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Risk-Focused Financial AnalysisRisk-Focused Financial Analysis

David A Vacca, CPADavid A Vacca, CPAInsurance Analysis & Information ServicesInsurance Analysis & Information Services

NAIC Regulatory Services DivisionNAIC Regulatory Services Division

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Presentation OverviewPresentation Overview

Risk-Focused Financial Analysis OverviewRisk-Focused Financial Analysis Overview Typical Duties of Financial AnalystsTypical Duties of Financial Analysts Priority Based ReviewsPriority Based Reviews Use of the NAIC Financial Analysis Use of the NAIC Financial Analysis

HandbookHandbook Financial Analysis Working Group Financial Analysis Working Group

(FAWG)(FAWG)

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Risk-Focused Financial Analysis Risk-Focused Financial Analysis OverviewOverview

Regulators have enhanced their solvency monitoring Regulators have enhanced their solvency monitoring activities to facilitate more timely regulatory action activities to facilitate more timely regulatory action against troubled insurers against troubled insurers

Financial analysis occurs Financial analysis occurs everyevery quarter on all multi- quarter on all multi-state insurers within each statestate insurers within each state

States prioritize the review of their domiciliary States prioritize the review of their domiciliary companies to ensure potentially troubled companies companies to ensure potentially troubled companies are reviewed promptlyare reviewed promptly

Most states also perform some analysis on non-Most states also perform some analysis on non-domestic insurers operating within their statedomestic insurers operating within their state

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Risk-Focused Financial Analysis Risk-Focused Financial Analysis OverviewOverview

Depth of the analysis will depend on the complexity Depth of the analysis will depend on the complexity and the financial strength of the insurer and the and the financial strength of the insurer and the existing or potential issues and problems found during existing or potential issues and problems found during review of the financial statementsreview of the financial statements

At a minimum the following must be analyzed:At a minimum the following must be analyzed:– Annual and quarterly financial statementsAnnual and quarterly financial statements– Actuarial opinionActuarial opinion– Management’s discussion and analysisManagement’s discussion and analysis– Audited CPA reportAudited CPA report– Holding company filingsHolding company filings– Financial ratiosFinancial ratios

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Risk-Focused Financial Analysis Risk-Focused Financial Analysis OverviewOverview

Group holding company analysis is a standard part Group holding company analysis is a standard part of the financial analysis process as outlined in the of the financial analysis process as outlined in the NAIC’s Financial Analysis HandbookNAIC’s Financial Analysis Handbook– Includes reviewing the upstream and Includes reviewing the upstream and

downstream holding company entities (both downstream holding company entities (both financial or non-financial entities)financial or non-financial entities)

– Understanding the structure, affiliated Understanding the structure, affiliated relationships, financial condition, management, relationships, financial condition, management, etc.etc.

– Utilizing public available information, such as Utilizing public available information, such as SEC filings, international filings, and/or SEC filings, international filings, and/or requested informationrequested information

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Risk-Focused Financial Analysis Risk-Focused Financial Analysis OverviewOverview

Lead State ConceptLead State ConceptThe concept of a lead state is used to help states coordinate The concept of a lead state is used to help states coordinate regulatory activities in their review of insurance groupsregulatory activities in their review of insurance groupsThe concept of a lead state is not intended to relinquish the The concept of a lead state is not intended to relinquish the authority of any state, nor is it intended to increase any state’s authority of any state, nor is it intended to increase any state’s statutory authority or to put any state at a disadvantage statutory authority or to put any state at a disadvantage It is intended to facilitate efficiencies when one or more states It is intended to facilitate efficiencies when one or more states coordinate the regulatory processes of all states involvedcoordinate the regulatory processes of all states involved

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Typical Duties of Financial AnalystsTypical Duties of Financial Analysts

Analysis of insurer and group financial and non-Analysis of insurer and group financial and non-financial informationfinancial information

Desk audits to assess prospective risks and Desk audits to assess prospective risks and compliancecompliance

Review of specific insurer material transactions (e.g. Review of specific insurer material transactions (e.g. acquisition, reinsurance, investment, dividends, etc.)acquisition, reinsurance, investment, dividends, etc.)

