World Bank Distance Learning

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1 World Bank Distance Learning The Early Warning Test Ratios for General Insurers Washington, DC April 9, 2001 Lawrie Savage & Associates Inc.

2 History of Early Warning Ratios Until early 1970's, everyone had their favourite ratio NAIC undertook major investigation (McKinsey & Co.) Hundreds of ratios tested for statistical significance in predicting past U.S. insolvencies Conclusion: small number of ratios can explain almost all failures LS&A

) Hundreds of ratios tested for statistical significance in predicting past

3 This makes sense when you think about it... A company is a company, regardless of whether it's in an emerging market or Canada. The key relationship for solvency is the size of the company's equity base compared to its liabilities: there are only so many ways you can measure it.

4 OSFI Early Warning Ratios Canadian Property & Casualty Insurance Companies Test Number Name Change in netwriting Change in gross writings Net Risk Ratio Gross Risk Ratio Change in capital and surplus Amounts due from agents, subs Usual Range - 33% to +33% -33% - +33% Up to 3 X Up to 7 X - 10% to +50% Up to 50%

Ratio Gross Risk Ratio Change in capital and surplus Amounts due from agents,

5 OSFI Early Warning Ratios Canadian Property & Casualty Insurance Companies Test Number Name Surplus aid Capital & Surplus as % of liabilities 516 Margin as % of total assets required Investment risk ratio Investment yield Usual Range Up to 25% Minimum 25% Minimum 10% Up to 100% Various (current at least 5%

Margin as % of total assets required Investment risk ratio Investment yield

6 OSFI Early Warning Ratios Canadian Property & Casualty Insurance Companies Test Number Name Liabilities as % of liquid assets Loss reserves to surplus Return on GAAP capital 1 year development as a % of capital and surplus Usual Range No more than 105% Not more than 2.5x Various (current at least 6%)

to surplus Return on GAAP capital 1 year development as a % of capital and

7 What do the Ratios Mean? Change in in Net Writings: + or - 33% = significant changes in in reinsurance or substantial expansion or contraction of business.

8 What do the Ratios Mean? Change in in Gross Writings: + or - 33%, again signals substantial volatility in in production.

9 CS = Capital & Surplus NPW = Net Premiums Written ROE = Return on Equity Underwriting Income + Investment Income = Net Income Before Tax = NI NI/CS = ROE NI/NPW = Return on Sales NPW/CS = Risk Ratio And therefore: NI NPW NI X = NPW CS CS OR Return on Sales X Risk Ratio = ROE Why Net Premiums Capital and Surplus, or "Risk Ratio, is an especially important indicator

Sales NPW/CS = Risk Ratio And therefore: NI NPW NI X = NPW CS CS OR Return on Sales X Risk

10 So if return on sales = 5% and risk ratio = 2, then ROE will be 10%. If return on sales = - 5% and risk ratio = 2, then ROE will be -10%. But if return on sales falls to -20%, and risk ratio is 5, then ROE will be -100%, AND THE COMPANY IS INSOLVENT. Therefore, in a business where there is considerable volatility in return on sales, the risk ratio has to be kept reasonably low. Normal Range: Less than 3 to 1 LS&A

But if return on sales falls to -20%, and risk ratio is 5, then ROE will be -100%, AND THE COMPANY IS

11 Return on Return on Sales Sales 15% 15% Risk Ratio 2 to 1 Return on Equity 30% Return on Sales -20% Risk Ratio 5 to 1 Return on Equity -100%!! So, in a business where Return on Sales can be quite variable, the risk ratio has to remain at a reasonable level. LS&A

12 Gross Risk Ratio: Same as net risk ratio except we are looking at the gross return on sales, i.e. before reinsurance, rather than after reinsurance. Percentage Change in Capital & Surplus: The equity base of a company is the primary "cushion" that protects against insolvency. A drop of more than 10% or an increase of more than 50% signals instability in this critical measure.

Percentage Change in Capital & Surplus: The equity base of a company is the primary "cushion"

13 Amounts due from Agents and Related Parties as % of Capital and Surplus: If there are financial problems in a group, amounts from related parties may not be collectable. Unusually large amounts due from agents may be a signal that the agents don't believe the company is going to continue, or that they have some other serious grievance with the company. Also, if an agent becomes insolvent when owing a large amount to the insurer, it may seriously impact the insurer's financial position. If the ratio exceeds 50%, there is an inordinate amount of risk that the capital and surplus base of the company may be seriously depleted.

