Cpcu 540 - Finance & Accounting For Ins Professionals

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Main goals of corporate finance and accounting

Back 1

* Maximize shareholder wealth
* Provide for transparency in financial reporting
* Conduct financial operations in an ethical manner

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T or F: Wealth = profits

Back 2

FALSE. Also, maximizing wealth is not the same as maximizing profits

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Stakeholder

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Anyone with financial interest in the corporation

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Sarbanes-Oxley Act of 2002

Back 4

A federal statutory law governing corporate directors in the areas of investor protection, internal controls, and penalties, both civil and criminal.

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Working capital management

Back 5

A corporate finance department that focuses on a corporation's short-term needs for cash and other resources. The activities involved in working capital management mainly involve the receipt and disbursement of cash.

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Capital structure management

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A corporate finance department that focuses on raising capital through borrowing or selling stock as well as the specific financial vehicles that will be used.

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Capital budgeting

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A corporate finance department that focuses on planning and managing of a corporation's long-term investments, which can be for tangible or intangible assets.

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Accounting activities

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A corporate finance department that handles financial accounting, taxation, and financing reporting

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Working capital

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A liquidity measure that is calculated by subtracting current liabilities from current assets. It is used to determine a company's ability to finance immediate operations (to buy inventory, finance growth, and obtain credit).

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Capital structure

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A corporation's mix of long-term debt and equity.

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Two major decisions that a financial manager needs to make in terms of capital structure are these:

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* How much capital will be financed by borrowing, and how much will be raised through the sale of stock in the corporation?
* What specific financial vehicles will be used to raise capital?

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Capital budgeting

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The planning and managing of a corporation's long-term investments.

These investments can be for tangible assets (such as machinery, offices, or computer equipment), or they can be for intangible assets (such as technical expertise, patents, patents, advertising, or insurance writing capacity).

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Difference between finance activities and accounting activities

Back 13

Whereas finance activities focus on obtaining and managing an organization's capital, accounting activities focus on accumulating and reporting financial data for both internal and external use

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Securities Exchange Act of 1934

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The SEC was granted authority to promulgate financial accounting standards for publicly held companies. (The SEC has looked to the private sector to establish these standards.)

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Going Concern

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A GAAP concept:

An accounting assumption that a business entity will continue to operate indefinitely. (The assumption affects the values that an organization assigns to assets recorded in its financial statements.)

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Cost Principle

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A GAAP Principle:

Requires an organization's assets to be recorded at their purchase price or production price.

(As a result of this principle, financial statements do not indicate how much a business is worth, nor do they indicate the values for which assets can be sold or replaced; they simply record the historical costs of the assets.)

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Revenue Recognition Principle

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A GAAP Principle:

Requires revenues to be recognized and recorded at the time services are rendered or goods are sold to customers.

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Matching Principle

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A GAAP Principle:

Requires expenses incurred in generating revenues to be matched against those revenues.

(As a result, the profitability of the organization's activity can be accurately measured.)

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Accrual versus Cash Basis Accounting

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Accrual basis: revenues and expenses are recorded as they are incurred

Cash Basis: revenues and expenses are recorded when cash is received or paid

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Materiality Principle

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A GAAP Principle:

Allows accountants to ignore generally accepted accounting principles (GAAP) when recording items that are not material IF to do so is less expensive and more convenient.

(An item is considered to be material if knowledge of the item might reasonably influence the decisions of users of the financial statements.)

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Materiality

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A GAAP concept:

An item is considered to be material if knowledge of the item might reasonably influence the decisions of users of the financial statements.

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Consistency Principle

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A GAAP Principle:

Requires an organization to use the same accounting principles and reporting practices in every accounting period.

(This principle prevents an organization from selecting alternate accounting methods from one period to the next for the purpose of presenting a more favorable financial position or manipulating earnings.

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Conservatism Principle

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A GAAP Principle:

Requires transactions to be recorded in a manner such that assets and earnings are not overstated.

(For example, the recorded value of many assets must be reduced if they are currently worth less than book value and unlikely to recover. The application of the matching principle is an important part of applying the conservatism principle, because the matching principle ensures that the costs of generating specific revenues are recorded in the same accounting period as the revenues are recorded. When making decisions about estimates that are used in the accounting process, the conservative approach is to anticipate losses and not to anticipate gains.)

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Statutory accounting principles (SAP)

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The accounting principles and practices that are prescribed or permitted by an insurer's domiciliary state and that insurers must follow.

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Fair value

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The market value, either actual or estimated, of an asset or a liability.

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Similarity between GAAP & International Financial Reporting Standards (IFRS)

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They use fair value reporting for many assets (e.g., intangible assets and financial instruments, including derivatives, equities, and debt securities)

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Difference between GAAP & International Financial Reporting Standards (IFRS)

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GAAP uses historical cost, and IFRS allows for fair value, for the reported value of property, plant, and equipment assets.

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T or F: When fair value is used in accounting, realized and unrealized gains/losses are not recognized on either the income statement or on the balance sheet.

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FALSE. When fair value is used, realized and unrealized gains/losses are recognized both on the income statement and on the balance sheet.

(This leads to reported values that are consistent with the concepts of economic income and economic net worth, which are based on market valuations.)

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GAAP definition of 'fair value'

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The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.

(Compared to IFRS, which defines fair value as the amount for which an asset could be exchanged or for which a liability could be settled between knowledgeable, willing parties in an arm's-length transaction.)

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IFRS definition of 'fair value'

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The amount for which an asset could be exchanged or for which a liability could be settled between knowledgeable, willing parties in an arm's-length transaction.

(Compared to GAAP, which defines it as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.)

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The Norwalk Agreement

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In 2002, both the FASB and IASB pledged to use their best efforts to (a) make their existing financial reporting standards fully compatible as soon as is practicable and (b) to coordinate their future work programs to ensure that once achieved, compatibility is maintained.

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Financial statement

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A document that quantitatively presents an organization's financial activities or status.

Their purpose is to communicate information about an organization's financial activities, and the results of those activities, to individuals who need to make informed financial decision about the organization. (Management, investors, insurers, and employees.)

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Accounting

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The classification, analysis, and determination of the appropriate method of reporting the effects of the bookkeeping records in an organization's financial statements.

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Bookkeeping

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Systematically record data on financial activity

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Balance sheet

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The financial statement that reports the assets, liabilities, and owners' equity of an organization as of a specific date.

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Shareholder's equity

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Assets - Liabilities = Shareholders' equity (owners' equity)

this is also known as "the accounting equation" or "the balance sheet equation"

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Assets

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The resources an organization owns or uses to operate its business.

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Current assets

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A balance sheet asset classification that includes cash and other assets that are expected to be converted into cash, sold, or exchanged within the business's normal operating cycle, usually one year.

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Noncurrent assets

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Those assets that will be used over a period greater than one year.

They are grouped into tangible assets (land, buildings, and equipment) and intangible assets (leaseholds, patents, copyrights, trademarks)

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Goodwill

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An intangible asset usually generated as part of an acquisition.Whenever the acquiring organization pays more than the book value for the acquired organization, the difference between teh price paid for the organization and the book value can be listed as goodwill on the balance sheet. Goodwill is not amortized over any specific time period, like other intangible assets.

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Net value of the asset (a depreciation concept)

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Historical cost - accumulated depreciation

There are many methods of depreciating assets, such as straight-line depreciation or declining balance depreciation. On the balance sheet, the historical cost of a noncurrent asset is reduced by the depreciation amount, leaving the net value of the asset on the balance sheet

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Liabilities

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The debts and obligations that represent claims against an organization's assets.

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Current liabilities

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A balance sheet liability classification that includes obligations whose payments are reasonably expected to require the use of cash or the creation of other current liabilities within one year.

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Noncurrent liabilities

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Liabilities that will be paid or satisfied more than one year after the balance sheet date, such as long-term notes payable

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Retained earnings

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The cumulative net income that an organization has retained, after payment of dividends, for reinvestment in the organization's operations

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Revenue

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Teh inflow of assets, usually cash or accounts receivable, resulting from the sale of products or the rendering of services to customers.

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T or F: Revenue does not include gains from the sale of property, plant, or equipment.

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TRUE. Revenue does NOT include gains from the sale of property, plant, or equipment.

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Cost of goods sold expense

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(appears on the income statement; is calculated according to this formula:)

Beginning inventory
+ additions to inventory
= amount that could have been sold
- ending inventory
= Cost of goods sold

In a service operation, such as an insurance agency, the cost of goods sold is minimal or nonexistent because no physical product is being sold.

(Note that, under this formula, there can be a cost of goods sold only if there has been a sale that lowers the ending inventory from the amount that could have been sold.)

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Gross profit

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An income statement value that represents sales or operating revenue minus the cost of goods sold.

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Gross margin (gross profit margin)

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The percentage of sales remaining after deducting the cost of goods sold from sales, calculated by dividing gross profit by sales.

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Operating income

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An income statement value that reflects income that results from the normal operations of the business during the period covered by the statement; calculated as teh gross profit less selling, general, and administrative expenses

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Capital expenditures

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Large purchases of land, buildings, or equipment are called capital expenditures.

Although capital expenditures may seem to be very large operating expenses, showing such large expenditures as a one-time expense on an income statement would skew the income statment because capital investments and expenditures are not considered operations.

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Net income

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Net income = Revenue - Expenses (including depreciation) + Gains - Losses - Taxes

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Comprehensive income

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A measure of income that goes beyond that reported on the income statement by including items such as unrealized gains and losses

In other words, comprehensive income includes an organization's net income from the income statement plus other income that is not required to be reported on the income statement.

(Those other income include unrealized gains and losses on securities for sale, foreign currency translation gains or losses, and minimum pension liability adjustments)

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Statement of changes in shareholders' equity

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The financial statement that explains any changes that have occurred in the organization's capital accounts during a specific period

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Four major components of shareholders' equity

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* Paid-in capital
* Retained earnings
* Accumulated other comprehensive income
* Treasury stock

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Paid-in capital

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The total amount invested in an organization by the owners

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Par value

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An arbitrary dollar value that a corporation assigns to its shares. Par value generally bears no relationship to the market value of a share of stock.

(Relevant to paid-in capital)

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Three components of other comprehensive income:

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1. Change in unrealized appreciation or depreciation of investments (these are the same as unrealized gains and losses)
2. Foreign currency translation gains or losses
3. Changes in minimum pension liability

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Treasury stock

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A corporate stock issued as fully paid to a stockholder and subsequently reacquired by the corporation to use for business purposes.

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Statement of cash flows

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The financial statement that summarizes the cash effects of an organization's operating, investing, and financing activities during a specific period.

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Depreciation expense

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An accounting method that spreads out the expense of a purchase over the life expectancy of the item

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Elements int he GAAP Statement of Changes in SHareholders' Equity (example on 2.15)

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Paid in capital:
* Beginning balance
* Common stock issued
* Ending balance

Retained earnings
* Beginning balance
* Net income
* Shareholder dividends
* Ending balance

Accumulated Other Comprehensive Income (Loss)
* Beginning balance
* Other comprehensive income (loss)
* Ending balance

Treasury Stock
* Beginning balance
* Repurchase of shares
* Ending balance

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Three sections in the Statement of Cash Flows

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* Operating activities
* Investing activities
* Financing activities

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Elements in the GAAP Statement of Cash Flows (example on 2.16)

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* Cash Flows from Operating Activities (i.e., Net Income)
* Add (Deduct) Items Not Affecting Cash (e.g., depreciation expense, add/deduct in accounts receivable, add/deduct in inventories, supplies, payables, and cash used for operating activities)
* Cash flows from Investing Activities (e.g., additions to property, plant, & equipment, cash from (used for) investing activities)
* Cash flows from financing activities (e.g., proceeds from issuance of debt, proceeds from issuance of common stock, purchase of treasury stock, dividends paid to shareholders, cash used for financing activities)

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An insurer's financial investments are usually broken down into four categories:

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1. Short-term investments
2. Fixed maturity investments
3. Equity securities
4. Other invested assets

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Investment Income

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Consists of the coupon payments on fixed incomes securities, the dividend payments on equity holdings, and any income generated by real estate holdings less the insurer's investment expenses

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Why is comprehensive income important to insurers?

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Because unrealized net capital gains or losses on investments may be substantial for insurers.

