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The Art of Financial Regulation:


Financial Analysis of Insurance Companies
By Beverly J. Day, MBA, CFE, CIE, Chief of Financial Affairs
Published in The Examiner, Winter 1998

On a Monday morning four years ago, I dashed through the pouring rain to get to the office. I barely had my coat off when a co-worker came rushing in. “Bev,” he panted, “the Commissioner wants to see you right now.” My stomach tightened as I headed toward her office. There are only two reasons the Commissioner wants to urgently see one of us ... she wants to know why an assignment isn’t finished, or she needs your report to be redone.

This time was different. As I approached her office, several people were buzzing around. “Bev, come on in right away,” the Commissioner greeted me and quickly announced, “I just received the court approval. You have been appointed the receiver for Phantom Insurance Company.”

Receiver? I stood frozen in place. I’d never been a receiver for a delinquent company before. I soon became excited ... it meant I’d take over the Phantom Insurance Company (a fictitious name to protect the innocent), martial all its assets and pay the policyholders’ claims. “Yes, Commissioner,” I responded with confidence. “I will start immediately.”

I dug into the court records to understand the situation. The Phantom Insurance Company had sold health insurance to small companies for their employees. In the next few days, I pawed through stacks of records, then started receiving phone calls from policyholders - 10 calls, 20 calls, then 100. The numbers kept growing. This was big. This company had not paid medical bills for policyholders. Many were several months old. The situation was worse than I thought.

Mission: Protect Policyholders
In my career at the Colorado Division of Insurance, my mission for years had been to protect policyholders. These phone calls about Phantom’s non-payments really troubled me. One person owed his doctor $100. He didn’t know how he could pay this bill and still find money for rent at the end of the month. Another owed $1,000 to his doctor and would have to borrow it. Breast cancer treatment for a woman totaled $35,000; a pacemaker for an elderly man came to $27,000.
As receiver, I alone held the purse strings. These people touched me deeply. And they looked to me to pay their medical bills so they could get on with their healing.

My dilemma was serious. How can I help them? I only have 25 cents on the dollar to work with ... a measly 25 cents on the dollar. I need money. Lots of it

Return Their Commissions
I studied the law; I searched the records. It finally came to me. The agents needed to return their commissions ... the illegal commissions they earned. My next step: to get both the records and the money back from the agents. I needed to move fast.

I marched to the Commissioner’s office, grabbing the assistant attorney general, Steve, on the way. As we dashed into her office, I explained my strategy to both of them. “I am so worried we may not have the vital records we need. The agents may be destroying key information as we speak -- information to help the policyholders. I’m particularly concerned about six agents ... the big players in Phantom. I want to seize their records post haste.”

Steve turned to me and suggested, “Bev, don’t you think we should make appointments with them first?”
“Appointments!” I replied with surprise. “And let these agents destroy vital information. They will disappear if we call them first. We need their records to help policyholders. It’s the law—we’re entitled to have them.”

The Commissioner stood up, tucked her thumbs in her waistband and said in jest, with a touch of adventure, “Yes, I want to go too!” That told me I was granted the authority to carry out the necessary raids.

A Case for Elliot Ness
I walked back to my office, pleased as punch. Then I panicked. “Wait a minute,” I thought. “What am I doing? I’m not Elliot Ness. What if some of these agents are truly bad dudes? Okay, I’ll send the investigators to those suspected of being corrupt, and select some tough examiners to help. Then I’ll check with the investigators to learn who the wimpiest agent is for me to visit.”

Within two days, 12 of us met in the hearing room and planned our strategy. We formed six teams and would make the “sting” in one hour. With an investigator named Bob, I headed for a selected agent’s office. He was standing near his office exit door when we walked in. After I introduced us and our mission, he nearly hugged me ... in the style of Bugsy Malone. Then, realizing he had to be on his best behavior, he declared he was worried about the situation and what could he do? I responded by handing him the Commissioner’s order and said, “Abide by all these demands.” He glared at the order as he plopped into a nearby chair to read it. Then he jumped up, slapping the paper and shooting me a fierce look. “What do you mean I have to give my commissions back? I’ve already spent the money.” As he commenced pacing, the phone rang. He picked it up and we heard him say, “Yah, yah, those insurance guys are here too. How many are at your office? Two? Yah, two here. Yah, they want all my records. Of course, I’m going to give them my records ...but the commissions? This broad ain’t going to see one red cent.”

