SOFA-CFE Practice Questions

Payroll and expense reimbursement schemes are classic examples of fraudulent disbursements that rely on false documentation. In payroll schemes, perpetrators may create ghost employees, falsify timesheets, or inflate commission records. In expense reimbursement schemes, they submit claims for fictitious expenses, mischaracterized personal costs, or overstated amounts. In both cases, the perpetrator submits falsified documents to the victim organization, which then unwittingly processes and issues a fraudulent payment based on that deceptive information.

A. "Frequency of fraudulent disbursements" is a statistical metric used to measure how often a type of fraud occurs; it is not a category of fraud itself.

C. "Inventory & Purchase reimbursement schemes" is not a standard fraud classification. Inventory fraud typically involves the theft of physical assets, not fraudulent disbursements.

D. "Sales & Equipment reimbursement schemes" is not a recognized category in the fraud tree. While an expense claim could be for equipment, it falls under the broader expense reimbursement category.

1. Association of Certified Fraud Examiners (ACFE). Fraud Examiners Manual, International Edition. 2023.

Section 2, Subsection: Payroll Schemes (p. 2.701): "Payroll schemes are occupational frauds in which a person who works for an organization causes that organization to issue a payment by making false claims for compensation." This section details how ghost employees, falsified hours, and falsified wages rely on creating and submitting false records (e.g., timecards, personnel files).

Section 2, Subsection: Expense Reimbursement Schemes (p. 2.801): "Expense reimbursement schemes are a form of fraudulent disbursement in which employees make false claims for reimbursement of fictitious or inflated business expenses." This section explains that schemes like mischaracterized expenses, overstated expenses, and fictitious expenses require the perpetrator to submit false documentation (e.g., altered receipts, fabricated support).

2. Albrecht, W. S., Albrecht, C. O., Albrecht, C. C., & Zimbelman, M. F. Fraud Examination (5th ed.). 2016. Cengage Learning.

Chapter 7, "Fraudulent Disbursements": This chapter explicitly categorizes payroll and expense reimbursement schemes as types of fraudulent disbursements. It states, "Expense reimbursement frauds are schemes in which an employee makes a claim for reimbursement of fictitious or inflated business expenses... To be reimbursed, the employee must typically submit a document... that supports the claim." (p. 228). Similarly, it describes payroll schemes as involving the manipulation of payroll system records to generate fraudulent payments.

Statutory Surplus Relief is the immediate increase in a ceding insurer's surplus resulting from a reinsurance agreement. This relief is primarily generated by the ceding commission received from the reinsurer and the transfer of the unearned premium reserve liability. This accounting treatment provides an immediate, but temporary, benefit to the ceding company's surplus. As the reinsured premium is earned over the policy period in the subsequent year(s), the initial surplus gain is reversed or "unwinds" as the ultimate profit or loss from the business is recognized. This mechanism is often used by insurers to manage their premium-to-surplus ratios and support growth.

A. Law of insurance premium relief: This is not a standard or recognized term within statutory accounting principles for reinsurance transactions.

B. Financial growth relief: This is a general business outcome, not the specific accounting term for the temporary surplus enhancement provided by reinsurance.

D. Spread risk relief: This describes a fundamental purpose of reinsurance—risk diversification—not the specific statutory accounting entry that reverses over time.

1. Cummins, J. D., & Weiss, M. A. (2009). Convergence of Insurance and Financial Markets: Hybrid and Securitized Risk-Transfer Instruments. The Journal of Risk and Insurance, 76(3), 493–545. In Section 4.2, the paper discusses traditional reinsurance functions, noting that a primary motivation is "to provide surplus relief for a ceding insurer that is growing rapidly." This relief stems from the statutory accounting treatment of acquisition expenses and unearned premium reserves, which unwinds as premiums are earned. (DOI: https://doi.org/10.1111/j.1539-6975.2009.01321.x)

2. Pinto, A. C., & Pukthuanthong, K. (2009). Reinsurance and the Firm's Life Cycle. Working Paper, San Diego State University. Page 5 discusses that "reinsurance provides surplus relief" by allowing the ceding company to reduce its unearned premium reserves and receive a ceding commission, which increases statutory surplus. The paper implicitly supports the concept that this is a timing benefit that normalizes as the business runs off.