For example, on its 2009 Statement of Comprehensive Income, XYZ Insurance Co.reported net income of $945 million from its income statement. It also had more than $5.2 billion in unrealized net capital gains, resulting in a comprehensive income of over $6 billion, more than six times its net income

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Generally accepted accounting principles (GAAP)

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A common set of accounting standards and procedures used in the preparation of financial statements to ensure consistency of presentation and reported results.

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Notes to the financial statements

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Contain additional details that are disclosed to explain or amplify the information presented in the financial statements.

These are included in the notes:

* A brief description of the nature of the company's operations
* A summary of significant accounting policies and changes to accounting policies
* A detailed listing of long-term debt
* A summary of loss contingencies and other commitments (such as long-term rental commitments for leased property)
* A report of selected financial information by business segment
* Any other explanations that management deems necessary to help the user understand the financial statements

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Contingency (in the context of notes to the financial statements)

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An existing condition, situation, ro set of circumstances involving uncertainty as a to a gain or a loss to the company.

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Filings that users of financial statements access most often:

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* Annual (Form 10-K report)
* Quarterly (Form 10-Q report)
* Material Event (Form 8-K report)

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Events that trigger an 8-k filing

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* Material definitive agreements entered into or terminated that are not in the ordinary course of the company's business, such as a definitive agreement to sell a significant operating division to an unrelated company
* Release of non-public information about a company's financial condition
* Creation of a direct financial obligation (such as a long-term operating lease)
* Change of independent auditor certifying the financial statements
* Departure or election of directors and departure or appointment of principal officers

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10-K filing

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Annual filing. Comprehensive view of financial condition. Annual report, similar to company annual report, but with mroe detailed information

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10-Q filing

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Quarterly. Continuing view of financial condition. An abbreviated 10-K report.

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8-K filing

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Current announcement of major event for organization.

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Annual Report - Required sections

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* Financial statements and notes
* Auditor's report
* Report of management
* Mgmt's discussion and analysis of results of operations and financial condition
* Selected financial data

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Report of Management

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A report to the users of the financial statements signed by the chairman of the board and the CFO in which the company's management acknowledges its repsonsibility for the quality and integrity fo the company's financial statements, as well as for the accuracy and effectiveness of internal controls over financial reporting.

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Management's Discussion and Analysis of Results - 3 goals for this section of the annual report

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1. Provide a narrative explanation that enables users to view the company from management's perspective
2. Improve overall financial disclosure and provide teh context within which financial statements should be analyzed.
3. Provide information about the quality and potential variability of the company's income and cash flow that addresses the likelihood that past performance indicates future performance.

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Transparency

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In the context of financial accounting, the provision of sufficient detail regarding transactions to enable a prudent investor to understand the economic effect of those transactions on the company's financial statements

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Letter to Shareholders

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Optional part of annual report. Usually written by the chairman of the board, the CEO, or both. It provides a review and analysis of the significant events of the year and typically addresses any issues and successes the company experienced.

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Significant limitations of financial statements (2):

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- Do not measure the economic value of an organization's qualitative assets
- Do not give the current fair (market) value of all the organization's assets and liabilities for determining the organization's true worth

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Cost principle of accounting

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Requires assets to be recorded at the price agreed on at the time of exchange. Results in a balance sheet needing to reflect a building purchased 30 years ago at the original purchase price, even though it may have a substantially higher current value because of inflation and other market conditions.

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Vertical analysis

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The use of common-size statements to highlight basic relationships among items within a single set of financial statements

Especially useful when the goal is to search for abnormal values

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Trend analysis

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An analysis that identifies patterns in past losses and then projects these patterns into the future

Especially useful when the goal is to evaluate how an organization has been performing through time

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Three common techniques used to analyze financial statements:

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* Vertical analysis
* Trend analysis
* Ratio analysis

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When to use vertical analysis to analyze financial statements

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When the goal is to search for abnormal values.

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When to use trend analysis

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When the goal is to evaluate how an organization has been performing through time

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Ratio analysis

Back 89

A financial analysis tool used to study the financial condition of an account; two or more data items from accounting records of a company are related to one another and the result is compared to results for prior accounting periods or for similar businesses

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Common-size statement

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A financial statement in which amounts are reported as a percentage of a base figure

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Minimum number of years that must be compared in trend analysis

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Two. Trend analysis involves making comparisons across two or more years of financial statement data.

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Net profit margin

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The percentage of sales remaining after deducting all expenses.

The company's overall success in maintaining profitability is demonstrated by its ability to maintain a consistent net profit margin.

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Year-to-year trend analysis

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Determines the percentage change in values for statement items between consecutive years in the period under consideration.

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Base-year-to-date trend analysis

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Uses the earliest year of the period under consideration as a base year and determines the percentage change in statement item values for each successive year relative to that base year

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Annual Percentage Change - how to calculate it

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(You know this.)

(This Year's Value - Last Year's Value) / Last Year's Value * 100

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Accounts receivable turnover ratio

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Credit sales / Accounts receivable

An efficiency ratio that indicates how quickly a business collects the amounts owed by its customers.

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Asset turnover ratio

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Sales / Total assets

Measures the use of assets. The more efficiently a company uses its assets to generate sales, the higher its asset turnover.

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Inventory turnover ratio

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Cost of goods sold / Inventory

An efficiency ratio that indicates how quickly inventory is sold, generating either cash (from cash sales) or accounts receivable (from credit sales). A low inventory turnover ratio may indicate inefficiency (inventory is not being sold quickly enough)

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Current ratio

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Current assets / Current liabilities

A liquidity ratio that indicates the company's ability to meet its short-term financial obligations; calculated by dividing current assets by current liabilities.

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Acid-test, or quick, ratio

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(Cash + marketable securities + accounts receivable) / Current liabilities

A liquidity ratio that provides a measure of a company's ability to meet its current obligations if it cannot sell its inventory.

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Debt-to-equity ratio

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Long-term debt / Shareholders' equity

A leverage ratio that measures the extent to which a company is financed using borrowings rather than its own funds (owners' equity). Although the typical debt-to-equity ratio varies by industry, an analyst would normally expect a nonfinancial company to have a debt-to-equity ratio below 100 percent. If the ratio is higher than 100 percent, the company is mostly financed by debt; if the ratio is lower than 100 percent, the company is mostly financed by equity.

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Debt-to-assets ratio

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Total liabilities / Total assets

A leverage ratio that shows the extent to which a company's assets are financed by debt; uses balance sheet data and is calculated by dividing total liabilities by total assets. If the ratio is less than 1.5, then the company is financing most of its assets through the equity contributions of its shareholders. If greater than 1.5, then most of the company's assets are financed through debt. A high debt-to-asset ratio indicates that a company is highly leveraged and could be at risk if it is not able to keep up with debt payments.

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Equity multiplier ratio

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Total assets / Shareholders' equity

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Net profit margin

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Net income / Sales

A profitability ratio that measures the percentage of sales remaining after deducting all expenses that indicates how effective an insurer is at cost control; uses income statement data and is calculated by dividing net income after taxes by sales.

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Return on assets

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Net income / Total assets

A profitability ratio that shows how well a company has used its resources by comparing net income to the assets invested to generate that income.

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Return on equity

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Net income / Shareholders' equity

A profitability ratio expressed as a percentage by dividing a company's net income by its net worth (book value). Depending on the context, net worth is sometimes called shareholders' equity, owners' equity, or policyholders' surplus. Some analysts use an average of teh shareholders' equity over the time period being analyzed, rather than the shareholders' equity as of a single date.

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DuPoint identity (a special version of return on equity)

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(Net income / Sales) * (Sales / Total assets) * (Total assets / Shareholders' equity)

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Days sales outstanding

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A measure of the number of days it takes, on average, for a company, to collect its accounts receivable. A lower days sales outstanding is preferable. (A figure below thirty is typically desirable)

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Fixed assets

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Resources that cannot be expected to be sold or consumed within the business's normal operating cycle and that are usually considered to be long-lived.

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Working capital

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Current assets - current liabilities

Working capital is the excess of a company's current assets over its current liabilities

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Leverage

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A measure of the extent to which a company has borrowed money. A company with no debt employs no financial leverage.

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Policyholders' surplus

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Under statutory accounting principles (SAP), an insurer's total admitted assets minus its total liabilities

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Accounting equation

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The equation that relates assets to liabilities and owners' equity. (I.e., in SAP, it's Policyholders' surplus = assets - liabilities)

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Conservative valuation of policyholders' surplus

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Assets are valued at what they would bring in a quick sale, and liabilities are valued at the highest point in their range of possible values. Under SAP, illiquid assets are not counted as "assets" and therefore are not counted toward policyholders' surplus

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Going concern concept

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An organization should be valued as if it will continue to operate indefinitely. (A key concept of accounting; requires accounting practices that take a long-term view of the organization.)

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T or F: SAP emphasizes an insurer's liquidation value over its going concern value.

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TRUE. SAP emphasizes an insurer's liquidation value over its going concern value.

However, there are exceptions. Regulators might use a going-concern valuation to perpetuate insurer operations that benefit the public. Also, SAP allows some invested assets to be valued at cost rather than market value.

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Matching principle

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An accounting rule that requires expenses incurred in generating revenues to be matched against those revenues.

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Nonadmitted assets

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Types of property, such as office furniture and equipment, that regulators do not allow insurers to show as assets on financial statements because these assets cannot readily be converted to cash at or near their market value.

Examples include:
* Furniture
* Fixtures
* Equipment
* Supplies
* Automobiles
* Uncollected premiums over ninety days due
* Prepaid expenses
* Loans or advances to certain company personnel

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Enhanced accounting equation (SAP)

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Policyholders surplus = [Total assets - nonadmitted assets] - Liabilities

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Admitted assets

Back 120

Assets meeting minimum standards of liquidity that an insurer is allowed to report on its balance sheet in accordance with statutory accounting principles

Front 121

T or F: Under SAP, most bonds are valued at an adjusted cost amount called amortized cost.

Back 121

TRUE. Under SAP, most bonds are valued at an adjusted cost amount called amortized cost, which evenly amortizes any premium or discount over the remaining life of a bond. Under GAAP, amortized cost valuation is permitted only if the insurer is able and intends to hold the bond to maturity; otherwise, bonds are classified as "available for sale" or "trading" and reported at market value. Amortized cost valuation benefits the insurer because it shields teh value of its invested bond assets, and therefore its policyholders' surplus, from short-term fluctuations in market bond prices.

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Premium Balances due from Agents (SAP)

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Under SAP, premium balances more than 90 days past due are nonadmitted. GAAP requires that premium balances due from agents be offset with a reserve for amounts that are deemed uncollectible.

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Reinsurance recoverables

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Amounts for losses and loss adjustment expenses owed to an insurer under reinsurance agreements covering paid losses.

Under SAP, reinsurance recoverables are netted (subtracted) from loss and loss adjustment expense reserves, so there is no need to show these recoverables as an asset. Under GAAP, these same reinsurance recoverables are shown as an asset and are not netted (subtracted) from loss and loss adjustment expense reserves.

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Unauthorized reinsurer

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A reinsurer that is not licensed or otherwise authorized to do business in the primary insurer's state of domicile.

SAP requires creation of a liability for a portion of overdue reinsurance reoverables and reinsurance recoverables from unauthorized reinsurers, unless the recoverables are collateralized. This supports the liquidation perspective.

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Policy acquisition costs under SAP

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Under SAP, insurers are required to recognize teh full amount of policy acquisition costs, including underwriting expenses, commissions, and taxes, at policy inception, even though the matching principle would require those expenses to be spread evenly over the term of the policy as the associated premium revenue is earned.

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Reporting of subsidiaries and affiliates under SAP

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Under SAP, investments in subsidiaries, controlled, or affiliated entities (SCAs) are considered admitted assets and must be shown on the parent company's balance sheet.

Under GAAP, the financial statements of majority-owned subsidiaries are consolidated into the parent company's financial statements.

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Pension accounting under SAP

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Under sAP, contributions made for nonvested employees under both defined-benefit plans and defined-contribution plans are not recognized when made and are therefore not a deductible expense on teh income statement.

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Statement of comprehensive income treatment under SAP

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SAP does not require a statement of comprehensive income. However, the capital and surplus accountin the Annual Statement shows similar types of items that are not included in net income and are entered directly as an adjustment to policyholders' surplus.

