National Insurance Company of Wisconsin, Inc.

Report of the Examination of National Insurance Company of Wisconsin, Inc. Brookfield, Wisconsin As of December 31, 2005 TABLE OF CONTENTS Page I. INTRODUCTION .................................................................................................................. 2 II. HISTORY AND PLAN OF OPERATION .............................................................................. 3 III. MANAGEMENT AND CONTROL ........................................................................................ 5 IV. AFFILIATED COMPANIES .................................................................................................. 7 V. REINSURANCE ................................................................................................................. 11 VI. FINANCIAL DATA .............................................................................................................. 16 VII. SUMMARY OF EXAMINATION RESULTS ....................................................................... 27 VIII. CONCLUSION.................................................................................................................... 41 IX. SUMMARY OF COMMENTS AND RECOMMENDATIONS.............................................. 42 X. ACKNOWLEDGMENT ....................................................................................................... 45 State of Wisconsin / OFFICE OF THE COMMISSIONER OF INSURANCE Jim Doyle, Governor Sean Dilweg, Commissioner Wisconsin.gov January 19, 2007 125 South Webster Street • P.O. Box 7873 Madison, Wisconsin 53707-7873 Phone: (608) 266-3585 • Fax: (608) 266-9935 E-Mail: information@oci.state.wi.us Web Address: oci.wi.gov Honorable Sean Dilweg Commissioner of Insurance State of Wisconsin 125 South Webster Street Madison, Wisconsin 53702 Honorable Alfred W. Gross Chair, Financial Condition (E) Committee, NAIC Commissioner of Insurance Commonwealth of Virginia 1300 East Main Street Richmond, Virginia 23219 Honorable Merle Scheiber Secretary, Midwestern Zone, NAIC Director of Insurance State of South Dakota 445 East Capitol Avenue Pierre, South Dakota 57501-3185 Commissioners: In accordance with the instructions of the Wisconsin Commissioner of Insurance, a compliance examination has been made of the affairs and financial condition of: NATIONAL INSURANCE COMPANY OF WISCONSIN, INC. Brookfield, Wisconsin and this report is respectfully submitted. I. INTRODUCTION The previous examination of National Insurance Company of Wisconsin, Inc., (the company or NICW) was conducted in 2002 as of December 31, 2001. The current examination covered the intervening period ending December 31, 2005, and included a review of such 2006 transactions as deemed necessary to complete the examination. The examination consisted of a review of all major phases of the company's operations and included the following areas: History Management and Control Corporate Records Conflict of Interest Fidelity Bonds and Other Insurance Employees' Welfare and Pension Plans Territory and Plan of Operations Affiliated Companies Growth of Company Reinsurance Financial Statements Accounts and Records Data Processing Emphasis was placed on the audit of those areas of the company's operations accorded a high priority by the examiner-in-charge when planning the examination. Special attention was given to the action taken by the company to satisfy the recommendations and comments made in the previous examination report. The company is annually audited by an independent public accounting firm as prescribed by s. Ins 50.05, Wis. Adm. Code. An integral part of this compliance examination was the review of the independent accountant's work papers. Based on the results of the review of these work papers, alternative or additional examination steps deemed necessary for the completion of this examination were performed. The examination work papers contain documentation with respect to the alternative or additional examination steps performed during the course of the examination. 2 II. HISTORY AND PLAN OF OPERATION National Insurance Company of Wisconsin, Inc., was originally organized in 1895 as a town mutual insurance company under the name Campbellsport Mutual Insurance Company. In 1976, the company became a domestic mutual insurance company and changed its name to Camco Insurance a Mutual Company. In 1980, the company converted to a stock insurance company and changed its name to Wisconsin Employers Indemnity Company. From 1980 to 1989, the company’s ultimate parent was American Express Company. The company was sold as an inactive shell corporation to National Services, Inc., in 1989. The principals of National Insurance Services of Wisconsin, Inc., reactivated the company, adopted the current name of National Insurance Company of Wisconsin, Inc., and commenced business on February 9, 1989. In 2005, the company wrote direct premium in the following states: Wisconsin Minnesota Michigan North Dakota All others Total $2,714,877 975,984 628,898 134,507 149,533 $4,603,799 59.0% 21.2 13.7 2.9 3.2 100.0% The company is licensed in the following states: Alabama Colorado Delaware Georgia Idaho Illinois Indiana Kentucky Maryland Michigan Minnesota Mississippi Missouri Montana Nebraska North Dakota South Dakota Washington Wisconsin Wyoming National Insurance Company of Wisconsin, Inc., primarily writes group long-term disability insurance for school districts and municipalities. The company also writes a small volume of group short-term disability insurance. The business is marketed through an affiliated managing general agent, National Insurance Services of Wisconsin, Inc. (NIS). The affiliated agent places the majority of the business either directly with the company or with Lafayette Life Insurance Company and Madison National Life Insurance Company. Lafayette Life cedes 100% of the business risk to Hartford Life and Accident Insurance Company, who, in turn, retrocedes 50% of the business on groups up to 1,000 lives and 25% on groups in excess of 1,000 lives to 3 National Insurance Company of Wisconsin, Inc. The company also assumes 10% of Madison National Life Insurance Company’s group long-term disability business. In addition, the company has recently partnered with LifePlans, Inc., to administer a long-term care policy, with the intent that employees insured under the company’s long-term disability policy could acquire long-term care coverage upon retirement. 100% of the long-term care risk is ceded to Munich American Reassurance Company. Further comments regarding the affiliate company relationships and reinsurance programs may be found in Sections IV and V of this report, respectively. The following table is a summary of the net insurance premiums written by the company in 2005. Direct Premium Reinsurance Assumed Reinsurance Ceded Net Premium Line of Business Group accident and health Other accident and health Total All Lines $4,599,631 4,168 $4,603,799 $9,833,676 0 $9,833,676 $2,271,692 3,960 $2,275,652 $12,161,615 208 $12,161,823 During 2005, the company’s direct premium written provided approximately 19% of the total net premium written, while reinsurance premium assumed accounted for 81% of the total net premium written. The above results reflect the company’s overall role related to supporting its affiliated agency, National Insurance Services of Wisconsin, Inc., in developing and maintaining relationships with other principal carriers through a demonstrated commitment to share in the business risk based on assumption of a portion of business written by its affiliate. The growth of the company is discussed in the “Financial Data” section of this report. 4 III. MANAGEMENT AND CONTROL Board of Directors The board of directors consists of ten members. All directors are elected annually to serve a one-year term. Officers are elected at the board's annual meeting. Members of the company's board of directors may also be members of other boards of directors in the holding company group. The board members currently receive $1,500 annual compensation for serving on the board. The board member fees were changed beginning with the 2002 term from $500 per meeting to $1,500 per year with payments made in installments at the meetings and final payment due by December 31 of each year. Currently the board of directors consists of the following persons: Name and Residence Terry D. Briscoe Franklin, Wisconsin Scott P. Briscoe New Berlin, Wisconsin Joesph M. DeRosa Elm Grove, Wisconsin Thomas D. Ehrsam Hartland, Wisconsin Henry J. Ehrsam Hartland, Wisconsin Frank J. Lauck, Jr. Brookfield, Wisconsin Stephanie G.Laudon Whitefish Bay, Wisconsin Bruce A. Miller Delafield, Wisconsin David M. Norton Muskego, Wisconsin Donald L. White Oconomowoc, Wisconsin Principal Occupation Chairman / CEO of NICW Chairman / CEO of NIS Exec. Vice President / Secretary of NICW Vice President / Secretary / Director of NIS President DeRosa Corporation Vice Chairman / COO of NICW COO / Director of NIS Vice President - Marketing / Director of NIS Term Expires 2007 2007 2007 2007 2007 Executive Vice President of NIS 2007 Vice President / Director of NIS 2007 President of NICW President / Director of NIS Vice President / Treasurer of NICW Vice President / Treasurer / Director of NIS Vice President of Sales of NIS 2007 2007 2007 5 Officers of the Company The officers serving at the time of this examination are as follows: 2005 Compensation $373,874 187,727 ** 210,096* ** 49,757* Name Terry D. Briscoe Thomas D. Ehrsam Bruce A. Miller Scott P. Briscoe David P. Norton John Norton Office Chairman and Chief Executive Officer Vice Chairman and Chief Operating Officer President Executive Vice President and Secretary Vice President and Treasurer Investment Manager The notation ** indicates the officer is compensated entirely by NIS, an affiliate of National Insurance Company of Wisconsin, Inc. See further discussion of the organizational relationships under the Summary of Current Examination Results section captioned “Affiliated Parties.” The notation * indicates the above salary represents adjustments to the amount reported on the Company’s “Report on Executive Compensation” to reflect other indirect remuneration for services. See further discussion of compensation reporting under the Summary of Current Examination Results section captioned “Executive Compensation Reporting.” Committees of the Board The company's bylaws allow for the formation of certain committees by the board of directors. The committees at the time of the examination are listed below: Investment Committee Terry Briscoe, Chair Scott Briscoe Thomas Ehrsam Frank Lauck Bruce Miller David Norton John Norton Audit Committee Scott Briscoe, Chair Bruce Miller David Norton The Audit Committee was recently established in 2004, primarily to address potential communication issues between the NICW and its external auditors in response to SarbanesOxley. There have been no formal meetings of the Audit Committee to date. The external auditors have issued letters to the Audit Committee chair during the last two years which have been reported to the board. 