Selecting A Suitable Company

At one time it was thought than any insurance company would do. As we have seen companies go into receivership, this attitude has changed. Agents now should realize that company strength is extremely important to the consumer of any product, but especially those that may not be called upon to pay benefits for many years. It would be hard to understand why an agent would use any company that could not demonstrate financial strength. It would be even harder to explain replacing a policy underwritten by a financially strong company with one from a weak company.

There are multiple rating firms that rate insurance companies based on various financial data. Many professionals recommend looking at the rating of more than one financial service.

An Ethical Obligation to the Consumer

Due diligence involves doing what was required in a reasonably prompt manner. It also means knowing enough about the companies represented to feel comfortable about their financial strength. Agents are required by ethical standards to practice due diligence.

Agents have an ethical obligation to describe accurately the financial strength (or weakness) of the insurers they represent. This is true of any insurance policy being proposed or replaced. In fact, it has been held that an agent has a legal obligation to accurately describe such financial data. A lawsuit could be brought against an agent who causes a client to suffer financially as a result of the agent's failure to fulfill these "due diligence" responsibilities.

Most agents wish to provide his or her clients with the best products available. Certainly a career agent would want to do so simply to remain in business. It may be the agent's lack of understanding of (or attention to) some of the technical terminology used in documents pertaining to the financial strength of insurers that causes problems down the road. In other words, many agents either do not understand or fail to read much of the material that is available regarding the companies they deal with. Terms such as admitted assets, consolidated assets, projected mortality, plus many other terms can cause confusion or misunderstanding. The agent may have a vague idea of what the terms mean, but not an actual understanding. Certainly, much of the printed material available is not stated in a way that makes the information understandable.

Many of the terms used are associated with the company's balance sheet, its statement of assets, liabilities, and the owner's equity. The following are terms that agents need to be familiar with:

ADMITTED ASSETS are those assets the company is allowed by state regulatory authorities to include in its statutory annual balance sheet. Some of a life insurance company's assets may be excluded in the interest of balance sheet conservatism, although most assets are admitted. If an asset is a nonadmitted asset, regulators generally regard it as a bit less sound than admitted assets. Nonadmitted assets are typically thought to provide less security for the company's policyholders. Nonadmitted assets include such things as the agents' balances owed to the company, office furniture, and mortgage loan interest income that is overdue by more than a specified length of time.

CONSOLIDATED ASSETS are the total of the assets of the parent insurance company and all the subsidiary companies, if more than 50 percent of the voting stock is owned. Even though two or more separate companies, for the purpose of the balance sheet, own the assets the assets are combined and treated as if they were owned entirely by the parent company. This is due to the voting control the parent company has. Even the assets of subsidiaries not engaged in the life insurance business are included in the consolidated assets of the parent company.

INVESTMENT GRADE ISSUES are often seen in a percentage form. These are bonds whose insurers have been evaluated by a recognized rating agency that has placed them in one of the agency's few highest quality rating classifications. Generally speaking, the higher this percentage is, the greater the safety of the bonds in the portfolio. Therefore, the greater the insurance company's financial soundness. Even so, the rating assigned to any particular bond issue can be lowered without warning as a result of many circumstances or events.

It is common for insurance companies to advertise that their assets exceed large quantities of money, such as $2-billion. While it is important to have sufficient quantities of assets, the amount of those assets will mean nothing if the company's liabilities equal or top the amount of assets. The sizes of a companys assets are less important than the percentage of liabilities to assets. There is a basic balance sheet equation:

Assets = liabilities + owners' equity.

All three components must be considered before the strength of a company may be correctly judged.

OWNERS' EQUITY is the amount of the insurance company's assets that are financed with funds that were supplied by owners rather than by creditors.

CONTINGENCY RESERVES are accounts (from owners' equity) that are voluntarily set aside by the insurance companies for the possibility of unforeseen future adverse circumstances. Usually the board of directors will not pay dividends from these reserves.

