Author: Nancy Germond
According to Richard Faber, founder of Underwriter's Resource located in Arizona, financial strength of a company matters to underwriters and agents for several reasons.
- Evaluation of financial strength confirms the accuracy of rating data, for example, payroll submitted may be different than what the insured estimates on the application.
- Evaluation allows the underwriter to confirm that the insured can afford solid risks prevention controls. A business that is on shaky financial ground often cuts safety and training first.
- Evaluation allows the underwriter to ensure the organization can meet deductibles and self-insured retentions commitments.
- Financial strength indicates solid organizational management techniques, which usually include solid risk management.
While credit ratings from Dunn & Bradstreet or Experian are indicators, deeper dives into financial data can help underwriters see the “big picture" of management practices and financial soundness.
Basic Terms Used in Both Personal and Commercial Insurance
Let's review some brief descriptions of the terms, and how you may use them while servicing your commercial clients.
Credit ratings – These ratings from a variety of sources indicate the insured's history of creditworthiness in general, or with respect to specific financial obligations. The shortcoming of credit ratings? They provide a “superficial" look at the business, according to Faber. They do not evaluate the organization's “true financial strength." Only the underlying financial documents can indicate with more certainty the organization's fiscal footing.
Square footage – Square footage is the amount of flat space in a particular area. You calculate square footage by multiplying the length of a room by its width.
Commercial Insurance Financial Terms
Here are some key terms you'll want to know as a commercial insurance producer.
Financial statements – Financial statements are any documents detailing a commercial organization's financial activities or financial position. Listed below are many of the main documents an underwriter may request to better understand your client's financial flow and financial status.
Balance sheet – The balance sheet provides a window into the business's current financial position on the day the bookkeeper or business owner generates that document. The balance sheet documents an organization's assets and its financial liabilities – liabilities meaning what it owes, for example, vehicle lease payments, mortgages, leases, etc.
There are three parts of the balance sheet – assets, liabilities and shareholder's/owner's equity. This is the balance sheet formula
Assets – Liabilities = Shareholders/Owners Equity
EBITA is a frequently used measure of a business's profitability. It measures earnings before interest, taxes and amortization. Often used to benchmark one business against another in the same industry, you may also see it referred to as EBITDA, which includes removing depreciation from the equation. It shows cash profit from operations.
Equity in essence means the shareholder's (for a public company) or owner's (privately owned) financial balance in the company, after subtracting all liabilities.
Assets – Resources an organization has in its possession, such as cash on hand, accounts receivable and inventory. These are called current assets.
Noncurrent assets are assets the business owner will use in periods longer than one year. This can include tangible assets such as buildings and equipment, and intangible assets such as all types of an organization's intellectual property such as patents, and goodwill, which includes an organization's reputation. Intangible assets are assets that you can't normally touch or see.
Shareholder's/Owner's Equity – Simply explained, equity in the company is the business's assets minus its liabilities. For a nonprofit, often called “surplus."
Depreciation – In a normal economy, the value of tangible assets declines over time. Organizations, usually through their accountants, depreciate tangible assets such as vehicles, buildings, etc. In viewing the balance sheet, the depreciated value of the asset, known as net value, appears.
Liabilities – These include debts the business owes to others. Liabilities are either current or noncurrent.
Current liabilities – Includes debt due within one year.
Noncurrent liabilities – Includes debt due more than one year after the sheet the business generates the balance sheet.
Income statement – The income statement outlines an organization's fiscal health because it shows profitability over a length of time. The income statement will show the revenue brought in against the expenses incurred during that time.
Cash-flow statement – Cash flow statements outline the business's cash into the business received from its ongoing operations and external investments and outline all cash outflows for business expenditures and investments during a quarter. Simply said according to Faber, it shows
- Effects of depreciation
- Where cash is coming from
- Where cash is going
- An ability to evaluate if more is coming in than going out
Revenue – Revenue is the inflow of money, accounts receivable, or in the case of associations or non-profits, it can be memberships or donations.
Expenses – Expenses are monies expended to make money, said simply. Expenses vary by the type of organization. For a service company, for example, supplies will be a large expense category, as will vehicle expenses. Two categories of expenses are general operating expenses or expenses tied to sales. General operating expenses include the costs to heat or run a building, for example. Expenses tied to sales include commissions, shipping costs, etc.
Cost of goods sold – This can be the cost to buy merchandise or items to resell such as a heating unit for a heating contractor, as well as shipping costs. For manufacturers, this can include materials used to build a product, labor costs, and overhead.
