OVERALL TEST TEST 2 CHANGE IN WRITINGS Major increases or decreases in net premiums written indicate a lack of stability in the company's operations. A major increase in premium may signal abrupt entry into new lines of business or sales territories. In addition, such an increase in writings may be a sign that the company is increasing cash inflow in order to meet loss payments. DESCRIPTION OF THE CALCULATION The change in writings ratio, as diagramed in Exhibit V, is the increase or decrease in net premiums written taken as a percentage of net premiums written in the prior year. If the net premium written is zero or negative in both the current and the prior year, the change in writings ratio is given as zero. If the net premium written is positive in the current year but zero or negative in the prior year, the change in writings ratio is given as 999 percent. INTERPRETATION OF TEST RESULTS The usual range for the change in writings test is from an increase of 33 percent to a decrease of 33 percent. As shown in Exhibit VI, 18 percent of all companies fell outside of this range in 1972. Of companies becoming insolvent in the past five years, 43 percent had test results outside these bench marks in the third year prior to insolvency (all of which were beyond the upper growth bench mark), and 45 percent fell outside the bench marks in their final year (30 percent above and 15 percent below). Familiarity with the company's operations and history is useful in judging the importance of test results falling beyond the bench marks. Such results frequently indicate a lack of stability in the company's operations and management. Other evidence of such instability may include dramatic shifts in product mix, marketing areas, underwriting policy, and similar factors. L Where an unstable situation is apparent, further analysis or examination should be directed at answering the following questions: 1. Are the company's assets properly valued and sufficiently liquid to meet possible cash demands? Consider the results on the ratio of liabilities to liquid assets (Test 7) and make a careful review of Schedule D. 2. Are the company's reserves adequate? Consider the results of It is important to determine whether a dramatic increase in writings indicates that the company is increasing cash flow in order to pay current claims. This may be the case if the company's recent reserves were inadequate (see the one- and two-year reserve development tests, Tests 9 and 10). If increased writings is accompanied by a shift to the liability lines of business, the problem is more serious. Increasing writings, particularly in the liability lines, to pay current claims provides a very shortlived solution to underlying problems and quickly increases the risk of insolvency. Immediate regulatory action may be required to deal with such a company. On the other hand, if large increases in writings are accompanied by a reasonably low premium to surplus ratio (Text 1), adequate reserving (Tests 9, 10 and 11), profitable operations (Tests 4 and 4A) and a relatively stable product mix, they generally do not indicate difficulties that would threaten the company's solvency. OVERALL TEST TEST 3 SURPLUS AID TO SURPLUS The use of surplus aid reinsurance treaties may be taken as an indication that company management believes surplus to be inadequate. In addition, the continued solvency of companies with a large portion of surplus deriving from surplus aid may depend upon the continuing cooperation of the reinsurer. DESCRIPTION OF THE CALCULATION Surplus aid consists of commissions on ceded reinsurance unearned premium. Since this amount cannot be determined exactly from the annual statement, it must be estimated. As shown in the diagram in Exhibit VII, this estimate is made by multiplying the ratio between ceding commissions and ceded premium for all reinsurance ceded by the amount of unearned premium on reinsurance ceded to nonaffiliated companies. This estimated surplus aid is taken as a percentage of stated surplus to obtain the test result. Unearned premium on reinsurance ceded to affiliated companies is excluded from the calculation to avoid prejudicing the test against members of groups or fleets with pooling arrangements. The surplus aid to surplus calculation is illustrated in the work sheet for Test 3 in Appendix A. INTERPRETATION OF TEST RESULTS The usual range for the ratio of surplus aid to surplus is less than 25 percent. As shown in Exhibit VIII, about 5 percent of all companies scored above 25 percent on the surplus aid test in 1972. Of companies becoming insolvent in the past 5 years, 24 percent exceeded the surplus aid bench mark in the third year before insolvency, and 33 percent exceeded the bench mark in their final year. TEST RESULTS Companies with test results equal to the score dividing two categories are included in the higher category. *Basel on a sample of 100 companies. The surplus aid test is of primary importance for two reasons: 1. The existence of significant amounts of surplus aid may be taken as a strong indication that surplus is inadequate. 2. Surplus aid may improve results on other tests enough to conceal important areas of concern. For these reasons, all companies with ratios higher than 25 percent should be given careful scrutiny, regardless of their scores on the other tests. The following test results should be recalculated with surplus adjusted to remove surplus aid: Premium to surplus (Test 1) Change in surplus (Test 6) Agent balances to surplus (Test 8) One-year reserve development to surplus (Test 9) Two-year reserve development to surplus (Test 10) Estimated current reserve deficiency to surplus (Test 11). Of course, these adjustments can be made without recalculating the numerator: simply divide the result for each test by the difference between one and the surplus aid test result expressed as a decimal. If, as a result of this analysis, a company fails several of the above tests, it should be considered a priority company for examination. In any case, a thorough analysis should be made of the reinsurance treaties of all companies with a ratio of surplus aid to surplus of more than 25 percent. This analysis should determine the legitimacy of the company's reinsurance treaties and the potential impact on the company's sulvency of a cancellation of these treaties. The surplus aid test may also provide an approximate check on the accuracy with which the company has completed the reinsurance interrogatory in the association blank. |