1.1 Financial Management and Finance Departments
A business’s decision about whether to retain loss exposures or transfer them to an insurer is mainly a financial decision; producers need to be able to determine whether a business meets an insurer’s basic financial underwriting guidelines. Corporate finance departments acquire, invest, and manage the business’s resources and provide financial information to other company managers. Finance focuses on managing capital; accounting focuses on reporting financial data. A typical finance department is headed by a chief financial officer, who supervises a treasurer (in charge of capital budgeting and managing capital structure and working capital) and a controller (who handles accounting, reporting, and taxes).

1.2 Financial Management Goals
The three primary goals of corporate finance are to (1) maximize the organization’s present stock value, (2) be financially transparent, and (3) conduct operations in an ethical manner. Financial transparency means that the board of directors and shareholders must have access to accurate, informative, timely, and understandable financial reporting with full disclosure of accounting methods and key events. The Sarbanes-Oxley Act of 2002 imposes significant financial reporting and disclosure requirements aimed at protecting investors.

1.3 Accounting Standards and Principles
Companies need a common set of accounting principles, standards, and procedures to compile their financial statements; many companies use GAAP accounting. Many multinational companies and national regulators support the use of International Financial Reporting Standards (IFRS) because they believe one accounting language will help investors to understand opportunities better. GAAP and IFRS are similar in their theoretical framework, general principles, and accounting results, but differ in their definition and treatment of fair value.

1.4 Corporate Finance and Financial Markets
Investors provide capital for corporations to use to finance their business operations. Financial markets match the users with the providers. Securities underwriting is the selling of a new issue of stock. Primary markets bring new cash into the corporation; there are four types of primary markets: auction, broker, dealer, and direct search. Secondary markets allow investors to buy and sell previously issued securities; these markets must have sufficient breadth and depth to supply liquidity.

2.1 Accounting Overview
Understanding how to use a business’s financial statements is the key to assessing the business’s financial status. Because a single set of financial statements serves all users whose needs vary, accounting principles require that financial statements be free of bias toward any particular interest and present information conservatively and consistently.

2.2 Financial Statement Basics
The four main financial statements are balance sheets, cash flow statements, income statements, and statements of changes in owners’ equity. Each of the four types of financial statements is valuable on its own, but when all are taken as an interrelated whole, they give a more complete picture of a business’s financial status and operations results. Financial statements do have some limitations because they use assumptions and estimates; they don’t include the financial value of a business’s intangible assets, and they don’t measure the economic value of assets because assets are not recorded at fair market value.

2.3 Using Financial Statements in the Insurance Industry
A business’s financial statements are used by all professionals in the insurance industry, including agents, brokers, claim representatives, risk managers, and underwriters.

2.4 Annual Reports and SEC Information
A company’s annual report gives information on a business’s purpose, financial results, and future directions, which insurance professionals use to make underwriting decisions. In response to the Sarbanes-Oxley Act of 2002 (SOX), the SEC is placing greater emphasis on transparency in financial accounting.

2.5 Other Sources of Financial Reporting Information
Independent, external sources of information, such as analysts, credit bureaus, news articles, and rating agencies, also provide information about a company.

3.1 Steps in Analyzing Financial Statements
Systematic financial analysis follows a fivestep process: (1) identify goals, (2) review the financial statements, (3) select the techniques that will achieve the defined goals, (4) apply the techniques, and (5) interpret the results. A major part of the analysis process involves constructing common-size statements, which use percentages instead of dollar amounts so that it’s easier to compare firms of different sizes or different times at a single company.

3.2 Vertical Analysis of Financial Statements
In vertical analysis, the focus is on the relative size of each reported item to a common base for each year considered; use of percentages in the common-size statement format eliminates differences in company sizes or purposes. One use of vertical analysis is to highlight unusual percentages in common-size statements. These help identify items that have a noticeably larger or smaller value when compared to other values in the same accounting period.

