Insurer Financial Statements

1. Insurer Financial Statements Chapter 12 Welcome to the Property and Casualty course in the Belk College of Business. Today we will be discussing CHPT 12 Insurer Financial Statements in the 2nd edition of the AICPCU textbook titled Insurer Operations, Regulation and Statutory Accounting by Myhr and Markham. This lecture is intended to supplement CHPT 12 of the textbook, not replace it. Students are encouraged to read CHPT 12 in its entirety. Welcome to the Property and Casualty course in the Belk College of Business. Today we will be discussing CHPT 12 Insurer Financial Statements in the 2nd edition of the AICPCU textbook titled Insurer Operations, Regulation and Statutory Accounting by Myhr and Markham. This lecture is intended to supplement CHPT 12 of the textbook, not replace it. Students are encouraged to read CHPT 12 in its entirety.

2. Myhr and Markham, Insurer Operations, Regulation and Statutory Accounting, 2nd Edition, 2004, AICPCU Who Looks at Insurer�s Financial Statements? Company managers need information to plan, monitor and control operations. Earn a profit and maximize firm value. Assess performance for class of business and/or policy type. Reports for middle managers, and others to evaluate divisions, units, offices. Investors need information to assess the financial health of an insurer. Want satisfactory, competitive return on investment. Regulators assess insurer solvency to protect consumers. PHs, producers and risk managers need to know how stable insurers are. Rating services evaluate insurer�s ability to pay claims, grow, remain solvent. Who looks at an insurer�s financial statements? Corporate managers, regulators, policyholders, producers, investors and risk managers to name a few. Who looks at an insurer�s financial statements? Corporate managers, regulators, policyholders, producers, investors and risk managers to name a few.

3. Myhr and Markham, Insurer Operations, Regulation and Statutory Accounting, 2nd Edition, 2004, AICPCU Key Financial Statements Balance Sheet Income Statement However, components of these statements are different than for other firms. SAP � statutory accounting principles Specific to insurers GAAP � generally accepted accounting principles Two key financial statements that are very important to insurers are the Balance Sheet and the Income Statement. The Balance Sheet contains a list of an insurer�s assets and liabilities at a specific point in time. It is a snapshot in time of everything the insurer owns and everything the insurer owes. The Balance Sheet also shows the difference between the firm�s assets and liabilities. For most types of companies that use GAAP accounting the difference between assets and liabilities is called net worth. For insurers who file using SAP principles, the difference between assets and liabilities is called Surplus or the complete name is Surplus as Regards Policyholders. If net worth or surplus is negative, then the firm owes more than it owns and is most likely insolvent. A negative surplus is rarely, if ever, seen in insurance companies as regulators will step in and take over the company well before an insurer deteriorates to that point. The Income Statement provides the financial results of a firm over time such as a quarter or a year. It shows how profitable a firm has been during the time period it covers. Again, an insurer�s Income Statement produced using SAP will look somewhat different that another firm�s Income Statement that uses GAAP. Two key financial statements that are very important to insurers are the Balance Sheet and the Income Statement. The Balance Sheet contains a list of an insurer�s assets and liabilities at a specific point in time. It is a snapshot in time of everything the insurer owns and everything the insurer owes. The Balance Sheet also shows the difference between the firm�s assets and liabilities. For most types of companies that use GAAP accounting the difference between assets and liabilities is called net worth. For insurers who file using SAP principles, the difference between assets and liabilities is called Surplus or the complete name is Surplus as Regards Policyholders. If net worth or surplus is negative, then the firm owes more than it owns and is most likely insolvent. A negative surplus is rarely, if ever, seen in insurance companies as regulators will step in and take over the company well before an insurer deteriorates to that point. The Income Statement provides the financial results of a firm over time such as a quarter or a year. It shows how profitable a firm has been during the time period it covers. Again, an insurer�s Income Statement produced using SAP will look somewhat different that another firm�s Income Statement that uses GAAP.

4. Myhr and Markham, Insurer Operations, Regulation and Statutory Accounting, 2nd Edition, 2004, AICPCU Financial Statement Users Management � to assist in reaching primary goal of firm value maximization and secondary goal of earning a profit. Allows managers to evaluate performance, set new goals and objectives, restructure, or reformulate policies. Also gives specific details about performance of particular lines and classes of business Competitive prices? Cash being distributed effectively to highest performing lines? How are geographic areas performing? Provides specific information regarding the performance of departments, divisions, units, offices, etc� Investors � desire competitive return on investment By examining quarterly and annual reports they can decide if investment is still the �best� option for them. Returns must be competitive with other investments of similar risk and liquidity. Rating services � evaluate financial insurer financial strength for investors and policyholders. Interested in growth, solvency, claims paying ability and return to investors. Company managers use insurer financial statements to help them set goals and objectives, develop strategic plans, organize operations, allocate scarce resources and monitor their performance to make sure their goals and objectives are being met. The primary goal of most insurance companies is to maximize the value of the firm. To do this they must first earn a profit. Financial statements enable managers to evaluate how their actions are affecting the bottom line of a firm. Insurer financial statements also break down results by line of insurance such as homeowners, medical malpractice, commercial auto, etc� and also by state. With this more detailed information managers can analyze how specific lines of insurance are doing as well as how different geographic regions are performing. They can decide whether to increase growth in certain lines (the highest performing lines) or withdraw from a particular market if that market is performing poorly. They can also determine if they are taking in enough premiums to cover losses in a particular line. Managers can also obtain information from these reports to determine how specific departments, divisions, offices or other entities within the firm are performing. Investors use insurer financial statements to evaluate the performance of a particular insurer against their competitors. Investors want to obtain a competitive return on their investment and use financial statements to evaluate the return realized as well as the insurer�s future prospects. By examining an insurer�s financial statement the investor may decide that he or she could obtain a better return with another insurer. Rating services also use insurer financial statements to evaluate an insurer�s financial strength for investors, policyholders and others. Rating services typically evaluate an insurer�s solvency, ability to pay claims, return to investor�s and growth prospects. Company managers use insurer financial statements to help them set goals and objectives, develop strategic plans, organize operations, allocate scarce resources and monitor their performance to make sure their goals and objectives are being met. The primary goal of most insurance companies is to maximize the value of the firm. To do this they must first earn a profit. Financial statements enable managers to evaluate how their actions are affecting the bottom line of a firm. Insurer financial statements also break down results by line of insurance such as homeowners, medical malpractice, commercial auto, etc� and also by state. With this more detailed information managers can analyze how specific lines of insurance are doing as well as how different geographic regions are performing. They can decide whether to increase growth in certain lines (the highest performing lines) or withdraw from a particular market if that market is performing poorly. They can also determine if they are taking in enough premiums to cover losses in a particular line. Managers can also obtain information from these reports to determine how specific departments, divisions, offices or other entities within the firm are performing. Investors use insurer financial statements to evaluate the performance of a particular insurer against their competitors. Investors want to obtain a competitive return on their investment and use financial statements to evaluate the return realized as well as the insurer�s future prospects. By examining an insurer�s financial statement the investor may decide that he or she could obtain a better return with another insurer. Rating services also use insurer financial statements to evaluate an insurer�s financial strength for investors, policyholders and others. Rating services typically evaluate an insurer�s solvency, ability to pay claims, return to investor�s and growth prospects.

