Antonio Caxide, CFA LUSIADS Investment Management LLC 1

Transcription

1 Ohio Association i of Mutual Insurance Companies Pre-convention Morning Education Course Financial Literacy Workshop February 16, 2011 Columbus, OH Antonio Caxide, CFA 1

2 Learning Objectives A warm-up session, preparing participants for the Basics of Financial Statements and more advanced programs It serves as a refresher for some participants and an introduction to others It will cover fundamental concepts in: Accounting Investments and Finance 2

3 The Approach 9:00 to 9:45 Definitions; What an Insurance Company does Last 15 minutes for Exercise 1 9:45 to 10:15 Capturing key financial events in company books Last 15 minutes for Exercise 2 10:15 to 10:45 What s essential in Investments Last 15 minutes for Exercise 3 10:45 to 11:15 What s essential in Capital Structure Last 10 minutes for Exercise 4 3

4 The Balance Sheet The Basics of Modern Finance There are two sides to the balance sheet the left side and the right side. On the left side, there is nothing right. On the right side, there is nothing left. * * Unknown source, but I, regrettably, did not come up with it 4

5 Some Definitions Premium: A fee paid for insurance of a risk the policyholder o needs coverage for Surplus = Net Worth ~ Stockholder s Equity ~ Capital: The value of the enterprise after the company s liabilities are deducted d d from its assets Risk can refer to volatility in the price of an asset, or to an outcome other than anticipated (e.g., claims higher than priced for, or credit losses higher than anticipated when buying bonds) or reputation risk, or Liabilities are the obligations of the insurance company to others (including employees) Reserves are liabilities. They reflect an insurer s financial obligations with respect to the insurance policies it issued. The two key reserves are loss reserves (set up when claims emerge) and unearned premium reserves. Contributed capital are the funds that are provided usually at start up of a company 5

6 Some Definitions (cont.) Treasury Bonds are issued by the US Government Cash usually does not refer to money in the vault. Rather it means any short term investment that can readily be switched into true cash with little or no volatility in its price Operating balance means a balance in a bank account used for ongoing business transactions. It s cash with a specific purpose Reinsurers are insurers of insurance companies. Insurers cede or transfer certain risks to reinsurers for a variety of reasons P&L = Income Statement t t NII = Net Investment Income BPs = Basis Points 1.00% = 100 bp 0.50% = 50 bp 6

7 Some Definitions (cont.) Investments in the Balance Sheet In Rough Order of Increasing Risk * Fixed Income = Short Term; Notes; Bonds; Loans US Government, Agencies, Corporate Bonds Public bonds and private placements Floating rate and Fixed rate Mortgage-backed (house loans), Asset-backed (based on credit cards, auto loans, leases, etc.), Commercial Mortgage Loans (collateralized by commercial property) Taxable and Tax-Exempt (Municipals) IG = Investment Grade (AAA, AA, A, BBB rated) HY = Below Investment Grade or High Yield or Junk Bonds (BB+ or below) Equities = Stocks = Public Common Stock, Private Equity, International ti Equity (Developed and Emerging Countries), Preferred stock Real Estate t Equity (owned) * Risk is defined here as volatility of the asset price 7

8 Agenda Summary What does an Insurance Company do? How are revenues, expenses, assets and obligations reflected in the accounting books? Capturing investments in Income Statement and Balance Sheet First steps in Capital Structure 8

9 What Does An Insurance Company Do? Policyholder s Perspective The insurance company promises that it will have the resources in the future to pay for some risk I want to protect against. 9

10 What Does An Insurance Company Do? Policyholder s Perspective As the policyholder I want: To pay the lowest possible premiums My company to be strong (financially sound) My company to be strong (lots of surplus to pay claims with) My company to grow with me in terms of size, new products, new ideas 10

11 What Does An Insurance Company Do? Insurance Company Perspective We receive premiums (cash) to cover policyholders against various risks. Those premiums may or may not be enough to cover losses and expenses. Then we invest that cash ( float ) so that we have the resources to make payments when needed, and are able to cover new risks 11

12 What Does An Insurance Company Do? Insurance Company Perspective As the insurance company we want: Premiums to be set at an appropriate level for the cost of the insurance risk A diversified group of policyholders so we can spread the insured risk To estimate our loss reserves correctly To invest at the right mix of investment return and investment risk so we can cover insurance losses and internal expenses and also grow our net worth 12