3.3 Trend or Horizontal Analysis of Financial Statements
Horizontal analysis involves comparing two or more years of financial statement data; when five or more years are compared, it is called trend analysis.

3.4 Ratio Analysis: Calculations, Interpretations, and Limitations
Financial ratios are used to measure a company’s profitability, efficiency, leverage, and liquidity; they are based on either GAAP (for noninsurers) or SAP (for insurers). Because ratios examine relationships, not amounts, they can be used to compare companies of different sizes or in different industries. The ability to analyze financial statements and recognize when ratios are not within normal ranges for the industry helps identify areas that might need more review.

4.1 Basics of Insurer Financial Statements
The NAIC requires insurers to submit a balance sheet and an income statement, prepared according to statutory accounting principles (SAP), to state insurance departments every year; supplements must also be filed. Main insurer liabilities are unearned premium reserves (these result when an insured pays the entire premium before the policy period starts) and loss reserves (these result from the delay between when a claim occurs and when it is settled). An income statement shows how a business has performed over a specified time period; it measures net income by calculating the difference between income and expenses and includes investment earnings, earned premiums, incurred losses, and underwriting expenses.

4.2 Insurer Financial Statement Users
Producers, risk managers, and policyholders use insurers’ financial statements to measure the insurer’s financial strength. Regulators use financial statements to monitor the insurer’s ability to pay claims; the NAIC Annual Statement is the main statement that all state insurance departments require from insurers, but insurers also have to file financial reports and tax returns with the SEC and IRS. Investors use insurers’ financial statements to gauge the companies’ financial strength based on its abilities to remain solvent, grow, reward investors, and pay claims. Management uses financial statements to monitor progress toward company profit goals, employee and office performance, and class of business and product performance.

4.3 Annual Statements and Statutory Accounting
An insurer must use SAP to prepare financial statements unless state law provides otherwise. Detailed supporting schedules must be filed with balance sheets; Schedule P is a critical filing that provides information on incurred losses and loss reserve development. Unlike GAAP (generally accepted accounting principles) used by most businesses, SAP was developed for the regulatory purpose of promoting insurer solvency. SAP differs from GAAP in the treatment of policy acquisition commission and costs, bonds, nonadmitted assets, pensions, subsidiaries, and controlled or affiliated entities.

4.4 Statutory Accounting Sources
SAP’s fundamental concepts are recognition, consistency, and conservatism. SAP sources include the NAIC’s Accounting Practices and Procedures Manual and other publications such as Statements of Statutory Accounting Principles (SSAP).

5.1 Rating the Financial Strength of Insurers
The most important ratings for insurers are from A.M. Best Company and use both quantitative and qualitative criteria. Quantitative tests, based on reported data, include profitability tests, underwriting leverage, liquidity ratios, and loss reserve ratios. Qualitative tests include analysis of risk spread and reinsurance, investment quality, surplus relative to other factors, capital structure of the holding company, management, market position, and event risk.

5.2 Operational Analysis Using Ratios
Insurers determine whether they’re making money by using ratios based on data in income statements and balance sheets; different ratios are used for different purposes. One of the main ratios is the combined ratio (CR), a single number that summarizes the performance of the underwriting function and provides a percentage of how much of each premium dollar is spent on expenses. The CR is calculated by adding the expense ratio and the loss ratio; the ER includes budgeted expenses such as payroll, taxes, rent, outside vendors, and unallocated loss adjustment expenses; the LR is paid losses plus allocated loss adjustment expenses plus IBNR/case reserves plus bulk reserves/net written premium. A combined ratio of 100 indicates that every premium dollar is being used to cover expenses and losses.

5.3 Overview of the Insurance Regulatory Information System (IRIS)
The NAIC developed the IRIS to alert regulators to insurers’ financial problems. IRIS and A.M. Best may use the same tests. Among the 12 IRIS tests are two-year overall operating ratio; agents’ balances to surplus; net and gross premium-to-surplus ratio; oneand two-year reserve development to surplus; change in writings; investment yield; change in surplus; and liabilities to liquid assets.