Unusually large amounts due from agents may be a signal that the agents don't believe the company is going to continue, or that they have some other serious

14 Surplus Aid: If a company is overly dependent on reinsurance, the bulk of its profit may be generated by reinsurance commissions. This leaves the company in a vulnerable position, dependent on its reinsurers for continued financial health. Also, as the commissions flow from the income statement into surplus, a considerable portion of surplus may be comprised of reinsurance commissions. Sometimes, if the reinsurance is cancelled or if the company becomes insolvent, commissions could have to be repaid to the reinsurer, which would mean that the "surplus" was to some extent illusory.

Also, as the commissions flow from the income statement into surplus, a considerable portion of surplus may be comprised of reinsurance

15 Capital & Surplus as a % of Liabilities: Basic leverage. In an insurer, it is the liabilities which are difficult to quantify. Clearly the smaller the c&s base relative to liabilities, the less capacity the company will have to absorb unforeseen "shocks" (e.g. catastrophic losses due to earthquake or hurricane, failure of a reinsurer, exceptionally bad underwriting results, investment losses and so on.)

Clearly the smaller the c&s base relative to liabilities, the less capacity the company will have to

16 Investment Yield: This has to be compared to current market rates. However, if a company is unable to generate market rate returns, it may be an indication of poor quality investments. If the yield is unduly high it could also be an indication of exceptional risk in the portfolio, which could be followed by substantial losses. Liabilities as a Percent of Liquid Assets: For property/casualty insurers, a large percent of claims must be paid within the year. Therefore liquid assets are critical in ensuring that funds will be available as required. If liabilities are greater than 105% of liquid assets, the company may be heading into cash flow problems. LS&A

If the yield is unduly high it could also be an indication of exceptional risk in the portfolio, which could be followed by substantial losses.

17 Loss Reserves to Surplus: This is another one of the "leverage" type ratios. If loss reserves are 1.5 times surplus, then a 10% understatement of the claims liability is equivalent to 15% of the company's surplus. But if the ratio of reserves to surplus is 5 to one, a 20% understatement of the claims liability is equal to 100% of surplus, so the company would actually be bankrupt. It is difficult to know the extent to which the claims liability might be understated, so keeping the ratio below about 2.5 avoids excessive risk. GAAP Return on Equity: A fundamental measure of financial health. The rate of return to the shareholders who have invested in the company. If the return is low, or negative, why would investors put more money into the company? This is a critical question for the supervisor, because if a company is in financial difficulty one of the primary remedies is to push for additional capital.

But if the ratio of reserves to surplus is 5 to one, a 20% understatement of the claims liability is equal to 100% of surplus, so the company would actually be bankrupt.

18 One Year Loss Development to Capital & Surplus: For a property/casualty insurer, the liability for outstanding claims, including claims that have been incurred but not reported, is probably the single largest liability, and the most difficult to assess in terms of its accuracy of reporting. For example, if we can measure that the inaccuracy in the claims liability from year N to year N+1 is greater than 10% of capital and surplus, then (1) there is significant probability that the extent by which outstanding claims have been understated, will ultimately turn out to be considerably larger than we know and, (2) there is a reasonable probability that capital & surplus is presently overstated by an unknown, but perhaps significant percentage.

For example, if we can measure that the inaccuracy in the claims liability from year N to year N+1 is greater than 10% of capital and surplus, then (1) there is significant probability

19 How to Use the Ratios Ratios should be considered as FLAGS. signaling a need to investigate problems A few abnormal ratios may not be an indication of problems. The trend in the ratios is also a telling sign of possible problems. Basic financial parameters and especially the trends in those parameters over time, are also powerful indicators of developing problems. Benefits of having companies calculate all the ratios, track basic financial parameters over time. LS&A

The trend in the ratios is also a telling sign of possible problems.

20 In 1997 supervisory staff raise a concern with the company and bring the matter to the attention of senior supervisory personnel: exceedingly high ratio value for this company. Increasing Risk Normal Range Important ratio for a supervised company.

personnel: exceedingly high ratio value for this company.

21 But no action taken in earlier years because the ratio was not outside the normal range!! A true story. Yes, we must look at the trend! Increasing Risk Normal Range

22 Typical Comparison Between Emerging Market and Canada For Performance on Ratio For Canada we typically see a large % of companies in the "normal" range For emerging market the curve is much steeper and a higher % of companies are out of range Graphical representation of all company scores for a particular ratio.

23 World Bank Distance Learning End of The Early Warning Test Ratios for General Insurers Washington, DC April 9, 2001 Lawrie Savage & Associates Inc.

Chapter 17: Financial Statement Analysis

FIN 301 Class Notes Chapter 17: Financial Statement Analysis INTRODUCTION Financial ratio: is a relationship between different accounting items that tells something about the firm s activities. Purpose