6 IV. AFFILIATED COMPANIES National Insurance Company of Wisconsin, Inc., is a member of a holding company system. The holding company is owned by two individual investors, Terry D. Briscoe (75%) and Thomas D. Ehrsam (25%), who participate in the ownership of several companies collectively know as the National Services Group. The organizational chart below depicts the relationships among the affiliates in the group. A brief description of the significant affiliates follows the organizational chart. Organizational Chart National Services Group As of December 31, 2005 Owners: Terry Briscoe 75% Thomas Ehrsam 25% Owners: Terry Briscoe – 24.0% Thomas Ehrsam – 14.4% Scott Briscoe – 14.4% Stephanie Laudon – 14.4% Henry Ehrsam – 9.6% Bruce Miller – 9.6% David Norton – 9.6% Frank Lauck – 4.0% Owners: Terry Briscoe – 50% Mike Briscoe – 25% Chris Briscoe – 25% National Services, Inc. (NSI) C-Corp National Insurance Services of Wisconsin, Inc. (NIS) S- Corp 250 Executive, L.L.P. National Insurance Company of Wisconsin, Inc. (NICW) C-Corp See further organizational comments under the Summary of Current Examination Results section captioned “Affiliated Parties.” 7 National Services, Inc. National Services, Inc., is the parent of National Insurance Company of Wisconsin, Inc. It was created for the sole purpose of holding ownership of NICW and conducts no other specific business. As of December 31, 2005, the audited financial statements of National Services, Inc., and subsidiary reported assets of $39,630,890, liabilities of $26,086,970, and total shareholders’ equity of $13,543,920. Operations for 2005 produced net income of $969,847. National Insurance Services of Wisconsin, Inc. National Insurance Services of Wisconsin, Inc., is a managing general agent, which is licensed as a third-party administrator in jurisdictions that require such licensure. NIS produces virtually all of the business written by NICW. As of December 31, 2005, the audited financial statements of National Insurance Services of Wisconsin, Inc., reported assets of $6,351,370, liabilities of $2,653,194, and total stockholders’ equity of $3,698,176. Operations for 2005 produced net income of $2,505,579. 250 Executive, L.L.P 250 Executive, L.L.P., is a limited liability partnership that owns the home office building in which the company and other National Services Group entities are located. As of December 31, 1997, the owner of the building was a partnership named Briscoe Ehrsam Investments that had the same ownership as NICW. In 1998, the Briscoe Ehrsam Investments partnership was dissolved and 250 Executive, L.L.P., was formed under the ownership of new partners as noted in the organization chart. As of December 31, 2005, the compiled financial statements of 250 Executive, L.L.P., reported assets of $3,217,200, liabilities of $3,204,735, and a partners’ equity of $12,465. Operations for 2005 produced net income of $408,391. NICW had extended a second mortgage to Briscoe Ehrsam Investments on September 17, 1993, collateralized by a security interest in the home office property. The second mortgage was a five-year note for the principal amount of $750,000, with scheduled payments through November 1998. In 1998, the outstanding debt on the second mortgage was assumed by the 250 Executive, L.L.P., partnership. At year-end 2005, the remaining outstanding unpaid balance on the note was fully paid. 8 Agreements with Affiliates National Insurance Company of Wisconsin, Inc., is a party to the following affiliated agreements: Commission and Administrative Services Agreement The company has appointed National Insurance Services of Wisconsin, Inc., (NIS) as Administrator to perform various agency and administrative business services for its group policies under a Commissions and Administrative Service Agreement effective February 9, 1989. NIS is responsible for providing various policy services including enrollment solicitation, advertising support, delivery of coverage evidence, beneficiary processing and lapsed coverage notification. NIS is also responsible for various premium processing services including premium billing, collection and remittance reporting, in accordance with the agreement’s Administrative Services Schedule. Under the agreement, the company pays a commission fee for insurance marketing services provided by NIS, as well as, an administration fee for NIS performance of various NICW operating services. The above fees are calculated as a percentage of premiums paid to the company, in accordance with various amendments to the agreement’s Commissions and Administration Fee Allowance Schedule. Commission fees are not to exceed 10% and administration fees are defined as 7% for standard plans and 2% for high benefit plans, with total fee allowances not to exceed 20% under the most recent amendment. The agreement may be terminated by either party providing 60 days’ written notice. Profit-Sharing Agreement A Profit-Sharing Agreement between the company and its affiliate National Insurance Services of Wisconsin, Inc., effective February 9, 1989, recognizes the considerable influence that NIS has on the profitability of the block of business placed with NICW, due to its position as Managing General Agent and Administrator. Accordingly, NICW agreed to pay NIS profit-sharing compensation in an amount equal to 50% of profits generated after July 1, 1989, from long-term disability policies underwritten by NICW which are sold, issued and administered through NIS. Profit is defined under the contract as the excess of the accumulated aggregate total of all earned premiums for the policies over the accumulated aggregate total of all incurred claims, expenses and previous profit-sharing payments to NIS attributable to the policies. The profit-sharing percentage was amended from 50% to 10%, effective July 1, 2001, in accordance with an amendment to the agreement dated December 13, 2001. The agreement may be terminated by NICW by giving 60 days’ advance written notice. Marketing Services Agreement NICW has appointed National Insurance Services of Wisconsin, Inc., as agent with respect to marketing services for its long-term care insurance coverage under a Marketing Services Agreement effective January 1, 2002. NIS is responsible for performing enrollment 9 solicitation, case material delivery, advertising and sales support, evidence of coverage delivery and marketing plan development under the agreement’s Marketing Services Schedule. NICW pays a commission fee of 14% calculated as a percentage of premiums paid to the company under the agreement’s Commissions Schedule. The agreement continues for a period of five years with automatic one-year extension periods, unless terminated by either party with 60 days’ advance notice. Tax Allocation Agreement The company is a party to a Tax Allocation Agreement with its parent, National Services, Inc., effective June 29, 1999. NSI is responsible for the filing of a consolidated income tax return for its affiliated group. Each member of the affiliated group is responsible for the computation of its separate tax liability as if it had filed a separate tax return. The agreement applies to the tax year ending December 31, 1999, and all subsequent taxable periods unless the parent and subsidiary agree to terminate. 10 V. REINSURANCE The company's reinsurance portfolio and strategy is described below. The description includes an overview of major ceding and assumed reinsurance relationships followed by an outline of the individual contract terms. The contracts contain proper insolvency provisions. Reinsurance Program Overview Ceding Contracts National Insurance Company of Wisconsin, Inc., has two active ceding reinsurance contracts and one contract in run-off, as follows: American United Life Insurance Company (AUL)—NICW ceded 25% of long-term disability business under a coinsurance treaty with American United Life Insurance Company, effective January 1, 1997. The percentage increased to 50% effective January 1, 1998. AUL subsequently made a request to cease the assumption of risk from NICW on future business. The above contract is now in run-off based on the ReliaStar replacement relationship discussed below. ReliaStar Life Insurance Company (ReliaStar)—NICW cedes 50% of long-term disability to ReliaStar, who replaced AUL based on their request to cancel assumption of risk per agreement effective July 1, 1999. Accordingly, AUL retains liability for 50% of the disability claims insured from January 1, 1997, through June 30, 1999, while ReliaStar retains liability for 50% of claims incurred on or after July 1, 1999. Munich American Reassurance Company—NICW has developed a longterm care policy with the intent that employees insured under the company’s long-term disability could acquire long-term care coverage upon retirement. LifePlans, Inc., is the administrator and Munich American Reassurance Company assumes 100% of the risk under an agreement, effective May 1, 2002. Assuming Contracts The company has two active assumption reinsurance contracts and one contract in run-off, as follows: American United Life Insurance Company—NICW assumed a varying percentage based on business type of existing long-term disability policies