Strengthening the Insurance Sector of Nepal Framework for Regulatory reporting and review process Manual on Off-site Monitoring MAY, 2018 FIRST Initiative Funded Beema Samiti New Supervisory Framework for Off-site Review and Reporting Manual on Off-site Monitoring Table of Contents Step 1: Gather Information 5 Step 2: Perform Assessment 6 Step 3: Calculations and Estimations 8 Step 4: Carry Out Further Analysis, if Required 13 Step 5: Determine Priority Level 14 Step 6: Problem Resolution 19 Step 7: Communication with Other Departments 21 Exhibit 1: Step 2 Procedures Form ...............................................................................................................22 Exhibit 2 Procedures and Inquiries for Further Analysis (Step 4)................................................................26 Exhibit 3 Insurance Profile Summary Illustration ........................................................................................32 Exhibit 4 Ratios ............................................................................................................................................42 Overview The World Bank Technical Assistant team (WB team) prepared this Off-site Financial Analysis and Reporting Process manual (manual) as part of the deliverables for the Nepal Insurance Sector Strengthening activity supported by the Financial Sector Reform and Strengthening Initiative (FIRST) Initiative. The manual was prepared to assist Beema Samiti, also known as the Insurance Board (IB), in enhancing its supervisory off- site surveillance and reporting process. The off-site monitoring process is a continual monitoring process that is designed to assist the analyst in reviewing and analyzing insurers throughout the annual cycle in a logical manner. The analysis process is performed to identify and monitor the risks associated with each insurer’s activity. The necessary level of activity performed at each step in the off-site monitoring process will be dependent upon concerns noted in each procedure performed. The off-site monitoring includes a review of both an insurer’s qualitative and quantitative information. The review should not be limited to the analysis of financial information only. All activity impacting the organization needs to be incorporated into the off-site monitoring process which includes assessing the impact on prospective solvency risks as well. Risks impacting the insurer are reviewed on a current and prospective basis. A prospective risk is a residual risk that may impact future operations of an insurer. These anticipated risks arise due to assessments of company management and/or operations or risks associated with future business plans. The analyst’s understanding of these potential risks is critical to monitor the insurer’s ability to appropriately manage the risk during the current and prospective periods. These prospective risks require assessment and identification of how they may evolve related to the insurer’s overall risk profile. Understanding how risks that may or may not appear urgent now will potentially impact future operations and how management plans to address those risks is key to prospective risk analysis. The central tenet of RBS is the relationship between risks, controls and capital. The risk profile should be consistent to the controls and capital. In fact, the higher the risk profile, the stronger the controls and the higher the capital the entity must hold. RBS ensures that IB has a formal framework to supervise and efficiently allocate scarce supervisory resources. Resources can be directed to the entities that present higher risks relative to their peers and allocated to higher risk areas within individual entities. RBS is designed to operationalize a risk rating model that will ensure consistent measurement of risk in the regulated entities. The risk rating model should be developed to assess and evaluate the qualitative and quantitative components of an entity allowing IB to deal with problems and to detect issues and trends before they become significant problems. The main purpose of risk rating model is to determine the risk profile of an entity and plan a suitable supervisory response. The risk rating model should specify components important in the risk assessment process and early warning. The key components are inherent risk, management and control and capital support. Inherent risk can be defined as any uncertainty in relation to the business operations of an entity, whether statistically quantifiable or not, that has the potential to affect the financial position of an entity. To manage and offset the inherent risks entity structures and processes put in place by the board of directors, trustees and management is assessed. The risk rating model has Management and control component that assesses the effectiveness of the underlying policies, practices, systems and controls established. Capital resources of entities must be review under RBS to determine the adequacy of capital to absorb unexpected losses. The overall risk-focused surveillance process requires a significant amount of communication and coordination between the analysis and examination (or “off-site” and “on-site” supervision) function to be effective. Analysts should identify and document all current and prospective risks for domestic insurers and communicate those risks to the respective examiners. An effective Risk Based Supervisory framework (RBS) should ensure there is proper coordination and communication between the off-site monitoring team and the on-site inspection team. It is important that both teams share information regarding the examination of the business of each insurer, evaluation of its condition, risk profile and conduct, the quality and effectiveness of its corporate governance and its compliance with relevant legislation and supervisory requirements. All components of the RBS need to consider the nature, scale and complexity of the insurer, and confidentiality requirements. It should be noted that both the off-site and on-site supervisory processes constitute merely a set of tools to achieve certain supervisory goals and relevant strategies. The exact mix of such supervisory goals depend on various market characteristics, e.g. its competitiveness, reliance on and availability of external capital, usage/dominance of various mediation channels, overall market conduct and consumer protection effectiveness, but also consumer-side behavior like insurance fraud, overall insurance awareness – to name just a few of such market characteristics and drivers. It should be also noted that supervisory goals to be pursued do not always work in conformity with each- other, e.g. the focus on capital sufficiency (and sometimes pursued by supervisor’s substantial excess over levels deemed to be adequate) will inevitably affect the adequate pricing of products, insurance penetration rate in society and overall competitive environment – especially if tariffs are regulated. Considering using the current manual and methods described therein, it is ultimately up to the supervisor (along with legislators) to establish what constitutes the “sound” insurance market, given its current characteristics, and in what proportion and priority ranking to focus on different supervisory aspects described. The time dimension plays its role as well – supervisory solutions addressing short-term issues need not automatically rectify risks related to long term. Having said that, the overall off-site supervision framework of BM envisages and proposes the following steps: Step 1: Gather Information Step 2: Perform Assessment Step 3: Calculations and Estimations Step 4: Carry Out Further Analysis if required Step 5: Determine Priority Level Step 6: Problem Resolution Step 7: Communication with Other Departments Each step is discussed in further detail in efforts to provide the IB team the necessary understanding to effectively perform each procedure. As a note, for the IB to fully implement the following off-site monitoring process, many components in the current risk based supervisory framework needs to be addressed. This includes the IB establishing a supervisory plan that is supported by adequate resources, and establishes appropriate on-site and off-site work activity to support the current insurance market conditions; revisions and modifications to current insurance laws and regulations to better support such things as valuation methods, solvency requirements, and supervisory actions; restructuring the current regulatory financial reporting templates to better obtain adequate information from insurers, as well as uniformity in the financial information reported by all insurers; and, sufficient legal authority to adequately take action against insurers. Note: The sequence of above listed steps could also vary depending on the market situation and most notably its size and number of participants. Below a critical number of participants it is possible for BM to perform sufficient scrutiny on each and every market participant, mentioned under Step 2 and Step 3, and proceed with other steps listed. However, beyond a certain level of insurers it is very resource consuming to perform uniformly thorough scrutiny of the whole market, and the first step would rather comprise of various scoring methods to identify first the companies most prone to risks, and take the other appropriate steps from that point onwards. Step 1: Gather Information Information should be gathered from insurers, other departments and outside agencies. The information should include both qualitative and quantitative information surrounding the company’s activity. The information should come from the company, external third-party sources, and intra-departmental sources (IB departments). The information gathered should be helpful to the analysis team to identify company financial and prospective risks, monitoring and mitigation strategies, and areas of concern. The information captured should be adequate to provide the off-site monitoring team with a full picture of the company’s current operations as well as the company’s strategic focus and plans. The IB needs to be in a position where it can be responsive to issues and concerns that may arise instead of being reactive to problems a company may encounter. As part of the off-site analysis process, the analyst must have a full understanding of the company’s: 1. Current financial position (including off-balance sheet commitments), its overall performance over recent years and direction where the company would be heading, given its current Key performance indicators (KPI). 2. Activities related to the core functions of an insurance company (e.g. actuarial methods, underwriting policy, reinsurance policy); 3. Treatment of customers and marketing practices; 4. Accounting and internal control systems; 5. Business plan and strategies 6. Corporate governance and risk management practices; and 7. Organizational structure The following sources of information will aid the analyst in formulating an understanding of the above areas of the company’s operations: • The insurer monthly, quarterly and/or annual statutory filings (1) • External audit reports, and any management letters or notes provided by auditors to the managers (1) (footnote 1 for above: It should be noted that in practice the external auditors, to mitigate their legal risks, communicate most critical observations to the management orally, rather than in written form) • Actuarial opinions and memorandums (1) • Holding company filings (7) • Foreign supervisory reports (for companies that are foreign owned or have foreign subsidiaries) (1,2,6,7) • Intra-departmental information from licensing, legal, on-site… (1,2,3,4,5,6,7) • Board minutes to support large or unusual transactions needing board approval (1,3,4,5,6) • Public filings (1,2,3,4,5,6,7) • Rating Organizations (AM Best, S&P, Fitch) (1,2,3,4,5,6,7) • Enterprise Risk Management (ERM) documents (5,6) • Business plans (5,6) • Company web site (2,6,7) • Complaint logs (3,6) Note: Numbers in parentheses correspond to the bullets in the preceding paragraph, representing the type of information that may be captured from the information source. Step 2: Perform Assessment The objective of the off-site analysis is to perform a sufficient level of analysis to derive an overall assessment that highlights areas where a more detailed analysis may be necessary. The assessment process should include a review of the company background, management and financial review. Background Review The analyst should perform a review of prior year assessment and identify changes that may impact the insurer’s operations that may need further analysis. The review should include: • Follow up required from prior year analysis • Priority designation from last review and for start of current review • Issues, concerns or prospective risks noted in previous analyses • Inter-departmental communication concerns • Company structure, new products, regulatory actions against the company • Changes to regulations that impact the company • Recent Credit Rating Provider’s report • Business plan, financial projections, etc. • News releases, etc. Management Review The analyst should work with the examination (on-site supervision) staff to assess the quality and reliability of corporate governance to identify, assess and manage the risk environment facing the insurer. This assessment will assist in identifying current or prospective solvency risk areas. By understanding the corporate governance structure and assessing the “tone at the top,” the analyst will obtain information on the quality of guidance and oversight provided by the board of directors and the effectiveness of management, including the code of conduct established in cooperation with the board. It is also important to keep in mind that in some circumstances the management, for practical purposes, could be more nominal than in others. It could occur in situations where the company is a full subsidiary of a foreign (insurance) group, and as such its independent decisions in practice are limited to less areas, compared to companies with full domestic capital. The area always under local control (for the most part of it) is sales and various sub-activities related to it (because the company must adjust to the market). On the other end, purchase of reinsurance in group entities is usually arranged via group, as well as certain aspects of financial management. There could be also other aspects of activities that would have to follow group standards and where the management exercises less discretion. As part of the review of management, the analyst should determine: • changes in management philosophy/culture • changes in officers, directors or trustees? • inquire about reason for changes • changes in organizational structure • changes in ownership Financial Review The analyst should perform an overall analytical review of the insurer’s current financial statements. The goal of financial review (and subsequent calculations and estimations in Step3) is assessing the solvency and overall financial health and viability of an insurance company. For efficient use of resources, it is feasible to use the “top-down” approach, i.e. we first observe some financial outcome, or deviation in some important indicator, and subsequently we try to establish which are the underlying input factors or drivers that have resulted in observed financial outcome or indicator, or make our estimations and projections as to what direction those factors and accordingly the resulting critical indicators of a company, might develop. There are several angles that the financial state of a company could be looked upon, and there is a common logic in the sequence of sub-analyses in each of those. In this step we look foremost at the current state of the company, which ultimately translates to its current (required) solvency margin/capital requirement and its coverage, based on its balance sheet and equity composition. We also look broadly at certain changes. The subcomponents of this step ought to be the following: • Review the balance sheet and for balances that have changed by > +/- 20% from prior year determine the reason for the change in balance. Note: this is applicable to major categories and line items in the balance sheet, and for both comparison periods. Relatively big changes in a line item which itself is AND was insignificant, remains by definition insignificant, hence an adequate threshold should be used. • Review the profit and loss statement and determine if the absolute value of current year net income/(loss) decreased > 20% or increased > 40% from prior year. Try also to establish the broad ranking of contributing factors to the observed change in net income/loss (e.g. (1) GWP growth (2) improved loss ratio (3) increased reinsurance reliance with increased loss ratio of the latter, etc.) o For individual income