5. Myhr and Markham, Insurer Operations, Regulation and Statutory Accounting, 2nd Edition, 2004, AICPCU Financial Statement Users Regulators � state insurance regulators are concerned with insurer solvency and require insurers to meet many standards. Minimum start up capital and sufficient capital to continue after start up. Set restrictions on the amount of premiums an insurer can write based on its amount of capital. Premiums are earned over period of policy and not when received. Must set adequate reserves for incurred losses to pay claims. Regulators are primarily concerned with insurer solvency. In order to maintain a well-functioning insurance market, consumers must have the confidence that insurance companies will have the ability to pay claims when, and if, a claim occurs. Because premiums are paid for in advance for a loss that may, or may not, occur, policyholders are purchasing a �promise to pay� from insurers. Also, insurers invest premium dollars and are earning a return on premiums. Therefore, it is imperative that insurance companies are able to keep this promise when the need arises. In order to ensure insurer solvency, regulators require insurance companies to meet many standards. First, in order to insurance companies to begin operations they must have a minimum amount of start up capital. After start up, insurers must maintain a sufficient level of capital to continue operations. Second, regulators require that insurers hold a certain amount of surplus in proportion to the amount of premiums written. Although calculation of the required amount is complex, a general rule of thumb is that insurance companies must have $1 in surplus for every $3 in premiums written. Regulators also monitor financial statements to make sure that insurers are setting adequate reserves for incurred losses so that money will be there when needed to pay claims. So, not only do insurers have to set reserves for losses that are both known and reported, they also set reserves for losses that are expected but have not yet occurred or been reported. These reserve amounts are liabilities. The Balance Sheet calculates surplus as the difference in assets and liabilities. Therefore, although reserves are set aside for all known or expected losses, insurers must still carry adequate surplus as a �cushion� in the event of an unexpected claim or catastrophe. Regulators are primarily concerned with insurer solvency. In order to maintain a well-functioning insurance market, consumers must have the confidence that insurance companies will have the ability to pay claims when, and if, a claim occurs. Because premiums are paid for in advance for a loss that may, or may not, occur, policyholders are purchasing a �promise to pay� from insurers. Also, insurers invest premium dollars and are earning a return on premiums. Therefore, it is imperative that insurance companies are able to keep this promise when the need arises. In order to ensure insurer solvency, regulators require insurance companies to meet many standards. First, in order to insurance companies to begin operations they must have a minimum amount of start up capital. After start up, insurers must maintain a sufficient level of capital to continue operations. Second, regulators require that insurers hold a certain amount of surplus in proportion to the amount of premiums written. Although calculation of the required amount is complex, a general rule of thumb is that insurance companies must have $1 in surplus for every $3 in premiums written. Regulators also monitor financial statements to make sure that insurers are setting adequate reserves for incurred losses so that money will be there when needed to pay claims. So, not only do insurers have to set reserves for losses that are both known and reported, they also set reserves for losses that are expected but have not yet occurred or been reported. These reserve amounts are liabilities. The Balance Sheet calculates surplus as the difference in assets and liabilities. Therefore, although reserves are set aside for all known or expected losses, insurers must still carry adequate surplus as a �cushion� in the event of an unexpected claim or catastrophe.

6. Myhr and Markham, Insurer Operations, Regulation and Statutory Accounting, 2nd Edition, 2004, AICPCU Financial Statement Users NAIC Financial Statement � required by every state and prepared by insurers under special rules (SAP) developed by the NAIC. Balance sheet Income statement Cash flow statement Account of changes to surplus Many supporting schedules Other filings SEC � for insurers whose stock is publicly traded. Initial registration, 10K � annual statement filed within 90 days of end of fiscal year, 10-Q � filed quarterly and is unaudited. For these statements go to www.sec.gov/edgar IRS � federal income tax return Based on SAP with adjustments Insurers recognize expenses when incurred and premiums when earned. Losses are recognized when incurred and reserved but PV estimates are used. Net income and taxable income is reduced by recognizing expenses and losses incurred immediately. Insurance companies are required to file financial statements in every state that they do business. This is because insurance is still regulated by the states and some states do have different guidelines or regulations than others. The National Association of Insurance Commissioners (NAIC) has developed an annual statement called the NAIC Annual Statement, that all states accept. As a result, insurers can complete this one annual statement and submit it to all states. Because of the unique characteristics of the insurance contract (the promise to pay) insurers must use Statutory Accounting Principles (SAP) to prepare the annual statement. SAP is unique and only used by insurers. It imposes a higher level of fiscal care on insurers as well as enables insurers to report data that is specific to insurers such as reserves, surplus, unearned premiums, etc� that other firms do not have. Contained within the NAIC Annual Statement is the Balance Sheet, Income Statement, Cash Flow Statement, Account of Changes to Surplus and many different supporting schedules used to develop the main financial statements. Insurers that have publicly traded stock also have to file financial statements with the SEC. They use the same accounting as all other firms for this filing, GAAP. They have to file an annual statement and quarterly statements with the SEC. Insurers also have to file federal income tax returns just like all other firms. However, filings for their federal income tax is based on SAP accounting with some adjustments. For example, insurers are able to recognize expenses when incurred but do not recognize premiums until they are earned (versus when they are received.) Losses are also recognized when they are incurred and reserved however, since they claims may not be paid until some time in the future they must incorporate the time value of money and report the losses using present value estimates. Insurers are able to reduce net income an taxable income by recognizing expenses and losses immediately. Insurance companies are required to file financial statements in every state that they do business. This is because insurance is still regulated by the states and some states do have different guidelines or regulations than others. The National Association of Insurance Commissioners (NAIC) has developed an annual statement called the NAIC Annual Statement, that all states accept. As a result, insurers can complete this one annual statement and submit it to all states. Because of the unique characteristics of the insurance contract (the promise to pay) insurers must use Statutory Accounting Principles (SAP) to prepare the annual statement. SAP is unique and only used by insurers. It imposes a higher level of fiscal care on insurers as well as enables insurers to report data that is specific to insurers such as reserves, surplus, unearned premiums, etc� that other firms do not have. Contained within the NAIC Annual Statement is the Balance Sheet, Income Statement, Cash Flow Statement, Account of Changes to Surplus and many different supporting schedules used to develop the main financial statements. Insurers that have publicly traded stock also have to file financial statements with the SEC. They use the same accounting as all other firms for this filing, GAAP. They have to file an annual statement and quarterly statements with the SEC. Insurers also have to file federal income tax returns just like all other firms. However, filings for their federal income tax is based on SAP accounting with some adjustments. For example, insurers are able to recognize expenses when incurred but do not recognize premiums until they are earned (versus when they are received.) Losses are also recognized when they are incurred and reserved however, since they claims may not be paid until some time in the future they must incorporate the time value of money and report the losses using present value estimates. Insurers are able to reduce net income an taxable income by recognizing expenses and losses immediately.

