Understanding Insurance Companies in Financial Distress

<p>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.

</p><p>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.

</p><p><i>GAAP vs. SAP.</i> 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.

</p><p>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.

</p><p><i>Admitted/Non-admitted Assets.</i> 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.

</p><p>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.

</p><p><i>Investment Portfolio.</i> 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>i.e.,</i> 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:

</p><ol>
<li>The majority of insurers' portfolios are fixed-income securities.

</li><li>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.

</li><li>Generally, the lower the duration, the lower the expected return.
</li></ol>

<p>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.

</p><p><i>Involuntary Underwriting.</i> 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.

</p><p><i>Rating.</i> 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:

</p><ol>
<li>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.

</li><li>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.

</li><li>The insurance company's "producers" (<i>i.e.,</i> 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.

</li></ol>

<p><i>Non-insurance Entities.</i> 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.

</p><p><i>Time.</i> 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 (<i>e.g.,</i> 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.

</p><p><i>Actuarial Forecasts.</i> 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.

</p><p>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.

</p><hr>
<h3>Footnotes</h3>

<p>^{<small><a name="1">1</a></small>} The authors are professors at Boston University's School of Management and managing directors of The Michel/Shaked Group. <a href="#1a">Return to article</a>