One of the most critical components of running a business or managing wealth is known as a “cash flow,” more specifically, cash flow projections. They provide a tool to recognize key risk factors likely to impact expected mortality, such as underwriting class and age at the time of purchase, and can incorporate alternative premium strategies such as premium loans or cash value reductions. Let's take a look at the importance of cash flow projections as it relates to the insurance market.
Defining cash flow projections for insurance companies
Generally speaking, a cash flow projection is an estimate of the amount of money that is expected to come into and flow out of your business or other financial assets. This is the same when operating an insurance business. A business that uses cash flow projections must keep track of its income versus its expenditures to have an accurate statement.
This will help the business calculate future cash flows in its future projections. A cash flow projection will also take into account how quickly your partners or customers will make payments or take payments, respectively. Cash flow management is a generally important concept for businesses and wealth direction.
If we take a closer look at how a cash flow projection and cash flow forecasting impacts the insurance industry, the idea is similar. Some insurance companies use cash flow projections as a pricing strategy. This is especially true when the company prices an insurance product below the usual rate of a premium that is required to cover the cost of expected losses. This strategy has some risks because it relies on knowing the expenses that need to be covered. Insurance companies also practice liability cash flow projections and acquisition cash flows, concepts that both play into their success in the long term.
The cash flow projections recognize key risk factors likely to impact expected mortality, such as underwriting class at the time of purchase and can incorporate alternative premium strategies such as premium loans or cash value reductions. For example, cash flow projections can help a company recognize key risk factors likely to impact expected mortality in the case of life insurance. The cash flow projections will also focus on projected lapse rates going forward which will drive expected cash flows going forward for the product.
How cash flow projections work for insurance companies
Creating a cash flow projection is relatively simple, but all the components must be calculated correctly. Making an accurate cash flow forecast as it relates to insurance and potential claims is similar to creating one as you would for a business.
Our consultants utilize cash flow projections to do the following:
- Assign a current value to the portfolio.
- Calculation of reserve requirements for the insurance company that factors in Asset Adequacy Requirements
- Asset/Liability Matching which is important in determining which assets need to be purchased/sold
- Calculation of capital and surplus
- Sensitivity and stress testing to see how the insurance company would respond under ideal conditions from the liability and the asset side
Here is a basic layout of how a typical cash flow projection should be constructed:
Create a timeline
The first thing that must be done is to create a timeline that the cash flow projection should cover for insurance companies. One of the most beneficial things about having a reliable cash flow projection is being able to make a plan based on the forecast. Because of this, the projection needs to cover a predetermined amount of time. Team members should use previous years, similar periods and additional data to determine accurate projections. The timeline should start with operating cash, which is the amount of money available at the beginning of the time period.
Maintain income lists
When it comes to creating a cash flow projection, income is a large piece of the puzzle. Insurance companies should keep track of the money that comes in as a positive component of the cash inflow. Here are some examples of income types that should be included:
- Premiums
- Reinsurance payments to the insurance company
- Asset cash flows
- Anything else from that would be in your income statement
Create a list of outgoing currency
The main reason that insurance companies are encouraged to conduct cash flow projections is to determine the reserve requirements as well as how much capital/surplus to hold to cover future liabilities. A reliable list of the ways that the income is used, or outgoing cash forecasting, should be included and can help create an accurate projection based on experience. Here are some examples of cash outflow:
A successful cash flow projection operates to forecast a predetermined period, so having an accurate list of payments on a cash balance sheet that will be made that month is extremely important. Each time period is different due to the nature of the policies in force and ongoing cash flows in the form of claim payments, as well as changes in the assets in force at any point in time.
Subtract expenses from income
The next step is to subtract your estimated future liability cash flows from the expected income to determine the future cash flow for the time period of the insurance product. If all future liabilities, reserve requirements and projected future asset cash flows have been included in the previous steps, the result will be a reliable cash flow forecast. The answer you get in this step is critical because it will tell the team or individual whether additional funds need to be set aside to cover future liabilities.
In the insurance industry, this is where appraisals can also be used to recognize key risk factors in the product through the projections in the future cash flow.
How to mitigate errors
For insurance companies, errors can be dangerous. The more often cash flow projections are made, the more reliable they will be for in-force business as well as for future insurance products.
The result will illuminate any adjustments needed to future cash flow projections. Projections will constantly need to be updated based on how experience emerges and then the model adjusted accordingly to account for that future experience
It is best to be conservative when it comes to your operating cash. Making an underestimation here and having more than expected is preferable to overestimating and ending up with a short ball at the end of the time period. For insurance companies, it is important to create cash flow projections in the model at least annually, and for larger companies at least on a quarterly basis, with potential adjustments to the model at least on an annual basis.
In this case, it is essential to update the components of the cash flow projection as new experience emerges or new information or requirements from the insurance industry comes out. This will make sure that the model is as accurate as possible at the time the projection is made.
The value of cash flow projections that are done right
A cash flow projection can be one of the most important calculations that a business makes and can offer many benefits and additional uses. With a good cash flow projection, better decisions can be made with the resulting information. For example, if the cash flow projection reveals that there will be a negative discrepancy between income and outgoing net cash flow for a new product, adjustments can be made to the product and/or additional reserves/capital set aside to handle the future liability.
A well-constructed cash flow projection can also tell the insurance company where potential issues and risks may lie. If there is a forecast shortfall of incoming revenue, decisions can be made to account for this in the model and have management make adjustments to account for this. The cash flow model needs to incorporate all areas of the company, including the investment department, to ensure all future income and liabilities are accounted for properly. A cash flow projection is an essential way of having hard data to show to regulators and other stakeholders.
To learn more about how cash flow projections work to determine key risk facts in the insurance industry and provide other guidance, reach out to Lewis & Ellis today.