30 February 2014 | The Self-Insurer © Self-Insurers’ Publishing Corp. All rights reserved.

This article originally appeared in “Analysis of Risk Retention Groups” – Third Quarter 2013

In reviewing the reported financial results of risk retention groups (RRGs), one gets the impression that this is a group of insurers with

a great deal of financial stability. Based on third quarter 2013 reported financial information, RRGs continue to effectively provide specialized coverage to their insureds. Over the past five years, RRGs have remained committed to maintaining adequate capital to handle losses. It is important to note that ownership of an RRG is restricted to the policyholders of the RRG. This unique ownership structure required of RRGs may be a driving force in the strengthened capital position exhibited by RRGs.

RRGs Report Financially Stable Results at Third Quarter 2013 Financial analysis of Risk Retention Groups based on reported historical results through third quarter 2013. by Douglas A. Powell, Senior Financial Analyst, Demotech. Inc.

Since RRGs are restricted to liability coverage, they tend to insure medical providers, product manufacturers, law enforcement officials and contractors, as

Figure 1 – RRG Balance Sheet Metrics at 9/30 (In billions)

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well as other professional industries. While RRGs have reported direct premium written in nine lines of business so far in 2013, nearly 60 percent of this premium was in the medical professional liability lines.

Balance Sheet AnalysisComparing the last five years of

results, cash and invested assets, total net admitted assets and policyholders’ surplus have all continued to increase at a faster rate than total liabilities (figure 1). The level of policyholders’ surplus becomes increasingly important in times of difficult economic conditions, as properly capitalized insurers can remain solvent while facing uncertain economic conditions.

Since third quarter 2009, cash and invested assets increased 25.9 percent and total net admitted assets increased 19.7 percent. More importantly, over a five year period from third quarter 2009 through third quarter 2013, RRGs collectively increased policyholders’ surplus 42.9 percent. This increase represents the addition of nearly $1.1 billion to policyholders’ surplus. During this same time period, liabilities increased only 6.1 percent, approximately $258 million. These reported results indicate that RRGs collectively are adequately capitalized and able to remain solvent if faced with adverse economic conditions or increased losses.

Liquidity, as measured by liabilities to cash and invested assets, for third quarter 2013 was approximately 66.4 percent. A value less than 100 percent is considered favorable as it indicates that there was more than $1 of net liquid assets for each $1 of total liabilities. This also indicates an improvement for RRGs collectively as liquidity was reported at 68.3 percent at third quarter 2012. Moreover, this ratio has improved steadily each of the last five years.

Loss and loss adjustment expense (LAE) reserves represent the total reserves for unpaid losses and unpaid LAE. This includes reserves for any

incurred but not reported losses as well as supplemental reserves established by the company. The cash and invested assets to loss and LAE reserves ratio measures liquidity in terms of the carried reserves. The cash and invested assets to loss and LAE reserves ratio for third quarter 2013 was 237.9 percent and indicates an improvement over third quarter 2012, as this ratio was 229.1 percent. These results indicate that RRGs remain conservative in terms of liquidity.

In evaluating individual RRGs, Demotech, Inc. prefers companies to report leverage of less than 300 percent. Leverage for all RRGs, as measured by total liabilities to policyholders’ surplus, for third quarter 2013 was 127 percent. This indicates an improvement for RRGs collectively as leverage was reported at 131.9 percent at third quarter 2012.

The loss and LAE reserves to policyholders’ surplus ratio for third quarter 2013 was 80.4 percent and indicates an improvement over third quarter 2012, as this ratio was 84.2 percent. The higher the ratio of loss reserves to surplus, the more an insurer’s stability is dependent on having and maintaining reserve adequacy.

In regards to RRGs collectively, the ratios pertaining to the balance sheet appear to be appropriate.

Premium Written AnalysisRRGs collectively reported over $2.4

billion of direct premium written (DPW) through third quarter 2013, an increase of 3.9 percent over third quarter 2012. RRGs reported nearly $1.2 billion of net premium written (NPW) through third quarter 2013, an increase of 9.6 percent over third quarter 2012. These results are reasonable.

The DPW to policyholders’ surplus ratio for RRGs collectively through third quarter 2013 was 90.6 percent and indicates an improvement over third quarter 2012, as this ratio was 91.1 percent. The NPW to policyholders’ surplus ratio for RRGs through third quarter 2013 was 44.2 percent and indicates a diminishment over 2012, as this ratio was 42.1 percent. Please note that both of these amounts have been adjusted to reflect projected annual DPW and NPW based on third quarter 2013 results.