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T or F: The lag between when the reinsurer is asked for payment and when the reinsurer actually pays generates a receivable that falls into a category called reinsurance receivables.

Back 129

FALSE. The lag between when the reinsurer is asked for payment and when the reinsurer actually pays generates a receivable that falls into a category called reinsurance RECOVERABLES.

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NAIC Annual Statement

Back 130

The primary financial statement prepared by insurers and required by every state insurance department.

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Loss adjustment expense reserves

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Estimates of the future cost of defending and settling claims for losses that have already occurred.

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Loss reserve

Back 132

An estimate of the amount of money the insurer expects to pay int he future for losses that have already occurred and been reported, but are not yet settled.

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Unearned premium reserve

Back 133

An insurer liability representing the amount of premiums received from policyholders that are not yet earned.

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Earned premium calculation for Statement of Income

Back 134

Reported on a calendar-year basis and calculated as teh sum of this year's written premiums plus the unearned premium reserve at the beginning of the year, less the unearned premium reserve at the end of teh year.

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Net investment income

Back 135

The interest, dividends, and real estate income earned on invested assets during the year, minus expenses incurred in conducting investment operations.

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Net realized capital gains

Back 136

The gains or losses realized from selling invested assets during the year.

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Other income (on the Statement of Income, NAIC Annual Statement)

Back 137

Revenues and expenses that are not related to either underwriting or investment activities.

Examples include charge-offs of outstanding receivables from agents, dividends to policyholders, and finance and service charges not included in premiums.

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Surplus note

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A type of unsecured debt instrument, issued only by insurers, that has characteristics of both conventional equity and debt securities and is classified as policyholders' surplus rather than as a liability on the insurer's statutory balance sheet.

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Net deferred income tax

Back 139

The difference between deferred tax assets (which arise when tax payments will be lower in the future) and deferred tax liabilities (which arise when tax payments will be higher in the future). Changes in the relative balance are charged to surplus.

Front 140

Cash from Investments section - NAIC Annual Statement

Back 140

Shows the cash inflows and outflows from the sale and purchase of investment assets

Front 141

Cash Flow from Financing and Miscellaneous Sources section - NAIC Annual Statement

Back 141

Includes changes in borrowed funds and contributed capital

Front 142

Schedule D - NAIC Annual Statement

Back 142

A series of schedules that describe an insurer's investments in bonds, preferred stocks, and common stocks. The schedules can be classified into two types: detail schedules and summary schedules

Front 143

Detail schedules (in the context of the NAIC Annual Statement)

Back 143

Provide specific information on each bond, preferred stock, and common stock bought, sold, or owned by an insurer during the past year.

Front 144

Summary schedules (in the context of the NAIC Annual Statement)

Back 144

Summary schedules are used to aggregate the stocks and bonds in a variety fo categories so that an analyst can evaluate the overall investment strategy.

Front 145

Schedule F (NAIC Annual Statement)

Back 145

An eight-part schedule that provides expanded information on an insurer's reinsurance arrangements and the effect of those transactions on the insurer's balance sheet)

Front 146

Schedule P (NAIC Annual Statement)

Back 146

Has seven major sections that provide up to ten accident years of data, and subschedules are prepared for each of twenty-two separate lines of insurance.

e.g.,

Part 1 - Current Estimate of Premiums and Losses
Part 2 - Incurred Loss Development
Part 3 - Paid Loss Development

...and so on

Front 147

Liquidity

Back 147

The ease with which an asset can be converted to cash with little or no loss of value

Front 148

Capacity

Back 148

Teh amount of business an insurer is able to write, usually based on a comparison of the insurer's written premiums to its policyholders' surplus.

Front 149

Written premiums

Back 149

The total premium on all policies written (put into effect) during a particular period.

Front 150

Earned premiums

Back 150

The portion of written premiums that corresponds to coverage that has already been provided.

Front 151

Benchmarking

Back 151

The process of comparing results to industry standards or best practices.

Front 152

Premium-to-surplus ratio or capacity ratio

Back 152

A capacity ratio that indicates an insurer's financial strength by relating net written premiums to policyholders' surplus.

Written premiums net of reinsurance (net written premiums) divided by policyholder's surplus

Greater than 3 to 1 is problematic

Front 153

Reserves-to-surplus ratio

Back 153

(Unearned premium reserve + Loss and Loss adjustment expense reserves) / Policyholders' surplus

A financial ratio that provides a measure of the ability of an insurer's surplus to absorb increases in reserves.

The higher an insurer's reserves-to-surplus ratio, the more impact relatively small reserve underestimation errors have in reducing its policyholders' surplus in the future after the errors are discovered.

No well-established benchmark exists for an acceptable value for the reserves-to-surplus ratio, although a higher value (greater leverage) is usually associated with long-tail liability coverage.

Front 154

Liquidity ratio

Back 154

(Cash + Invested assets at market value) / (Unearned premium reserve + loss reserves and loss adjustment expense reserves)

Greater than or equal to 1 is desirable

The liquidity ratio is a ratio that measures the extent to which an insurer can meet its obligations as they come due and is the sum of cash plus invested assets (market value) divided by unearned premium reserve plus loss and loss adjustment expenses

Front 155

Loss Ratio

Back 155

(Incurred losses + loss adjustment expenses) / Earned premiums

* My note: Not a separate LAE ratio here

A ratio that measures losses and loss adjustment expenses against earned premiums and that reflects the percentage of premiums being consumed by losses.

Front 156

Expense Ratio

Back 156

Underwriting expenses / Written premiums

An insurer's incurred underwriting expenses for a given period divided by its written premiums for the same period.

Front 157

Combined Ratio

Back 157

(Loss Ratio + Expense Ratio)

A profitability ratio that indicates whether an insurer has made an underwriting loss or gain

Front 158

Operating Ratio

Back 158

Combined Ratio - Investment Income Ratio

A ratio that measures an insurer's overall pretax operational profitability from underwriting and investment activities and is calculated by subtracting the investment income ratio from the combined ratio.

Front 159

Investment Yield Ratio

Back 159

(Net investment gain or loss) / (Total cash + Invested assets)

A profitability ratio that indicates the total return on investments for an insurer's investment operations. Unlike the investment income ratio, the investment yield ratio measures investment returns relative to the invested assets that actually generated the investment income.

Front 160

Return on Policyholders' Surplus

Back 160

Net income / Policyholders' surplus

A profitability ratio that shows the rate of return an insurer is earning on its resources.

Front 161

Various factors affect an insurer's policyholders surplus and therefore its premium-to-surplus ratio, include these 4:

Back 161

* Underwriting results
* Growth
* Reinsurance programs
* Investment results

Front 162

T or F: Insurers writing predominantly long-tailed lines, which are inherently less predictable, should have relatively lower premium-to-surplus ratios due to the unpredictability involved in setting loss reserves.

Back 162

TRUE. Insurers writing predominantly long-tailed lines, which are inherently less predictable, should have relatively lower premium-to-surplus ratios due to the unpredictability involved in setting loss reserves.

Front 163

Ceding commission

Back 163

An amount paid by the reinsurer to the primary insurer to cover part or all of the primary insurer's policy acquisition expenses

Front 164

Insurance leverage

Back 164

An indication of the extent to which policyholders' surplus can support a given level of reserves

Front 165

Investment income ratio

Back 165

Net investment income divided by earned premiums for a given period

Front 166

T or F: Negative net income is considered to produce a 0 percent return.

Back 166

TRUE. Negative net income is considered to produce a 0 percent return.

Front 167

A.M. Best Financial Size Category (FSC) is based on this:

Back 167

the policyholder's surplus

Front 168

4 areas of ratios highlighted in Best's Key Rating Guide

Back 168

* Profitability
* Liquidity
* Capital and leverage
* Loss reserves

Five years of each is provided

Front 169

A.M. Best liquidity tests measure this

Back 169

An insurer's ability to meet claim obligations without selling long-term investments or fixed assets that might be saleable only at a substantial loss during unfavorable market conditions.

Front 170

Operating stability (A.M. Best concept)

Back 170

In insurer's ability to withstand losses from unfavorable underwriting results, catastrophes, poor management decisions, industry trends, and adverse economic developments; this depends on the insurer's capital and leverage.

Front 171

Best's Capital Adequacy Ratio

Back 171

Measures the adequacy of the insurer's capital relative to the risks it assumes in its operations.

Any deficiency or redundancy in reserves is incorporated into the BCAR model. Similar to, but not the same as, the NAIC's RBC formula

Front 172

Deficiency in reserves (A.M. Best concept)

Back 172

When the insurer's reported reserves are less than the A.M. Best calculated economic loss reserve

Front 173

Redundancy in reserves (A.M. Best concept)

Back 173

When the insurer's reported reserves are greater than the A.M. Best calculated economic loss reserve

Front 174

Difference between A.M. Best's BCAR and the NAIC's RBC model:

Back 174

Risk-based capital model establishes a regulatory minimum, but BCAR is used to develop a measure of the relative financial strength of the insurer and is used to evaluate an insurer's capital strength above and beyond the minimum requirement.

Front 175

Elements in the A.M. Best qualitative review:

Back 175

* Capital structure of the insurer holding company
* Reinsurance and other risk mitigation programs
* Loss reserve adequacy and accuracy
* Quality and diversity of investments
* Spread of risk
* Management
* Market position
* Surplus adequacy
* Exposure to event risk

Front 176

IRIS

Back 176

To identify insurers that may be financially impaired and direct appropriate regulatory resources to where they are most needed, state regulators and the NAIC have developed the Insurance Regulatory Information System. It has two phases: a statistical phase and an analytical phase

Front 177

3 Levels that prioritize each insurer's financial statements for IRIS review (an NAIC concept)

Back 177

1. Level A - The insurer should be given the highest priority for comprehensive review so that state regulators can ascertain the reasons for the adverse results observed during the statistical phase.

2. Level B - The insurer has some adverse results but does not require the same type of immediate response as Level A

3. Reviewed - No level

Front 178

Level A of the IRIS

Back 178

The insurer should be given the highest priority for comprehensive review so that state regulators can ascertain the reasons for the adverse results observed during the statistical phase.

Front 179

Level B of the IRIS

Back 179

The insurer has some adverse results but does not require the same type of immediate response as Level A

Front 180

Third level of the IRIS system

Back 180

Reviewed - no level (i.e., not Level A or Level B)

Front 181

IRIS ratio: Gross Premiums Written to Policyholders' Surplus ratio

Back 181

Measures an insurer's total insurance exposure before recognizing the effect of reinsurance cessions. An acceptable value is 900 percent or less.

Front 182

Gross premiums (IRIS concept)

Back 182

Include direct premiums written plus reinsurance assumed from non-affiliates plus reinsurance assumed from affiliates.

Front 183

IRIS ratio: Net Premiums Written to Policyholders' Surplus Ratio

Back 183

A gauge of the insurer's retained insurance exposure after reinsurance transactions. An acceptable value is less than 300 percent.

Front 184

A large difference between the IRIS Net Premiums Written to Policyholder's Surplus Ratio and the IRIS Gross Premiums Written to Policyholders' Surplus ratio may indicate what?

Back 184

An over-reliance on reinsurance

Front 185

IRIS ratio: Change in Net Writings Ratio

Back 185

The percentage change in the insurer's net written premiums during the most recent year.

An increase or a decrease of 33 percent or less is considered acceptable for this ratio.

Front 186

IRIS ratio: Surplus Aid to Policyholder's Surplus Ratio

Back 186

Surplus aid consists of commissions on reinsurance ceded to non-affiliated companies. Exceptionally large amounts of surplus aid indicate that the capitalization is not sufficient for the amount of direct insurance being written. An acceptable value for the Surplus Aid to Policyholders' Surplus ratio is below 15 percent.

Front 187

Surplus Aid

Back 187

Consists of commissions on reinsurance ceded to non-affiliated companies.

Front 188

IRIS ratio: Two-Year Overall Operating Ratio

Back 188

The insurer's combined ratio minus its investment income ratio, measured over the past two years.

An acceptable value for this ratio is less than 100 percent.

Front 189

IRIS ratio: Investment Yield Ratio

Back 189

Divides net investment income earned for the year by the average cash and invested assets for the year.