previously insured by Amex Life Assurance Company and new group long-term disability business written by AUL and sold through NIS on or after January 1, 1996. The above contract is in run-off based on the Lafayette Life replacement relationship discussed below. Hartford Life / Lafayette Life—All AUL business above was moved to The Lafayette Life Insurance Company per agreement, effective January 1, 2002, whereby 100% of Lafayette’s long-term disability business is assumed by Hartford Life and Accident Insurance Company. Hartford, in 11 turn, retrocedes 50% of the business on groups up to 1,000 lives and 25% on groups in excess of 1,000 lives to NICW. Madison National Life Insurance Company (MNL)—NICW assumes 10% of group long-term disability policies issued by Madison National Life Insurance Company and sold through NIS, effective January 1, 2003. Nonaffiliated Ceding Contracts 1. Type: Reinsurer: Scope: Quota Share ReliaStar Life Insurance Company Group long-term disability policies written by the company on or after July 1, 1999 50% of the company’s liability on a quota share basis, subject to a maximum of $10,000 gross monthly benefit 50% of the company’s liability on a quota share basis, subject to a maximum of $10,000 gross monthly benefit 50% of the gross direct long-term disability premium earned 10% commission to NIS (allocated 4.5% to commissions and 5.5% to marketing fees) 10% expense allowance to NIS for administrative expenses 10% expense allowance to company 50% of net underwriting profits to the company subject to an additional 6% of premium under income to ReliaStar to cover administrative expenses July 1, 1999 Agreement shall be in continuous force and effect until terminated. Either party can terminate agreement on any anniversary date by giving 90 days’ prior written notice. Quota Share Munich American Reassurance Company Long-term care insurance policies written by the company through its third-party administrator, LifePlans, Inc. None 100% of all direct long-term care business risk 100% of all direct long-term care premiums 14% commission to NIS 5% expense allowance to company for use of paper Retention: Coverage: Premium: Commissions: Profit-sharing Effective date: Termination: 2. Type: Reinsurer: Scope: Retention: Coverage: Premium: Commissions: 12 LifePlans administration fee based on actual expenses which approximates 30% of premium Effective date: Termination: 3. Type: Reinsurer: Scope: May 1, 2002 Either party may terminate by giving 90 days’ written notice Quota Share American United Life Insurance Company (AUL) Group long-term disability policies issued by the company through June 30, 1999 75% of business issued between 1/1/97 and 12/31/97 50% of business issued between 1/1/98 and 6/30/99 25% of business issued between 1/1/97 and 12/31/97 50% of business issued between 1/1/98 and 6/30/99 Gross earned premiums for group long-term disability policies written by the company up to July 1, 1999, in the same proportions as reinsurer coverage percentages 10% commission to NIS 10% expense allowance to NIS 10% expense allowance to the company January 1, 1997 Risk was transferred to ReliaStar effective July 1, 1999 Agreement is in run-off Retention: Coverage: Premium: Commissions: Effective date: Termination: Nonaffiliated Assuming Contracts 1. Type: Reinsured: Scope: Retrocession Agreement Hartford Life and Accident Insurance Company (Hartford) Group long-term disability business from Hartford which was assumed from The Lafayette Life Insurance Company 50% of insured groups with 1,000 covered lives or less 75% of insured groups with over 1,000 covered lives 50% of insured groups with 1,000 covered lives or less 25% of insured groups with over 1,000 covered lives Net premiums attributable to the coverage percentages for group long-term disability business from Hartford, which was assumed from The Lafayette Life Insurance Company 10% combined expense allowance for The Lafayette Life Insurance Company and Hartford. NIS expense allowance is based on actual NIS expenses incurred. Ceding company Retention: Coverage: Premium: Commissions: 13 Effective date: Termination: January 1, 2002 Automatically renewed annually until cancelled at any time by either party with 180 calendar days advance written notice Quota Share Madison National Life Insurance Company, Inc. (MNL) Group long-term disability policies issued by MNL and sold through NIS 90% of group long-term disability policies issued by MNL and sold through NIS 10% of group long-term disability policies issued by MNL and sold through NIS 10% of gross written premium for group long-term disability policies issued by MNL and sold through NIS Expense allowance to MNL not to exceed 9% of the gross premium written. NIS expense allowance is based on actual NIS expenses incurred. January 1, 2003 Contract may be cancelled by either party giving 180 days’ prior written notice Quota Share American United Life Insurance Company (AUL) Existing long-term disability policies previously insured by AMEX Life Assurance Company New group long-term disability insurance written by AUL and sold through NIS on or after January 1, 1996 50% of company’s liability from an existing block of business 50% of new business groups in NIS exclusive territory with less than 500 lives 75% for new business groups in NIS exclusive territory with greater than 500 lives and all non-school group business 80% for all group business in NIS non-exclusive territory 50% of company’s liability from an existing block of business 50% of new business groups in NIS exclusive territory with less than 500 lives 25% for new business groups in NIS exclusive territory with greater than 500 lives and all non-school group business 20% for all group business in NIS non-exclusive territory Gross earned premiums associated with existing long term disability policies previously insured by AMEX Life Assurance Company 2. Type: Reinsured: Scope: Ceding company retention: Coverage: Premium: Commissions: Effective date: Termination: 3. Type: Reinsured: Scope: Ceding company Retention: Coverage: Premium: 14 New group long term disability insurance issued by NIS on or after January 1, 1996, in the same proportions as reinsured covered percentages Commissions: 10% commission to NIS 10% expense allowance to NIS 10% expense allowance to the company January 1, 1996 Business risk moved to Lafayette Life Insurance Company effective July, 2003 Contract is in run-off Effective date: Termination: 15 VI. FINANCIAL DATA The following financial statements reflect the financial condition of the company as reported to the Commissioner of Insurance in the December 31, 2005, annual statement. Also included in this section are schedules that reflect the growth of the company, NAIC Insurance Regulatory Information System (IRIS) ratio results for the period under examination, and the compulsory and security surplus calculation. Adjustments made as a result of the examination are noted at the end of this section in the area captioned "Reconciliation of Surplus per Examination." 16 National Insurance Company of Wisconsin, Inc. Assets As of December 31, 2005 Net Admitted Assets $13,104,565 703,170 675,911 182,294 1,910,618 153,859 Assets Bonds Stocks: Preferred stocks Common stocks Real estate: Properties held for sale Cash, cash equivalents, and short-term investments Investment income due and accrued Premiums and considerations: Uncollected premiums and agents' balances in course of collection Reinsurance: Funds held by or deposited with reinsured companies Other amounts receivable under reinsurance contracts Net deferred tax asset Receivable from parent, subsidiaries, and affiliates Write-ins for other than invested assets: Prepaid expenses Misc - state tax receivable Total Assets $13,104,565 703,170 675,911 182,294 1,910,618 153,859 Nonadmitted Assets $ 108,732 108,732 18,807,801 426,272 130,241 10,557 193,238 18,614,563 426,272 75,472 10,557 54,769 15,505 22,720 $36,252,245 15,505 22,720 $263,512 $35,988,733 17 National Insurance Company of Wisconsin, Inc. Liabilities, Surplus, and Other Funds As of December 31, 2005 Losses Reinsurance payable on paid loss and loss adjustment expenses Loss adjustment expenses Other expenses (excluding taxes, licenses, and fees) Taxes, licenses, and fees (excluding federal and foreign income taxes) Current federal and foreign income taxes Advance premium Ceded reinsurance premiums payable (net of ceding commissions) Amounts withheld or retained by company for account of others Total liabilities Common capital stock Gross paid in and contributed surplus Unassigned funds (surplus) Surplus as regards policyholders Total Liabilities and Surplus $ 2,000,000 1,000,000 10,238,166 13,238,166 $35,988,733* $21,855,077 71,052 189,391 215,272 683 47,834 66,161 208,513 96,584 22,750,567* * Annual Statement balance was adjusted for immaterial rounding difference. 18 National Insurance Company of Wisconsin, Inc. Summary of Operations For the Year 2005 Underwriting Income Premiums earned Deductions: Losses incurred Loss expenses incurred Other underwriting expenses incurred Total underwriting deductions Net underwriting (loss) Investment Income Net investment income earned Net realized capital gains Net investment gain Other Income Write-ins for miscellaneous income: Interest earned on assumed reserves Total other income Net income before dividends to policyholders and before federal and foreign income taxes Dividends to policyholders Net income after dividends to policyholders but before federal and foreign income taxes Federal and foreign income taxes incurred Net Income $12,161,823 $8,182,086 220,789 3,998,076 12,400,951 (239,128) 639,065 113,197 752,262* 962,881 962,881 1,476,015* 0 1,476,015* 462,801 $ 1,013,214 * Annual Statement balance was adjusted for immaterial rounding difference. 