Insurance 3-Statement Modeling Questions Flashcards
How do you project the financial statements for an insurance company?
Start by projecting the company’s Direct Written Premiums – how much it is selling directly to customers. Then, project the company’s Assumed Premiums and Ceded Premiums and the percentages it is earning in all those categories to get its Net Earned Premiums.
Next, project the Claim and Claim Adjustment Expense Ratio, the commission rate, and the underwriting expenses as a percentage of the Net Written Premiums.
List the company’s Net Earned Premiums and its Interest and Investment Income for revenue on the Income Statement. You’ll need the Balance Sheet to get the full numbers for Interest and Investment Income. Expenses consist of Claims, Commissions, Underwriting Expenses, and Interest. Calculate Pre- Tax Income and Net Income the normal way.
The Balance Sheet flows in from the company’s revenue/expense recognition (the Reserves and corresponding items on the Assets side), and Cash and Equity flow in as they normally do. You might project Investments and Debt independently, or you might link them to Premiums.
The Cash Flow Statement works the same way: Start with Net Income, make non-cash adjustments, factor in Changes in Working Capital, and sum up each section of the CFS to calculate the Net Change in Cash at the bottom.
Finally, return to the Income Statement and link in Interest/Investment Income and Interest Expense, which you projected based on Balance Sheet numbers and separate assumptions.
How do you project an insurance company’s Written Premiums?
You normally assume growth rates in volume and rates. For example, you might assume that the company sells 10% more policies per year and raises its prices by 5% per year.
Those figures would result in a ~15% overall growth rate in Written Premiums.
Both components would be based on historical trends, the economy, what other insurance companies
are doing, and this company’s market share.
Direct Written Premiums tend to follow clear trends; Assumed and Ceded Written Premiums might be a bit more random because they depend on other companies.
How do you project the Loss & LAE Ratio (AKA the Claim and Claim Adjustment Ratio)?
Normally, you link the Loss & LAE Ratio for the next year to this ratio from this year and adjust it by the
Premium Growth Rate and “Loss Cost Trend,” which represents the growth rate in Losses:
Next Year’s Loss & LAE Ratio = Ratio This Year * (1 + Premium Growth Rate) / (1 + Loss Cost Trend)
So, if the Loss & LAE Ratio is 75% this year, the Premium Growth Rate is 3%, and the Loss Cost Trend is 2%, the Loss & LAE Ratio the next year would be 75% * (1.03) / (1.02) = 74%.
This calculation tells you whether the company’s revenue or expenses are increasing more quickly.
How do you project other key expenses in the model, such as the Commissions and Underwriting Expenses?
Both of these figures should be percentages of Net Written Premiums; the exact numbers vary by region and company, but they often add up to around 20-30% of NWP.
You could base the numbers on historical trends or take an average over a few years if there’s no clear
trend. You could also look at industry-wide percentages or figures from comparable companies.
How do you project the key Balance Sheet items for an insurance company?
First, on the Assets side:
- Cash: Flows in from the bottom of the Cash Flow Statement.
- Investments: This one flows in from Investment Purchases on the CFS; you might link it to historical spending, the company’s float, or the company’s Written Premiums. If the company is growing, it should be spending more on Investments.
- Ceded Unearned Premiums: This balance increases by the difference between Ceded Written Premiums and Ceded Earned Premiums each year.
- Reinsurance Recoverables: This item increases by the difference between Ceded Losses & LAE Incurred and Ceded Losses & LAE Paid in Cash each year.
- Deferred Acquisition Costs: This item increases by the difference between the Cash
Commission Expense and the Commission Expense Recognized each year.
On the L&E side of the Balance Sheet, Debt, Equity, and other items work in similar ways. The main items that are different include:
- Unearned Premium Reserve: This item increases by the difference between Gross Written Premiums and Gross Earned Premiums each year.
- Loss & LAE Reserve: This item increases by the difference between Losses & LAE Incurred and Losses & LAE Paid in Cash each year.
How do you project an insurance firm’s Interest and Investment Income and Gains / (Losses)?
First, you might assume that the Investment Assets grow based on the company’s cash flow available to purchase more Investments, or you might link the growth rates to the company’s Premium Growth Rates.
Then, you would assume an Interest Rate or Yield on each class of Investments, based on fixed rates or a spread against benchmark rates.
Then, you could multiply those and sum up everything.
Gains / (Losses) are trickier to project because you don’t know how the values of stocks, bonds, and other investments will change each year, but you might use historical averages or make them simple percentages of the book values of Investments.