13 What Does An Insurance Company Do? Insurance Company Perspective Loss reserves are estimates, they are usually the largest liability and the approach varies between companies: Governance Issues Responsibility of management, Board has fiduciary duty to monitor The appointed actuary is responsible for the formal and public Statement of Actuarial Opinion Objective process, with key controls but judgment matters Objectivity achieved with separation of duties (reserving, pricing, underwriting), oversight or reserve committees, external opinions from external auditor or third party, independent consulting actuary 13

14 What Does An Insurance Company Do? Insurance Company Perspective Approach Issues Known claim reserves and IBNR Incurred but Not Reported - Balancing item between known claims and the ultimate amount, or for claims that won t be filed for some time Review of historical reserve accuracy and industry and competitor reserving trends Key statistics include: - loss ratios by accident year and product line; - changes in prior-year estimates of loss reserves You may hear of Average or Formula reserves (actuary and accountants), Individual Case reserving (claims and actuary), Factor reserving, Judgment reserving. Understand how your management is conducting it Reserves may be found to be deficient or redundant 14

15 Exercise I - Instructions Please consider the following questions for 10 minutes. Then participate in the ensuing full group discussion. 1. What does enough resources mean? Where does an insurance company keep its resources? Are they the same for large and small companies? Provide examples or comparable terms. 2. In what way can insurance companies make sure they have sufficient resources? 3. Another word(s) for financially sound 4. How do you build strong surplus? 15

16 Exercise I Instructions (cont.) Discuss questions and share answers (cont.) 5. What s float and why is it very important? 6. Why must the Board/Audit committee monitor reserves? 7. If reserves are found to be materially lower than necessary, they are labeled. If they are materially higher than necessary, they would be described as. 16

17 Key Accounting Concepts What does an Insurance Company do? How are revenues, expenses, assets and obligations reflected in the accounting books? Income Statement, Balance Sheet 17

18 Key Accounting Concepts An auto policy is written on January 1, for one year * We receive a premium, as our revenue $120 We cede some of it to a reinsurer ($20) and retain the balance as our net exposure $100 In the 4 th quarter, we receive a claim ($55) (Including cost of estimate, etc.) Our underwriting expenses during the year ($40) * Numbers are illustrative and not representative of industry results 18

19 Key Accounting Concepts How the Income Statement will show it GWP $120 (= Gross Written Premium) NWP $100 (= Net Written Premium) Earned Premium 1 st Quarter $25 Earned Premium Full Year $100 In the 4th quarter, a claim (or loss expense) is paid ($55) Underwriting expenses during the full year ($40) Underwriting Result: +$5 19

20 Key Accounting Concepts How the Balance Sheet will show it At Jan 1, end of day ASSETS LIABILITIES Cash +$100 Unearned Prem Reserve +$100 SURPLUS Retained Earnings +$0 20

21 Key Accounting Concepts Time Passes, and Investments staff gets busy At Jan 1, end of day ASSETS LIABILITIES Cash +$100 Unearned Prem Reserve +$100 At March 31 ASSETS LIABILITIES Cash +$5 Unearned Prem Reserve +$75 Trsy Bnds +$75 US Equities +$20 SURPLUS Retained Earnings * +$25 * For now, let s ignore underwriting expenses and investment income, will be captured later 21

22 Key Accounting Concepts Time Passes and Investments staff gets busy At March 31 ASSETS LIABILITIES Cash $5 Unearned Prem Reserve $75 Trsy Bonds $75 Equities $20 SURPLUS At September 30 ASSETS Retained Earnings * $25 LIABILITIES Cash $5 Unearned Prem Reserve $25 Trsy Bonds $20 Corp Bonds $55 Equities $20 SURPLUS Retained Earnings * $75 * For now let s ignore underwriting expenses and investment income, will be captured later 22

23 Key Accounting Concepts Time Passes and Investments Staff gets busy At September 30 ASSETS LIABILITIES Cash $5 Unearned Prem Reserve $25 Trsy Bonds $20 Corp Bonds $55 Equities i $20 SURPLUS Retained Earnings $75 At December 31 ASSETS LIABILITIES Trsy Bonds $25 Unearned Prem Reserve $0 Corp Bonds $55 Losses payable reserve $55 US Equities $15 Salaries/Exp Payable $40 Non US Eq $5 SURPLUS Retained Earnings $5 23

