Financial Management and Analysis for Insurance

Companies

INTRODUCTION

Financial strength, broadly used, refers to the ability to withstand financial strain. It provides an
indication of the size and quality of an entity’s assets relative to its liability. Although size is
generally used to measure strength, the quality of net assets is much more important than its
magnitude. The interest in analysing an insurer’s financial strength therefore will be to provide
an opinion on the ability to meet its current and on-going obligations to its policy holders on a
timely basis. (Re)insurers do not just provide covers. They provide guarantees / promises that
they will be there with a big umbrella during the torrential rains that are bound to happen when
the heavens open up. You need to know how big the umbrella is and how strong it is to
weather the storm.

Assessing financial strength involves a thorough and comprehensive quantitative as well as

qualitative analysis of a company’s balance sheet strength, operation, performance and
business profile. To achieve a credible assessment, the analyst should evaluate both the
quantitative and the qualitative aspects of a company. It goes beyond just computing ratios.
The interpretation of the result of the analysis is the key.

There are various groups within an entity’s operating environment and each of them are
interested in the financial strength of the firm. These potential users and beneficiaries include
management and employees, shareholders, governments and tax authorities, competitors,
financial analysts, etc.

Before any analysis can be performed, there is the need to obtain relevant and reliable
information sufficient to provide a basis for such assessment. By far the most important source
of information about a company is its financial statements, including its audited accounts and
Annual Reports, quarterly accounts (where available), reports filed with regulatory agencies and
other publicly available documents such as rating agencies, brokers and agents. Of course a
very important source of information, about which you would probably read the least, is the good
old market gossip!

In analysing financial strength, the single most important area to evaluate is the balance sheet
strength. Balance Sheet here used, not in the narrow sense, but to mean the full audited
Financial Statements. Due to the importance of the financial statements as a source of
information for analysing financial strength, it is important to understand the underlying rules
governing the preparation of those statements as well as their general structure and contents.

GENERAL FINANCIAL STATEMENTS

The purpose of any business is to make a profit for the owners and in order for a
businessperson to establish whether the business s/he is involved in is making a profit s/he
must therefore keeps an accurate record of his/her trading practices. These records are set out
in a formalized manner in the Annual Financial Statements of the business.

Whilst it is only compulsory for a company or close corporation to maintain accurate records,
even a sole proprietor would wish to know the status of the business. As a company may have

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many shareholders, some of whom (being minority shareholders) have little control over the
running of the company, annual financial reporting criteria has been laid down in law to protect
these shareholders. It is assumed that these reports will always be sufficiently detailed in order
to clearly establish the status of the company.

A company is thus required, on an annual basis to provide the following:

a Director's Report;

an Auditor's Report;

a Cash Flow Statement (also known as the Cash Flow Report);

a Balance Sheet;

notes to the Balance Sheet and Income Statement;

an Income Statement.

We will concentrate on the balance sheet, the income statement and the notes to these two
documents but looking briefly at the other documents.

The director’s report

The director's report will provide an insight into the operation of the business during the past
financial year. Should any circumstances have materially affected the company's state of affairs
or be expected to affect future operations the directors are required to bring this to the attention
of the shareholders in this report. Where new shares or debentures where issued or where
major changes in the fixed assets of the company occurred during the past year these must also
be disclosed. The director's report must also explain the policy of the directorate in terms of the
declaration and distribution of dividends. Further the names of all the directors and the company
secretary must be clearly set out.

Of late it has become important for the Directors’ Report to contain mention of the broader
aspects of the so-called “triple bottom line”, which requires companies to address staff and
social issues in addition to the all-important shareholder profits. Thus mention may be made of
progress in employment equity or achievements in line with a Black Empowerment drive as well
as activities addressing social upliftment and general welfare projects.

The auditor’s report

Every company is required to have its books audited by an independent auditor. The auditor
must examine the operation of the business and compare his/her findings with the documented
annual financial reports. Should s/he be satisfied that the financial statements reflect,
accurately, the state of the company's affairs s/he will state this in his/her report. Where the
auditor feels it necessary to qualify his/her report an investor should study this very carefully as
this is normally an indication of an unsatisfactory state of affairs within the organisation.

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Cash flow statement

This statement provides an analysis of the various sources from which the company derived
funds during the year and how they where utilized. An astute investor who can correctly
interpret this information will find, in this document, valuable information with regard to the
financing of the business operations of the organisation. Note that only registered public
companies are required to provide this report.

The balance sheet

The balance sheet reflects the true state of the company frozen in time, almost like a
photograph taken on a specific date that will reflect the state of the affairs of the company on
that date only. The balance sheet consists solely of assets and liabilities and provides the
businessperson with a measurement of the wealth of the company on the date specified at the
top of the balance sheet. The balance sheet is commonly divided into two sections being
"capital employed" and the "employment of capital".

Capital employed

The capital employed within the company is reflected as a long term liability within the balance
sheet. The reason is simple. On setting up a business there are basically two areas of finance -
capital injected by shareholders and the creation of long term loans.

On the winding up of the company these loans and the capital provided to the company by the
shareholders will need to be repaid - hence the liability. A further source of capital employed is
the retention of profits at the end of a trading year. These are also the property of the
shareholders and are thus also a long term liability to the company.

On the balance sheet the capital employed will thus fall under the following headings.

(i) Ordinary share capital

This is the total amount that the shareholders have paid into the company in order to
acquire a share in the ownership. Whilst a shareholder within a public company will be
able to sell his/her shares (for example: on the stock exchange) the company will normally
not return any of the ordinary share capital held by it to the shareholders until the company
is wound up. It is fairly common (particularly within a private company) to see the ordinary
share capital divided into two groups i.e. the issued share capital and the unissued share
capital. Unissued share capital is normally held in reserves by the directors and is issued
(and paid for) when the company wishes to raise more capital. Shares are normally
reflected on the balance sheet at their par value i.e. the value of the shares at the inception
of the company.

(ii) Capital reserves

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 Where a company issues shares at a value greater than the par value of the shares the
additional capital will form a part of the capital reserves of the company.

Should a company make a profit in a particular year (reflected in the income statement) the
directors may choose to retain a portion or all of these profits for the benefit of future
growth within the company. Where the decision of the directors is to transfer the retained
profits to the capital reserve these retained profits will be classified as non-distributable. As
all capital reserves can only be paid to the shareholders upon the winding up of the
company the directors will be unable to distribute these profits at a later date.

(iii) Distributable reserves

When a company first begins operations it has no profits, only the ordinary share capital
provided by the shareholders. If, after the first year of trading the company makes an after
tax, net profit the directors of the company may at their discretion, declare a dividend and
pay this profit over to the shareholders, or choose to retain the profit in order to assist in
the growth of the company. Should the transfer be to the capital reserve the profits will
need to remain within the company until it is wound up (see "Capital Reserves" above).
The directors may, however, elect to transfer the money into the distributable reserve
account. It would then be possible for the directors to utilise this money for the payment of
a dividend at some later stage of the company's existence.

(iv) Ordinary shareholder’s interest

This is an accumulation of the Ordinary Share Capital, the Capital Reserves and the
Distributable Reserves due to the shareholders on the winding up of the company.
The shareholders would, however, only receive this value if the assets of the company, on
its winding up, are realised at the book values reflected on the balance sheet. In practise
this is seldom the case.

(v) Long term liabilities

Debts due by the company that are only repayable on a date more than one year from the
date of the balance sheet are considered long term. Included in this category would be the
director's loan accounts. Long term debts are normally secured by the pledge or cession of
a specific fixed asset for the duration of the loan. Should the company then default on the
debt by either the non-payment of interest or the non-repayment of the loan (perhaps in
annual installments) the assets in question would be sold and the proceeds used to repay
the loan plus any unpaid interest.

