Author: Bill Wilson
Mission. Integrity. Ideal. Excalibur. Universal. Enterprise. Great Global. American Excel. Champion. Adjectives for the Virtual University? Nope...names of companies that used to insure millions of individuals, families and businesses. Perhaps you were affected in some way by these or other insolvencies because you were blind sided when they went belly up. There are proactive steps that you can take today to protect yourself and your clients.
In Part 1, we took a look at some potential E&O exposures and introduced a checklist that you can use as one tool in performing a "diligent" review of carriers. In this concluding part, we'll use that checklist to examine a real carrier that was declared insolvent. What you'll discover is that, with only marginal vigilance, this insolvency could have been "predicted"...at least a year or more prior to the actual insolvency.
(Important Disclaimer: This checklist is a tool for documenting financial and marketing information about property and casualty insurance companies for the purpose of establishing due diligence in the event of errors and omissions claims against agents. It is not a predictor nor guarantor of financial condition, and no warranties, express or implied are made.)
To illustrate the use of this checklist, you'll need to download the financial information below which was excerpted from a 1983 A.M. Best report on an real carrier we'll call the Big Red Insurance Company (in order to protect the innocent, guilty and embarrassed). Big Red was declared insolvent in 1985.
Click here to download the financial exhibit for Big Red
This document includes seven broad categories of A. M. Best information presented as seven exhibits:
1. General Information (Exhibit 1)
2. Assets, Liabilities, Surplus & Other Funds (Exhibit 2)
3. Investment Data (Exhibit 3)
4. Summary of Operations (Exhibit 4)
5. Comparative Financial and Operating Exhibit (Exhibit 5)
6. Underwriting Experience (Exhibit 6)
7. Best's Operating Comments (Exhibit 7)
With reference to this and other data, we'll now evaluate each checklist factor in order to gauge the Big Red's relative potential for financial difficulty. The checklist factors are divided into five major groups: Organizational factors, Capitalization & Growth factors, Cash Flow & Profitability factors, Marketing factors, and Best's Rating factors. We'll review each checklist factor, followed by comments for Big Red as they apply to that factor.
1. Has the company been in business for less than 15 years? Yes. The company was organized in 1978 (see Exhibit 1).
2. Is the company's primary line(s) of insurance private passenger auto, workers comp, or predominantly commercial or E&S/specialty? Yes. Almost 2/3 of premium volume was workers comp and 1/3 other commercial (see Exhibit 6).
3. Have there been any recent atypical ownership/management changes, heavy use of MGA's or delegated authority? Yes. Big Red was purchased by a savings and loan holding company in 1983 and entirely new management accompanied the change in financial control (see Exhibit 1).
4. Have there been any general premium finance company or E&O or umbrella/excess carrier refusals? Unknown (you would have to answer this question, since the information is usually not available from Best).
5. Have there been any known problems with insurance departments or other government agencies? Unknown (some information may be available from Best, but this question may necessitate a call to the rating or examination division of the insurance department).
Capitalization & growth factors
6. Is current policyholders' surplus (PHS) less than $5 million? No, but only for the reason outlined in factor 8 below.
7. Has there been an abnormal decline, or significant fluctuation, in PHS in the last 3-5 years? No, but for the same reason indicated below.
8. Have there been any significant increases in PHS from non-operating revenues in the last 3-5 years? Yes. Exhibits 2 & 4 indicate that surplus would have been significantly depleted without the massive capital contributions made by the new owners in 1983 and 1984.
9. Is the ratio of net premiums written (NPW) to PHS significantly in excess of 2:1? No. Due to reinsurance cedings and capital contributions to surplus, this ratio was maintained at acceptable levels.
10. Have there been increases in premium volume or reinsurance of 25%+, or erratic NPW fluctuations, in the last 3-5 years? Yes. Exhibit 5 indicates fluctuating NPW, with direct writings increases as high as 38%.
Cash flow & profitability factors
11. Have there been any cash flow problems (reflected by slow/low claims payments, unearned premium returns, commissions, etc.)? Unknown (you would have to answer this question, since the information is usually not available from Best).
12. Have any significant combined ratios been abnormally high or increasing in the last 3-5 years? Yes. As shown in Exhibit 5, the overall combined ratio increased in each of the last five years to a level of 111.5%. (Exhibit 6 further indicates by-line pure loss ratios of, for example, 283% for general liability and 973% for auto liability).
13. Has there been any negative operating income or sustained underwriting losses during the last 3-5 years? Yes. Exhibit 5 indicates significantly deteriorating underwriting and bottom-line operating losses over the last five years.
14. Are there any questionable investments (in affiliates, real estate, cash increases, low yields, etc.)? Yes. Using the yields and asset values from Exhibit 2, Big Red's return on investments (ROI) was only about 2%. In addition, the cash component of the investment portfolio increased from 12.2% to 43.6% of assets, accompanied by a reduction in bonds of 32.7% to 12.4% (a concern would be why bonds were cashed and whether the transaction resulted in a gain or loss...Exhibit 4 provides some limited information). Also note that "loans" increased from 0% to 14%.
15. Have there been any major market withdrawals/changes or assumed books of business? Unknown (you would have to answer this question, since the information is usually not available from Best).
16. Has the company (particularly if involuntarily) implemented any significant rate increases or decreases? Yes. Exhibit 7 details the nature of voluntary rate increases, although often this information is not provided by the Best's report.
17. Does the company pay above-average commissions on below-average premiums? Unknown (you would have to answer this question, since the information is usually not available from Best).
18. Does the company's product pricing seem overly competitive for the market and nature of risks? Unknown (you would have to answer this question, since the information is usually not available from Best).
Best's rating factors
19. Is the company's current Best's Rating less than "A-"? Yes. Exhibit 7 indicates that Big Red's rating over the last four years declined from an "A" to an "NA-7" (Below Minimum Standards) to "Deferred" (effectively no rating).
20. Is the company's Best's Rating an NA-3, NA-5, NA-6, NA-7 (now "D"), NA-10 (now "E"), or no rating? Yes. See Exhibit 7 and the above.
21. Does the company's Best's Rating include a "c" (now discontinued), "q", "w", or "x" rating modifier? No.
22. Have there been significant or multiple declines in the company's Best's Rating in the last 5 years? Yes. See Exhibit 7 and factor 19.
23. Any other Best's, or other, adverse information? A yes/no for this factor depends on a more detailed review of the Best's data and/or other pertinent data known to the agency.
Summary and conclusions
Generally, eight or more total "Yes" answers or three or more "Yes" answers to factors 1, 2, 8, 9, 10, 12, 13, 14, 17, 18, 19, 20, or 22 may indicate a need for further investigation. Obviously, as the number of "Yes" answers increases, the greater the need for urgency.
In this case of the Big Red Insurance Company, we came up with a minimum of 12 "Yes" answers and, depending on an agent's response to the "unknown" subjective factors, a potential for as many as 19 "Yes" answers.
Once again, as a caveat, this methodology should not be used as a definitive indicator of insurer financial difficulty. Nor should it be used as the sole criteria for company representation. Its purpose is to provide, within a practical framework, another tool which an independent agent can use in exercising reasonable care in evaluating a carrier's financial stability and, thus, minimize the likelihood of an E&O claim.
Finally, if you would like to take a more detailed look at these issues, below is the original seminar manual that your are free to download.
Click here to download the Insolvency Manual
Go back to Part 1
Copyright 1995 by William C. Wilson, Jr. Used with permission.