19 National Insurance Company of Wisconsin, Inc. Cash Flow For the Year 2005 Premiums collected net of reinsurance Net investment income Miscellaneous income Total Benefit- and loss-related payments Commissions, expenses paid, and aggregate write-ins for deductions Federal and foreign income taxes paid Total deductions Net cash from operations Proceeds from investments sold, matured, or repaid: Bonds Stocks Miscellaneous proceeds Total investment proceeds Cost of investments acquired (long-term only): Bonds Stocks Real estate Miscellaneous applications Total investments acquired Net cash from investments Cash from financing and miscellaneous sources: Other cash provided Net cash from financing and miscellaneous sources Reconciliation: Net change in cash, cash equivalents, and short-term investments Cash, cash equivalents, and short-term investments: Beginning of year End of year $12,196,806 653,343 (1,565,721) 11,284,428 $ 6,707,814 4,413,735 38,408 11,159,957 124,471* $4,168,419 596,760 253,362 5,018,541 4,203,389 585,213 180,667 113,196 5,082,465 (63,924)* 503,646 503,646 564,193 1,346,425 $ 1,910,618 * Annual Statement balance was adjusted for immaterial rounding difference. 20 National Insurance Company of Wisconsin, Inc. Compulsory and Security Surplus Calculation December 31, 2005 Assets Less liabilities Adjusted surplus Annual premium: Group accident and health Factor Total Compulsory surplus (subject to a minimum of $2 million) Compulsory surplus excess (or deficit) $35,988,733 22,750,567 13,238,166 $12,161,823 10% $1,216,182 2,000,000 $11,238,166 Adjusted surplus (from above) Security surplus: (140% of compulsory surplus, factor reduced 1% for each $33 million in premium written in excess of $10 million, with a minimum factor of 110%) Security surplus excess (or deficit) $13,238,166 2,800,000 $10,438,166 21 National Insurance Company of Wisconsin, Inc. Reconciliation and Analysis of Surplus For the Four-Year Period Ending December 31, 2005 The following schedule is a reconciliation of total surplus during the period under examination as reported by the company in its filed annual statements: 2005 Surplus, beginning of year Net income Change in net unrealized capital gains/losses Change in net deferred income tax Change in non-admitted assets Dividends to stockholders Surplus, end of year $12,215,774 1,013,214 (177,222) 149,988 36,412 2004 $12,693,751 (306,372) 175,707 (257,722) (89,590) 2003 $11,480,308 990,160 (187,298) (340,969) 1,899,851 (1,148,301) $12,693,751 2002 $ 9,790,585 1,691,276 421,351 150,514 (573,418) $13,238,166 $12,215,774 $11,480,308 Overall, the net loss in 2004 is attributed to higher loss ratios experienced on assumed business of 89% versus a target of 71%. In particular, the company attributed the above loss experience to various factors associated with each of the following assumed blocks of business. American United Life—AUL concluded that their state offset assumptions were too aggressive and adjusted offset factors accordingly in 2004. Conversely, they determined that termination rate assumptions were excessively conservative. The later increase in termination rates had minimal effect, since statutory accounting only allows modification of the first two years of termination factors and the majority of claimants for this block of business are past two years in duration. The benefit of improved termination rates is envisioned to have a more favorable impact going forward, which appears to be supported by 2005 AUL results which generated an underwriting gain. Madison National Life—MNL made a change to their IBNR formula in 2004 to account for their exposure to reopened claims. The above reserving formula change increased the total loss ratio by an estimated 5%. Hartford / Lafayette Life—The Lafayette Life assumed block of business incurred a loss ratio of 85% in 2004, but improved to 70% in 2005. Reserves for the first five years of 22 duration under this assumed business are established using Hartford’s own experience. In 2004, the company questioned the inherently conservative reserving practices for this business, based on the fact that they were approximately $10,000 higher per claimant than other blocks which they insure and have the same risk profile. Accordingly, the company hired a consulting actuary, Meyer Disability Consulting, to evaluate the reserves for the Lafayette block of business in 2005. The consulting actuary’s initial results appeared to support the above concerns, particularly due to the relatively conservative reserve model accounting for state offset assumptions. The actuary for Lafayette Life subsequently adjusted their reserves downward by approximately $400,000 as of year-end 2006, which appears to support the initial conservative reserving practice concerns. In addition, the company noted that Lafayette Life and NICW subsequently will be purchasing and implementing the reserve model used by the above consulting actuary on a going-forward basis. This consistent reserve model usage is anticipated to enhance business growth, while maintaining a more reasonable loss ratio. The company attributed the net income growth in 2002-2003 to continued improvement in reserve termination rates generating loss ratios of 33% on direct business and 23% on assumed business in 2002. The growth was also attributed to the new business partner relationship established with Lafayette Life, which is dedicated to growing the business and investing in its long-term success. The major change in nonadmitted assets in 2003 included the payoff of $808,000 in shareholder loans. These loans were originally designed to meet the financial needs of certain executives, while providing NICW with an investment yield equivalent to the company’s overall portfolio. Other components of the above change in nonadmitted assets included decreases in Deferred Tax Assets and Reinsurance Receivable. 23 National Insurance Company of Wisconsin, Inc. Insurance Regulatory Information System For the Four-Year Period Ending December 31, 2005 The company’s NAIC Insurance Regulatory Information System (IRIS) results for the period under examination are summarized below. Ratio #1 #2 #3 #4 #5 #6 #7 #8 #9 #10 #11 #12 #13 Gross Premium to Surplus Net Premium to Surplus Change in Net Writings Surplus Aid to Surplus Two-Year Overall Operating Ratio Investment Yield Gross Change in Surplus Net Change in Adjusted Surplus (first used in 2005) Liabilities to Liquid Assets Agents’ Balances to Surplus One-Year Reserve Development to Surplus Two-Year Reserve Development to Surplus Estimated Current Reserve Deficiency to Surplus 2005 109% 92 9 0 96 4.0 8 8 137* 1 3 -3 -18 2004 109% 92 10 0 95 3.9* -4 N/A 130* 1 -9 -27 -36 2003 95% 80 46* 0 71 4.7 11 N/A 104 1 -18 -45 -5 2002 77% 60 11 0 63 5.8 17 N/A 88 0 -32 -47 -20 The Change in Net Writings ratio exception in 2003 was attributed to the new reinsurance agreement with Madison National Life Insurance Company. NICW assumed 10% of Madison National Life’s group long-term disability business under this agreement, which the company indicated generated approximately $2.3 million of additional premium in 2003. The Investment Yield ratio exception in 2004 was attributed to investment portfolio concentration in government and government agency securities. The company also maintained short-term investments to meet reinsurer settlement requirements due to the higher loss ratios experienced in 2004, as previously discussed under the “Reconciliation and Analysis of Surplus.” The relatively high ratio of Liabilities to Liquid Assets during the above history period is attributed to the ongoing growth of Funds Held by Reinsurer balances, which are directly related to the growth of offsetting reserve balances held by the reinsurer under the company’s assumed reinsurance program. The Liabilities to Liquid Assets ratio calculation is impacted by the fact that the increase in reserve liabilities, due to assumed premium growth, is not offset by liquid assets since the Funds Held by Reinsurer balances are not treated as liquid assets. 24 Growth of National Insurance Company of Wisconsin, Inc. Surplus As Regards Policyholders * $13,238,166 12,215,774 12,693,751 11,480,308 9,790,585 Year 2005 2004 2003 2002 2001 Admitted Assets * $35,988,733 33,200,277 28,511,493 24,545,803 23,339,109 Liabilities * $22,750,568 20,984,502 15,817,744 13,065,494 13,548,525 Net Income $1,013,214 (306,372) 990,160 1,691,276 891,136 * Immaterial differences between Assets and Liabilities plus Surplus are due to rounding in the company’s annual statement presentation. Gross Premium Written $14,437,475 13,285,591 12,094,983 8,867,181 7,890,408 Net Premium Written $12,161,823 11,188,945 10,129,649 6,918,600 6,246,242 Loss And LAE Ratio 69.1% 85.6 65.8 29.3 51.2 Year 2005 2004 2003 2002 2001 Premium Earned $12,161,823 11,267,234 10,105,344 6,910,818 6,225,609 Expense Ratio 25.0% 23.9 27.2 32.2 37.1 Combined Ratio 94.1% 109.5 93.0 61.5 88.3 The growth in admitted assets of approximately $11.5 million from 2002 to 2005 is primarily attributable to the growth in Funds Held by Reinsurance Companies. Funds Held by Reinsurer balances increase in direct proportion to the assumed business, which the company indicated accounts for approximately $9.8 million or 85% of the growth. The increase in liabilities of approximately $9.8 million during the same period is due to the growth of assumed reserves, which is consistent with the growth in assumed premiums. The growth of gross premium written from $8.9 million in 2002 to $14.4 million in 2005 is attributable to the ongoing growth in assumed premiums under the company’s reinsurance agreements with Lafayette Life Insurance Company and Madison National Life Insurance Company. The growth of net premium written and premium earned are similarly associated with the noted assumed premium growth, which increased approximately 100% during the period under examination. The increase in the loss ratio and the combined ratio in 2004 are attributed to the loss experience on the assumed business, as previously discussed in Section VI under the “Reconciliation and Analysis of Surplus” section of this report. 