Pleas for Exoneration
Despite the protest, nearly 50 of the 100 agents involved came forward with records and pleas to be exonerated from penalties. Throughout the long process that followed, I couldn’t get the plight of the policyholders out of my mind. Thankfully, I was able to recover thousands of dollars from the agents to help right a serious wrong.

To this day, no matter what decision I make concerning an insurance company, I remember the devastation inflicted on so many people by so few agents acting improperly. I recall the impact I felt of people suffering, trying to pick up the pieces after a medical and financial disaster. More profoundly, I always ask myself, “Will this decision I am about to make help or hurt the policyholders concerned?”

Keep the Basics in Mind
Our jobs are about people. Whether you’re an analyst or a field examiner, think about the basic concepts you uphold as you determine the financial stability of an insurance company. With so much information to analyze, sometimes it’s hard to get to the basics, let alone stay with them. Always remember the purpose of our jobs ... the reason you strive to make a difference every day. The following sections are designed to help you do just that.


Maintain a healthy perspective. Approach your work with curiosity, preserve your sense of skepticism and blend these with a recognition of reality and an open mind.

If it ain’t broke, don’t fix it. Josephine Driscoll, former Insurance Commissioner for Oregon, gave a presentation years ago and strongly emphasized the idea “if it ain’t broke, don’t fix it.” Be sure of what you are doing, for unnecessary or inappropriate regulatory interference could do more damage than good. Don’t get me wrong. I’m in favor of swift and decisive action upon troubled insurers. Our job, in fact, is to detect as early as possible those companies operating illegally or in a hazardous financial condition. Think about the power you have. A doctor affects the life of one person at a time. A lawyer affects the life of one person at a time. But your decisions (or lack thereof) affect thousands of people.

Basic Components of Insurance Business
A company cannot operate and succeed without these basic components.

Pricing the insurance product - If the insurer prices the product too high, it will lose market share. If the insurer prices the product too low, it will get high market share, but will likely not be able to pay claims when they come due.

Managing the funds - The insurer has the fiduciary responsibility to receive and handle the funds (premiums) properly and not to misuse them.

Sharing risks through reinsurance - To maintain a proper financial balance and diversification, the insurer needs to engage in sound reinsurance arrangements to share risks.

Establishing adequate reserves - It is of paramount importance that insurers establish and maintain adequate reserves. (Reserves being the liability established in recognition of amounts that are due and will be due to policyholders.)

Handling claims - The insurer must have the funds to pay claims and make the claim payments in a timely manner.

All these components of insurance business require good organization, sound judgment and competence of management. Without these, an insurer may be successful for awhile, but will suffer failure in time.

Overview of Financial Statement Analysis

Catherine Weatherford, former insurance commissioner for Oklahoma and current Executive Vice President of the National Association of Insurance Commissioners (NAIC) stated it well when she said, “The cornerstone of solvency regulation is the financial reporting.” The basic component of financial reporting is the annual statement, often referred to as the convention blank. Folks, this statement is not new by any stretch of the imagination. In 1851 New Hampshire enacted a law which established the requirements for a full-time board of three insurance commissioners to oversee the yearly examinations of the affairs of all insurance companies in New Hampshire. In 1871, uniform financial reporting was initiated at the first convention of what was to become the NAIC. There, the term “convention blank” arose. Today, they are generally referred to as the NAIC annual statement blanks.

The NAIC financial statements are unique to the insurance industry. They are designed not only to describe the financial position of the company at a point in time, but also to trace the financial progress of the company over time. The statements provide continuity in reporting. Albeit, various state laws differ and permitted practices prevail which causes variances in reporting. The format and content are continually reviewed and revised to keep it current with industry changes and enhance its utility to the state regulator.

Financial statements filed with the state insurance departments are prepared on a statutory accounting principles (SAP) basis.

Statutory accounting principles are based on the concepts of solvency, conservatism, consistency and flexibility. The NAIC Statutory Accounting Principles Statement of Concepts 1994 draft define these concepts as follows:

Solvency - The ability to meet policyholder obligations is predicated on the existence of readily marketable assets available when both current and future obligations are due. All liabilities that will eventually require the use of assets should be recorded as they are incurred.

Conservatism - Financial reporting by insurers requires the use of substantial judgments and estimates by management. Such estimates may vary from the actual amounts for various reasons. SAP requires that the concept of conservatism be followed in developing such estimates to provide a margin of protection against adverse fluctuations in financial condition or operating results.

Consistency - The need for meaningful, comparable financial information to determine an insurer’s financial condition requires consistency in the development and application of SAP.