Gross profit – The income statement reflects gross profit, which is sales/operating revenue minus the cost of goods sold.
Operating income – The income statement reflects the gross profit minus selling, general and administrative costs.
Net income – Net income, also called “net earnings," defined as the sales revenue, with the cost of goods sold, general expenses, taxes and interest deducted. The formula is shown here.
Net income = Revenue – Expenses (including depreciation) + Gains – Losses - Taxes
Cash accounting versus accrual accounting – A key accounting term is the cash versus accrual method of accounting. If a business records revenue when earned and expenses when paid, it's on the cash method of accounting. If the business records revenue when they create an invoice, and records a bill when received, it's on the accrual method. Many smaller businesses use the cash accounting method because they don't pay taxes on income until received. Accrual accounting matches expenses and income in the same year, providing a more accurate picture of the business's financial status.
Business Income Financial Terms
Business income losses can generate significant errors and omissions (E&O) exposures. In other words, if your insured finds him or herself underinsured or without coverage after an event that disrupts the business, you may be on the receiving end of an E&O claim.
Here are some key terms that you should understand as you write business income insurance. Remember, businessowners policies (BOP) usually include business income, so even if you haven't written a commercial property policy with business income, if you're writing BOPs, you have this exposure.
All normal operating expenses – Operating expenses such as utilities the business would have incurred if the business had not closed or reduced its operations due to the loss.
Business income – Had no loss occurred, the normal net profit or loss that would have developed plus normal continuing normal operating expenses.
Compensable business income – Compensable business income is the actual amount of business income paid to cover the amount of income lost during the period of restoration. This is the amount necessary to indemnify the insured.
Continuing (normal) operating expenses – Normal or customary operating expenses that continue during the period of restoration (the time period the business discontinues business operations due to a covered property loss).
Discretionary payroll – Payroll attached to specific employees or classes of employees not required to resume operations. For example, if owners must close the business, you may not need service technicians or dispatchers for a time.
Extra expense – Expenses needed that the business would not have needed had the loss not occurred. For example, this could include expedited shipping costs, overtime, or moving costs.
Insurable business income – Total amount of business income by which the insurer calculates the business income premium.
Maximum coinsurance percentage – The number of months needed to achieve the periods of restoration objectives divided by twelve.
Ordinary payroll – Payroll of “ordinary" employees. These are employees, officers, executives, department heads, contract employees, or any specifically listed employee or job description.
Period of restoration – The time period after the physical loss by a covered cause of loss at the premises which ends on the earlier of: (1) The date when the property at the described premises should be repaired, rebuilt, or replaced with reasonable speed and similar quality; or (2) the date when the business resumes at a new permanent location. A time deductible applies based on whether the coverage is business income or extra expense.
Pre-loss operational income – The business's ability to generate the same level of income prior to suspending operations from a covered loss.
Production-related expenses – Cost of goods sold, outside services resold, non-contracted utility costs, specified payroll and some special considerations for mining enterprises.
To quote Chris Boggs' book Business Income Insurance Demystified, “All business income losses are settled based on the coverage limit purchased. An accurate business income coverage limit calculation depends on an accurate estimation of 1) the 12-month business income exposure; and 2) the legitimate estimation of the worst-case period of restoration.
"Estimating the worst-case period of restoration necessitates understanding the time required to accomplish each of the ten steps in the four period of restoration objectives. The key to business income is the correct estimation of time."
What if My Insured Balks at Releasing Financial Information?
Sometimes your insured will balk at releasing financial information, which will be a red flag for underwriters. Explain to your insured why underwriters require this information. According to Faber, here are the nine data points typically requested by underwriters.
- Gross sales
- Net income before taxes
- Interest expense
- Accounts receivable
- Inventory on hand
- Total current assets
- Total assets
- Total current liabilities
- Total liabilities
Once the insurer binds coverage, the carrier has the right to access any of this information, because at audit the insurer will verify payroll, sales, or other financial data points. If your insured understands the need for this information, he or she may be more willing to comply with reasonable requests by the underwriter.
This Financial Terms Cheat Seat May Help
Nicolas Boucher, a financial consultant and auditor, offers a handy financial terms cheat sheet that can quickly help you understand what your underwriter may be requesting. You can reach Nicolas at nicolasboucher.online if you'd like to follow him for more financial tips.
Last Updated: June 2, 2023
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