2. The importance of insurer
selection
In insurance, what is the product?
– Insurer’s guarantee
The duration of guarantee for life insurance?
– Very long
Information asymmetry
3. Ch11 Part 1 Agenda
Criteria for life insurer Evaluation
1. Financial Soundness & Performance
2. Product Availability
3. Service Quality
4. Ethical Behavior
4. 1. Financial Soundness &
Performance
the most important
financially weak high probability of insolvency
Basic measure of competency: licensed
Is size a good measure of financial security?
Overall financial picture matters, measured by,
e.g.,
– Assets, liability
– Capital Sufficiency
– Profitability
– Other risks
5. AIG background
a world leader in insurance and financial
services
leading international insurance organization
(130 countries and jurisdictions)
Major serve areas:
– property-casualty, life insurance, retirement
services, financial services ($5.88b loss in
second quarter of 2008) and asset
management
Listed on major stock exchanges
6. AIG stock activities
Stock Price History, Change as of Oct 27,
2008
– Last 3 Months -94.4%
– Last 6 Months -97.1%
– Last 12 Months -97.8%
Historical chart
7. 2. Product Availability
comprehensive lines of products
– Benefit from economies of scale and/or scope
specialized in a particular area.
– better at offering cost effective, high quality
service
8. 3. Service Quality
a subjective measure + difficult to assess
– Consumer’s instinct + lapse rate
depends on
– the management efficiency and philosophy, and
– the quality of its employees and agents
Related to quality of services in handling
– information request
– Policy loan
– Claim settlement
– Other aspects of service
increased flexibility increase the importance of
customer service
9. 4. Ethical Behavior
Ethical elements
– Fairness, e.g., equitable sharing surplus
– Credibility of illustrations
Ers and agents are guided by a principle/code of
ethics
Rules governing sales practices, e.g.
– dividends cannot be guaranteed
– life insurance cannot be referred to as an investment
Producers and Ers can be held accountable for
unethical behavior.
10. Ch11 Part 2 Agenda
Information Sources for Evaluating Insurers
1. Rating Agencies
2. Governmental Associations and Agencies
o NAIC, state insurance department, SEC
3. Insurance Companies
4. Trade Associations
o For example: American Council of Life Insurers (ACLI),
America’s Health Insurance Plans (AHIP)
5. Publications and other Public Sources
o E.g., insurance related or general press,
o Publications of rating agencies, e.g., A.M. Best’s aggregates
and Averages, and key Rating Guide
6. Agents and other Insurance Advisors (most
important for individual buyers)
11. 1. Rating Agencies
(see Table 11-1, page 265). For example,
– A.M. Best
– Standard & Poor’s
– Moody’s
– Duff & Phelps
– Weiss
13. 1. Rating Agencies
--Rating
quantitative and qualitative information
Subjective: represent the rating agency’s
opinion of
– ERs’ financial condition
– ability to meet their obligations to P/O
Not a guarantee as to the future
performance of the insurer
Rating downgrades are watched closely
14. 1. Rating Agencies
-Factors Evaluated in the Rating
Process
1. Surplus (Risk Based Capital)
2. Investment Portfolio (assets)
3. Asset-Liability Management
o Mismatch
o Resulting potential investment risk
4. Miscellaneous Qualitative Factors, e.g.,
o Competence of management
o Strategic direction
15. 1. Rating Agencies
-Exercise
Which of the following statements about the rating
provided by rating agencies is/are correct?
a) The ratings are subjective
b) The ratings provide a guarantee as to the future
performance of the insurer
c) Ratings are based only on quantitative information
d) Asset-liability management is one of the important
evaluation factors in the rating process.
Answer: a, d
16. 2. Governmental Associations and Agencies
- insurance regulator
Insurance regulation: primarily at the state level
State insurance department
– Evaluate domestic Ers
– Solvency evaluation is a primary evaluation focus
– Conduct financial examination of its domestic Ers
– Provides report on if ER complies with state laws
– ER needs to file annual financial statements with each
state in which they are licensed.
National Association of Insurance Commissioners
(NAIC)
– set standards and establish best practices (model laws)
– provides support to insurance regulators
– offers information and resources for consumers.
17. 2. Governmental Associations and Agencies
- insurance regulator
Information
1. Licensing
2. Financial status
3. Financial statements based on SAP
o Balance sheet
o Income statement
o Numerous supporting exhibits and schedules
4. Consumer complaints
5. Insurer examination reports
18. 2. Governmental Associations and Agencies
- insurance regulator
Insurance Regulatory Information System
(IRIS)
– an early warning system used by regulators
– Used for solvency analysis
– It is a ratio analysis.
– has two phases
• (1) statistical phase
• (2) analytical phase (if 4 or more ratios outside of
usual range, earmarked for further review)
19. Insurance Regulatory Information System
(IRIS)
R1: Net change in Surplus (AR: -10%~50%)
R1 A: Gross change in Surplus (AR: -10%~50%)
R2: Net gain to total income (AR: >0%)
R3: commissions and expenses
to premiums and deposits (AR: <60%)
R4: Adequacy of investment income (AR: 125%~900%)
R5: Nonadmitted to admitted assets (AR: <10%)
R6: Real Estate to Capital and Surplus (AR: <200% if C&S>$5m
<100% if C&S<=$5m)
R7: Investment in Affiliates to C&S (AR: <100%)
R8: surplus relief ratio (AR: -99%~30% if C&S>$5m
-10%~10% if C&S<=$5m)
R9: change in premium (AR: -10%~50%)
R10: Change in product mix (AR: <5%)
R11: Change in assets mix (AR: <5%)
R12: change in reserving ratio (AR: -20%~20%)
20. 2. Governmental Associations and Agencies
-SEC
Securities and Exchange Commission
(SEC)
– For: publicly traded stock insurers
– Require: financial statement information (10-K
forms) based on Generally Accepted
Accounting Principles (GAAP).