(vi) Director's loan account

We have already looked at the creation of equity within a company by means of the sale of
ordinary shares to prospective shareholders. It is, however possible (particularly within a
private company) that the principal shareholder would not wish to tie up his/her capital to
such an extent within the company that s/he would be required to sell the company (his/her
shares) or liquidate the company merely to withdraw his/her capital. S/he would therefore

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 as a director create a loan account within the company and lend it the capital and withdraw
the capital at some later stage when the company arrived on a sound financial footing.

The total of all the sums reflected on the balance sheet under the headings explained
above would provide the Capital Employed.

Employment of capital

The balance sheet items listed under this heading generally refer to the assets in which the long
term funds in the business (the Capital Employed) have been invested in order to support the
business activities.

On the balance sheet the employment of capital will reflect the assets and current liabilities of
the company. Assets can be divided into 3 basic categories, being the Fixed Assets, Current
Assets and Intangible Assets. Intangible Assets are items such as goodwill and patents.
Goodwill is usually not reflected on a company's balance sheet. (They may, however be
reflected on its own or “tucked away” under fixed assets and hence reflected on the balance
sheet.)

(i) Fixed assets

This item on the balance sheet usually refers to the fixed property (land and buildings) as
well as the plant, office equipment, motor vehicles, fittings and furniture needed to run the
business. These are not purchased for resale but are used in the manufacturing, control,
delivery or other normal functions of the business.

It is not uncommon to see the fixed assets of the company listed in separate groups on the
balance sheet (for example: motor vehicles; office equipment).
Fixed assets are normally reflected on the balance sheet at their initial purchase price less
accumulated depreciation. This therefore does not reflect the fair market value of the asset
nor does it reflect its replacement cost. It can also be said that the fixed assets of a
company are those tangible assets that have a period of use or value of more than one
year.

(ii) Current assets

(a) Stock

This item is composed of raw material, work in progress and completed

manufactured products. The value of raw materials is usually reflected at the cost
price to the business. Work in progress needs to include the cost of any labour and
possible overhead expenses that have already been incurred in the processing of the
raw material into the finished article.

Manufactured goods are valued at the cost of raw materials plus the direct labour
cost and production overhead expenses. Should the realisable value of the
manufactured goods, however, be lower than the actual costs incurred the lower
value will need to be reflected on the balance sheet.

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 (b) Accounts receivable

This item reflects the value of any credit sales currently outstanding to customers on
the date of the balance sheet. It is normal for a manufacturer to grant periods of credit
to good customers of 30, 60, 90 or 120 days.

(c) Bank balances and Cash

A company will always need to retain a certain amount of cash on hand for normal
operating expenses (for example: petty cash). Should the cashflow into the company
in a certain period exceed the amount needed for normal operating expenses the
company may elect to bank the excess. This money may well be needed in a period
of high productivity (for example: a special order requiring additional temporary
labour).

The three items mentioned above (Stock, Accounts Receivable and Bank Balances and
Cash) reflect the total Current Assets on the balance sheet and are usually blocked
together as a single item.

It must however be realised that the items mentioned herein are only a sample of the many
items that may occur in order to make up the Current Assets on the balance sheet and that
the list indicated here is by no means exhaustive.

(iii) Current liabilities

(a) Bank Overdraft

During peak production periods it is not unusual for a manufacturer to request an

overdraft from its banker for "bridging finance". Additional labour and raw materials
may be required and the additional outlay may result in a shortage of ready capital.
It is usual for a banker to require that the overdraft be repaid within a period of 1 year,
but overdrafts are demand loans and could be recalled immediately. This thus makes
the overdraft a current liability and not a long term loan that would need to be
included in the Capital Employed.

(b) Accounts Payable

In the same way as a company will usually grant credit to its good customers
(reflected under Accounts Receivable) so too will the financial director of the
company request a period of grace from its creditors. These outstanding amounts
(payable within 30, 60, 90 or 120 days) must be reflected as an outstanding liability
on the date of the balance sheet.

(c) Taxation

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 This figure represents the amount of assessed tax due to the Receiver of Revenue
but not yet paid. This will not only indicate that there is currently still unpaid tax due
on any profits that the company has made. Any Value Added Tax (VAT) that is due
but not yet paid must also be reflected. VAT due will, however, normally be indicated
as a sub-heading in this section.

(d) Dividends proposed

A dividend may have been declared by the directors of the company and will have
been reflected on the Income Statement. It is possible that the dividend has not yet
been paid at the date of the balance sheet. As this money has already been allocated
to the shareholders, payment must be made and it should be reflected as a liability
against the company on the balance sheet.

The four items mentioned above (Bank Overdraft, Accounts Payable, Taxation and
Dividends proposed) reflect the Current Liabilities on the balance sheet and are usually
blocked together as a single item. It must however be realised that the items mentioned
herein are only a sample of the many items that may occur in order to make up the Current
Liabilities on the balance sheet and that the list indicated here is by no means exhaustive.

(iv) Working capital

In order to establish the Working Capital one needs to deduct the value of the Current
Liabilities from the value of the Total Current Assets. The answer reflected here gives one
an indication of the value of the current assets that are permanently funded out of the
Capital Employed (long term funding).

(v) Total employment of capital

By adding together the value of the working capital and the value of the fixed assets one
will arrive at the "total employment of capital". In order for the balance sheet to balance the
"employment of capital" must equal the "capital employed".

Notes to the balance sheet and Income statement

Not all the useful information that may be needed to do an accurate evaluation of the company
is necessarily found on the balance sheet or income statement.

A lot more detail is very often available in the explanatory notes attached to these two
documents. One will usually find a more detailed breakdown of the assets and liabilities of the
company as well as a statement reflecting the company's accounting policy.

Items to look for in the notes are contingent liabilities and future capital expenditure.

Contingent liabilities

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A contingent liability will indicate the possibility of the company perhaps having been sued and
needing to therefore make provision for legal expenses. To a potential investor this is usually
taken as an indication to tread warily and perhaps to reconsider the purchase of shares.

Future capital expenditure

No company should ignore the need to expand into the future. The changes in technological
advances and the constant expansion of markets will mean that a company, in order to retain
market share, will need to constantly provide for future capital expenditure. This item listed in
the notes should thus be fairly common. Should the amount allocated for future capital
expenditure seem excessive, the investor should take note. It is possible that the current
manufacturing plant and machinery now needs upgrading or replacement. This will not
necessarily result in an increase in production and could thus effect the future bottom line.

Financial Statements contain summarised information of a firm’s financial affairs, organised

systematically. They are the means of presenting reports of the firm to the owners, creditors,
employees, government and the general public. Since modern day business structures entail
separation of ownership from management, managers have to report periodically to owners on
how efficiently or otherwise owners resources have been utilised. Basically, the preparation of
the financial statement is the responsibility of the Accountant and is generally covered under the
accounting and financial reporting functions.

Financial statements are prepared to assist management in decision making and provide
reliable and up-to-date financial information about the economic activities and obligations of the
business enterprise. They also provide information about changes in the net resources of an
enterprise as well as giving useful information to the investors, creditors and other stakeholders
or predicting, comparing and evaluating potential earning power and cash flows in terms of
amount, timing and related uncertainty.

