Fundamentals of Insurance Company Financial Analysis
The ability of any insurance company to meet its policy obligations is the foundation of the industry. Absent the trust of
policyholders in the financial integrity of any insurer and the industry as a whole, this risk transfer mechanism/industry
would collapse. This truth is even more acute in the E&S industry where no guaranty funds exist, except New Jersey.
Duty of the Excess Line Broker
In New York, the excess line broker has a non-delegable duty to use “due care” in the selection of a financially secure
excess line insurer. Some brokers are under the mistaken impression that the vetting by ELANY which establishes which
insurers meet the minimum qualifications to be an eligible excess line insurer, relieves the excess line broker from its duty
to use due care and insulates them from liability for claims should an eligible insurer subsequently become insolvent.
THIS IS NOT THE CASE!
A number of other state insurance departments publish a “white list”; New York does not. A white list state provides an
excess/surplus lines broker the imprimatur or stamp of approval of the insurance department. In New York, the ultimate
decision, the ultimate responsibility belongs to the excess line broker.
What Every Excess Line Broker Should Know
You can rely on ELANY’s review of an insurer’s financial condition as one spoke in the wheel of your effort to use “due
care” in the selection of an excess line insurer. You should also be aware of an insurer’s rating or ratings by independent
rating agencies, how they evaluate the carrier, the financial size of the carrier, the book of business it writes, where
applicable, and its reinsurers.
Most of this information is available in ELANY’s financial library which is maintained for your use. Under Regulation 41,
you do not have to maintain financial statements and records on each insurer, as you were required to do prior to
ELANY’s formation because ELANY now does that for you.
Set forth below are a number of significant financial stress or analytical tests used by ELANY’s financial analysis staff,
led by Richard Schlesinger, and by the various rating agencies. For your own protection, you should be or become familiar
with these tests.
Perhaps, even more importantly, you need to recognize that the financial condition and strength of any given company is a
forever moving target. This is why ELANY’s evaluations are ongoing and continuous.
Finally, it is relatively easy to accept as financially secure, large insurers with consistently high ratings from multiple
rating agencies. What you should also understand, is the relative liability exposure to you in placing risks with any insurer
which is suffering significant or multiple step downgrades by rating agencies. Your ultimate exposure greatly increases
under such circumstances. While the company may remain on ELANY’s list for some period of time after a significant
downgrade, this only means that the company appears to continue to meet the “minimum requirements” and that ELANY
is offering due process to the insurer to provide substantial information including its plan of action in regard to its current
financial troubles. Continuing to place business with a company in financial trouble simply because it has not yet been
removed from ELANY’s list, is clearly the wrong decision.
ELANY can help you by providing information based upon financial analysis and stress tests results calculated by
The following are some of the tools used by ELANY’s staff in analyzing the financial strength of insurance companies
currently eligible to write excess lines business in New York or of those who are seeking eligibility.
NET WORTH/POLICYHOLDERS SURPLUS.
The most fundamental concept of financial analysis is the amount by which a company’s assets exceed its liabilities which
is known as net worth for most companies and known as policyholders surplus for insurance companies. Net worth or
policyholders surplus is the asset cushion which an insurance company maintains to protect itself, its policyholders and its
shareholders against an adverse development of losses and/or other adverse conditions. To be an eligible excess line
insurer in New York you must have a minimum of $15,000,000 of policyholders surplus. The average US domiciled New
York eligible company currently has over $80,000,000 of policyholders surplus and that is after eliminating any insurer
with more than a billion dollars of surplus from the calculation to prevent the numbers from being skewed.
The quality of an insurance company’s assets and the return on investments that the assets generate are looked at very
closely. Most U.S. based insurance companies invest conservatively in treasury securities and other highly rated corporate,
municipal, state or other bonds. Many companies have some equity investments but they usually are not substantial in
comparison to the whole asset base. Insurers which have inordinate amounts of capital invested in real estate, non-
investment grade securities, equities and/or other illiquid assets are companies with signs of trouble.