21. 2. Governmental Associations and Agencies
-Exercise
Which of the following statements is/are correct?
a. Insurance regulatory information system (IRIS) is a
ratio analysis and includes two steps: statistical phase
and analytical phase.
b. Four or more than four IRIS ratios outside of the
prescribed acceptable range indicates the insurer is
insolvent.
c. Agents and other insurance advisors is the most
important information source for individual insurance
purchasers.
d. State insurance department can advise whether an
insurer is in good standing within the jurisdiction.
Answer: a, c, and d
22. Ch11 Part 3 Agenda
Financial Elements of Life Insurer
Evaluation
1) Surplus Adequacy
2) Asset Quality
3) Profitability
4) Liquidity
5) Leverage
23. Financial Elements of Life
Insurer Evaluation
Financial analysis relies on the financial data based
on either SAP or GAAP
SAP: Statutory Accounting Principles
– for financial reports sent to state insurance department and
NAIC
– more regulatory and conservative, results in smaller
surplus
– Balance Sheet oriented
GAAP: Generally Accepted Account Principles
– for financial reports sent to SEC and IRS
– Income Statement oriented
24. Financial Elements of Life
Insurer Evaluation
Attention!!
– None of the individual element itself is
determinative
– Relative level (!!) vs. absolute level
• Peer analysis
• Trend analysis
– Collections of all the information should be used
to form an overall impression.
25. 1. Surplus adequacy
Surplus=assets-liability
Greater surplus higher security
two surplus ratios
o Surplus Adequacy=surplus/liability
o Rate of surplus Formation=(growth rate of
surplus)/ growth rate of liability
26. 2. Assets Quality
Two categories of assets
1) admitted assets
• assets that support the payment of claims, for example,
invested assets.
• allowed to appear on the SAP balance sheet
2) Non-admitted assets
• Not support the payment of claims
• not recognized by regulatory authority in assessing solvency
• Are not allowed to appear on the SAP balance sheet
• For example, furniture, automobiles and other equipment,
agents’ balances. (exception: Computer equipment can be
counted as an admitted asset.)
Regulators evaluate the quality of an insurers’
invested assets.
27. 2. Assets Quality
1) Investment in Junk Bonds Ratio (IJBR)
=(Non-Investment-Grade Bonds)/Surplus
Note: Junk Bond is a.k.a. non-investment-grade bond.
(lower than S&P’s BBB rating)
2) Mortgages Default Ratio (MDR)
=(mortgages in default)/surplus
3) Investment in Common Stock Ratio (ICSR)
= (investment in common stock)/surplus
28. 3. Profitability
Important profitability ratios are:
1) ROE = Net Income/Surplus
2) Yield on Investments = Net Investment
Income/ Invested Assets
3) Net Operating Gain Ratio= Net Income/
(Premium Income + Investment Income)
29. 4. Liquidity
ability to meet expected cash needs
objective of asset-liability management.
Current Liquidity
= (cash +Unaffiliated Investments) /Liability
Note:
• Unaffiliated investments
o stocks, bonds, and other investment holdings in
companies neither owned by the insurer nor
companies that share joint ownership of securities
with the insurer.
30. 5. Leverage
the level of debt financing
Insurer’ main source of debt
– Policy reserves.
Three measures of leverage
1) Liabilities-to-Surplus ratio=liability/surplus
2) Capacity Ratio = Net Written Premiums/surplus.
3) Surplus Relief Ratio= surplus relief/surplus
Note:
surplus relief: Reinsurance Commissions and Expense
Allowances
31. Financial ratio exercise 1
Which of the following relationships is/are correct?
a. Surplus Adequacy=surplus/liability
b. Rate of surplus Formation
=(growth rate of surplus)/ growth rate of liability
c. Net Operating Gain Ratio
= Net Income/ Premium Income
d. Capacity Ratio
= Net Written premiums/surplus.
e. Surplus Relief Ratio= surplus relief/surplus
Answer: A, b, d, and e are correct.
32. Financial ratio exercise 2
Which of the following ratios provide(s)
indication of insurer’s surplus adequacy?
a. Surplus adequacy ratio
b. Rate of surplus formation
c. Surplus relief ratio
Answer: A and b
33. Review Exercise 1
List the four criteria for life insurer
evaluation. Which one is considered most
important?
1) Financial Soundness & Performance
2) Product Availability
3) Service Quality
4) Ethical Behavior
34. Review Exercise 2
What are the five financial elements of life
insurance financial soundness evaluation?
1) Surplus Adequacy
2) Asset Quality
3) Profitability
4) Liquidity
5) Leverage
35. Ch11 summary
Four Criteria for life insurer Evaluation
– Financial Soundness & Performance
– Product Availability
– Service Quality
– Ethical Behavior
Source of information about life insurers
Five Elements of a life insurer financial
soundness evaluation