7. Myhr and Markham, Insurer Operations, Regulation and Statutory Accounting, 2nd Edition, 2004, AICPCU Financial Statement Users Policyholders, Producers, and Risk Managers Policyholders need to be sure that claims will be paid even if filed far after policy expires. Producers must be assured of financial strength of company since may be liable for E&O if they should have known of any solvency issues. Risk managers are concerned due to high exposure of very large losses that may take years to develop. Must be sure insurer is financially stable now and in the future. Must also be aware of reinsurer�s solvency since large firms may have high attachment points and reinsurers are more vulnerable to rate inadequacy. Policyholders, producers and risk managers all have reason to examine insurer financial statements. However, policyholders, even very educated policyholders rarely look at or have the expertise to examine insurer financial statements. Fortunately, with insurance regulators and producers constantly evaluating insurer solvency, policyholders can feel relatively comfortable about most insurers� solvency. Producers are very concerned about insurer solvency because if they sell a policy to a consumer from an insurance company that they knew, or should have known, was having financial difficulties, they can be held liable for that error or omission. Most agents do purchase Errors & Omissions (E&O) insurance coverage to protect them in event this type of claim occurs. Risk managers are very sophisticated insurance consumers and highly educated. Because they oversee what can be very complex insurance programs they must make sure that insurers that they are purchasing coverage from remain solvent. There are several reasons why risk managers are very concerned about insurer solvency. First, they may have complex programs that include high retention levels. Once that retention level has been reached and the attachment point (the level where the insurance coverage begins) is reached then it is very important for the insurer to actually have the money available to pay claims. The financial solvency of the risk manager�s company may well depend on the financial solvency of their insurance company or companies in the event of a very large claim or claims. Second, the larger losses that firms can be exposed to usually take a long amount of time to develop. Therefore, it is imperative that once the claim has been settled or a judgment rendered, even if it is several years after the policy has expired, the insurance company is still in a financial position to pay for the part of the claim that they owe. Third, usually several insurers will be involved in a risk management program. Risk managers must regularly assess the financial strength of all insurers that they do business with. Lastly, many times reinsurers are involved especially when very high attachment points are involved. As we have previously discussed, reinsurers are not strictly regulated. Therefore, it is up to the risk manager to monitor the solvency of any reinsurers and the primary insurers that may be ceding business to the reinsurers. As we discussed previously, very often the policyholder is not aware of the reinsurers involvement. Financial stability of the primary insurer provides protection in the event the reinsurer becomes insolvent. Policyholders, producers and risk managers all have reason to examine insurer financial statements. However, policyholders, even very educated policyholders rarely look at or have the expertise to examine insurer financial statements. Fortunately, with insurance regulators and producers constantly evaluating insurer solvency, policyholders can feel relatively comfortable about most insurers� solvency. Producers are very concerned about insurer solvency because if they sell a policy to a consumer from an insurance company that they knew, or should have known, was having financial difficulties, they can be held liable for that error or omission. Most agents do purchase Errors & Omissions (E&O) insurance coverage to protect them in event this type of claim occurs. Risk managers are very sophisticated insurance consumers and highly educated. Because they oversee what can be very complex insurance programs they must make sure that insurers that they are purchasing coverage from remain solvent. There are several reasons why risk managers are very concerned about insurer solvency. First, they may have complex programs that include high retention levels. Once that retention level has been reached and the attachment point (the level where the insurance coverage begins) is reached then it is very important for the insurer to actually have the money available to pay claims. The financial solvency of the risk manager�s company may well depend on the financial solvency of their insurance company or companies in the event of a very large claim or claims. Second, the larger losses that firms can be exposed to usually take a long amount of time to develop. Therefore, it is imperative that once the claim has been settled or a judgment rendered, even if it is several years after the policy has expired, the insurance company is still in a financial position to pay for the part of the claim that they owe. Third, usually several insurers will be involved in a risk management program. Risk managers must regularly assess the financial strength of all insurers that they do business with. Lastly, many times reinsurers are involved especially when very high attachment points are involved. As we have previously discussed, reinsurers are not strictly regulated. Therefore, it is up to the risk manager to monitor the solvency of any reinsurers and the primary insurers that may be ceding business to the reinsurers. As we discussed previously, very often the policyholder is not aware of the reinsurers involvement. Financial stability of the primary insurer provides protection in the event the reinsurer becomes insolvent.

