financial analysis

Financial Analysis

Lou Felice, Health and Solvency Policy AdvisorNAIC

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© 2012 The National Association of Insurance Commissioners

Presentation Overview

• Overview of the Financial Analysis Handbook (Handbook)

• Financial Analysis vs. Financial Examiner Roles

• NAIC I-SITE Reports & Insurer Profile Summary

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NAIC Financial Analysis Handbook

• 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

Confidential – Regulator Only

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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 Procedureso Management Considerations, Audited Financial Report, Actuarial

Opinion, Management Discussion & Analysis, Holding Company Analysis

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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:o Annual and quarterly financial statementso Actuarial opiniono Management’s discussion and analysiso Audited CPA reporto Holding company filingso Financial ratios

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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.

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Handbook - Annual Level 1 Procedures• Background Analysis

o Last priority designation, inter-department communication, regulatory actions, NRSRO rating

• Management Assessmento Shift in management or philosophy

• Balance Sheet Assessment• Operations Assessment• Investment Practices• Review of Disclosures

o Notes to Financial Statements, General Interrogatories, etc.

• Assessment of Latest Examination Report and Results

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FAH

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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 1o For example, does the insurer have complex

affiliated agreements in place that would require further detailed review beyond discovery work completed within Level 1?

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Handbook – Annual Level 2 ProceduresLevel 2 Procedures• Detailed analysis focused on key risk areas• Procedures are quantitative (benchmark oriented) and

qualitativeo Investmentso Unpaid Losses and LAEo Income Statement and Surpluso Risk-Based Capitalo Cash Flow & Liquidityo Reinsuranceo Affiliated Transactionso MGAs & TPAs

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Handbook – Supplemental ProceduresSupplemental Procedures• Management Considerations• Audited Financial Report• Statement of Actuarial Opinion & Actuarial Opinion

Summary• Management’s Discussion and Analysis• Holding Company Analysis

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Handbook – Supplemental ProceduresManagement ConsiderationsProcedures 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

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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.

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Handbook – Supplemental ProceduresAudited Financial ReportProcedures address:• Overview of opinion

o Opinion issued and rationaleo Accounting basis and type of opinion (individual insurer or

consolidated)o Data cross-checking to annual financial statement

• Internal controls• CPA’s Letter of Qualifications• Change in CPA• Audit Committee

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Handbook – Supplemental ProceduresStatement of Actuarial Opinion and Actuarial Opinion SummaryProcedures 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 Summary15


Handbook – Supplemental ProceduresManagement’s Discussion and AnalysisProcedures 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

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Handbook – Supplemental ProceduresHolding Company AnalysisProcedures 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

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Handbook – Holding Company Analysis• Holding company analysis is a standard

part of the financial analysis process as outlined in the NAIC’s Financial Analysis Handbooko Includes reviewing the upstream and

downstream holding company entities (both financial or non-financial entities)

o Understanding the structure, affiliated relationships, financial condition, management, etc.

o Utilizing public information, such as SEC filings, international filings, and/or requested information

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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

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Link to SEC Filings

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Lead State Report

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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

o Background informationo Management assessmento Balance sheet and operations assessmento Review of disclosures and assessment of results from analytical tools

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I-SITE Categories Page

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Summary Reports

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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

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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 Document26

Risk-Focused Exams

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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.

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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;30

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.

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Financial Analysis vs.

Financial Examiner Roles

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Roles of Examiner and Analyst

• Examinero Identifies risk by

reviewing business processes

o Utilizes control & detail tests to identify solvency concerns and findings

o Focuses on Residual Risk

• Analysto Identifies risk by

reviewing reported financial results

o Utilizes analytical review, (ratio analysis, benchmarking, inquiry) to identify solvency concerns and compliance

On-site and Off-site solvency monitoring involve roles and skill-sets that are different, but complement each other:

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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

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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.