or expense categories for which the current or prior year balance was > 5% of capital and surplus, has it changed by > +/- 20% from prior year? Provide some details and determine why. Note: the same criteria of significance apply, as in balance sheet comparison. • Review the capital and surplus account (i.e. equity) category that changed > +/- 10% from prior year o Are net unrealized gains/(losses) > 10% of prior year capital and surplus? Provide some details and determine why. • Regarding cash Flow, Is current year net cash from operations negative? Review trend for past 5 years. Review Notes to Financial Statements determine any areas of concern Keep in mind, the purpose of the analytical review is to identify any unusual trends that may need further assessment. The analyst must be able to understand the reasoning for material changes or trends, and to determine how these changes impact the company’s risks components. Any changes that may have an increased effect on the company’s risk factors may need further review or monitoring. The analyst must document any areas of increased risks in order to evaluate appropriate actions to be performed. To assist the analyst in performing the Step 2 procedures a procedures form has prepared, please see Exhibit 1- Step 2 Procedures Form. Step 3: Calculations and Estimations Ratio analysis process should be developed to assist in the off-site monitoring process. The following ratios provide the primary components that should be incorporated into developing the early warning system. Ratio analysis may be considered an extension of Step 2. However, due to the importance of ratio analysis, it is broken out as a separate step for purpose of this manual. Inherent Risks To better understand the inherent risks associated with the activities of the insurer and how these risks impact the insurer’s financial results, the WB team suggests that the risks associated with each of the performance indicator be labeled accordingly. For example, the primary risk associated with claims is insurance risk. As such unmitigated insurance risks may have a significant impact on an insurer’s claims ratio. By associating the specific risks with the performance indicator will allow the IB to better identify potential areas of concern that may impact the outcomes of those performance indicators. The WB team suggests the following risk categories or a variation of these categories: 1. Insurance risk- Underwriting practices are inadequate to provide for risks assumed, and actual losses or other contractual payments reflected in reported reserves or other liabilities will be greater than estimated. The following activities that have adverse consequences directly impact insurance risk: o Data integrity o Underwriting process o Pricing o Product design o Concentration o Claims process o Net retention o Provisioning 2. Operational risk- Problems associated with the operating units of an insurance company. Each department has its own risks which must be managed. Primary sources of operational risk include: o Employees competence o Internal control process o Management oversight o Systems reliability 3. Market risk- Risks associated with the degree of risk inherent in the investment portfolio. Primary sources of market risk include: o Interest rates o Foreign exchange rates o Equity pricing o Concentration The market risk is very important (and has most impact) in certain long-term life products, pending also valuation rules of underlying assets and reserving formulas for corresponding products. 4. Liquidity risk- Inability to meet contractual obligations as they become due because of an inability to liquidate assets or obtain adequate funding without incurring unacceptable losses. o Asset liability matching o Investment holdings mix The usual first sign for liquidity risk to manifest itself is delays of claim payments (in non-life insurance). In life insurance growing phase and under normal circumstances (with e.g. no CAT losses), the liquidity issues should not occur. If they do, then it is likely a sign of grave systemic problem in the company. The essence of liquidity ratios is to measure at predefined future deadlines (+3 months, +6 months etc.) the respective cash outflow needs, and compare those with available assets that can be used to settle those liabilities as they become due by those deadlines. The most exact liquidity needs in core activities (i.e. insurance) can be forecasted by loss triangles by each LOB (in non-life) and portfolio/maturity analysis (in life insurance). In life insurance the liquidity analysis constitutes the main area of analysis. 5. Credit risk - Amounts actually collected or collectable are less than those contractually due. Some typical sources of credit risk include the following: o Investment securities ▪ Credit quality ▪ Maturity ▪ Concentration o Reinsurance ▪ Credit rating ▪ Collateralization o Agents/brokers ▪ Repayment history ▪ Financial condition ▪ Credit limits o Related Party ▪ Financial condition at the group holding level and subsidiaries The main sources of credit risk for an insurance company are reinsurers, insurance intermediaries (depends on balance settlement arrangements), and credit institutions – pending importance of bank deposits in assets. In Nepalese case the latter, along with reinsurance are likely the main credit risk sources. 6. Strategic risk- Inability to implement appropriate business plans, to make decisions, to allocate resources or to adapt to changes in the business environment will adversely affect competitive position and financial condition. Some typical sources of strategic risk include the following: o Governance o Capital management o Resource allocation o Risk appetite o Product offering o Pricing decisions o Expansion decisions o Corporate structure In assessing the strategic risk, as also mentioned under “management review”, the supervisory should have good understanding to what extent the company is driven locally and to what extent the strategic decisions are taken externally, and just communicated locally for execution. 7. Legal and regulatory risk- Non-conformance with laws, rules, regulations, prescribed practices or ethical standards in any jurisdiction in which the entity operates will result in a disruption in business and financial loss. As a note, other jurisdictions may combine strategic risks and Legal and Regulatory Risk in operational risks. For purposes of this manual, those risks were broken out separately. Ratios The following is a list of key financial ratios for both non-life and life companies that are grouped into categories that they most notably impact, which are solvency, profitability, liquidity, and leverage The ratios can be further aligned with the potential risk areas affected in the insurer’s key functional activities. Risks are abbreviated as follows: IR Insurance Risk MR Market Risk LR Liquidity Risk CR Credit Risk OP Operational Risk SR Strategic Risk LR Legal and Regulatory Risk Non-Life1 Ratio Main Other Indicator Computation Type Risk Risks Solvency Solvency margin ratio Solvency margin (A) / Minimum solvency margin (B) All All Equity of this year (A) - equity of the previous year (B) / Solvency Change in equity SR IR,OR equity of the previous year (B) Claim ratio (x1) + Insurance business op cost ratio (x2) x1 = Total insurance claim expenditure under the Profitability Combined ratio retention responsibility (A) / Net premium revenue (B) IR SR,OR x2 = Total costs of business activities (C) / Net premium revenue (B) Profitability Loss ratio (Incurred Claims / Net Earned Premiums)*100 IR (Expenses including Commissions / Net Earned Profitability Expense ratio OR Premiums)*100 Profit from financial activities (A) / 0,5 x (Total of Profitability Return on investment investment assets at the beginning of period + Total of MR investment assets at the end of period) (B) Profitability Return on equity After-tax profit (A) / Equity (B) SR IR,MR,CR,OR Reserve and Technical provisions (Technical Provisions / Total Equity) % IR OR Leverage Reserve Gross premiums over and Total premium (A) / Equity (B) IR OR,SR, owner’s equity Leverage Reserve Net premiums over and Net premium (A) / Equity (B) IR OR,SR, equity Leverage Reserve (Receivables from Reinsurers, Intermediaries and and Insurance debt CR SR Policyholders) / Total Equity) % Leverage Reserve Net premium revenue of this year (A) Net Premium growth and - Net premium revenue of the previous year (B) / Net SR IR rates Leverage premium revenue of the previous year (B) Reserve Change in gross written (Gross Written Premiums current year / Gross written and SR IR premiums premium past year)*100 Leverage Reserve 1-(Net Written Premiums / Gross Written and Cession ratio CR SR Premiums)*100 Leverage Asset and Short-term liability over Short-term liability (A) / Cash and cash equivalents (B) + LR Liquidity the short-term assets Deposit with term (C) Asset and Receivables from Affiliates + Investments in Affiliates / Affiliate ratio CR Liquidity Equity 1 The ratios in red reflect ratios not listed in the Circular for Mandatory Ratios for Non-Life Insurance Companies. These ratios may be considered for an early warning system for Step 3. Life2 Main Other Ratio Computation Risk Risks Solvency Margin Ratio = Solvency margin / Minimum Solvency Solvency Margin All All solvency margin Equity this year (A) - equity last year (B) / Equity last Solvency Change in Equity All All year (B) Operating expense Total expense of insurance business (exclusive of Profitability OR SR ratio commission) (A) / Net premium revenue (B) Net profit from insurance business (A) / Net revenue Profitability Return on Revenue IR OR from insurance business (B) Profit from financial activities (A) / 0.5 x (Opening total Profitability Return on Investments MR CR investment + Closing total investment) (B) MR,CR,OR,IR, Profitability Return on Equity Post-tax profit (A) / Equity (B) SR CR Profitability Return of assets Net profit from insurance business (A)/ Total assets MR CR Total premium this year – Total premium last year / Profitability Premium Growth Rate SR IR Total premium last year Change in Gross (Gross Written Premiums current year/Gross written Profitability SR IR,OR Written Premiums premium past year) *100 Reserve Level of reserves of each operation in the year (A) / and Actuarial provisions Revenue from premium of equivalent operation in the IR leverage year (B) Reserve Technical Reserves and (Technical Reserves/ Total Equity) % IR OR Cover leverage Reserve and Reinsurance ratio Reinsurance premium (A) / Total premium revenue (B) CR SR,IR,CR leverage Reserve Gross premium Gross premium revenue (A) / 0.5 x Equity last year (B) and SR IR revenue to equity + equity this year (C) leverage Reserve Net premium revenue Net premium revenue (A) / 0.5 x Equity last year (B) + and SR IR to equity Equity this year (C) leverage Reserve Equity (A) / Minimum capital corresponding to the and Capital sufficiency CS SR,OR scale and risks of the insurer (B) leverage 2 The ratios in red reflect ratios not listed in the Circular for Mandatory Ratios for Life Insurance Companies. These ratios below may be considered for an early warning system for Step 3. Reserve and Insurance Debt Receivable from customers (A) / Charter capital (B) CR IR,OR leverage Asset and Cash and cash equivalents (A) + Bank deposits / Liquidity ratio LR OR liquidity Short-term liabilities (B) Asset and Receivables from Affiliates + Investments in Affiliates/ Affiliate Ratio CR CR liquidity Capital & Surplus Because a specific performance indicator may impact more than one risk, a primary risk and secondary risks are listed. Regarding the ratios listed. For the ratio analysis to be useful, a market assessment should be performed to determine reasonable thresholds for each ratio. This will give the IB a gauge to determine results that may indicate results that may be indicative of problems or risk areas in the insurer’s activity. Any unusual results that fall outside of the thresholds need to be reviewed to understand the reason for the departure from normal ratio results. Trend Analysis In addition to reviewing ratios for a stated period, specific ratios should be reviewed over stated time periods in efforts to identify negative trends as well. Trend analysis should be performed over three to five- year periods. It is useful to be able to record and examine trends in ratios over time, and for effective early warning, ratios over time may be calculated quarterly in many cases. Ratios can be grouped and compared side by side to identify any unusual patterns. For example, the Combined ratio includes both expense and loss components in its calculation. A side by side comparison of the combined ratio, expense ratio and loss ratio can assist the analysis in identifying the relationship and patterns of these components to better isolate activities that may be causing any unfavorable tends or fluctuations. Graphs may also be prepared to show cumulative results of specific ratios over stated time periods, such as three or five years. These can further be enhanced by comparing the company’s ratio result to the industry averages for those periods. After reviewing and assessing the information obtained, the analyst has additional questions or determines that additional information is still needed, the analyst may choose to conduct in-person meetings with the insurer, hold conference calls, submit written information requests or take other steps necessary to obtain a sufficient understanding of the insurer. If meetings or conference calls are scheduled with the insurer to gather additional information, the analyst consider the level at which the meetings should be conducted (i.e., legal entity, intermediate holding company or ultimate controlling parent). Step 4: Carry Out Further Analysis, if Required Further analysis may need to be performed as the analyst identifies areas of higher risk, concerns or unusual events that were identified in the previous steps. The supervisor should be evaluating the risks to address any areas of concerns. In addition, the supervisor should be considering assessing the overall risk of the insurer to determine the level of concerns in its overall operations. Again, to assist the analyst in performing the Step 2 procedures a procedures form has prepared, please see Exhibit 1- Step 2 Procedures Form Step 5: Determine Priority Level One method to enhance the risk based supervisory approach that the IB may consider would be utilizing a broad priority scoring system that is focused on rating the risk components described earlier. The purpose of the rating process is to better manage the supervisor’s resources and focus on higher risk areas. For example, if the risk types of an insurer are all considered very low to low, and its overall priority rating is deemed low, the supervisor may limit its resources and attention on that insurer. If an insurer has a risk rating for Liquidity as high, but and overall priority rating of low, then the supervisor may just limit resources on addressing the insurer’s liquidity issue. If an insurer has several risk categories that are high and/or extreme, most likely the overall priority rating will be high. As a result, the supervisor most likely will have to focus more resources and attention on this insurer The scoring basis would consider the magnitude of impact of the risk as well as the likelihood of occurrence. The scoring system is considered more of an internal scoring method that is based upon the Analyst’s assessment. The scoring method rates risks of particular risk categories, as well as an overall priority rating score. The results of both a risk rating and the overall priority rating will determine the necessary actions that the supervisor may consider. The supervisor should be evaluating the risk for a particular category to address any areas of concerns. In addition, the supervisor should be assessing the overall priority rating of the insurer to determine the level of concerns in its overall operations. The following represents a risk scoring system. The analyst assesses the level of each risk type depicted in Illustration 2. The risk rating ranges from very low risk to extreme risk. Depending on the risk rating level, the analyst will determine the necessary procedures to take. Illustration 1 Risk Rating Risk Level Risk 0 Very Low No risk 1 Low Minimal risk 2 Moderate Moderate 3 High Significant 4 Extreme Very Significant Illustration 2 Risk Summary Risk Type Risk Scores Area of Concern Solvency Financial Performance Strategic Reserving Insurance (Pricing/Underwriting) Credit Liquidity Market Operational Legal Priority Rating The analyst’s responsibility should be to document an overall summary and conclusion regarding the financial condition of the insurer as well as the insurer’s strengths and weaknesses, and to determine the supervisory action required. The insurer’s priority level should be reconsidered as the result of each review performed to determine whether the designation is still appropriate. The analyst should understand specifically the insurer’s activity and the associated risks. Any risks that are elevated, the supervisor needs to understand the reasons why the risk is elevated to determine the appropriate action to take. The following provides a general guideline of supervisory actions to take based upon the determined risk level. Supervisory action may be anywhere from no additional analysis is needed to implement some supervisory actions, such as requiring the insurer to suspend offering of a specific product. Risk Level Actions The following represents an example of what actions should be taken based upon the assessed risk level. 