25 Reconciliation of Surplus per Examination The following schedule is a reconciliation of surplus as regards policyholders between that reported by the company and as determined by this examination: Surplus December 31, 2005, per annual statement Increase Aggregate write-ins for gains and losses in surplus – correction of errors Net (decrease) Surplus December 31, 2005, per examination Decrease $13,238,166 $ $ $(307,267) $(307,267) (307,267) $12,930,899 Examination Reclassifications Debit Due from reinsurer - assumed Losses Reinsurance payable on paid losses Unearned premium Total Reclassifications $1,081,499 59,443 $ 1,081,499 59,443 $1,140,942 $1,140,942 Credit 26 VII. SUMMARY OF EXAMINATION RESULTS Compliance with Prior Examination Report Recommendations There were 20 specific comments and recommendations in the previous examination report. Comments and recommendations contained in the last examination report and actions taken by the company are as follows: 1. Management and Control—It is recommended that the board of director’s minutes be expanded to more completely demonstrate oversight of company activities associated with: (a) Material transactions including management bonus amounts and approval as well as non-investment grade security status. (b) Directors who abstain from voting because of potential conflicts of interest associated with their National Services Group affiliate ownership and / or employment status, in accordance with s. 611.60, Wis. Stat. Action—Compliance. 2. Holding Company Filings—It is recommended that the company obtain and file audited financial statements going forward for National Services, Inc., as the holding company for National Insurance Company of Wisconsin, in accordance with s. Ins 40.15, Wis. Adm. Code. Action—Compliance. 3. Holding Company Filings—It is recommended that the holding company registration statement include both forms B and C, in accordance with s. 617.11, Wis. Stat., and s. Ins 40.15, Wis. Adm. Code. Action—Compliance. 4. Holding Company Filings—It is again recommended that the company report holding company changes and material affiliated transactions, in compliance with the requirements of s. Ins 40.04 (2), Wis. Adm. Code. Action—Compliance. 5. Affiliate Agreements—It is recommended that quarterly intercompany settlement be made on a timely basis, in accordance with the affiliate commission and administrative services agreement terms. Action—Compliance. 6. Information Technology—It is suggested that the company enhance its disaster recovery plan through inclusion of additional desirable items including documentation of manual procedures performed by functional department personnel, hardware priorities, critical external contact lists and non-standard software to be loaded on personal computers. Action—Partial compliance. See further disaster recovery plan enhancement comments under the Summary of Current Examination Results section captioned “Disaster Recovery Plan.” 7. Invested Securities—It is again recommended that the company: (a) report all investment ratings in accordance with NAIC designations, 27 (b) file applicable securities valuation reports to obtain required ratings and (c) maintain sufficient evidence of NRSRO documentation supporting PE bond and Class 1 short-term investment ratings, in accordance with the Purposes and Procedures Manual of the NAIC Securities Valuation Office. Action—Partial compliance. See further comments under the Summary of Current Examination Results section captioned “SVO Security Filing.” 8. Cash on Hand and Deposit—It is again recommended that the company establish an unclaimed funds liability account for checks that are outstanding over one year to facilitate tracking for appropriate unclaimed property filings and payments with the state treasurer, in compliance with ch. 177, Wis. Stat. Action—Compliance. 9. Cash on Hand and Deposit—It is recommended that the company review and adhere to its banking resolutions, which should address who is authorized to sign as well as the facsimile and manual signature requirements based on dollar risk limits. Action—Partial compliance. See further comments under the Summary of Current Examination Results section captioned “Cash Disbursement Controls.” 10. Cash on Hand and Deposit—It is also recommended that the company secure signature stamps when not in use. Action—Compliance. 11. Funds Held By or On Deposit With Reinsured Companies—It is again recommended that the company ensure that settlement of balances under its reinsurance contracts be completed on a timely basis, in accordance with the settlement provisions of each reinsurance treaty. Action—Compliance. 12. Funds Held by or On Deposit With Reinsured Companies—It is recommended that the company ensure that the annual statement and schedule F correctly report funds held yearend balances and transactions in conformity with the NAIC Annual Statement Instructions – Property and Casualty and SSAP 62 and 64. Action—Partial compliance. See further comments under the Summary of Current Examination Results section captioned “Reinsurance Accounting and Reporting.” 13. Accrued Interest and Dividend Income—It is recommended that the company not accrue dividend income on preferred stock securities until the dividend amounts are declared and an ex-dividend date is established per SSAP 32, Investments in Preferred Stock. Action—Compliance. 14. Agents Balances in Course of Collection—It is recommended that the company classify premiums billed and due on the annual statement as “premiums and agents’ balances in course of collection” in conformance with NAIC Annual Statement Instructions – Property and Casualty, going forward. Action—Compliance. 28 15. Loans to Shareholders—It is recommended that (a) all stockholder loans be fully repaid with accrued interest within 90 days and (b) the company not make any future loans of any type to officers, directors, employees, stockholders or partnerships who have an affiliate interest without prior written notice to OCI. Action—Compliance. 16. Unearned Premium—It is recommended that the company classify advance premiums under aggregate write-ins for liabilities on its balance sheet rather than unearned premiums, going forward, in conformity with NAIC Annual Statement Instructions – Property and Casualty and SSAP 53, Property Casualty Contracts - Premium. Action—Compliance. 17. Wages Payable—It is recommended that (a) the CEO and COO bonus programs be formalized going forward, similar to other officer bonus programs, to identify specific performance criteria and minimize discretionary elements or (b) alternatively treat them as stockholder dividend distributions. Action—Compliance. 18. Deferred Compensation—It is recommended that the phantom stock plan employer benefit accrual be valued on an annual basis, in accordance with plan provisions, to accurately reflect benefit funding. Action—Not applicable. Phantom Stock program was terminated in 2005. 19. Taxes, Licenses and Fees—It is recommended that a premium tax recordkeeping system be implemented to track estimated tax due and payments by state to facilitate more reasonable accrual estimates. Action—Compliance. 20. Capital Stock—It is recommended that the company secure original stock certificate documentation or obtain replacement certificates supporting its common capital stock balance reported on the Annual Statement. Action—Compliance. 29 Summary of Current Examination Results Shareholder / Board of Director Meetings Article II, Section 2.01 of the Amended By-laws of National Insurance Company of Wisconsin, Inc., states that the annual meeting of shareholders shall be held on the second Friday in the month of March of each year or on such other date within 30 days thereof as may be authorized by the board of directors and set forth in the notice of the meeting. Review of the minutes of shareholders’ meetings indicated that meetings in 2005 and 2006 were held within 30 days of the designated meeting date in accordance with the above Amended By-law provisions. However, NICW’s Secretary acknowledged that the rationale for the change in date was not recorded in writing and that the arrangement was made verbally with no written notice. Article III, Section 3.03 of the Amended By-laws of National Insurance Company of Wisconsin, Inc., states that a regular meeting of the board of directors shall be held without other notice immediately after the annual meeting of shareholders. Review of the Board minutes indicated that meetings were not held immediately after the annual meetings from 2002 through 2006. NICW’s Secretary indicated that management and the board agreed that the first meeting in any year should be delayed until the financial results of the first quarter of the year are also available. However, management also indicated that no written record of this agreement exists. In addition, no records of the communications which led to the ultimate selection of a mutually agreeable date or of the meeting notices have been retained. It is recommended that the company amend its by-laws to conform to the desired shareholder and board of director meeting practices and policies, in accordance with s. 180.0701, Wis. Stat., and s. 180.0822, Wis. Stat., respectively. Board of Director Minutes The minutes of NICW’s board of directors continue to comment on various Strategic Planning Committee planning programs and goals, which NICW’s Secretary confirmed are primarily related to the overall programs of its affiliate, NIS. Management indicated that the Strategic Planning Committee is no longer reported as a NICW board committee because of its current emphasis on NIS planning. 