Look to the financial statement notes for 8 indicators of risk
Underwriters glean valuable information from reviewing the financial statement notes that helps them to assess an organization’s overall risk profile.
When you analyze a set of financial statements you learn a lot about the organization and its financial situation as of the date of those statements. It is all good information, especially information on cash flow, but for Directors and Officers (D&O) Liability Insurance underwriters that’s not sufficient. They need to understand not only the events of the past and present but also what risk the FUTURE may hold. Underwriters want to know:
- What events or factors exist that could lead to a Claim in the coming policy period? and,
- What is the risk that, should a claim arise, the organization will not be able to fulfill its indemnity obligations?
Answers to these types of questions are help underwriters determine an organization’s D&O insurance risk and how to structure and price the insurance policy.
To find those answers, underwriters look to the financial statements and the accompanying notes (a.k.a. footnotes to the financial statements).
Read: 5 Ways Financial Statements Deliver D&O Risk Insights for more on financial statement analysis.
The analysis of the notes begins with Note 1. which states where and when the company was incorporated, information that is important for a claims made policy. In addition, this note also typically includes a brief description of operations and may reference the organization’s subsidiaries or partnership ventures.
The rest of the notes provide explanations and additional details that guide one’s interpretation of the numbers in the financial statements and fill in information gaps.
Here are some key things that underwriters look for in the notes:
1. Revenue trends
Revenue is the value of all sales and services recognized by an organization in a period; and is the lifeblood of the organization.
Underwriters need to understand how much revenue the organization generated in the previous year and if they can reasonably expect revenues to continue at that level. If there is an upward or downward trend that may affect the risk profile. Without revenue, the organization will need to fund operations by either debt or equity.
Revenue, also referred to as Sales or Income (or even “Top Line”), is shown at the top of the Income Statement. It is important to understand that revenue doesn’t necessarily mean cash. Organizations often sell goods or services on credit, and may not receive payment until a later date. Also, revenues fluctuate, or may even be at risk if sales are dependent on one customer or only one product.
Underwriters look at the notes to learn where revenue comes from, what payment terms are offered, what amounts are allocated for refunds or warranties, and other relevant information that affects revenue flow. The notes should also disclose information on the organization’s accounting policies – what is their approach to revenue recognition, to estimates, and to valuing inventory? And has there been a recent policy change? All of the above will color the underwriter’s interpretation of the revenue numbers in the financial statements.
For both brokers and underwriters, understanding how an organization generates revenue is fundamental in gaining a good understanding of the organization’s business operations.
2. Going concern
When an organization is considered to be a going concern that means it is financially stable and you can expect it to remain in business and to meet its obligations for the foreseeable future. While revenues may be strong, there are many other factors both internal and external, that go into assessing an organization’s long-term viability.
Underwriters view financial solvency as a proxy for overall risk as a bankruptcy proceeding can lead to claims against both the organization and its directors and officers. Allegations of breach of fiduciary duty may arise, at a time when the organization is not in a financial position to defend itself or provide indemnification. For example, a court appointed trustee may assert claims against current or former directors, alleging a breach of fiduciary duties if their activities are thought to have caused the insolvency. Lenders or vendors may also pursue their own claims alleging misrepresentation during a credit application process or even fraud.
The notes disclose any doubts about an organization’s ability to continue to operate as a going concern. Examples of this include: negative trends in operating results without a change in sight, continuously reported losses period after period, an inability to make loan payments, lawsuits, or an inability to secure credit from suppliers.
Going concern is an inherent risk in some industries. For challenging sectors, such as junior mining or technology start-up, insurers may have specialist underwriters on staff who have a deep understanding of the industry. While these underwriters may be looking at specific factors, be sure they will also look at the notes to understand the organization’s past activities and prospects for the future.
3. Operating segment details
The financial statements of larger corporations often include a section for operating segments within the notes. Here underwriters will find the financial data for specific segments of the organization, for example divisions, subsidiaries or other business segments. This section of the notes is only required for publicly traded companies.