UNASSIGNED OR PERMANENT SURPLUS is the amount of the mutual insurer's owners' equity that has not been set aside for any specific reserve or purpose.

COMMON STOCK that is referred to in financial statements is the total number of shares of common stock outstanding. They are usually valued at an arbitrary (and usually low) dollar amount. This may be called par or stated value per share.

ADDITIONAL PAID-IN CAPITAL and CONTRIBUTED SURPLUS is the same thing. It is the excess of the selling price of the stock at the time it was issued over its par value. Neither the amount of the capital stock account nor the additional paid-in capital account has any relationship to the present value of the stock life insurer's common shares.

A balance sheet also contains a section on the company's liabilities. The largest amount listed will be for amounts owed to policyowners and the beneficiaries of the life insurance policies. There may be (though not always) the normal borrowed funds and accrued expenses payable.

MANDATORY SECURITIES VALUATION RESERVE is also generally listed in the liability section. This is a reserve (as the name implies) of some of the assets (not necessarily cash) that is set aside to prevent changes in the amount of the company's unassigned or permanent surplus, which may result from fluctuations in the market value of other assets such as bonds, preferred stock and common stock.

Even though the Mandatory Securities Valuation Reserve is listed in the liability column of the balance sheet, it is not a true liability. It is more like a reserve for amounts owed to others. State regulatory authorities decide the size the reserve must be which is determined by a number of factors.

CAPITAL RATIO is the portion of the company's total assets that are financed by owner's funds. This is often the measure used to determine the insurance company's financial strength. It may also be called Capital-To-Assets Ratio or Surplus-To-Assets Ratio. The higher this percentage is, if all other things are basically equal, the greater the company's financial strength is thought to be.

Notice that the previous statement said: "if all other things are basically equal." Since the Capital Ratio is so often used to compare the financial strength of companies, it is important to realize that different ingredients may be used in determining the ratio.

Sometimes an insurance company will make reference to its income statement as a basis of financial strength. Income is only part of the picture, of course. A company's direct premium income does not show any premium income or outlays resulting from reinsurance transactions, for example.

NET PREMIUM INCOME is typically defined as its direct premium income plus premiums it earns from reinsurance it assumes, minus premiums it gives up due to reinsurance that it transfers to another company.

The equation is basic:

1. Direct premium income

2. Plus premiums earned from reinsurance it assumed

3. Minus premium it gives up due to reinsurance it cedes to other companies

4. Equals = NET PREMIUM INCOME.

Even though this formula may be used by an insurance company to suggest its financial strength, it really is only about half of the needed information to make a sound judgment call. In fact it is more likely to tell an agent the size of the company, rather than its financial strength.

SURPLUS REINSURANCE is the transfer of a portion of the amount of coverage under a life insurance policy to a reinsurer. The ceding or surrendering company then is allowed, if regulatory requirements are met, to also transfer to the reinsurer a corresponding portion of the aggregate reserve liability under the policy. The ceding company (transferring company) receives a credit against its liability for the portion transferred. Some feel the use of surplus reinsurance may be a sign of an insurance company's financial weakness.

Many agents overlook the terms from the balance sheet that we have discussed here. Typically, agents are more concerned with a company's rating from the rating firms, such as A.M. Best. That information is certainly easier for the agent to obtain and understand. It is also probably easier to relay to a potential client in a sales situation. However, it is becoming increasingly evident that such rating firms are not infallible. There are also differing opinions among rating firms. Which one is the correct rating? There have been insurance companies who enjoyed a high rating and yet ended up in financial trouble. A career agent simply must look beyond the rating of the companies he or she chooses to recommend.

Guaranty Funds

Guaranty funds are designed to protect consumers from insurer failures. Not all states have such funds. Many agents probably are not aware that such state guaranty associations typically cover only the guaranteed values of the policy, not the projected, assumed or illustrated values. Some states exclude specific products from their guaranty fund guarantees.

