FINANCIAL MANAGEMENT OVERVIEW

Financial Management is management by the insurance companies to meet their solvency & profitability goals.

The Responsibilities & Organization of Financial Management

Specific responsibilities of financial management include

• Planning the company’s financial strategy.
• Managing capital & surplus.
• Managing cash flows.
• Managing investments
• Reporting the company’s finances.
• Performing other accounting duties.
• Conducting financial audits & internal control.
• Performing financial analysis.

Three departments what’ve financial management responsibilities are investments, accounting & actuarial.

The CFO usually reports to the president and generally has authority over the company’s comptroller who is head of the accounting area.

Duties of a CFO:

• Present financial results to the company’s board of directors.
• Coordinate, monitor, and report on all of the financial activities.
• Act as a final arbiter to resolve internal financial management issues.
• Work with investment bankers to obtain external financing.
• Act as a financial spokesperson.
• Respond to financial Mgmt. questions raised by the company’s president or board of directors.

Basic Accounting Documents

A financial statement is a report that summarizes a company’s financial situation or major monetary events & transactions.

A balance sheet is a financial document that lists the values of a company’s assets, liabilities and capital and surplus as of specific date.

The process of establishing a value for an insurer’s required policy reserves is called reserve valuation. An insurer’s appointed actuary- an actuary who has been appointed by an insurer’s board of directors to render an official actuarial opinion as to the insurance company’s financial condition-is responsible for certifying that the amount of the company’s policy reserves is sufficient to meet the company’s future obligations.

Reserve valuation assumptions are considered to be conservative if they’re likely to result in reserves that are greater than needed to meet the company’s obligations.

In addition to policy reserves, other required reserves that insurers typically maintain include

• A reserve for policy dividends payable
• A reserve for premiums that policy owners ‘ve paid in advance
• A reserve for life insurance claims that have been incurred but not yet paid.
• Asset fluctuation reserves a type of contingency reserve, which are designed to absorb gains and losses in the insurer’s investment portfolio.

Three key components on the balance sheet assets, liabilities, and capital & surplus can be expressed using the basic accounting equation:

            Assets = Liabilities + Capital & Surplus

The income that a company generates from its core business operations is called revenue. A life insurer’s two main sources of revenue are

• Insurance and annuity premiums
• Earnings from its investments.

An amount of money that a company spends to support its business operations is called an expense. Insurance Company expenses are

           

• Contractual benefit payments to policy owners & beneficiaries.
• Producer commissions.
• Employee salaries & benefits.
• Product development, marketing & administration costs.
• Information technology costs.
• Facility maintenance costs.
• Taxes.

An income statement, also called a statement of operations, is a financial document that reports on an insurer’s net income or net loss for a given period by summarizing the company’s revenues & expenses during that period. It is linked to the balance sheet through the capital and surplus account on the balance sheet.

Solvency

Solvency is the ability of a business to meet its financial obligations on time. For insurance companies, however solvency also refers to the ability to maintain capital and surplus at or above the minimum standard of capital and surplus required by the law. Because this minimum standard is a legal requirement, insurer solvency is sometimes referred to as statutory solvency.

Risks Affecting Solvency

The actuarial profession in the US has identified several areas of risk-known as contingency risks or C risks-that may affect insurer’s solvency. It includes

Asset risk (C-1 risk) is the risk that the insurer will lose asset value on its investments in assets such as stocks, bonds, mortgages, and real estate for a reason other than a change in market interest rates. Ex. Stocks owned by an insurer lose market value.

Pricing Risk (C-2 risk) also called insurance risk, is the risk that the insurer’s experience with mortality or expenses will differ significantly from expectations, causing the insurer to lose money on its products. Ex. Product related expenses increase.

Interest-rate risk (C-3 risk) is the risk that market interest rates might shift, causing the insurer’s assets to lose value and/or its liabilities to gain value. Interest rate changes sometimes result in disintermediation, which is a situation in which customers withdraw money from one financial intermediary. Ex. An insurer incurs a loss on the sale of a bond when interest rates rise.

General Mgmt Risk (C-4 Risk) is the risk of loss resulting from the insurer’s ineffective general business practices or environmental factors beyond the company’s control. Ex. Inefficient management, Losses from fraud & litigation.

Measuring Solvency

To measure their solvency, Insurance companies use capital ratio which is 

                        Capital ratio = Capital & surplus/Liabilities

Unweighted Ratio does not take into account the level of risk inherent in the insurer’s operations. When an unweighted ratio is adjusted to take into account an insurer’s level of risk exposure, the ratio becomes a risk-weighted ratio, also called a risk-based ratio.

In the US, risk-based capital (RBC) ratio requirements, modeled after the NAIC’s Risk-Based Capital for Insurers Model Act, enable state regulators to evaluate the adequacy of an insurer’s capital relative to the riskiness of its operations.

A rating agency is an organization, owned independently of any insurer or government body that evaluates the financial condition of insurers and provides information to potential customers of and investors in insurance companies.

Profitability

One profitability measure that makes use of both the income statement and the balance sheet is the return on capital ratio which is

Return on Capital = Net gain from operations/Beginning capital and surplus

The result of the return on capital ratio indicates how effectively an insurer has employed its capital and surplus to generate a profit during a given period.

Planning Financial Goals & Strategies

Financial goals

To earn a sufficiently high rate of return for their owners while maintaining a high level of solvency.

Solvency Goals

To maintain or to improve the company’s industry rating.

Profitability Goals

To increase the value of its assets by a stated percentage each year.

Financial Strategies

A company that places a strong emphasis on taking risks that could enhance its rate of return but potentially threaten its solvency pursues a aggressive financial strategy which include investing in relatively-high risk assets, developing many new and unusual products, expanding into new lines of business.

Conservative financial strategy places a strong emphasis on avoiding risks that could threaten its solvency which include investing in relatively low-risk assets, using existing distribution systems.

Managing Company’s Capital & surplus  

• Analyze the company’s capital & surplus needs.
• Measure the return expected from a particular use of capital & surplus
• Compare the projected return on capital with the company’s hurdle rate
• A hurdle rate is the minimum percentage rate of return on capital that a company must earn for a given level of risk.
• Determine whether a particular use of capital and surplus has been effective.
• Arrange for financing any required additional capital.

o   Internal financing involves raising funds through the core business operations of the company.

o   External financing involves raising funds from outside the company.

Managing Cash Flows

A cash flow is any movement of cash into (cash inflow) or out of an organization (cash outflow).

Liquidity is the ease and speed with which an asset can be converted to cash for an approximation to its true value.

Asset/Liability Management

Is the system that coordinates the administration of an insurer’s contractual obligations to customers with the administration of the insurer’s investment portfolio so as to achieve the best possible financial assets? Through ALM, financial managers identify the patterns of the company’s cash outflows and then construct a portfolio of assets.

Cash-Flow Testing

Insurance companies undertake periodic cash-flow testing to evaluate the effect of different interest-rate assumptions on projected cash flows. Cash-Flow testing is the process of projecting into a future period the cash flows associated with an insurer’s existing business and comparing the timing and amounts of assets and liability cash flows as of a given date.

Standard Valuation Law requires insurers to test cash flows under several different interest-rate scenarios, such as interest rates rising or falling gradually, interest rates rising or falling rapidly, and interest rates reversing directions.