Income Statement

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

• surplus: calculation of surplus, surplus changes, non-I/S surplus changes & reasons for surplus changes
• statutory income: calculation of statutory income
• basic accounting terms and concepts: (SAP = Statutory Accounting Principles)

   => balance sheet, income statement, assets, liabilities, revenue, expenses, reinsurance

• calculation of of bond values

reference	part (a)	part (b)	part (c)	part (d)
E (2018.Spring #10)	statutory income: - calculate	expense allocation: - impact on profitability	expense allocation: - actuary's involvement
E (2017.Fall #9)	statutory income: - calculate	users & purpose: - B/S & I/S 1
E (2017.Fall #10)	surplus: - calculate surplus
E (2017.Fall #13)	calculate: - value of bonds	regulator concerns: - regarding assets
E (2016.Fall #14)	surplus: - calculate surplus	financial health: - evaluate
E (2015.Fall #15)	surplus: - non-I/S surplus changes	surplus: - total surplus change	surplus: - reasons for surplus chg
E (2014.Fall #12)	surplus: - calculate surplus	see NAIC.IRIS	see Odomirok.10-Notes
E (2013.Fall #19)	SAP: - identify errors	surplus: - calculate surplus	reinsurance: - reasons to purchase	regulator concerns: - fair value
E (2012.Fall #14)	surplus: - impact on surplus	see Odomirok.19-RBC

¹ B/S stands for Balance Sheet, and I/S stands for Income Statement.

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In Plain English!

If you've taken a university course in accounting then you're in good shape because you're already familiar with the layout of financial statements. If you haven't, it's not a great problem, but it might be a little harder to understand the big picture.

Some of the content in this wiki article is from other chapters of Odomirok. It's basic accounting material but since we're covering the chapters in a different order, I just threw it in here.

SAP versus GAAP

Before doing anything else, you need to know the frameworks that companies use for accounting.

Question: define SAP and GAAP

• Both are frameworks of accounting principles/rules for reporting financial transactions and operating results:

==> SAP: prescribed by an insurer’s domiciliary state

==> GAAP: used by public & private companies (insurers & non-insurers)

Obviously there is a difference between how insurers and non-insurers do their accounting.

Question: why do insurers follow different accounting rules versus non-insurers [Hint: intended user & purpose]

==> SAP:

• used by regulators
• primary concern is solvency
• SAP is more conservative (protects policyholders)

==> GAAP:

• used by investors/creditors
• primary concern is measurement of earnings

That's all well and good, but what do we mean when we say SAP is more conservative? Well, GAAP came first and SAP evolved from GAAP to satisfy the specific goal of monitoring for solvency.

Question: identify 3 important differences between SAP and GAAP

The answer is covered in detail in a another chapter of Odomirok, Odomirok.22-23-GAAP, but just to give you a taste, here are a few important differences: [Hint: ART]

item	SAP treatment	GAAP treatment
Asset recognition	asset is recognized when expense is incurred	may defer recognition to to achieve matching of revenue & expenses 1
Reinsurance in loss reserves	loss reserves are recorded NET of reinsurance	loss reserves are recorded GROSS of reinsurance
Taxes	taxes not deferred	tax can be deferred

¹ An example of GAAP asset recognition to achieve matching of revenue & expenses is for DAC (Deferred Acquisition Costs). Acquisition costs like advertising are not "counted" immediately. Rather they are earned over the term of the policy that was acquired by that particular advertising.

Elements of Financial Statements

If you google "elements of financial statements" you'll find many websites that list the 5 elements as follows:

• Assets (Ex: cash, investments)
• Liabilities (Ex: loss reserves)
• Equity (= net assets = assets minus liabilities)
• Revenue (Ex: premiums)
• Expenses (Ex: salaries, advertising)

Now, the 5 statements in a completed set of financial statements are: (The red items above relate to mainly to the Balance Sheet, while the green items relate mainly to the Income Statement)

• B/S or Balance Sheet (Statement of Financial Position – Chapter 7 in Odomirok)
• I/S or Income Statement (Statement of Financial Performance – Chapter 8 in Odomirok)
• Statement of Change in Equity
• Statement of Cash Flow
• Notes the the Financial Statement

These are different but related to the 5 elements.