Flexibility - Because the marketplace, the economic and business environment, and insurance industry products and practices are constantly changing, regulatory concerns are also changing. In recognition of such changes, SAP must be flexible enough to respond to regulatory concerns.

As you likely know, the NAIC is engaged in developing codification of accounting principles. The project will result in more consistent and comparable financial statements which will make our analysis techniques more meaningful and effective.

Financial analysis techniques vary among states. I suggest that you review the NAIC Financial Analysis Handbooks (life-health and property-casualty) and the guidelines used by your department for guidance in performing your financial analysis.

Purpose of Financial Analysis
The financial analyst evaluates data derived from financial statements and other sources to reach conclusions regarding the insurer’s current and future financial stability. A number of resource documents must be filed along with the annual statements. We often tend to go through the motions after awhile due to the enormous volume of information. But it is good to stop and think about what these documents and reports provide us. The following chart shows documents and reports which are valuable tools for the financial analysis process. Though not an exhaustive list, it does contain the most frequently used resources.

Conducting the Analysis
You can pick up the NAIC Financial Analysis Handbook or your own department’s analysis guidelines and follow them precisely to conduct an analysis and come to a conclusion. The goal is to arrive at the best conclusion; the key is to know what you are looking at. Critical questions include: What are the primary causes of failure among insurers? When I see a trend, what does that really indicate? Answers to these questions come through knowledge, experience and sound judgment. The following compilation of ideas and factors will assist you in reaching sound conclusions about the financial stability of insurers.

Remember, the insurer receives large sums of money and will not have to pay a claim until sometime in the future. An opportunity exists for an insurer to waste assets through greed, incompetence and neglect of duty. You may ask, “How am I going to prevent such activity?” Obviously, prevention is difficult, but detecting such activity early is the key. On-site examination may be the only way to get behind the numbers and ascertain illegal activity. Though difficult to determine this through analysis, trends and sudden changes can trigger your sense that something is not right. Ask for an examination to target the detected problem area(s). And, remember the idiom, “If it walks like a duck, and quacks like a duck, then it is a duck.”

In an article about Best’s Insolvency Study of Life/Health Insurers published in Best’s Insurance Management Reports, June, 1992, some interesting facts emerged. Best’s insolvency study covered 290 life/health insurers which became insolvent or financially impaired during the period from 1976 through 1991. (This study did not cover Blue Cross and Blue Shield organizations, managed care companies and like-type entities.) While economic and market conditions change and the industry changes with it, the chart below shows the primary causes of financially impaired companies. This offers background and assistance in conducting financial analysis of insurers.

Primary Causes of Financially Impaired Companies

Primary Causes 

% of Total Identified 

Inadequate Pricing/Surplus


Rapid Growth


Affiliate Problems


Overstated Assets


Alleged Fraud


Significant Change in Business


Reinsurance Failure




Inadequate pricing/surplus and rapid growth top the causes of impairment. This information alone indicates that the primary causes of financially impaired companies involved some form of company mismanagement. It stands to reason, that insurance company management is primary in preventing failures. Hence, the quality and completeness of the regulator’s relationship with the management of insurers is important in continuously assessing the competence of management.

Another report, a publication of the Federal Bureau of Investigation concerning insurance company insolvency fraud schemes, published in 1991, was included in a presentation by Betty Cordial at this year’s SOFE CDS. Of the 74 FBI investigations, “premium diversion” was the most prevalent form of fraud, occurring in 41 of these investigations. One type of premium diversion was the failure of an insurance agent, broker, or managing general agent to remit premiums to the insurer. Another type of premium diversion was selling insurance without being licensed.

“Use of fraudulent assets” was the second most frequent scheme, occurring in 38 investigations. The most recent trend involved the purported assignment of GNMA (Government National Mortgage Association) securities not actually owned by the insurer.

“Affiliated company transactions” was the third most frequent scheme, occurring in 17 investigations. The presence of affiliated companies cannot by itself be considered a fraudulent scheme. One of the common types of fraud using affiliates is for a holding company to contribute surplus to the insurance subsidiary while retaining the offsetting liability on its books. This makes the financial position of the insurer stronger and the insurance company can write additional premiums.

A second common fraud scheme using affiliates involves collecting premium income and under-reserving for future losses, thereby booking excessive profits in the current accounting period. The income produced by the insurance subsidiary is then “upstreamed” to the parent where it is dispersed outside the range of review by state insurance departments. This type of fraud is extremely difficult to prove since the method of establishing loss reserves is highly technical and somewhat subjective.

