What You Can Do About Insurer Insolvency

Though you carry E&O insurance that should cover carrier insolvency, recent court cases have not completely absolved agencies when problems with carriers arise. In this document, with links to a checklist and a sample financial statement, Bill Wilson explains how to determine the financial health of carriers.

Mission. Integrity. Ideal. Excalibur. Universal. Enterprise. Great Global. American Excel. Champion. Adjectives for the Virtual University? Nope. All were companies that used to insure millions of individuals, families, and businesses. Perhaps these or other insolvencies blindsided you when they went belly up. Take these proactive steps to protect yourself and your clients.

If you’ve ever taken a time management course or read a book on the subject, you probably learned about focusing your efforts within a 'priority grid' by Importance and Urgency. The experts say that most of your time should be focused on tasks and issues that are 'Important, but Not Urgent' — i.e., the critical functions that affect survival and success.

The same can be said for monitoring the financial stability of the carriers you use for direct and brokered business. With more urgent tasks at hand, it’s all too easy to ignore warning signs that you could uncover with minimal effort. This article will review methods for you to protect yourself and your clients from insurer insolvency, and provide a handy downloadable tool that streamlines the process.

General Jimmy Doolittle once said, 'One trouble with Americans is that we’re fixers rather than preventers.' Although many articles have been published on insurer insolvency, most have been retrospective: 'here’s what happened and why.' This approach does little to fix the problem and even less to prevent its reoccurrence.

This article will give you, the independent agent, a practical methodology to examine the ongoing financial stability of your carriers and to take corrective action as warranted. Although this approach can’t prevent an insolvency, it can help minimize the likelihood that you and your clients will become active participants in the process.

Legal Obligations to Clients
Your first question might be 'Why should I bother?' After all, you carry E&O insurance that should cover insolvencies, your state has a guaranty fund, the Texas Higginbotham court case held that independent agents aren’t liable when an insurer goes under, and so on. To answer a question with a question, would you suggest to your insureds that they rely on a single, limited risk management technique to address their all their loss exposures?

What’s more, the Higginbotham case did not totally absolve agents of responsibility for carrier insolvencies. The court stated: 'We ... conclude that an agent is not liable for an insured’s lost claim due to the insurer’s insolvency if the insurer is solvent at the time the policy is procured, unless at that time or at a later time when the insured could be protected, the agent knows, or by the exercise of reasonable diligence should know, of facts or circumstances which would put a reasonable agent on notice that the insurance presents unreasonable risk.' [emphasis added]. In other words, failure to exercise reasonable diligence in ascertaining an insurer’s financial stability might put the agent at risk. As the Roman statesman Cicero said more than 2,000 years ago, 'The safety of the people is the highest law.'

FINANCIAL INFORMATION SOURCES
Financial data on companies is widely available from such services as A.M. Best, Standard & Poor’s, Moody’s Investors Services, Duff & Phelps, and Weiss Research. You can also gather supplementary and/or subjective information from company annual statements and stockholder reports, insurance departments, trade periodicals, other agents, and a variety of other sources. Because the scope of this article is limited, we’ll examine the use of information readily available from A.M. Best Co., specifically Best’s Insurance Reports (P/C).

INSOLVENCY CHECKLIST
This article relies on an Insolvency Checklist that combines financial data from A.M. Best with subjective observations of company behavior by agency personnel. Unlike most such lists, which require complex calculations of numerous Best’s or NAIC ratios and financial indicators, this Checklist asks only for a Yes/No answer to 23 or fewer questions.

We’ll use an actual insolvency to illustrate the use of the list to monitor insolvency indicators for your carriers on an ongoing basis. What you’ll discover is that, with only marginal vigilance, this real-life insolvency could have been 'predicted' at least a year or more before the insurer went under Disclaimer: This Checklist provides a tool for documenting financial and marketing information about P/C insurers in order to establish due diligence in the event of Errors and Omissions claims against agents. No warranties, express or implied, are made that the list is either a predictor or a guarantor of a company’s financial condition.

To illustrate the use of the Insolvency Checklist, please download this financial information excerpted from a 1983 A.M. Best report on a real carrier we’ll call the Big Red Insurance Co. (to protect the innocent, guilty, and embarrassed). Big Red was declared insolvent in 1985.

The document presents seven categories of A. M. Best information as exhibits:

1. General Information (Exhibit 1)
2. Assets, Liabilities, Surplus & Other Funds (Exhibit 2)
3. Investment Data (Exhibit 3)
4. Summary of Operations (Exhibit 4)
5. Comparative Financial and Operating Exhibit (Exhibit 5)
6. Underwriting Experience (Exhibit 6)
7. Best’s Operating Comments (Exhibit 7)

Using this and other data, we’ll evaluate each checklist factor in order to gauge Big Red’s relative potential for financial difficulty. These factors are divided into five major groups: Organizational, Capitalization & Growth, Cash Flow & Profitability, Marketing, and Best’s Ratings. We’ll review each factor, then comment on its applicability to Big Red:

ORGANIZATIONAL FACTORS

1. Has the company been in business for less than 15 years? Yes. The insurer was organized in 1978 (see Exhibit 1).
2. Does the company write primarily Private Passenger Auto, Workers Comp, Commercial or E&S/Specialty business? Yes. Almost two thirds of Big Red’s premium volume was Workers Comp and one third other Commercial (see Exhibit 6).
3. Have there been any recent atypical ownership/management changes, heavy use of MGAs, or delegated authority? Yes. A savings and loan company purchased Big Red in 1983 and brought in a new management team (see Exhibit 1).
4. Have there been any general premium finance company, E&O or Umbrella/Excess carrier refusals? Unknown. (Because this information is usually not available from Best’s, you might have to find the answer elsewhere).
5. Has the company run into any significant problems with insurance departments or other government agencies? Unknown (Although some information may be available from Best’s, this question might require contacting the rating or examination division of your state insurance department).

