CPA Risk Assessment & Underwriting 3 — Questions and Answers
Question 1: Which condition would most likely cause an auditor to assess control risk at the maximum level?
- The entity operates in a highly competitive industry
- Management has not established a formal internal audit function
- The entity lacks effective internal controls over a financial reporting process (Correct answer)
- The company changed its accounting software during the year
Correct answer: The entity lacks effective internal controls over a financial reporting process
When an entity lacks effective internal controls over a process, the auditor must assess control risk at maximum, requiring more extensive substantive testing.
Question 2: In insurance underwriting, 'facultative reinsurance' differs from 'treaty reinsurance' in that facultative reinsurance:
- Covers an entire portfolio of risks automatically
- Is negotiated separately for each individual risk (Correct answer)
- Is cheaper per unit of coverage
- Only applies to catastrophic losses
Correct answer: Is negotiated separately for each individual risk
Facultative reinsurance is negotiated on a case-by-case basis for individual risks, while treaty reinsurance covers an entire book or portfolio of business automatically.
Question 3: When performing risk assessment for a client with significant estimates, an auditor should:
- Rely entirely on management's specialists for all estimates
- Assess whether management has used reasonable assumptions and methods (Correct answer)
- Automatically treat all estimates as high-risk without further analysis
- Only test estimates that exceed the audit materiality threshold
Correct answer: Assess whether management has used reasonable assumptions and methods
The auditor must evaluate whether management's assumptions and methods for developing estimates are reasonable and consistent with applicable accounting standards.
Question 4: Which type of underwriting risk arises from the uncertainty in the frequency and severity of future insurance claims?
- Credit risk
- Liquidity risk
- Insurance risk (underwriting risk) (Correct answer)
- Operational risk
Correct answer: Insurance risk (underwriting risk)
Insurance risk (underwriting risk) is the core risk that insurers take on, arising from uncertainty about when losses will occur and how large they will be.
Question 5: Under PCAOB standards, an auditor's understanding of the company's risk assessment process should include:
- Evaluating management's compensation structure
- How management identifies and responds to risks of material misstatement (Correct answer)
- Reviewing board minutes from the past five years
- Assessing the effectiveness of the internal audit charter
Correct answer: How management identifies and responds to risks of material misstatement
Understanding the entity's risk assessment process includes learning how management identifies business risks, estimates their significance, and responds to them.
Question 6: A property insurer uses 'schedule rating' in underwriting. This means the insurer is:
- Publishing its rates in a public schedule
- Adjusting filed rates up or down based on specific risk characteristics (Correct answer)
- Following a mandatory state rate schedule
- Rating only commercial properties
Correct answer: Adjusting filed rates up or down based on specific risk characteristics
Schedule rating allows underwriters to apply credits or debits to filed rates based on specific physical or operational characteristics of the individual risk.
Question 7: When a CPA identifies a 'material weakness' in internal controls, this means:
- A minor deficiency that management should correct when convenient
- A significant deficiency that, if exploited, would likely not cause a material misstatement
- A deficiency where there is a reasonable possibility of material misstatement that will not be prevented or detected (Correct answer)
- Any control deficiency identified in the audit
Correct answer: A deficiency where there is a reasonable possibility of material misstatement that will not be prevented or detected
A material weakness is a deficiency, or combination of deficiencies, in internal control such that there is a reasonable possibility that a material misstatement will not be prevented or detected on a timely basis.
CPA Risk Assessment & Underwriting 3
Which condition would most likely cause an auditor to assess control risk at the maximum level?