6.1 Time Value of Money
Most financial analysis assumes that a sum of money will grow over time. Time-value-of-money equations allow you to make predictions about four quantities: future value, present value, interest rate, and time period.

6.2 Future Value
Future-value calculations tell you how much money you will have in the future if you invest money today. The common feature of all future calculations is (repeatedly) multiplying the principal amount (i.e., the investment) by 1 + the interest rate.

6.3 Present Value
The present-value calculation reverses the future-value (compound interest) calculation. To compute present value, you need to know the amount of the future sum, the interest rate, and the time from today until the future payment.

6.4 The Magic of Compound Interest
Compound interest makes money grow faster than simple interest because with compound interest, interest is paid on both principal and interest.

6.5 Determining Rates of Return and Numbers of Periods
The TVM formula allows you to solve for interest rate or time period if the other three variables are known.

6.6 How TVM Calculations Are Done
TVM calculations can be done using various tools: computers, calculators, financial tables, and estimation techniques.

6.7 Time Value of Multiple Cash Flows
Time-value-of-money (TVM) calculations can be used to analyze uneven cash flows in a business or a series of equal periodic payments, as in an annuity or in the repayment of a loan. Figuring uneven cash flows is simple: find the present or future value of each cash flow separately and then add up all of them. TVM analysis makes it possible to evaluate many different types of financial investments.

6.8 Future Value of Annuities and Other Regular Payment Streams
The future value of a stream of equal payments is known as the future value of an annuity, but it applies to any regular plan to accumulate money until a future date. Calculations relating to an ordinary annuity assume that payments are made at the end of each payment period. Calculations relating to an annuity due assume that payments are made at the beginning of each payment period.

6.9 Present Value of Annuities and Other Regular Payment Streams
The present value of an annuity is the lump sum of money needed to generate a stream of regular periodic payments. The most common examples are the lump-sum premium for an annuity or the borrowed amount in a loan; both generate regular periodic payments. A perpetuity is a stream of periodic payments without a definite end.

6.(10) How Cash Flow Valuation is Done
Cash flow valuation can be done in a number of ways: by hand, by using tables, or by using calculators or computers.

7.1 An Insurer’s Investments in Bonds and Stocks
Stocks and especially bonds are the foundation of the financial strength of insurance companies.

7.2 Bond Characteristics
Corporations and governments borrow money by issuing bonds to the public; as with all lending instruments, bonds state a principal amount (face value), a rate of interest (coupon rate), and a repayment date (maturity). Like other types of loans, some bonds are secured with a claim on assets owned by the borrower (asset- or mortgaged-backed bonds). Some bonds have an adjustable interest rate (floating rate bonds), and some bonds allow the borrower to repay the loan early (callable bonds). Bonds issued by the United States government are considered to have no risk of default; bonds issued by states and municipalities are low risk; and bonds issued by foreign issuers vary in risk.

7.3 Bond Value and Pricing
The riskier the bond, the higher the yield. The prices (and yields) of bonds with long maturities and/or low coupon rates are most sensitive to changes in market interest rates. The price of a bond is the present value of all future interest payments plus the present value of the principal repaid at maturity, all discounted at the market interest rate for the particular type of bond. When market interest rates go up, the price of bonds tends to go down, and when rates go down prices tend to go up.

7.4 Stock Characteristics
Corporations can issue two types of stock: common and preferred. The assets and earnings of a corporation go first to paying bondholders, next to preferred stockholders, and last to common stockholders.

7.5 Stock Value and Pricing
In theory, the price of stock should equal the present value of all future dividends. In reality, stock is priced in the stock market; different investors evaluate how they think an issuer’s business will perform and how that performance will play out in the stock market against all the other available investment opportunities.

