Study 7 - Financial Evaluation Skills

Question 1

Important to make sure the risk has the financial resources to perform normal business tasks as the following:

Answer 1

• Maintaining and improving equipment and premises
• Implementing loss-control measures
• Providing a quality product or service
• Attracting and retaining quality people

Question 2

What can be observed from available financial information?

Answer 2

• Stability of company
  
  • Will they be in business for a long time or are they operating on a minimal budget, taking drastic steps just to meet payroll
  • Will they be able to pay premiums? Is there a possible moral hazard? Can they accept a deductible? Candidate for SIR?
• Where the risk’s revenue is generated
  
  • Is this a litigious region where courts award high settlements?
• How the risk employs people
  
  • Employ its own staff, hire contractors, retain other companies to provide some of its services, employees might be unionized
• Whether the risk has purchased (or is about to purchase any new operations
  
  • How do new ops affect the corporation as a whole, do they have sufficient experience?, types of liability associated with new ops, how is overall exposure affected?
• Whether the risk has discontinued any operations and why

Question 3

Financial Information and Underwriting Judgement

Answer 3

• To assess a risk’s financial position, an underwriter needs to analyze the market for a risk’s goods or services and watch for any business or legislative factors that could be a threat to that market

Question 4

Sources of Financial Information

Answer 4

• Credit reporting services such as Standard & Poor’s, D&B, DBRS
  
  • Provide some financial information and show a number of key financial ratios
• The risk’s public affairs or PR department
• Prospectuses
• Business Plans

Question 5

Pro Forma Statement

Answer 5

An accounting or financial projection made in advance of the facts: a financial forecast

Question 6

SWOT Analysis

Answer 6

An analysis of a company’s strengths, weaknesses, opportunities, and threats

Strengths: What do you well?, What unique resources can you draw on?

Weaknesses: What could you improve? What are others likely to see as your weaknesses?

Opportunities: What opportunities are open to you? What trends can you take advantage of?

Threats: What threats could harm you? What is your competition doing?

Question 7

3 Financial Statements of particular interest to an underwriter

Answer 7

1. The balance sheet
2. The income statement
3. The statement of cash flow

Question 8

3 Classes of Financial Statements

Answer 8

1. Audited statements
2. Review statements
3. Compilation statements

Question 9

Auditor’s Standard Report

Answer 9

The stated purpose is typically to ensure the financial statements fairly represent the company’s financial position and that the statements have been prepared in accordance with GAAP

Question 10

Auditor’s Non-standard Report

Answer 10

• Indicates that there is something to watch for in the financial statements that follow the report. Expresses one of three kinds of opinion on the part of the auditor:

1. A qualified opinion attests that the financial statements are fairly presented except for a specific matter
2. An adverse opinion expresses the auditor’s belief that the financial statements are not fairly presented because of a specific matter
3. A denial of opinion attests that the auditor is unable to express an opinion on whether the financial statements are fairly presented

Question 11

Review Statements

Answer 11

• Financial statements that the auditors have reviewed to determine if they are plausible
• The auditor does not undertake any study of the company’s internal controls, nor do they test the statements as they would in an auditing process
• For this reason, no auditor’s opinion is expressed

Question 12

Compilation Statements

Answer 12

• Least reliable class of financial statements
• Come from an accounting service and are prepared from information supplied by the client
• No guarantee GAAP was followed

Question 13

6 Major parts of financial statements

Answer 13

1. An independent auditor’s report
2. Balance sheet
3. Income statement
4. Statement of cash flow
5. Statement of change
6. Notes to the financial statements

Question 14

Asset

Answer 14

• An economic resource
• Anything that has financial value, including cash, bank balances, investments, proceeds of a life insurance policy, vehicles, real estate, household goods, and personal effects

Question 15

Difference between tangible and intangible assets

Answer 15

Tangible assets can be objectively valued, intangible assets can only be subjectively valued

Question 16

Net Income

Answer 16

The difference between the revenues and the costs and expenses of a company

Revenues - Cost of Goods Sold - Expenses = Net Income (or loss)

Question 17

Combined Ratio

Answer 17

The sum of the loss ratio and the expense ratio of an insurer for a specified period

A combined ratio above 100% indicates that earned premiums have been less than acquisition costs and other expenses incurred to generate those premiums. The insurer’s surplus is reduced by the difference.

A combined ratio below 100% indicates earned premiums have been greater than acquisition costs and other expenses the insurer incurred to generate those premiums. The insurer’s surplus is increased by the difference.

Question 18

Loss Ratio

Answer 18

The ratio of total losses paid out in claims plus adjustment expenses divided by the total earned premiums

Question 19

Expense Ratio

Answer 19

The ratio of an insurer’s acquisition costs and other expenses to its earned premium over a specified period

Question 20

Questions that can be answered using the cash flow statement

Answer 20

• What is the business’s payment experience with creditors? Does it pay its bills on time? If any are past due, how much is owed?
• What is the state of the business’s A/R? Is there much outstanding?
• Are excessive funds tied up in inventory? Is this due to sales being seasonally driven or does it signal a lack of demand for their product(s)?
• Is the business nearing the maximum amount of credit its creditors will extend?

Question 21

Statement of Change

Answer 21

• supplies any information that is missing from the other financial statements
• provides a summary of major cash sources and dispositions, how the business generated funds, how cash reserves have been used over the reporting period

Question 22

Notes to Financial Statements

Answer 22

• Narratives that are used to explain important financial items that cannot be adequately quantified or even otherwise shown.
• For example; outstanding litigation that could adversely affect earnings if the judicial ruling goes against it

Question 23

Identifying the problem risk

Answer 23

• Is there a difference in how certain items are booked? (accrual vs cash basis)
• Was there an infusion of capital? Why was it needed?
• Does the business depend too much on a limited number of revenue sources?
• Has the company changed auditors at any time in the past? Why?

Question 24

Current Ratio

Answer 24

The ratio of current assets to current liabilities

Question 25

Quick Ratio

Answer 25

Similar to the current ratio but uses only the most liquid of the current assets (cash, marketable securities, current receivables)