24 Key Accounting Concepts A more realistic look At Jan 1, end of day ASSETS LIABILITIES Cash $100 Unearned Prem Reserve $100 Oper. Balance $60 SURPLUS Contributed Capital $60 Retained Earnings $0 At December 31 ASSETS LIABILITIES Op. balance $20 Unearned Prem Reserve $0 Trsy Bonds $25 Losses payable reserve $55 Corp Bonds $55 Salaries/Exp Payable $0 US Equties $18 SURPLUS Non US Eq $7 Contributed capital $60 Retained Earnings $5 Change in unrealized g/l $5 24

25 Sample Balance Sheet Report (Selected Items) GERMAN MUTUAL INSURANCE COMPANY BALANCE SHEET Dec 200X Dec 200X CHANGE ASSETS BONDS $12,795,203 $13,458, % STOCKS $6,913,822 $7,279, % CASH AND SHORT TERM $9,874,205 $6,549, % REAL ESTATE $1,698,471 $1,752, % EDP EQUIP & SOFTWARE $402,158 $302, % EDP EQUIP & SOFT (NON-ADMIT) ($341,829) ($229,836) 48.7% PREMIUM RECEIVABLES $2,017,258 $2,009, % REINSURANCE RECOVERABLE $189,825 $88, % 25

26 Sample Balance Sheet Report (Selected Items) GERMAN MUTUAL INSURANCE COMPANY BALANCE SHEET Dec 200X Dec 200X CHANGE ASSETS (cont.) DEFERRED Fed Inc Tax $932,823 $938, % DEFERRED FIT (NON-ADMITTED) ($178,592) ($223,741) -20.2% PREPAID EXPENSES $225,085 $24, % PREPAID EXP (NON-ADMITTED) ($225,085) ($24,880) 804.7% INTEREST RECEIVABLE $158,403 $119, % TOTAL ASSETS $34,461,747 $32,044, % 26

27 LIABILITIES Sample Balance Sheet Report (Selected Items) Dec 200X Dec 200X Change LOSSES PAYABLE $4,842,148 $5,425, % LOSS ADJUSTMENT PAYABLE $1,101, $1,490, % UNEARNED PREMIUM $8,740,708 $8,752, % UNEARNED PREMIUM (CEDED) ($117,032) ($115,713) 1.1% ADVANCE PREMIUMS $16,594 $18, % COMMISSIONS PAYABLE $509,342 $516, % CEDED REINS PREM PAYABLE ($177,794) ($416,116) -57.3% TAXES PAYABLE ($12,568) $231, % OTHER LIABILITIES $1,077, $983, % TOTAL LIABILITIES $15,980,440 $16,887, % SURPLUS UNASSIGNED FUNDS $18,481,307 $15,157, % TOTAL LIABILITIES AND SURPLUS $34,461,747 $32,044, % 27

28 Exercise II - Instructions Please consider the following gq questions for 10 minutes. Then participate in the ensuing full group discussion. 1. What are the key revenues and expenses for an insurance company? Are they different for small and large companies? 2. Premiums are fees to cover future risk, and are usually paid in cash. T F 3. Premiums are paid in arrears. T F 4. Why do insurance companies sometimes cede, or lay off some of the risk they accept when they write a policy? 5. What shifts premiums from being written to being earned? 6. Underwriting results are always positive T F 28

29 Exercise II Instructions (cont.) Discuss questions and share answers (cont.) 7. Describe the process that the investment team goes through after cash comes in the door. Describe what Cash typically refers to (e.g., money in the vault?) 8. Before premiums are earned, how do we show them on the balance sheet? What is the difference between a liability and a reserve, if any? 9. Name the key insurance company reserves. 10. Liabilities are estimated t via a rigorous process but judgment can impact it significantly T F 11. Surplus, or net worth, typically y increases in what way? 12. Insurance companies need to keep lots of liquidity to pay for operating expenses, such as salaries. T F 29

30 Key Investment Concepts What does an Insurance Company do? How are revenues, expenses, assets and obligations reflected in the accounting books? A deeper look at Investments in Financial Statements, including the Cash Flow Statement 30

31 Key Investment Concepts Investment Activity in the Income Statement Gross Written Premium $120 Net Written Premium $100 Earned Premium Full Year $100 Minus Claims (and related expenses) ($55) Underwriting expenses ($40) = Underwriting Result: $5 Net Investment Income $5 (Net of Investment Management Expenses) Net Realized Gains (Losses) on Investments $1.8 (Gains and Losses netted against each other) = Income Before Taxes and Dividends $

