World Bank Distance Learning

Washington, DC April 9, 2001

Lawrie Savage & Associates Inc.

The Early Warning Test

Ratios

for General Insurers

World Bank

Distance

Learning

History of Early Warning Ratios

§ Until early 1970's, everyone had their favourite ratio

§ NAIC undertook major investigation (McKinsey & Co.)

§ Hundreds of ratios tested for statistical

significance in predicting past U.S. insolvencies

§

LS&A

Conclusion:

small number

of ratios can

“explain”

almost all

failures

This makes sense when you

think about it . . .

§

A company is a company,

regardless of whether it's in an

emerging market or Canada.

§

The key relationship for

solvency is the size of the

company's equity base compared

to its liabilities: there are only so

many ways you can measure it.

OSFI Early Warning Ratios

Canadian Property & Casualty Insurance Companies

Up to 50% Amounts due from

agents, subs

6

- 10% to +50% Change in capital and

surplus

5

Up to 7 X Gross Risk Ratio

4

Up to 3 X Net Risk Ratio

3

2

1

OSFI Early Warning Ratios

Canadian Property & Casualty Insurance Companies

Various (current at least 5% Investment yield

11

10

9

of liabilities

8

7

OSFI Early Warning Ratios

Canadian Property & Casualty Insurance Companies

1 year development as a % of capital and surplus

15

Various

(current at least 6%)

Return on GAAP capital

14

Not more than 2.5x Loss reserves to surplus

13

12

What do the Ratios Mean?

Change in Net Writings:

+ or - 33% = significant changes in

reinsurance or substantial expansion or

contraction of business.

Change in Net Writings:

+ or - 33% = significant changes in

reinsurance or substantial expansion or

contraction of business.

What do the Ratios Mean?

Change in Gross Writings:

+ or - 33%, again signals substantial

volatility in production.

Change in Gross Writings:

+ or - 33%, again signals substantial

volatility in production.

CS = Capital & Surplus

NPW = Net Premiums Written ROE = Return on Equity

Underwriting Income + Investment Income = Net Income Before Tax = NI

NI/CS = ROE

NI/NPW = Return on Sales NPW/CS = Risk Ratio

And therefore: NI NPW NI

OR

Return on Sales X Risk Ratio = ROE

X

NPW CS = CS

Why Net Premiums ÷ Capital and Surplus, or "Risk Ratio“, is an especially important indicator

So if return on sales = 5% and risk ratio = 2, then ROE will be 10%.

If return on sales = - 5% and risk ratio = 2, then ROE will be -10%.

But if return on sales falls to -20%, and risk ratio is 5, then ROE will be -100%, AND THE

COMPANY IS INSOLVENT.

Therefore, in a business where there is

considerable volatility in return on sales, the risk ratio has to be kept reasonably low.

Normal Range: Less than 3 to 1

Return on Sales 15% Risk Ratio 2 to 1 Return on Equity 30% Return on Sales -20% Risk Ratio 5 to 1 Return on Equity -100%!!

So, in a business where Return on Sales can

be quite variable, the risk ratio has to remain at

a reasonable level.

J

L

Gross Risk Ratio: Same as net risk ratio except

we are looking at the gross return on sales, i.e.

before reinsurance, rather than after

reinsurance.

Percentage Change in Capital & Surplus: The

equity base of a company is the primary

"cushion" that protects against insolvency. A

drop of more than 10% or an increase of more

than 50% signals instability in this critical

Amounts due from Agents and Related Parties

as % of Capital and Surplus: If there are

financial problems in a group, amounts from

related parties may not be collectable.

Unusually large amounts due from agents may

be a signal that the agents don't believe the

company is going to continue, or that they have

some other serious grievance with the company.

Also, if an agent becomes insolvent when owing

a large amount to the insurer, it may seriously

impact the insurer's financial position. If the

ratio exceeds 50%, there is an inordinate

amount of risk that the capital and surplus base

of the company may be seriously depleted.

Surplus Aid: If a company is overly

dependent on reinsurance, the bulk of its

profit may be generated by reinsurance

commissions. This leaves the company in a

vulnerable position, dependent on its

reinsurers for continued financial health. Also,

as the commissions flow from the income

statement into surplus, a considerable portion

of surplus may be comprised of reinsurance

commissions. Sometimes, if the reinsurance

is cancelled or if the company becomes

insolvent, commissions could have to be

repaid to the reinsurer, which would mean that

the "surplus" was to some extent illusory.

Capital & Surplus as a % of Liabilities: Basic leverage. In an insurer, it is the liabilities which are difficult to

quantify. Clearly the smaller the c&s base relative to liabilities, the less capacity the company will have to absorb unforeseen "shocks" (e.g. catastrophic losses due to earthquake or hurricane, failure of a reinsurer, exceptionally bad underwriting results, investment losses and so on.)

Investment Yield: This has to be compared to current market rates. However, if a company is unable to

generate market rate returns, it may be an indication of poor quality investments. If the yield is unduly high it could also be an indication of exceptional risk in the

portfolio, which could be followed by substantial losses. Liabilities as a Percent of Liquid Assets: For

property/casualty insurers, a large percent of claims must be paid within the year. Therefore liquid assets are critical in ensuring that funds will be available as required. If liabilities are greater than 105% of liquid assets, the company may be heading into cash flow problems.

Loss Reserves to Surplus: This is another one of the "leverage" type ratios. If loss reserves are 1.5 times

surplus, then a 10% understatement of the claims liability is equivalent to 15% of the company's surplus. But if the ratio of reserves to surplus is 5 to one, a 20% understatement of the claims liability is equal to 100% of surplus, so the

company would actually be bankrupt. It is difficult to know the extent to which the claims liability might be understated, so keeping the ratio below about 2.5 avoids excessive risk. GAAP Return on Equity: A fundamental measure of

financial health. The rate of return to the shareholders who have invested in the company. If the return is low, or

negative, why would investors put more money into the company? This is a critical question for the supervisor, because if a company is in financial difficulty one of the primary remedies is to push for additional capital.

One Year Loss Development to Capital & Surplus: For a property/casualty insurer, the liability for outstanding claims, including claims that have been incurred but not reported, is probably the single largest liability, and the most difficult to assess in terms of its accuracy of

reporting. For example, if we can measure that the

inaccuracy in the claims liability from year N to year N+1 is greater than 10% of capital and surplus, then (1) there is significant probability that the extent by which

outstanding claims have been understated, will ultimately turn out to be considerably larger than we know and, (2) there is a reasonable probability that capital & surplus is presently overstated by an unknown, but perhaps

Ratios should be considered as

FLAGS

§ signaling a need to investigate problems

§ A few abnormal ratios may not be an indication of problems.

§ The trend in the ratios is also a telling sign of possible problems.

Basic financial parameters and especially the

trends in those parameters over time, are also powerful indicators of developing problems. Benefits of having companies calculate all the ratios, track basic financial parameters over time.

LS&A

Increasing Risk

Normal Range

1995 1996 1997

In 1997 supervisory staff raise a concern with the company and bring the matter to the attention of senior supervisory

personnel: exceedingly high ratio value for this company.

Yes, we must look at the trend!

But no action taken in earlier years because the ratio was not outside the normal range!!

A true story.

For Canada we typically see a large % of companies in the "normal" range

For emerging market the curve is much steeper and a higher % of companies are out of range

Typical Comparison Between Emerging Market and

Canada For Performance on Ratio

Washington, DC April 9, 2001

Lawrie Savage & Associates Inc.

World Bank

Distance

Learning

End of

The Early Warning Test

Ratios