Cpcu 540 Ch.5

Front 1

SAP statement analysis

Back 1

Analysts look at the following concepts when analyzing insurer financial stmts:

Capacity (similar to GAAP leverage): amount of capital that an insurer can commit to underwriting a portfolio of loss exposures.

Liquidity: ability to convert an asset to cash with little of no loss of principal.

Profitability: earnings from underwriting and investments.

Front 2

SAP capacity

Back 2

Measured by comparing net written premiums (gross written premiums - any LEE?? insurance) to PH's surplus. Written premiums are reduced by reinsurance.

Has specific application to the property and casualty insurance industry. Is a function of PH's surplus. Capital an insurer can commit to underwriting. Important for evaluating insurer solvency and operating results.

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SAP capacity pt.2

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Growth puts strain on capacity. The larger the written premium the larger the surplus required by regulators. SAP requires immediate recognition of policy acquisition of premium revenue.

Investment results also affect capacity. Realized gains/losses directly affect surplus. Certain investments carried at market value.

Front 4

SAP liquidity

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Represents the ability to raise cash to meet financial obligations. Satisfactory when value of cash and marketable securities exceeds insurer's loss reserves and unearned premium reserve. Negative cash flow may be an indication the insurer's liquidity is decreasing.

Not to be confused with working capital.

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SAP profitability

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Insurer profitability provides additional surplus which allows further growth. Based primarily on underwriting and investment results. Past earnings retained by an insurer typically comprise majority of PH's surplus.

Analysts typically compare earned premiums to losses, LAE and other expenses.

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SAP statement analysis ratios

Back 6

Calculated based on NAIC annual stmt. Ratios can be used to evaluate insurer, groups of insurers, or the industry. Ratios can track trends over time.

Benchmarking is the comparison of an insurer's ratios to industry standards. Results outside accepted ranges require further analysis.

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SAP liquidity ratio

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Similar to GAAP current ratio. Compares current assets of an insurer and insurer liab.

Compares liquid assets to reserves. Reserves are subject to estimation errors which can have large affect on ratio.

Value of 1.0 or greater is desirable. Indicates ability to liquidate investments and have enough cash to pay obligations.

Accounts receivable is not a significant factor. Most insurers collect premiums in advance.

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SAP liquidity ratio pt.2

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If an insurer is too aggressive with valuing its reserves for losses and LAE the liquidity ratio may be substantially overstated.

The numerator of the liquidity ratio includes the market price of invested assets. Influenced by changes in markets. Could cause increase or decrease in ratio.

Cash + invested assets (FMV) / unearned premium + loss and LAE reserve

Front 9

SAP premium-to-surplus ratio

Back 9

Capacity ratio measures insurer's relative exposure to underwriting risk.

Weakness is that it only considers one year of net written premiums.

Higher ratio means insurer is aggressive in using surplus to leverage premium writing. NAIC suggests 3 to 1 (3.1) or less. If losses and LAE exceed earned premiums surplus will be depleted, increasing the ratio.

Company with the lowest premium-to-surplus ratio is the company with the highest ability to write new policies.

Net written premiums / PH surplus

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SAP reserves-to-surplus ratio

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Capacity ratio that measures leverage. One of the most widely used leverage ratios for insurance companies. Similar to debt-to-equity ratio for GAAP.

The higher the reserve the larger the impact of reserve estimation errors in reducing surplus. Higher reserve value is often associated with long-tail liab coverage (claims that take a long time to settle.)

No well established benchmark exists.

Unearned premium reserves + loss and LAE reserves / PH surplus

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SAP loss ratio

Back 11

Profitability ratio that reflects percentage of earned premiums consumed by losses. Less predictable than expense ratios.

Incurred losses + LAE / earned premiums

Front 12

SAP expense ratio

Back 12

Profitability ratio that reflects percentage of written premiums consumed by expenses.

Underwriting expenses / written premiums

Front 13

SAP combined ratio

Back 13

Profitability ratio. If greater that 100% means insurer experienced an underwriting loss. Common for long-tail lines.

Loss ratio (incurred losses + LAE / earned premiums) + expense ratio (underwriting expenses / written premiums)

Front 14

SAP investment income ratio equation

Back 14

Net investment income / earned premiums

Front 15

SAP operating ratio

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Profitability ratio. If below 100% indicates an insurer is able to generate a profit from core operations.

Excludes other income and expenses meaning ratio below 100% does not include overall net income.

Combined ratio - investment income ratio

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SAP investment yield ratio

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Profitability ratio that measures investment not underwriting results. Includes investment income such as interest and dividends. Also includes realized capital gains. More broad measure than investment income ratio.

(Net investment income / loss) / (total cash + invested assets)

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SAP return on policyholder's surplus ratio

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Assists in comparison of insurers. Similar to return on equity for GAAP. Eliminates issues related to premium volume, underwriting results and investment gains. Summarizes overall operating success relative to resources.

Net income / PH surplus

Front 18

SAP AM best ratings

Back 18

AM best is a 3rd party company that analyzes credit of insurance companies (publishes credit ratings.)