32 Key Investment Concepts Investment Activity Detail in Income Statement Investment Income Cash $.08 $08 2% Interest Yield US Treasury Bonds $1.6 4% Interest Yield Corp Bonds $ % Interest Yield Equities (US and Non-US) $.36 $36 1.8% Dividend Yield Subtotal $5.04 Net Realized Gains (Losses) Cash $0 No volatility or risk US Treasury Bonds ($.4) Int Rates Rose 50 bp Corporate Bonds $.55 Spreads Narrowed 100 bp Equities (US and Non-US) $1.6 8% price appreciation Subtotal $

33 Key Investment Concepts Scenario Analysis BASE CASE Gross Written Premium $120 Net Written Premium $100 Earned Premium Full Year $100 Minus Claims (and related expenses) ($55) Underwriting expenses ($40) = Underwriting Result: $5 Net Investment Income $5 (Net of Investment Management Expenses) Net Realized Gains (Losses) on Investments $1.75 (Gains and Losses netted against each other) = Income Before Taxes and Dividends $

34 Key Investment Concepts Scenario Analysis EXPENSES TOO HIGH Gross Written Premium $120 Net Written Premium $100 Earned Premium Full Year $100 Minus Claims (and related expenses) ($65) Underwriting expenses ($45) = Underwriting Result: ($10) Net Investment Income $5 (Net of Investment Management Expenses) Net Realized Gains (Losses) on Investments $1.8 (Gains and Losses netted against each other) = Income Before Taxes and Dividends ($3.3) 3) 34

35 Key Investment Concepts Scenario Analysis LOWER INVESTMENT RESULTS Gross Written Premium $120 Net Written Premium $100 Earned Premium Full Year $100 Minus Claims (and related expenses) ($55) Underwriting expenses ($40) = Underwriting Result: $5 Net Investment Income $3 (Net of Investment Management Expenses) Net Realized Gains (Losses) on Investments ($5) (Gains and Losses netted against each other) = Income Before Taxes and Dividends $3 35

36 Key Investment Concepts Scenario Analysis WEAK INSURANCE AND INVESTMENT RESULTS Gross Written Premium $120 Net Written Premium $100 Earned Premium Full Year $100 Minus Claims (and related expenses) ($65) Underwriting expenses ($45) = Underwriting Result: ($10) Net Investment Income $3 (Net of Investment t Management Expenses) Net Realized Gains (Losses) on Investments ($5) (Gains and Losses netted against each other) = Income Before Taxes and Dividends ($12) 36

37 Sample Income Statement (Selected Items) GERMAN MUTUAL Statement of Operations YTD 200X YTD 200X CHANGE DIRECT PREMIUM WRITTEN $23,747,320 $24,200, % NET PREMIUM WRITTEN $21,480,556 $21,332, % NET PREMIUM EARNED $21,493,248 $21,145, % NET LOSS INCURRED $10,074,020 $10,810, % NET LAE INCURRED $901,614 $1,329, % TOTAL LOSSES INCURRED $10,975,634 $12,139, % COMMISSIONS $3,511,941 $3,311, % OTHER EXPENSES $3,788,145 $3,662, % TOTAL EXPENSES $7,300,086 $6,973, % UNDERWRITING GAIN/(LOSS) $3,217,528 $2,032, % 37

38 Sample Income Statement (Selected Items) GERMAN MUTUAL Statement of Operations (cont.) YTD 200X YTD 200X CHANGE UNDERWRITING GAIN/(LOSS) $3,217,528 $2,032, % INVESTMENT INCOME $1,364,524 $988, % NET REALIZED GAIN/(LOSS) $34,541 ($103,751) % INVESTMENT INCOME $1,399,065 $884, % OTHER INCOME $170,818 $170, % INCOME BEFORE FEDERAL INC TAX $4,787, $3,087, % FEDERAL INCOME TAXES (REFUND) $1,609,471 $1,211, % NET INCOME $3,177,940 $1,876, % 38

39 The Basics of Cash Flow Statements Cash From Operations Premiums Collected (net of reinsurance) $100 Net Investment Income $5 minus Benefit and Loss related Payments ($55) Commissions, expenses paid ($40) Net Cash from Operations $10 Cash From Investment Activities Proceeds from investment sales, maturities, repayments $60 minus Investments acquisitions ($160) Net Cash from Investments ($100) Cash From Financing Activities, Miscellaneous Sources Funds raised (Surplus/capital notes, borrowed funds) $60 minus Dividends, other uses ($0) Net Cash from Financing $60 Net Change in Cash, Cash Equivalents, S/T $(30) 39