Underwriters need to understand the organization’s business operations. This section of the notes breaks it all down enabling them to see more clearly how risk and performance varies across the organization. This information can be especially helpful if the organization has operations in high-risk sectors or geographies – for example in a highly litigious location or in a country with a history of nationalizing local operations of overseas entities – or if one operating entity is performing better than another one.
Operating segment reporting helps provide clarity for investors and creditors. Management uses this section to elaborate on the financial results and position of the most important operating units of an organization, and this is the information they use for making decisions related to the organization, making it a key underwriting point.
4. Extraordinary or non-recurring items
Extraordinary or non-recurring items, is the blanket term used to refer to unusual events such as an acquisition, winding down, the sale of a business segment or subsidiary, or the writing off of a line of business.
In the financial statements, such events appear simply as an unusual increase or decrease of a line item. An underwriter looks to understand one-off events that affect profitability. Let’s not forget that the underwriter wants to write the risk just as much as the broker wants to place the risk and the buyer wants a policy. Explanations of one-off events can help the underwriter justify offering to sell a new insurance policy or renewing it. It is the notes to the statements that provide the underwriter with the necessary explanations. Equally important, this disclosure can provide valuable insight to a broker who wants to quickly understand how an organization has changed or evolved during the most recent reporting period.
5. Related party transactions
Related parties, refers to parties that have direct or indirect control, joint control, or influence over each other. Examples of transactions between related parties includes the sale of equipment between two companies owned by the same person or a CEO hiring their son or daughter as the President.
These types of transactions may put the organization’s directors in a conflict of interest and attract litigation alleging breach of fiduciary duties, unfair trade practices, or self-dealing. In 2019, WeWork made headlines for its quantity of related party transactions, some of which involved the CEO, his wife and other family members. While related party transactions are not unusual, it may be an indicator of improper corporate governance.
Underwriters examine the related party transactions to get a sense of an organization’s corporate governance practices.
6. Debts & covenants
Debts and covenants, refers to obligations, generally financial, that the organization owes to those outside the organization.
Taking on debt enables organizations to grow and is a cheaper form of financing than issuing equity. Problems may arise however, when an organization is unable to service its debt.
Underwriters will look for information on debts and covenants in the notes to understand the organization’s credit and liquidity risk. In specific, underwriters will make a note of the following:
- terms on debt agreements (interest rates, repayment periods, conversion features)
- access to unused credit (such as lines of credit)
- assets tied up as security
- recorded debt amount vs. fair value
- compliance with covenants (and consequences for breaching agreements)
7. Commitments & contingencies
A commitment is a promise to an external party made by an organization, arising out of a legal or contractual requirement. A contingency, on the other hand, is an obligation that is still uncertain and is dependent on whether or not another event happens, such as an ongoing court case.
The disclosure of commitments and contingencies in the notes to the financial statements provides transparency and allows increased faith by stakeholders.
While commitments and potential obligations (like pending lawsuits or disputes) are recorded in the notes, they are not recorded in the actual financial statements. This is important to understand because, depending on the size of the obligation, it may represent a significant cash outflow for the organization. The notes may provide clues on the organization’s expectations of future events or outcomes and might trigger follow-up questions.
8. Subsequent events
A subsequent event is an event that occurred after the date of the financial statement but before the financial statements were authorized for issue. Events listed here typically include things like:
- Acquisitions or divestitures
- New commitments
- New financing agreements (sale of shares, debt)
This information provides underwriters early notice of items that have already happened and will affect the organization’s future financial statements. Underwriters may ask further questions and incorporate these new events in their current analysis of the organization’s insurance risk.
- Reading the notes is necessary for understanding the balance sheet, income statement, and cash flow statement.
- The notes provide information beyond the numbers that give additional insight into an organization’s past, present and future risks.
- Underwriters depend on the notes for determining D&O insurance risk, policy structure and price.