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 EXAMPLE OF A TYPICAL BALANCE SHEET

ABC LIMITED
CONSOLIDATED BALANCE SHEET
AT 31 DECEMBER 2008

2008 2007
CAPITAL EMPLOYED
Ordinary share capital
(being 500 000 shares @ R1,00 each) 500 000 500 000
Capital reserves 350 000 350 000
Distributable reserves 1 250 000 1 000 000
Ordinary shareholder's interest 2 100 000 1 850 000
Long term liabilities 400 000 350 000
Director's loan account 2 500 000 2 500 000
TOTAL CAPITAL EMPLOYED 5 000 000 4 700 000

EMPLOYMENT OF CAPITAL
Fixed assets 700 000 800 000

Current assets 6 800 000 4 500 000

Stock 2 800 000 1 325 000
Accounts receivable 3 540 000 2 975 000
Bank balances and cash 460 000 200 000

Current Liabilities 2 500 000 600 000

Bank overdraft 800 000 200 000
Accounts payable 1 000 000 350 000
Taxation 200 000 50 000
Dividends proposed 500 000 ----

Working capital 4 300 000 3 900 000

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TOTAL EMPLOYMENT OF CAPITAL 5 000 000 4 700 000

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USING RATIOS TO ESTABLISH PROFITABILITY AND VIABILITY

Knowing what the various items on the financial statements of a company are assist us in
placing them correctly as the assets and liabilities of the company. Indices are a useful way of
telling us how the business is performing.

The best way to establish how the business is doing is by expressing certain key figures found
in the financial statements as ratios. One of the prime factors looked at when a business is
being investigated is its ability to meet its short term debts (i.e. liquidity). Short term debts are
those that have to be repaid within one year. As these debts can only be paid out of the
available cash resources of the company it must therefore be obvious that liquidity is dependant
upon the company's ability to generate cash. Naturally this cash must be readily available to pay
the debts and not be earmarked for some other purpose. As cash is generated by the current
assets and the short term debts constitute the current liabilities it makes sense to compare
these two. The two methods of comparison that are most often used are:

the current ratio method;

the acid test ratio method.

The current ratio

In order to establish the current ratio one simply divides the current assets by the current
liabilities. Using figures that we can extract from the sample Income Statement and Balance
Sheet that were drawn up for ABC Limited

Current assets 6 800 000

= = 2,72 : 1
Current liabilities 2 500 000

It is generally accepted in the accounting profession that a ratio of 2,:,1 or better is the ideal
situation for a company to be in. ABC is thus in an extremely healthy position.

Acid test ratio

Bank managers often consider stock on hand to be the least liquid of a company's current
assets. They are thus inclined to exclude these from the ratio when they investigate a company
to determine its ability to repay short term debts. The acid test ratio therefore uses only those
assets that are either already in cash or are considered to be readily converted. Looking at the
acid test ratio for ABC Limited:

Current assets 6 800 000

Less stock 2 800 000
"Quick" assets 4 000 000

Quick assets 4 000 000 = 1,6 : 1

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 Current liabilities 2 500 000

This is still a very healthy position for a company to be in. Most bankers would accept a ratio of
between 1 and 1,5.

Leverage ratio

When a banker is asked to lend further funds to a company s/he will wish to establish to what
extent the company assets have been funded with borrowed money. The greater the
percentage of borrowed money used the higher the risk. A banker who thus lends to a company
considered to be a high risk will demand a higher interest rate. A ratio considered acceptable is
usually one below 50% (dependant naturally on factors such as the type of business and the
state of the economy). Looking at ABC one would have to consider the director's loan account
as part of the equity placed into the business by shareholders. Should this not be the case the
company would be over exposed and an unacceptable risk to a money lender. Thus, excluding
the director's loan account from our calculation:

Long term liabilities 400 000

Current liabilities 2 500 000
Total Debt 2 900 000

Fixed assets 700 000

Current assets 6 800 000
Total assets 7 500 000

Total debt 2 900 000 = 38,67%

Total assets 7 500 000

Another version of this, known as the debt equity ratio, assesses the relationship between funds
raised by borrowing and those supplied by the owner(s).

Thus we could have:

Total debt = 2 900 000 = 1,38

Equity 2 100 000

(The equity used includes the original share purchase plus reserves built up in the company
subsequently.)

Profitability ratios

The most common of these is the return on investments (ROI), which measures the efficiency of
the use of capital:

Net income (after tax) = 750 000 = 5,24%

Total assets 14 300 000

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The net income can also be expressed over the owner’s equity to check the return to the
owner(s) or over sales to ascertain the net income margin on sales.

Thus:

Net income after tax = 750 000 = 35,7%

Owner’s equity 2 100 000
Net income after tax = 750 000 = 9,93%
Sales 7 550 000

Activity ratios

These ratios measure the efficiency of cash moving through the business, for example stock
turnover, debtors’ period and creditors’ period but they are probably not relevant to most broking
businesses.

Break even analysis

The costs involved in running a business can be divided into fixed costs (those that will be
incurred whether sales are made or not) and variable costs (those that relate to sales activity
and which are incurred in proportion to sales made).

The break even analysis determines the level of sales at which income covers the fixed costs
and the relevant variable costs. This is then the point at which the business starts to make a
profit.

FINANCIAL VALUATION

The valuation of business enterprises

There are a number of different ways of determining the value of the shares in a business. The
purpose behind this valuation is to ensure that an investor, interested in purchasing shares in
the company, does not pay more for the shares than they are truly worth. Naturally an investor
may be prepared to pay a premium on the shares in anticipation of future growth. Note that the
use of the "Intrinsic valuation method" (also known as the “net asset valuation method”) is
usually limited to an application in the valuation of property or investment owning companies, it
will suffice for our purposes.

Other methods of valuation are also available and set out below. You will find that every method
of valuation has its own strengths and weaknesses and will thus be used for specific
applications.

Intrinsic valuation method

• Value all the assets at their market value.

• Value all the liabilities.

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• Deduct the liabilities from the market value of the assets.

• Divide the answer obtained by the number of issued shares to determine a price per share.

Using ABC as an example:

Assets(assume all assets are listed on the balance sheet at their market value)

Capital reserves 350 000

Distributable reserves 1 250 000
Fixed assets 700 000
Current assets 6 800 000
9 100 000
Liabilities
Long term liabilities 400 000
Director’s loan account 2 500 000
Current liabilities 2 500 000
5 400 000
Assets less liabilities 3 700 000

As there are 500 000 issued shares in ABC the value per share can be determined by dividing
R3 700 000 by 500 000.

Thus the value per share = R7,40

Using the earnings yield method

• Establish the anticipated future earnings of the business, per annum and after tax.

• Establish what is considered a fair rate of return.

• Capitalise the annual anticipated earnings at the fair rate of return.

Example

 Assume annual earnings after tax to be

Assume a fair rate of return of
300 000
12%

The value of the business would thus be

100
× 300 000 = R 2 500 000
12

Should the number of issued shares = 100 000 then each share is worth R2,50.

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While this method is widely used in practice the main objections to this method are:

profits are treated as a perpetuity; and

the capital employed in the business are ignored.

Using the dividend yield method

• Establish an anticipated future dividend declaration.

• Establish what is considered a fair rate of return.

• Capitalise the anticipated dividend at the fair rate of return.

Example:

 Assume an annual dividend of

Assume a fair rate of return of
R3,00
12%

The value per share would thus be

100
× 3,00 = R25
12

Should the number of issued shares = 100 000 then the business is worth
R2,500 000.

As a minority shareholder can play no part in the management of the company and is also
unable to influence the dividend distribution this is perhaps the most appropriate method to be
used in assessing the value of his/her investment. A holding below 30% can be construed as a
minority stake.

Using the future benefits method

This method is most appropriate when valuing redeemable preference shares, debentures and
participation mortgage bonds.

Example:

 Nominal value of the debentures

Fixed interest rate
Period to repayment
R100 000
8,5% per annum
10 years

Calculate the present value:

The yield on a similar investment (taking into account current interest rates)
should provide a fair rate of return of 10%.