40 Exercise III - Instructions Please consider the following gq questions for 10 minutes. Then participate in the ensuing full group discussion. 1. Is underwriting income the same as total income? If not, what else is added to underwriting results to reach total income (before taxes and dividends)? 2. Investment t income is always larger than net realized gains. T F 3. Yield and total return are usually very close T 4. Please rank order the following asset classes in terms of their typical yield. Is the rank the same for their expected total return? If not, also rank them in total return terms. Cash Stocks Treasury Bonds Corporate Bonds F 40

41 Exercise III - Instructions Discuss questions and share answers (cont.) 5. If Treasury bonds show a loss it does not mean that investors are losing faith in the federal government s credit quality. T F 6. Corporate bonds can show a gain, even if interest rates rose in what circumstances? Does the opposite hold true (show a loss even if interest rates fell)? 7. Cash is said to be a high risk asset because its price rises and falls with significant volatility. T F 41

42 Key Accounting Concepts What does an Insurance Company do? How are revenues, expenses, assets and obligations reflected in the accounting books? Capturing Investments in Income Statement and Balance Sheet First steps in Capital Structure 42

43 The Capital Structure The Capital Structure refers to the manner in which h an organization finances its assets. The capital structure is the composition, or structure of its liabilities and capital accounts. If a company has 25% in surplus or stockholder s equity and 75% in borrowings (bank debt or bonds it issued), it is said to be 25% equity financed and 75% debt financed. Its ratio of debt to total capital is also referred to as its leverage 75% in this case. 43

44 The Capital Structure A common liability/capital structure * LIABILITIES Current Liabilities Bank Debt Accounts Payable Current Tax Liability Unearned Prem Reserve Loss payable reserve Sample External Ratings Obs. Long Term Liabilities Mortgage Debt on Plant * AA Collateralized li Bonds and Notes * A+ Senior Subordinated Bonds and Notes ^ Baa+ Junior STOCKHOLDER S EQUITY Preferred Stock ** Common Stock ** Retained Earnings * A mix of industrial and insurance company structure, for discussion purposes ** Available to be purchased and owned by investors in the company 44

45 Exercise IV - Instructions Please consider the following questions for 5 minutes. Then participate in the ensuing full group discussion. 1. Capital structure is a measure of how a company is financing itself T F 2. Companies have limited choices in their capital structure T F 3. Borrowings should be done in similar maturities as the assets they are financing T F 4. Equity can be a low cost form of financing when stock prices are high h T F 5. In a mutual the providers of equity capital are policyholders T F 45

46 Additional Information Feel free to contact the speaker for additional information on this material or more support on a range of investment or financial issues. Tony Caxide Chief Investment Officer, Hamilton Capital Phone: acaxide@aol.com 46

47 Bio Antonio M. Caxide, CFA Mr. Caxide is the Chief Investment Officer at Hamilton Capital Management, a Columbus, Ohio investment t manager and financial i advisor to institutions and individuals. Tony has 26 years experience in money management. Prior to HCM, Tony founded LUSIADS Investment Management in 2005, prior to which he served as Chief Investment Officer of Nationwide Financial, serving on its Risk Committee and Nationwide s Pension Investment Committee. He also spent 15 years at CIGNA Investment Management, heading the International Fixed Income group and serving as a special assistant to the CIO in a change process for its $60 billion portfolio. Tony has led investments for insurance, pension, foundation and individual assets. He managed equity and fixed income portfolios in over 30 countries. Tony is a CFA with an MBA in Finance from the University of Connecticut and 2 BS degrees in Biology and Natural Resources Conservation. He has been an invited speaker and lecturer in MBA programs. He was born in Portugal and speaks several languages. Chief Investment Officer acaxide@aol.com Hamilton Capital Management LUSIADS Investment Management LLC 47

48 Addendum Answers to Exercises 48

49 Exercise I - Answers 1. What does enough resources mean? Where does an insurance company keep its resources? Are they the same for large and small companies? Provide examples and comparable terms. Net Worth; Surplus; Assets or Assets in excess of obligations (liabilities); Investments; Liquidity They can be the same for large and small companies but small companies with a short track record may get more scrutiny by regulators 2. In what way can insurance companies make sure they have sufficient resources? Invest profitably; Keep expenses low; Increase premiums 49

50 Exercise I Answers (cont.) 3. Another word for financially sound Safe; Conservative; Low Risk; Strong returns; Predictable; Lots of surplus; Lots of resources 4. How do you build strong surplus? Contribute it (as equity); Sell more policies (profitably); Invest more profitably; Borrow it (surplus notes) 5. What s float and why is it very important? It s the activity of investing the cash that we receive as premiums while we hold it, until we need it to pay claims Many insurance companies need it to be profitable and grow surplus 50