Determining regulatory courses of action regarding Determining regulatory courses of action regarding identified troubled insurance companiesidentified troubled insurance companies

Evaluating and monitoring corrective plansEvaluating and monitoring corrective plans Communicating results of regulatory actionsCommunicating results of regulatory actions Licensing and admissionsLicensing and admissions

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Typical Duties of Financial AnalystsTypical Duties of Financial Analysts

Understanding the insurance industryUnderstanding the insurance industry Understanding historical causes of insolvencyUnderstanding historical causes of insolvency Develop early warning systems, analytical tools and Develop early warning systems, analytical tools and

benchmarksbenchmarks Communicate with other regulators on an on-going Communicate with other regulators on an on-going

basisbasis Meet regularly with managementMeet regularly with management Researching issues, industry topics, etc.Researching issues, industry topics, etc. Following-up on exam findingsFollowing-up on exam findings

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Typical Duties of Financial AnalystsTypical Duties of Financial Analysts

ExaminerExaminer– Identifies risk by Identifies risk by

reviewing business reviewing business processesprocesses

– Utilizes control & Utilizes control & detail tests to detail tests to identify solvency identify solvency concerns and concerns and findingsfindings

AnalystAnalyst– Identifies risk by Identifies risk by

reviewing reported reviewing reported financial resultsfinancial results

– Utilizes analytical Utilizes analytical review, (ratio analysis, review, (ratio analysis, benchmarking, inquiry) benchmarking, inquiry) to identify solvency to identify solvency concerns and concerns and compliancecompliance

On-site and Off-site solvency monitoring involve roles and skill-sets that are different, but complement each other:

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Typical Duties of Financial AnalystsTypical Duties of Financial Analysts

Example: InvestmentsExample: Investments

Off-site analysis can monitor balance and composition of Off-site analysis can monitor balance and composition of portfolio, benchmark the company’s investments against portfolio, benchmark the company’s investments against competitors and gather information from the insurer to explain competitors and gather information from the insurer to explain significant changessignificant changes

On-site examination can evaluate the process in place at the On-site examination can evaluate the process in place at the insurer to monitor investment performance and reporting by insurer to monitor investment performance and reporting by testing the underlying transactions, reviewing reconciliations, testing the underlying transactions, reviewing reconciliations, obtaining confirmations, etc.obtaining confirmations, etc.

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Priority-Based ReviewPriority-Based Review

Financial analysis procedures are priority based to Financial analysis procedures are priority based to ensure that potential problem companies are ensure that potential problem companies are reviewed first and promptlyreviewed first and promptly

State prioritization schemes utilize appropriate factors State prioritization schemes utilize appropriate factors as guidelines to assist in the consistent determination as guidelines to assist in the consistent determination of priority designationsof priority designations

Justification for priority and any change in priority is Justification for priority and any change in priority is documented each quarterdocumented each quarter

Change in priority ranking should be approved by the Change in priority ranking should be approved by the appropriate supervisorappropriate supervisor

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Priority-Based ReviewPriority-Based Review

Timing of AnalysisTiming of AnalysisAssuming a March 1Assuming a March 1stst financial statement deadline, financial statement deadline, priority insurers should have their annual review priority insurers should have their annual review performed by the end of April and the non-priority performed by the end of April and the non-priority insurers completed by the end of Juneinsurers completed by the end of June

The date by which the Department should finish its The date by which the Department should finish its analysis of the annual statements depends in part upon analysis of the annual statements depends in part upon the size and complexity of the domestic industrythe size and complexity of the domestic industry

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Use of the NAIC Use of the NAIC Financial Analysis HandbookFinancial Analysis Handbook

All states utilize the HandbookAll states utilize the Handbook Purpose is to assist regulators in Purpose is to assist regulators in

performing risk- focused financial performing risk- focused financial analysis of insurance companies in a analysis of insurance companies in a consistent and uniform mannerconsistent and uniform manner