30 It is recommended that the minutes of the board of directors provide a more meaningful record of planning oriented programs and objectives by incorporation of NICW specific programs and goals or NIS project specific impacts on NICW business, consistent with the recent Strategic Planning Committee disassociation from NICW due to its NIS affiliate program focus. Executive Compensation Reporting The NICW Report on Executive Compensation filed as of December 31, 2005, indicates that the report is filed based on the company’s option to report total gross compensation paid to each individual by or on behalf of all companies which are a part of a group of insurers or other holding company system, as opposed to the option to report an allocation to each insurer. Review of the Report on Executive Compensation filed for 2005 noted that NICW reports no executive officer compensation for officers paid wholly or in part by NIS, based on the assumption that NIS is not part of the National Services, Inc., holding company organizational structure. In addition, it was noted that the report did not consistently include various forms of non-salary compensation such as performance bonus, stock plan payout, and other fringe benefit reimbursements, in accordance with s. 611.63, Wis. Stat. It is recommended that the Report on Executive Compensation be completed properly in accordance with s. 611.63, Wis. Stat., by: (a) reporting all direct and indirect remuneration for services, (b) inclusion of all executive officers including those paid by affiliates under the current elected option to report total gross compensation by or on behalf of all companies, based on the common affiliate relationships discussed further under “Affiliated Parties” or (c) company election of the option to report based on allocation to each insurer. Schedule Y Reporting The company paid ordinary stockholder dividends of $1,148,301 in 2003, which were not subject to disapproval by this office, in accordance with company notice and subsequent correspondence dated August 29, 2003. However, the stockholder dividends were not reported on Schedule Y, Part 2, Summary of Insurer’s Transactions with Affiliates. It is recommended that shareholder dividends be reported on Schedule Y, Part 2, Summary of Insurer’s Transactions with Affiliates, in accordance with NAIC Annual Statement Instructions – Property & Casualty. 31 Management Bonus Program The company has implemented a formal bonus program formula for its Chief Executive Officer and Chief Operating Officer bonus calculation, in accordance with prior examination recommendations. The bonus formula components encompass various loss ratio, operating expense and new annualized growth performance goals. The bonus components are converted to a bonus amount based on weighted percentages and factors related to actual versus expected performance results. Target bonus incentive amounts only are reviewed and documented in the board of director minutes. It is recommended that the executive management bonus program formula also be reviewed and formally approved by the board of directors to demonstrate board oversight of the reasonableness of bonus components and methodology. Conflict of Interest The company has developed a Statement of Conflict of Interest using a format recommended in previous examinations. The statement is distributed to all officers and directors of NICW on an annual basis, typically on or before the first board meeting of each calendar year. At that time, the officers and directors are asked to read and sign the statement indicating any possible sources of conflict of interest. The Secretary is responsible for reviewing responses noting any changes, which are brought to the attention of the shareholders, as applicable. Examination review observed compliance with the above Statement of Conflict of Interest process for the examination period 2002 through 2006. At the same time, the completed statements do continue to demonstrate significant personal and family ownership interests between the principal owners and related officers and/or directors. It was also noted that the board membership of ten currently consists of only one outside director, which is allowed under s. 611.51(4), Wis. Stat., when employees and representatives of a corporation constitute a majority of the board for closely held corporations, as it relates to a stock insurance corporation where all of the voting shares are board members. It is suggested that management may want to consider future external board membership expansion in conjunction with the growing concerns for control independence being driven by Sarbanes-Oxley initiatives, given the closely held nature of the current membership. 32 Affiliated Parties Organizationally, NICW is a subsidiary of National Services, Inc., an insurance holding company owned by two principals, Terry D. Briscoe and Thomas D. Ehrsam. The company’s affiliate, National Insurance Services of Wisconsin, Inc., is heavily relied on to provide the majority of marketing, sales, administrative, underwriting, accounting and systems support. A corporation is defined as an affiliate of another corporation, regardless of ownership, if substantially the same group of persons manages both corporations under s. 600.03, Wis. Stat. Furthermore, there is a presumption of control if a person directly or indirectly owns or holds more than 10% of the voting securities under s. 600.13, Wis. Stat. The examination noted various factors demonstrating the common ownership, management and interdependence of NICW and NIS in accordance with the above statutes as well as management reporting inconsistencies related to affiliate relationships. All these considerations point to the need to recognize NIS as an affiliate for reporting purposes, as follows: Common NICW / NIS Ownership and Management • Principal parties owning 100% of NICW also own 38.4% of NIS. • Principal owners are Chief Executive Officer and Chief Operating Officer of both NICW and NIS. • Majority of NICW board members are officers and/or directors of NIS. • Conflict of Interest Statements document significant ownership interests between officers and directors. NICW / NIS Interdependence • NICW resources are limited to four staff with heavy reliance on NIS administrative and operating resources, in accordance with its Commission and Administrative Services Agreement, in effect since the company commenced business. • NICW board minutes record planning objectives which are tied to NIS programs. • Intercompany account is used to settle some officer bonus paid on behalf of NIS. Management Reporting Inconsistencies Related to Affiliate Relationships • NICW annual statement jurat page does not list the Chief Executive Officer and Chief Operating Officer. • NICW Report on Executive Compensation includes only the Chief Executive Officer and Chief Operating Officer compensation paid by NICW. NIS compensation is not included. • NICW’s Report on Executive Compensation does not include NICW’s President or Treasurer because they are paid solely by NIS. 33 It is recommended that future NICW annual statement reporting recognize NIS as an affiliate based on the common ownership and management as well as company interdependence by inclusion of all key officers on the Jurat page and Report on Executive Compensation, as applicable. This recommendation is not intended to restrict any of the company’s options in completing the Report on Executive Compensation in accordance with its instructions. Reinsurance Accounting and Reporting The company’s reinsurance agreements are on a funds-held basis, whereby a Funds Held by Reinsurer receivable balance is established by NICW for premiums payable from the reinsurer. NICW reports a corresponding liability for its proportionate share of loss reserves held by the reinsurer applicable to the assumed risks. Ceding reinsurers retain premiums, maintain loss reserves and pay all claims for their book of NIS produced business. The reinsurance agreements provide for quarterly settlement of net reinsurance balances, which consists of interest earned on reserve balances and the proportionate share of underwriting gain or loss. Funds held accounting is considered material based on the fact that assumed business is a major segment of NICW business, accounting for 81% of net premium in 2005. Reinsurance account breakout to recognize applicable reinsurance payable and receivable balance components in accordance with prior examination recommendations was noted, based on company and external auditor procedural interpretations. However, the current reclassification at year-end does not completely reflect the various assumed Reinsurance Payable on Paid Loss balances related to the 4th quarter settlement, which are settled subsequent to year-end. The “Funds Held Reclassification Summary” on the following page summarizes the impact of this Reinsurance Payable on Paid Loss reclassification. Funds held reclassification resulted in recognition of a Reinsurance Payable on Paid Loss balance of $1,152,551 versus the general ledger reported balance of $71,052 or an increase of $1,081,499. Net Admitted Funds Held increased as a result of the above reclassification from $18,236,244 to $19,388,795 versus the general ledger reported balance of $18,614,563, resulting in an increase of $774,232. The difference of $307,267 due to the excess of the Reinsurance Payable on Paid Loss balance over the Net Admitted Funds Held increase represents an Aggregate Surplus Write-in – Correction of 34 Errors, which is most likely reflective of interest components and differences between 4th quarter settlement and gain / loss balances. The above reclassification entry, along with a related $59,443 reclassification of Losses to Unearned Premium, is reflected in Section VI of this report under the headings “Reconciliation of Surplus per Examination” and “Examination Reclassification.” FUNDS HELD RECLASSIFICATION SUMMARY Description Case Reserves Funds Held Net Admitted General Ledger Difference Adjustment IBNR UNE Assumed Reserves True-up 12/31/05: AUL Hartford MNL Total 5,723,236 7,146,682 2,570,782 15,440,700 0 1,815,994 920,107 2,736,101 0 35,391 24,052 59,443 5,723,236 8,998,067 3,514,941 18,236,244 Gross Up – Reclassify Reinsurance Payable: AUL – Claims Hartford – Claims Hartford – ER FICA MNL – Claims MNL - ER FICA MNL – Claim Costs (191,828) (598,654) (7,920) (340,706) (4,858) (8,585) (1,152,551) 19,388,795 (71,052) 18,614,563 (1,081,499) 774,232 307,267 Total Reinsurance Payable Funds Held + Reinsurance Payable Reclass Surplus Adjustment – Correction of Error Funds held or deposited with reinsured companies, whether premiums withheld as security for outstanding loss reserves and unearned premium or advances for loss payments, are considered admitted assets provided they do not exceed the liabilities which they secure under Statement of Statutory Accounting Principle (SSAP) 62, Paragraph 20. Funds in excess of these liabilities are considered nonadmitted. 