8. Myhr and Markham, Insurer Operations, Regulation and Statutory Accounting, 2nd Edition, 2004, AICPCU Insurer Financial Statements Two key statements; balance sheet and income statement. Balance sheet is a listing of assets (property that insurer owns) and liabilities (what insurer owes others) at a point in time. Insurance companies list different elements in this report than most other companies. Policyholders� surplus = assets � liabilities PHS is first to pay claims before insurer can use any for growth or investment projects. If negative, then insurer owes more than it owns. Most likely insolvent. If positive, then insurer owns more than it owes. Insurer assets � most are intangible with bonds being the largest class of insurer assets. Bonds � issued by insurers to raise capital. Insurers make regular interest payments to the bondholder and then the face amount at maturity. Stocks, cash (and equivalents), receivables � most important being premium balances owed by agents, reinsurance recoverables � funds due from reinsurers or affiliated companies. Buildings, equipment, office furnishings. Two key insurer financial statements are the Balance Sheet and the Income Statement. As we have previously discussed, the balance sheet is a snapshot in time of everything a firm owns or owes. An income statement illustrates the financial operations (or profitability) of a firm over a period of time, usually a quarter or a year. The balance sheet lists a firms assets and liabilities with the resulting surplus. The assets of an insurance company typically consist of buildings, equipment and inventory. However, the majority of insurer assets are intangible with the largest class of insurer assets being bonds. Insurers prefer to use bonds because they are typically a very stable investment with a reasonably predictable income stream. Insurers prefer this predictability because it enables them to earn a stable investment income that facilitates payment of future losses. Stocks, cash and cash equivalents (money market funds and instruments) also comprise a large part in of insurer assets. Insurers also have a class of assets called receivables that are very important. The most important receivables are �premium balances� which are balances owed to the insurer by the insurance agents and are the result of agents receiving premium payments but not yet transferring them to the insurance company. Another type of receivable is �reinsurance recoverables�. This is money that a reinsurer owed to the primary insurance company as a result of claims paid that fall under a reinsurance contract. Two key insurer financial statements are the Balance Sheet and the Income Statement. As we have previously discussed, the balance sheet is a snapshot in time of everything a firm owns or owes. An income statement illustrates the financial operations (or profitability) of a firm over a period of time, usually a quarter or a year. The balance sheet lists a firms assets and liabilities with the resulting surplus. The assets of an insurance company typically consist of buildings, equipment and inventory. However, the majority of insurer assets are intangible with the largest class of insurer assets being bonds. Insurers prefer to use bonds because they are typically a very stable investment with a reasonably predictable income stream. Insurers prefer this predictability because it enables them to earn a stable investment income that facilitates payment of future losses. Stocks, cash and cash equivalents (money market funds and instruments) also comprise a large part in of insurer assets. Insurers also have a class of assets called receivables that are very important. The most important receivables are �premium balances� which are balances owed to the insurer by the insurance agents and are the result of agents receiving premium payments but not yet transferring them to the insurance company. Another type of receivable is �reinsurance recoverables�. This is money that a reinsurer owed to the primary insurance company as a result of claims paid that fall under a reinsurance contract.

9. Myhr and Markham, Insurer Operations, Regulation and Statutory Accounting, 2nd Edition, 2004, AICPCU Insurer Financial Statements Insurer Liabilities Two main liabilities (and are specific to insurers are loss reserves and unearned premiums. Loss reserves � losses that have occurred but not yet been paid. Loss adjustment expense reserves � costs to handle claim that have occurred but not yet been paid. These two reserves are estimates, can be inaccurate and directly affect PHS because balance sheet must always balance. If reserves too low then PHS will be stated too high. PHS is very important because it directly affects the financial strength and solvency of an insurer. Unearned premium reserve � premiums that have been received but not yet earned by insurer. May receive entire premium (or portion) at beginning of policy period but premiums are earned proportionately throughout the period. The two most important liabilities that an insurance company has are loss reserves and unearned premiums. Loss reserves are reserves for losses that have occurred but not yet been paid. These reserves are necessary because there is almost always a delay between the time a claim has occured and a claim is paid. These delays can be a result of several factors. First, there may be a delay between the time a claim occurs and it is reported. Second, after a claim is reported it must be investigated and negotiated. Third, if there are any disputes regarding coverage, liability or damages, the claim may go to trial which can make the delay between occurrence and settlement much longer. Some claims have a very short time between occurrence and settlement. For example, auto physical damage claims are usually settled fairly quickly for several reasons. The damage is very easy to evaluate and claimants are motivated to get their vehicles repaired as quickly as possible. Some claims generally take a very long time from occurrence to settlement and typically involve third party claims such as liability claims. In these cases, extensive investigation must be performed and damages may be hard to evaluate. Also, they are generally more likely to be more difficult to negotiate and have a higher probability of ending up in court. Some of these claims may take several years to resolve. Loss adjustment expense reserves are also an important liability. These are reserves for incurred or expected costs to handle claims. They may include defense and court costs, appraisal fees, independent consultants, charges for police reports, fire department reports, medical records, an independent medical exam, etc� The other main liability that an insured has is unearned premium reserves. This is the amount of premium that an insured has received from a policyholder but has not yet earned. Since policyholders pay premiums before the period they are covered, insurers have received money for services that have not yet been received. As a result, insurers earn premiums proportionately throughout the policy period. Once a certain portion of premiums has been earned then it is moved to the earned premiums account. At the end of the policy period, all premiums will be earned and unearned premiums should equal zero. The two most important liabilities that an insurance company has are loss reserves and unearned premiums. Loss reserves are reserves for losses that have occurred but not yet been paid. These reserves are necessary because there is almost always a delay between the time a claim has occured and a claim is paid. These delays can be a result of several factors. First, there may be a delay between the time a claim occurs and it is reported. Second, after a claim is reported it must be investigated and negotiated. Third, if there are any disputes regarding coverage, liability or damages, the claim may go to trial which can make the delay between occurrence and settlement much longer. Some claims have a very short time between occurrence and settlement. For example, auto physical damage claims are usually settled fairly quickly for several reasons. The damage is very easy to evaluate and claimants are motivated to get their vehicles repaired as quickly as possible. Some claims generally take a very long time from occurrence to settlement and typically involve third party claims such as liability claims. In these cases, extensive investigation must be performed and damages may be hard to evaluate. Also, they are generally more likely to be more difficult to negotiate and have a higher probability of ending up in court. Some of these claims may take several years to resolve. Loss adjustment expense reserves are also an important liability. These are reserves for incurred or expected costs to handle claims. They may include defense and court costs, appraisal fees, independent consultants, charges for police reports, fire department reports, medical records, an independent medical exam, etc� The other main liability that an insured has is unearned premium reserves. This is the amount of premium that an insured has received from a policyholder but has not yet earned. Since policyholders pay premiums before the period they are covered, insurers have received money for services that have not yet been received. As a result, insurers earn premiums proportionately throughout the policy period. Once a certain portion of premiums has been earned then it is moved to the earned premiums account. At the end of the policy period, all premiums will be earned and unearned premiums should equal zero.