0- Very Low • No additional procedures required, continue monitoring on a regular basis 1- Low • No additional procedures required, continue monitoring on a regular basis 2- Moderate • Contact the insurer seeking explanations or additional information • Require additional interim reporting from the insurer • Refer concerns to examination section for targeted examination 3- High • Require additional interim reporting from the insurer • Refer concerns to examination section for targeted examination • Engage an independent actuary to perform cash flow analysis • Meet with the insurer’s management 4- Extreme • Engage an independent actuary to perform cash flow analysis • Meet with the insurer’s management • Obtain a corrective plan from the insurer Insurance Profile Summary The Priority rating may be included as a component of the Insurer Profile Summary. Implementation of an Insurer Profile Summary (IPS) may enhance the ISA’s risk based supervisory approach. The IPS is intended to provide a high-level overview of the current and prospective solvency of the insurer as well as the ongoing regulatory plan to ensure effective supervision. It provides a vehicle for information sharing among the various supervisory functions and support for assessing the individual risk components of an insurer’s operations. The financial analysis team should be the primary responsible party for administering the IPS. Exhibit 3 Insurance Profile Summary, provides an example of an IPS. As a note, the IPS should be modified to Nepal’s insurance market, law and regulations. The Insurer Profile Summary should be concise and should contain information related to each of the five elements of the regulatory Risk-Focused Surveillance Cycle: • Financial Analysis • Financial Examination • Internal/External Changes • Priority System • Supervisory Plan The Insurer Profile Summary should provide an assessment of the insurer’s prospective exposure to each of the risk categories. This assessment is intended to foster improved communication regarding risk exposures between functions. A modified version may be used to communicate insurer’s status with foreign jurisdictions as well. Note: The priority rating may be incorporated into the IPS and the Risk Assessment Section of the IPS. See Exhibit 2 to see example. Priority Scoring Considerations The scoring should take into consideration the results of performing the Step 2 and Step 3 procedures. The results documented in Exhibit 1, Step 2 Procedures Form; Exhibit 2 Analytical Review; Exhibit 3, Insurer Profile Summary; and, Ratio analysis should all be used to determine the scoring for Illustration 2. As a general guide for assessing a risk level, the analyst should identify the area of exposure and determine the impact of that risk on the activity of the insurer. It should take into consideration the potential magnitude of the risk if it occurred and the frequency of occurrence. Below is a brief summary of the contents of each risk type, along with points to consider when assigning risk scores to them. Factoring in Corporate Governance As the analyst establishes priority scoring for the specified risks, the corporate governance should be factored in. Corporate governance may contribute to an increase/decrease in the risk exposure. Corporate governance assessment is based upon the supervisor’s expert opinion and cannot be directly quantified. The supervisor, however, can prioritize critical areas in insurance company that would have to be for the company to function as “going concern”. Such areas are usually Insurance (pricing/underwriting), reserving, liquidity, and in Nepalese case the third rank of importance could belong to credit – due to high reliance on bank deposits (and on banks as business counterparts, as well). Operational risk might be of high importance as well (being next). Presumably the market risk has lesser significance on Nepalese insurance market, due to limited variety of investment types. Based on factoring in corporate governance, the supervisor can subsequently assign the appropriate risk score to this risk type, by exercising his/her expert judgement on these areas. Sometimes a certain area is well documented (with hired external expertise), but still poorly implemented in real life. Such background knowledge should be available form discussions with on-site examiners from past on-site inspections (examinations). In the context of this risk area it should also be looked upon whether the duties and functions established by Commercial Law for both The Board of Directors and other senior management, are properly established and executed. Solvency The solvency i.e. the ratio of available capital vs. required capital is already quantified (as a percentage or coefficient), and as such provides ready basis for scoring. It is feasible to calibrate the four ranges so that they either follow the principles described under Step 6 (i.e. >120%, 120%-100%, 100%-33%, below 33%) or by comparing the ranges to relevant values prevalent on the market. It is important that the legal thresholds are represented in such scoring (i.e. 100%) as well as the level which is deemed to be critical (e.g. 33%). The remaining “safe zone” range limits can be chosen arbitrarily based on overall market situation. It is important to bear in mind that the solvency capital coverage is an ultimate result of many other components, some of which are also represented in the list of risk types, most notably reserving (hidden equity with overestimated reserves and bloated equity with underestimated reserves), but also financial performance. The latter could be volatile from year to year, yet it gives additional information as for the direction where the solvency is going. Two companies having equal solvency coverages of e.g. 110% might be looking foreseeably different within 1 year into the future, if one has had loss in recent years and thus ending in deficit, and the other one moving further upwards to safest score form supervisory point of view. Financial Performance Since the insurance technical side is looked upon as a separate item, it is feasible to avoid overlapping between this risk area and “insurance”. In assessing the financial performance one should look at overall net income and its sources other than those related to underwriting, and various performance ratios related to profit sources (again, other than U/W), e.g. return on assets, return on investments (short and long term), volatility of underlying assets (it automatically translates to volatility in equity and solvency), and other relevant indicators that characterize the quality of managerial choices made in regard of financial Strategic It is natural that different companies have different risk appetite, tolerance and profile. Yet such profile should be well grounded, and decisions executed by management should be coherently with it. The top management in question should possess necessary competences as well. Reserving The main indicator and judgement criteria for reserving is whether they are under- or overestimated. In choosing the limits for risk ranges it is feasible to apply those in such a manner that the resulting effect on equity is quantitatively comparable to some other major indicator e.g. solvency coverage. For example, if one of the risk ranges in solvency is 120%, and reserves (technical provisions) comprise 2/3 of the balance sheet volume the rest being equity (for simplicity), then the respective range limit in reserving ought to be chosen so that it results in same effect on equity (in absolute terms) as would the 20% excess on equity. The range limit for that corresponding interval in reserving risk ranking would be thus 110% (110% of 2/3 gives the same gain as 120% of 1/3). Good non-life tools for assessment of over/under reserving are so called loss triangles, both for event count and settlement delays, as well as for monetary sums. If the triangles are applied properly, the reserving mismatch will always surface in supervisory analyses. Without getting do deep in actuarial matters, the reserving risk score should also consider the relevant “non-numeric” background. For example – whether the reserving principles are properly approved and consistent from year to another, and do not include any ambiguous or undefined principles – which are left to the discretion of top management (being sometimes dependent on dividend expectations (yes- reserves can be and quite often are adjusted in accordance with dividend expectations (unofficially), and disguised as legitimate changes resulting in application of different actuarial principles. Insurance It is utmost feasible to assess the adequacy of pricing risks on a products level or on a level of group of products that behave in a similar manner about loss statistics and distributions. This gives a good picture which are the sources of ultimate aggregate loss or profit for the whole insurance portfolio. For pricing adequacy each of those products or groups thereof should be first assessed on a gross level. Subsequently the (ceded) reinsurance results should be assessed along the same groups, in order to evaluate the effect of reinsurance in the ultimate net result of insurance activities. One important principles to be observed in these assessments (esp. that on gross basis) is the matching principle, i.e. the losses for a product (or a group) should be measured against the premiums of only those policies that these losses originate from. The most useful way to achieve this matching principle is the usage of loss triangles, which are split usually by product groups (or lines of business, LOB). It is important, besides ratios, to consider the volume, homogeneity and volatility of any given LOB in respective risk assessments. More detailed analysis of loss ratios and loss triangles is presented in Annex ZZZ As for calibration of individual ranges, it is feasible to adjust them so that the resulting effect on equity matches that of other risk items (e.g. by applying principles described under “reserving”). Credit The insurance company, being a net borrower due to the economic nature of its core business, is usually not excessively exposed to credit risks. The main source of credit risk originates typically from reinsurers and major intermediaries (pending settlement frequency and invoicing principles i.e. if mediator holds premiums before transferring them to insurer). However, in Nepalese case the significant credit risk counterparties are also banks – due to asset exposure that insurers have in them. The above said does not imply this credit risk being high, it merely states the importance of banks in credit risk that the insurance companies have. The credit risk is assessed as the product of Probability of Default Times Loss Given Default (PD x LGD). The PD correlates with the credit rating of respective counterparty, and LGD depends on exposure to any of the counterparties, adjusted by recovery rate. Liquidity The overall liquidity risk of an insurance company is the possibility of shortage of cash, and resulting delays in claim payments. Therefore, the first reliable sign of liquidity issues is prolonged delays in claim payments. The useful tool to reveal such delays is again the loss triangles. As for calibration or risk ranges, the volume of delayed claim payments (e.g. beyond a market average, by each LOB) can be matched to excess or deficiency in equity as in other quantifiable risk items. For example – if the overall delay of claims exceeds the market average by some factor, it can be calibrated so that this factor will be proportionate to the risk ranges in reserving. This ensures that the factor bears comparable weight with other risk factors. Market The market risk and its assessment can be one of the most complex risk items in this list. This risk could realize as a result of market price movements of different asset categories, e.g. stocks, bonds, real estate prices, exchange rates etc. It is feasible to look into market risk of any Nepalese company within such different categories (since they behave differently, some partially correlated, some partially reverse-correlated). The exchange rate risk should be fairly limited for Nepalese insurers, due to geographical constraints of their activities, and also domestic origin of their assets (including financial instruments). Due to limited investments abroad, the exchange rate risk is important mostly in the context of outwards reinsurance, if the contracts are nominated in a currency other than Nepal Rupies. It would be predominantly relevant to various forms of non-proportional contracts, where the price of risk is ultimately set by the reinsurer. Operational Operational risk (OR) correlates quite closely with corporate governance (described above) – it just reflects the relevant risks on a more detailed and technical level. It is very hard to quantify (as is the case throughout the world), and any quantification requires availability of good and reliable statistics on failure events. Therefore, the supervisor must exercise his/her expert opinion in assessing the magnitude and assigning a risk score. A good guidance and indication of properly managed OR is the existence of business continuity routines which are also properly documented, and existence of the same for all other crucial workflows in an insurance company, i.e. claim handling, underwriting, IT, cash management, proxy rights (signatory limits), and alike. For practical purposes in a modern insurance company, the operational risk is most frequently related to IT failures. Legal The legal risk, for the purposes of this analysis, comprises mostly of compliance-related negative impacts that the company might face, first and foremost from supervisory side, but also from other state institutions (tax authority etc.). The overall developments in legal environment that affects companies in some uniform manner, should be looked at the scope of the whole market, along with market-wide impacts. In practice most of the legal actions (other than claim-related disputes) against an insurance company are initiated by the supervisor, in some jurisdiction the supervisor could also have legal prerogative in initiating the bankruptcy procedures (not carrying it through itself, though). If any external third party could initiate bankruptcy proceedings against the insurer, the related legal risks should be looked together with liquidity risks. The compliance risks of legal risks should be easier to evaluate, since the supervisor itself acts upon these. Step 6: Problem Resolution The analyst should list any specifically identified items that require further monitoring or specific testing by the on-site inspection team. In addition, the analyst should indicate if the company is or should be subject to any enhanced monitoring, such as monthly reporting, a targeted inspection, or a more frequent inspection cycle, as indicated in the previous step. Instances may arise where the analyst has identified issues with the insurer’s operations that may require some additional action to be taken, specifically when the analyst has deemed the risk rating of a specific risk category as extreme or when the overall priority level is high. Courses of action are dependent upon the nature and scale of the identified issue. Setting aside current legal implications and/or restrictions, the following is a list of possible actions that may be instituted: • Monitoring • Surveillance • Regulatory action Once the analyst has gathered sufficient information to formulate an understanding of the cause of the problem, the IB may be able to determine the appropriate actions to take. For problems identified that may pose a more severe risk to the company, the IB may be required to take stronger regulatory action. • The IB may direct the company to develop a preliminary plan to correct the situation, evaluate the company’s corrective plan, and determine what resources will be needed to monitor implementation of the plan. • The IB should ascertain its regulatory authority and legal responsibilities as well as evaluate various tactical considerations and alternatives in developing