The annual income is 8,5% on R100 000 = R8 500

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 Using the "Present value of R1 per Period" table for 10 years @ 10% the factor
is - 6,14457

8 500 × 6,14457 = R52 228,85 (Present value of future interest payments due)

Nominal value at maturity is R100 000

Using the "Present Value of R1" table for 10 years @ 10% the factor is -
0,385543

100 000 × 0,385543 = R38 554,30 (Present value of the discounted nominal
value)

The present value of the debenture = 52 228,85 + 38 554,30 = R90 783,15

Using the super profit method

• Determine the capital employed in the business.

• Establish an anticipated income flow for a reasonable period (usually 5 years).

• Establish a fair rate of return.

• Ascertain super profits.

• Establish the present value of goodwill.

• Goodwill added to the capital base indicates the value of the business.

Example:

 Total assets employed in the business

Anticipated income flow (per annum for the
next 5 years)
R100 000

25 000
Fair rate of return 15%

Anticipated income flow 25 000

Fair rate of return (based on 15% of R100 000) 15 000
Super profit per annum R10 000

The value of the goodwill is based on the present value of the super profit for
the reasonable period chosen.

Using the "Present value of R1 per Period" table for 5 years @ 15% (the factor
is - 3,35216)

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 10 000 × 3,35216 = R33 521,60 (Value of goodwill)

Total assets employed in the business R100 000

Goodwill as calculated 33 521,60
Total value of the business R133 521,60

This method is appropriate when one is valuing a majority holding in a company. It would not be
valid for an assessment of the value of a minority stake in the company.

Cash flow management

Although a more detailed section on accounts has been included elswhere, the importance of
cash flow management to a broking business is so great that this deserves special mention. It is
a sad fact that many small businesses, especially broking operations, fail simply because of
poor cashflow management.

The company’s cash flow should be projected ahead.

Proper plans need to be put in place to ease cash flow “squeezes” as and when they occur.
(The use of a bank overdraft facility, whilst generally readily available and simple, is often not
the most efficient solution.)

Care needs to be taken to follow up on outstanding payments awaited to speed up the cash
inflow into the business.

Payments need to be regulated to time major cash outflows as best as possible.

The financing of major expense items to ease cash flow needs to be carefully evaluated.

OTHER ISSUES

SECURITY

Security has become a major component of doing business in the world due to the high rate of
crime, both violent / physical as well as fraud related white collar crime.

Whist steps need to be taken to protect the physical safety of all staff, there is also a need to
secure the financial position of the company as best as possible.

On the financial side there are several procedures and policies that need to be worked through
to enhance the security of the finances. Some of these are discussed below.

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Minimise the cash handling

1. Electronic payment systems are an effective way of doing this, while they are also more
cost effective than transactions in cash or by postal cheques.

2. Any cash should be regularly deposited to limit the holding on the premises.

3. Any cash handling needs to be properly controlled and recorded, whilst it is always a good
idea to make sure that two people confirm all amounts received or disbursed.

4. Proper storage facilities (such as a secure safe) need to be installed, with suitable controls
on the access.

Control signing powers

Secure the exit points

Some office designs are easier in this regard than others. Whilst there is always a threat of theft
from outsiders coming onto the premises (unless this is well controlled), it is also true that many
businesses lose a lot of money through staff simply taking office property home.

(This includes stationary, electronic equipment and, possibly grocery items where the business
maintains some form of catering facility, for example: coffee units.)

Institute systems

Proper systems need to be set up to control purchases of the various items needed to run the
business, using a procedure for requisitions and orders. Any guidelines that are to be adhered
to, need to be formulated and written down. For example, if it is a policy that only locally
manufactured stationary will be bought, this needs to be spelt out at the outset. All deliveries
need to be checked for quality and quantity.

Look for patterns

Be aware of the behaviour patterns of staff and, particularly, for those that could indicate a
penchant for embezzlement, such as regular participation in gambling, accounts staff who work
regularly on weekends, etc.

Investments

Any business will need some form of investment to maximise the return that can be got on
“surplus” cash. The range of available investments will need to be investigated in order to
decide what form would be applicable to the business. Any investments outside of the
business’s needs need to be carefully weighed up in terms of the long term strategy, taking into
account tax implications, estate duty, ownership, etc.

Current account

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It is likely that at least one current bank account will be needed to allow for the daily deposits
and the regular account payments. In some cases it may even be wise to run more than one
account in order to facilitate cash management. Banks will usually levy charges according to the
traffic through the account and the best terms need to be negotiated. Often banks are open to
allowing lower fees (or even no fees) where a minimum balance is retained in the account and
this should be investigated, even though it ties up a limited amount of capital.

Call account

A version of account that is ideal to operate alongside the current account is the call account.
Although this account does not have the typical transaction facilities available on a current
account, it can be used to store bulk cash amounts, accessing the money infrequently via
electronic transfer to top up the current account. A daily balance interest rate is paid.

Notice account

Another form of account that is useful for storing money that is not required to be accessible at
all times is the notice account. Typically a 32-day notice period is required for withdrawals and,
provided adequate financial planning is done, this can result in considerable interest earnings
for the business.

Deposits

A slightly more rigid form of deposit is a stated period deposit. Terms of 60 days, 90 days, six
months and 12 months can be considered. The higher interest rate offered needs to be weighed
against the tying up of the capital and good financial planning is necessary, although it should
be noted that funds can be accessed before the end of the stated period on negotiation with the
bank, even though the interest rate will be adjusted downwards.

Longer term fixed interest investments

The use of longer term fixed interest investments for money that is not likely to be needed for
some time needs to be considered as an alternative to other forms of investment (such as
equities) or, more likely, as part of the overall investment strategy to earn good interest returns
when interest rates are relatively high and the stock market is in decline.

Equities

Whilst care needs to be taken not to go overboard with stock market investments (an area that
is not core to the brokerage business) it is likely that bigger firms will be involved in share
purchases from time to time, often as part of a business strategy.

Property

19
The attraction of a firm owning its own premises is not to be denied, both in curtailing the
otherwise ongoing rental escalations and in providing a long term fixed asset. However, against
this the following needs to be considered:

• working capital is tied up;

• the cost of maintenance could be high, whilst

services such as security, cleaning, etc will have to be handled by the broking business,
which is not a key focus area;

• the risk of property ownership in a fast changing

urban landscape is considerable;

• ownership may be restrictive on future growth or

downsizing;

• property investment is not the main focus of the

broker’s expertise.

Where property is leased, the terms of the lease need to be carefully examined before any deal
is concluded. Care should be taken not to accept unreasonable inflation escalations, whilst the
vagaries of business are such that leases of over 5 years need to be considered with
considerable caution, even if they offer attractive benefits in terms of settling in allowances, etc.
or bigger firms the issue of naming rights will have to be a part of the negotiations.

FINANCIAL REPORTS

Proper financial control requires regular reports. Some of these would be needed on a daily
basis, such as a cash flow analysis including bank balances and, probably, sales. Others should
be prepared weekly, such as the income and expense statement.

The monthly figures should follow the pattern of the formal year end books i.e. include a full
balance sheet, income and expenditure statement and even a source and application of funds
report. These monthly figures are then rolled up to produce the year end figures.

The monthly accounts should be compared with the budgeted figures, preferably including the
year to date and a reference back to the same period in the previous year.

This allows a reasonably good analysis of the figures, with a view being taken as to whether any
variances are purely cyclical (and will be eliminated in time) or whether they are as a result of a
fundamental shift in the business. It is a good thing to use this information to then recalculate
the projected annual position. Remember that often it is necessary to take action if the figures
are weakening, since a small business may not survive a full year of operation if interim
corrective steps are not put in place.