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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

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Model Law on Examinations

• Exams must be conducted on each licensed insurer at least once every 5 yearso Some state statutes require more frequent

exams o Initial Priorities se through analysis process

• A state may accept an examination report on a company prepared by another state if:o The state department performing the exam

was accredited at the time of the exam; oro The exam was performed under the

supervision of or participation by an accredited insurance department

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Examination Classifications

• Insurer Typeo Single-state insurer: A company that does

not meet the definition of a multi-state insurer such as a Health Maintenance Organization.

o 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.

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• Exam Scope:o 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. o Review all areas of exam and focus on high-risk

areas.o Limited-scope: An examination which is

limited to a review or examination of specific financial statement line items or particular risk areas. 39


• Examination Typeo Individual exam: A financial exam over one

insurer.o 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.


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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:o Chief Examiner (or designee): Schedule examinations,

assign staff, coordinate with other state and zones examiners, and approve exam plan

o Examiner-in-charge: Coordinate review of company and examination testwork. Coordinate meetings with company and personnel.

o Staff Examiner: Conduct examination testwork and become knowledgeable of company operations.

o Financial Analysts: Interpret key financial and operational ratios, provide examiners with insight on company management, operating results, current events, etc.

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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. 42


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:

o Corporate Governanceo Future Business Planso Rate of Company Growtho Liquidity of Assets

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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.

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Risk Assessment Matrix

1a

Phase 1 Phase 5 Phase 6 Phase7

1d 2a 2b 2c 2d 2e 3a 3b 3c 4a 4b 4c 5 6 7

Key Activity

1c – Analytical Assessment:

Risk Identificatio

nInherent Risk Assessment

Risk Mitigation Strategy/Control

AssessmentResidual Risk Assessment

Phase 2 Phase 3 Phase 4

Impa

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1b – Overall Risk Statement:

Risks Other than Financial ReportingFinancial Reporting Risks

Exa

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Prio

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Seven Phase Examination Process

Understand the Company and Identify KeyFunctional Activities to be Reviewed

Identify and Assess Inherent Risks in Activities

Identify and Evaluate Risk Mitigation Strategies/Controls

Determine Residual Risk

Establish/Conduct Exam Procedures

Update Prioritization and Supervisory Plan

Draft Exam Report and Management LetterBased on Findings

Phase 1

Phase 2

Phase 3

Phase 4

Phase 5

Phase 6

Phase 7

Planning

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Risk Assessment Cycle

INSURER PROFILE

SUMMARY

Internal/External Changes

Examination

Priority System

Supervisory Plan 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

Develop Ongoing Supervision That

Includes:•Frequency of Exams•Scope of Exams•Meetings with Company Management•Follow-Up on Recommendations•Financial Analysis Monitoring

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

Financial Analysis

Consider Changes to:•NRSRO Ratings •Ownership/Management/ Corporate Structure•Business Strategy/Plan•CPA Report or Auditor•Legal or Regulatory Status 47


Steps to Phase 1, Part 1

Understanding the Company

Gather necessary planning

information

Review the gathered

information

Perform Analytical

and Operational

Reviews

Consider Information Technology

Risk

Update the Insurer Profile

Summary

Step 1 Step 2 Step 3 Step 4 Step 5

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Note: Portfolio Analysis would be completed in conjunction with Phase 1, Part 1.48


Parts to Phase 1Understanding the

Corporate GovernanceStructure

Assessing the Adequacyof the Audit Function

Indentifying KeyFunctional Activities

Consideration of Prospective Risk

2

3

4

5

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Phase 2 – Identify and Assess Inherent Risk• Inherent risk – Risk of economic loss or

inaccurate financial reporting before considering internal controls

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Phase 2 – Identify and Assess Inherent Risk• Identify inherent risk

o Other than financial reporting inherent risk• Items not directly related to a current f/s line item• Generally related monitoring, policies, BOD interaction,

strategic type risk, etc.o Financial reporting inherent risk

• Typically directly related to a current f/s line item

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Phase 2 – Identify and Assess Inherent Risk• Assess inherent risk based on:

o Likelihood of Occurrenceo Magnitude of Impact

• To reach overall inherent risk levels of:o Higho Moderateo Low

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CALCULATED OVERALL INHERENT RISK

