Odomirok.6-7-BS

Reading: Financial Reporting Through the Lens of a Property/Casualty Actuary - Chapter 6 & 7 - Introduction to Financial Statements and the Balance Sheet

Author: Kathleen C. Odomirok, FCAS, MAAA, Liam M. McFarlane, FCIA, FCAS, Gareth L. Kennedy, ACAS, MAAA, Justin J. Brenden, FCAS, MAAA, EY

These introductory chapters explain the basic layout of the balance sheet: assets, liabilities, surplus.

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BA Quick-Summary: Balance Sheet & Income Statement Chapter 6 and 7 provide an overview of Statutory Accounting Principles (SAP) and their application in the U.S. insurance industry. They explain fundamental aspects of the Annual Statement, including key financial statements like the balance sheet which shows: assets liabilities surplus

BattleTable

Based on past exams, the main things you need to know (in rough order of importance) are:

• bond values and regulator concerns
• layout of balance sheet
• identifying risks based on balance sheet information

Questions held out from Fall 2019 exam: #11,12. (Skip these now to have a fresh exam to practice on later. For links to these questions, see Exam Summaries.)

reference	part (a)	part (b)	part (c)	part (d)
E (2018.Fall #10)	calculate: - value of bonds	Odomirok.8-9-IS	Odomirok.8-9-IS
E (2017.Fall #13)	calculate: - value of bonds	regulator concerns: - regarding assets
E (2012.Fall #18)	balance sheet: - construct from given info	financial health: - identify insurer risks

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In Plain English!

This chapter of Odomirok on the balance sheet is very important, but there are not very many old exam problems exclusively on this chapter. But to answer questions from later chapters, you have to have at least a general understanding of the balance sheet. We covered the basics of the balance sheet in Odomirok.8-9-IS but there are a few additional things you need to know.

Balance Sheet Layout

The layout of the balance sheet is one of the foundations of accounting.

Question: why is the balance sheet important to actuaries

• loss & LAE are the majority of the liabilities and actuaries either set or have a significant role in determining the amount
• actuaries have a role in assessing the capital required to support an insurer's risks

Question: define the terms asset, liability, surplus

asset: a property, right, or claim arising from past events that has future value

liability: an obligation that the company must fulfill, based on past events, which will require the use of the company’s resources.

surplus: (sometimes called equity) is the difference between assets & liabilities

If you take a look at the exam question from 2012 that's listed in the BattleTable, you'll see that they ask you to construct the balance sheet based on the given information. To do this, you have to have a basic understanding of the layout of the 2 pages of the balance sheet. In very rough terms the asset side of the balance sheet looks like this:

item	ASSETS	nonadmitted assets	NET admitted assets	prior year
bonds	B	x	B – x	y
...	...	...	...	...
...	...	...	...	...
SUBTOTAL: cash & invested assets	...	...	...	...
uncollected premiums & agents balances	U	a	U – a	b
...	...	...	...	...
...	...	...	...	...
SUBTOTAL: non-invested assets	...	...	...	...
TOTAL: assets	...	...	...	...

You should memorize the layout of this table. The first part of the exam problem isn't too hard. They provide the balance sheet items on an "admitted" basis – you just have to figure which items go in the top half (cash & invested assets) and which go in the bottom half (non-invested assets). To do that, it helps to know these 2 definitions:

• cash & invested assets: assets that could be readily sold in the near term to meet the insurer's liabilities
• non-invested assets: assets that are less liquid

The main examples of cash & invested assets are:

• bonds, preferred stocks, common stocks, real estate, cash & cash equivalents, other invested assets

Examples of non-invested assets include:

• uncollected premiums & agents balances, reinsurance recoveries, DTA (Deferred Tax Asset)

Note that there's some overlap between non-invested assets and non-admitted assets. Non-admitted assets is a SAP concept and refers to assets that have economic value but cannot easily be used to fulfill policyholder obligations. Each state has its own definition of non-admitted assets but it generally means assets that are not liquid or difficult to sell. Examples: office furniture, prepaid expenses, or intangible assets such as trademarks.

You can now take a pretty good guess as to how to construct the asset side of the balance sheet.

Let's now look at the layout of the liabilities & surplus side of the balance sheet

item	current year	prior year
losses	x	y
...	...	...
...	...	...
SUBTOTAL: liabilities	...	...
aggregate write-ins for special surplus funds	a	b
...	...	...
...	...	...
SUBTOTAL: surplus as regards policyholders	...	...
TOTAL: (liabilities + surplus) = assets	...	...

The main examples of liabilities are:

• loss, UEP (Unearned Premium), LAE, reinsurance payables for losses and premiums, funds held, provision for reinsurance

The main examples of surplus line items are:

• unassigned funds, gross paid in & contributed surplus, aggregate write-ins for special surplus funds, common capital stock

Tip: I'm not sure you specifically need to memorize these examples of line items in the balance sheet. My advice is just to pay attention as you go through Odomirok and old exam problems. You'll absorb what you need to know gradually as you study.