We're not going to delve too deeply into all of this, but here are couple of basic definitions:

Balance Sheet: shows a company's assets, liabilities and equity at a specific point in time

- shows strength of a company's capital (whether assets are sufficient to cover liabilities and remain solvent)

Income Statement: shows a company's revenue and expenses over a particular period

- shows company's current profitability (a company could have strong capital based on strong prior performance but weak current performance ==> could indicate impending insolvency)

Notice that the Balance Sheet shows the first 3 elements: assets, liabilities, equity, and the Income Statement shows the last 2: revenue, expenses. Everything fits together nicely! Here's an example of each. (You might want to first duplicate the tab so you can have the wiki and the exhibit open at the same time.)

Balance Sheet example (Liberty Mutual)

Spend a minute or two looking at it and observe:

• The Balance Sheet consists of 2 pages: 1 page shows assets, the other page shows liabilities & equity
• Note the columns for admitted assets and non-admitted assets.
• Line 37 on the second page shows Surplus as regards policyholders which is something you have to calculate in exam problems. (see BattleTable above)

Income Statement example (Liberty Mutual)

Observe:

• There are 3 types of income: U/W income, investment income, other income
• Note that Liberty's U/W income on line 8 is negative 807 million, which means their COR must be over 100%.
• But their total net income on line 20 is positive 823 million. (Their investments save them! See line 11.) Pay special attention to line 20 because you had to calculate this on exam problems.

2018.Spring #10a

Let's look at this exam question from 2018.Spring:

E (2018.Spring #10a)

I only want to look at part (a) since that's a calculation. (Parts (b) & (c) of this problem are short answer and you can easily get the answer from the examine'rs report or the mini BattleQuiz.) Recall Liberty Mutual's income statement from the previous section where we noted the 3 components of income. Here are the "formulas":

item	formula
U/W income	= EP – (current AY loss) – (change in prior years' AY loss) – LAE – (other U/W expense)
Investment income	= (investment revenue) – (investment expenses) 1
other income	= SUM(all the little things) 2

¹ investment revenue includes realized capital gains but excludes unrealized capital gains

² If you look at the given information in the exam problem, all of the little items in the bottom box (below unrealized capital gains) are included in the income calculation except dividends to stockholders.

Pop Quiz!    :-o

• Use the formulas in the above table to calculate the net income. Use the examiner's report if necessary. (Answer = 8,965)

Sometimes you're not given EP directly. You may instead be given WP and the change in UEP (Unearned Premium) and then have to calculate EP for the current year. Note also that UEP is also sometimes denoted UPR (Unearned Premium Reserve)

item	formula
EP	= WP – (change in UEP)

Side point: The question specifically asked for statutory income. That would be the income as defined by SAP (Statutory Accounting Principles). Recall that SAP is specifically for insurance companies and all the calculations we'll be doing will be according to SAP.

There is another old problem that asks you to calculate statutory net income but it's harder. It involves the concept of policyholder's surplus. It will make more sense once we've covered other problems that specifically ask you to calculate policyholder's surplus. Here's the link if you want to take a quick look but don't worry if you don't know how to solve it:

E (2017.Fall #9a)

Then part (b) of that problem is pretty easy. They ask you to identify a user of the balance sheet and a user of the income statement, but both have almost the same answer! The only difference is that the income statement lists competitors as a user whereas the balance sheet doesn't. The actual use of each exhibit is easy and was covered earlier in this wiki article.

2017.Fall #10

Here is a second problem from the same exam, but here you have to calculate the policyholder's surplus. It's actually a very good problem because it directly teaches you how to do the calculation. The solution in the examiner's report is also nicely written. The link is provided below. Study the solution, then see if you can do the 2 practice problems.

E (2017.Fall #10)

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