Financial Analysis Lou Felice, Health and Solvency Policy Advisor NAIC
Presentation Overview Overview of the Financial Analysis Handbook (Handbook) Financial Analysis vs. Financial Examiner Roles NAIC I-SITE Reports & Insurer Profile Summary
NAIC Financial Analysis Handbook Confidential – Regulator Only Assists regulators in performing risk-focused financial analysis to identify companies that may have financial problems or that have the greatest potential for developing financial problems Provides guidance to evaluate particular areas of concern in troubled companies Consistent and uniform method Qualitative and quantitative analysis Updated annually
Financial Analysis Handbook • Analyst Reference Guides • Level 1 Procedures • Level 2 Procedures • Level 2 – Investments, Cash Flow & Liquidity, Reinsurance, Affiliated Transactions, MGA & TPAs, Risk-Based Capital, Income Statement and Surplus, Unpaid Losses and LAE • Supplemental Procedures • Management Considerations, Audited Financial Report, Actuarial Opinion, Management Discussion & Analysis, Holding Company Analysis
Handbook - Risk-Focused Financial Analysis • Depth of the analysis will depend on the complexity and the financial strength of the insurer and the existing or potential issues and problems found during review of the financial statements • At a minimum the following must be analyzed: • Annual and quarterly financial statements • Actuarial opinion • Management’s discussion and analysis • Audited CPA report • Holding company filings • Financial ratios
Handbook - Analyst Reference GuideExample - Investments • Overview - Discusses specific topics: investment income, asset and liability matching, diversification of a portfolio, key areas of consideration when reviewing a portfolio • Discussion of Level 1, 2 and Supplemental Procedures – provides considerations and guidance for the procedures • Additional Reference Sources - SVO Purposes & Procedures Manual, Accounting Practices & Procedures Manual, NAIC Annual Statement Instructions, etc.
Handbook - Annual Level 1 Procedures • Background Analysis • Last priority designation, inter-department communication, regulatory actions, NRSRO rating • Management Assessment • Shift in management or philosophy • Balance Sheet Assessment • Operations Assessment • Investment Practices • Review of Disclosures • Notes to Financial Statements, General Interrogatories, etc. • Assessment of Latest Examination Report and Results
Handbook - Annual Level 1 Procedures • Overall high-level review of insurer • At the conclusion of the Level 1, the analyst is directed as to whether greater analysis must be completed within the Level 2 procedures given risk discovered in Level 1 • For example, does the insurer have complex affiliated agreements in place that would require further detailed review beyond discovery work completed within Level 1?
Handbook – Annual Level 2 Procedures Level 2 Procedures • Detailed analysis focused on key risk areas • Procedures are quantitative (benchmark oriented) and qualitative • Investments • Unpaid Losses and LAE • Income Statement and Surplus • Risk-Based Capital • Cash Flow & Liquidity • Reinsurance • Affiliated Transactions • MGAs & TPAs
Handbook – Supplemental Procedures Supplemental Procedures • Management Considerations • Audited Financial Report • Statement of Actuarial Opinion & Actuarial Opinion Summary • Management’s Discussion and Analysis • Holding Company Analysis
Handbook – Supplemental ProceduresManagement Considerations Procedures address: • Assessment of corporate governance pertaining to the board of directors and management • Compliance with state statutes, accounting and reporting • Reputational risk • Legal issues • Business plans and projections • Risk management
Handbook – Supplemental ProceduresManagement Considerations • Special Note: It may not be necessary to complete all procedures within this chapter. Procedures completed are based on the level of concern an analyst may have with management performance and the driving forces behind operations. • In performing analysis of management considerations, the analyst should utilize the risk-focused surveillance examination work that has been most recently completed related to these risk areas. Where applicable, the analyst should follow up on the work performed by the examiners including any comments or recommendations made by the examiners.