10. Myhr and Markham, Insurer Operations, Regulation and Statutory Accounting, 2nd Edition, 2004, AICPCU Principal Balance Sheet Elements Assets Bonds Stocks Cash Premium balances Reinsurance recov Liabilities Losses Loss Adj Expenses Unearned Premiums PH Surplus This slide shows the main data elements in an insurance company�s Balance Sheet. On the left side of the balance sheet are the assets which include bonds, stocks, cash (and its equivalent), premium balances due from agents and reinsurance recoverables due from reinsurers. On the right side of the balance sheet are the liabilities including loss reserves, loss adjustment expenses reserves and unearned premiums. The difference between assets and liabilities is policyholder surplus. Please note that policyholder surplus may also be referred to as �surplus as regards policyholders: and also simply, �surplus�. Take a minute to look at how the balance sheet is laid out and how errors, particularly in reserves, can affect policyholder surplus. Reserves consist of estimates based on actual documentation received and also estimates of losses where documentation has not yet been received. Therefore, both loss and loss adjustment expense reserves can contain large errors either underestimating the amount of the actual claim or overestimating the value of the claim. Either way, policyholder surplus is affected and not always in a positive way. If loss reserves are too low, then surplus is too high and insurers may be writing more premiums than they should be based on what the amount of surplus actually is. As losses develop the ratio of premiums to surplus becomes too low attracting the attention of regulators and exposing the insurance company to financial weakness. If the reserves are overestimated, or too high, then the insurance company actually has more surplus than they realize and could be writing more premiums than they are. As a result, they may decline writing business that they could have underwritten and lost that opportunity forever. This slide shows the main data elements in an insurance company�s Balance Sheet. On the left side of the balance sheet are the assets which include bonds, stocks, cash (and its equivalent), premium balances due from agents and reinsurance recoverables due from reinsurers. On the right side of the balance sheet are the liabilities including loss reserves, loss adjustment expenses reserves and unearned premiums. The difference between assets and liabilities is policyholder surplus. Please note that policyholder surplus may also be referred to as �surplus as regards policyholders: and also simply, �surplus�. Take a minute to look at how the balance sheet is laid out and how errors, particularly in reserves, can affect policyholder surplus. Reserves consist of estimates based on actual documentation received and also estimates of losses where documentation has not yet been received. Therefore, both loss and loss adjustment expense reserves can contain large errors either underestimating the amount of the actual claim or overestimating the value of the claim. Either way, policyholder surplus is affected and not always in a positive way. If loss reserves are too low, then surplus is too high and insurers may be writing more premiums than they should be based on what the amount of surplus actually is. As losses develop the ratio of premiums to surplus becomes too low attracting the attention of regulators and exposing the insurance company to financial weakness. If the reserves are overestimated, or too high, then the insurance company actually has more surplus than they realize and could be writing more premiums than they are. As a result, they may decline writing business that they could have underwritten and lost that opportunity forever.

11. Myhr and Markham, Insurer Operations, Regulation and Statutory Accounting, 2nd Edition, 2004, AICPCU Income Statement Financial results over a period of time, one year or quarter. Reports gains or losses from asset activity. Measures profitability of a firm that occurs when revenues are greater than expenses. Net income = revenues - expenses The income statement shows financial results over a period of time usually a quarter or a year. It also shows gains and losses from activities such as the sale of assets. The income statement shows how profitable (or not) a company has been during the time period covered. For most firms, the income statement shows the revenues and expenses of a firm. The difference between these is the net income (or profit). An income statement for an insurance company is very similar but includes data elements unique in the insurance industry. The income statement shows financial results over a period of time usually a quarter or a year. It also shows gains and losses from activities such as the sale of assets. The income statement shows how profitable (or not) a company has been during the time period covered. For most firms, the income statement shows the revenues and expenses of a firm. The difference between these is the net income (or profit). An income statement for an insurance company is very similar but includes data elements unique in the insurance industry.

12. Myhr and Markham, Insurer Operations, Regulation and Statutory Accounting, 2nd Edition, 2004, AICPCU Main Elements of Income Statement Earned Premium - Losses Incurred - Loss Adj Exp Incurred - Othr UW Expenses Net UW Gain(Loss) + Investment Income + Net Real Cap Gains(Loss) Net Income (B4 div&tax) The general form of an income statement is premiums minus losses minus operating expenses = net income from operations. In the case of insurance companies their revenue consists of earned premiums. Earned premiums are calculated as unearned premiums at the beginning of the year plus net premiums written during the year minus unearned premiums still on the books at the end of the year. Losses incurred and LAE Incurred are calculated the same way. Underwriting expense are also deducted from revenues (earned premiums) and consist of sales commissions to agents, employee compensation including wages and benefits, advertising costs, mortgage and or rent, etc� Summing all of these elements produces the net underwriting gain or loss. The majority of the time insurance companies show a net underwriting loss. Then the insurer adds in investment income and capital gains (losses) to calculate the insurer�s net income before dividends and taxes. The general form of an income statement is premiums minus losses minus operating expenses = net income from operations. In the case of insurance companies their revenue consists of earned premiums. Earned premiums are calculated as unearned premiums at the beginning of the year plus net premiums written during the year minus unearned premiums still on the books at the end of the year. Losses incurred and LAE Incurred are calculated the same way. Underwriting expense are also deducted from revenues (earned premiums) and consist of sales commissions to agents, employee compensation including wages and benefits, advertising costs, mortgage and or rent, etc� Summing all of these elements produces the net underwriting gain or loss. The majority of the time insurance companies show a net underwriting loss. Then the insurer adds in investment income and capital gains (losses) to calculate the insurer�s net income before dividends and taxes.

