PREFACE

This report contains two documents. The first, Improving the Life and Health Early Warning System, presents our recommendations for improving the system in two phases, for implementation in 1974 and 1975. The second, Using the Life and Health Early Warning System, is a draft user's manual to accompany the recommended system.

The manual's first chapter and appendix would be suitable, as written, for use during the current year. For use in 1975, after the recommended system is completely implemented, this draft manual can be finalized by substituting information on the 1973 test results of all companies for the references and exhibits showing data for a sample of solvent companies in 1972.

IMPROVING THE LIFE AND HEALTH

EARLY WARNING SYSTEM

NATIONAL ASSOCIATION OF INSURANCE COMMISSIONERS

This report presents our recommendations for improving the Early Warning System for life and health insurance companies. These recommendations are based on analysis discussed with the NAIC Task Force and Industry Advisory Committee in Chicago on March 18, 1974. In making these recommendations, we have given consideration to a number of suggestions made by the task force members and advisors at that meeting. The recommendations, however, are our own; they are not intended to represent the consensus of task force members.

Judging from experience during the past decade, the recommended system would be dramatically more effective in distinguishing between troubled and sound companies than the current system. As shown in the final pages of this report, half of the improvement in effectiveness results from dropping ineffective tests; the other half results from adding and modifying tests and altering the cutoffs for determining exceptional values.

The recommendations are divided into two groups for phased implementation. For the current year, we recommend that the number of early warning tests be reduced from 26 to 9, including four new tests. For 1975, we recommend that a system based on these nine tests be used to identify priority companies for further analysis and examination.

This report consists of three chapters:

1. Our approach

2. Recommendations for 1974

3. Recommendations for 1975.

As we see it, the basic purpose of the Early Warning System is to identify the companies that may be experiencing financial difficulty. Thus, we suggest that the system should include only those tests which are effective in distinguishing between troubled and sound companies. For companies that may be experiencing difficulties, there is a broad variety of further analyses that should be made and additional ratios that might be calculated in order to determine the source of the difficulty and its degree of severity. The users' manual should provide guidelines for this type of further analysis. However, the inclusion of some of these diagnostic analyses in the basic early warning report would distract the user's attention from the more important ratios intended to help him identify potentially troubled companies. Our interviews with state insurance department personnel indicated that a complex system is much less likely to be understood and used than one that is reasonably simple. Therefore, we suggest that the report include only information that contributes to the basic purpose of identifying companies for which further analysis and examination may be required.

In order to determine the effectiveness of a given ratio in distinguishing between troubled and sound companies, we compared the ratios of a group of companies that became insolvent during the past decade with the ratios of a group of financially sound companies. We believe that this historical, or retrospective, approach provides the most solid, factual basis for judging the effectiveness of a test in discriminating between troubled and sound companies. Since conditions change, it is possible that the discriminating effectiveness of a given test will improve or decline over time. However, we have identified no trends in the life insurance industry that would lead us to conclude that the historical approach to judging the effectiveness of the tests discussed in this report should be set aside.

This chapter of the report describes the samples of insolvent and sound companies used in our analysis and explains the method by which test results for these two groups of companies were compared.