35 It is recommended that the company implement a quarterly Funds Held by Reinsurer reconciliation process which properly reclassifies and reports Reinsurance Payable on Paid Losses, in accordance with NAIC Annual Statement Instructions – Property & Casualty and SSAP 62 (20). In addition, it was noted that the general ledger currently does not provide for accounts to reflect various reinsurance accounting reclassifications. It is recommended that the company establish general ledger account controls for all reinsurance payable and receivable reporting requirements to correspond to applicable annual statement line items. Reserving Methodology In 2005, the company switched from the use of American United Life Insurance Company to Meyer Disability Consulting for reserve calculation methodology reviews, based on the run-off of its relationship with AUL. Meyer Disability Consulting was also engaged by NICW to review the Lafayette Life reserving practices, which contributed to the underwriting loss on assumed business in 2004. It is envisioned that the Meyer Disability Consulting reserve methodology will provide a more consistent reserving approach for all assumed business going forward, as previously discussed under the “Reconciliation and Analysis of Surplus” section of this report. No formal contractual relationship with Meyer Disability Consulting currently exists. In addition, management comments noted that NICW Underwriting Guidelines provided during the examination, although similar, do not completely reflect the updated rate factors under the newer Meyer Disability Consulting methodology. It is recommended that a contract between NICW and Meyer Disability Consulting be consummated to formally establish the contract responsibilities of both parties, cost of services and confidentiality provisions. It is also recommended that the NICW Underwriting Guidelines be periodically reviewed and updated to reflect newer actuarial consulting reserving methodology and rate factor considerations to provide consistent and complete underwriting documentation. LAE Reserves The company’s Loss Adjustment Expense (LAE) reserving methodology is based on actuarial consultant factors established in 1989. In addition, all LAE reserves are allocated to 36 Defense and Cost Containment. No allocation is reported for Adjusting & Other Expense, although the Actuarial Opinion did include a provision. It is recommended that the company establish procedures for periodic review and assessment of LAE reserving methodology for current applicability to support ongoing reserving practices, in accordance with ss. 623.04 and 601.42, Wis. Stat. It is also recommended that the company establish LAE reserve allocations for both Defense & Cost Containment as well as Adjusting & Other Expense, in accordance with SSAP 55. IBNR Reserves The company’s IBNR reserving methodology is based on factors established in 1996, which is reflective of the methodology used by its predecessor reinsurer relationship with American United Life Insurance Company. This IBNR reserving methodology is based on a formula (1.10 multiplied by the last three months’ premium). It is recommended that the company establish procedures for periodic review and assessment of IBNR reserving methodology for current applicability to support ongoing reserving practices, in accordance with ss. 623.04 and 601.42, Wis. Stat. Cash Disbursement Controls Cash disbursement controls have been formalized in accordance with prior examination recommendations, including identification of authorized officer signatures on behalf of NICW on all accounts, wire transfer authorizations and check amount limits for establishing dual signature requirements. General Operating Account disbursement controls allow facsimile signature for amounts under $2,500 with provision for actual signature of one authorized individual for disbursement amounts over $2,500. However, examination results indicated that internal practices typically allow Operating Account disbursement exceptions for larger regular intercompany or reinsurance transactions (amounts over $100,000 observed), requiring only one facsimile signature. Claim Account disbursements utilize an electronic check signature with requirements for an actual second signature on amounts greater than $10,000. However, claim check testing 37 noted no checks over $10,000 and indicated that claim disbursements over $10,000 are extremely limited. It is recommended that the company’s check disbursement authorization threshold limits be reviewed and strengthened to provide for more realistic and effective dual control signature requirements, as it relates to both General Operating Account expenses as well as Claim Account benefit disbursements. Investment / Subsidiary System Recordkeeping NICW procedures review noted an informal guideline exists for accounting record retention of seven years. The company utilizes the EPS Investment System for investment subsidiary system recordkeeping. EPS Investment System summary reports were not maintained for year-end 2005. System limitations prevent recreation of reporting as of a specified prior date. Accordingly, the examination was unable to trace investment confirmations and statements to the company’s supporting investment system. It is recommended that the company review and establish formal retention schedules for major applications to ensure significant application system report trails are retained in either electronic or hardcopy format for both company and examination reference, in accordance with s. Ins 6.80, Wis. Adm. Code. Schedule D Reporting The company’s Schedule D reporting of investments owned uses settlement versus trade date for recording date of acquisition. It is recommended that the company record security acquisitions as of trade date, in accordance with SSAP 26. SVO Security Filing Company procedures for controlling “provisionally exempt” security filing under NAIC requirements were developed in accordance with prior examination recommendations. However, NAIC requirements converted the “provisionally exempt” security to “filing exempt” securities as of January 1, 2004. Current exemptions are now based on only one rating requirement by a nationally recognized statistical rating organization. In addition, the examination noted the company responded “no” to the General Interrogatory related to compliance with NAIC securities filing, but reported no exceptions, apparently due to system problems experienced with the NAIC. 38 It is recommended that the company update its security filing procedures to reflect recent NAIC Security Valuation Office (SVO) filing requirement changes from “provisionally exempt” to “filing exempt” securities, as set forth in the Purposes & Procedures Manual of NAIC – Securities Valuation Office. It is also recommended that the Annual Statement General Interrogatory related to SVO filing compliance requirements be properly completed along with the resolution of any associated SVO filing or reporting problems contributing to proper completion. Callable Bonds The Annual Statement Schedule D reporting of all callable bonds did not correspond with company classifications. Approximately 50% of the callable bonds were not properly classified on Schedule D. The reporting problem was attributed by company management to its internal software system’s method of identifying callable bonds, which apparently impacts proper reporting of bonds previously set up on the system. It is recommended that the company review its internal system entry and reporting procedures to ensure proper Schedule D reporting of all callable bonds, in accordance with NAIC Annual Statement Instructions – Property & Casualty. Disaster Recovery Plan The company’s Disaster Recovery Plan Manual primarily provides for general evacuation, management team responsibilities and personnel contact lists. The prior examination suggested Disaster Recovery Plan enhancement to incorporate documentation of manual procedures performed by functional departments, hardware priorities and critical external contact lists. Company comments indicate that updates have been primarily related to personnel contact updates. Disaster Plan Supplements were noted to include external contact lists and various claim and billing procedures with no specific organization. Major in-process system application development planned in 2006-07 in the premium and claims areas will most likely create major new system changes impacting functional procedures and recovery issues. It is recommended that the company continue ongoing Disaster Recovery Plan enhancement to provide for an adequate plan for recovery in conjunction with new, in-process system application development. This should include consolidation of backup data pertaining to: • • Backup site scenarios Network system requirements 39 • • • • • System recovery priorities System recovery processing requirements by application as it relates to master, transaction and history files Major functional department procedures System backup cycle Periodic test plans Information Technology (IT) Password Security Both the company’s network system architecture and its primary application system have inadequate password and change control provisions. It is recommended that the company’s network and application password control security be strengthened to reduce the potential for security compromise by incorporating requirements for (a) minimum password length of five characters, (b) periodic password change controls and (c) restriction of password reuse. IT File Retention / Backup Security The company maintains its backup data files on-site in locked containers which are not fireproof or waterproof until the files are rotated to off-site storage on a weekly basis. It is recommended that the company provide backup file protection against loss due to catastrophic events through implementation of daily file rotation to off-site storage or improved physical storage controls over backup files retained on-site. IT Computer Room Access The computer room access is controlled by a passcode which is not periodically changed. It is recommended that the company implement periodic computer room password change controls to minimize potential compromise of physical access security. 