PROFIT AND LOSS ACCOUNT

This is the scorecard of the firm’s financial performance during a particular period. Whereas the
balance sheet shows the resources and obligations of the firm at a particular date, the income

20
statement shows how effectively the firm’s resources were utilized in the generation of wealth
during a particular period. It shows how well the firm has been able to control expenditure
during the accounting period.

The difference between the revenues and expenses is defined as net income or profit (loss) and
is transferred to the balance sheet (owner’s equity) through the appropriation account.

(a) Revenues

Revenues are recognized when ownership risks and rewards are transferred irrespective
of cash receipt. Care should be taken in recognizing revenue in special cases like long-
term contracts including life insurance, or where there exist a right of return.

(b) Expenses

These are usually divided into two different categories viz:

♦ Cost of goods sold (cost of sales) / underwriting outgo
♦ Selling, general and administrative expenses.

Cost of goods sold will relate to direct / identifiable cost of buying and/or manufacturing
goods sold. It is usually the single largest expense group. In an insurance office /
company, these will typically include paid / incurred losses, incurred losses,
commissions paid, brokerages and charges, payroll cost of technical staff and other
underwriting outgo.

Selling, general and administrative expenses will include all other expenses not treated
as cost of goods sold. This will include depreciation, financial charges, auditors’
remuneration, directors’ fees etc.

In the financial statement of an insurance company, it is usual to separate the income

statement into two:

♦ Underwriting Revenue Accounts

♦ Profit and Loss Account

The underwriting revenue account will contain all the technical items: premium,
adjustment for changes in unearned premium provision, losses paid adjustment for
movement in outstanding losses provision, commission, brokerages, management
expenses etc.

The excess of income over outgo (underwriting profit) is determined at this level and
then transferred to the Profit and Loss Account. This can be likened to the gross profit in
a normal trading or manufacturing organization.

The Profit and Loss Account reports the Investment and other non-underwriting income
with the financial and other administrative expenses. The profit and loss is then
transferred to the owner’s equity account through the profit and loss appropriation
account.

REGULATORY FRAMEWORK

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As a result of the diversity in the interests and requirements of different users of financial
statements, it is imperative that financial statements be produced using known and common
basis, policies and principles.

The preparation of financial statements is governed by Statutes and Accounting Standards.

The statutes define the generic framework for conducting business transactions and accounting
for such transactions. Every country will have its own set of laws designed to regulate business
practices. The majority of the laws for the English speaking countries of the continent will have
the English companies Act as their root, while the Francophone derives from the French codes.

In addition to the requirement for compliance with the relevant legislation, financial statements
are prepared in accordance with standards set by the relevant accounting regulatory bodies. In
those countries where the practice of accounting is sufficiently organized, you will have national
accounting standards, otherwise the International Accounting Standards are adopted as
proxies.

Accounting standards include:

♦ Statement of Accounting Standards (SAS)

♦ International Financial Reporting Standards (IFRS), formerly IAS

While the statutes provide the general framework and define broad requirements, the standards
are designed to ensure at the very minimum, compliance with the laws using acceptable
accounting principles.

To properly appreciate financial statements, it is necessary to understand the conventions and

rules guiding the preparation of such statements.

ACCOUNTING CONVENTIONS AND RULES

♦ Business entity
♦ Going concern
♦ Prudence
♦ Realisation
♦ Materiality
♦ Monetary measurement
♦ Consistency
♦ Matching
♦ Objective / Fairness

Having reviewed the structure and content of financial statements and the principles guiding
their preparation, we would now turn to the real task of identifying the salient points contained in
those statements and present them in a form that will allow conclusions to be drawn on the
strength of the entity.

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ANALYSIS OF FINANCIAL STATEMENTS FOR INSURANCE COMPANIES

Financial statement analysis is the process of identifying the relationship between various items
in the Balance Sheet and Profit & Loss statements as a way of assessing the strength and
weaknesses of the reporting entity. Financial statement analysis helps to measure the liquidity,
the efficiency, the solvency and the profitability of an enterprise. Therefore in reading financial
statements, users are interested in answering one or more of the following questions:

♦ How liquid is the company?

♦ How profitable is the company?
♦ How efficient is the company?
♦ How stable is the company?

These questions are pertinent for the (re)insurance manager who is seeking good security to
provide (re)insurance cover, or for the investment manager responsible for managing the
investment portfolio or for the business development manager wishing to identify targets for
marketing.

Typically, analysts would focus on the underwriting, financial as well as asset leverage in
assessing overall balance sheet strength. The key focus of Balance Sheet analysis is to
determine the impact of a company’s operating and financial practices on its capital. In
principle, a highly geared or poorly capitalized company is likely to be more exposed to a high
risk of instability resulting from catastrophes, unexpected losses, adverse changes in
underwriting results, fluctuating investment returns, investment losses and changes in
regulatory or economic conditions than a company with a conservative level of leverage. To
gain a better insight into the “story” the financial statements tell and highlight the relationship
amongst several areas of the financial statements, analysts make extensive use of financial
ratios.

RATIO ANALYSIS

The absolute figures reported in the financial statement may not provide a meaningful
understanding of the performance and financial position of the company. Accordingly, financial
ratios are designed to show the relationship between two numbers or group of numbers on the
financial statement which may be expressed in fraction, percentage or in absolute number. In
analysing the financial strength of an insurer, it is pertinent to review the following areas:

Capital
Stability
Investment / Assets
Profitability
Business Profile

The list is by no means exhaustive. Neither does it seek to be prescriptive. They have been
highlighted to guide our discussion of the process of financial strength assessment.

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CAPITAL

By far, the most important issue in the financial strength assessment is the capital in terms of its
adequacy and appropriateness. Several aspects of capital are considered including the
absolute size and quality while a number of tests are applied to gain a better understanding of
this critical Balance Sheet area.

a) Change in Net Premium Written

NPW1 - NPWO x 100

NPWO

The objective here is to assess the company’s ability to support controlled

business growth. Growth or decline by more than 30% would require further
investigation. As with other ratios, the result is NOT conclusive. It merely
provides a basis to make further enquires especially where it falls outside what is
considered the standard range.

b) Reinsurance Utilisation

Measures a company’s dependence, on the security provided by third parties

(Reinsurance).

Ceded Premium
Gross Written Premium

c) Solvency Margin

NPW or SHF
SHF NPW

In its simple form, the solvency margin relates to the shareholders’ funds to the net written
premiums, expressed as a percent. Statutory solvency margins usually take the form of a

24
somewhat arbitrary value (say 5x or 20%) and a formula is shown for qualifying assets (assets
to be included) and assets to be excluded.

This percentage gives a crude appreciation of the adequacy of shareholders’ funds in relation to
the level of underwriting exposure. It is used to assess the company’s exposure to pricing
errors in its current book of business. Generally, the higher the ratio, the stronger the firm is
adjudged. There are a number of variants to the computation which seeks to measure the
number of times that an insurance company’s eligible assets exceed the local regulatory
minimum margin. Whatever the variant however, the basic aim is to assess the adequacy of
amounts available over and above the premiums to meet the future claims obligations of the
insurer.

The fundamental flaw of the current solvency measures is that it relates capital to
premium not risk and assumes that one unit of premium equates one unit of exposure.
As the industry has witnessed over the past few years, a reduction in rates (and therefore
written premiums) tend to produce a much stronger solvency while in actual fact the real risk
could be as great and the probability or underwriting loss very much greater due to premium
inadequacy. Similarly, if rates fall and the insurer write more business the solvency ratio may
remain the same but the risk exposure has substantially increased.