3. Webb, B. L., Harrison, C. M., & Markham, J. J. (2002). Insurance Operations, Regulation, and Statutory Accounting. American Institute for Chartered Property Casualty Underwriters. Chapter 10, "Reinsurance," explains that surplus relief arises because ceding commissions offset acquisition costs that must be expensed immediately, reducing the drain on surplus. This effect reverses as the premium is earned in subsequent periods.

The provided description is the formal definition of benchmarking. It is a continuous and systematic management process for evaluating and comparing an organization's work processes, products, and services with those of the best performers and recognized industry leaders. The primary objective is to identify, understand, and adapt outstanding practices from both inside and outside the organization to help improve performance. This involves measuring performance against a chosen benchmark, identifying gaps, and implementing changes to close those gaps and achieve superior results.

B. Flowcharting: This is a graphical tool used to map out a process or workflow. It helps in understanding a process but is not the improvement methodology itself.

C. Capital budgeting: This is a financial planning process for evaluating and selecting long-term investments and projects, not a method for adopting operational best practices.

D. None of the above: This is incorrect as benchmarking accurately describes the process detailed in the question.

1. Camp, R. C. (1989). Benchmarking: The Search for Industry Best Practices that Lead to Superior Performance. ASQC Quality Press. In Chapter 1, "A New Beginning," Camp defines benchmarking as "the continuous process of measuring products, services, and practices against the toughest competitors or those companies recognized as industry leaders" (p. 10).

2. Zairi, M. (1998). Benchmarking: The best tool for measuring competitiveness. Benchmarking for Quality Management & Technology, 5(1), 3-4. The article's abstract and introduction define benchmarking as a process of learning from others and a pragmatic way of improving performance. (https://doi.org/10.1108/14635779810206805)

3. MIT Sloan School of Management. (2002). 15.762, Strategic Management of Technology and Innovation. Course Notes, Lecture 12: Process and Product Development. The lecture notes describe benchmarking as a key method for process improvement by "studying practices at 'best in class' companies and adapting them for your own use." (Available through MIT OpenCourseWare).

Statutory Accounting Principles (SAP), which state insurance departments use to evaluate an insurer's solvency, are designed to be conservative. Under SAP, only assets that are liquid and available to pay policyholder claims are recognized on the statutory balance sheet. These specific assets are termed "admitted assets." Assets that are not easily convertible to cash to meet obligations (e.g., office furniture, automobiles, certain receivables) are classified as "non-admitted" and are excluded from the calculation of the insurer's surplus, providing a more conservative view of its financial strength.

A. Assets: This is a general accounting term. SAP makes a crucial distinction between admitted and non-admitted assets for solvency evaluation, making this answer too broad.

B. Determined assets: This is not a standard or recognized term within the framework of Statutory Accounting Principles or general accounting practices.

D. Altered assets: This is not a recognized accounting classification and has no relevance to the regulatory evaluation of an insurer's financial condition.

1. National Association of Insurance Commissioners (NAIC). Accounting Practices and Procedures Manual, Vol. I, SSAP No. 4—Assets and Nonadmitted Assets, Paragraph 2. This official source states, "An admitted asset is an asset that is permitted by statute to be included in the statutory financial statements of an insurer... The primary focus of solvency regulation is to ensure that assets are available to meet policyholder obligations."

2. Grace, M. F., & Klein, R. W. (2009). The Regulation of Insurance Markets. World Bank Policy Research Working Paper 5106, Page 11. The paper explains that Statutory Accounting Principles (SAP) are "more conservative than GAAP" and that "certain assets, such as furniture and fixtures, are 'non-admitted' and given a value of zero in SAP financial statements." This highlights the concept of admitting only certain assets for solvency purposes.