51 Exercise I Answers (cont.) 6. Why must the Board/Audit committee monitor reserves? Fiduciary duty; complexity in predicting future; different methods; management s ability to differ from actuary 7. If reserves are materially lower than necessary they are and if higher than required they are. Deficient.. Redundant 51

52 Exercise II Answers (cont.) 1. What are the key revenues and expenses for an insurance company? Are they different for small and large companies? Revenues are premiums. Expenses are claims and underwriting. There is no material difference between large and small cos. 2. Premiums are fees to cover future risk, and are usually paid in cash. T F True. Sometimes a premiums receivable is established when the premium is to be paid later by the policyholder. 3. Premiums are paid in arrears. T F False, they are paid in advance so the company can earn returns from float. 4. Why do insurance companies cede, or lay off some of the risk they accept when they write a policy? To reduce their exposure; to protect surplus; to do business with a client while managing their exposure 52

53 Exercise II Answers (cont.) 5. What shifts premiums from being written to being earned? Passage of time 6. Underwriting results are always positive T F False. They can be negative (claims and expenses exceed premiums earned), in which case the returns from investments are key to earn income and grow surplus 7. Describe the process that the investment team goes through after cash comes in the door. Describe what Cash typically refers to (e.g., money in the vault or other). Shifting assets from very liquid and low returning to higher earning assets of various types. Usually also results in higher risk and lower liquidity, but not always. 53

54 Exercise II Answers (cont.) 8. Before premiums are earned, how do we show them on the balance sheet? What is the difference between a liability and a reserve, if any? Unearned Premium Reserve, one of the 2 largest reserves or liabilities on the balance sheet. 9. Name some of the key insurance company reserves. Loss Reserves, Loss Expense Reserve e 10. Liabilities are estimated via a rigorous process but judgment can impact it significantly T F True. The actuary and management participate in the process and db board members need dt to broadly understand dth the process of establishing and changing these estimates 54

55 Exercise II Answers (cont.) 11. Surplus, or net worth, typically increases in what way? Through contributions, earnings, unrealized gains in investments 12. Insurance companies need to keep lots of liquidity to pay for operating expenses, such as salaries. T F False. Usually operating expenses are handled out of operating cash flow. Insurance companies try to limit their liquidity because it usually lowers return. 55

56 Exercise III - Answers 1. Is underwriting income the same as total income? If not, what else is added to underwriting results to reach total income (before taxes and dividends)? No. Typically you have to add investment income and realized gains from investments t to the underwriting result. 2. Investment income is always larger than net realized gains. T F False. It depends on the exposure to assets other than fixed income; the change in price they experience; and how much is realized 3. Yield and total return are usually very close. T F False. Yield refers to the income that is generated. Total return also includes the change of price in the asset and can differ materially. 56

57 Exercise III Answers (cont.) 4. Please rank order the following asset classes in terms of their typical yield. Is the rank the same for their long term total return? If not, also rank them in historical total return terms. Yield: Corp Bonds; Treasury Bonds; Stocks; Cash Total Return: Stocks; Corp Bonds; Treasury Bonds; Cash 5. If Treasury bonds show a loss it does not mean that investors are losing faith in the federal government s credit quality. True. It usually means that market interest rates rose T F 57

58 Exercise III Answers (cont.) 6. Corporate bonds can show a gain, even if interest rates rose, in what circumstances? Does the opposite hold true (show a loss even if interest rates fell)? They can show a gain if spreads between corporate bonds and Treasuries narrow more than rates rose. The opposite is also true 7. Cash is said to be a high risk asset because its price rises and falls with significant volatility. T F False. Cash refers to very short term instruments where price volatility is minimal 58

59 Exercise IV - Answers 1. Capital structure is a measure of how a company is financing itself T F True 2. Companies have limited choices in their capital structure T F False. Industrial companies have a broad range of financing options (if healthy). Insurance companies have somewhat less flexibility and face more regulation 59

60 Exercise IV Answers (cont.) 3. Borrowings should be done in similar maturities as the assets they are financing True. If management deviates from this basic tenet, there could be good reasons and the Board should understand why 4. Equity can be a low cost form of financing i when stock prices are high True. When P/E multiples are high, equity financing is cheap. The opposite is also true 5. In a mutual the providers of equity capital are policyholders True. They are the owners 60