Odomirok.8-9-IS

The balance sheet and income statement are 2 of the 5 statements in a completed set of financial statements. Of the 2, the income statement is much more heavily tested on Exam 6 which is why we cover it first. To cover it properly, however, we need some basic information about the balance sheet (and accounting concepts in general.) This basic information is covered in the first couple of sections of this wiki article and refers to Odomirok.6-7-BS.

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BattleTable

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

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

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

• calculation of bond values

Questions held out from Fall 2019 exam: #11, 13. (Skip these now to have a fresh exam to practice on later. For links to these questions, see Exam Summaries.)

reference	part (a)	part (b)	part (c)	part (d)
E (2019.Spring #9)	statutory income: - calculate U/W income	statutory income: - calculate inv income	bonds & derivatives: - SAP treatment 4
E (2019.Spring #10)	surplus: - calculate surplus 5	NAIC.IRIS	NAIC.IRIS
E (2018.Fall #14)	net losses unpaid: - calculate	net losses incurred: - calculate	net U/W gain (loss): - calculate
E (2018.Fall #11)	investment income: - calculate	U/W income: 2 - calculate	PDR: - when is PDR ≠ 0
E (2018.Fall #10)	Odomirok.6-7-BS	surplus: - calculate surplus	surplus: - impact on surplus 3
E (2018.Spring #10)	statutory income: - calculate	expense allocation: - impact on profitability	expense allocation: - actuary's involvement
E (2017.Fall #9)	statutory income: - calculate	users & purpose: - B/S & I/S 1
E (2017.Fall #10)	surplus: - calculate surplus
E (2016.Fall #14)	surplus: - calculate surplus	financial health: - evaluate
E (2015.Fall #15)	surplus: - non-I/S surplus changes	surplus: - total surplus change	surplus: - reasons for surplus chg
E (2014.Fall #12)	surplus: - calculate surplus	see NAIC.IRIS	see Odomirok.10-Notes
E (2013.Fall #19)	SAP: - identify errors	surplus: - calculate surplus	reinsurance: - reasons to purchase	regulator concerns: - fair value
E (2012.Fall #14)	surplus: - impact on surplus	see Odomirok.19-RBC

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

² There is a weird "trick" in sample answer 2 for part (b) in the examiner's report. It is discussed further down in this wiki article for a different exam problem Statutory Income 2017.Fall #9. The "trick" is that the change in certain balance sheet items, like provision for reinsurance, is defined as (prior – current) rather than the usual (current – prior).

³ Part (c) requires basic knowledge of subsequent events which is covered in NAIC.SSAP-9.

⁴ See this forum discussion for more on derivatives and hedge accounting.

⁵ There may be an error in the examiner's report solution to part (a). See this forum discussion on the calculation of the UEPR liability (Unearned Premium Reserve). (shout-out to luohuasheng for noticing this!)

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In Plain English!

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

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

SAP versus GAAP

This section is an intro to SAP versus GAAP. Before doing anything else, you need to know the frameworks that companies use for accounting. (More details are covered in SAP versus GAAP - Chapter 22-23)

Question: define SAP and GAAP

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

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

==> GAAP: used by all public companies

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

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

==> SAP:

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

==> GAAP:

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

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

Question: identify 3 important differences between SAP and GAAP

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

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

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

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Elements of Financial Statements

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

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

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

• B/S or Balance Sheet (Statement of Financial Position – Chapter 7 in Odomirok)
• I/S or Income Statement (Statement of Financial Performance – Chapter 8 in Odomirok)
• Capital & Surplus (shows changes in surplus not recorded in the income statement)
• Statement of Cash Flow (shows the inflow and outflow of cash & cash equivalents)
• Notes to Financial Statement (quantitative & qualitative disclosures - Chapter 10 in Odomirok)

These are different but related to the 5 elements. (another shout-out to TD!)