13. Myhr and Markham, Insurer Operations, Regulation and Statutory Accounting, 2nd Edition, 2004, AICPCU Statutory Accounting Used in the annual statement that is submitted to state insurance departments. �the principles and practices prescribed or permitted by an insurer�s domiciliary state.� State law prevails though NAIC has developed standards for reporting that most states follow. If insurer�s statement differs from the NAIC standards due to state law then the insurer must disclose How it differs and its effect on net income and surplus. Insurers file statements in the state they are domiciled and in each state they do business. Can file with NAIC to meet �each state� filing. also must file supplements as demanded by each state. Due to unique characteristics of insurance companies they must use a special accounting system, called Statutory Accounting Principles (SAP) for their annual reports. Each state regulates insurance within their state. Therefore, insurers must submit their annual financial statement to each state that they are doing business in. Fortunately, the NAIC has worked hard to standardize SAP and the annual statement. As a result, all states accept the NAIC Annual Statement. This is important because if the formats were not standardized then insurers would have to complete annual reports for each state in accordance with each state�s guidelines. Now, they complete the NAIC Annual Statement and it is accepted by all states. They must file one statement in the state in which they are domiciled and can either file statements in each state they are also doing business or can file the statement with the NAIC who then makes it available to all states. Due to unique characteristics of insurance companies they must use a special accounting system, called Statutory Accounting Principles (SAP) for their annual reports. Each state regulates insurance within their state. Therefore, insurers must submit their annual financial statement to each state that they are doing business in. Fortunately, the NAIC has worked hard to standardize SAP and the annual statement. As a result, all states accept the NAIC Annual Statement. This is important because if the formats were not standardized then insurers would have to complete annual reports for each state in accordance with each state�s guidelines. Now, they complete the NAIC Annual Statement and it is accepted by all states. They must file one statement in the state in which they are domiciled and can either file statements in each state they are also doing business or can file the statement with the NAIC who then makes it available to all states.

14. Myhr and Markham, Insurer Operations, Regulation and Statutory Accounting, 2nd Edition, 2004, AICPCU Annual Statement http://www.naic.org/documents/store_idp_deguide_PropertyAnnual.pdf Title page and Jurat Assets Liabilities, Surplus and Other Funds Underwriting and Investment Exhibit Statement of Income Underwriting Income Investment Income Other Income Capital and Surplus Account Cash Flow Cash from Operations Cash from Investments Cash from Financing and Miscellaneous Sources Reconciliation of Cash and Short-Term Investments Underwriting and Investment Exhibit Part 1 � Premiums Earned, Part 1A � Recapitulation of All Premiums, Part 2 � Losses Paid and Incurred, Part 2A � Unpaid losses and LAE, Part 3 � Expenses. General Interrogatories Five-Year Historical Data Schedules A - Real Estate, B � Mortgage Loans, BA � Other Long-Term Invested Assets, D � Bonds and Stocks, DA � Short-Term Investments, DB � Derivative Investments, E � Cash and Special Deposits, F � Reinsurance, P � Analysis of Losses and Loss Expenses This slide outlines the general organization of the annual statement. The �Title Page and Jurat� identifies the legal name of the insurance company, their NAIC company code, a contact name and number, the address, a list of the Board of Directors and other demographic information. This page has to be reviewed, confirmed and signed by the company president, secretary and treasurer. The following two pages showing the assets and liabilities are the main part of the annual statement. The income statement cover half a page and is contained in the �Underwriting and Investment Exhibit�. Obviously the NAIC places greater importance on the Balance Sheet since it indicates the degree of insurer solvency. To take a look at a blank NAIC Annual Statement click on the link provided in the title of this slide. Keep in mind that the statement is very long and will take a few minutes to download. However, I encourage you to look through it to gain a better understanding of insurer financial statements. You need to pay particular attention to the first few pages in the statement as they are the most important and summarize the data found in subsequent pages. The Five-Year Historical Data page is of interest because it provides 5 year results for the most important data elements. This slide outlines the general organization of the annual statement. The �Title Page and Jurat� identifies the legal name of the insurance company, their NAIC company code, a contact name and number, the address, a list of the Board of Directors and other demographic information. This page has to be reviewed, confirmed and signed by the company president, secretary and treasurer. The following two pages showing the assets and liabilities are the main part of the annual statement. The income statement cover half a page and is contained in the �Underwriting and Investment Exhibit�. Obviously the NAIC places greater importance on the Balance Sheet since it indicates the degree of insurer solvency. To take a look at a blank NAIC Annual Statement click on the link provided in the title of this slide. Keep in mind that the statement is very long and will take a few minutes to download. However, I encourage you to look through it to gain a better understanding of insurer financial statements. You need to pay particular attention to the first few pages in the statement as they are the most important and summarize the data found in subsequent pages. The Five-Year Historical Data page is of interest because it provides 5 year results for the most important data elements.

15. Myhr and Markham, Insurer Operations, Regulation and Statutory Accounting, 2nd Edition, 2004, AICPCU Balance Sheet Various items come from supporting documents. Mortgage loans on real estate come from SCH A. Cash comes from SCH E. Other invested assets from SCH DA Reinsurance recoverables from SCH F SCH D � key invested assets; bonds, preferred stock, common stock. Lists country, quality ratings and maturity. SCH F � lists insurer�s reinsurance arrangements and can have large impact on insurer financial strength. Reinsurance recoverables � amt owed to insurer for losses and LAE from reinsurance contract. Unauthorized reinsurance � with reinsurers that are not licensed or authorized in the primary insurer�s domicile state. Note that almost all elements of the Balance Sheet are taken from supporting documentation that are found later in the Annual Statement. Mortgage loans on real estate come from Schedule A. Cash figures come from Schedule E. Schedule DA provides other invested assets and the amount of reinsurance recoverables can be obtained from Schedule F. Schedule D lists key invested assets such as bonds and common and preferred stock. Schedule F also list the insurer�s reinsurance arrangements and can have a large impact on the financial strength of an insurer. Note that almost all elements of the Balance Sheet are taken from supporting documentation that are found later in the Annual Statement. Mortgage loans on real estate come from Schedule A. Cash figures come from Schedule E. Schedule DA provides other invested assets and the amount of reinsurance recoverables can be obtained from Schedule F. Schedule D lists key invested assets such as bonds and common and preferred stock. Schedule F also list the insurer�s reinsurance arrangements and can have a large impact on the financial strength of an insurer.