An acceptable value for this test ranges from 3.0 percent to 6.5 percent.

Front 190

IRIS ratio: Gross Change in Policyholders' Surplus Ratio

Back 190

Measures the percentage change in policyholders' surplus over the past year.

An acceptable value for this ratio is between -10 percent and 50 percent.

Front 191

IRIS ratio: Change in Adjusted Policyholders' Surplus Ratio

Back 191

Measures changes in surplus from an insurer's core operations. Surplus changes related to surplus notes, capital changes, and surplus adjustments are omitted. What remains is the change in surplus attributable to these elements:

* Net income
* Unrealized capital gains and foreign exchange
* Changes in deferred income taxes
* Changes in non-admitted assets
* Changes in the provision for reinsurance
* Dividends to shareholders
* Net remittances to or from the home office
* Changes in treasury stock
* Other aggregate write-ins for changes to surplus

An acceptable value for this ratio is between -10 percent and 25 percent

Front 192

IRIS ratio: Adjusted Liabilities to Liquid Assets Ratio

Back 192

Measures an insurer's ability to meet its obligations with its most liquid assets.

An acceptable value for this ratio is less than 100 percent. If the ratio is over 100 percent, it could indicate that the insurer could face liquidity problems and an examiner would then focus attention on reserve adequacy, investment mix, and asset valuation

Front 193

Liquid assets (in the context of IRIS)

Back 193

Limited to bonds, common and preferred stock, cash and short-term investments, receivables for securities, and accrued investment income.

Investments in parents, subsidiaries, and affiliates are excluded.

Front 194

IRIS ratio: Gross Agents' Balances to Policyholders' Surplus Ratio

Back 194

Divides agents' balances in the course of collection by policyholders' surplus. Indicates how dependent surplus is on an asset of questionable liquidity. The usual value is less than 40 percent.

Front 195

IRIS ratio: One-Year Reserve Development to Policyholders' Surplus Ratio

Back 195

Measures the percentage change in the current year's policyholders' surplus attributable to loss development of prior accident year reserves.

An acceptable value for this ratio is 20 percent or less. A high value on this test may indicate that the insurer's loss reserves are inadequate, or it could indicate that the insurer is deliberately strengthening loss reserves.

Front 196

IRIS ratio: Two-Year Reserve Development to Policyholders' Surplus Ratio

Back 196

Calculated int he same manner as the One-Year Reserve Development to POlicyholders' Surplus ratio, except the loss reserves and policyholders' surplus for the second prior year are used instead of those for the prior year.

A ratio of less than 20 percent is considered to be in the acceptable range.

Front 197

IRIS ratio: Estimated Current Reserve Deficiency to Policyholders' Surplus Ratio

Back 197

Divides the estimated current loss reserve deficiency by policyholders' surplus.

This ratio is considered to be in an acceptable range if it is less than 25 percent.

Front 198

Future value

Back 198

The value than an amount today will be worth at a certain point in the future

Front 199

Simple interest

Back 199

Interest earned only on the original amount invested

Front 200

Future value over a single period

Back 200

Future value over a single period =

(Present value or value at the beginning of the period)
x
(1 + interest rate)

Front 201

Compound interest

Back 201

Interest earned on the original amount invested plus previously earned interest

Front 202

Future value at the end of *n* periods

Back 202

FV at the end of *n* periods
=
(Present Value) x ((1 + interest rate) to the *n* power)

Front 203

Future value at the end of *n* years and *m* times per year the interest is paid

Back 203

FV at the end of *n* years
=
(Present Value) x ((1+(interest rate / *m*))^(*n* x *m*))

(on p 6.6)

Front 204

Stated interest rate

Back 204

The quoted annual rate of interest that does NOT take account of the frequency of compounding

Front 205

Present value

Back 205

The value today of money that will be received in the future

Front 206

Discounting

Back 206

The process of calculating the present value of a future amount

Front 207

Discount rate

Back 207

The interest rate on loans made by Federal Reserve Banks to depository institutions

Front 208

Present value over a single or multiple periods formula

Back 208

Present value
=
(Future value at the end of *n* periods) / ((1 + interest rate)^(*n*))

Front 209

Annuity

Back 209

A series of fixed payments made on specified dates over a set period

Front 210

Ordinary annuity

Back 210

A series of equal periodic payments made at the end of each period

Front 211

Future value of an annuity formula

Back 211

Future value of an annuity for *n* periods
=
(((1 + interest rate)^*n*) - 1) / interest rate

Front 212

Present value of an annuity formula

Back 212

Present value of an annuity for *n* periods
=
(1 - (1 / ((1 + interest rate)^*n*))) / interest rate

(p 6.17 for simpler version of that)

Front 213

Annuity due

Back 213

A series of equal periodic payments made at the beginning of each period.

An annuity due has one more earning period for each of the payments than an ordinary annuity.

(good illustration of this on 6.18)

Front 214

Future value of an annuity due formula

Back 214

FV(annuity due)
=
FV(ordinary annuity) x (1 + interest rate)

Front 215

Present value of an annuity due formula

Back 215

PV(Annuity due)
=
PV(Ordinary annuity) * (1 + interest rate)

Front 216

Perpetuity

Back 216

A series of fixed payments made on specified dates over an indefinite period

Front 217

Present value of a perpetuity formula

Back 217

PVP = (Payment per period) / (Discount rate)

Perpetuity is a series of fixed payments made on specified dates over an indefinite period

Front 218

Present value of unequal payments

Back 218

With unequal payments, the present value of each individual payment must be calculated and the results summed

Front 219

Net present value (NPV)

Back 219

The present value of all future net cash flows (including salvage value) discounted at the cost of capital, minus the cost of the initial investment, also discounted at the cost of capital

* Review this formula, page 6.23

When an investment's NPV is negative, the NPV rule suggests that the organization should nto make that investment.

Front 220

Limitations of Net Present Value (NPV) analysis

Back 220

* The amounts and timing of cash flows may differ from those expected over the life of an investment
* NPV analysis does not formally factor in the effect of uncertainty (risk) with respect to future cash flows, losses, discount rates, or time horizons
* NPV analysis focuses on maximizing economic value and disregards an organization's nonfinancial goals and other stakeholders' interests

Front 221

Financial market

Back 221

A mechanism used for trading securities.

It contains these four elements:
* The item traded
* The buyer
* The seller
* The individuals or institutions that organize the market

Front 222

Securities

Back 222

Written instruments representing either money or other property, such as stocks and bonds

Front 223

Money market

Back 223

A financial market in which short-term securities are traded

Front 224

Capital market

Back 224

A financial market in which long-term securities are traded

Front 225

Short-term (in the context of financial markets)

Back 225

The securities will mature in one year or less.

Money markets are markets in which short-term securities are traded.

Front 226

Long-term (in the context of financial markets)

Back 226

Long-term means the securities will mature in more than one year.

Capital markets are markets in which long-term securities are traded.

Front 227

Two most typical users of capital

Back 227

Corporations (both domestic & international) and the government

Front 228

Primary market

Back 228

A mechanism in which new securities are sold, with the proceeds going directly to the issuer

Front 229

Four types of primary market structures:

Back 229

1. Direct search
2. Broker
3. Dealer
4. Auction

Front 230

Direct search (primary market structure)

Back 230

Direct search market participants must find interested trading partners by themselves

Front 231

Broker (primary market structure)

Back 231

Broker market participants employ agents to conduct the search for trading partners

Front 232

Dealer (primary market structure)

Back 232

Dealer market participants complete their transactions by trading with dealers who hold themselves out as willing to buy and sell.

In dealer markets, when trading in a security is active, some market participants begin to maintain bid and offer quotations of their own.

Dealer markets eliminate the need for time-consuming searches for trading partners because investors know that they can buy or sell instantly at the dealer quotes.

Front 233

Auction (primary market structure)

Back 233

Auction market participants transact directly against the orders of other investors by communicating through a single, centralized intermediary.

Auction markets allow investors to participate in a single price-setting process, virtually eliminating the search for best price associated with broker and dealer markets.

The best examples of the auction technique in a primary market are the U.S. Treasury auctions of bills, notes, and bonds. When the Treasury receives bids for an announced issue of securities (which occurs weekly for Treasury bills), it accepts the highest bid first and continues to accept the next highest bid until the entire issue has been subscribed (sold)

Front 234

Bid price

Back 234

The price a dealer is willing to pay for a security

Front 235

Asked price

Back 235

The price at which a dealer is willing to sell a security

Front 236

Bid-asked spread

Back 236

The difference between the bid price and the asked price of a security

Front 237

Secondary market

Back 237

A mechanism for investors to buy and sell previously issued securities

Front 238

Firm commitment underwriting

Back 238

An example of a dealer market.

Firm commitment underwriting occurs when the dealer buys the new shares from the issuing corporation at an agreed-upon price and resells them to investors at a higher price.

Front 239

Trading on an organized exchange differs from trading in 'over-the-counter' dealer markets in these 2 ways:

Back 239

* All trading in a given stock occurs at a single place on an exchange floor.
* Transaction prices are broadcast to the public

Front 240

Market depth

Back 240

The ability of the market to handle a large number of securities transactions without a significant effect on prices.

A market with depth AND breadth provides liquidity for investors. Markets that display the greatest liquidity include the NYSE, the currency markets, and the U.S. Treasury markets.

Front 241

Market breadth

Back 241

The percentage of the overall market that is participating in the market's up or down move.

A market with depth AND breadth provides liquidity for investors. Markets that display the greatest liquidity include the NYSE, the currency markets, and the U.S. Treasury markets.

Front 242

Four classifications of bonds

Back 242

* Federal debt
* Corporate bonds
* State and local debt
* International bonds

Front 243

Treasury debt includes these four types of securities:

Back 243

1. Treasury bills
2. Treasury notes
3. Treasury bonds
4. Treasure inflation protected securities (TIPS)

Front 244

Treasury bills

Back 244

also called T-bills

Have maturities of one year or less, are sold at a discount from face value, and are repaid at face value

Front 245

Treasury notes

Back 245

also called t-notes

These notes range in maturity from two to ten years, have a stated coupon rate, and pay coupons twice a year

Front 246

Treasury bonds

Back 246

also called t-bonds

These bonds have a maturity of thirty years, have a stated coupon rate, and pay coupons twice a year

Front 247

Treasury inflated protection securities (TIPS)

Back 247

Securities whose principal is tied to inflation - specifically, the Consumer Price Index. Therefore, if the inflation rate increases, the principal increases, and if the inflation rate decreases, the principal decreases. At maturity, the holder is paid the greater of the inflation-adjusted principal or the original principal. Coupons are paid twice a year.

Front 248

Reasons a government-sponsored enterprise (GSE) might issue debt:

Back 248

* To alleviate economic recessions
* To correct market imperfections that lead to misallocation of resources
* To redistribute wealth
* To channel credit into spectial sectors of the economy, such as housing, agriculture, education, and foreign trade.

(Freddie Mac and Fannie Mae are two of the largest GSEs)

Front 249

Corporate bond

Back 249

An agreement between a corporation (the borrower) and an investor (the lender).

Usually issued by large corporations

Typically classified as utility bonds, industrial bonds, or bank and finance company bonds.

Front 250

General obligation bond

Back 250

A municipal debt instrument secured by the full faith, credit, and taxing authority of the issuing state or municipality

Front 251

Revenue bond

Back 251

A municipal debt instrument that is payable entirely from revenue received from the users or beneficiaries of the projects financed.

Revenue bonds involve higher risk than general obligation bonds because of the possibility that the projects financed may not bring in enough revenue to pay bondholders. However, as a result of the increased risk, these bonds also pay higher yields.

Front 252

Eurobond

Back 252

A long-term debt instrument that is denominated in U.S. dollars or another currency and that is offered and issued outside the issuer's country of origin.

For exmaple, Eurobonds issued in U.S. dollars are called Eurodollar bonds, those issued in Japanese yen are called Euroyen bonds, and those issued in euros are called Euroeuro bonds.

Front 253

Foreign bond

Back 253

A debt instrument issued by a corporation or government outside its own country.