a regulatory course of action. The IB should be prepared to act quickly, if necessary, to stabilize a situation and to prevent further deterioration or exposure to unnecessary risk. Preliminary actions may include instituting controls over operations or transactions, including access to and use of the company’s assets. For issues surrounding solvency, usually there are several levels of supervisory intervention (regarding solvency) that the supervisor considers. The “no action” zone usually covers situations where the required level of equity is sufficiently covered (e.g. above 120%). The next level includes situations where the coverage is equal or narrowly above the required level – this need more frequent supervisory off-site monitoring and more thorough analysis and projections, as necessary. The third level of intervention is deficiency of equity, but still above some critical level. In this case the supervisor usually requires a detailed action plan with accompanying financial projections that show how the required size for equity will be achieved in over the period of e.g. next 6 months. The last level of intervention is usually the situation when the company’s equity falls below certain critical level, e.g. 1/3 of its required size. In such case the supervisor requires immediate capital injections or initiates portfolio transfer process. If the supervisory work routines related to first levels are adequately implemented then the last level should not be reached, unless e.g. some catastrophic event along with inadequate reinsurance has caused it. Of course, beyond the financial considerations (of solvency) there could be also certain market conduct or other issues that could warrant immediate supervisory intervention or sanctions. The corrective plan developed by the company must be specific, appropriately timed and subject to oversight to ensure the plan can be accomplished effectively within a reasonable time frame. The IB should evaluate whether the company’s preliminary corrective plan adequately addresses all the company’s situation and adequately meets department objectives. Accountability for the progress of the corrective plan should be based not only on achieving specific plan goals, but also on achieving goals within a controllable time frame. Among the more typical actions that may be considered by the IB are taking control of the company’s assets, changing the company’s management, changing the company’s operations, raising new capital, entering into reinsurance transactions, changing the mix of the company’s asset portfolio, merging with a financially sound insurance company, and selling certain assets or the entire company. As indicated, the IB’s authority to undertake certain of these regulatory actions is dependent upon the applicable laws and regulations. The IB needs to consider its legal authority and responsibilities before commencing any regulatory action. Periodically throughout the implementation of the corrective plan, the department should review the progress of the plan and determine whether the problem has been eliminated. The IB should also determine what, if any, surveillance efforts need to be continued to monitor any possible recurrence of the situation. For example, the department might require the company to report financial information more frequently than normal or require the company to file certain information in addition to the information it is ordinarily required to file. Step 7: Communication with Other Departments Communication and/or coordination with other departments is crucial during the consideration of these procedures. Communication between the analyst and the examiner in preparation of an examination should include a thorough discussion of key risks (current and prospective) highlighted in the Insurer Profile Summary, as well as the company’s financial condition and operating results since the last examination. The analyst should be prepared to explain during this discussion the reasons for any unusual trends, abnormal ratios and transactions that are not easily discernible. This discussion should occur through a meeting (in- person or via conference call), rather than only through e-mail exchanges, which are not deemed sufficient to achieve the expectation of a planning meeting with the examiner. During this discussion, the analyst should communicate and provide access to relevant information that has already been obtained by the analyst function and is available to the department. Such internal discussions and meetings amongst IB units serve the purpose of passing information, creating uniform understanding of issues of the insurer and establishing more detailed goals and tasks for potential subsequent on-site inspection (examination) and provide any needed inputs for the on-site inspection (examination) plan. Exhibit 1: Step 2 Procedures Form Review the documentation obtained. The information gathered should be helpful to the analysis team to identify company financial and prospective risks, monitoring and mitigation strategies, and areas of concern. The information captured should be adequate to provide the off-site monitoring team with a full picture of the company’s current operations as well as the company’s strategic focus and plans. The IB needs to be in a position where it can be responsive to issues and concerns that may arise instead of being reactive to problems a company may encounter. The following procedures provide the analyst guidance in performing the necessary procedures to effectively evaluate the information obtained and identify areas of concern. The Analyst should be accumulating all areas identified that may pose increased risk to the insurer’s solvency position that may need further understanding and/or monitoring (the IPS as described in the manual may be used for this purpose). Background Analysis 1. Review the analysis performed on the insurer for the prior year and prior quarters. a. Indicate the priority designation as of the last review and start of the current review: Priority Designation b. Were there any issues, concerns or prospective risks noted in previous annual or quarterly analysis completed in the prior year? If “yes,” discuss the issues, concerns or prospective risks, the follow-up conducted, and include any correspondence with the insurer, along with any conclusions. (Consider the prospective risks previously identified in the scope of the current analysis.) c. Review the Insurer Profile Summary, including the Supervisory Plan, if applicable, and document any areas of concern that impact the current analysis. 2. Review any inter-departmental communication, as well as communication with other departments and the insurer. Note any unusual items or areas that indicate further review or follow-up is necessary. Any changes in Certificates of Authority, licenses or registrations. Complaints received and resolution of the complaints. 3. Are there any changes in the state’s statutes and/or regulations that could impact the insurer’s financial position or reporting? If “yes,” to the extent information is available, has the insurer failed to comply with the new state’s statutes and regulations enacted during the period? 4. Review any industry reports, news releases and emerging issues that have the potential to negatively impact the insurer. 5. Review any public filings, credit rating reports and the company website for additional background information on the company that may raise any areas of concern. 6. Review the most recent business plan, ERM and financial projections, if available from recent surveillance activity and if considered necessary based on the insurer’s priority designation and financial condition. a. If significant changes in business plan or philosophy have occurred, assess the insurer’s ability to attain the expectations of the business plan. b. If actual results are not consistent with management’s expectations, provide a summary of the differences. Management Assessment 7. Has there been any change(s) in officers, directors, or trustees since the previous Annual statutory filing? If “yes,” indicate the position(s) in which the change(s) occurred. Review the Biographical Affidavit(s) for any new officers, directors, or trustees indicated above and note any areas of concern that would indicate further review is necessary. In conducting such review, also consider whether officers, directors and trustees are suitable (e.g., does the individual have the appropriate background and experience to perform the duties expected of him/her?) for the positions they hold within the insurer. 8. Follow-up on any previously identified corporate governance issues, assess any significant corporate governance changes and determine whether these changes appear to indicate a shift in management philosophy, or whether management has made any changes in business culture or business plan. Financial Review 9. Review the quarterly/annual statutory filings balance sheet. a. Is surplus/capital and surplus (based on business type) below the statutory minimum amount required? b. Has surplus/capital and surplus (based on business type): i. Increased by more than 20 percent or declined by more than 20 percent from the prior year-end? Display the percentage change and the ending surplus/capital and surplus for each of the past five years. c. Is the current year Risk Based Capital (RBC) ratio less than or equal to required amounts? Display the RBC ratio for each of the past five years. d. Display the results of the RBC Trend for each of the past five years. Perform an analytical review of the statutory financial statements (See Exhibit 2: Analytical Review, for example) e. Has any individual asset category that is greater than 5 percent of total admitted assets (excluding separate accounts) changed by more than +/- 20 percent from the prior year- end? If “yes,” indicate the asset category, current year-end balance, and the percentage change from the prior year-end. Also consider shifts within individual asset categories (e.g., between investment grade and non-investment grade bonds) and between publicly traded and privately placed securities. f. Is the amount of any individual liability category greater than 10 percent of total liabilities (excluding separate accounts), excluding the following lines: i. Losses, loss adjustment expenses, and unearned premiums (property/casualty insurers)? ii. Aggregate reserve for life contracts, aggregate reserve for accident and health contracts and liability for deposit-type contracts (life/A&H insurers and fraternal societies)? iii. Claims unpaid, aggregate policy reserves and aggregate claim reserves (health entities)? iv. Known claims reserve and statutory premium reserve (title insurers)? If “yes,” indicate the liability category and amount. g. Has any individual liability category that is greater than 5 percent of total liabilities (excluding separate accounts) changed by more than +/- 20 percent from the prior year- end? If “yes,” indicate the liability category, current year-end balance, and the percentage change from the prior year-end. h. Review the statutory Statement of Income Change in Net Income (Loss). If net income (loss) exceeded +/- 10 percent of surplus, has the net income (loss) increased by more than 30 percent or decreased by more than 15 percent from the prior year-end? i. Display the percentage change in net income (loss) and the actual net income (loss) results for each of the past five years. j. Has any individual income or expense category, for which the absolute value of the current or prior year balance was greater than 5 percent of surplus/capital and surplus (based on business type), changed by more than +/- 20 percent from the prior year-end? If “yes,” indicate the percentage change from the prior year-end, the income or expense category, and the current year-end balance. 10. Review the statutory, Cash Flow page. Is current year net cash from operations negative? Display the net cash from operations for each of the past five years. 11. Review the Audited Financial Report and note any unusual items or areas that indicate further review is essential. 12. Review the Statement of Actuarial Opinion and document any unusual items or areas that indicate further review is necessary. 13. Evaluate the insurer’s investment management practices. a. Has the purchase or sale of any investments not been approved by the board of directors or a subordinate committee thereof? b. Were any securities owned that the insurer has exclusive control of, not in the actual possession of the insurer? c. Note any unusual valuation methods or areas that indicate further review is necessary. d. Note any unusual items or areas that would indicate a non-diversified portfolio or inadequate liquidity. e. Is the book/adjusted carrying value of total special deposits greater than 10 percent of assets? Other critical information sources 1. If the company is part of a holding company, it may be necessary to communicate with the supervisory authority that oversees the holding company. Determine if the impact the holding company has on the insurer and if any concerns are raised by the foreign supervisor. 2. If a financial inspection is currently being planned, meet with the inspection team to: a. Discuss information on risks and concerns provided in the Insurer Profile Summary as well as additional information on the company’s financial condition, operating results since the last inspection, and reasons for any unusual trends, abnormal ratios and transactions that are not easily discernible; b. Communicate and provide access to relevant information that has already been obtained by the analyst function and is available to the department. Recommendation for Further Analysis (Step 4) Based on the procedures performed indicate any sections that the analyst recommends further review is needed. Specify the section and the reason for further review: Exhibit 2 Procedures and Inquiries for Further Analysis (Step 4) The following are guiding procedures and inquiries to perform in areas that the analyst has identified that need further review. The purpose is to provide the analyst with some general guidance in obtaining additional information to adequately make a determination of appropriate supervisory actions. Note that this is not an all-inclusive list and should be used as guidance. The analyst may inquire with the insurer or perform additional procedures that may not be reflected in this exhibit. External Auditor and Audited Financial Statements Types of Risk: Strategic Risk, Operational Risk Areas of Concern: (1) Governance, (2) Internal Controls, (4) Oversight, and (5) Compliance 1) Review the external audit opinion and note whether it was unqualified, qualified or adverse. In the case of qualified or adverse, discuss with the external auditor the reasons for issuing a qualified or adverse opinion. Assess how the this may impact the insurer’s solvency currently and in future periods. 2) Review any management letters to determine potential risk areas. 3) Inquire with external auditors their review of internal control process. Inquire as to what they reviewed and if they performed any testing around the controls. 4) Inquire with the external auditor how they assessed the insurer’s IT system a) Does the insurer have a disaster recovery plan? b) Did they review data integrity? c) Does the insurer have adequate safeguards to protect data? 5) For additional inquiries with the external auditor, review unrecorded audit adjustments. 6) Ensure the Audit Committee is adequately reviewing the audited financial statements. Income Statement Analytical Review Types of Risk: Strategic Risk, Insurance Risk, Credit Risk, Market Risk, Operational Risk Areas of Concern: (1) Volume, (2) Product mix, (3) Pricing, (4) Expenses, (5) Leverage 1) Review, by line of business, earned premiums by year for shifts in the mix of business between years. 2) Review, by line of business, the incurred loss and LAE ratios and note any unusual fluctuations or trends between accident years. 3) Compare, by line of business, the incurred loss and LAE ratio to the industry average to determine any significant deviations. 4) Review the loss ratios for direct, assumed, and ceded business, as well as contingent commissions per the Commissions and Brokerage Ratios and note any unusual fluctuations or trends between years. 5) Compare the commission ratios per the Commissions and Brokerage Ratios to the industry average to determine any significant deviations. 6) Determine the insurer’s leverage position. Review the insurer’s retention and reinsurance policy. Is the insurer assuming more risk (increased retention), if so, determine the reason for the shift. 