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shown on the Priority Company Data Sheet.

For other companies, the oper

ating ratio should be calculated for each of the past three to five years. This work can be simplified by calculating the combined loss and expense ratio for each year and checking the trend in net investment income during

the period.

Calculation of the combined ratio is also helpful in determining the reasons behind the company's poor performance whether it is due to a

high loss ratio or a high expense ratio. If the combined ratio is near 100 percent, poor performance may be the result of low investment income, which can be checked by the investment yield (Test 5).

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PROFITABILITY TEST

TEST 5

INVESTMENT YIELD

In addition to measuring one important element in profitability, the investment yield test also provides an indication of the general quality of the company's investment portfolio.

DESCRIPTION OF

THE CALCULATION

As shown in Exhibit XII, investment yield is net investment income as 2 percentage of the average invested assets during the year. Invested assets is the amount of cash and invested assets plus accrued investment income minus borrowed money. The average invested assets during the year is determined by taking half of the following sum: invested assets at the end of the prior year plus invested assets at the end of the current year minus net investment income during the year. This calculation is laid out in the work sheets in Appendix A.

INTERPRETATION

OF TEST RESULTS

The usual range for investment yield is more than 3.5 percent. As shown in Exhibit XIII, 13 percent of all companies had investment yields below this bench mark in 1972. Of companies becoming insolvent during the past five years, about 62 percent had investment yields below 3.5 percent in the third year before insolvency, and 75 percent fell short of the bench mark in their final year.

Analysis of the reasons for a low investment yield may uncover significant problems. This analysis should include a determination of the types of investments (from page 2 and Schedule D) and of the yield on each type of investment (using page 5, Part 1). Low yields may be caused by:

If

1. Speculative investments intended to produce large capital gains
over the long run, but providing little income in the interim.
this is the case, analysis should focus on the proper valuation of
these investments and a determination of their stability and
liquidity.

2. Large investments in affiliated companies or enterprises under
the control of company managers or owners.
If this is the case,
analysis should focus on the propriety of these investments and
their value and liquidity.

3. Large investments in home office facilities. If this is the case, analysis should focus on the ability of the company to afford its facilities while maintaining liquidity and on the appropriateness of the amount of rent charged to underwriting expenses and credited to investment income.

PROFITABILITY TEST

TEST 6

CHANGE IN SURPLUS

The change in surplus is, in a sense, the ultimate measure of the improvement or deterioration in the company's financial condition during the

year.

DESCRIPTION OF

THE CALCULATION

The calculation of the change in surplus test is diagramed in Exhibit XIV and laid out in detail in the work sheets in Appendix A.

The change in surplus is the difference between surplus at the end of the current year and surplus at the end of the prior year, taken as a percentage of surplus at the end of the prior year. For this test, stated surplus for each year is adjusted in three ways. First, the excess of statutory over case basis reserves is added back to stated surplus. Second, surplus is adjusted for the deficiency or redundancy of loss reserves. The prior year surplus is decreased by any reserve deficiency revealed by the one-year reserve development (Test 9) or increased by any redundancy. The current year surplus is decreased or increased by the deficiency or redundancy of current reserves, as estimated by averaging the numerators of the three reserve tests (Tests 9, 10 and 11). Finally, surplus is increased by the deferred acquisition expenses. This amount is calculated by multiplying the unearned premium reserve by the ratio between acquisition expenses and net premium written. Acquisition expenses include commissions; taxes, licenses and fees; and half of all other underwriting expenses.

The adjustment for deferred acquisition expenses makes the change in surplus test somewhat more complex. However, it significantly improves the effectiveness of the test for distinguishing troubled from sound

companies.

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