There are so many things that play a part in an insurance company's financial strength. Things such as underwriting standards, how reserves are set up, risk spreads, management, and reinsurance practices are a few of the things that will affect a company's financial strength. An agent cannot know all that is involved in a company, but an agent can look past the surface of the brochures put out. Remember that any given company is selling itself not only to policyholders, but to the agents as well.

Realizing that insurers are also selling the insurance agent (so that insurance agents will sell their products), an agent can take a common sense approach to due diligence. For a busy agent, it can be difficult to follow through on all financial details involved in an insurance company's financial report. While the technical analysis is certainly important, such analysis is not always possible.

There may be a combination of factors to consider when assessing a companys financial strength. A company that makes one or more obviously big financial mistakes may end up with financial problems. An example of this is the companies that invested in junk bonds. Although the bonds looked good at the time, there was no lack of warnings from the professionals about the problems that could (and eventually did) occur.

Signs of Company Trouble

Losses should not exceed gains. While this may occasionally happen, it is most definitely a warning signal. Losses eat up capital and surplus funds. In fact, if money is going out faster than it is coming in, for whatever reason, a red flag should go up.

Sometimes a lack of public trust can cause problems. If the consumers perceive a problem within a company, they will begin to withdraw funds or quit paying premiums. A company that is trying to hang on may be pushed over the edge when such actions occur.

Perhaps the best common sense approach is simply looking at the products being offered. If any given product seems to give much, much more (commissions plus high interest rates for the policyholder, for example) than other similar products, then it is possible that trouble is waiting down the road. Product design may also reflect the company's outlook and philosophy. If gimmicks rather than sound design seem to hold the product together, that could well be the philosophy of the company. Is the product set up to "catch and hold" a policyowner rather than benefit them? Could you find yourself in an embarrassing situation down the road when your client requires service or benefits?

If a company is not a mutual company, then it is often a good idea to know who owns the company. The company's owners will reflect their own values and ethics throughout the company itself. While it may not be possible to know what the values and ethics are of any given person, the agent can look to their past history. Do they come from the insurance field? What financial education do they have? Looking at their backgrounds can give the field agent a general idea of what to expect.

The object of using these common sense approaches is not necessarily to find the best companies, but rather to weed out the worst of them. An alert insurance agent must keep their eyes and ears open. Listen to other agents.

The quality of service clients receive from the home office is also a mark of financial strength or weakness. Does the insurer listen to their clients? Do clients receive help in an appropriate time frame? Is the home office willing to work with their clients to satisfy them? A financially strong company works to retain their policyholders.

Certainly, there is concern in any industry if the number of insolvencies dramatically increases. The majority of companies that become insolvent are in the property/casualty field. Insolvency usually reflects poor management and/or the amount of claims incurred. Natural disasters can contribute to property/casualty failures.

Real estate investments have haunted the insurance industry to a certain degree. However, when you look at the types of loans made by insurance companies when compared to the savings and loan industry, the differences cannot be overlooked. Most of the commercial real estate loans made by the S&Ls were for new construction. The primary loans made by insurance companies were on completed projects that were occupied and do, therefore, have a cash flow.

There is one area where many businesses, including the life insurance industry, has attempted to divert attention. In the past, debt levels were highly stressed. We are now seeing the emphasis placed more on returns and profitability. An S&L may boast about the amount of deposits they have. What they fail to mention is that deposits are actually considered liabilities; not assets. An insurance company may flaunt the amount of insurance in force. Again, this is a liability; not an asset. Financial strength is based upon assets and profitability.

Persistency of in-force policies is one of the best indicators of strong products and good service. Persistency is a measure of marketing strength and service effort. It is also a measure of how well the agents have matched products to a client's needs.

It is never an easy task to be both a successful agent in the field and a company watchdog as well. Over the long run it will pay off, however. Think of each contract (policy) as a personally signed document. You place your name on each policy you write. Do you want your name on anything less than the very best?

End of Chapter Eight

United Insurance Educators, Inc.