7) Review the expense ratio to determine any unusual fluctuations. a) Determine if there is any indication regarding issues with operating performance b) Determine if there is concerns with internal controls of the company c) Has there been a change with management? If so, determine the impact of the change. d) Has there been a change in organizational structure? If so, determine the impact of the change 8) Review the yield on invested assets and note any unusual fluctuations or trends between years. 9) Compare the yield on invested assets to the industry average to determine significant deviation. 10) Determine whether concerns exist regarding changes in the volume of premiums written or changes in the insurer’s mix of business (lines of business written and/or geographic location of premiums written). Does the analyst consider the company to be diversified in terms of product lines and geographical exposure? 11) Determine whether the insurer has expertise (e.g., distribution network, underwriting, claims, and reserving) in the lines of business written. 12) Determine whether the insurer is exceeding its capacity (over leveraging itself) based upon its surplus levels. Is its reinsurance policy adequate for the volume and risk? Surplus and Risk Based Capital Types of Risk: Strategic Risk, Insurance Risk, Credit Risk, Market Risk, Operational Risk Areas of Concern: (1) Volume, (2) Product mix, (3) Pricing, (4) Expenses, (5) Leverage 1) Determine whether concerns exist regarding the amount of the insurer’s surplus a) Review the past three to five years for trends. Has the insurer’s surplus decreased by more than 10 percent from the ending balance for any of the prior four years? Determine the reason and ensure there is not a negative trend over multiple years b) Determine whether the insurer is excessively leveraged due to the volume of premiums written. Surplus can be considered as underwriting capacity, and the ratios of gross and net writings leverage measure the extent to which that capacity is being utilized and the adequacy of the insurer’s surplus cushion to absorb losses due to pricing errors and adverse underwriting results. Compare the ratios of gross and net writings leverage to industry averages to help evaluate the insurer’s leverage. c) Compare the surplus to assets ratio to the industry average to determine any significant deviation. 2) Determine if the insurer is properly reinsured. Determine treaty limits that may restrict loss recoveries. 3) Identify dividend payments or declarations to determine if any necessary approvals were obtained. 4) Determine whether concerns exist regarding the insurer’s Risk-Based Capital (RBC) position. a) Has there been a downward trend in the RBC ratio over the past two years? If “yes,” document the cause(s) of the decline. If a broader trend (e.g., five or more years decline) has been noted, document how the insurer plans to mitigate this continued decline. b) Determine if the change in the insurer’s RBC ratio was due to the Total Adjusted Capital. If so, identify the reason Cash Flow and Liquidity Types of Risk: Strategic Risk, Insurance Risk, Credit Risk, Market Risk, Operational Risk Areas of Concern: (1) Liquidity, (2) Cash Management, (3) Investments Policy, (4) Asset/Liability Matching 1) Determine whether concerns exist regarding the insurer’s cash flow and liquidity. a) If net cash from operations is negative, determine and note the underlying reasons. b) Review cash flow trends for the past five years and note any unusual fluctuations or negative trends between years. c) Compare the insurer’s adjusted liabilities to liquid assets ratio with industry and peer group averages in order to identify significant deviations. 2) Determine the adequacy of the company’s cash management process. How do they monitor cash needs? Do they have an adequate ALM (long term business)? Management Types of Risk: Strategic Risk, Operational Risk Areas of Concern: (1) Planning, (2) Risk Management, (3) Internal Controls, (4) Oversight, and (5) Compliance Procedures to perform and/or Inquiries 1) Discuss with onsite team any concerns noted at the governance level noted in the most recent exam. 2) Note any changes in the board and management since the last onsite exam. Do new team members have adequate experience and expertise? Has there been significant turnover, if so, why? 3) Determine if the board of directors and management provide a sufficient level of oversight and support. Review the board minutes, determine if board is engaged in review of operations and strategy. 4) Has the board taken any significant actions that may result in changes in operations, business structure, or management that may result in a material financial impact on the insurer? 5) Determine if there are any conflict of interest concerns, obtain conflict of interest statement if necessary. 6) Ensure that the internal audit function is appropriately independent, ensure that it reports directly to the audit committee. 7) Ensure remuneration arrangements does not pose potential issues. 8) Determine if there has been any changes in the organizational structure, if so determine if how the change may impact the future business. For mergers, determine if the organization is maintaining the necessary expertise. 9) Is the insurer complying with all reporting requirements, if not determine why and the impact it may have on the financial results. 10) Review the complaints filed against the insurer. Have the complaints been properly acted on. How do the number and type of complaints compare to other insurers. 11) Review legal actions taken against the insurer. Determine the reason for litigation and note any trends that may pose financial issues with the insurer. 12) Does the insurer have adequate IT systems to capture necessary information? Are there concerns regarding IT controls? Are there concerns regarding data integrity? 13) Have there been significant changes to the companies business plan and strategy, if so, how has the company assessed the risk of such changes, and how do they monitor the performance of those changes? 14) Understand the insurers strategic planning process. Determine how the board is involved in the process. Does the company factor in capital adequacy in its strategic planning process. 15) Does the business plan reflect realistic goals, is management’s remuneration tied into performance levels that may not be realistic or hard to achieve? 16) Does the insurer have an ERM process, if so: a) how do they set their risk appetite? b) how is there risk appetite factored into their strategies. c) How do they determine their risks, do they establish mitigating and monitoring processes for the identified risks? d) Do they have minimum thresholds for their risk levels and appropriate action plans if those thresholds are hit? 17) Has there been a change of actuary or external auditor, is so, need to understand the reason for the change. a) Discuss the reason for the change with the former actuary or external auditor. Determine if the reason was because of any disagreements. Investments Types of Risk: Market Risk, Credit Risk, Liquidity Risk Areas of Concern: (1) diversification, (2) liquidity, (3) quality, (4) valuation, and (5) asset/liability matching. Procedures to perform and/or Inquiries: Need to understand the insurer’s investment strategy and goals, including its policies and guidelines that specify the type, credit quality and maturity of investments to be held. In addition, understand roles and responsibilities related to investment decision making, oversight and reporting. 1. Determine whether the insurer’s investment portfolio appears to be adequately diversified to avoid concentration of investments by type or issue. Has the insurer failed to comply with specific investment laws, regulations, or guidelines for diversity and limitations? a. Compare the insurer’s distribution of cash and invested assets to total assets to industry averages and determine any significant deviations. b. Request a copy of the insurer’s formal investment plan that discusses investment objectives and strategy with specific guidelines as to quality, maturity, and diversification of investments: i. Evaluate whether the investment plan appears to result in investments and practices that are appropriate for the insurer based on the types of business written and its liquidity and cash flow needs. ii. Determine whether the insurer appears to be adhering to their investment plan. iii. Determine how the insurer monitors concentration risks c. If there are concerns regarding liquidity or cash flows, consider having a cash flow analysis performed by an actuary. d. Are affiliated investments a large portion of invested assets? If so, how are the investments valued? e. Has the insurer increased its investment risk or reduced its level of liquidity? Inquire why there has been a change in the investment strategy. 2. Determine whether there are concerns due to the level of investment in certain types of securities that tend to be riskier and/or less liquid than publicly traded investment grade bonds, stocks, and cash and short-term investments. a. Inquire to the company’s cash management process. Do they forecast cash needs (ALM), are they evaluating its investments to match up to projected cash needs? What is the possibility that securities may be sold at a loss to satisfy short term cash flow requirements? b. Has there been significant turnover in investments, if so, why? c. Determine whether the insurer appears to be adhering to its investment plan. i. Investigate any instances where a property has a book/adjusted carrying value in excess of its cost. How is the value of the investment determined, request audited financial statements of the property, if available. d. Determine whether there are concerns due to the level of investment in real estate and mortgage loans. i. Investigate any instances where a property has a book/adjusted carrying value in excess of its cost. Request audited financial statements of the property, if available. e. Determine whether there are concerns due to the level of investment in privately placed bonds. i. Investigate how the investment are valued. Request audited financial statements of the property, if available. 3. Determine whether any concerns exist regarding third party investment advisers and associated contractual arrangements. a. Inquire as to the approval process requirements for investment purchase and sales transactions. Are investments reviewed by the Board, are investment transactions reviewed for compliance to investment policy and investment ranges b. Determine how investments are held. 4. Determine how investments are valued. 5. Investigate any instances where property has a book/adjusted carrying value in excess of its cost. Request audited financial statements of the property, if available. Unpaid Losses and LAE Types of Risk: Insurance Risk, Reserve Risk, Operating Risk, Strategic Risk Areas of Concern: (1) underwriting process, (2) pricing, (3) data systems and data collection, (4) product design, (5) claims, (6) provisioning, (7) management oversight, (8) risk management, (9) expansion decisions Procedures to perform and/or Inquiries: 1) Has there been a shift in the mix of business from short-tail property lines to long-tail liability lines within the past five years? Review the business composition and note any changes, compare changes over time to see if there trends or unusual fluctuations. 2) Determine whether the insurer has adequate expertise (e.g., distribution network, underwriting, claims, and reserving) in the lines of business written. Consider seeking additional information from the insurer to determine the insurer’s expertise in the lines of business written (Actuaries, product development team, management oversight...) 3) Review loss trends over the past five years to identify any unusual trends. Compare to industry averages. 4) Has there been new products issued? a) Compare, by line of business, the one-and two-year development in incurred losses and defense and cost containment expenses by accident year b) Has there been a change in the new products development team? Does the team have proper expertise and experience? 5) Has the insurer expanded its geographic coverage a) Does the company have qualified agents or sales staff in the particular new geographic areas? b) How is the insurer setting its underwriting policy in the new geographic area? 6) Has the insurer added new agents/brokers? a) Are the agents properly trained in the insurers product offerings? b) Has the insurer properly vetted the agents c) Compare the commission ratios from year to year for any unusual fluctuations. 7) Has there been a change in the reserving methodology, if so, the reason for the change. 8) Is the company recording its reserve in line with the actuarial best estimates? 9) Is there a concentration of risk? What does the company do to monitor concentration of risk? 10) Has there been a change in pricing? If so, what is the reason for the change in the pricing structure? 11) Has there been a change in the underwriting policy and process? New management oversight? Understand the insurer’s overall underwriting strategy and goals, including its target market(s), geographic locations, products/lines of business, profitability challenges and distribution channels. 12) Has there been a change in the claims process? New management oversight? 13) Does the company have inhouse adjusters/valuators or does it use a third party? 14) Has there been a change in IT systems? How does the company ensure the integrity of the data? 15) Has the company changed its corporate strategy and related risk appetite? Life Reserves Types of Risk: Insurance Risk, Reserve Risk, Operating Risk, Strategic Risk Areas of Concern: (1) underwriting process, (2) pricing, (3) data systems and data collection, (4) product design, (5) claims, (6) provisioning, (7) management oversight, (8) risk management, (9) expansion decisions Procedures to perform and/or Inquiries: 1) Determine whether the insurer’s life reserves are valued in accordance with statutory valuation standards. a) Review the results of the Actuarial report. Note any concerns regarding the valuation of the insurer’s life reserves. b) Inquire with the actuary the nature and scope of the life reserve valuation procedures performed. 2) Determine whether there were any changes in life and annuity reserve valuation bases during the year. a) Discuss such changes with the actuary 3) Determine whether the insurer’s underlying assets are adequate to support the future obligations of its life insurance policies. a) Did the actuarial report note any concerns noted regarding the adequacy of the insurer’s underlying assets to support future life insurance policy obligations. b) Is the net interest spread on life reserves adequate Exhibit 3 Insurance Profile Summary Illustration BEEMA SAMITI INSURER PROFILE SUMMARY COMPANY NAME As of 12/31/2015 Updated as of 09/30/2016 Insurer’s Group Number: 0411 RBC BUSINESS SUMMARY 2015 – 240% The Company principally engages in the business of personal lines, 2014 – 120% commercial lines and commercial agricultural products in 15 Midwest, Southwest and Pacific Northwest states: Arizona, Idaho, Illinois, Iowa, 2013 – 114% Kansas, Minnesota, Missouri, Montana, Nebraska, North Dakota, 2012 – 292% Oregon, South Dakota, Utah, Washington and Wisconsin. ABC CO’s 2011 – 181% business is underwritten through a network of independent agents. Insurer’s Financial In 2012, ABC CO entered into an affiliation agreement with the ZYX Strength/Credit Ratings Insurance Company (ZYX). ZYX is a subsidiary of Main Street America AM Best A; Outlook- Stable Group, Inc. (NSN), which, in turn, is 100% owned by Main Street America Group Mutual Holdings, Inc. The affiliation included a 35% net quota share reinsurance agreement and change of control of the board of Contact at Insurer directors. A Form A was filed and approved for the change of control. (exam) Sam Bill 555-657-8600 As part of the affiliation and change in business strategy for ABC CO, SBIll@abcgroup.com the multi-peril crop program was terminated. This program had been (Analyst) Gerard Dell underwritten through managing general agent arrangements. 