Provides a uniform means for qualitative Provides a uniform means for qualitative and quantitative analysis techniquesand quantitative analysis techniques

Prompts the analyst to conduct more in-Prompts the analyst to conduct more in-depth analysis based upon risk factorsdepth analysis based upon risk factors

Includes automated calculations for Includes automated calculations for quantitative questions to increase quantitative questions to increase efficiencyefficiency

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Use of the NAIC Use of the NAIC Financial Analysis HandbookFinancial Analysis Handbook

Developed by the Financial Analysis Handbook Developed by the Financial Analysis Handbook Working Group (FAHWG)Working Group (FAHWG)

Property and Life - Pilot Programs - 1995 and Property and Life - Pilot Programs - 1995 and 19961996

Property and Life - Annual Release - February Property and Life - Annual Release - February 19971997

Life and Property - Quarterly Release - May 1998Life and Property - Quarterly Release - May 1998 Health – Developed by the Health Entities Health – Developed by the Health Entities

Working Group and Adopted in 2003Working Group and Adopted in 2003 Updated every year Updated every year

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Use of the NAIC Use of the NAIC Financial Analysis HandbookFinancial Analysis Handbook

Financial Analysis Framework Financial Analysis Framework Analyst Reference Guide Analyst Reference Guide

– Level 1, 2, and Supplemental Level 1, 2, and Supplemental Annual Procedures Annual Procedures

– Level 1 and 2 Level 1 and 2 Supplemental ProceduresSupplemental Procedures Quarterly Level 1 & 2 ProceduresQuarterly Level 1 & 2 Procedures Guidance for Notes to Financial StatementsGuidance for Notes to Financial Statements

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Use of the NAIC Use of the NAIC Financial Analysis HandbookFinancial Analysis Handbook

Analyst Reference GuideAnalyst Reference GuideBackground information, if neededBackground information, if neededOverview of the topicOverview of the topicDetailed discussion of the procedures Detailed discussion of the procedures included in the checklistsincluded in the checklistsBibliography of additional reference Bibliography of additional reference sourcessources

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Use of the NAIC Use of the NAIC Financial Analysis HandbookFinancial Analysis Handbook

Level 1 ProceduresLevel 1 ProceduresConsists of an overall analysis of the insurer and its Consists of an overall analysis of the insurer and its operationsoperationsAt the conclusion of the Level 1, the analyst must At the conclusion of the Level 1, the analyst must determine whether the extent and areas, if any, for determine whether the extent and areas, if any, for which Level 2 procedures may be necessarywhich Level 2 procedures may be necessary

– Are there any prospective risks, unresolved risks Are there any prospective risks, unresolved risks or sophisticated activity as a result of the or sophisticated activity as a result of the completion of the Level 1?completion of the Level 1?

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Use of the NAIC Use of the NAIC Financial Analysis HandbookFinancial Analysis Handbook

Level 1 ProceduresLevel 1 ProceduresBackground AnalysisBackground Analysis

–Last priority designation, inter-department communication, Last priority designation, inter-department communication, regulatory actions, NRSRO rating,regulatory actions, NRSRO rating,

Management AssessmentManagement Assessment–Shift in management or philosophyShift in management or philosophy

Balance Sheet AssessmentBalance Sheet AssessmentOperations AssessmentOperations AssessmentInvestment PracticesInvestment PracticesReview of DisclosuresReview of Disclosures

–Omission of Notes, General Interrogatories, etc.Omission of Notes, General Interrogatories, etc.Assessment of Latest Examination Report and ResultsAssessment of Latest Examination Report and Results

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Use of the NAIC Use of the NAIC Financial Analysis HandbookFinancial Analysis Handbook

Level 1 Procedures - ContinuedLevel 1 Procedures - ContinuedAssessment of Results from Prioritization and Analytical Assessment of Results from Prioritization and Analytical ToolsToolsAssessment of Supplemental FilingsAssessment of Supplemental FilingsRecommendation for Further AnalysisRecommendation for Further AnalysisSummary and ConclusionSummary and Conclusion