Foreign bonds differ from Eurobonds in that they tend to be more highly regulated by the country they are issued in

Front 254

Bond

Back 254

A long-term debt instrument that requires the issuer to pay a set annual rate of interest and to repay the borrowed sum on a specified date

Front 255

Indenture agreement

Back 255

A legal document that details the terms of a bond

Front 256

Maturity date

Back 256

The date on which a bond's principal or par value becomes payable to the bondholder

Front 257

Principal

Back 257

In finance, the amount borrowed under a loan

Front 258

Face value

Back 258

A bond's original value and the amount that will be paid at the bond's maturity date

Front 259

Coupon rate

Back 259

A bond's annual interest rate stated as a percentage of its par value

Front 260

Coupon

Back 260

The amount of interest to be paid on the dates specified in an indenture agreement

Front 261

Bond rate of return

Back 261

A bond's rate of return for a specified period is the percentage of the value of the bond earned for that specific period, represented by the total of the coupon payments plus any capital gain or loss divided by the face value.

For exapmle, a $1,000 bond with a $40 coupon and a $50 capital gain over a specific period had a 9 percent rate of return over that period.

Front 262

Straight bonds

Back 262

Bonds that consist of just the basic components.

Front 263

Convertible bond

Back 263

A debt instrument that gives the holder the option to convert the bond into another security (generally common stock) of the issuing company at a specified price, within a given time, and under stated terms

Front 264

Guaranteed bond

Back 264

A debt instrument guaranteed by an entity other than the issuer.

Front 265

Serial bonds

Back 265

Debt instruments that have different portions of the principal maturing on different dates.

Front 266

Participating bonds

Back 266

Debt instruments that link interest payments to the financial performance of the issuer.

(e.g., participating as in 'participating in company earnings')

Front 267

Floating rate bonds

Back 267

A debt instrument that pays interest at a rate that is indexed to the rates on U.S. Treasury securities or other money market instruments.

Front 268

Callable bonds

Back 268

Debt instruments that give the issuer the right to pay off the bond before maturity.

The specific provision that allows the issuer to redeem the bond before maturity is known as a call provision.

Front 269

Zero-coupon bond

Back 269

A corporate bond that does not pay periodic interest income.

Front 270

Sinking fund provision

Back 270

A provision that requires a bond issuer to set aside money at periodic intervals for the specific purpose of repaying a portion of its existing bonds each year.

Front 271

Secured bond

Back 271

A debt instrument that is secured by specific assets and has priority over the funds received in the liquidation of those assets.

Front 272

Debenture bond

Back 272

A debt instrument that is an unsecured general obligation of the issuing corporation.

Front 273

Asset-backed security

Back 273

A financial instrument collateralized by a pool of loans, leases, or other receivables

Front 274

Mortgage-backed security

Back 274

A financial instrument collateralized by a pool of mortgages

Front 275

Yield to maturity (YTM)

Back 275

A measure of the total rate of return a bondholder will earn over the life of the bond if it is held to maturity

Front 276

The yield demanded by investors is based on a number of risk factors specific to that bond, including these 3:

Back 276

* Credit risk
* Liquidity risk
* Term to maturity

Front 277

Credit risk

Back 277

The risk that customers or other creditors will fail to make promised payments as they come due

Front 278

T or F: A rating of "AAA" (or "Aaa") is the highest grade issued by S&P and Moody's AND is reserved for bonds with the highest degree of credit risk.

Back 278

FALSE. T or F: A rating of "AAA" (or "Aaa") IS the highest grade issued by S&P and Moody's BUT is reserved for bonds with the LOWEST degree of credit risk.

Front 279

Investment grade bond

Back 279

A bond issued that receives one of the top four investment quality ratings from one or both of the two main bond rating agencies, Moody's and Standard & Poor's

A triple-B (i.e., BBB or Baa) or better rating is required for consideration of a bond as an investment grade bond

Front 280

Junk bond

Back 280

A bond that receives a BB/Ba rating or lower from one or both of the two main bond rating agencies, Standard & Poor's or Moody's

Front 281

The lowest grade issued by S&P and Moody's

Back 281

D (a rating of 'D')

It indicates that the issuer is in default. Default occurs when interest and/or principal payments are past due.

Front 282

Liquidity risk

Back 282

The risk that an asset cannot be sold on short notice without incurring a loss.

Front 283

Liquidity premium

Back 283

An additional return to compensate investors for the relative illiquidity of an investment. The more illiquid an investment, the higher the return demanded by investors.

Front 284

Term structure

Back 284

The effect on a bond's price of the length of time to maturity.

Front 285

A yield curve can have one of these three shapes, each indicating something different.

Back 285

* Upward sloping, with long-term interest rates above short-term interest rates. A curve is more likely to have this shape when short-term interest rates are low. This is the MOST COMMON yield shape.

* Flat, with short- and long-term interest rates equal.

* Downward sloping, with long-term interest rates below short-term interest rates. A curve is more likely to be downward sloping, or inverted, when short-term interest rates are high.

(context: bond term of maturity)

Front 286

Maturity premium

Back 286

For a given security, the difference in yield between one term of maturity and another.

For upward sloping yield curves, the maturity premium is positive, meaning that investors require a higher interest rate on longer-term securities. For flat yield curve, the maturity premium is zero. For downward sloping yield curves, the maturity premium is negative, as investors require a lower rate of return on longer-term securities.

Front 287

Discount rate of a bond

Back 287

The yield to maturity for a bond is the required rate of return by the marketplace; it is also referred to as the discount rate.

Front 288

Real rate of return

Back 288

The rate of return adjusted for the effects of inflation

Front 289

Inflation premium

Back 289

An increase in return on a security to account for an expected decrease in purchasing power associated with price inflation

Front 290

A bond's yield to maturity is influenced by three main factors:

Back 290

* Real rate of return
* Inflation premium
* Risk premium

The yield to maturity on all bonds contemplates the real rate of return, the inflation premium, and the risk premium. For example, if a bond has a real rate of return of 2 percent, an inflation premium of 3 percent, and a risk premium of 2 percent, the yield to maturity is 7 percent.

Front 291

Risk premium

Back 291

This premium compensates bondholders for credit risk and liquidity risk, as well as any maturity premium associated with a specific bond

Front 292

T or F: The yield to maturity and the market price of bonds are negatively related.

Back 292

TRUE. The yield to maturity and the market price of bonds are negatively related.

Front 293

Preferred stock

Back 293

Stock that is generally nonvoting but that has priority over common stock, usually regarding dividends and capital distribution if the corporation ends its existence.

Front 294

Cumulative preferred stock

Back 294

A security that gives the holder the right to receive accrued unpaid dividends before any dividends can be paid to the common stockholders

Front 295

Noncumulative preferred stock

Back 295

A security that does nto give the holder the right to receive accrued unpaid dividends

Front 296

Convertible preferred stock

Back 296

A type of preferred stock that allows the holder to convert it into a stated number of common shares of the issuing company

Front 297

Common stock

Back 297

An ownership interest in a corporation that gives stockowners certain rights and privileges, such as the right to vote on important corporate matters and to receive dividends

Front 298

Financial theory of stock price volatility

Back 298

The hypothesis that the price of any investment, including stock, equals the discounted present value of the future cash flows it generates. In the specific case of stock, the price is the present value of the dividend stream plus the value of the stock at the end of a holding period.

Front 299

Fundamental analysis

Back 299

A method used to determine the price of a stock by analyzing data that are fundamental to the company, such as expected growth, dividend payouts, risk, and interest rates

Front 300

Dividend payout ratio

Back 300

Dividends paid divided by earnings

Front 301

Technical analysis

Back 301

A method of determining stock prices by trying to detect patterns in market activity statistics, past prices, and market volume.

Technical analysts believe the historical performance of teh stock will repeat itself in predictable trends and patterns based on prior results

Front 302

Efficient market hypothesis

Back 302

Asserts that stock prices reflect the expectations of all market participants and that no individual investor has superior knowledge.

An efficient market is one in which new information is quickly and accurately reflected in the price of the stock.

3 forms of efficient market hypothesis: weak form efficiency, semi-strong form efficiency, and strong form efficiency

Front 303

Weak-form efficiency (efficient market hypothesis)

Back 303

Asserts that the current stock price reflects all historical information about the stock's price fluctuations.

The implication is that the analysis of historical price relationships, or the nature of technical research, is of no value in forecasting future stock prices, and any information about past price fluctuations will not assist an investor to earn a high profit.

Rejects technical analysis

Front 304

Semi-strong form efficiency (efficient market hypothesis)

Back 304

Asserts that the current stock price reflects not only all historical data, but also all current information about the stock. By implication, this form of the efficient market hypothesis rejects fundamental analysis.

Considerable evidence supports the efficient market hypothesis in the weak and semi-strong forms. This evidence implies that most investors in most circumstances cannot expect to outperform the market consistently.

Front 305

Strong form efficiency

Back 305

Asserts that stock prices reflect not only historical information and current public information, but also insider information that might be available only to insiders or experts.

The most controversial form of the efficient market hypothesis. This form suggests that not even the experts (for example, portfolio managers or mutual fund managers) can consistently outperform the market

Front 306

Two components to the annual return on a bond or a stock:

Back 306

1. Periodic payments in the form of bond interest or stock dividends
2. A capital gain or loss based on the change in the value of the bond or stock from the beginning of the year to the end of the year

Front 307

Annual Rate of Return for a Bond

Back 307

Annual rate of return = (Interest + Capital Gain) / Bond price at the beginning of the year

Front 308

Annual Rate of Return for a Stock

Back 308

Annual rate of return = (Capital gain + Dividend) / Share price at the beginning of the year

Front 309

Amortized cost

Back 309

An accounting recognition of the difference between a bond's purchase price and face value from purchase date to maturity

Front 310

T or F: A company that purchases a bond or a stock as an investment should initially value it at cost, which is equal to its purchase price, including any costs of purchase such as broker's fees

Back 310

TRUE.A company that purchases a bond or a stock as an investment should initially value it at cost, which is equal to its purchase price, including any costs of purchase such as broker's fees

Front 311

T or F: Amortized cost causes a bond's reported value to fluctuate wildly over time.

Back 311

FALSE. Amortized cost stabilizes a bond's reported value over time, insulating the investor from reporting large swings in market value.

At maturity, the bond's market value, amortized cost value, and face value are all equal.

A key assumption underlying this valuation method is that the investor intends to hold the bond until maturity

Front 312

Mark-to-market

Back 312

An adjustment in an asset's valuation to reflect changes in its actual or estimated market price.

Fair value is equal to market value if a bond or stock is actively traded. If the bond or stock is not actively traded, its fair value (market value) must be estimated by observing market prices for similar classes of investments and/or by modeling its expected future cash flows.

Front 313

Statement of Financial Accounting Standards No. 157 (SFAS 157)

Back 313

Issued by the Financial Accounting Standards Board (FASB) in 2007; it calls for increased disclosures of fair value and transparency in mark-to-market calculations.

Furthermore, it clarifies the measurement of fair value by specifying that it is equal to an asset's exit price, or the price at which the asset can be sold in the marketplace.

Valuation under SFAS 157 assumes an orderly exit from an asset position; it does not require the forced liquidation or distressed sale of a financial instrument.

Front 314

International Financial Reporting Standards (IFRS)

Back 314

Financial standards developed by the International Accounting Standards Board (IASB)

Front 315

SFAS 157 Fair Value Hierarchy

Back 315

Level 1 - Valuation from observable inputs of quoted prices for the asset in the marketplace.

Level 2 - Extrapolation of value via observed prices and yield curves for similar instruments.

Level 3 - Assignment of value via assessment of unobservable inputs.

Front 316

GAAP provide guidance for the valuation and reporting of bonds and stocks. This guidance primarily depends on both of these factors:

Back 316

* The length of time the investor intends to hold the bond or stock
* Whether the value of the bond or stock is considered to be "impaired"

Front 317

T or F: Even if the fair value of a bond or stock falls below its cost/amortized cost, it is not considered to be impaired

Back 317

FALSE. If the fair value of a bond or stock falls below its cost/amortized cost, it is considered to be impaired, and, under certain conditions, the reported value of the bond or stock would need to be decreased

Front 318

Realized capital gain

Back 318

The profit earned by an insurer when an asset, such as a bond or stock, is sold for more than its cost

Front 319

Unrealized capital gain

Back 319

The profit not yet earned on a held asset when it exceeds its original purchase price but has not been sold

Front 320

Impairment

Back 320

In accounting, the reduction in the cost basis of a financial asset by an amount that is deemed to be unrecoverable.