Financial size category (FSC) indicates size of insurer. Based on PH's surplus, adjusted for reserves and contingencies.

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SAP AM best financial strength rating (FSR)

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An opinion of insurer's financial strength and ability to meet insurance obligations. Rates insurers based on quantitative and qualitative measures.

Best key rating guide provides 5yr history of 19 insurer ratios. Ratio results are compared to peers. Peer standards are based on 20yr history.

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SAP AM best financial strength rating ratios

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Ratios are determined in the following areas: profitability (ability to support future growth), liquidity (ability to meet claims), capital and leverage (operating stability), loss reserves (measured for adequacy)

Front 21

SAP AM best financial strength rating proprietary model (don't need to know inner workings for exam, just general overview)

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Calculates needed reserves. Reserves are discounted for anticipated income to obtain economic reserve amount. If actual reserves are less than discounted reserve, a deficiency exists. Any deficiency is included in best capital adequacy ratio (BCAR) model.

An insurer's loss reserves are measured for adequacy through proprietary model.

Front 22

SAP AM best financial strength rating qualitative tests (try to know for exam)

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Include evaluation of: capital structure (insured and subsidiary reviewed to ensure obligations can be met), reinsurance agreements (studied to determine if they are sound and reinsurer is also evaluated), loss reserves (uncertainty related to reserve estimates is determined), investment diversity (evaluation of liquidity of investments and investment diversity)

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SAP AM best financial strength rating qualitative tests pt.2 (try to know for exam)

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Include evaluation of: management (assessment of integrity, experience and capabilities), market position (review of insurer's ability to increase market share), event risk (exposure to risk is reviewed), surplus adequacy is reviewed

Front 24

SAP AM best financial strength ratings scale

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FSRs use a letter grade.

A++ through B+ is considered secure.

B through F is considered vulnerable.

S is suspended

Front 25

SAP AM best financial strength ratings scale modifiers

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u: rating under review

g: rating considers group affiliation

p: rating considers pooling affiliation

r: rating considers reinsurance affiliation

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SAP AM best financial size category

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Measures size by adjusted surplus. There are 1-15 classes. Roman numerals are assigned based on size. Class I is smallest and represents less than 1mil of adjusted PH's surplus. Class XV is largest.

Not a measure of financial strength. Instead measures ability to handle large insurance or investment risks.

Front 27

SAP IRIS

Back 27

Insurance regulatory information system was developed by NAIC and state regulators. Identifies insurers that may be impaired. Contains statistical and analytical phases. Results may not be used by insurance companies for advertising purposes.

Statistical phase consists of 13 ratios: overall, profitability, liquidity and reserve.

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SAP IRIS ratios

Back 28

Ratios are compared to NAIC benchmarks. Ratios can be negative. Help identify companied for whom regulatory oversight or regulatory review is necessary.

There are no specific rules or procedures to follow when accompany falls outside the appropriate ranges. Regulatory response depends on several factors including the number of results outside the usual range.

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SAP IRIS analytical phase

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Conducted by state examiners who review ratios. No specific rules or procedures when company falls outside the appropriate ranges. Response depends on several factors including the number of results outside usual range, severity and previous actions.

Insurers are placed into one of three levels prioritizing need for review.

Front 30

IRIS overall tests (not as important as SAP ratios to memorize, just have general idea)

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Measure insurer exposure to unfavorable underwriting results.

1- gross premiums written to surplus: measures insurance exposure

2- net premiums written to surplus: measures exposure after reinsurance

Large difference between 1 and 2 may indicate over-reliance on reinsurance. Liab insurers should generally maintain lower ratio than property insurers.

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IRIS overall tests pt.2

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3- change in net writings: percentage change in premiums written in most recent year. Increase/decrease of 33% or less acceptable. Excessive premium growth may be sign of poor pricing.

4- surplus aid to surplus: surplus aid is commissions on ceded reinsurance (insurance company reduces risk exposure by passing risk to another company, accepting company receives premium for taking on risk.) Large amounts of aid indicate insufficient capitalization for direct insurance written.

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IRIS profitability tests

Back 32

5- 2yr overall operating: combined ratio less investment income ratio for past 2yrs.

6- investment yield: investment income divided by cash and invested assets.

7- gross change in surplus: measures percentage change in surplus for the year. Decreases can result from poor underwriting or investment results, dividends etc.

8- change in adjusted surplus: measures percentage change in surplus from operations.

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IRIS liquidity tests

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9- adjusted liabs to liquid assets: ability to meet obligations with liquid assets. Ratio over 100% may indicate liquidity issues.

10- gross agent's balances to surplus: indicates dependency of surplus on assets of questionable liquidity. Agents balance may be uncollectable in the case of insurer liquidation.

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IRIS reserve tests

Back 34

11- 1yr reserve development to surplus: measures change in surplus attributable to loss development of prior year reserves. High value may indicate inadequate reserves.

12- 2yr reserve development to surplus: can help determine if reserves have been understated to inflate surplus.

13- estimated current reserve deficiency to surplus: based on historical reserves.