555-657-8653 Effective January 1, 2013, ABC CO was 100% combined in the ZYX’s DellG@NSNgroup.com pool arrangement. Effective January 1, 2015, the ZYX reinsurance program was modified, such that Amazon Mutual receives a 5% Key Personnel commission on net premiums ceded to the pool. Jeffrey Kann – President Sam Waters - In 2015, ABC CO’s top lines are homeowners and personal auto, and Edward Lue - Treasurer Minnesota is its top market. CPA Firm Ernst & Young, LLP Appointed Actuary Dean Door - internal Analyst Tim Peterson Date of Last Exam 2014 AM Best: ABC CO was rated A with a Stable outlook as of June 2015. As of December 31, 2015, ABC CO was licensed in 34 states. See the referenced graphic on the next page for ABC CO’s 2015 premiums written by line of business. Management Both management and its operations are centralized across all insurance entities including ABC CO. As such, the operations and oversight of ZYX, subsidiaries and affiliates are performed on a functional basis and not by legal entity. The Company currently has twelve members on the board of directors. Governance is maintained at the NSN level and flows down to each of the entities. Based on understanding of how NSN’s Audit Committee functions, it is considered to be well controlled and adequately serves as an oversight role of the Internal Audit Department and ERM functions, as well as an integral part of corporate Board oversight of management. NSN has an established Enterprise Risk management (ERM) program that is updated continuously as new risks emerge and better tools to measure correlations are developed. The formal ERM process was launched in March 2006. The group annually presents its board with a report which identifies catastrophic, reserve and investment risks and qualifies the probability of these events occurring. The tone for the ERM program is set by the Chief Executive Officer who assures that ERM is integrated into organizational planning and execution efforts and the appropriate resources are allocated. ERM is the responsibility of NSN management with reporting accountability to the Board of Directors. Oversight of the ERM program resides with the Audit Committee of the Board, with other committees having responsibility for oversight of certain risks and controls. Recent Board and Management Changes There were no changes in either management or the board in the past year. REGULATORY ACTIONS Permitted Practices There were no permitted practices. Examination Adjustments There were no adjustments required to surplus in the 2015 financial examination. Regulatory Concerns or Actions There are no overarching solvency concerns as a result of this examination. Non-Compliance Issues There were no compliance issues in 2015 FINANCIAL SNAPSHOT (SUMMARY DATA) Years Ended December 31 ($000) 2014 2015 BALANCE SHEET Total Invested Assets 45,019 48,267 Other Assets 4,510 4,743 Total Assets 49,529 53,010 Other Expenses 7,439 6,866 Borrowed Money 7,000 6,000 Provision for Reinsurance 25 28 Payable to Parent 1,684 166 Aggregate write ins 1 3 Total Liabilities 16,150 13,063 Capital and Surplus 33,378 39,947 Total Liabilities and Capital 49,529 53,010 OPERATIONS 2014 2015 Direct & Assumed Premiums Written 63,785 66,138 Net Reinsurance Premiums (43,785) (46,138) Net Premiums Written 43,785 46,138 Net underwriting gain 0 3,172 Net Investment Income 678 730 Net Realized Capital Gains (Losses) (241) 1,230 Income Tax 0 82 Net Income 436 5,050 RATIO ANALYSIS Non-Life Yr 2015 Yr 2014 Yr 2013 Yr 2012 Yr 2011 Ratio Type Indicator Solvency Solvency margin ratio 240 120 114 292 181 Solvency Change in equity 5.5% 1.5% -29% 25.5% 5.5% Profitability Combined ratio 86% 98% 130% 72% 94% Profitability Claims ratio 69% 79% 98% 44% 67% Profitability Expense ratio 28% 29% 32% 28% 27% Profitability Return on investment 5.5% 5.0% 4.5% 5.5% 6.0% Profitability Return on equity 8% 5% -12% 11% 7% Reserve and Leverage Technical provisions 25% 22% 27% 40% 25% Gross premiums over owner’s 190% 160% 140% 290% 120% Reserve and Leverage equity Reserve and Leverage Net premiums over equity 130% 125% 120% 210% 110% Reserve and Leverage Insurance debt 18% 15% 28% 22% 14% Reserve and Leverage Net Premium growth rates 1% 8% -10% 25% 14% Change in gross written 1% 10% -12% 30% 17% Reserve and Leverage premiums Reserve and Leverage Cession ratio 32% 32% 32% 32% 32% Short-term liability over the 105% 102% 101% 89% 110% Asset and Liquidity short-term assets Asset and Liquidity Affiliate ratio 2% 2% 2% 2% 2% RISK ASSESSMENTS Risk Classification Heat Map A:   Increasing Trend B:  Static C:  Decreasing 1: No/Minimal Concern 2: Moderate Concern 3: Significant Concern Assessment Credit: Total bonds increased from $28.4 million at YE2014 to $29.1 million at YE2015. Holdings of bonds as a percentage of invested assets increased from 50% at YE2014 to 58% at YE2015. Substantially all bond holdings are rated investment class 1 or 2. The Company has limited exposure to structured securities, consisting of $4.2 million in RMBS, $5.4 million of CMBS and $1.9 million in CMBS at YE2015. This exposure has increased over YE2014. Exposure to common stock increased, with an additional $1.4 million invested in PDR S&P 500 ETF. In 2015, the Company sold the real estate held in the Amazon Grove subsidiary, and financed the purchase. The property is fully leased, and ABC CO has an assignment of the lease as well as the mortgage. This increased mortgages and decreased real-estate related BA assets in 2015. The Amazon Calais property was moved from BA assets (non-admitted) to properties held for the production of income (non-admitted). Holdings of CSTI declined from $8.4 million at YE2014 to $4 million at YE2015 as net cash flows were reinvested in long-term bonds. The Company cedes to an affiliate. In order to compensate the Company for investment income and returns earned on the reserve balances ceded to the pool, ZYX pays a commission to each affiliate equal to 5% of the net premiums cede to the “pool”. The ceding commission is paid each month when premiums, expenses and losses are settled with ZYX. No/Minimal Concern Moderate Significant Concern Trend Concern Reinsurance ↔ Investments- Bond Portfolio Mortgage Loan ↑ and other investment holdings Overall Credit Assessment: Moderate Overall Trend: ↑ Risk Score 2 Legal: During the last exam period, one litigation suit was filed by a former MGA related to 'wrongful termination', however, the Company does not have any past or current litigation issues that raises elevates the legal risk concern. Review of the 2015 Annual Statement indicated that the Company was in compliance with statutory principles. The Company had adequate controls surrounding legal risk management that appear to be designed and operating effectively. No/Minimal Concern Moderate Significant Concern Trend Concern Litigation ↔ Statutory Practices ↔ Overall Legal Assessment: Minimal Overall Trend: ↔ Concern Risk Score 1 Liquidity: The Company reported negative net cash flow from operations in three of the last five years, but positive net cash flow following the loss portfolio transfer in 2013. ABC CO is expected to show positive results in the future as the pool absorbs any underwriting losses. Net cash from operations declined from CY2014 to CY2015, and CSTI balances were reduced. The Company’s bond portfolio is nearly all investment grade bonds; it continues to have exposure higher than peers to real estate related assets. In addition, liquidity is reduced by pledged assets: for statutory deposits, FHLB borrowings and bank borrowings. No/Minimal Concern Moderate Significant Concern Trend Concern Cash Position ↑ Investment Holdings ↔ Overall Liquidity Assessment: Minimal Overall Trend: ↑ Concern Risk Score 1 Market: Investment portfolio is conservative. The investment yield is low based on the limited risk in the bond portfolio. In 2015, ABC CO changed its investment strategy, with exposure to government and special revenue bonds declining and corporate increasing to 35% of the portfolio. As with most insurers, the low interest rate market does impact the Company’s investment performance. Because of the low interest rate environment, the Company has increased its duration in order to obtain higher returns. This exposes the Company to increased exposure if interest rates rise. No/Minimal Concern Moderate Significant Concern Trend Concern Interest Rates ↑ Overall Market Assessment: Moderate Overall Trend: ↔ Risk Score 1 Operational: Based upon review of the Company’s corporate governance, there were no major areas of concern or risk noted upon review of the Board of Directors, Senior Management and organizational structure. Cyber security has been an increasing risk industry wide and is considered a significant risk to any company. Cyber risks are addressed at the NSN level with control standards consistently applied throughout the group. Regarding IT systems, IT policies and procedures documentation is maintained at the NSN level. ABC CO maintains its own systems within its corporate offices. Overall, it was concluded that the IT functions were adequate. No/Minimal Concern Moderate Concern Significant Concern Trend Corporate Governance ↔ IT Security ↑ Overall Operational Assessment: Significant Overall Trend: ↑ Risk Score 2 Pricing/Underwriting: Direct written premium increased 2.5% in 2015 to $66 million. Direct written premium declined 89% in 2013, due to the elimination of the crop insurance program. No/Minimal Concern Moderate Concern Significant Concern Trend Pricing ↔ Overall Pricing/Underwriting Assessment: Overall Trend: ↔ Minimal Concern Risk Score 1 Reserving: ABC CO cedes 100% of net premiums to an affiliate; therefore, there are no net reserves. No/Minimal Concern Moderate Concern Significant Concern Trend Overall Reserving Assessment: Moderate Overall Trend: Choose an item. Risk Score 1 Strategic: The Company reported a net loss in two of the last five years. Profitability declined in 2014 from a profit of $2.4 million in 2013 to $437,000 in 2014. The difference was related to a reduction in net investment income and net realized capital gains. Profits increased in 2015 due to the new reinsurance program which provided a 5% commission on net premiums, as well as a realized gain related to the sale of the Amazon Grove property. All insurance risk is transferred to ZYX Insurance Company. The affiliation with the NSN Group has provided the solvency support for the Company. No/Minimal Concern Moderate Concern Significant Concern Trend Board and Management ↔ Strategic Decisions ↔ Overall Strategic Assessment: Moderate Overall Trend: ↔ Risk Score 1 IMPACT OF HOLDING COMPANY ON INSURER Due to the nature of the holding company structure and the 100% Quota Share Agreement with ZYX that is in place for the Company, there is very little risk retained at the Company level, other than that related to its investment portfolio. OVERALL CONCLUSION AND PRIORITY RATING The Company was unprofitable until 2013 when the new affiliation with the NSN group kicked-in. With the 100% quota share agreement with its affiliate, it is believed that Amazon Mutual is protected from most losses. Corporate governance appears to be adequate. There were not risks identified or areas of concern noted related to management and corporate governance. PRIORITY RATING Risk Type Risk Scores Solvency 1 Financial Performance 1 Strategic 1 Reserving 1 Insurance (Pricing/Underwriting) 1 Credit 2 Liquidity 1 Market 1 Operational 2 Legal 1 Solvency 1 Priority Rating 1.2 Summary The Company is relatively stable and highly conservative in its operations. It is deemed to have overall low risk. There were no changes to the financial condition of the Company as a result of the 2014 examination. As such, the Examiner did not recommend any changes to the prioritization level of the Company. SUPERVISORY PLAN As there were no changes to the prioritization rating of the Company and no examination comments, the Examiner does not propose any changes to the supervisory plan for the Company. Analysis Follow Up • Obtain further detail regarding the impact of proposed rate increases and monitor through monthly financial reporting • Obtain further detail regarding the insurers liquidity strategy. • Assess the reasonableness of the Company’s business plan as soon as it is received, given the inability to execute the most recent strategy. Consider attending board meetings to reflect the concern regarding the future viability of the Company. Examination Follow-Up • During the next regularly scheduled examination, audit the specific risks associated with the Company’s agents balances and uncollected premiums to determine if further concerns exist. • Follow-up on segregation of duties issues noted in the last examination. • Perform a targeted examination of the reserves, pricing and claims management. Consider in the reserve study any pricing review, information related to the changing legal environment as well as the mix of business in states outside of X and Y. Exhibit 4 Ratios Financial analysis in off-site supervision Table of contents: 1. General rationale 2. Technical ratios on gross basis 2.1. Gross loss ratio (Gross Risk Ratio –GRR) 2.2. Gross Expense Ratio (GER) 2.3. Gross Combined Ratio (GCR) 3. Technical ratios for reinsurer’s part 3.1. Reinsurance (RI) cession rate 3.2. Reinsurance (RI) loss ratio (Reinsurance Risk Ratio - RRR) 3.3. Reinsurance Commission Rate (RCR) 3.4. Reinsurance Combined Ratio (herinafter RCR) 4. Technical ratios for cedant’s part (ratios net of RI) 4.1. Net loss ratio (Net Risk Ratio –NRR) 4.2. Net Expense Ratio (NER) 4.3. Net Combined Ratio (NCR) 5. Other financial ratios and analyses 5.1. General considerations 5.2. Equity / technical provisions 5.3. Equity / GWP 5.4. Equity growth rate / GWP growth rate 5.5. Average duration of claim handling 5.6. Liquidity ratios 1. General rationale One of the main subjects of off-site supervision of insurance (besides market conduct etc.) is financial analysis, with the ultimate goal of assessing the solvency and overall financial health and viability of an insurance company. There are several angles that the financial state of a company could be looked upon, and there is a common logic in the sequence of sub-analyses in each of those. The common rationale is usually that we first observe some financial outcome, or deviation in some important indicator, and subsequently we try to establish which are the underlying input factors or drivers that have resulted in observed financial outcome or indicator. And to the extent possible, we would also try to quantify each of those contributing factors, to establish their importance ranking and to choose adequate and suitable supervisory measures in order to improve the situation (reflected by that outcome, usually solvency). As for the different angles, we can look at (a) the current state of the company, which first and foremost translates to its current required solvency margin and its coverage, based on its balance sheet and equity composition. On the other hand it is also important to look at (b) the direction the company is going – in financial analysis this is usually more difficult than assessing (or in essence – just looking at) the current situation. There are many reasons for these difficulties in assessing (b), i.e. the direction the company is going: - the shareholders expectations (meaning ROE) can change over time, along with investment opportunities in other sectors of economy, or with loss performance within insurance sector itself - Any insurance market, beyond a certain level of development and penetration, tends to get more competitive year by year - The distribution channels and distributors can change from year to year, having impact of the expense level in sales (and losing a major sales mediator could have a substantial effect on the company, and this is not easily predictable) - The company can engage in entirely new products or new variations of current products with significant alterations affecting their performances - The composition or mindset (e.g. risk appetite) of the management can change over time - There could be changes in the legal framework, which can affect any aspect of insurance business, e.g. market entrance threshold via minimum capital level, applying or lifting restrictions on certain components of some products (mandatory tariff levels, limitations on expenses, technical profit of a given line of business (LoB) etc.), and so on The financial outcome and solvency of an insurance company are combined result of two areas, the technical side i.e. its incomes and expenditures immediately related to insurance-business, and the non technical side, i.e. all other incomes and expenditures, related to investments, administrative overheads etc (in non-life). In Life Insurance, due to longer business cycle, the investment inflows and outflows constitute an integral part of its technical side. In both life and nonlife insurance the main contributor to its ultimate financial performance is obviously the technical side (as the „engine“ of the insurer), and in life insurance the influence of non-technical side is negligible. Therefore the technical ratios described below capture most of the driving forces of an insurance company, and various other ratios in essence just accompany those, to get the full picture. In non-life insurance such other ratios are mostly either liquidity-related or measure various performances of assets (including equity – which represents „excess of assets“ over liabilities to creditors and policyholders). Some solutions that the company could undertake to solve its immediate or short term problems, could actually exacerbate its problems in the long term e.g. taking an embedded loan via reinsurance contract, resorting to underpricing of risk in products or overpricing of mediators or sales channels to increase sales revenue while prolonging claim handling and delaying payments, attracting new life policies with above-market guaranteed interests, etc. Sometimes also certain accounting „measures“ could be employed to improve the picture – and not the real situation. Notes: 1) in this text we express all ratios as plain coefficients rather than percentages, in order to avoid the unnecessary „× 100“ residue in each formula. 