16. Myhr and Markham, Insurer Operations, Regulation and Statutory Accounting, 2nd Edition, 2004, AICPCU Income Statement Very similar to previous slide on income statement. Other income � gains or losses from charge-offs of agents� balances, finance charges, other misc income. Dividends to policyholders and taxes are deducted. SCH P � more than 50 pages in the annual statement. Analysis of Losses and Loss Expenses. Provides info to analyze loss reserve and incurred loss development. Compares a given year�s earned premiums with incurred losses. The Income Statement in the Annual Statement is brief consisting of only a half a page. It does contain a few additional elements that we did not discuss earlier in the presentation. The data needed for the Statement of Income is taken from several different statements or parts. Premiums Earned come from Part 1; Losses Incurred from Part 2 and LAE Incurred from Part 3 of the Annual Statement. Investment income consists of income from dividends, interest and real estate. �Other Income� consists of gains or losses from charge-offs of agents� balances, finance charges and other miscellaneous income. Taxes and dividends to policyholders are also deducted in this section to compute net income. Schedule P reports the losses and loss expenses that a company has and takes up more than 50 pages of the annual statement. The most important function of Schedule P is to allow the insurer and others to analyze loss reserve and incurred loss development. It allows insurers to analyze and make �adjustments� to their reserves and allows others to look at historical data and assess how well the insurer estimated losses over the past 10 years. Schedule P allows others to determine if an insurer�s reserves are accurate or if they have been consistently under- or over- reserving claims with the result of consistently over- or under- stating surplus, respectively. Mis-estimation of reserves can be a serious problem because loss reserves comprise a very large part of the balance sheet and is the element that contains the most uncertainty. Insurance companies must also file supplements with the NAIC and state insurance departments. They must file the Insurance Expense Exhibit that contains more specific detail regarding expenses for each type of insurance. This allows an analysis of how profitable (or not) each type of insurance is. Insurers also must file a �Management Discussion and Analysis.� This is a narrative by the company manager reporting on operations and material changes in financial reports, trends and events that have impacted the firm. This statement includes discussions on changes in the insurer�s business or investments mix, changes in the liquidity of its investments, the status of loss reserves, the status of reinsurance recoverables, and any other event that had a material impact on the firm and is not addressed anywhere else. This would be where the manager would discuss the impact Katrina on operations or the impact of any other catastrophe that materially affected the firm including large lawsuits including D&O and employment practices liability suits. Insurers also must file a �Statement of Actuarial Opinion.� In this statement, the representative company actuary must express their opinion regarding the quality and accuracy of the loss and LAE reserves. They also discuss the actuarial methods used as well as the assumptions they use to develop the reserves. They also must render an opinion as to whether the reserves meet state laws, if the methods used to develop the reserves are acceptable and their opinion as to whether the insurer has the capacity to pay all outstanding losses and LAE. The Income Statement in the Annual Statement is brief consisting of only a half a page. It does contain a few additional elements that we did not discuss earlier in the presentation. The data needed for the Statement of Income is taken from several different statements or parts. Premiums Earned come from Part 1; Losses Incurred from Part 2 and LAE Incurred from Part 3 of the Annual Statement. Investment income consists of income from dividends, interest and real estate. �Other Income� consists of gains or losses from charge-offs of agents� balances, finance charges and other miscellaneous income. Taxes and dividends to policyholders are also deducted in this section to compute net income. Schedule P reports the losses and loss expenses that a company has and takes up more than 50 pages of the annual statement. The most important function of Schedule P is to allow the insurer and others to analyze loss reserve and incurred loss development. It allows insurers to analyze and make �adjustments� to their reserves and allows others to look at historical data and assess how well the insurer estimated losses over the past 10 years. Schedule P allows others to determine if an insurer�s reserves are accurate or if they have been consistently under- or over- reserving claims with the result of consistently over- or under- stating surplus, respectively. Mis-estimation of reserves can be a serious problem because loss reserves comprise a very large part of the balance sheet and is the element that contains the most uncertainty. Insurance companies must also file supplements with the NAIC and state insurance departments. They must file the Insurance Expense Exhibit that contains more specific detail regarding expenses for each type of insurance. This allows an analysis of how profitable (or not) each type of insurance is. Insurers also must file a �Management Discussion and Analysis.� This is a narrative by the company manager reporting on operations and material changes in financial reports, trends and events that have impacted the firm. This statement includes discussions on changes in the insurer�s business or investments mix, changes in the liquidity of its investments, the status of loss reserves, the status of reinsurance recoverables, and any other event that had a material impact on the firm and is not addressed anywhere else. This would be where the manager would discuss the impact Katrina on operations or the impact of any other catastrophe that materially affected the firm including large lawsuits including D&O and employment practices liability suits. Insurers also must file a �Statement of Actuarial Opinion.� In this statement, the representative company actuary must express their opinion regarding the quality and accuracy of the loss and LAE reserves. They also discuss the actuarial methods used as well as the assumptions they use to develop the reserves. They also must render an opinion as to whether the reserves meet state laws, if the methods used to develop the reserves are acceptable and their opinion as to whether the insurer has the capacity to pay all outstanding losses and LAE.

17. SAP vs. GAAP Chapter 12.30 There are several important differences between SAP and GAAP accounting principles. SAP meets a specific regulatory purpose and that is to measure the liquidity of a firm in order to assess the financial solvency of an insurer. GAAP is primarily concerned with measuring earnings. There are several important differences between SAP and GAAP accounting principles. SAP meets a specific regulatory purpose and that is to measure the liquidity of a firm in order to assess the financial solvency of an insurer. GAAP is primarily concerned with measuring earnings.

18. Myhr and Markham, Insurer Operations, Regulation and Statutory Accounting, 2nd Edition, 2004, AICPCU SAP vs. GAAP � 6 differences GAAP rules are made by the Financial Standards Accounting Board and used by most businesses. Insurer SEC filings must use GAAP 1 - Have different objectives: GAAP is targeted to all users of financial statements and measures emerging earnings. Focus: correctly measuring earnings SAP is targeted to regulators and measures the ability to pay future claims. Focus: correctly measuring liquidity. Today�s assets should be able to meet all claims. SAP began with GAAP rules and then made appropriate changes to the rules. There are 6 differences between SAP and GAAP. Again, GAAP is concerned with measuring earnings and SAP is concerned with measuring liquidity. There are 6 differences between SAP and GAAP. Again, GAAP is concerned with measuring earnings and SAP is concerned with measuring liquidity.