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

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

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

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

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

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

Balance Sheet example (Liberty Mutual)

Spend a minute or two looking at it and observe:

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

Income Statement example (Liberty Mutual)

There are 3 types of income: U/W income, investment income, other income

• Note that Liberty's U/W income on line 8 is negative 807 million, which means their COR must be over 100%.
• But their total net income on line 20 is positive 823 million. (Their investments save them! See line 11.) Pay special attention to line 20 because you had to calculate this on exam problems.
• The item "dividends to policyholders" is subtracted from other total income. (This is important later in the web-based problem based on (2017.Fall #10))

(shout-out to ZB!)

Capital & Surplus Account: This is shown below the 3 types of income.

• These line items are direct charges to surplus that do not flow through income.
• The item "dividends to stockholders" is subtracted from surplus (but not from income)

It also might be an idea to look at Odomirok.6-7-BS for some extra background information about the balance sheet.

Note: There is a practice template in this mini BattleQuiz where you have to identify the location of particular line items in the financial statements. You should do that particular practice template MANY, MANY TIMES. Often on an exam problem, you're given financial statement information and you have to know where in the annual statement each item comes from. Sometimes it's obvious (like Cash is from the asset side of the balance sheet) but sometimes it isn't. For example, do you know where Federal and foreign income taxes incurred is located? It's in the Income Statement under Other Income. Or how about Current federal and foreign income taxes? It sounds a lot like the last one but this one is a liability from the balance sheet. It can be very confusing and you probably won't have much time to think about it on the exam. The only way to learn it is to practice it a about a googelplex number of times so it becomes second nature. And if you think I'm kidding, I'm not. How many times do you want to take this exam? If the answer is once, then you gotta practice the calculations and memorize the facts like an absolute maniac. That goes for the whole syllabus, but especially the top 24 articles.

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Statutory Income (2018.Spring #10a)

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

E (2018.Spring #10a)

We're only going to look at part (a) since that's a calculation. (Parts (b) & (c) of this problem are short answer and you can easily get the answer from the examiner's report or the mini BattleQuiz.) Recall Liberty Mutual's income statement from the previous section where we noted the 3 components of income. Click below to see the table of income statement items from Odomirok that this question is based on. (Note also the footnote to the table explaining that the numbers in the table don't quite "add up" the way they are supposed to.)

Table of Income Statement Items

The formulas are in the table below, but first note these bullet points:

• The "other income" formula in this table has been clarified. For the prior version, click Archived Version of Other Income Formula.
• Items highlighted in blue were inserted on Oct 02, 2022 to make the presentation clearer. You should make sure you understand parts (a) and (b) of E (2018.Fall #11). It isn't too hard but it might be a little confusing when you first look at it.,
• On Oct 18. 2022, a correction was made of a typo in the formula for "Total Income" on the last row of the table below. It is highlighted in orange. The term "income" was crossed out and replaced by the term "gain" (shout-out to JH!)

item	formula
U/W income	= EP – (current AY loss) – (change in prior years' AY loss) – LAE – (other U/W expense)   1 = EP – (current AY loss & LAE) – (change in prior years' AY loss & LAE) – (other U/W expense)   1a
net investment income ( same as: net investment income earned )	= (investment revenue) – (investment expenses) – (non-federal TLF)   2
net investment gain	= net investment income + (net realized capital gains) – taxes   2a
other income	= SUM(agents' balances charged off, service fees, aggregate write-ins)
TOTAL net income	= (U/W income) + (net investment income gain ) + (other income) – (dividends to policyholders) – (fed/foreign taxes incurred)  3

¹ SAP uses incurred expenses (not paid expenses because incurred is more accurate than paid)

→ Use version 1 of the U/W Income formula for E (2018.Spring #10a) because the LAE is given as a single number. (shout-out to jaarndt!)

^1a This version of the formula treats Loss and LAE the same way but the information must be provided in that format.

→ Use version 1a of the U/W Income formula for of E (2016.Spring #18b) because loss & LAE are given in the same format.

² Typo fixed Jan 28, 2023: investment revenue includes excludes realized capital gains AND excludes unrealized capital gains (shout-out to jaarndt!)