What about the every day events that can provide insight into the financial stability of an insurer? Numerous operating conditions may indicate troubles dwelling within an insurer. Though mere existence of these events is not an assurance that problems exist, these factors are worthy of observation and potential investigation. The NAIC Troubled Company Handbook is a great source for providing information on indicators for trouble. The following chart of operational conditions shows a selection of indicators leading to potential problems.

To control the analysis process, have an orderly flow, and review the highest risk companies first, it is important to prioritize or classify insurance companies according to each insurer’s relative stability and the perceived need for analysis. Suggested factors to consider (though not totally inclusive) include some or all of the following factors:

1. Result of the prior year analysis
2. Whether the insurer was a priority company in the prior year
3. Adequacy of the insurer’s capital and surplus
4. Significant changes in the insurer’s capital and surplus
5. Negative trends in income and/or cash flow
6. IRIS ratio results and the NAIC Examiner Team Synopsis
7. FAST ratio results
8. Changes in the insurer’s management or board of directors
9. Results of the preliminary annual statement analysis
10. Analysis performed by the NAIC’s Financial Analysis Working Group
11. Examination reports issued (financial condition and market conduct)
12. Information from other divisions or areas of the insurance department
13. Independent rating organization ratings and reports
14. Impact on the public of insurer insolvency

As an analyst you should use professional judgment in prioritizing the reviews. Past analysis experience will give you considerable insight into the company’s stability, regardless of some adverse trends.

Interpreting the Data
During your analysis develop and document your findings to support and explain your overall conclusion regarding the insurer’s financial condition. Take into consideration significant financial and operational conditions and trends. While you may see a predominant trend, generally there are a number of factors that will cause a company to become troubled and these should be included with your data.

Suppose you find that the company you are analyzing made a shift in investments from conservative to high-yield, risky investments. The new investments resulted in a large non-admitted amount (based on your state law) on the annual statement. They also made a shift in product line from life products to annuity products. This could explain the change in investment portfolio to support the higher yield products being sold. But can the surplus and investment structure of the company support the new product line? Can it support the cost of placing new business on the books? Is the new annuity product promising too much - a higher than feasible interest return? How do you interpret what is going on? Basically, it is often difficult to come to a final interpretation from the documents in front of you when you are confronted with a troubled company.

You have a variety of directions you can take based on guidelines (used by your state) and your judgment. For a starter, it is advisable to discuss your findings with company management. At this point, put everything in writing. You may need this information later to support your actions. Ask the management to answer questions about everything that concerns you - the change in investments, the change in the product line, etc. Make your inquiry as comprehensive as possible. Review the managers’ response and determine the reasonableness of their answers. You can often see if they are genuinely giving you valid responses or just blowing smoke. You are the judge. And if you are not satisfied with their responses, let them know.

Once you have all the pertinent details in front of you, make a determination about the stability of the company. Record (in the workpapers) your conclusion, spell it out and include the factors that indicate problems with this company. For example, include comprehensive notes about the investment portfolio, the change in product line, and the policyholder surplus level. You need to answer the question. “Do we have a solvency issue here?”

Once you have determined that the company is troubled, develop a plan for monitoring the company. Involve the company. This will let management know you are serious about your concerns. Ask for special filings or more information as you deem appropriate. A business plan prepared by the company is a valuable tool - a plan that sets forth projected income, expenses, investment activities, surplus infusions from the parent, marketing plans and so forth. With this plan in hand, you can monitor the company’s ability to meet its objectives over time. Remember, it is easy for the company to deceive you, either intentionally or unintentionally.

If the company is dangerously close to impairment or indeed has become impaired, then regulatory action is in order. When your analysis results in a recommendation for regulatory action (supervision, conservatorship, rehabilitation, receivership), the commissioner will need sufficient and competent information that will stand the test of court proceedings.

Regardless of the level of regulatory action recommended, your evidentiary records must be accurate and descriptive. Have you ever written something and, months later, picked up the document and couldn’t figure out what your were talking about? If not, you are doing better than I have at times. The most helpful record of your analysis will stand on its own, interpret the data clearly, and can be understood months later.

While we have an abundance of tools to assist us today in our analysis, your skills and abilities are the key to carrying out the regulatory process. Remember, this narrative offers ideas and suggestions, but the “artistry” in regulation comes from you. Despite the obstacles, creative solutions abound. When you practice the art of financial regulation, you’ll paint a “picture” you can view with pride because you’ve helped policyholders who couldn’t help themselves.

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