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Bonds

Bonds generally account for 50-60% of an insurer's assets. You have to know something about them! (Bonds are shown in Schedule D of the annual statement but Schedule D is not on the syllabus.)

Question: define the term 'bond' as it pertains to financial statements

• a bond is a security (or investment product) that makes pre-determined interest payments (or coupon payments) according to a fixed schedule

A bond is also often called a fixed-income security. The buyer knows exactly what they will be paid and when they will be paid. They are low-risk, which is why insurers like them. Here's an example:

face value of bond 1	$1,000
price of bond	$1,000
interest or coupon rate	5%
maturity	10 years

¹ face value is also called par value

• Assuming the bond pays annual coupons, the holder of the bond would receive 5% x $1,000 = $50 once-per-year for 10 years. (If coupons were paid semi-annually, the bondholder would receive $25 twice-per-year for 10 years.)
• At maturity, which is at the end of the 10 years, the bondholder would also receive a single lump-sum payment equal to the face value of the bond. In this case the final payment would be $1,050, or the sum of the face value and the final coupon payment.

In this example, the price equals the face value but this doesn't have to be the case. I don't want to get into this too deeply so let's just note the following:

==> if (price > face value) then the bond was sold at a premium

==> if (price < face value) then the bond was sold at a discount

The premium or discount is then amortized over the life of the bond. This eliminates an extra lump sum gain/loss at maturity.

Ok, we're almost done with bonds! There's just one more thing to cover...

Question: how are bonds recorded on the balance sheet under SAP

The recorded value or adjusted carrying value depends on the rating of the bond, and the rating represents the riskiness of the bond. (Bonds are low-risk but they are not NO-risk!) There are 6 ratings: NAIC 1 (highest) through NAIC 6 (lowest). In other words:

• NAIC 1 is the highest quality (and the lowest risk of default)
• NAIC 6 is the lowest quality (and the highest risk of default)

Based on its rating, bonds are recorded on the balance sheet as follows:

• NAIC 1&2: amortized cost
• NAIC 3,4,5,6: min(amortized cost, fair value)

Note that the fair value is the present value of all future payments associated with the bond.

And just a quick reminder:

amortization is an accounting technique that lowers the book value of a loan or intangible asset over time (Ex: goodwill, patents)

depreciation is similar to amortization except that it applies to tangible assets (Ex: machinery)

fair value is the price of an asset when a willing buyer and seller have reasonable knowledge of the value of the asset

Then if the fair value (market value) of an asset changes:

• surplus is not affected for assets valued at amortized cost
• surplus is affected for assets valued at fair value (market value)

About 2/3 of the bonds that insurers hold are issued by the government; the remaining 1/3 are issued by corporations.

Bond valuation in GAAP is really from Odomirok.22-23-GAAP but I've included it here to show how it compares to bond valuation under SAP.

Question: how are bonds recorded on the balance sheet under GAAP

Bonds are classified differently under GAAP as compared to SAP. Under GAAP, there are 3 categories:

• AFS (Available-For-Sale): acquired with intent to hold for > 1 year BUT sell before maturity
• HTM (Held-To-Maturity): acquired with intent to hold until maturity
• HFT (Held-For-Trading): acquired with intent to hold only for hours or days

GAAP then records these bonds as follows:

• AFS: fair value

   → changes in fair value are recorded in other comprehensive income (OCI)

   → results in a direct change to surplus (instead of flowing through the regular income statement)

• HTM: amortized cost
• HFT: fair value

   → changes in fair value are recorded in the income statement

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Deferred Tax Asset (DTA)

A topic that seems to appear quite often is Deferred Tax Asset or DTA.

Question: define the term Deferred Tax Asset

• A DTA represents expected future tax benefits related to amounts previously recorded in the statutory financial statements not expected to be reflected in the tax return as of the reporting date.

Note that DTAs are reported net of DTLs (Deferred Tax Liabilities)

Question: identify & explain 2 examples of DTAs that are relevant to the actuary (note that DTAs are the largest single source of nonadmitted assets)

• difference in tax accounting & statutory accounting for loss reserves

- statutory loss reserves are discounted to find the reserves for tax reporting purposes

- in other words, the difference represents the time-value of money

• carryforward of net operating loss from previous years

- when losses in 1 year offset gains in future years

These details are probably giving you a headache but don't worry: If you persevere, you'll absorb everything without even realizing it!

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Constructing a Balance Sheet

Ok, here is the hard problem where you actually have to construct a balance sheet given raw data. This problem is from 2012 and the nature of exam problems has changed since then. I think there are other problems that are more important for you to learn how to do. You should definitely know the layout of the balance sheet as described above so if you get another problem like this, you'll be able to take a good educated guess. Even if you didn't get it perfectly correct, you'd get most of the points.

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