On the asset side of the balance sheet, ultimately a company is looking to continuously increase not only its assets but its
income producing assets for an overall increase in return on its portfolio of investments. If a company is not increasing its
invested assets, this can be a red flag for financial problems. ELANY also verifies that each insurer is sufficiently liquid,
that it can liquidate invested assets to meet all potential current liabilities and claims.
Most insurers have large assets in two categories which provide no return on investment to the insurance companies.
Those assets are reinsurance recoverables and agents balances.
An insurer’s financial security in part, depends on the quantity of reinsurance recoverables and quality, from a financial
security standpoint, of the reinsurers providing the reinsurance coverage. ELANY looks upon recoverables from reinsurers
rated below the “A” category as potentially uncollectible by the reinsured. Insurers which cede a large percentage of their
risk to reinsurers leave themselves vulnerable to disputes or collection problems with some of their reinsurers. While these
reinsureds often reply that their reinsurance recoverables are secured to the extent of funds held in trust or letters of credit,
those collateral vehicles do not adequately provide for adverse loss development. When a company’s reinsurance
recoverables far exceed its surplus, the company is vulnerable to financial problems if a reinsurer becomes insolvent or if
a substantial recoverable ends up in dispute.
Similarly, with agent’s balances, an insurer needs to be able to ultimately convert such balances to cash in order to timely
realize them as a liquid asset.
The loss ratio is a measure of an insurer’s success in pricing its product. The pure loss ratio is the cost attributable to
losses incurred and allocated loss adjustment expenses, such as costs of investigating losses, claims adjusters and attorneys
involved in the process. The pure loss ratio, while easily calculated to premiums earned, is only an estimate and is subject
to future adjustment based on actual payments and reserve increases versus the original estimated future payments. Most
insurers are subject to the requirement that an actuary issue an opinion as to the validity of the loss reserve estimates
however the actuarial opinion provides a range of valid reserve estimates which gives the insurer latitude in finalizing its
ELANY analyzes the “loss development” for each insurer. Losses take several years to materialize, especially on long tail
business. As part of the Annual Statement filing with the insurance department, insurers are required to provide a
“Schedule P” which compares accident year paid and unpaid losses over a 10-year period to determine if the original
reserves developed favorably or unfavorably. If loss reserves were underestimated at the original date, they will develop
unfavorably. If reserves were adequate or redundant, they will develop favorably.
Over the long haul however, when losses continue to develop adversely, the insurer will be forced to re-estimate its
ultimate losses in order to obtain an unqualified actuarial certification. When insurers have to substantially increase their
reserves it often adversely affects the insurers’ financial strength ratings and potentially its stock price if the company’s
stock is publicly traded.
Another important concept related to loss estimates and loss development is the concept of leverage. Reserves are
indicative of debts that are owed by the insurance company. If the reserves are inadequate and ultimately develop
adversely, a company’s surplus is dimished by a like amount. For example, assume an insurance company has
$20,000,000 in policyholders surplus and $10,000,000 of net loss reserves. If this insurance company was 50% under-
reserved, and the reserves were increased by another $5,000,000, the insurer would still be solvent, however its surplus
would be reduced to $15,000,000. If, on the other hand, an insurer with $20,000,000 in policyholders surplus and
$100,000,000 of net loss reserves, the company would become insolvent if it was under-reserved by 20%, as its surplus
would be depleted.
On the expense side of the income statement, ELANY looks first to the operating costs and expenses - or what is known
as the expense ratio. Generally speaking, ELANY verifies that the expense ratio consisting of the expenses of acquiring
the business, commissions, underwriting costs, staff salaries, rent and general overhead costs of operating the insurer are
within the industry norms for the types of business, classes of insurance and methods of distribution by that particular
insurer. The typical range for expense ratios is between 28% and 36% of the net premiums written in any given year.