3. Harrington, S. E. (2009). "The Financial Crisis, Systemic Risk, and the Future of Insurance Regulation." Journal of Risk and Insurance, 76(4), 785-819. In its discussion of insurance solvency regulation, the paper implicitly relies on the SAP framework, where the valuation of assets and the distinction between admitted and non-admitted assets are fundamental to determining statutory capital and surplus (p. 791). https://doi.org/10.1111/j.1539-6975.2009.01330.x

The tax components of continuing operations represent the income tax expense or benefit related to a company's core, ongoing business activities. This calculation typically includes the effects of changes in tax laws or rates, adjustments to the valuation allowance for deferred tax assets, and changes in judgment about uncertain tax positions. These events, collectively described as "changes in tax status," directly impact the current or deferred tax provision attributable to income from continuing operations for the period. Accounting standards require the tax effects of other major events, such as discontinued operations, to be reported separately.

B. Discontinued operations: The income or loss from discontinued operations, along with its related tax effect, is required to be presented separately from continuing operations on the income statement.

C. Extraordinary items: This classification was eliminated from U.S. GAAP in 2015. Even when it existed, the tax effects of extraordinary items were reported separately from continuing operations.

D. All of the above: This option is incorrect because discontinued operations and extraordinary items are specifically excluded from the tax calculation for continuing operations.

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1. Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) 740-20-45-3. This section on intraperiod tax allocation states, "Income tax expense or benefit for the year shall be allocated among continuing operations, discontinued operations, other comprehensive income, and items charged or credited directly to stockholders’ equity." This explicitly separates the tax allocation for continuing and discontinued operations.

2. FASB Accounting Standards Codification (ASC) 740-10-45-15. This paragraph specifies that the tax effect of a change in tax laws or rates on deferred tax assets and liabilities "shall be included in income from continuing operations for the period that includes the enactment date." This directly supports that changes in tax status are part of continuing operations.

3. FASB Accounting Standards Update (ASU) No. 2015-01, "Income Statement—Extraordinary and Unusual Items (Subtopic 225-20): Simplifying Income Statement Presentation by Eliminating the Concept of Extraordinary Items." This official update removed the concept of extraordinary items from GAAP, making option C obsolete and incorrect.

4. Spiceland, J. D., Nelson, M. W., & Thomas, W. B. (2021). Intermediate Accounting (11th ed.). McGraw-Hill Education. In Chapter 16, "Accounting for Income Taxes," the text explains that intraperiod tax allocation involves separating the total income tax expense among continuing operations, discontinued operations, and other financial statement components. It also clarifies that changes in enacted tax rates are recognized as part of the tax expense from continuing operations.

The scenario describes an arrangement where a payment is postponed or made in installments, which is known as a deferred payment. In insurance, this often takes the form of a premium financing agreement or an installment plan. If the insured fails to make a scheduled payment when it is due, they are in default. The terms of such agreements typically allow the insurer or the financing company to cancel the policy and claim the unearned premium—the portion of the premium that corresponds to the remaining policy period—to settle the outstanding balance.

A. unrecognized assets: This is an accounting term for a potential economic benefit not recorded on a balance sheet; it is unrelated to a policyholder's payment obligation.

C. irrecoverable credits: This term implies a debt that is already deemed uncollectible, which contradicts the action of canceling a policy to recover the funds.

D. All of the above: This is incorrect because options A and C do not fit the context of the question.

1. Jerry, R. H., & Richmond, D. R. (2012). Understanding Insurance Law (5th ed.). LexisNexis Matthew Bender. In Chapter 4, Section 4.03[c] "Nonpayment of Premium," the text establishes that failure to pay a premium installment (a form of deferred payment) is a valid ground for policy cancellation by the insurer. The return of unearned premium is a standard consequence of mid-term cancellation.

2. National Association of Insurance Commissioners (NAIC). (2010). Insurance Premium Finance Company Model Act. Section 9, "Cancellation of Insurance Contract Upon Default," explicitly outlines the process described in the question. It states that upon default, the premium finance company may cancel the policy, and the insurer must return any gross unearned premiums to the finance company to be credited against the defaulted balance.