8.1 Historical Data to Evaluate Returns
An insurer relies on historical data, risk metrics, and portfolio and investment theories to develop an investment strategy. The geometric average total rate of return measure is more accurate than the arithmetic average total rate of return; it is the appropriate method if many different return rates affect a return. An investor’s annual return on an investment in stocks (percentage total return) equals the sum of the dividend yield and the percentage gain.

8.2 Types of Risk and Risk Metrics
Historical data alone is not sufficient to evaluate future returns, because it does not indicate the kinds of risk involved with investments; investors should also consider the related risks and their effects on returns. Diversification can eliminate unsystematic risk but cannot eliminate any systematic risk. Risk metrics are used to calculate the probability that returns will not meet expected returns. Standard deviation is the most commonly used risk metric, because it is easy to calculate and is stated in the same units as the data set.

8.3 Managing an Investment Portfolio
Beta reflects an investment’s volatility and, therefore, risk; investments with betas higher than 1.0 are fairly volatile, therefore risky, while investments with betas lower than 1.0 are fairly conservative. Systematic, or market risk, is measured by beta; beta does not measure unsystematic risk. The security market line (SML) is the graphical form of the capital asset pricing model (CAPM). The SML’s slope equals a security’s or portfolio’s market risk. Insurers should tie their investment strategy to their underwriting goals (i.e., payment of covered loss) because insurers mainly use returns on investments to pay loss.

9.1 Capital Needs of Insurers
Insurers need adequate capital to conduct business with a profit and satisfy requirements set by insurance regulations. Insurers need additional capital beyond their initial capital to increase reserves to pay for unexpected loss, pay for increased sales and capabilities in everyday operations, and replenish policyholders’ surplus for the decrease in net income due to statutory accounting rules. Insurers satisfy risk-based capital requirements only if the total adjusted capital (TAC) is greater than 200% of authorized control level risk-based capital (ACL).

9.2 Meeting Capital Needs Externally
Insurers use four methods to meet external capital needs: mutual insurer reorganizations, alternative sources of capital, long-term debt, and equity.

9.3 Meeting Capital Needs Internally
Insurer can internally satisfy its capital needs by earning net profits, selling insurance policies, recognizing assets and liabilities not included on balance sheets, and lowering the amount of capital needed by reducing the insurer’s risk exposure. Reinsurance is the most important way an insurer can lower its risk exposure. Insurer’s gradual recognition of revenue and immediate recognition of costs causes the policyholders’ surplus of insurers to decrease. Primary insurers must satisfy certain financial and accounting requirements for reinsurance contracts to be treated as reinsurance for reporting purposes.

9.4 Dividend Policy of Insurance Companies
The best dividend policy for any company is one maximizing the company’s market value. All insurers, both stock and mutual, can pay policyholder dividends; however, only stock insurers can pay shareholder dividends. Dividend policy should be a financing decision for companies able to effectively get more equity capital; otherwise, the dividend policy should be an investing decision.

9.5 Measuring Income of Insurance Companies
Insurance professionals must understand three fundamental principles of income measurement: difference between accounting income and economic income, difference between book value and market value, and elements of income specific to insurance companies. Accounting income is different from economic income. A company’s accounting records show book value based on accounting income; the value of the company to shareholders reflects market value based on economic income. Accounting income is only an estimate of economic income because it is based only on financial statements that reflect historical costs and do not reflect the current market value of a company. Accounting income calculations are based only on accounting income rules. Economic income calculations, however, rely on both accounting income rules and how the company’s financial performance affects the market.

9.6 Elements of Total Income of Insurance Companies
An insurer’s investment strategy focuses more on liquidity when cash flow from investments may be needed to pay underwriting costs, and it focuses more on yield when cash flow from underwriting is enough to pay existing costs and claims. Insurers can get positive cash flows from underwriting operations without producing a profit from underwriting because of timing differences between recognition of revenue and recognition of costs, and between cash receipts and disbursements. Two primary sources of money available to insurers for investing are policyholdersupplied funds and capital and policyholders’ surplus.