An insurer’s DPW to surplus ratio is indicative of its policyholders’ surplus leverage on a direct basis, without consideration for the effect of reinsurance. An insurer’s NPW to surplus ratio is indicative of its policyholders’ surplus leverage on a net basis. An insurer relying heavily on reinsurance will have a large disparity in these two ratios.

A DPW to surplus ratio in excess of 600 percent would subject an

Figure 2 – RRG Income at 9/30 (In millions)

32 February 2014 | The Self-Insurer © Self-Insurers’ Publishing Corp. All rights reserved.

individual RRG to greater scrutiny during the financial review process. Likewise, a NPW to surplus ratio greater than 300 percent would subject an individual RRG to greater scrutiny. In certain cases, premium to surplus ratios in excess of those listed would be deemed appropriate if the RRG had demonstrated that a contributing factor to the higher ratio was relative improvement in rate adequacy.

In regards to RRGs collectively, the ratios pertaining to premium written appear to be conservative.

Income Statement AnalysisThe profitability of RRG operations remains positive (figure 2). RRGs reported

an aggregate underwriting gain through third quarter 2013 of $28.4 million, a decrease of $15.8 million over third quarter 2012, and a net investment gain of $155.6 million, a decrease of $13.5 million over third quarter 2012. RRGs collectively reported net income of $163.9 million, a decrease of $20.4 million over third quarter 2012.

The loss ratio for RRGs collectively, as measured by losses and loss adjustment expenses incurred to net premiums earned, through third quarter 2013 was 68.6 percent and is a diminishment over third quarter 2012, as the loss ratio was reported at 63.7 percent. This ratio is a measure of an insurer’s underlying profitability on its book of business.

The expense ratio, as measured by other underwriting expenses incurred

Figure 3 – RRG Ratios at 9/30

Figure 4 – Key Ratios and Metrics – 9/30/13

to net premiums written, through third quarter 2013 was 23.8 percent and indicates an improvement over third quarter 2012, as the expense ratio was reported at 26.4 percent. This ratio measurers an insurer’s operational efficiency in underwriting its book of business.

The combined ratio, loss ratio plus expense ratio, through third quarter 2013 was 92.4 percent and is a diminishment over third quarter 2012, as the combined ratio was reported at 90.1 percent. This ratio measures an insurer’s overall underwriting profitability. A combined ratio of less than 100 percent indicates an underwriting profit.

Regarding RRGs collectively, the ratios pertaining to income statement analysis appear to be appropriate. Moreover, these ratios have remained fairly stable each of the last five years and well within a profitable range (figure 3).

Analysis by Primary Lines of Business

The financial ratios calculated based on third quarter results of the various primary lines of business appear to be reasonable (figure 4). Also, the RRGs have continued to report changes in DPW within a reasonable threshold (figure 5). It is typical for insurers’ financial ratios to fluctuate year over year. Moreover, none of the reported results are indicative of a continuing negative trend.

© Self-Insurers’ Publishing Corp. All rights reserved. The Self-Insurer | February 2014 33

Figure 6 – Direct Premium Written by State (000’s omitted)

Figure 5 – Direct Premium Written by Lines of Business (000’s omitted)

Jurisdictional AnalysisMuch like insurers, it is typical

for jurisdictions to compete for new business. Some of the factors that may impact an insurer’s decision to do business in a certain jurisdiction include minimum policyholders’ surplus requirements and the premium tax rate. RRGs have continued to report changes in DPW, on a jurisdictional basis, within a reasonable threshold (figure 6).

Conclusions Based on Third Quarter 2013 Results

Despite political and economic uncertainty, RRGs remain financially stable and continue to provide specialized coverage to their insureds. The financial ratios calculated based on the third quarter results of RRGs appear to be reasonable, keeping in mind that it is typical for insurers’ financial ratios to fluctuate over time.

The third quarter results of RRGs indicate that these specialty insurers continue to exhibit financial stability. It is important to note again that while RRGs have reported net underwriting gains and net profits, they have also continued to maintain adequate loss reserves while increasing premium written year over year. RRGs continue to exhibit a great deal of financial stability. n

Mr. Powell has nearly ten years of progressively responsible experience involving financial analysis and business consulting. Email your questions or comments to Mr. Powell at dpowell@demotech.com. For more information about Demotech, Inc. visit www.demotech.com.