Understanding Insurance Companies in Financial Distress
Following the events of Sept. 11, much attention has been focused on the insurance industry. The U.S. government is even in the process of approving legislation aimed at partially protecting the insurance industry from future terrorist attacks. Nevertheless, it is clear that several insurers are already financially distressed, and turnaround and bankruptcy experts are expected to be busy working with the industry.
Whether the situation at hand is a turnaround attempt, bankruptcy reorganization plan or litigation on the basis of a fraudulent conveyance or preference, there is often a need to assess the insurance company's viability, including asset-valuation and the development of future cash-flow projections. Based on our experience in assessing insurance companies in financial distress, there are several issues an expert might consider when performing his/her analysis.
GAAP vs. SAP. Although most corporations usually file financial statements according to Generally Accepted Accounting Principles (GAAP) in order to conform with state insurance regulations, insurance company financial statements are typically prepared according to Statutory Accounting Principles (SAP). Publicly traded insurers will compile both sets of statements. Why is this important? Generally, with a few exceptions, SAP is a more conservative presentation of the insurer's assets and typically shows a lower surplus than the comparable GAAP statement.
One of the issues where SAP can potentially present a higher value than GAAP is related to bond valuation. In financial statements using SAP, bond values are amortized over time, but GAAP presents bonds at the lower of cost or market value. Thus, if, for example, market interest rates have risen unexpectedly, resulting in a bond's market value being significantly lower that its book value, the value under SAP (amortized value) can present a figure higher than the GAAP value (market value). This is particularly important given that bonds typically represent insurers' largest single asset.
Admitted/Non-admitted Assets. An expert valuing a company's assets sometimes starts with its balance sheet and adjusts the assets' book values to supposedly reflect fair-market values.
Unfortunately, financial statements based on SAP do not present on the balance sheet assets referred to as non-admitted assets (which are assigned a zero value). For example, non-admitted assets include automobiles, supplies, furniture/fixtures, loans/advances to certain company personnel, uncollected premiums more than 90 days due, and overdue reinsurance. While the omission of automobiles and fixtures usually does not present a major problem, in certain cases, the uncollected premiums over 90 days due can be a significant amount, with a reasonable chance of eventually collecting some or all of it. Similarly, a financially distressed firm might face an increased proportion of its reinsurers "stretching" the due date of their payments. However, it does not necessarily mean that overdue reinsurance has a fair market value of zero.
Investment Portfolio. When assessing the solvency and capital adequacy of an insurance company, the investment portfolio plays a major role. In projecting an insurer's cash flow, the investment income is typically a major source of capital needed to cover future claims/payments. Usually, the market values of securities in the portfolio are reasonably known. However, a less certain figure is the future income expected to be generated by the portfolio. Frequently, a financial expert studies the portfolio's asset mix (i.e., proportion and types of each asset class such as fixed income, equity and convertibles) and, using a cash-flow model, projects the future investment income. However, there are several issues to bear in mind:
- The majority of insurers' portfolios are fixed-income securities.
- A financially distressed firm, because of the need to maintain a higher level of liquid assets, sometimes has to shorten the duration of its fixed-income portfolio.
- Generally, the lower the duration, the lower the expected return.
Thus, even if the bond market conditions are not expected to change drastically, the liquidity need due to financial distress might lead to a shortened duration of the fixed-income portfolio, which could then result in a lower level of investment income.
Involuntary Underwriting. In turnaround situations, every dollar counts. One area the experts should pay attention to is the underwriting of involuntary policies. Generally, in order to be allowed to do business in a certain state, the state regulators force insurance companies to collect what is referred to in the industry as "involuntary premiums." The interesting issue with these policies is that it is almost a certainty that the insurance companies will lose money on them. And the more you have of this kind of policy, the more you lose. Usually, this involuntary business represents a small fraction of an insurer's cash flow and is simply considered the "cost of doing business" in these states. However, for a financially distressed insurance company, negative cash flow business can often be detrimental. Therefore, it is worthwhile forecasting the expected extent of involuntary premiums of a distressed insurer and the related projected cash outflows.
Rating. An insurance policy is typically renewed on an annual basis, and thus the policy-holder has an option not to renew it once the word spreads that the insurance company is financially distressed. Moreover, often, once the insurer's financial ratios have deteriorated, the credit-rating agencies respond by lowering the insurer's claim-paying ability rating, which compounds the insurer's troubles with respect to several issues, including:
- Numerous loan agreements include the following language: "The borrower should maintain insurance with financially sound and reputable insurers with an A.M. Best rating of A- or better." Thus, once the rating has been lowered beyond this critical level, such borrowers have no other option but to take their policies to another insurer, leading to a further worsening of the cash-flow situation for the already distressed insurer.
- Once the rating of the insurer's claim-paying ability is downgraded, we often observe an "adverse selection" phenomenon: While policy-holders with attractive business are able to easily shift their policies to a more financially sound insurer, the policies with low or negative profit margins remain with the financially distressed insurer.
- The insurance company's "producers" (i.e., its agents and brokers) might start redirecting new business to other firms. A certain proportion of virtually every insurance company's agents are not "exclusive" and have ongoing relationships with other insurers.
Non-insurance Entities. Insurance companies' executives often diversify into non-insurance businesses, such as investment advisory, money management, real estate, and pension and benefits consulting. Obviously, the market conditions and nature of the cash flows of these entities might well be different from the insurer's core business. Time should be allowed and appropriate experts retained to value these entities. Furthermore, there is a difference between one insurance company where the non-insurance businesses are under a separate holding company and a firm where these non-insurance businesses are under the corporate structure of the insurance company. In the latter, the ability to divest these assets is much more limited given the insurance commissioner's power and duty to protect the policy-holders, and thus restricting the insurer's ability to quickly change its asset mix.
Time. In a bankruptcy or turnaround situation involving an ordinary industrial corporation, a plan can be developed and implemented in a fairly short period. Plants can be closed, services offered can be cut and other measures can be applied. In contrast, given the regulatory nature of the insurance industry, the time it takes to get the plan approved is often longer than the turnaround expert can afford. The regulatory hearings usually take place in one state, while representatives of other states are also invited. In addition, the insurance commissioner overseeing the process also invites the public to attend such meetings, which often attracts various groups to the hearings, including representatives of the policy-holders (e.g., a corporation with significant potential liabilities concerned about its insurer's viability). In addition, sometimes the insurance commissioner hires several consultants to opine on the actuarial, financial and legal aspects of the financially distressed insurer. Obviously, to perform their duties diligently, they all need time. The bottom line is clear: Professionals undertaking reorganization and turnaround plans involving insurance companies should allow for significantly more time than the comparable turnaround plan of a non-regulated entity.
Actuarial Forecasts. An insurance company's viability is critically dependent on its payment pattern: the timing and future amounts expected to be paid in the form of losses and loss-adjustment expenses. Although the typical valuation expert is often able to perform financial forecasts, it is useful to have an actuary on the team who is qualified to render a certified opinion on the adequacy of the insurer's reserves. This is relevant for both ordinary workouts and the litigation process.
The issues described in this article are only a small subset of the potential topics that the expert must consider. Moreover, the relevance of each of these issues varies from case to case. Nevertheless, they are useful in understanding the unique nature of the insurance industry, particularly when the margin for error may be quite narrow.