40 VIII. CONCLUSION National Insurance Company of Wisconsin, Inc., reported admitted assets of $35,988,734, liabilities of $22,750,568 and surplus of $13,238,166 as of December 31, 2005. The company’s growth is primarily attributed to its assumed reinsurance program which accounted for 81% of net premium in 2005. This assumed reinsurance program reflects the company’s overall role in supporting its affiliated agency, National Insurance Services of Wisconsin, Inc., in maintaining relationships with other primary carriers through a demonstrated commitment to share in the business risk through assumption of a portion of the business written. The assumed reinsurance program results in a large Funds Held by Reinsurer balance of $18.6 million, representing approximately 50% of admitted assets, which is offset by a corresponding liability for the proportionate share of loss reserves held by the reinsurer. The company has experienced positive net income growth in all years under examination except for 2004. The net loss in 2004 was attributed to higher loss ratios experienced in assumed business, particularly with respect to the Lafayette Life block of business. The company subsequently hired a consulting actuary and concluded that reserving practices were excessively conservative, particularly as it relates to the reserving model for state offset assumptions associated with group health and disability claim benefits. Subsequent adoption of the consulting actuary model practices has resulted in a downward reserve adjustment by Lafayette Life of approximately $400,000 in 2006. Going forward, it is anticipated that the consulting actuary model will be more consistently used for all assumed business. The current examination’s major financial recommendation relates to proper annual statement classification and reporting of Funds Held by Reinsurers on a gross versus net basis, with recognition of Reinsurance Payable on Paid Losses and Loss Adjustment Expenses. The other recommendations relate to control procedure improvements associated with: • • • • • • By-law compliance with shareholder and board of director meeting provisions Affiliated party recognition and transaction reporting consistency Loss reserving contractual and methodology documentation Cash disbursement control enhancement Investment reporting consistency in accordance with annual statement requirements IT system access security, file retention and disaster recovery plan enhancement 41 IX. SUMMARY OF COMMENTS AND RECOMMENDATIONS 1. Page 30 - Shareholder / Board of Director Meetings—It is recommended that the company amend its by-laws to conform to the desired shareholder and board of director meeting practices and policies, in accordance with s. 180.0701, Wis. Stat., and s. 180.0822, Wis. Stat., respectively. Page 31 - Board of Director Minutes—It is recommended that the minutes of the board of directors provide a more meaningful record of planning oriented programs and objectives by incorporation of NICW specific programs and goals or NIS project specific impacts on NICW business, consistent with the recent Strategic Planning Committee disassociation from NICW due to its NIS affiliate program focus. Page 31 - Executive Compensation Reporting—It is recommended that the Report on Executive Compensation be completed properly in accordance with s. 611.63, Wis. Stat., by: (a) reporting all direct and indirect remuneration for services, (b) inclusion of all executive officers including those paid by affiliates under the current elected option to report total gross compensation by or on behalf of all companies, based on the common affiliate relationships discussed further under “Affiliated Parties” or (c) company election of the option to report based on allocation to each insurer. Page 31 - Schedule Y Reporting—It is recommended that shareholder dividends be reported on Schedule Y, Part 2, Summary of Insurer’s Transactions with Affiliates, in accordance with NAIC Annual Statement Instructions – Property & Casualty. Page 32 - Management Bonus Program—It is recommended that the executive management bonus program formula also be reviewed and formally approved by the board of directors to demonstrate board oversight of the reasonableness of bonus components and methodology. Page 32 - Conflict of Interest—It is suggested that management may want to consider future external board membership expansion in conjunction with the growing concerns for control independence being driven by Sarbanes-Oxley initiatives, given the closely held nature of the current membership. Page 34 - Affiliated Parties—It is recommended that future NICW annual statement reporting recognize NIS as an affiliate based on the common ownership and management as well as company interdependence by inclusion of all key officers on the Jurat page and Report on Executive Compensation, as applicable. Page 36 - Reinsurance Accounting and Reporting—It is recommended that the company implement a quarterly Funds Held by Reinsurer reconciliation process which properly reclassifies and reports Reinsurance Payable on Paid Losses, in accordance with NAIC Annual Statement Instructions – Property & Casualty and SSAP 62 (20). Page 36 - Reinsurance Accounting and Reporting—It is recommended that the company establish general ledger account controls for all reinsurance payable and receivable reporting requirements to correspond to applicable annual statement line items. 2. 3. 4. 5. 6. 7. 8. 9. 42 10. Page 36 - Reserving Methodology—It is recommended that a contract between NICW and Meyer Disability Consulting be consummated to formally establish the contract responsibilities of both parties, cost of services and confidentiality provisions. Page 36 - Reserving Methodology—It is also recommended that the NICW Underwriting Guidelines be periodically reviewed and updated to reflect newer actuarial consulting reserving methodology and rate factor considerations to provide consistent and complete underwriting documentation. Page 37 - LAE Reserves—It is recommended that the company establish procedures for periodic review and assessment of LAE reserving methodology for current applicability to support ongoing reserving practices, in accordance with ss. 623.04 and 601.42, Wis. Stat. Page 37 - LAE Reserves—It is also recommended that the company establish LAE reserve allocations for both Defense & Cost Containment as well as Adjusting & Other Expense, in accordance with SSAP 55.. Page 37 - IBNR Reserves—It is recommended that the company establish procedures for periodic review and assessment of IBNR reserving methodology for current applicability to support ongoing reserving practices, in accordance with ss. 623.04 and 601.42, Wis. Stat. Page 38 - Cash Disbursement Controls—It is recommended that the company’s check disbursement authorization threshold limits be reviewed and strengthened to provide for more realistic and effective dual control signature requirements, as it relates to both General Operating Account expenses as well as Claim Account benefit disbursements. Page 38 - Investment / Subsidiary System Recordkeeping—It is recommended that the company review and establish formal retention schedules for major applications to ensure significant application system report trails are retained in either electronic or hardcopy format for both company and examination reference, in accordance with s. Ins 6.80, Wis. Adm. Code. Page 38 - Schedule D Reporting—It is recommended that the company record security acquisitions as of trade date, in accordance with SSAP 26. Page 39 - SVO Security Filing—It is recommended that the company update its security filing procedures to reflect recent NAIC Security Valuation Office (SVO) filing requirement changes from “provisionally exempt” to “filing exempt” securities, as set forth in the Purposes & Procedures Manual of NAIC – Securities Valuation Office. Page 39 - SVO Security Filing—It is also recommended that the Annual Statement General Interrogatory related to SVO filing compliance requirements be properly completed along with the resolution of any associated SVO filing or reporting problems contributing to proper completion. Page 39 - Callable Bonds—It is recommended that the company review its internal system entry and reporting procedures to ensure proper Schedule D reporting of all callable bonds, in accordance with NAIC Annual Statement Instructions – Property & Casualty. 11. 12. 13 14. 15. 16. 17. 18. 19. 20. 43 21. Page 39 - Disaster Recovery Plan—It is recommended that the company continue ongoing Disaster Recovery Plan enhancement to provide for an adequate plan for recovery in conjunction with new, in-process system application development. Page 40 - IT Password Security—It is recommended that the company’s network and application password control security be strengthened to reduce the potential for security compromise by incorporating requirements for (a) minimum password length of five characters, (b) periodic password change controls and (c) restriction of password reuse. Page 40 - IT File Retention / Backup Security—It is recommended that the company provide backup file protection against loss due to catastrophic events through implementation of daily file rotation to off-site storage or improved physical storage controls over backup files retained on-site. Page 40 - IT Computer Room Access—It is recommended that the company implement periodic computer room password change controls to minimize potential compromise of physical access security. 22. 23. 24. 44 X. ACKNOWLEDGMENT The courtesy and cooperation extended during the course of the examination by the officers and employees of the company are acknowledged. In addition to the undersigned, the following representatives of the Office of the Commissioner of Insurance, State of Wisconsin, participated in the examination: Name Richard Anderson Angelita Romaker Jerry DeArmond Randy Milquet Title Insurance Financial Examiner Insurance Financial Examiner Insurance Financial Examiner – Advanced Insurance Financial Examiner – Advanced Respectfully submitted, Tom M. Janke Examiner-in-Charge 45