ACE Financial Analysis & Valuation 2 — Questions and Answers
Question 1: An insurance company's combined ratio is 108%. What does this indicate about its underwriting performance?
- The company is profitable overall
- The company is losing money on underwriting operations (Correct answer)
- The company's investment income exceeds its underwriting losses
- The company has a surplus in its reserve funds
Correct answer: The company is losing money on underwriting operations
A combined ratio above 100% means the insurer is paying out more in losses and expenses than it collects in premiums, indicating an underwriting loss.
Question 2: Which financial statement component best reflects an insurer's ability to meet short-term policyholder obligations?
- Surplus notes
- Unearned premium reserve
- Liquid assets on the balance sheet (Correct answer)
- Reinsurance recoverables
Correct answer: Liquid assets on the balance sheet
Liquid assets (cash and short-term investments) on the balance sheet indicate an insurer's immediate capacity to pay short-term obligations.
Question 3: In the context of ACORD data standards, which metric is used to assess the adequacy of an insurer's loss reserves relative to its earned premiums?
- Loss ratio
- Reserve development ratio (Correct answer)
- Expense ratio
- Retention ratio
Correct answer: Reserve development ratio
The reserve development ratio tracks how original reserve estimates change over time, indicating whether initial reserves were adequate.
Question 4: What does the term 'policyholder surplus' represent on an insurance company's balance sheet?
- The total premiums collected minus claims paid
- The excess of assets over liabilities, representing net worth (Correct answer)
- The amount set aside for future claims
- The dividends paid to policyholders
Correct answer: The excess of assets over liabilities, representing net worth
Policyholder surplus is the difference between an insurer's total admitted assets and total liabilities, representing the company's net worth.
Question 5: Which valuation approach would be MOST appropriate when assessing a specialty insurance line with limited market comparables?
- Market comparable analysis
- Income-based discounted cash flow approach (Correct answer)
- Book value approach
- Price-to-earnings ratio method
Correct answer: Income-based discounted cash flow approach
When market comparables are scarce, a discounted cash flow (DCF) approach is preferred as it values the business based on projected future earnings.
Question 6: An insurer's operating leverage ratio measures the relationship between:
- Net premiums written and policyholder surplus (Correct answer)
- Investment income and total assets
- Loss reserves and net premiums earned
- Reinsurance ceded and gross premiums written
Correct answer: Net premiums written and policyholder surplus
Operating leverage (net premiums written to surplus) measures how much premium volume an insurer writes relative to its capital base.
Question 7: When analyzing an insurer's return on equity (ROE), which factor distinguishes insurance ROE from that of non-financial companies?
- Insurance ROE includes policyholder dividends as revenue
- Investment income from the float is a significant ROE component (Correct answer)
- Insurance ROE is calculated pre-tax while others use after-tax figures
- Insurance ROE excludes underwriting results
Correct answer: Investment income from the float is a significant ROE component
Insurers generate significant investment income from holding premium payments (the float) before claims are paid, making it a key ROE driver unique to the industry.
ACE Financial Analysis & Valuation 2
An insurance company's combined ratio is 108%.
What does this indicate about its underwriting performance?