^2a by definition: (net investment income earned) is already net of expenses and in this problem also net of taxes

(there is a helpful forum discussion on the difference between "investment income earned" and "investment gain".)

³ If you look at the given information in the exam problem, all of the little items in the bottom box (below unrealized capital gains) are included in the income calculation except dividends to stockholders. Normally you would also have to subtract federal & foreign income taxes, but this is not provided in the given information.

Pop Quiz!    :-o

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

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

item	formula
EP	= WP – (change in UEP)

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

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

E (2017.Fall #9a)

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

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Surplus (2017.Fall #10)

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

Tips from BA user mec06e: The information provided in the next section on the problem from 2017.Fall #9 may be helpful in understanding this problem. mec06e also came up with useful a formula in this forum post. You have to scroll down to the 3rd post to find the formula. (shout-out to mec06e!)

E (2017.Fall #10)

And here are the practice problems. (Just like the exam problem but with different numbers!)

2 practice problems like 2017.Fall #10

The mini BattleQuiz has a practice template based on this problem. To summarize, if NI = Statutory Net Income then use this formula to calculate surplus:

(surplus) CY   =   (surplus) CY-1   +   (NI) CY   +   (direct charges to surplus) CY

Now, the prior year surplus, (surplus) _CY-1, is usually given. That means you have to calculate the other 2 terms in the formula:

• (NI) _CY: Use the formulas from the previous section.
• (direct charges to surplus) _CY: The items that are not part of (NI) _CY are direct charges. Here you calculate the change in value from CY-1 to CY. The catch is that you have to remember which changes are added (unrealized capital gains, deferred tax), and which are subtracted (provision for reinsurance, non-admitted assets).

Another problem that's similar is part (a) the following. It's also included in the mini BattleQuiz:

E (2016.Fall #14)

Yet another similar problem from 2019.Fall is given below but there are a couple of important differences. The hardest part of the problem is calculating surplus but what they ask for is the Total Assets. Once you have the surplus, all you have to do is rearrange the standard formula:

Surplus = Net Assets - Liabilities = (Total Assets – Nonadmitted Assets) - Liabilities      (shout-out to pete.a for pointing out a typo here!)

The other trick in this problem is inclusion of a line item for surplus notes. You must include the change in surplus notes when calculating surplus.

E (2019.Fall #12)

Now you're ready for the quiz...

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Statutory Income (2017.Fall #9)

Let's return now to another problem that asks you to calculate statutory net income:

E (2017.Fall #9)

It's quite different from the other problem on statutory net income and we need some extra facts. Note that according to the first page of Chapter 9 of Odomirok (Capital & Surplus Account) direct charges to surplus consists of 3 main items:

• other surplus changes (includes 6 separate items, 4 of which came up in the exam problem above.)
• additional capital contributions (includes change in surplus notes and change in gross paid-in & contributed surplus)
• stockholder dividends

The 6 items under other surplus changes are: (items in red are subtracted)

• changes in unrealized capital gains
• changes in unrealized foreign exchange
• changes in deferred income tax
• changes in nonadmitted assets
• changes in provision for reinsurance
• cumulative effect of changes in accounting principles

Pop Quiz!    :-o

• See if you can solve part (a) of the above exam problem with your current knowledge. (I'm assuming you've done the previous mini BattleQuizzes and are proficient with the practice templates that were covered there.) There is something you need to watch out for however:

Watch out!! Normally the change in a quantity is calculated as:         (current year value) – (prior year value) BUT for the 2 "other surplus items" in red above, the exam question lists the changes backwards as:         (prior year value) – (current year value).

• The reason for this madness is that if you look at the section for Capital & Surplus Account on the Income Statement, these sign reversals allow you to simply sum lines 22-37 to get the total change in surplus on line 38. Otherwise you'd have a more complicated formula for line 38 that would involve treating lines 27 & 28 differently by subtracting them instead of adding them. (line 27: nonadmitted assets, line 28: provision for reinsurance).

Here are 2 practice problems. (Just like the exam problem but with different numbers!)

2 practice problems like 2017.Fall #09

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Exam Problems

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