Other facts affecting the validity of the solvency margin computation include:

♦ Current level and trend of underwriting and overall loss

♦ The size of technical reserves relative to net premiums
♦ The volatility of investment value
♦ Possible failure of reinsurers to pay.

It is for these (and more) reasons that the rating agencies adopted a broader, rather more
rigorous risk based model of assessing capital adequacy. The models are typically fashioned
after those of the U.S. National Association of Insurance Commissioners. Capital adequacy is
measured by the ratio of Adjusted Capital (AC) to Required Capital (RC).

The second part of the analysis seeks to ascertain the amount of capital required to support
each of the areas of business activity at a level considered satisfactory.

CAR = AC x 100
RC

Where: AC = Total Adjusted Capital

RC = Total Required Capital
CAR = Capital Adequacy Ratio

The first part of the analysis tries to establish the true capital base of an insurer by taking the
published shareholders’ funds and then adjusting this gross figure by what is termed a prudent
“hair cut”. This entails adjusting the gross figures for a margin against possible future downturn
in investment values, hidden reserves, including deliberate over reserving (unearned premium
and loss reserves), valuation differences, off balance sheet items, valuation and amortization of
intangible assets, non-recurring profit or loss, etc. These serve to even the playing field by

25
seeking to reflect and/or standardize certain economic values not properly or uniformly captured
in the statutory financial statements. It will also provide a more economic and comparable basis
for assessing capital adequacy.

The required capital is therefore defined as the capital needed to support all those identified
risks, adjusted for a co-variance calculation on the basis that all the risks are unlikely to develop
simultaneously. Typical risk categories include:

 Fixed Income Securities

 Equity Securities
 Interest Rate Exposure
 Credit Risk
 Loss Reserves
 Written Premium
 Business Risk

While the key risk areas for P&C companies are the loss reserve risks and written premium
risks, life companies are more exposed to credit risk and interest rate risks.

Underwriting Risk

Not surprisingly, the largest risk category that typically accounts for about 66% of an insurer’s
gross required capital is underwriting, including net premiums as well as loss and loss
adjustment expenses reserve.

Investment Risk

Investment risk relates to the risk of default, illiquidity as well as market value variation in the
case of equities and fixed income.

Credit Risk

Risk of non-collection of receivables due to third party default. This include due from foreign
and local reinsurers. Mitigating factors are collateral held against the receivables and the rating
of those counterparties.

A ratio of 100% - 125% gives a rating equivalent of “BBB” which is the benchmark for a good
security. The classification of the other results are as follows:

26
 S&P AM BEST
CAR RATING CAR RATING CAR RATING
175%+ AAA 175 A++ 90 B
150% - 175% AA 160 A+ 80 B-

125% - 150% A 145 A 70 C++

100% - 125% BBB 130 A- 60 C+

115 B++ 50 C
75% - 100% BB
100 B+ 40 C-
50% - 75% B

The model is used for measuring how well a company’s capital base would stand up to a
reasonably stressful (but by no means worst case) underwriting and investment scenario. It
should be noted however that in addition to the Capital Adequacy Ratio, other quantitative and
qualitative measures are used in assessing capitalization levels. Such considerations include
quality of capital, reserve adequacy, appropriateness of reinsurance protection, among others.
In addition, the capital structure of holding companies can have a significant impact on the
overall financial strength of an insurance company subsidiary. And it is a double edged sword.
While a bog, credible and properly capitalized holding company can provide subsidiaries with
additional financial flexibility (capital infusion, access capital markets etc.), a debt-ridden holding
company can reduce financial flexibility and place a strain on the earnings and cash flows of the
subsidiary.

Accordingly, where the company being analyzed belongs to a group, it would be useful to take a
look at the financial position of the other companies within the group, especially the holding
company. When the holding company engages in other non-insurance businesses, it would be
necessary to review those non-insurance operations to determine their impact, if any, on the
overall financial strength of the insurance operations. Recent case of an insurance company in
South Africa with major investment in a night club!

STABILITY MEASUREMENT

Stability is measured by the ability of the company to make principle and interest payments on
its outstanding debts and its ability to pay regular dividends to its stockholders. Common
measures of stability include:

♦ Debt-Equity ratio:

Total Debt
Total Owners Equity

27
♦ Total Interest bearing debt to Total Capitalization:

Total Interest Bearing Debt

Total Interest Bearing Debt + Owners’ Equity

♦ Times interest earned:

Earning Before Interest & Taxes

Interest Expenses

♦ Dividend payout ratio:

Dividend paid
Net Income

QUALITY OF ASSETS

A key indicator of an insurer’s financial stability is the quality and appropriateness of invested
assets. Insurers would typically invest in money instruments, fixed income securities, equities,
real estate, etc. It is necessary to evaluate the risks associated with the assets and the
potential impact a forced sale could have on shareholders’ funds. Generally, the better the
liquidity, diversification and/or quality of the assets the greater the level of financial stability. In
assessing financial strength therefore, analysts will review invested assets for liquidity,
diversification, single obligor concentration, sensitivity to interest rate / exchange rate changes,
speculation etc.

Liquidity

Because liquidity measures a company’s ability to meet its obligations to third parties on a
timely basis, a lot of attention is devoted to liquidity measurement in assessing financial
strength. As insurance is about risk and uncertainty, liquidity is a very critical issue to consider.
To measure a company’s ability to meet its financial obligations without having to sell fixed
assets or other (long-term) investments under unfavourable market conditions, the analyst
would review the level of cash and cash equivalents that have a very low exposure to market
fluctuations. It is also necessary to evaluate the size and stability of operational cashflow as
well as the quality, diversification and market value of invested assets.

Liquidity assures additional importance for a life insurer. It is therefore necessary to establish a
life insurer’s potential vulnerability by reviewing the asset and liability maturities under normal
conditions as well as “stress cycles” in the event of a crisis of confidence. Such crises, which
can be triggered by internal events or the external environment can lead to a “run on” the
insurer. The analysis will include an assessment of the insurer’s liability structure and the
withdrawal pattern for life policies. Obviously, companies with a high concentration of current
surrenderable liabilities will be expected to maintain a significant level of liquidity.

Generally various tests are performed to assess a company’s liquidity.

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Current Ratio:

Current Assets
Current Liabilities

The current ratio estimates the degree to which current assets cover current liabilities. It
measures reserve of liquid funds in excess of current obligations available as a margin of safety
against unexpected interruptions in operations. The rule of thumb commonly employed (by
bankers) is that the current ratio should be at least 2.

Quick ratio

The quick ratio estimates how far current liabilities are covered against easily convertible current
assets. Generally in the current assets group, Inventories are considered less liquid and are
therefore deducted from total current assets in determining the quick ratio.

Quick Ratio:

Current Assets less Inventories

Current Liabilities

A ratio of not less than 1 is considered normal. It measures the proportion of net liabilities
covered by cash and cash equivalent. It gives an indication of an insurer’s ability to settle its
outstanding liabilities without borrowing or prematurely disposing of long term assets.

Other ratios that can supplement the current ratio are:

♦ Cash Ratio:

Cash + Cash Equivalent

Total Current Assets

♦ Average collection period:

Average Accounts Receivable

Net Credit Sales

The debtors and creditors ratios deserve special mention especially as it affects the insurance
industry in the continent. Because trade practices in most part of Africa have not caught up with
the rest of the world, receivable still constitute a significant percentage of the total assets being
carried in the balance sheet of a number of African insurers and reinsurers. Considering the
level of inflation and currency devaluation or depreciation in most countries, the financial losses
being suffered are enormous. It is not unusual to find balances outstanding and unpaid for
more than one year. It is very important therefore to pay particular attention to this term in
financial statement and it’s relationship to premium income.