According to A.M. Best’s 2002 Aggregates and Averages, the expense ratio for predominant surplus line insurers over the
past 10 years has averaged between 32% and 33%. This number will increase significantly if a company has cutback
substantially on its written premiums.
An area of particular importance is a company’s profitability. We look to see if a company is generating profits through
its underwriting activities or its investment portfolio. A number of companies have been profitable these past several
years as a result of capital gains. The volatility in the equity market and the lower interest rate environment are forcing
companies to adequately price their product to generate an underwriting profit.
Simply stated, cash flow is the net position of the insurer comparing losses and expenses paid to premiums received and
return on invested cash assets in any given annual period. It is a red flag when an insurer’s assets and perhaps its
policyholder surplus are growing but, where the income producing assets have either not increased or even in fact have
HOLDING COMPANY STRUCTURE
The holding company structure of any given insurance company is quite important in ELANY’s financial security review.
If the holding company is publicly traded and has borrowed money in the form of bonds, preferred stock or other debt
instruments, that holding company has to meet its obligations on that borrowed money. This is usually accomplished by
up-streaming dividends from the insurance company subsidiaries’ earnings. This prevents the insurance company from
growing as their earnings are continuously removed by their parent. This also has the adverse effect of increasing leverage
at the insurance company level. While a reasonable amount of debt in the holding company is not troublesome, a company
with a heavy debt structure raises the potential for future financial weakness at both the holding company and the
insurance company subsidiary. The biggest exposure under these circumstances is, should the insurance company have a
bad year, or years, and not generate sufficient income, the holding company will not be able to meet its debt service
requirements. The holding company structures are also analyzed for inter-company transactions which often include
reinsurance pooling arrangements or other types of internal reinsurance arrangements among affiliated companies. Finally,
ELANY looks to determine whether any sweetheart deals are apparent by and among the insurance company, its affiliates,
its parent and/or any of the officers or directors of the company.
The analysis and ratings of any given insurer by A.M. Best, Standard & Poor’s, Moody’s or Fitch’s are reviewed by
ELANY as one component of its analysis. In essence, ELANY uses many of the same tools as these rating agencies in
analyzing the financial condition of our eligible insurance companies. The vast majority of insurers that are eligible excess
line insurers in New York are rated in the secure range by either A.M. Best or Standard & Poor’s. Excess line brokers can
take some comfort in that but should not rely exclusively on a rating agency to determine the future viability of any given
insurer. More importantly, should an insurance market you are currently using receive a one notch downgrade by a rating
agency, this should not be considered fatal to the insurer if the rating downgrade nevertheless, leaves the insurer in the
secure range. However, when insurers suffer multiple level downgrades or multiple downgrades in a short period of time,
it is very important to understand the reasons for the downgrade(s). Also, when an insurer moves from a secure rating to a
vulnerable rating level, the excess line broker has to consider whether it is appropriate to continue to do business with that
carrier. Since the excess line broker has a duty to use due care in the selection of each insurer from whom it procures
insurance, it is appropriate to ask yourself on what basis can I say I used due care in selecting this given insurance
company especially in light of a recent history of downgrades.
ELANY analyzes each insurer based on certain industry ratios such as the IRIS tests, BCAR Ratio, Risk Based Capital
Ratio, as well as the books of business written by the carrier and the production force producing the majority of the
business to each carrier. Setting forth each analytical tool is beyond the scope of this paper but the ELANY staff and
resources are available to each excess line broker as one of the numerous methods available by which an excess line
broker can meet its due care selection process.
The Compliance Advisor Disclaimer
The Compliance Advisor is a publication of the Excess Line Association of N.Y. This publication brings to the insurance marketplace, issues of interest involving
regulation and compliance which affect your business.
This Advisor is not intended to be nor should it be construed as legal advice. These guidelines are provided for your consideration and for use in consultation with
your legal counsel.