January 2012

Detecting Financial Trouble of Insurer

(Reprinted with the permission of the Florida Association of Insurance Agents)

A high degree of technical knowledge in the areas of accounting, insurance law, and investment management is necessary in order to do a complete and accurate evaluation of an insurance company's financial condition. For the agent, the best tools available are common sense and past experiences. (Editor's note: and, of course, the various rating agencies.) Very few, if any, previous insolvencies have occurred in a vacuum. The grapevine among agents is always active when it comes to companies with apparent difficulties. The agent should not rely on gossip alone, but it may be one of the earliest warnings. Combined with obtained knowledge of the company, the following guidelines should give the agent a better picture of the company's financial condition:

1.     Rates vs. Commissions. There is just so much of the premium dollar that can be used for commissions. If a given company is paying the highest commission levels combined with the lowest rates, watch out—particularly if the company also combines the high commission to the producer with an additional override to a managing general agent. The combination normally does not leave enough dollars to pay claims and other expenses and has been historically lethal.

2.     Claims Payments. If a company starts delaying payment of proper claims, it may be attempting to preserve cash.

3.     Changes in Writing. Major increases or decreases in net premiums written may indicate a lack of stability in the company's operations. One NAIC test holds that an increase or decrease of more than 33% is beyond the norm.

4.     Reserves. If the agent observes a distinct change in the reserving practices of his own book of business with the company, this may signal a problem. The agent should be particularly wary of a company which has a tendency to set reserves much lower than most of the companies the agency represents. Loss reserves are a liability on the company's balance sheet. If they are understated, then the policyholder's surplus is overstated. If a company under reserves, it is likely to under price its product, plunging it into a “death spiral” where solvency is impacted by both pricing and overstating surplus.

5.     Dramatic Changes in Agents' Underwriting or Binding Authority. Some companies attempt to increase or cut back on certain lines of business by loosening or restricting agents' binding authority. This is not unusual on an individual agency basis but could be a sign of trouble if it is done on a wholesale basis.

6.     Loss Ratios and Operating Ratios. An agent does not have to be an insurance accountant to get a fairly accurate picture of the company's profitability or lack thereof. The agent could really ignore such things as written premiums, loss reserves, investment gain, and zero in on two items: the combined loss and expense ratio and underwriting profit or loss. An insurance company which has consistently been losing money on its underwriting operations is in just as much trouble as any other business that has consistently lost money. The agent is certainly aware of his own loss ratio with the company. Several publications are available that give the total loss ratio of most companies: Best's Insurance Reports, Best's Key Rating Guide, Property-Casualty and The Fiscal Year Report of the Department of Insurance.

7.     Type of Business Written. Past experience shows that carriers who restrict their writings to the “nonstandard risks,” in territories that have been historically unprofitable, combined with very competitive rates, have had financial problems.

8.     A. M. Best Company Rating. An agent should check the Best policyholder's rating of all his companies. The Best rating system has proven to be fairly reliable over the years. An agent should understand that any company rated below “A” must be looked at very closely. A. M. Best itself says, “only nominal variances from industry standards generally exist among “A” companies. For other gradations the variances, or median points, widen at each level.” It is estimated that fewer than 30% of all companies are currently rated “B” or below.

9.     Arguments Over Agents' Balances. If a company develops a pattern of problems with balances due or is consistently late in reconciling agency accounts—watch out. One method of overstating a company's assets is to overstate agents' balances due.

10.     Refusals to Finance Premiums. One good clue is to watch for independent premium finance companies' refusals to finance a company's premium. The finance companies are fairly sophisticated. If they become concerned about a company's ability to return unearned premiums, they may stop doing business with that company.

11.     Company Morale. Watch out for low morale or a sudden mass exodus of company employees, both top level executives and lower level technical personnel. This is a good indication that something is wrong.

Agents should not be afraid to ask questions of company management, company employees, accountants, regulators and other agents. Some typical questions an agent should ask of:

1.     Insurance Company Management. Is the company regularly audited by independent CPAs and has it received certified non-qualified financial statements from auditors? This is not a guarantee, but it is an indication that at least the company's records have been reviewed by an outside third party.

1a.     Will you mail me a copy of your financial statement? If you are doing business with a publicly owned company, write the secretary of the company and ask to be put on the company's financial mailing list.

1b.     What percentage of a given line of business is reinsured and by what reinsurer? Generally, companies which rely heavily on reinsurance as a means to generate surplus should be considered carefully. The amount of reinsurance is available as a part of the company's annual statement.

2.     The Regulator. How did the company score on the NAIC Insurance Regulator Information System (IRIS)? Many states take different approaches to releasing this information. Some states will not give out copies of the results but will respond to specific questions. ( Florida will answer specific questions.) On or before March 1 of each year, the NAIC office in Kansas City gets a copy of the annual convention statement of about 2,000 property/casualty insurers operating in more than one state. The reports and tests are then summarized on a computer printout. These printouts are sent to the various insurance commissioners. If a company is outside the norm on four or more of the audit tests, it has an “exceptional” ratio and is placed on a “priority” list. This is to advise the Insurance Department that the company should receive special attention, as it is more likely to be in financial trouble than are companies which are outside the established norm on fewer than four tests. Ask the Commissioner if the company has failed four or more tests and is on a priority list. If you can't get the answer from the Commissioner, ask your company. Every company with which you do business should know how it did on these tests. If the company refuses to tell you the results, this could be a sign of problems.

2a.     Has the company withdrawn from a given line of business or has it totally withdrawn from another state? A company may have withdrawn voluntarily, but its withdrawal may be due to Insurance Department orders. Since the Florida Insurance Department receives copies of all formal orders issued by other departments against companies doing business in Florida , they should be in a position to tell the agent why the company withdrew.

2b.     Is the company on a quarterly report? Each insurance company licensed to operate in Florida must file an annual statement of its income and financial condition. These reports are called “convention statements” and are prepared in a uniform manner for most states. When the Insurance Department feels it needs a financial report on a more frequent basis, it can require an individual company to report more frequently than annually. The mere fact that a company is on a quarterly report does not necessarily mean the company is in serious financial difficulty. The Department may want more timely information from the company for many reasons, such as proposed or pending merger plans, acquisition of other non-insurance firms, a substantial change in certain assets and many other reasons. However, it is fairly safe to say most of the companies that have previously become insolvent have been on a quarterly report. There is no published “list” of companies on a quarterly reporting basis. The Insurance Commissioner's office will respond to specific questions concerning an individual company's reporting status.

3.     Stock Brokers. If the company is one whose stock is publicly traded, then a producer's own stockbroker may provide some valuable information. It is the stockbroker's business to keep up with the latest financial information for clients. Obviously, an investor's interest may not be the same as your interest, but if a company is having financial problems, an interested broker should be among the first to know.

4.     Banks and Other Suppliers. If you have a contact with a bank, office supply company, rental car agency or travel agency you may want to inquire as to the company's record of paying bills. If the company has had a line of credit terminated or has encountered other adverse credit-related actions, this may be a sign of financial difficulty.

Many of the above questions could be asked of other agents. This can be done informally or formally through your local board.

In conclusion, an agent can act on his own and get at least some signals that one of his companies may have financial difficulties. Armed with this information, what should the agent do? The best and simplest answer is “stop writing business with the problem company.” This is easier said than done. If the company in question has the best rates, is growing by leaps and bounds, is paying the highest commission levels, is writing all applicants and is providing fair service, it is very difficult to stop placing business with it. Remember, however, if you continue to place business with a company once you know it has trouble, then you can blame only yourself for the ultimate problems that are sure to come.