The AM Best model differentiates between overall liquidity and current liquidity.

29
The overall liquidity is defined as total assets divided by total liabilities, less conditional
reserves, expressed as a percent. This ratio assumes the collectability and marketability of
reinsurance receivables, affiliated investments as well as other uninvested assets. We are all
aware of the settlement record of a number of companies in our industry. A range of 110% -
180% is considered acceptable, with liability companies expected to have lower ratios than
property insurers.

The current liquidity relates the sum of cash and cash equivalents, accrued investment income
and unaffiliated invested assets to net liabilities. The ratio measures the proportion of liabilities
covered by cash and cash equivalents and can be compared to the quick ratio. Where this ratio
is less than 100%, the company’s solvency is highly dependent on the collectability or
marketability of premium balances and investment in affiliates. The acceptable range for this
measure is 95% - 140%, with life and liability risks underwriters expected to produce the lower
ratios.

Operating Cash flows

This ratio measures an entity’s ability to meet current obligations through internally generated
cash flows from insurance operations. Negative operating cash flow may indicate unprofitable
underwriting and/or low yielding assets.

PROFITABILITY

While liquidity is important in determining a firm’s ability to meet maturing obligations in a timely
and efficient manner, in the long run, profitability is what enables an insurer to operate as a
going concern and perpetuate balance sheet strength, including liquidity. The analyst is
interested in the stability and sustainability of the insurer’s sources of income in relation to its
liabilities profile. To fully understand the insurer’s profit, it may be necessary to analyze the
sources of profit, including underwriting, investment, capital gains / losses and any other
unusual or other non-recurring income or expenditure. Because profitability is easily susceptible
to valuation / measurement methodologies, it is also important to fully understand the
accounting basis used in measuring income and expenditure as well as assets and liabilities.
The profitability ratios measure the profit earning capacity of the company. Commonly used
measures of profitability include:
Premium:

Primary determinant of the profitability or loss expenditure should be analysed by class,

geographic area and should be computed on gross, net, paid and incurred / earned basis.

% Change in Net Premium

Change in Premium
Base Year Premium

This will measure the percentage increase or decrease in the premium income over the
previous year. This will enable the company to determine whether they are growing or
otherwise in terms of production capacity. It will also enable an assessment of whether growth
is controlled or is haphazard. Where the growth rate is less than the rate of inflation, then in real
terms, the company is actually writing less than it did the previous year. Where the rate of
growth is lower than the industry average, it could mean that the company is actually losing
business to competitors. A range of + 30% is considered normal.

30
Loss Ratio:

♦ Losses paid / Gross premium

♦ Losses incurred / Earned premium
♦ Net losses paid / Net premium.

This measures the percentage of premiums that is consumed by losses. There are variations in
measurement.

Although insurance companies are generally in the business of paying claims or incurring
losses, high level of professionalism and prudent underwriting (including an efficient reinsurance
programme) can help to properly manage those losses to within acceptable limits.

It is a fact that high loss ratios will adversely affect the entity’s ability to continue in operational
existence in the long run.

Expense Ratio

Measures the operational efficiency in underwriting

Underwriting expenses
Premium

Combined Ratio

The combined ratio is the sum of the loss ratio and expense ratio. A combined ratio under
100% means the insurer has made an underwriting profit for the period. It is a measure of the
company’s pure underwriting profitability before adjustment for investment income and is
defined as:

Incurred Loss + Underwriting Expenses x 100

Earned Premium Earned Premium

As per the AM Best guidelines, the normal range for this test is set at 95 – 110, with property
underwriters expected to return lower ratios than companies underwriting predominantly long-
tailed liability risks.

Return on Revenue

Pre-tax operating income

Net earned premium

Return on Equity

31
 Net Profit
Shareholder’s Funds

This measures the efficiency of the operation and use of company capital during the accounting
period. Since most companies are not run as charities, this is probably the most important ratio,
especially from the view point of the owners of the company.

Investment Yield

Investment Income
Gross Premium

This is a composite measure of how promptly written premiums are collected and how efficiently
collections are invested. Investment income is a major component of an insurance company’s
income. The general rule is that investment income should at least cover the management
expenses and produce a profit. This is why a lot of emphasis is placed on prompt collection of
premiums and settlement of balances to reinsurers or co-insurers.

TECHNICAL RESERVES

Before any meaningful conclusion can be reached on an insurer’s profitability, liquidity and
capitalization, it is necessary to evaluate the adequacy or otherwise of its reported reserves.
Invariably, profit and capital are directly affected by movement in reserves. While loss reserve
is vital in determining financial strength, unfortunately, the ability to predict ultimate reserve
requirements is as much as an art as it is a science. Although the industry has developed some
rather sophisticated stochastic models to estimate reserve levels, the fact that there are
significant shortfalls in reserves (asbestos, environmental production, etc.) goes to show that at
the end of the day, it remains what it is – a miserable estimate!

Common tests of reserve adequacy include:

_ Technical Reserves x 100

Written Premium

 Compute gross and net

 Compute general business separately

_ Technical Reserves
Shareholders’ Funds

Again, care should be taken when analyzing the results of these computations. In addition to
looking at trends and comparing with industry standard or peers, exceptions should be analyzed
by reference to the company’s specific situation. The portfolio composition, tail of business,
whether reserves are discounted or not are some of the issues that the analyst should take into
consideration in interpreting the results of the computed ratios

REINSURANCE PROGRAMME

32
Reinsurance is an integral part of an insurer’s risk management process and it provides
additional financial flexibility. Often, an insurer’s ability to meet its financial obligations can
become highly dependent upon the performance of its reinsurers. The profitability of an
insurance company can also be significantly exposed to the ups and downs of the reinsurance
markets. Where there is a huge dependence on reinsurers, the insolvency or dispute with a
major reinsurer can become problematic for the company. Generally speaking, the more a
company is dependent upon reinsurance, the more vulnerable it’s underwriting capacity and
financial strength is to negative movements in the reinsurance market. As a cedant, I would
expect my reinsurer to have a decent level of retention ratio. Otherwise, the signal to me is that
in the case of a major catastrophe, the reinsurer and invariably my company will be dependent
on a 3rd party, who incidentally may be totally unknown to me. A cedant should therefore be
interested in not just the current retention ratio, but the development of that ratio over time.

BUSINESS PROFILE

An insurer’s business profile is influenced by the degree of risk inherent in the company’s mix of
business, competitive market position and the depth and experience of its management. Key
business profile issues include:

 Spread of Risk

Here, the analyst must analyze the book of business by line, geographical spread, product
and distribution. The size of a company, measured simply by its premium volume, is not
sufficient to support a conclusion on the spread of risk. While the general assumption is that
large companies have a natural spread of risks, a small company, which is professionally
managed, writing conservative lines of business and avoiding a large concentration of risks
can attain the same or higher degree of stability.

 Revenue Composition

It is also important to analyze written premiums by line of business and determine the
impact of changes in the amount, type and geographical distribution. External changes in
economic, regulatory, legal and financial market environments can have profound impact on
the financial strength of an insurer.

 Ownership and Management

For any corporate organization, the quality and depth of experience of management are
amongst the key ingredients for success. In addition, because insurance is based on the
foundation of trust and good faith, prudent management is generally more important than is
required in other industries. The analyst will need to make qualitative judgments on
management’s ability to develop and sustain appropriate strategies to respond to the ever
changing business and market environment.

 Market Risk

The insurance market risk reflect the potential financial volatility that is very much an integral
part of the overall financial system. While some risks are generic and common to all market
participants, others are specific to individual segments of the insurance market or specific
entities. The analyst will need to consider potential exposure to and impact of the identified
risks on individual insurers and their ability to manage those risks.