Handbook – Supplemental ProceduresAudited Financial Report Procedures address: • Overview of opinion • Opinion issued and rationale • Accounting basis and type of opinion (individual insurer or consolidated) • Data cross-checking to annual financial statement • Internal controls • CPA’s Letter of Qualifications • Change in CPA • Audit Committee
Handbook – Supplemental ProceduresStatement of Actuarial Opinion and Actuarial Opinion Summary Procedures address: • Identification and qualifications of the actuary • Scope of the opinion • The Opinion • Relevant comments and exhibit disclosures • Conclusions and recommendations • Procedures related to the Actuarial Opinion Summary
Handbook – Supplemental ProceduresManagement’s Discussion and Analysis Procedures address: • Overview of filing in accordance with Annual Statement Instructions • Non-consolidated basis? • Results of operations • Prospective information • Material changes • Assessment of balance sheet and liquidity • Assessment of investment transactions • Summary and conclusion
Handbook – Supplemental ProceduresHolding Company Analysis Procedures address: Holding company structure Interstate coordination Evaluate financial condition of holding company Form A – Statement of Acquisition of Control of or Merger with a Domestic Insurer Form B – Insurance Holding Company System Annual Registration Statement Form D – Prior Notice of a Transaction Extraordinary Dividend/Distributions
Handbook – Holding Company Analysis • Holding company analysis is a standard part of the financial analysis process as outlined in the NAIC’s Financial Analysis Handbook • Includes reviewing the upstream and downstream holding company entities (both financial or non-financial entities) • Understanding the structure, affiliated relationships, financial condition, management, etc. • Utilizing public information, such as SEC filings, international filings, and/or requested information
Holding Company Analysis Considerations NAIC has been conducting HC analysis training for state insurance departments Recently adopted amendments to accreditation program for Part B – Financial Analysis guidelines with regard to HC analysis effective 2012 GSIWG continues to create best practices and standards for HC analysis Focus on lead state report Maintaining the Holding Company Analysis Liaison List
Handbook - Quarterly Procedures • Level 1 and 2 procedures • Focuses on Significant Changes from Quarter to Quarter and Quarter to Prior Year End • Ratio calculations are automated NEW Quarterly Level 1 for Non-Troubled Insurers • Adopted for First Quarter 2012 • Significantly reduced procedures • Procedures address key risk areas • Background information • Management assessment • Balance sheetand operations assessment • Review of disclosures and assessment of results from analytical tools
Financial Profile Reports The Financial Profile Report is a summary of key financial information for a company over the last five years Includes a Financial Summary page There are also detailed sections for: Assets, Liabilities, Capital & Surplus, Loss & LAE Reserve Analysis, Income Statement, Cash Flow and Exhibit of Business and Profitability
Insurer Profile Summary Insurer Profile Summary Sharing Best Practices Guide Adopted by the Financial Analysis Handbook (E) Working Group Outlines best practices for effective and efficient sharing of a domestic state’s Insurer Profile Summary with other interested state insurance regulators Highly Confidential Document
What is a Financial Examination? • A financial condition exam is an on-site regulatory review of an insurer’s key processes with the primary goal of assessing financial solvency of the company. • An exam is risk-focused because the examiner focuses on areas of higher risk of an insurance company.
Why Conduct Financial Exams? Detect insurers with potential financial trouble; Picks up where analysis ends Determine compliance with state statutes and regulations; Compile information needed for timely, appropriate regulatory action;
Why Conduct Financial Exams? To provide a clear methodology for assessing residual risk and how it translates into examination procedures; To allow the assessment of risk-management processes in addition to those which relate to financial statement line items; and To utilize examination findings to establish, verify or revise company’s priority score.
Financial Analysis vs. Financial Examiner Roles
Examiner Identifies risk by reviewing business processes Utilizes control & detail tests to identify solvency concerns and findings Focuses on Residual Risk Analyst Identifies risk by reviewing reported financial results Utilizes analytical review, (ratio analysis, benchmarking, inquiry) to identify solvency concerns and compliance Roles of Examiner and Analyst On-site and Off-site solvency monitoring involve roles and skill-sets that are different, but complement each other:
Roles of Examiner and Analyst State Insurance Analysts typically perform the following functions: • Collection and analysis of insurer and group financial information • Desk audits to assess risk and compliance • Review of non-financial information regarding insurance companies that is routinely collected by other department units • Review of insurance company transactions • Coordination with other department functions • Determining regulatory courses of action regarding identified troubled insurance companies • Evaluating and monitoring corrective plans • Communicating results of regulatory actions • Licensing and admissions
Roles of Examiner and Analyst Example: Investments • Off-site analysis can monitor balance and composition of portfolio, benchmark the company’s investments against competitors and gather information from the insurer to explain significant changes. Help set priorities for examiner • On-site examination can evaluate the process in place at the insurer to monitor investment performance and reporting; establish company specific risks; gain an understanding of the effectiveness of controls; and tailor substantive procedures to apply underlying transactions, reviewing reconciliations, obtaining confirmations, etc.
Conducting Examinations The NAIC Financial Condition Examiners Handbook provides guidance to assist state insurance departments to effectively plan, conduct, and report on the financial condition of insurers. Approach changed to a Risk-Focused Surveillance approach in 2007 Model Law and Accreditation Standard
Model Law on Examinations • Exams must be conducted on each licensed insurer at least once every 5 years • Some state statutes require more frequent exams • Initial Priorities se through analysis process • A state may accept an examination report on a company prepared by another state if: • The state department performing the exam was accredited at the time of the exam; or • The exam was performed under the supervision of or participation by an accredited insurance department
Examination Classifications • Insurer Type • Single-state insurer: A company that does not meet the definition of a multi-state insurer such as a Health Maintenance Organization. • Multi-state insurer: A company that is domiciled or chartered in one state and licensed, registered, qualified or accredited, eligible or operating in at least one other state.