Front 321

GAAP: Held-to-maturity bonds: valuation and treatment

Back 321

Valuation: amortized cost

Unrealized gains and losses:
* Excluded from earnings (net income) and shareholders' equity
* Disclosed in the notes to financial statements

Front 322

GAAP: Available-for-sale bonds and stocks: valuation and treatment

Back 322

Valuation: fair value

Unrealized gains and losses:
* Excluded from earnings (net income)

* Reported in a separate component of shareholders' equity (other comprehensive income)

Front 323

GAAP: Trading bonds and stocks: valuation and treatment

Back 323

Valuation: fair value

Unrealized gains and losses:
* Included in earnings (net income)

Front 324

Other-than-temporary impairment (OTTI)

Back 324

Results in re-valuing the stock/bond at the reduced cost

Front 325

T or F: On the NAIC Annual Statement form, the highest-quality bonds (as determined by teh NAIC Securities Valuation OFfice) are valued at amortized cost, while lower-quality bonds are valued at the lower of amortized cost or market value.

Back 325

TRUE. On the NAIC Annual Statement form, the highest-quality bonds (as determined by teh NAIC Securities Valuation OFfice) are valued at amortized cost, while lower-quality bonds are valued at the lower of amortized cost or market value.

Front 326

SAP employs this concept regarding impairment.

Back 326

The OTTI (Other-than-temporary-impairment) concept. The cost/amortized cost basis for invested assets determined to be OTTI is reduced, and the reduction in value flows through the Statement of Income as a realized capital loss.

Front 327

Five quantitative measures of risk

Back 327

* Variance
* Standard deviation
* Coefficient of variation
* Value at risk
* Beta

Front 328

Variance

Back 328

Variance = Sum of squared deviations / (Number of elements in the data set - 1)

A measure of dispersion; a measure of the deviation of each variable in a data set from the mean of the data set.

Front 329

Deviation

Back 329

Actual - average

Front 330

Standard deviation

Back 330

A measure of dispersion between the values in a distribution and the expected value (or mean) of that distribution, calculated by taking the square root of the variance.

Front 331

Coefficient of variation

Back 331

A measure of dispersion calculated by dividing a distribution's standard deviation by its mean

Front 332

Value at risk

Back 332

A threshold value such that the probability of loss on the portfolio over the given time horizon exceeds this value, assuming normal markets and no trading in the portfolio.

The value at risk is based on two selected inputs: the probability of a loss, and the time horizon during which the loss can occur.

The output is the amount of loss that might occur with that probability during that time horizon. For example, the 5 percent, one-day, VaR of an investment portfolio might be $300,000. That means there is a 5 percent probability of losing $300,000 or more in one day.

VaR provides decision makers with three key benefits:
* The potential loss associated with a decision can be quantified
* Complex positions are expressed as a single amount
* Loss is expressed in monetary terms that are easily understood

Front 333

Beta

Back 333

A measure of an asset's volatility relative to that of the overall market for that type of asset.

For example, a stock with a beta of 0.50 is only half as volatile as the overall stock market. A beta above 1.0 indicates greater than average volatility.

Front 334

The goal of an investment portfolio

Back 334

The highest possible return at an acceptable level of risk

Front 335

Risk-return trade-off

Back 335

The tendency for the potential return to increase as risk increases

Front 336

Market risk

Back 336

Uncertainty about an investment's future value

Front 337

Company-specific risk (unsystematic risk)

Back 337

Risk that affects a specific company or a small group of companies

Front 338

Diversification

Back 338

A risk control technique that spreads loss exposures over numerous projects, products, markets, or regions

Front 339

It is not necessary to have a negative correlation between two portfolio components in order to reduce risk by combining them. The only requirement is that:

Back 339

The only requirement is that the returns of the new security not be perfectly positively correlated with the returns of the existing portfolio.

Front 340

Modern Portfolio Theory

Back 340

States that investors, through diversification, can optimize their overall risk and return by carefully considering how the risks and returns of the various available investments interact. Since there is an optimum (best) mix, MPT states taht there is a limit to the benefit of diversification.

Front 341

Efficient frontier

Back 341

The collection of securities portfolio combinations that generate the highest expected return for a given level of risk or that have the lowest risk for a given expected return.

Front 342

The most important objective of portfolio management (and especially of bond portfolio management)

Back 342

Structure the portfolio so that the amount and timing of investment cash inflows correspond to the firm's expected cash outflows.

Front 343

Cash matching

Back 343

The process of matching an investment's maturity value with the amount of expected loss payments

Front 344

Reinvestment risk

Back 344

The risk that the rate at which periodic interest payments can be reinvested over the life of the investment will be unfavorable.

Front 345

Duration

Back 345

A measure of a security's weighted average life

Front 346

Two important characteristics of bond duration:

Back 346

1. The duration of a zero-coupon bond is always equal to its time to maturity
2. The duration of a bond that pays interest over its life will always be less than its time to maturity.

Front 347

Portfolio immunization (asset-liability matching)

Back 347

The process of matching investment duration and liability duration.

When the durations of the underwriting and investment portfolio are matched, the portfolio is said to be immunized against changes in interest rates.

Front 348

Regulators are the primary source of constraints imposed on insurer investment practices. These constraints take two main forms:

Back 348

1. Asset restrictions (insurers are permitted to show only certain assets on their balance sheets and are limited in the types of investments they can hold)

2. Investment limitations (to achieve diversification in insurer investment portfolios, regulators also restrict how much an insurer can hold in any single investment

Front 349

Examples of permitted investments for insurers

Back 349

* Money market instruments
* High-quality investments that mature in less than one year, such as US T-bills and commercial paper
* Bonds of investment grade or better (issued by the US Treasury, state governments, certain municipalities, or credit-worthy private corporations)
* Common stock
* Preferred stock
* Real estate loans (mortgages)
* Real estate

Front 350

Three investment restrictions help ensure that insurers have well-diversified portfolios that support the goals of liquidity and solvency:

Back 350

1. Insurers can invest only up to a certain percentage of their assets in many of the permitted investments

2. Insurers are typically restricted in how much of their assets can be invested in any single investment

3. Insurers are restricted in the percentage of another company's securities they can own

Front 351

Solvency

Back 351

The ability of an insurer to meet its financial obligations as they become due, even those resulting from insured losses that may be claimed several years in the future.

Front 352

Risk-based capital (RBC)

Back 352

A method developed by the NAIC that establishes a minimum amount of capital that an insurer needs to support its overall ongoing business operations based on the risk-based capital formula.

Front 353

Insurer's primary source of internal capital

Back 353

Its business operations, either through net income or through unrealized capital gains.

Front 354

Short-tail claims

Back 354

Claims that become known within the policy period or within one year of expiration and that are finalized and paid quickly.

Front 355

Two types of activities commonly used to provide capital on a balance sheet:

Back 355

* Actions to change loss and loss adjustment expense reserve valuations
* Transactions that recognize existing asset market values

Front 356

Discounting of loss reserves for time value of money

Back 356

An action that affects the valuation of loss reserves. Discounting loss reserves directly increases policyholders' surplus. Generally, SAP does not permit discounting of loss reserves.

Front 357

Sale and leaseback transaction

Back 357

Used to increase capital; a transaction in which the owner of an asset sells the asset to another party and then leases the asset back from the new owner.

For example, doing so with an office building.

Front 358

Reinsurance

Back 358

The transfer of insurance risk from one insurer to another through a contractual agreement under which one insurer (the reinsurer) agrees, in return for a reinsurance premium, to indemnify another insurer (the primary insurer) for some or all of the financial consequences of certain loss exposures covered by the primary's insurance policies.

Front 359

Surplus note

Back 359

A type of unsecured debt instrument, issued only by insurers, that has characteristics of both conventional equity and debt securities and is classified as policyholders' surplus rather than as a liability on the insurer's statutory balance sheet. Because mtuual companies are owned by policyholders rather than shareholders, surplus notes are the main method mutual insurers use to raise surplus or equity.

Front 360

Surplus notes have this regulatory benefit

Back 360

The proceeds received from the issuance of surplus notes are included int eh insurer's adjusted capital for calculating its risk-based capital ratio

Front 361

T or F: Failure to pay interest or principal on a surplus note is not considered a default (even though payments need regulatory approval)

Back 361

TRUE: Failure to pay interest or principal on a surplus note is not considered a default (even though payments need regulatory approval)

Front 362

Mutual Holding Company Conversion

Back 362

Before conversion:

Mutual Insurer --> Subsidiaries


After conversion:

Mutual holding company --> Stock holding company --> Stock insurer and subsidiaries

Front 363

Loss Portfolio Transfer (a reinsurance concept)

Back 363

A type of retroactive plan that applies to an entire portfolio of losses.

It is typical for the insurer to gain capital from an LPT, as its cost is based on the present value of estimated future loss payments, whereas teh loss reserve liability is generally presented on an undiscounted basis. LPTs are used more often as a way for an insurer to withdraw from a segment of business than as a source of capital.

Front 364

If an insurer reinsures loss exposures, it may receive this from the reinsurer:

Back 364

A ceding commission.

This ceding commission is an amount paid by the reinsurer to the primary insurer to cover part or all of the primary insurer's policy acquisition expenses. It may also include a provision for profit on the ceded business. The ceding commission offsets the reduction in surplus caused by immediate recognition of expenses. NOTE: This effect is called 'surplus relief'

Front 365

Special purpose reinsurance vehicle (SPRV)

Back 365

To facilitate the issuance of catastrophe bonds, an insurer creates an SPRV. The SPRV issues a catastrophe reinsurance agreement to the insurer and issues catastrophe bonds to capitalize its reinsurance obligation. The catastrophe bonds are sold to investors directly through the capital markets.

The insurer pays the SPRV a premium for the coverage that is comparable to what it would have paid to a traditional reinsurer. The SPRV uses these premiums to pay its operating and bond interest expenses. If no claim is made during the coverage period, the bond principal is repaid to the investors and the SPRV is liquidated.

Front 366

In the absence of dividend neutrality, a company's dividend policy decision should consider sveral factors:

Back 366

* The company's access to external sources of capital
* The expected rate of return on investment opportunities
* Dividends as an indicator of the company's prospective performance
* Tax considerations
* Investor attitude toward uncertainty

Front 367

Dividend neutrality

Back 367

In the absence of uncertainty, taxes, transaction costs, and various inefficiencies, and various inefficiencies, an owner should have no preference between receiving dividends or having the company retain and reinvest all earnings, which increases the value of the owner's stock. In this context, the policy of a corporation is said to have a neutral effect on the value of the firm.

Note: in light of those factors NOT being present, the concept of dividend neutrality does not hold.

Front 368

Payout ratio

Back 368

The proportion of a company's earnings or net income paid out as dividends to shareholders

Front 369

An insurer's dividend decisions are complicated by these 5 factors:

Back 369

* Income measurement rules
* Cash flow
* Capital structure
* Ownership
* Regulatory restrictions

Front 370

Payment of cash dividends is not the only means of distributing income to company shareholders. Two common alternatives are:

Back 370

1. Repurchasing corporate stock

2. Expanding available investment opportunities

Front 371

Capital structure

Back 371

A corporation's mix of long-term debt and equity

Front 372

Cycle of a company's fund flow (in the context of capital structure)

Back 372

(1) The company sells common stock (equity), bonds (debt), or some other type of security in the capital market and receives cash

(2) Proceeds from the security's sale are used to purchase assets

(3) Cash returns from the assets can be retained in the company to finance operations or to finance the purchase of more assets

(4) Ultimately, cash returns can be distributed to the suppliers of capital. (Debt holders receive income in the form of interest payments, and equity holders can receive income as cash dividends

Front 373

Equity interest

Back 373

The shareholder's right to whatever profits remain after all other expenses and creditors have been paid

Front 374

Debt capital is usually raised in this manner

Back 374

Through the sale of bonds in the capital market

Front 375

Financial leverage

Back 375

The use of fixed cost funds (debt) to increase returns to shareholders. This increase is accomplished through the use of capital raised by the issue of debt to earn a rate of return higher than the fixed cost of that debt.

Typically, the fixed financial cost amount reported on a company's income statement reflects interest payments on debt. This amount must be paid regardless of the amount of earnings available.