Magnitude of Impact

Likelihood ofOccurrence Threatening Severe Moderate Immaterial

High

Moderate-high

Moderate-low

Low

High High High Moderate

High High ModerateModerate

High Moderate Low

Moderate Moderate Low Low

Moderate

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Phase 3 - Control Identification & Evaluation1. Identify and understand internal controls that the

insurer has in place for each risko Document Understanding

2. Consider whether the controls appear to be designed appropriately to mitigate each risko If not, no need to test controls

3. If so, test the controls for operating effectivenesso Not required if testing will be inefficient

4. Conclude whether the internal controls effectively mitigate each inherent risko Strong, Moderate or Weak

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Phase 3 – Risk Mitigation StrategiesAssessment of Controls

The Overall Risk Mitigation Strategy/Control Assessment ratings to be indicated in the Risk Assessment Matrix are:• Strong risk management• Moderate risk management• Weak risk management

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Phase 3 – Risk Mitigation Strategies

ControlTesting

Intended to provide assurancethat control procedures are

operating as prescribed

Control testing is generally performed using one of the following methods

Corroborativeinquiry

Re-performance

Observation

Examination ofDocuments

Walkthrough

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Phase 3 - Utilization of Existing Work

• Existing Control Documentationo SOX Workpaperso Internal Audit Workpaperso External Audit Workpapers

• Utilize where relevant to exam

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Phase 4 – Determine Residual Risk

• Residual risk is determined by how well the risk mitigation strategies/controls mitigate the inherent risk.

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Phase 4 – Residual Risk Grid

INHERENT RISK

STRONG RISK

CONTROLS

MODERATE RISK

CONTROLS

WEAK RISK CONTROLS

HIGH Mod or High Mod or High High

MODERATE Low or Mod Mod Mod

LOW Low Low Low

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Phase 5 – Establish/Conduct Exam ProceduresPhase 5 Handbook Guidance:• Detail examination procedures should be

selected to correspond with the level of residual risk determined for each identified risk.

High Residual Risk

Detail procedures required.

Moderate Residual Risk

Fewer detail procedures performed (i.e. tests of details of transactions), including more utilization of analytical procedures.

Low Residual Risk

Limited or no detail procedures performed, which may be limited to analytical procedures.

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Phase 6 – Update Prioritization & Supervisory Plan• Supervisory Plan

o Created/updated at least yearly by domiciliary state

o Based on recent exams and analysts’ reportso Lead state concept with multi-state companieso Outline type of surveillance planned, resources,

and how coordination plannedo Part of Insurer Profile Summary

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Phase 7 – Draft Examination Report & Management Letter• Examination Report

o Table of contentso Salutationo Scope of examinationo Body of report

• Company history & corporate governance• Financial statements• Findings & recommendations

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Phase 7 – Draft Examination Report & Management Letter• Management Letter

o Part of exam workpaperso Used for results or observations that are not

material to public reporto Optional

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Phase 7 – Draft Examination Report & Management LetterExamination Report-

Common Findings• Additional Reserves

Needed• Asset Valuation- OTTI• Items not recorded in

accordance with SAP

Management Report- Common Findings• Proprietary Company

Issues• Prospective Risk

Discussions• Internal Control

Deficiencies

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Post Examination Procedures

The following activities should be performed after the examination report is issued and prior to the next examination:

• Follow up on examination findings • Communication with financial analyst

between examination dates• Supervisory Report

The goal is to continually monitor the companies under examination, rather than to only perform examinations.

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Questions

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financial analysis

Documents

financial problems

financial data

financial report

financial strength

financial profiles

company analysis

financial examiner rolesnaic

upthe financial statements