3. Vaughan, E. J., & Vaughan, T. (2007). Fundamentals of Risk and Insurance (10th ed.). Wiley. Chapter 10, "The Insurance Contract," discusses policy provisions, including the obligation to pay premiums. The text explains that premiums can be paid in installments and that failure to pay an installment when due constitutes a breach, giving the insurer the right to cancel the policy according to its terms.

A call option contract represents a transfer of financial opportunity. The seller (writer) of a call option receives a premium (the option's price) from the buyer. In exchange for this premium, the seller transfers the right, or opportunity, for capital gains on the underlying stock to the buyer. The buyer will realize a net profit if the stock's market price rises above the agreed-upon exercise (strike) price by an amount greater than the premium paid. This arrangement allows the buyer to benefit from upward price movements while the seller accepts the corresponding risk for a fixed fee.

A. This phrasing is imprecise. A buyer transfers risk, not an "opportunity for capital loss." The seller assumes the risk of loss in exchange for the premium.

C. The seller of a call option incurs a loss if the underlying stock price rises significantly above the exercise price, not if it decreases.

D. A floor is typically created with a put option, which gains value when the underlying asset's price falls, not when it rises.

1. Hull, J. C. (2022). Options, Futures, and Other Derivatives (11th ed.). Pearson.

Chapter 1, Section 1.4, "Options": This section introduces call options, stating, "A call option gives the holder the right to buy the underlying asset by a certain date for a certain price." The profit/loss profiles discussed show that the buyer has unlimited upside potential (opportunity for gain), while the seller has unlimited downside risk. The break-even point for the buyer is explicitly when the asset price equals the strike price plus the premium. This confirms the mechanism described in option B.

2. Tuckman, B., & Serrat, A. (2011). Fixed Income Securities: Tools for Today's Markets (3rd ed.). Wiley.

Chapter 10, "Options": This chapter explains the fundamental transaction: "The buyer of an option pays the seller a price, called the option premium... In buying a call, an investor gets the upside of the underlying security... in exchange for the premium." This directly supports the concept of the seller transferring the opportunity for gain (the upside) to the buyer.

3. MIT OpenCourseWare. (2008). 15.401 Finance Theory I, Fall 2008. Lecture 18: Introduction to Options. Massachusetts Institute of Technology.

Lecture Slides & Transcript: The lecture materials explain that a call option buyer pays a premium for "exposure to the upside" of a stock. The seller receives the premium for taking the opposite position. This aligns with the seller transferring the opportunity for capital gain to the buyer. The payoff diagram for a long call position shows profit accruing only after the stock price exceeds the strike price plus the premium.

The treasury function is responsible for managing the insurance company's overall capital structure, liquidity, and cash flow. The investment function is tasked with managing the portfolio of assets, which are funded by policyholder premiums (the "float") and the insurer's capital. Together, these two functions work to manage the funds generated by the underwriting side of the business to earn investment income, thereby maximizing the overall profitability and financial stability of the entire entity.

A. "Cash and credit" is too narrow; the investment function encompasses a much broader range of assets than just credit, and cash management is only one component of the treasury role.

C. The "insurance" function (underwriting and claims) is the primary source of the funds, not the function responsible for managing them for investment profit.

D. "Revenues" is a financial outcome or metric, not a management function. The investment function's goal is to generate revenue, but "revenues" is not the function itself.

1. Cummins, J. D., & Weiss, M. A. (2013). Systemic Risk and the U.S. Insurance Sector. In R. W. Klein & J. R. Phillips (Eds.), Regulating and Supervising the U.S. Insurance Industry for the 21st Century (pp. 1-100). The Wharton School, University of Pennsylvania. In Section 3.2, "The Business of Insurance," the text distinguishes between underwriting activities that generate funds and the investment activities that manage those funds to produce income.

2. Harrington, S. E., & Niehaus, G. R. (2003). Risk Management and Insurance (2nd ed.). McGraw-Hill/Irwin. Chapter 5, "The Financial Performance of Insurers," explains how profitability is derived from both underwriting results and investment income, detailing the role of the investment function in managing the insurer's assets.

