Analyzing Insurers’Financial Condition

Robert KleinRMI 4700Insurance Operations11/3/09

Who Needs to Know?• Buyers and Intermediaries

• Reinsurers

• Investors

• Creditors

• Vendors

• Regulators– State Insurance Commissioners– SEC

Insolvencies – Over the Hump?

… But Getting More Costly?

Different Roles• Regulators

– Monitor, Report, Enforce– Compel Transparency– Limit Insolvency Risk– Intervention

• Rating Agencies– Assess Claims-Paying Ability– Rate Debt

• Other Analysts– Assess Value and Risk

External Reporting Systems• Regulatory

– annual & quarterly statutory financial statements– special reports, e.g., risk-based capital– independent CPA audited statements– certified actuarial opinions– management plan of operation– other reports on request

• Rating Agencies– regulatory reports– other rater-specific questionnaires, interviews

Other External Parties• SEC

– 10K Form– 10Q Form

• Buyers, Investors & Creditors– GAAP Financial Statements– Company Annual Reports

• Internal Revenue Service• Statutory vs. GAAP Reporting

– Statutory: insurer ability to meet claims obligations– GAAP: value of firm as going concern

Different Perspectives

• Accounting– What are the values of the firm’s assets, liabilities,

net worth, cash flows; are they accurate?

• Actuarial– What risks is the insurer exposed to?– Is it charging adequate prices & estimating costs

(historical & future) accurately?

• Financial– How well is the insurer managing its overall

financial risk & return and their components?

Insurer Financial Risks• Actuarial

– underpricing

– catastrophe

– other underwriting

– inadequate reinsurance

• Systematic– asset/liability changes due to

broad economic factors

• Interest Rate Risk

• Credit– borrower fails to perform

• Liquidity– large cash demand

• Operational Risks– mistakes in transactions

– poor claims adjusting

– information system failures

– regulatory problems

• Legal Risks– change in laws affecting

contract obligations or asset values

– lawsuits

Sector Specific Issues• Property-Casualty

– underpricing– underreserving– concentration of exposures– rapid growth; new lines

• Life– valuation– economic assumptions– duration mismatch– concentrations of assets– lapse rates

• Health– underpricing– adverse selection– underreserving– poor loss control

Functions of Capital• Absorb unanticipated losses & still ensure continued

viability of firm.– significance of “franchise value”

• Protect claim holders (especially policyholders in case of insurers).

• Protect insolvency guarantors.• Fund liquidation expenses.• Support investment and growth of firm.

– mutual vs. stock company considerations

• Recall importance of sending “positive signals” to investors & customers.

Capital Adequacy

• Surplus Assets – Liabilities

• Risk-Based Capital TAC/RBC BCAR

• Leverage GPW/Surplus NPW/Surplus Liabilities/Surplus Surplus/Assets (Life)

Total Assets 19,842,695,554Total Liabilites 12,961,588,288Surplus 6,881,107,266

TAC 6,881,107,266RBC 1,200,098,848TAC/RBC 573.4%

BCAR 275.9%

Net Premiums Written 4,670,846,424NPW/Surplus 67.9%

Liabilities/Surplus 188.4%

St. Paul Fire & Marine

Financial Performance

• Profitability Loss Ratio Combined Ratio Operating Ratio Net Income Rate of Return

• Efficiency Expense Ratio Investment Return

Net Premiums Earned 4,676,657,681Net Losses Incurred 2,171,617,087Pure Loss Ratio 46.4%

Loss Adjustment Expense 570,879,443Other Underwriting Expenses 1,423,355,487Dividends to PHs 5,767,644Total Expenses 2,000,002,574Combined Ratio 89.2%

Net Investment Income 845,862,624Operating Ratio 71.1%

Net Income 1,147,844,986ROR on Surplus (A.M. Best) 21.1%

Expense Ratio 42.6%Investment Yield (A.M. Best) 4.8%

St. Paul Fire & Marine

Reserve Adequacy• Property-Casualty

– 1-Year Loss Development– 2-Year Loss Development– Reserve Deficiency

Incurred Losses All Years as of Year-End 2007 12,000,000less Incurred Losses AY 2007 1,000,000minus Incurred Loss All Years as of Year-End 2006 10,000,000

One-Year Loss Reserve Development 1,000,000

minus Incurred Loss All Years as of Year-End 2005 9,000,000Two-Year Loss Reserve Development 2,000,000

PHS 10,000,000One-Year LRD/PHS 10.0%Two-Year LRD/PHS 20.0%

Fictional Insurer

Financial Risk• Credit Risk

NIG/ Total Assets Default Rates

• Interest Rate, Market Risk Asset Concentrations Asset/Liability

Durations Lapse Rates (Life)

• Liquidity Risk Liquid

Assets/Liabilities

• Rapid Growth Change in premiums

• Earnings Volatility

Reinsurance Recoverables/PHS 1.3%

Quick Liquidity Ratio 12.7%Current Liquidity Ratio 109.1%Overall Liquidity 153.6%Operating Cash Flow 975,699,000

Change in NPW 0.3%Figures from A.M. Best

St. Paul Fire & Marine

Measurement Issues

• Reported surplus is as accurate as reported assets and liabilities.

• Under-reserving most problematic for property-casualty insurers.

• Capital and leverage need to be assessed against risks that firm faces.

• Reliance BCAR was 77.8 in 1998 and 122.6 in 1999.

• Decline can be rapid.

Further Observations

• Events can rapidly overtake remedial action.

• Regulators and rating agencies proceed cautiously with lagging information.

• Desire not to undermine efforts to restructure or sell company.

• Size and importance of insurer can make regulators and raters even more cautious.

• More pro-active, risk-based oversight requires new mindset for U.S. regulators.

Ratio Limitations

• There is no ratio measure that provides “real-time” indication of underpricing, poor underwriting, and under-reserving.

• Performance measures lag these practices, especially for long-tail lines.

• Early detection requires alternative approaches including “street knowledge.”

• Regulators & raters reluctant to use “subjective” indicators to issue warnings.

Dynamic Analysis & ERM• Use of dynamic modeling tools to assess risk of firm• Approaches

– deterministic, scenario based

– stochastic

• Voluntary or Compulsory– Makes sense for internal management

– Should regulators compel it?

– External reporting of results?

• Enterprise Risk Management (ERM)– Comprehensive, integrated approach to managing all

significant risks.

– Qualitative & quantitative analysis