–Conclude after completion of all Level 1, 2s and Conclude after completion of all Level 1, 2s and Supplemental procedures, if applicableSupplemental procedures, if applicable

CorrespondenceCorrespondence–Documentation of any follow-upDocumentation of any follow-up

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Use of the NAIC Use of the NAIC Financial Analysis HandbookFinancial Analysis Handbook

Level 2 ProceduresLevel 2 ProceduresIn-depth analysis focused on key areas of risk In-depth analysis focused on key areas of risk Procedures are quantitative (bench-mark oriented) and Procedures are quantitative (bench-mark oriented) and qualitativequalitative

– InvestmentsInvestments

– Unpaid Losses and LAEUnpaid Losses and LAE

– Income Statement and SurplusIncome Statement and Surplus

– Risk-Based CapitalRisk-Based Capital

– Cash Flow & LiquidityCash Flow & Liquidity

– ReinsuranceReinsurance

– Affiliated TransactionsAffiliated Transactions

– MGAs & TPAsMGAs & TPAs

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Use of the NAIC Use of the NAIC Financial Analysis HandbookFinancial Analysis Handbook

Supplemental ProceduresSupplemental ProceduresManagement ConsiderationsManagement ConsiderationsAudited Financial ReportAudited Financial ReportStatement of Actuarial OpinionStatement of Actuarial OpinionManagement’s Discussion and AnalysisManagement’s Discussion and AnalysisHolding Company AnalysisHolding Company Analysis

– Form A – Statement of Acquisition of Control of or Merger with a Form A – Statement of Acquisition of Control of or Merger with a Domestic InsurerDomestic Insurer

– Form B –Holding Company System Annual Registration StatementForm B –Holding Company System Annual Registration Statement– Form D – Prior Notice of a TransactionForm D – Prior Notice of a Transaction– Form E – Or other required informationForm E – Or other required information– Extraordinary dividend distributionsExtraordinary dividend distributions

Captives and/or Insurers Filing on a US GAAP BasisCaptives and/or Insurers Filing on a US GAAP Basis

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Financial Analysis Working GroupFinancial Analysis Working Group

FAWG MissionFAWG Mission

Identify nationally significant insurers and groups that exhibit characteristics Identify nationally significant insurers and groups that exhibit characteristics

of trending towards or being financially troubled and determine if appropriate of trending towards or being financially troubled and determine if appropriate

action and communication is being takenaction and communication is being taken

Interact with domiciliary regulators and lead states to assist and advise as to Interact with domiciliary regulators and lead states to assist and advise as to

what may be the most appropriate regulatory strategies, methods, and what may be the most appropriate regulatory strategies, methods, and

action(s)action(s)

Encourages, promotes and supports coordinated multi-state efforts in Encourages, promotes and supports coordinated multi-state efforts in

addressing solvency problems, and assists in sharing information between addressing solvency problems, and assists in sharing information between

statesstates

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Financial Analysis Working GroupFinancial Analysis Working Group

For over a decade state insurance financial regulators have For over a decade state insurance financial regulators have shared information and ideas by informal means through the shared information and ideas by informal means through the NAIC Financial Analysis Working Group NAIC Financial Analysis Working Group

This Working Group creates a forum for state insurance This Working Group creates a forum for state insurance regulators to identify, discuss and monitor potentially troubled regulators to identify, discuss and monitor potentially troubled insurers that are of national significance insurers that are of national significance

The Working Group meets on a routine basis with the intent of The Working Group meets on a routine basis with the intent of adding further strength to the states’ financial monitoring adding further strength to the states’ financial monitoring system system

Although the insurers typically identified by the Working Group Although the insurers typically identified by the Working Group have already been identified by the respective states as being have already been identified by the respective states as being potentially troubled, the Working Group enhances the states’ potentially troubled, the Working Group enhances the states’ process by sharing ideas, experience and strategies on how to process by sharing ideas, experience and strategies on how to assist the state of domicile assist the state of domicile

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Questions from AudienceQuestions from Audience