Front 376

Tax shield

Back 376

Under federal tax law, interest on debt is deductible in calculating taxable income, but dividends paid to stockholders are not. As a result, more after-tax money is available to the company if it raises capital using debt rather than equity. The amount of income taxes saved because of the deductibility of interest expense is known as teh tax shield.

Front 377

The cost of financial distress

Back 377

In practice, bankruptcy involves legal and administrative costs, as well as the potential cost of selling assets at less than their true economic value. As a result, bondholders and stockholders receive less than they otherwise would. The difference between what they receive with and without bankruptcy is the cost of financial distress.

Front 378

T or F: As its ratio of debt to equity rises, a company will experience a decreased risk of defaulting on its debt and a decreased potential of bankruptcy.

Back 378

FALSE. As its ratio of debt to equity rises, a company will experience an INCREASED risk of defaulting on its debt AND an INCREASED potential of bankruptcy.

Front 379

Insurers have these two main sources of funds with which they can generate investment income to help pay for losses or provide additional profit:

Back 379

* Policyholders' surplus - Contributed capital plus earnings retained in the business plus other items, such as unrealized capital gains and losses.

* Policyholders' supplied funds (funds from operations) - Reserves for losses, loss adjustment expenses, and unearned premiums. These funds arise as part of the ongoing operations of the insurer. (The unearned premiums reserve arises because premiums are due faster than they are earned. Loss reserves accumulate as an insurer grows because claims are not immediately settled and paid.)

Front 380

Insurance leverage equation

Back 380

Insurance leverage = insurance exposure x ( Reserves / Premiums written)

- or -

(Reserves / policyholders' surplus) = ((Premiums written / Policyholders' surplus) X (Reserves / Premium written))

(on p 10.10 if needed)

Front 381

Financial leverage

Back 381

The use of fixed cost funds (debt) to increase returns to shareholders

Front 382

Cost of capital

Back 382

The opportunity cost of funds provided by investors

Front 383

Cost of equity

Back 383

The rate of return required to compensate a company's common shareholders for the use of their capital.

Essentially, it is an opportunity cost concept that compares the return on insurer shares with the return on other shares in an equivalent risk class.

Example on 10.14 if needed

Front 384

Unsystematic risk (specific risk)

Back 384

Risk that arises from factors that are unique to a particular investment

Front 385

Systemic risk

Back 385

The potential for a major disruption in the function of an entire market or financial system

Front 386

Cost of debt

Back 386

The rate of return required to compensate a company's debt holders for the use of their capital.

Like the cost of equity, the cost of debt is essentially an opportunity cost concept that compares the return on insurer debt with the return on other debts of equivalent credit risk.

Cost of debt = (risk free rate of return + risk premium) x (1 - tax rate)

Front 387

Cost of preferred stock

Back 387

Cost of preferred stock capital
=
(Dollar amount of dividend paid on each share)
/
(Market price of one share of preferred stock)

Front 388

Weighted average cost of capital (WACC)

Back 388

The average of the cost of equity and the cost of debt calculated according to the proportion of the whole invested capital that each represents.

WACC = (Cost of equity x percentage of capital that is equity) + (Cost of debt x percentage of capital that is debt)

In cases where there are two types of equity, the WACC equation can be divided into the capital components, such as:

WACC = (Cost of common stock x Percentage common stock) + (Cost of preferred stock x Percentage preferred stock) + Cost of debt x Percentage debt)

Front 389

Underwriting risk

Back 389

A measure of the loss volatility of the types of insurance sold by an insurer

Front 390

Risk-based capital (RBC)

Back 390

Amount of capital an insurer needs to support its operations, given the insurer's risk characteristics. (An NAIC concept)

Front 391

The Risk_Based Capital for Insurers Model Act

Back 391

Broadly requires that capital requirements be based on all risks that insurers face. For property-casualty insurers, the RBC takes into account asset risk, credit risk, and underwriting risk.

This Act has been enacted in some form in all states.

Front 392

Covariance adjustment (NAIC RBC)

Back 392

Because it is unlikely that all of the risks measured by the formula would befall an insurer simultaneously, the RBC formula adjusts the sum of the values assigned to each risk using a statistical technique called covariance. The covariance adjustment reduces the sum of the capital requirements indicated by the NAIC RBC formula. That is, the capital required by each element of an insurer's risk need not be arithmetically summed.

Front 393

T or F: Under the RBC formula, riskier assets (those more likely to have a loss, or greater degree of loss) require more underlying capital than less risky assets

Back 393

TRUE. Under the RBC formula, riskier assets (those more likely to have a loss, or greater degree of loss) require more underlying capital than less risky assets

Front 394

Credit risk (NAIC RBC)

Back 394

Credit risk reflects the possibility that the insurer will not be able to collect money owed to it.

Although it is specifically mentioned in the RBC Model Law, credit risk is another type of asset risk. Receivables, the source of much credit risk, are money owed to and assets of an organization. (e.g., reinsurance)

Front 395

Underwriting risk (NAIC RBC)

Back 395

An insurer is at risk of an underwriting loss if premiums charged and/or loss reserves are too low. Premiums can be inadequate for the losses they must cover. Loss reserving errors directly affect the amount of an insurer's capital.

For example, auto physical damage claims are quickly settled, and potential severity is not high, so the charge for that line's reserves is about 10 percent. For the more variable medical malpractice line, the reserve charge is around 40 percent.

Another underwriting risk recognized in the RBC formula is excessive premium growth. Growth is considered excessive if the three-year average growth rate is greater than 10 percent.

Front 396

NAIC RBC Action Levels (5):

Back 396

- No Action Required
- Company Action Level
- Regulatory Action Level
- Authorized Control Level
- Mandatory Control Level

Front 397

NAIC RBC: No Action Required

Back 397

If the insurer's capitalization level is above the Company Action Level (200 percent or more of the computed minimum RBC amount), no action is required by either the insruer or the regulator

Front 398

NAIC RBC: Company Action Level

Back 398

If the insurer's capitalization level falls between the Regulatory Action Level and the Company Action Level (between 150 and 200 percent of the computed minimum RBC amount), the insurer is required to submit a comprehensive financial plan to the regulator containing proposals to correct the insurer's financial problems

Front 399

NAIC RBC: Regulatory Action Level

Back 399

If the insurer's capitalization level falls between the Authorized Control Level and the Regulatory Action Level (between 100 and 150 percent of the computed minimum RBC amount), the regulator is required to conduct an examination or analysis as deemed necessary. The insurer is also required to file a comprehensive financial plan with the state insurance regulator.

Front 400

NAIC RBC: Authorized Control Level

Back 400

If an insurer's capitalization level falls between the Mandatory Control Level and the Authorized Control Level (between 70 and 100 percent of the computed minimum RBC amount), the regulator may place the insurer under regulatory control but is not required to do so.

Front 401

NAIC RBC: Mandatory Control Level

Back 401

If an insurer's capitalization level falls below 70 percent of the Authorized Control Level (the computed minimum RBC amount), the insurance regulator is required to place the insurer under regulatory control.

Front 402

Insurers should maintain this amount of capital to avoid any regulatory action

Back 402

200 percent of the Authorized Control Level, or more

Front 403

Economic capital

Back 403

A form of regulatory capital, it is an estimate of the amount of capital a firm needs to remain solvent at a given risk tolerance level.

It differs from other types of regulatory capital because rather than being based on a formula, it is based on the fair (market) values of the firm's asset sand liabilities as well as their variability.

Front 404

Most important factors incorporated into the fair value market price of an asset or liability:

Back 404

* Future cash flows
* The risk attached to those cash flows

Front 405

Market value surplus (MVS)

Back 405

The fair value of assets minus the fair value of liabilities.

Under GAAP, an organization's net worth (assets less liabilities) is often called equity. Under SAP, an insurer's net worth is called policyholders' surplus. Fair value accounting, which uses actual or estimated market values, calls net worth "market value surplus"

Market value surplus (MVS) of insurer = Fair value of assets - Fair value of liabilities

- or -

Market value surplus of insurer = Fair value of assets - (Present value of liabilities + Market value margin)

Front 406

Risk premium

Back 406

Also called risk margin, or market value margin

The additional payment required for the potential that assumed loss reserves (such as in a reinsurance-type situation) prove to be inadequate.

Front 407

A major difference between the calculation of RBC and economic capital

Back 407

RBC uses factors to calculate a risk margin for the underlying risks. In contrast, economic capital is calculated using probability models of the various factors affecting results.

Front 408

T or F: If an organization's MVS is larger than its economic capital, then it has excess capital. If its MVS is less than its economic capital, a deficiency exists.

Back 408

TRUE: If an organization's MVS is larger than its economic capital, then it has excess capital. If its MVS is less than its economic capital, a deficiency exists

Front 409

T or F: Economic capital is less than the value of a loss in MVS that is expected to be exceeded at the selected level of probability (threshold)

Back 409

FALSE. Economic capital is equal to the value of a loss in MVS that is expected to be exceeded at the selected level of probability (threshold) - for example, only 1 percent of the time if the standard is to have sufficient capital 99 percent of the time.

Front 410

Market-Consistent Balance Sheet

Back 410

Assets:

Fair (Market) Value of Assets

Liabilities:

Fair Value of Liabilities (Present Value of Liabilities + Market Value Margin)
+
Market Value Surplus (Economic Capital + Excess Capital)

Front 411

Enterprise risk management

Back 411

An approach to managing all of an organization's key business risks and opportunities with the intent of maximizing shareholder value

Front 412

Solvency II

Back 412

A fundamental review of the capitalization of insurers in the European Union (EU). It aims to establish a revised set of EU-wide capital requirements and risk mgmt standards.

3 pillars:
* Quantitative requirements of capital based on each insurer's specific circumstances
* Requirements for insurers' internal risk management process and for the supervision of insurers
* Reporting, disclosure, and transparency of the risk assessment to the public and regulators

Front 413

3 pillars of Solvency II

Back 413

3 pillars:
* Quantitative requirements of capital based on each insurer's specific circumstances
* Requirements for insurers' internal risk management process and for the supervision of insurers
* Reporting, disclosure, and transparency of the risk assessment to the public and regulators

Front 414

Merger

Back 414

A type of acquisition in which two or more business entities are combined into one.

Assets and liabilities of the two companies are merged and the target ceases to exist.

Front 415

Acquisition

Back 415

The purchase of one company's stock by another company.

The buyer continues to exist; the target may continue to exist as a wholly or partly owned subsidiary.

Front 416

Consolidation

Back 416

A combination of two or more business entities into a new entity.

Both buyer and target cease to exist and a new combined entity is formed with the combined assets and liabilities of the two.

Front 417

Takeover

Back 417

A change in the control of a company through merger, acquisition, or some other type of transaction.

Takeovers can be either friendly (supported by management) or hostile (resisted by management and board of directors of the target)

Front 418

Takeover

Back 418

A change in the control of a company through merger, acquisition, or some other type of transaction.

Takeovers can be either friendly (supported by management) or hostile (resisted by management and board of directors of the target)

Front 419

Proxy contest

Back 419

A strategy for gaining control of a company by obtaining the voting rights of the target's shareholders.

Not an acquisition but can facilitate an acquisition; it allows the buyer to avoid paying a premium for the target.

Front 420

Proxy contest

Back 420

A strategy for gaining control of a company by obtaining the voting rights of the target's shareholders.

Not an acquisition but can facilitate an acquisition; it allows the buyer to avoid paying a premium for the target.

Front 421

Tender offer

Back 421

A purchase offer made directly to the shareholders of the target, typically at an offer price greater than the current market price.

Not an acquisition but can facilitate an acquisition.

Front 422

Tender offer

Back 422

A purchase offer made directly to the shareholders of the target, typically at an offer price greater than the current market price.

Not an acquisition but can facilitate an acquisition.

Front 423

Divestiture

Back 423

The disposal or sale of part of a company.

The seller gives up all ownership in the divested portion.

Front 424

Divestiture

Back 424

The disposal or sale of part of a company.

The seller gives up all ownership in the divested portion.

Front 425

Spin-off

Back 425

The creation of a new company from part of an existing company.

Shareholders of the original company typically receive shares in the new company in the same proportion as their ownership of shares in the original company.

