways to cope with uncertainty in financial forecasts (102)
1. Sensitivity analysis - systematically changing one assumption at a time and observing how the forecast responds
2. Scenario analysis - looks at how a number of assumptions might change in unison in response to a particular economic event. Generates a separate forecast for each scenario.
3. Simulation - assign probability distributions to a number of uncertain inputs and use a computer to generate a distribution of possible outcomes
Stages of the financial planning process (111)
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
Life cycle of successful companies (124)
1. Startup - the company loses money while developing products and establishing market foothold
2. Rapid growth - the company is profitable but is growing so rapidly that it needs regular infusions of outside financing
3. Maturity - growth declines and the company switches from absorbing outside financing to generating more cash than it can profitably reinvest
4. Decline - the company is perhaps marginally profitable, generates excess cash, and suffers declining sales
Definition of sustainable growth rate (126)
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*ROEbop
R = earnings retention rate = 1 - dividends / earnings ROEbop = earnings / equity at beginning of period
3. Since ROEbop = PAT, then g* = PRAT
P = profit margin
A = asset turnover ratio
T = financial leverage = assets-to-equity ratio (using beginning-of-period equity)
Therefore, to increase g*, one of P, R, A, or T must increase
4. Since ROA = profit margin * asset turnover ratio, then g* = RT * ROA
Growth management strategies for when actual growth exceeds sustainable growth (131)
1. Sell new equity - many companies are unable or unwilling to do this
2. Increase financial leverage by increasing debt
3. Reduce the dividend payout - not possible for most companies since they do not pay dividends
4. Prune away marginal activities ("profitable pruning") - selling off marginal operations and putting that money back into the remaining business
5. Outsource some or all of production - outsource activities that are not core competencies
6. Increase prices - this will slow actual growth and could also lead to higher profit margins
7. Merge with a "cash cow" - look for a partner with deep pockets
Growth management strategies for when sustainable growth exceeds actual growth (138)
1. Look within the firm to remove internal constraints on company growth
2. Ignore the problem - continue to invest in the core business despite poor returns, or sit on idle resources. This may lead investors or the board of directors to force a management change.
3. Return the money to shareholders - done by increasing dividends or repurchasing shares
4. Buy growth - acquire an existing business or start a new product line from scratch
5. Reduce financial leverage
6. Cut prices
Reasons why US corporations don't issue more equity (144)
1. Recently, companies in the aggregate have not needed new equity
2. Equity is expensive to issue (costs about 5% to 10% of the amount raised)
3. Many managers consider anything that lowers earnings per share (EPS) as bad, and issuing new equity will initially lower EPS
4. Most companies feel their stock prices are undervalued, so they choose to not sell new stock at what they think is too low a price
5. Many managers view the stock market as an unreliable funding source, so they build funding strategies that do not rely on the stock market
Types of group insurance financial reporting (326)
1. Statutory - the focus is on solvency, so conservative standards are mandated
2. GAAP - attempts to accurately reflect the earnings during a reporting period. Therefore, much of the conservatism in statutory reporting is removed.

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 - in general, statutory financial reports are the starting point, with certain adjustments to reserve items
4. Managerial reporting - financial reports (usually GAAP) are modified to provide a more accurate picture of the impact of management decisions
5. Policyholder reporting - provides information for risk-sharing arrangements, for government reporting,
and for policyholders to complete their own financial reports
6. Provider reporting (US only) - provides information for provider risk sharing arrangements and medical management reporting
7. Assuris (Canada only) - reporting is needed for this consumer protection plan, which indemnifies the
policyholders of insolvent life insurers
Conservative standards mandated in statutory reporting in the US (326)
1. Certain items (such as agents' balances) are nonadmitted assets, meaning they are not allowed in determining solvency
2. NAIC prescribes the asset values to be used (does not allow flexibility)
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 (MR) are required in order to provide a cushion against investment losses and interest rate fluctuations
Solvency safeguards in the Canadian Insurance Companies Act (331)
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 the actuary 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
Major modifications to US statutory reporting to produce GAAP results (332)
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
Items included in the Canadian annual statement actuarial report (333)
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
Modifications to US statutory reporting to produce tax reporting results (335)
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%
Modifications to Canadian statutory reporting to produce tax reporting results (335)
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
Formula for the Gordon Constant Growth Model (746)
2. P/D=l/(k-G)
P = price
D = dividends one 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)
The components of ROE (the Dupont Formula) (747)
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.
Common income statement ratios for health insurers (754)
1. Administrative expense ratio = administrative expenses / revenues
2. Health benefit ratio (or loss ratio)= health benefit expenses / premium revenues
3. For simple insured business (i.e., no non-premium revenues such as ASO fees):
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 - investment expense - income taxes
Adjustments needed when preparing the same-size-income statement (758)
(this statement expresses all relevant financial components as a percent of revenue)
1. Reinsurance - should count reinsurance premiums paid as health expenses, and reinsurance recoveries as offsets to health care costs
2. Commissions - count as an adrnmistrative expense
3. Investment income - count as non-operating income
4. ASO products - look at financial reports separately for each product type
FAS 60 accounting requirements (7)
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 estimated 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 (see separate list)
7. Policyholder dividends - shall be accrued using an estimate of the amount to be paid
FAS 60 accounting for premium deficiencies (11)
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
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