3. National Association of Insurance Commissioners (NAIC). (2020). Financial Condition Examiners Handbook. Volume 1, Part 3, Section I. This handbook outlines the examination procedures for an insurer's financial condition, with distinct sections for reviewing investment practices (e.g., Part 3, Section IV - Investments) and capital/surplus management, which falls under the treasury's purview. It treats these as separate but related core functions for managing profitability and solvency.

For an insurance company to be classified as a "life insurance company" for U.S. federal income tax purposes, it must satisfy the reserve test defined in the Internal Revenue Code. This test requires that the sum of its life insurance reserves and its unearned premiums and unpaid losses on noncancellable life, accident, or health policies must comprise more than 50 percent of its total reserves. This statutory threshold ensures that the company's predominant business is life insurance, thereby justifying its taxation under the specific rules applicable to life insurers.

A. 25: This percentage is incorrect and falls significantly short of the statutory requirement for qualifying as a life insurer.

B. 50: The law specifies "more than 50 percent." A company with reserves at exactly 50 percent would fail to meet the qualification test.

C. less than 50: This is the inverse of the actual requirement; a company with reserves below this threshold would not qualify as a life insurer.

1. Internal Revenue Code, 26 U.S.C. § 816(a). This is the primary legal source defining a life insurance company for tax purposes. Section 816(a) explicitly states the "more than 50 percent" rule for the reserve test.

2. Pike, A. D. (2023). Federal Income Taxation of Life Insurance Companies. American Bar Association. Chapter 2, Section II.A, "The 'More Than 50 Percent' Reserve Test." This treatise details the application of IRC § 816(a).

3. KPMG. (2023). Taxation of Insurance Companies - United States. Section 3.2, "Definition of a life insurance company." This publication, often used in advanced accounting and tax courses, explains that "a company is a life insurance company for US federal income tax purposes if its life insurance reserves... comprise more than 50% of its total reserves."

4. PricewaterhouseCoopers (PwC). (2022). U.S. Taxation of Insurance Companies. Chapter 2, "Life Insurance Company Taxation," pp. 10-12. This guide, used as a reference in professional and academic settings, confirms the "more than 50 percent of total reserves" test under IRC Sec. 816.

Deferred taxes result from temporary differences between the carrying amount of assets and liabilities for financial reporting purposes and their tax bases. Unrealized gains and losses on certain investments are recognized in surplus for statutory accounting purposes but are not taxable until realized. The corresponding tax effect of these unrealized items is recorded as a deferred tax liability or asset. This deferred tax amount is reported as a direct adjustment to surplus, netting against the unrealized gain or loss, rather than being reported as part of the income tax expense on the income statement.

A. Depreciated: Depreciation is an accounting method for allocating the cost of a tangible asset over its life; it is not a type of tax.

C. Limited: "Limited tax" is not a standard accounting term for the tax treatment of unrealized gains and is not relevant in this context.

D. Venture: Venture refers to a type of investment (e.g., venture capital), not a classification of tax.

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1. National Association of Insurance Commissioners (NAIC). Statement of Statutory Accounting Principles (SSAP) No. 101—Income Taxes. In this standard, paragraph 11.d specifies that "The change in deferred income taxes attributable to unrealized capital gains and losses...shall be recorded as a direct adjustment to surplus as a component of the change in net unrealized capital gains and losses." This directly supports that the tax effect of unrealized gains/losses is a component of surplus.

2. Spiceland, J. D., Nelson, M. W., & Thomas, W. B. (2021). Intermediate Accounting (11th ed.). McGraw-Hill Education. In Chapter 16, the section on "Intraperiod Tax Allocation" explains that the income tax effect of items recognized in other comprehensive income (which is analogous to direct adjustments to surplus for unrealized gains) must also be allocated to that component of equity, separate from income from continuing operations.

3. Financial Accounting Standards Board (FASB). Accounting Standards Codification (ASC) Topic 740, Income Taxes. ASC 740-20-45-11 requires that the tax effect of gains and losses included in other comprehensive income (such as unrealized gains on available-for-sale securities) shall be charged or credited directly to other comprehensive income. This principle aligns with the statutory accounting treatment of reporting the tax effect in surplus.