19. Myhr and Markham, Insurer Operations, Regulation and Statutory Accounting, 2nd Edition, 2004, AICPCU Assets Treatment 2 - Main difference between SAP and GAAP is the treatment of assets. Some assets are given no value in SAP � nonadmitted assets. Cannot be used to pay claims Poor liquidity, encumbered, partial ownership by third party. Charged against surplus �when acquired or when availability becomes questionable.� Furniture, fixtures, leasehold improvements, office equipment, vehicles, unsecured loans, cash advances, prepaid expenses, agents� balances and premium balances > 90 days past due and bills receivable that are past due EDP equipment and software are admitted assets but restricted to 3% of capital and surplus. Admitted assets � those assets that are liquid enough to help meet insurer obligations. The second difference between SAP and GAAP concerns the treatment of certain types of assets. Since SAP is concerned with the liquidity of a firm and the ability of a firm to liquidate assets to pay claims, there are some assets that are �nonadmitted� in SAP and given no value as assets. Almost all of an insurer�s tangible assets are considered nonadmitted and given no value under SAP accounting. These assets cannot be readily liquidated to pay claims and consist of such items as furniture, fixtures, office equipment and vehicles. Unsecured loans and cash advances are also considered nonadmitted assets. Certain receivables such s agents balances and premium balances over 90 days past due are also considered nonadmitted assets because the longer these amounts are overdue, the less chance that the insurer will actually receive these amounts. Reinsurance recoverables from an unauthorized reinsurer are considered nonadmitted assets as are reinsurance recoverables that deemed uncollectible or unsecured. Other reinsurance recoverables are admitted assets. The second difference between SAP and GAAP concerns the treatment of certain types of assets. Since SAP is concerned with the liquidity of a firm and the ability of a firm to liquidate assets to pay claims, there are some assets that are �nonadmitted� in SAP and given no value as assets. Almost all of an insurer�s tangible assets are considered nonadmitted and given no value under SAP accounting. These assets cannot be readily liquidated to pay claims and consist of such items as furniture, fixtures, office equipment and vehicles. Unsecured loans and cash advances are also considered nonadmitted assets. Certain receivables such s agents balances and premium balances over 90 days past due are also considered nonadmitted assets because the longer these amounts are overdue, the less chance that the insurer will actually receive these amounts. Reinsurance recoverables from an unauthorized reinsurer are considered nonadmitted assets as are reinsurance recoverables that deemed uncollectible or unsecured. Other reinsurance recoverables are admitted assets.

20. Myhr and Markham, Insurer Operations, Regulation and Statutory Accounting, 2nd Edition, 2004, AICPCU SAP vs GAAP Differences 3 � policy acquisition costs and commissions are immediately written off as expenses when incurred. In contrast, premiums are earned over the policy period. Leads to decreases in surplus when writing new business and may have to purchase reinsurance to replenish surplus. 4 � valuation of bonds is at amortized amounts so that there is even depreciation and at maturity bond value = face amount. Exhibit 12-14, p. 12-33. GAAP reports bonds at market value. The third difference stems from how policy acquisition costs and agent commissions are handled under the two accounting systems. Under GAAP these expenses can be capitalized and amortized over the policy�s life. In contrast under SAP, these expenses are recognized immediately while the premiums are earned over a period of time. If an insurer is writing a large amount of new business then their surplus can be depleted. The insurer may have to purchase reinsurance to be able to continue to write new business. The fourth difference involves how bonds are treated. Under SAP the valuation of bonds is at amortized amounts. This leads to even depreciation and at maturity, the bond value is equal to the face (original) amount of the bond. Under GAAP bond values are usually reported at market value, unless an insurer intends on holding the bond until maturity. If they intend on holding the bond to maturity then they can amortize the bonds as in SAP. The third difference stems from how policy acquisition costs and agent commissions are handled under the two accounting systems. Under GAAP these expenses can be capitalized and amortized over the policy�s life. In contrast under SAP, these expenses are recognized immediately while the premiums are earned over a period of time. If an insurer is writing a large amount of new business then their surplus can be depleted. The insurer may have to purchase reinsurance to be able to continue to write new business. The fourth difference involves how bonds are treated. Under SAP the valuation of bonds is at amortized amounts. This leads to even depreciation and at maturity, the bond value is equal to the face (original) amount of the bond. Under GAAP bond values are usually reported at market value, unless an insurer intends on holding the bond until maturity. If they intend on holding the bond to maturity then they can amortize the bonds as in SAP.

21. Myhr and Markham, Insurer Operations, Regulation and Statutory Accounting, 2nd Edition, 2004, AICPCU SAP vs GAAP Differences 5 � subsidiaries, controlled or affiliated entities (SCAs) must be listed on parent�s balance sheet as admitted assets. Under certain circumstances SAP is used to evaluate these SCAs; for example, if SCA is an insurer or exists to hold assets for parent company. GAAP requires financial statements of majority-owned subsidiaries to be consolidated with parent�s. SAP does not allow consolidation 6 � Pensions � SAP considers retirees and fully vested employees. GAAP requires provisions for all employees, whether they are vested or non-vested. SAP does not recognize contributions for non-vested employees and they are not deductible under the income statement. These contributions are considered pre-paid expenses but they are classified as nonadmitted assets. GAAP recognizes expenses for all employees. The fifth difference is that subsidiaries, controlled or affiliated entities (SCAs) must be listed on the parent company�s balance sheet as admitted assets. Under certain circumstances SAP accounting is used to evaluate these SCAs for example, if the SCA is an insurer or if it exists to hold assets for the parent company. Also, GAAP requires that financial statements of majority-owned subsidiaries be consolidated with the parent company�s financial statement. SAP does not allow such consolidation. The sixth and final difference concerns how pensions are accounted for. SAP only considers fully vested employees and retirees. GAAP includes all employees in its accounting whether they are vested or not. This concludes the presentation on Insurer Financial Statements. Thank you!The fifth difference is that subsidiaries, controlled or affiliated entities (SCAs) must be listed on the parent company�s balance sheet as admitted assets. Under certain circumstances SAP accounting is used to evaluate these SCAs for example, if the SCA is an insurer or if it exists to hold assets for the parent company. Also, GAAP requires that financial statements of majority-owned subsidiaries be consolidated with the parent company�s financial statement. SAP does not allow such consolidation. The sixth and final difference concerns how pensions are accounted for. SAP only considers fully vested employees and retirees. GAAP includes all employees in its accounting whether they are vested or not. This concludes the presentation on Insurer Financial Statements. Thank you!