Companies with test results equal to the score dividing two categories are included in the higher category. LIQUIDITY TEST TEST 8 AGENTS' BALANCES TO SURPLUS The ratio of agents' balances to surplus measures the degree to which solvency depends upon an asset which frequently cannot be realized in the event of liquidation. In addition, the ratio is reasonably effective in distinguishing troubled from sound companies. The ratio represents the amount of agents' balances taken as a percentage of stated surplus (Exhibit XVIII). The usual range for the agents' balances to surplus ratio is less than 40 percent. As shown in Exhibit XIX, 15 percent of all companies had ratios above 40 percent in 1972. Of companies becoming insolvent during the past five years, 64 percent had ratios above this bench mark in the third year before insolvency, while 67 percent exceeded the bench mark in their final year. The test result can, of course, be improved by surplus aid reinsurance. If the amount of agents' balances is of concern, further analysis should determine whether agents' balances over 90 days old may have been included as an admitted asset. A quick check can be made by comparing agents' balances with one-quarter of the year's direct premium written and reinsurance assumed, net of commissions. This latter amount represents approximately 90 days of agents' balances. EXHIBIT XX TEST 9 ONE-YEAR RESERVE DEVELOPMENT TO SURPLUS One-Year Reserve 99-073 078 - 16 RESERVE TEST TEST 9 ONE-YEAR RESERVE DEVELOPMENT TO SURPLUS In addition to measuring the accuracy with which reserves were established one year ago, the ratio of one-year reserve development to surplus provides an indirect indication of management's opinion of the adequacy of surplus. Unless surplus is felt to be low, management frequently tends to overestimate reserves, for income tax and other reasons. DESCRIPTION OF THE CALCULATION The most up-to-date estimate of the losses that were outstanding a year ago is the sum of the current reserves for those losses still outstanding plus the payments on those losses made during the past year. The difference between this current estimate and the reserves that were established at the end of the prior year is the one-year reserve development. If the current estimate is greater, the prior year's reserves were deficient, as judged by one year's hindsight. If the current estimate is less, the reserves were redundant. The ratio of one-year reserve development to surplus is this deficiency or redundancy taken as a percentage of surplus. A positive test result indicates a deficiency, while a negative test result indicates a redundancy. The calculation of this ratio is illustrated in Exhibit XX and laid out in detail in the work sheet for Test 9 in Appendix A. For the property lines of business, the amount of salvage and subrogation applicable to prior years' losses received during the current year is subtracted from the change in losses for prior years. For liability lines, salvage and subrogation have already been netted out in the association blank. For liability lines, loss adjustment expenses are included in a manner similar to the treatment of losses; loss adjustment expenses are not included for property lines. It should also be noted that the test does not take into account voluntary reserves or the excess of statutory over case basis reserves. |