2) Signs (additions or subtractions) in formulas are presented based on all source figures being expressed as positive values 2. Technical ratios on gross basis A sufficiently good overview of the technical side of insurance can be achieved by the classical set of ratios, i.e. loss ratio, expense ratio and combined ratio, with all of them split by gross amount, reinsurance and net of reinsurance amount. Below is a brief description of each of them, along with their pro-s and con-s, i.e. what the reflect and what they do NOT reflect. In general, the ratios on gross basis are insufficient to make definite conclusions as for the performance of the insurance company itself, because they do not reflect all factors that result in technical profit or loss for the company. The latter is only achieved by also looking at relevant reinsurance ratios and moreover, ratios net of reinsurance i.e. for the cedant’s part only. Thus, the gross ratios can be considered as inputs in the analysis, that just serve as contributing factors to the ultimate output fo these technical ratios, i.e. the technical profit or loss for the company. 2.1. Gross loss ratio (or Gross Risk Ratio – hereinafter GRR) Gross Incurred Claims Gross Claims Paid   OCP GRR    Gross Earned Premiums GWP   UPP Gross Claims Paid  (OCPend  OCPstart )  GWP  (UPPend  UPPstart ) where: • OCP Outstanding Claims Provision (reserve) • Gross Claims Incurred = Gross Claims Paid + ∆ OCP • Gross Earned Premiums = GWP – ∆ UPP • GWP Gross Written Premiums • ∆UPP, ∆OCP change in Unearned Premium or Outstanding Claims Provision • UPPstart , UPPend UPP at the beginning or at the end of reporting period • OCPstart , OCPend OCP at the beginning or at the end of reporting period • ∆ OCP = OCPend – OCPstart (and the OCP increase is added to Gross Claims Paid) • ∆ UPP = UPPend – UPPstart (and the UPP increase is subtracted from GWP) This is one of the most objective indicators to reflect the technical performance of insurance business in a company – for a given LoB. Moreover, it is also well comparable throughout the market for the same product, especially if the compared LoB-s are sufficiently homogeneous mass retail product with little fluctuation and negligible deviations in product composition, like motor TPL, motor OD, homeowners, travel, and alike, since statistical loss performance trends in such products occurs usually in a fairly uniform manner for most market participants. This ratio is also quite free of abitrary (company management or governace-related, other than pricing) factors, since it is first and foremost driven by competitive forces, size/frequency of claims and pricing on the market. Since the major share of insurance business volume in most markets comprises of just such mass retail lines of business, this ratio and its trends over time also capture a major part of the driving forces on the market that ultimately translate to any other indicators, ratios, and solvency coverage of companies. It should be noted, however that this ratio is NOT a good comparison between whole portfolios of different companies, or at least we cannot make too many (supervisory) conclusions on the fact that company A has it x% and company B has it y%. The reason is that the two GRR values do not reflect the different composition of insurance portfolio of each company. The different LoB could have „naturally“ very different loss ratios, e.g. in motor TPL it could well be, say 85%, while in travel insurance it could be e.g. 40-50%, and in guarantee bonds it could be just 10%. The underlying reason is the different composition of premium components within these LoB-s, whereby acquisition costs in motor TPL are the lowest in almost all markets (the client base is in essence guaranteed by law). In guarantee bonds the acquisition costs are one of the highest, because due to the contractual mechanism of this type of policy the main risk component is financial failure of the construction company, and insurer has contractual recourse to it if it has to pay the claim to beneficiary. Thus the evaluation of the construction company books and other paperwork, compared to the price of risk of its financial failure are the main contributors to relatively higher expenses in this LoB. In travel insurance the main acquisition cost factor is (or rather - used to be) the relatively high commission rate that has to be paid to travel agencies, as main distrinution points of such policies. Their main mediator status in this LoB has declined significantly within internet and mobile sales era (NB! on markets where contract conclusion over the internet is legally possible). Above description gave some overview what the GRR reflects – inherently anything else it does not reflect, most notably any liquidity issues. From two companies with identical GRR one might have significant liquidity issues and the other one not, because GRR components are all based on accrual basis, and the size of gross amount of incurred claims is nof influenced by whether they have been paid or not. It is therefore important to realize that GRR (and in fact any other loss ratios, for that matter), merely relates the losses related to some period (whether paid or not) to premium inflow related to the same period (and in fact also irrespective of their collection, if the contract law permits to issue policies with delayed payments). Moreover, in real practice the the one delaying claim payments tends to have its reserves understated as well, compared to the other. And lastly – even if GRR is compared for the same LoB in the same period for two different companies the conclusions could be still far-fetched, because some companies, due to e.g. lack of underwriting skills and know-how, might just copy the tariffs of a competitor without any regard to underlying strategy of the latter for those tariffs, which could be e.g.: - slight underpricing for competitive expansion purposes, whereby the expanding company has allocated relevant budget for such cash needs, and the copier/follower has not - segmentation of profitable clients, whereby the tariff leader knows exactly what clients it intends to target with its tariffs with various adjustable components dependant on any give client, and the follower has no idea of such segmentation and applies blindly the base tariffs to all available clients in that LoB, thus having potentially much worse result in this LoB than the leader - „expulsion“ of unprofitable clients by applying higher tariffs, whilst the follower might, without any segmentation, expulse both profitable and unprofitable clients - etc. There are, however, other more composite ratios that ARE well comparable between whole portfolios and which allow direct conclusions to be made. One of such ratios is 2.2. Gross Expense Ratio (herinafter GER) Gross Incurred Acquisition Costs Paid Acquisition Costs   DAC GER   Gross Earned Premiums Gross Earned Premiums Paid Acquisition Costs  (DAC end  DAC start )  Gross Earned Premiums where: • DAC deferred acquisition costs • ∆DAC change deferred acquisition costs • DACstart , DACend DAC at the beginning or at the end of reporting period • ∆ DAC = DACend – DACstart (and the DAC increase is subtracted from Paid Acquisition Costs – since increase of this asset (DAC) reduces the value of incurred expenses) for details of Gross Earned Premiums see explanation under Gross Risk Ratio. This ratio measures the level of expenses and it is most meaningful as a comparison between different companies for the same LoB on the market – since the market environment and income expectations of insurance mediators are quite similar across the market. If for a given LoB it is substantially higher than in other companies, it could be an indication of some iregularity that needs to be further analysed in the company. It should be noted that for the whole portfolio of a company ths ratio has less meaning, since the different LoB-s with inherently different expense levels are mixed. For this very reason the same is valid if it is compared across companies for their whole portfolios. 2.3. Gross Combined Ratio (herinafter GCR) Gross Incurred Claims  Incurred Acquisition Costs GCR  Gross Earned Premiums Gross Claims Paid  (OCPend  OCPstart )  Paid Acquisition Costs  (DAC end  DAC start )  GWP  (UPPend  UPPstart ) where: • Gross Incurred Claims = Paid Claims + ∆OCP = Paid Claims – (OCPend – OCPstart) • Incurred Acquisition Costs = Paid AC – ∆DAC = Paid AC – (DACend – DACstart) • Gross Earned Premiums = GWP – ∆UPP = GWP – (UPPend – UPPstart) for details of individual components see explanation under Gross Risk Ratio.and Gross Expense Ratio. Since the GRR and GER share the same denominator (Gross Earned Premiums), the formula can be also expressed as: GCR = GRR + GER i.e. the Gross Combined Ratio is sum of Gross Risk Ratio and Gross Expense Ratio. ThGCR is similar to GRR except that another outflow (sales expenses) is included. And since the cash outflows of any (non-life) insurance product occur in the form of claims or acquisition costs, it thus captures the whole picture and makes it comparable (with some reservation, mainly volatility-related) both between different LoB-s but also between whole portfolios of different companies. Each company is eventually trying to strike a balance between gains from pure risk ratio result on one hand and on the other hand relevant expenses aimed to achieve it along with needed busines volume, i.e. contributing to underwriting and risk selection quality, related IT costs (for actuarial modelling, segmentation and respective tarification), sales expenses with agent awarding schemes etc. Such balance could differ substantially amongst companies, some of them having higher expense ratio with lower risk ratio, and the other companies having it vice versa. However, since all of them are aiming at achieving some ROE, it is the combination of risk ratio gains along with expense contributions that make the composite result comparable amongst companies. So, if below 1 (or 100%) it shows that the technical (insurance) side of business as such, for a LoB or for the whole portfolio, is profitable and if above 100% then the business is making a loss. The tougher the competition on the market, the closer this ratio is to 100% (or even higher). It should be noted that this ratio is also composed on accrual basis, i.e. consisting of premiums, claims and expenses that relate to the same reporting period. And thus it does not directly reflect the cashflow result, which could be both positive or negative, despite it is usually positive with below-100% ratio and negative with above-100% ratio. 3. Technical ratios for reinsurer’s part All below ratios on ceded reinsurance part of the business are usually meaningless when looked at without comparison to respective gross ratios – it is the latter that gives them context and reference point for measurement and judgement, to be able to assess their impact on the business and financial situation of the cedant – as the supervised entity. Accordingly, any gross ratios of the company just show the insurance result as such, irrespective of how the technical profit has been in essence split between the cedant and reinsurer, as a result of splitting the relevant subcomponents between them (premiums, claims, expenses, and related provisions). In essence, the below ratios are reinsurance equivalents of respective ratios on gross basis. The only exception is that from the financial reports of the cedant we would not know anything about the internal expenses of the reinsurer itself – we would only know the reinsurance commission (which partially compensates the cedant for its acquisition costs). There are also certain nuances related to claim handling expenses, more on that below. Note that signs in formulas, additions and subtractions are presented based on all source reinsurance figures being expressed (here also) as positive values. Some of these figures might be expressed as negative values in financial reports and would have to be changed accordingly sign-wise to fit below formulas. 3.1. Reinsurance (RI) cession rate RI Earned Premiums RI Premiums Cession rate  or simplified: Gross Earned Premiums GWP For RI Earned Premiums see 3.2. , for Gross Earned Premiums see see 2.1. This ratio shows the extent of reliance on reinsurance. When close to 100% it is effectively a fronting arrangement whereby the cedant’s result is entirely dependant on the difference of its level of acquisition costs and respective compensation rate by reinsurance (reinsurance commission). There is no rule-of-thumb principle for adequate cession rate, the companies with less equity would need to cede more business to meet solvency margin coverage. Also the LoBs with high volatility or low frequency/high severity loss distributions would need to have higher reliance on reinsurance. If the cession rate is excessively high in some LoB-s that constitute very homogeneous risk portfolios (e.g. motor OD, travel, home, but also motor TPL, if statutory limits per occurence and per risk are low) then it should raise supervisory concerns as for the feasibility of such arrangements, and more in-depth look is needed for potential deviations in other components, e.g. substantial difference between Gross Expense Ratio and Reinsurance Commission rates, embedded loans within reinsurance arrangements, etc. 3.2. Reinsurance (RI) loss ratio (or Reinsurance Risk Ratio - RRR, i.e. excluding reinsurance commissions) RI Incurred Claims RI Claims   ROCP RRR    RI Earned Premiums RP   RUPP RI Claims Paid  ( ROCPend  ROCPstart )  RP  ( RUPPend  RUPPstart ) where: • ROCP Reinsurance share of Outstanding Claims Provision (reserve) • RI Incurred Claims = RI Claims + ∆ ROCP • RI Earned Premiums = RI Premiums – ∆ RUPP • RP ceded Reinsurance Premiums • ∆RUPP, ∆ROCP change in Reinsurance share of Unearned Premium or Outstanding Claims Provision • RUPPstart , RUPPend UPP at the beginning or at the end of reporting period • ROCPstart , ROCPend ROCP at the beginning or at the end of reporting period • ∆ ROCP = ROCPend – ROCPstart (ROCP increase is added to Reinsurance Claims to get RI Incurred Claims) • ∆ RUPP = RUPPend – RUPPstart (RUPP increase is subtracted from Reinsurance Premiums to get RI Earned Premiums) Despite the visual similarity with Gross Risk Ratio, none of the conclusions mentioned under GRR (for single LoB or the whole portfolio of the company), can be made here if this ratio is looked at alone, without reference to GRR. Alone it would, at best, have some indirect indication on the effect of reinsurance to the balance of payments of the country – if reinsurers are foreign entities. However, when analyzed together with GRR, it gives a good overview about how the insurance risk itself has been split between the cedant and the reinsurer. In case of proportional reinsurance treaties the GRR and RRR are equal. The bigger the difference between GRR and RRR, the more it indicates usage of non-proportional risk cessions (e.g. excess of loss). This ratio, within one company, is first and foremost useful as indicator (as described), rather than quantifier or direct measurement of its contribution to some overall result, e.g. in assessing source factors of solvency coverage. For the latter other factors will play a part also, e.g. commission rates, commission schemes, cession compositions (proportional, non- proportional, combinations) etc. It should be noted that RI does not usually compensate the non-direct expenses related to claim handling, because it has no control them, and their exact size could be determined by somewhat arbitrary expense allocation principles of the cedant. This shares analogy with RI compensation for original sales expenses, as described below . The RRR is extremely useful to compare same LoB across the market, and enables to assess the pricing of different reinsurance providers on the market, if they have the same type of risk sharing (e.g. proportional QS reinsurance). In such case it is possible to detect if the holding company reinsurers, or reinsurers in the group the company belongs to, are charging higher rates for provided RI coverage than is common on the open market. 