Front 426

Spin-off

Back 426

The creation of a new company from part of an existing company.

Shareholders of the original company typically receive shares in the new company in the same proportion as their ownership of shares in the original company.

Front 427

Horizontal acquisition

Back 427

A combination of two companies in the same line of business.

Front 428

Vertical acquisition

Back 428

A combination of two companies involved in related lines of business but at different stages of production.

Front 429

Conglomerate acquisition

Back 429

A combination of two companies involved in unrelated lines of business.

Front 430

Three ways an acquisition can lead to cost savings:

Back 430

* Efficiencies
* Tax advantages
* Reduced cost of financial distress

Front 431

Revenue efficiency

Back 431

IN the context of acquisitions, a measure of the extent to which a company's revenues can be increased by combining the company with another entity or entities.

A company is considered to have achieved revenue efficiency when its revenues cannot be increased, holding economic inputs constant, by combining the company with another entity or entities.

Front 432

Cost efficiency

Back 432

IN the context of acquisitions, a measure of the extent to which a company's costs can be reduced by combining the company with another entity or entities.

A company has achieved cost efficiency when its costs cannot be decreased, holding economic outputs constant, by combining the company with another entity or entities. A cost-efficient company has obtained both technological and allocational efficiency

Front 433

Technological efficiency

Back 433

Using minimum-cost production technology to generate products and services

Front 434

Allocational efficiency

Back 434

When a cost-efficient company has exploited existing economies of scale and scope and employs the most appropriate technology to transform inputs, such as capital, into outputs, such as services

Front 435

Interesting thing about an unused net operating loss (NOL)

Back 435

If a profitable buyer acquires a target with an unused net operating loss (NOL), it may be able to more rapidly or fully use the NOL carryovers to recover taxes previously paid. Companies with an unused NOL are allowed to carry the loss back three years or to carry it forward fifteen years as an offset against taxable income in those prior or subsequent years. The increase in cash flows resulting from the recovery of taxes increases the company's value.

Front 436

Synergy

Back 436

Implies that some mutual advantage is achieved when two companies are combined.

In that sense, any increase in net cash flows resulting from a business combination reflects synergies.

In a narrower sense, synergy is thought of as the benefits generated from combining complementary activities. The strengths of one company in certain areas may compensate for the weaknesses of another company in those areas.

Front 437

Synergy implies some degree of these two things:

Back 437

* Economy of scale
* Economy of scope

Front 438

Difference between economies of scale and economies of scope

Back 438

Savings from economies of scale are size driven, leaving the range of products and services unchanged, whereas the savings from economies of scope result from broadening the range of products and services offered.

Economies of scale for both financial and human resources are expected in horizontal acquisitions.

Economies of scope are expected in vertical acquisitions because it costs less for combined companies to offer a broad range of products or services than it does for each company to provide a narrow range of products or services individually.

Front 439

An increase in market concentration via acquisition also increases what?

Back 439

The market power of the combined company. This increase in market power can enable the combined company to influence price, product offerings, and contract terms.

Front 440

Value of economic gain (in an acquisition) formula

Back 440

Value of economic gain
=
(Value of two companies combined) - (Value of Company A alone + Value of Company B alone).

An acquisition makes economic sense only when the value of economic gain is greater than zero.

Front 441

In an acquisition financed with cash, the acquisition price is:

Back 441

Simply the amount of cash paid for the target firm.

(Compared to a stock acquisition, where the acquisition price depends on the market price per share of stock in the combined entity after the merger.)

Front 442

Economic transactions have two main elements that must be evaluated together to assess the value

Back 442

* Price
* Terms

Front 443

Due diligence

Back 443

The process of examining a company's operations, finances, and management and verifying material facts that affect company value.

Front 444

T or F: An acquisition may be either taxable or tax free.

Back 444

TRUE. An acquisition may be either taxable or tax free. If the form of payment is cash, then the shareholders of teh acquired company incur a taxable gain or loss. This taxable gain or loss is the difference between teh cash received and the shareholders' tax basis in the shares sold (typically the original cost of the shares adjusted for previously recognized capital gains or losses). Shareholders of the target company may require a higher acquisition price to offset capital gains taxes.

Front 445

Loan covenant

Back 445

A condition that must be met to keep the loan in compliance

Front 446

Corporate raider

Back 446

An individual or company that is attempting to acquire a controlling interest in the target in order to launch a hostile takeover and replace existing management.

Front 447

Bear hug

Back 447

A type of hostile takeover that occurs when a hostile bidder makes an offer at a premium large enough to guarantee shareholder support, even in the face of opposition from the target's board of directors. The board is legally obligated to the shareholders to accept a sufficiently generous offer.

Front 448

Once a corporate raider has ___ % of the voting shares in a company, the raider must report its ownership to the SEC and to the target.

Back 448

5 percent

Front 449

Targeted repurchase price

Back 449

A target company may initiate a targeted repurchase from a corporate raider, usually at a substantial premium above the prevailing market price, in order to terminate the takeover attempt.

Front 450

Greenmail

Back 450

Payments made to a corporate raider as part of a targeted repurchase.

Giving in to greenmail can lead to further unfriendly takeover attempts by other corporate raiders hoping to collect greenmail.

Front 451

White knight

Back 451

A defensive tactic in a hostile takeover, in which the target finds a friendly buyer. Although the target will still be acquired, the buyer is a company that is acceptable to the target.

Front 452

Golden parachute

Back 452

A provision in an executive's employment contract that specifies that he or she will receive a large payoff, such as severance pay, immediate vesting of stock options, and enhanced retirement benefits, if his or her contract is terminated after the company is acquired.

Front 453

Super majority

Back 453

A company can amend its bylaws to require that a super majority approve any acquisition attempt. A super majority is a high percentage (for example, 67 percent versus a simple majority of greater than 50 percent) of voting shareholders. Such an amendment has teh effect of delaying the bidder's completion of a deal and giving a minority interest greater power.

Front 454

Staggered board

Back 454

A company can require that a minority fraction, such as one-third, of the board members is elected each year. This rotating board membership makes it more difficult for a bidder to obtain enough board votes to approve an acquisition or revoke defensive amendments to the bylaws.

Front 455

Poison pills

Back 455

Poison pill clauses give existing shareholders the right to purchase additional shares at a substantial discount or to redeem their shares at a significant premium when a buyer acquires a specified percentage of shares, typically 10 percent of voting common stock. These shareholder rights are not available to the buyer. A flip-in provision can give the holder the right to buy additional shares in the target at a bargain price, diluting the buyer's ownership share and the economic value of teh shares, as well as increasing the cost of acquiring additional shares.

Front 456

Poison puts

Back 456

Poison put options give bondholders the right to demand debt repayment, possibly at a premium, if there is a change in control as a result of a takeover. This provision protects the target company's existing bondholders from devaluation and causes immediate cash drain for the buyer.

Front 457

Crown jewel

Back 457

A target might sell or threaten to sell some key assets (crown jewels) to avert a takeover

Front 458

Lockup

Back 458

With a lockup, a friendly buyer is given the option to purchase certain key assets or stock of the target in the event of a hostile takeover attempt.

Front 459

Profit cycle

Back 459

A recurring increase and decrease in profits, usually regarding a single organization or industry.

The term "profit cycle," measured by the operating ratio, is a more accurate way to describe the 'underwriting cycle' for two reasons:

* The cyclical process is driven by profit expectations, not underwriting execution

* The relevant profit expectations are for operating profits, which are the sum of underwriting and investment income rather than underwriting profits alone

Front 460

Underwriting cycle

Back 460

A cyclical pattern of insurance pricing in which a soft market (low rates, relaxes underwriting, and underwriting losses) is eventually followed by a hard market (high rates, restrictive underwriting, and underwriting gains) before the pattern again repeats itself.

Front 461

Structural change

Back 461

Gradual, long-term, and fundamental change involving institutional arrangements, products, services, roles, and regulation.

Front 462

Unlike the demand for insurance, the supply of insurance does this:

Back 462

Varies significantly and can change dramatically over a short period of time. This variability has been the principal cause of changes in insurance prices and profits

Front 463

Historically, this is what has caused insurers to pull back from increasing their supply, and the resulting reduction in price:

Back 463

An unforeseen and devastating event that occurs when the market is soft. The event produces enough fear to cause a general withdrawal from teh market.

Front 464

Two examples of structural changes in society and business that have influenced the profit cycle:

Back 464

* An increase in litigation increased the demand for liability insurance in the 1970s
* New competition arose from the rise of giant corporations and their need for "all-risks," multiple-location coverage.

Front 465

Nonadmitted insurer

Back 465

An insurer not authorized by the state insurance department to do business within that state.

Front 466

Reunderwriting

Back 466

The process of analyzing the characteristics of policies within a portfolio and the trends of those characteristics.

Front 467

These four financial factors are examples of factors that determine insurers' profitability and, in turn, influence underwriting cycles:

Back 467

* Investment income
* Capacity
* Return on equity
* Cash flow

Front 468

Capital

Back 468

The accumulated assets of a business or an owner's equity in a business.

Front 469

Cash flow

Back 469

Cash inflow minus cash outflow.

Although some businesses can function on negative cash flow on a periodic basis, insurers cannot function on negative cash flow. Negative cash flow almost always precedes an insurer's insolvency and will quickly trigger a change in pricing.

Front 470

T or F: Demand is inversely proportional to its price

Back 470

TRUE. Demand IS inversely proportional to its price.

The opposite is true for supply: the higher the price of a product, the greater the quantity that sellers are willing to offer, and vice versa.

Front 471

Market equilibrium

Back 471

The point where demand and supply are equal.

In market equilibrium, all sales transactions occur at the equilibrium price (P*). Any price that is higher than the equilibrium price would generate a supply greater than demand and would result in an overabundance of the product. With an over-abundance of the product, the price declines back towards P*. Similarly, any price lower than the equilibrium price would generate a shortage, because demand would be greater than supply,. With a shortage, the price rises back toward P*. Eventually, the price of the product will return to P* and the amount supplied will return to Q* (equilibrium quantity)

Front 472

An insurance price is the sum of these (5) things:

Back 472

*Present value of expected claim payments
*Underwriting expenses
*The cost of capital
*Taxes
*Profit/loss

Front 473

Supply

Back 473

In insurance, the aggregate willingness of all insurers to assume risk at a given time.

Front 474

Factors affecting the supply of property-casualty insurance (7):

Back 474

* Reinsurance
* Ease of entry
* Difficulty of exit
* Regulatory environment
* Dedicated capital
* Underreserving
* Profit expectations

Front 475

Surplus relief

Back 475

A flow of funds into an insurer's policyholders' surplus when policyholders' surplus ahs been reduced by the insurer's rapid growth in written premiums.

By increasing the capacity of many insurers, reinsurance usually increases the aggregate supply of insurance.

Front 476

Elastic demand

Back 476

Willingness to purchase a product that varies significantly with price.

Front 477

Inelastic demand

Back 477

Willingness to purchase a product that does not tend to respond to a change in price.

Front 478

T or F: Insurance demand is only elastic.

Back 478

FALSE. Insurance demand has attributes of both elasticity and inelasticity.

However, insurance demand is relatively inelastic when compared with the demand for many other goods and services for two reasons:

* Buyers do not have much choice but to buy
* Buyers cannot store insurance as they can store other products, such as automobiles, that can be used for many years depending on buyers' needs and the price of replacements.

Front 479

T or F: A good or service with high price elasticity has a steeply sloping demand curve.

Back 479

FALSE. A good or service with LOW price elasticity has a steeply sloping demand curve. Most insurance demand is like this.

With an increase in the price, the quantity demanded falls much less.

Front 480

The underwriting cycle, more accurately described as the profit cycle, in property-casualty insurance is dominated by this:

Back 480

Supply.

Supply is highly variable in property-casualty insurance. Profit cycles in most other industries are dominated by changes in demand. Because demand in most industries tends to rise and fall with changes in the general economy, profit cycles in these industries usually coincide with the economy's general business cycles. The insurance industry is different. Since supply, not demand, is more important in influencing insurance prices and profits, insurance profit cycles usually do not coincide with general business cycles.

Front 481

T or F: Insurance profit cycles usually coincide with general business cycles.

Back 481

FALSE. Insurance profit cycles usually DO NOT coincide with general business cycles.