Examination Classifications • Exam Scope: • Full-scope: An examination in which the scope of the control and substantive procedures to be performed during the examination is based on the implementation and documentation of the risk assessment procedures required under the NAIC Financial Condition Examiners Handbook. • Review all areas of exam and focus on high-risk areas. • Limited-scope: An examination which is limited to a review or examination of specific financial statement line items or particular risk areas.
Examination Classifications • Examination Type • Individual exam: A financial exam over one insurer. • Group exam: A financial exam over more than one insurer. This type of exam is typically conducted when multiple companies in a holding company group have similar key processes, systems and/or management. • Exams can also be coordinated between regulators from multiple states.
Key Examination Participants • The following individuals from a state insurance department are the key participants that conduct and oversee the examinations of domestic insurance companies: • Chief Examiner (or designee): Schedule examinations, assign staff, coordinate with other state and zones examiners, and approve exam plan • Examiner-in-charge: Coordinate review of company and examination testwork. Coordinate meetings with company and personnel. • Staff Examiner: Conduct examination testwork and become knowledgeable of company operations. • Financial Analysts: Interpret key financial and operational ratios, provide examiners with insight on company management, operating results, current events, etc.
Risk-Focused Exam Approach • Examination methodology included within the NAIC Handbook is a ‘risk-focused’ approach. • Required by Accreditation Standards for exams commencing on or after Jan. 1, 2010. • Under this approach, examination fieldwork will emphasize the review of an insurer’s current or prospective solvency risk areas and the fair presentation of surplus. • Examiner will focus work and resources on identified risk areas and focus less on areas with less risk.
Risk-Focused Surveillance • The risk-focused surveillance process requires examiners to prospectively consider the company’s financial condition by assessing whether the company’s current processes provide indications of future solvency concerns. Examples of items considered for prospective assessments include: • Corporate Governance • Future Business Plans • Rate of Company Growth • Liquidity of Assets
Risk-Focused Surveillance • In accordance with the risk-focused surveillance guidance, examination work will shift so that more time is spent during the planning and risk assessment processes of the examination. • Efficiencies should be gained as examiners utilize knowledge from prior exams as well as information provided through on-going monitoring by analysts to stay aware of risks within insurer operations.
Seven Phase Examination Process Phase 1 Understand the Company and Identify Key Functional Activities to be Reviewed Planning Phase 2 Identify and Assess Inherent Risks in Activities Phase 3 Identify and Evaluate Risk Mitigation Strategies/Controls Phase 4 Determine Residual Risk Phase 5 Establish/Conduct Exam Procedures Phase 6 Update Prioritization and Supervisory Plan Phase 7 Draft Exam Report and Management Letter Based on Findings
Risk Assessment Cycle Examination • Risk-Focused Examination Seven Phase Process: • Identify Functional Activities • Identify/Assess Inherent Risk • Identify & Evaluate Controls • Determine Residual Risk • Establish Procedures and Conduct Exam • Update Supervisory Plan • Exam Report//Mgmt Letter Supervisory Plan • Develop Ongoing Supervision That Includes: • Frequency of Exams • Scope of Exams • Meetings with Company Management • Follow-Up on Recommendations • Financial Analysis Monitoring INSURER PROFILE SUMMARY Priority System Financial Analysis • Company Priority Score Determined By: • Priority System Based on Dept. analysis and NAIC financial Analysis tools: • Scoring System • ATS Results • IRIS Ratios • Exam Results • Financial Analysis includes: • Risk Assessment Results • Financial Analysis Handbook Process • Ratio Analysis (IRIS, FAST, Internal Ratios) • Actuarial Analysis • Update with internal/external changes Internal/External Changes • Consider Changes to: • NRSRO Ratings • Ownership/Management/ Corporate Structure • Business Strategy/Plan • CPA Report or Auditor • Legal or Regulatory Status
Steps to Phase 1, Part 1 Understanding the Company 1 Step 1 Step 2 Step 3 Step 4 Step 5 Gather necessary planning information Review the gathered information Perform Analytical and Operational Reviews Consider Information Technology Risk Update the Insurer Profile Summary Note: Portfolio Analysis would be completed in conjunction with Phase 1, Part 1.
Parts to Phase 1 Understanding the Corporate Governance Structure 2 Assessing the Adequacy of the Audit Function 3 Indentifying Key Functional Activities 4 Consideration of Prospective Risk 5
Phase 2 – Identify and Assess Inherent Risk • Inherent risk – Risk of economic loss or inaccurate financial reporting before considering internal controls