3.3. Reinsurance Commission Rate (RCR) This is a readily available ratio of expense recovery from RI to ceded premium, and which reflects compensation rate that the reinsurer provides for cedant for its expenses incurred in conclusion of original policies. In case of proportional treaties it should quite closely match the Gross Expense ratio, exept for the sales related overhead costs of the cedant which the RI would not normally compensate – since they have partially arbitrary nature and RI has no scope control over them. Technically, if the cedant accounts for DAC (on gross basis on asset side, for all of its sales expenses, i.e. without netting it with UPP on the liabilities side), then in case of proportional reinsurance, some of the RI commissions constitute in essence prepayments, or in other words they could be trated as „RI part if DAC“ (or RDAC). Formula-wise it behaves like the opposite of DAC, and the change in RI share of DAC is deducted from it. Thus, for more comparable figure with the gross basis equivalent we can use „RI part of Acquisition Costs“ (RAC (=RI commissions)) as well as „RI part of Deferred Acquisition Costs“ (RDAC), and the corresponding formula for Reinsurance (incurred) Expense Ratio (RER) is: RI part of Incurred Aquisition Costs RAC   RDAC RER   RI Earned Premiums RI Earned Premiums where: • RI Earned Premiums see 3.2. • ∆ RDAC = RDACend – RDACstart (and increase in RI share of DAC reduces RER) The RI commission can be slightly higher than the original commission rate, if the overall Gross Risk Ratio is positive and the ceded business has otherwise high quality as well. The usual reasons for this is that RI has some volatility gain compared to the cedant, due to its different porfolio magnitude (since it is many times bigger). On the other hand this effect can be off-set by the RI’s own expenses related to handling the treaty. There could ber also a motivation scheme for the cedant be embedded into the RI treaty whereby the cedant gets rewarded by higher commissions for higher quality portfolio (meaning - with lower loss ratio). In some rarer cases the commission scheme could also embed a hidden loan whereby the difference between original Gross Expense Ratio and RI commission rate is substantially favouring the cedant in the first year(s), and recovering this accordingly with reverse difference in later years. Such „profit brought forward“ principle enables the cedant to circumvent booking the future pre-planned loss as obligation on the onset. The inevitable prerequisite for such RI arrangement is that it is binding for cedant for more than one year. Another typical feature of such arrangement is higher than neccessary RI cession rate, because it enables to provide the underlying volume to make such arrangement economically „feasible“. Such embedded loans (but also excessive quality-rewarding commission rates) should trigger supervisory scrutiny as for their underlying reasons and overall financial situation of the cedant, along with evaluation of suitability of external auditor having certified such financial reports. 3.4. Reinsurance Combined Ratio (herinafter RCR) RI Incurred Claims  RI part of Incurred Acquisition Costs RCR  RI Earned Premiums RI Claims Paid  ( ROCPend  ROCPstart )  RI Acquisition Costs  ( RDAC end  RDAC start )  RP  (RUPPend  RUPPstart ) where: • RDACstart , RDACend RI part of Deferred Acquisition Costs at the beginning or at the end of period, respectively. • all other components – the same as in 3.2. Here also, as in GCR, there is a common denominator (RI part of earned premiums) that allows to express it as: RCR = RRR + RER This is the final outcome on RI side of the business, and it is directly comparable to Gross Combined Ratio. However, it should be noted here also (as in RRR) that this RI outcome, despite capturing all RI technical components from financials, is still more of an indicator, rather than quantifier or direct measurement, the reason being that it (by itself) does not measure the volume proportion ceded to RI. Therefore it has to be looked in conjunction with the cession rate. If the cession rate is small then RCR can deviate substantially from RCR. If the cession rate is more than, say, 30% (it depends on LoB and volatility), the significant deviation between the two would warrant a more in-depth supervisory look into source factors of each ratio to find reasons of difference. 4. Technical ratios for cedant’s part (ratios net of RI) While the gross ratios characterize the insurance business as a whole (or for a LoB as a whole), and various reinsurance ratios give some indication as for how the risk has been ceded, it is the net ratios which show the ultimate insurance technical outcome, from the viewpoint of the insurance company itself. And as such, they are comparable in between companies (for whole portfolios), but also in between different LoB within the portfolio of one company. If compared to between the different companies, they eventually show the contribution to or erosion of solvency coverage from company to company – which is one of the main analytical goals of an insurance supervisor, to establish its supervisory priorities and focuses between riskier and stable entities. If compared in between different LoB-s of the same company, it enables to analyze which of those LoBs have contributed to or eroded the capital base and solvency coverage of that company. It is worth noting that comparison of net ratios across the market for the same LoB provides much less analytical conclusions or supervisory inputs, because the mixture of various source factors for any of the net ratios may vary significantly between companies. Note that with some gross ratios it was the opposite, e.g. GRR well reflects the environment on the market for a given LoB as regards the statistical performance risks of that LoB (on the same market). One distinct feature of all below net ratios (within the same company) is that they are all well comparable to their reinsurance equivalents (net risk ratio to reinsurance risk ratio, net combined ratio to reinsurance combined ratio, etc) and enable to make some fundamental conclusions as regards potential irregularities in the way the business is run in the company, and the main contributing technical factors that make it having a profit or loss. 4.1. Net loss ratio (or Net Risk Ratio – hereinafter NRR) Gross Incurred Claims  RI Incurred Claims NRR  Gross Earned Premiums - RI Earned Premiums where for the split of components of: • Gross Incurred Claims see 2.1. • Gross Earned Premiums see 2.1. • Reinsurance Incurred Claims see 3.2. • Reinsurance Earned Premiums see 3.2. If the RI cession rate is significant (say, above 30%) and the NRR differs significantly from RRR , then it could indicate an inequality of the risk vs. premium pricing between the cedant and the reinsurer, and thus need for further analysis. Such deviations should (by definition) not occur in proportional reinsurance. In case of non- proportional reinsurance the price charged for the risk ceded could be unjustifiably high. In order to judge whether this is the case or not, the relevant RRR should be compared to the rest of the market, as described in chapter Chapter 3.2. 4.2. Net Expense Ratio (NER) Gross Incurred Acquisition Costs  RI Part of Incurred Acquisition Costs NER  Gross Earned Premiums - RI Earned Premiums where for the split of components of: • Gross Incurred Acquisition Costs see 2.2. • Gross Earned Premiums see 2.1. • RI Part of Incurred Acquisition Costs see 3.3. • Reinsurance Earned Premiums see 3.2. This ratio serves mainly one (yet very important) purpose – to be compared to the RI expense ratio (RER) for the same LoB in the company. As said before, if the RER is substantially higher than NER, and the reinsurer is a holding company or belongs to the same group, it could indicate a circumvented dividend extraction from the cedant, and thus unjustified erosion of its solvency coverage. In fact – this is the most common method of profit extraction from a cedant belonging to a group where the holding company is operating within another jurisdiction. 4.3. Net Combined Ratio (NCR) NCR  (Gross Incurred Claims  Incurred Acq.Costs)  ( RI Incurred Claims  RI part of Incurred Acq. Costs)  Gross Earned Premiums - RI Earned Premiums where for the split of components of: • Gross Incurred Claims see 2.1. • (Gross) Incurred Acquisition Costs see 2.2. • RI part of Incurred Claims see 3.2. • Gross Earned Premiums see 2.1. • RI Part of Incurred Acquisition Costs see 3.3. • Reinsurance Earned Premiums see 3.2. As was the case with GCR and RCR, the componets in this ratio have also common denominator (Gross Earned Premiums – Reinsurance part of Earned Premiums), and hence can be expressed as: NCR = NRR + NER This ratio is the ultimate technical outcome of insurance activity of a company and it captures all technical source components described so far. If it is higher than 100% then the company is having a technical loss, and accordingly technical profit if the ratio is below 100%. As an ultimate result, it is also well comparable in between the companies on the market, provided that the capital costs for owners of insurance companies on the market are fairly similar and resting on presumption that their expectations on ROE are also similar to some extent. The difference in ROE expectations can of course exist between State owned and privately owned companies. For supervisory purposes it could also be a good starting point for ranking of companies and setting its focuses of analysis amongst companies. This also serves as a good way to look in what direction the company has been going, or is likely to go in following financial year(s) or quarters, as described in the beginning of this guide. --------------------------------------------------------------------------------------------------------------------------- All of the above ratios are in essence based on components of income statement. Using difference of start and end balances in some cases constitutes an income statement item as well in all above examples. 5. Other financial ratios and analyses 5.1. General considerations Other ratios in insurance company can be aimed at various goals, e.g. assessing liquidity, quality of assets, solvency etc. In using any of these ratios it is important to understand their essence –if it is hard to understand the underlying rationale of some ratio or indicator, it is feasible to not to use it for supervisory judgements. There are various reasons why some set of ratios is used in one market, and a different (despite partially overlapping) set in another market. The set of ratios used is foremost related to the issues that are prevalent on that market, e.g. it could be heavy reliance on dominant mediators (and relevant cash/liquidity considerations depending on settlement frequency), or dependancy on foreign group ownership which effectively manages all finances of the company and leaves it just a narrow cash balance for daily needs, or extract equity/profit via reinsurance arrangements as described before in this guide. The market could also be very competitive and thus having the main focus of various technical ratios previously described. These are just a few samples of market varieties. This is also a reason why caution should be excercised when taking over any calibration ranges that have been used in some other market, e.g. some ratio N below 5% deemed as being in „red“ range, 5%-15% in „yellow“ and above 15% is „green“ range. Or, for example, if the market is still in rapid development phase and the penetration is still very low (which itself is also market specific, penetrations varies greatly even among mature markets) and the business is profitable, it could be perfectly OK to have a 25% growth rate in several consecutive years. On the other hand, if we have a mature and very competitive market with combined ratios fluctuating around 100%, we can be almost sure that 25% growth has been achieved by lax attitude on risk management and deviations in some component that will have adverse effect after some time. It is quite common that such excess growth has been achieved by outright underpricing of risk. Calibrating a premium growth of 25% as „red“ in the first case could be misleading for supervisory conclusions. For a supervisor it is first and foremost important to analyse whether the equity corresponds to risk exposure and will continue to do so also in the future, and that is represented by sufficient quality assets – since equity can be looked upon as „excess of assets“ over the amount needed to cover liabilities to policyholders (and some creditors). Therefore, if the market in general is performing normally (having sufficient quality and size of equity), it is feasible to calibrate any ratio ranges against market averages, as a starting point, and adjust them in line with market performance in following years. In general, when composing the ratios and customizing them for market needs (which also change over time), it is important to choose the numerators and denominators from components that somehow correlate to each other in a meaningful way. For example, it is not feasible to have profit/loss as denominator in any ratio, since it could take any value (including zero), thus resulting in meaningless ratio values. The same is valid for e.g. having change in some technical provision being used as denominator. The following is a list of some ratios along with interprertations. 5.2. Equity / technical provisions These should increase proportionally, since tech. provision reflect the insurance risk in the company (as not yet occurred – UPP or not yet paid - OCP) at a given moment, and equity (i.e. excess assets) perform as a buffer to absorb potential deviations in existing risk, being measured by technical provisions. The prerequisite is that these excess assets are of sufficient quality to be able to be used for settlement if need be. The tolerable range depends on market conditions, notably expense ratio and usual duration of claim handling. The higher the expense ratio, the lower the net size of unearned premium provision (with 20% expense ratio and all policies being annual, the UPP should be 40% of annual GWP). As for claim handling, the longer the duration, the higher the outstanding claim provision compared to annual amount of claims paid. If the average claim handling duration is 1 month, then OCP at year end equals 1/12 of claims paid during the year. Under Solvency I regime the required normal level of equity was (loosely) 18% of GWP. With aforementioned presumptions the UPP is (100-25)/2=37.5% of annual GWP, and the OCP with 75% loss ratio is 75/12=6.25% of annual GWP. Given the above, the normal ratio between equity and total sum of technical provisions would be 18/(37.5 + 6.25) ≈ 40%. 5.3. Equity / GWP This works similar to previous ratio, except that it expresses the relation to GWP directly rather than via technical provisions, based on fixed presumptions. In fact, it loosely represents directly the premium/based requirement for equity under Solvency I which is 18%, and max reduction by 50% can be made by increased reinsurance cession (or more precisely – by reinsurance recovery rate of losses paid). 5.4. Equity growth rate / GWP growth rate Under the normal circumstances, provided relations described under 5.1. and 5.2. the equity should grow in line with GWP growth, with some reservations attributable to „law of large numbers“ (resulting usually in lower volatility in for the whole portfolio), and thus this ratio should be close to 100%. It shoud raise caution if it falls substantially below this level. 5.5. Average duration of claim handling The length of claim handling is inherently different in different LoBs (can be longest in certain industrial and liability LoBs, and usually shortest in mass retail products, like motor OD). The duration length can be loosely expressed (in years) as the average of starting and ending balances of OCP divided by sum of claims actually paid during the year. To be expressed in months or in days, the result must be multiplied by 12 or 365, respectively. If calculated by quarterly returns, the measurement in months or days can be obtained by multiplication by 3 or 90, respectively. It should be noted that the most exact result can be obtained from loss triangles, where the liability extinction rate can be separately analysed for each period (e.g. quarter). In annual financial returns the liabilities originating from different past periods are mixed, as well as relevant payments made during the year. Any increase in claim handling duration should trigger supervisory concerns, along with subsequent liquidity analysis for the company. 5.6. Liquidity ratios The essence of liquidity ratios is to measure at predefined future deadlines (+3 months, +6 months etc) the respective cash outflow needs, and compare those with available assets that can be used to settle those liabilities as they become due by those deadlines. The most exact liquidity needs can be forecasted by loss triangles by each LoB (in non-life) and portfolio/maturity analysis (in life insurance). In life insurance the liquidity analysis constitutes the main area of analysis.