10.1 Flow of Funds in an Insurance Company
The mix of bonds and stocks affects returns for stockholders and the risk of bankruptcy.

10.2 Calculating the Cost of Capital
The cost of using bonds to finance business operations (cost of debt) is equal to the yield to maturity on those bonds adjusted to reflect the tax deduction that the business gets for interest payments. The cost of using stock to finance business operations (cost of equity) is determined in two ways: (1) using the dividend growth model, which calculates a rate of return based on a company’s dividend history, and (2) using the capital asset pricing model (CAPM), which calculates a rate of return based on how the company’s stock relates to the market as a whole. The cost of debt is generally less (often significantly less) than the cost of equity.

10.3 Financial Leverage
Adding debt to the capitalization mix increases the potential return for shareholders; this is known as financial leverage. Risk of default is also increased when the degree of financial leverage is increased. In an insurance company, loss reserves associated with the sale of policies have a leveraging effect that is the same as debt: both create a potential for increased returns and risk of default.

10.4 Factors Limiting Maximum Leverage
Increasing risk resulting from higher degrees of financial leverage increases the cost of capital, thereby limiting the desirability of high leverage. Companies incur costs to ensure that management is acting in the best interest of shareholders: monitoring costs, bonding costs, and incentive alignment costs. Mutual insurance companies have different capital structures because these companies are owned by policyholders, not shareholders.

11.1 Types of Acquisitions
Mergers and acquisitions have been common and continue in property and casualty insurance primarily because publicly held insurers use acquisitions to raise their stock value. More acquisitions than mergers have occurred in property and casualty insurance. Hostile takeovers happen more often in other industries than in the insurance industry.

11.2 Benefits of Acquisitions
The six benefits of a company acquiring control and ownership of another company are savings in costs, management concerns resolved, advantage that is competitive, rise in earnings per share, transactions involving excess cash, and synergies. The three ways an acquisition helps the acquiring company save money are tax benefits, cost and revenue efficiencies, and lowered probability of financial distress. The main difference between savings from economies of scope and savings from economies of scale is that economies of scope savings result from increasing the range of services and products offered, while economies of scale savings result from keeping the range unchanged.

11.3 Factors Affecting Acquisitions
Acquisitions are valuable ways to change control or ownership of a company because they are simple, save costs, and remove need to assign title to individual assets. The disadvantage is that over 50% of shareholders of both the acquiring and target companies must agree to the acquisition. Acquisitions financed by cash are taxable while stock acquisitions are tax free. After an acquisition, revenues commonly increase, capital needs are decreased, and taxes are often reduced.

11.4 Costs and Gains from Acquisitions
The acquiring and target companies’ gains in a cash acquisition equal their gains in a stock acquisition only if the number of new shares issued to the target in the stock acquisition is based on the value of the combined company’s shares after acquisition. An acquisition causes economic gain when acquiring and target companies are worth more combined than separated, as proven by extra net cash inflows after acquisition. A target company generally gains more than the acquiring company in an acquisition because the target is often smaller than the buyer. Acquisition benefits on a percentage basis increase the target’s value more than the buyer’s value.

12.1 Insurer’s Legal and Regulatory Environment
An insurer’s legal and regulatory environment is affected by social issues, political matters, and court decisions from different jurisdictions.

12.2 Cycles in the Insurance Industry
The underwriting cycle is the most important part of the operating environment in the property and casualty insurance industry. The terms profit cycle and underwriting cycle are not the same. A profit cycle is based on both investment and underwriting income, whereas an underwriting cycle is based on underwriting income only.

12.3 Underwriting Cycle in the Insurance Industry
An insurer’s capacity, investment income, and return on equity are the three main areas affecting the insurer’s underwriting cycle. A hard market is defined by increased premiums and profit for insurers; a soft market is defined by decreased premiums and profit for insurers. Demand for insurance may vary because of premium changes but is not as elastic as demand for many other products.