CAPITALIZATION & GROWTH FACTORS

1. Is current policyholders’ surplus (PHS) less than $5 million? No, but only for the reason outlined in factor 8.
2. Has there been an abnormal decline or significant fluctuation in PHS in the past three to five years? No, for the same reason.
3. Have there been any significant increases in PHS from non-operating revenues in the past three to five years? Yes. Exhibits 2 and 4 indicate that surplus would’ve been significantly depleted without the massive capital contributions made by the new owners in 1983 and 1984.
4. Is the ratio of net premiums written (NPW) to PHS significantly in excess of 2:1? No. Due to reinsurance cedings and capital contributions to surplus, Big Red maintained this ratio at acceptable levels.
5. During the past five years, has premium volume and/or reinsurance increased by 25% or has NPW fluctuated significantly? Yes. Exhibit 5 indicates instability in NPW, together with direct premium increases of up to 38%.

CASH FLOW AND PROFITABILITY FACTORS

1. Have there been any cash flow problems (reflected by slow/low claims payments, unearned premium returns, commissions, and so forth)? Unknown. (Because this information is usually not available from Best’s, you might have to find the answer elsewhere.
2. Have any significant combined ratios been abnormally high or increasing in the past three to five years? Yes. As shown in Exhibit 5, the overall combined ratio increased in each of the past five years to a level of 111.5%. (Exhibit 6 further indicates by-line pure loss ratios of 283% for General Liability and 973% for Auto Liability.
3. Has there been any negative operating income or sustained underwriting losses during the past three to five years? Yes. Exhibit 5 indicates a significant deterioration of underwriting and bottom-line operating losses over the past five years.
4. Has the company made any questionable investments (in affiliates, real estate, cash increases, low yields, etc.)? Yes. Using the yields and asset values from Exhibit 2, Big Red’s return on investment was only about 2%. In addition, the cash component of the investment portfolio increased from 12.2% to 43.6% of assets, accompanied by a reduction in bonds of 32.7% to 12.4% (You might also be concerned about why bonds were cashed and whether the transaction resulted in a gain or loss. Exhibit 4 provides limited information on this point). Also note that 'loans' increased from zero to 14%.

MARKETING FACTORS

1. Have there been any major market withdrawals/changes or assumed books of business? Unknown. (Because this information is usually not available from Best’s, you might have to find the answer elsewhere).
2. Has the company implemented any significant rate increases or decreases — particularly if involuntarily? Yes. Exhibit 7 details the nature of voluntary rate increases, although the Best’s report often doesn’t provide this information.
3. Does the company pay above-average commissions on below-average premiums? Unknown. (Because this information is usually not available from Best’s, you might have to find the answer elsewhere).
4. Does the company’s product pricing seem overly competitive for the market and nature of the risks it writes? Unknown. (Because this information is usually not available from Best’s, you might have to find the answer elsewhere).

BEST’S RATING FACTORS

1. Is the company’s current Best’s Rating less than 'A-'? Yes. Exhibit 7 indicates that Big Red’s rating over the past four years declined from an 'A' to an 'NA-7' (Below Minimum Standards) to 'Deferred' (effectively no rating).
2. Is the company’s Best’s Rating an NA-3, NA-5, NA-6, NA-7 (now 'D'), NA-10 (now 'E'), or no rating? Yes. See Exhibit 7 and Factor 19.
3. Does the company’s Best’s Rating include a 'c' (now discontinued), 'q', 'w', or 'x' rating modifier? No.
4. Have there been significant or multiple declines in the company’s Best’s Rating in the past five years? Yes. See Exhibit 7 and Factor 19.

MISCELLANEOUS CONSIDERATIONS

1. Is there any other adverse information on the company from Best’s or elsewhere? A yes/no for this factor depends on a more detailed review of the Best’s data and/or other pertinent data known to the agency.

Summary and Conclusion
Generally, eight or more total 'Yes' answers or three or more 'Yes' answers to factors 1, 2, 8, 9, 10, 12, 13, 14, 17, 18, 19, 20, or 22 might indicate a need for further investigation. Obviously, the higher the number of 'Yes' answers, the greater the need for urgency.

In this case of the Big Red Insurance Co., we came up with a minimum of 12 'Yes' responses and, depending on an agent’s response to the 'unknown' subjective factors, a potential for as many as 19 'Yes' answers.

As a caveat, do not use this methodology as either a definitive indicator of insurer financial difficulty or the sole criterion for deciding whether to represent a company! Its purpose is to provide another resource which an independent agent can use to take reasonable care in evaluating a carrier’s financial stability and minimizing the risk of an E&O claim from writing with it.