33
 Event Risk

Here, the analyst is looking at a variety of sudden or unexpected circumstances that can
potentially impact on insurer’s financial strength.

Reputation

Apart from the examination of the ownership structure and quality of management, each insurer
has a distinct image with its customers, reinsurers and the insurance world in general. Is the
company cautious and conservative or is it highly innovative whiz-kid stuff? What is the
relationship with the market bodies? Is it efficient in responding to correspondences etc. Are
the financial statements prepared and audited on a timely basis? The analyst will consider all
these and more as part of the overall financial strength assessment.

EVALUATION OF FINANCIAL RATIOS

Two broad measures for the evaluation of the ratios for individual companies are used. One is
to compare them with industry averages, while the other is to analyze historical trends.

Industry Standards

A comparison of individual ratios with industry composites is useful as a starting point. It is not
determinate, however. The product characteristics of the individual firm may differ somewhat
from those of the industry as a whole. For example, benchmarking the results of a company
specializing in life business with the industry average, where 75% of the markets general
business, could lead to inaccuracies. In addition, the firm may follow specific policies which
make its situation somewhat different from that of the industry. An important value of comparing
the individual firm with the industry, however, is that if differences are observed they form a
basis for raising the significant analytical questions: Why are the ratios different? What distinct
and different policies are being followed? What is the basis for these different policies? Under
what economic conditions would these policies be particularly advantageous? Under what
economic and financial circumstances would different policies of the firm be undesirable or
unfavorable? These are the kinds of questions that can be raised by a comparison of the
individual firm’s ratios with those of industry composites.

Industry data are usually available with the Insurance supervisory authorities, research
departments of large national corporations or the insurance institute.

Analysis of Historical Trends

Trend data is a comparison of ratios over time within a company. It would provide indications as
to whether the company is doing better or worse and lead to further enquiries where large and
unexplained variations are observed from year to year.

Although there is no agreed number of years to use when examining the trend in a company, a
range of three to six years is used in most analyses. Less than three years is not considered
sufficient to establish a trend while more than six years is less meaningful because the external
environment usually changes making the comparison difficult.

34
The statutes of a number of countries requires financial statements to contain a five year
summary of key financial data.

Selected firms in the same industry

Ratios of some selected firms in the same industry especially the most progressive firms within
the industry at that point in time could be carried out. This will enable the analyst ascertain the
position of the firm or the company within the industry i.e. whether the firm is a leader or a
follower.

A WORD OF CAUTION

Because the analysis of an insurer’s financial strength relies heavily on the financial statements,
the analyst should fully understand and factor in the limitations of the financial statements being
analysed. Many of those limitations relate to shortcomings identified with the underlying
statements being analysed. Without doubt, the document that draws the most criticism is the
Balance Sheet and some of the commonly cited disadvantages (which I must admit are inter
related) are as follows:

Focus on the past as against the future

The balance sheet record a position which existed on a certain date in the past, whereas what
most users want to know is the position which is likely to arise in the future. It should be noted
that past performance is useful only when it helps to forecast their likely future achievement.
Using historical data as the sole basis of judgment has been likened to attempting to drive a car
looking only at the rear-view mirror. Therefore, in addition to the historical financial statements
the analyst should review financial projections, where available, and subject these to the same
level of analysis.

They are out of date by the time they are seen

Some delay is inevitable because an audit cannot be completed within minutes of the end of the
financial year of an enterprise. Developments in information technology and audit practices
have helped a great deal in reducing the time lag between the end of the financial year and the
publication of financial statements. Time limits have been set (by law) within which accounts
have to be submitted to supervisory authorities and/or published. It is however still not
uncommon for accounts to be delayed by more than 12 months before they are finalized and
published. A number of companies try to reduce this problem by publishing interim or unaudited
financial statements immediately after the end of the reporting period.

They only show assets and liabilities which can be measured in financial terms

In most cases, financial statements are silent on:

♦ Quality of management, age and health of Directors, succession plan, etc.

♦ The presence of assets carrying zero book value but which may still possess operational
value.
♦ The trading environment etc.

35
In recent times, the Chairman’s and Director’s reports have tried to provide the non-quantitative
information to assist users in better appreciating the Dollars and Cents in the financial
statements.

The independent rating firms seek to overcome this by devoting a great deal of the review
process to analysing non-financial indicators. Such issues include the quality of management,
country risk, regulatory framework, level of diversification, strategic director etc.

Historical cost concept

Assets are recorded and reported at the lower of cost or net realisable value. Accountants’
conservatism. Although this concept is criticised, it has its merits.

The accounts are often produced for tax purposes

Various schemes are devised by individuals and organizations to minimise the tax liability,
ranging from what is referred to as tax planning to tax avoidance. Often times it is difficult to
determine when the dividing line is being crossed. Areas that are susceptible to manipulation
include stock valuation, technical reserves (unexpired risk and outstanding losses).

The accounts are a snapshot of a business at a moment in time

Most companies, like individuals, like to look their best when they are photographed. Creative
accounting has been known to take many dimensions.

Common practices include:

♦ Capitalizing revenue expenditure

♦ Canceling out extra-ordinary losses by transfer from reserves, or making sure that an extra-
ordinary credit appears the same year, possibly by revaluing land and building.

36
OPERATING REPORT FOR THE PERIOD ENDED – 31 MAY 2009

ALL BRANCHES UNAUDITED

ACTUAL BUDGET VARIANCE

$ $

Gross Premiums Written 2,760,420 4,591,979 1,831,559

Reinsurance Premiums 1,387,280 2,749,212 1,361,932

Net Premiums Written 1,373,140 1,842,767 469,627

Increase/(Decrease) in UPR 365,274 276,415 (88,859)

Premiums Earned 1,007,866 1,566,352 558,486

Other Underwriting Income - - -
Total Net Premiums Earned 1,007,866 1,566,352 558,486

Gross Claims Paid 256,626 781,452 524,826

Claims Recovered 222,546 380,243 157,697

Net Claims Paid 34,080 401,209 367,129

Increase/(Decrease) in Outs. Claims 131,992 296,010 164,018
IBNR Provision 68,640 92,138 23,498

Net Claims Incurred 234,712 789,357 554,645

Commissions Paid 526,109 561,602 35,493

Commissions Received 418,227 760,465 342,238

Net Commissions Paid 107,882 (198,864) (306,746)

OPERATING EXPENSES

Personnel 236,555 180,970 (55,585)

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Travel and Representation 64,315 102,730 38,415
Premises 22,232 41,623 19,391
Communication 29,588 5,350 (24,238)
Office Supplies and Expenses 15,648 17,250 1,602
Service Fees 60,429 67,215 6,786
Depreciation/Amortisation 7,098 38,500 31,402
Insurances 10,890 10,500 (390)
ZWD Write Off (67,641)
Other Expenses - -

Operating Expenses 379,114 464,138 17,383

Total Expenses 486,996 265,274 (289,363)

Underwriting Profit/(Loss) 286,158 511,720 293,203

Investment Income 3,797 33,170 21,523

Realised Gain/Loss - Shares - 83,477 62,680
Unrealised Gain/Loss - Shares 165,638 1,247,913 789,446
Exchange Gain/Loss - FCA (16) 25,062 18,832
Profit/(Loss) on Disposal of Fixed Assets (7,444) - 542

Profit Before Taxation 448,133 1,901,343 1,186,227

Taxation 44,813 190,134 118,623

Profit/(Loss) After Taxation 403,320 1,711,208 1,067,604

Dividend Paid -
Transfer to General Reserve -

Retained Profit/(Loss) for the Year 403,320 1,711,208 1,067,604

TECHNICAL RATIOS
Reinsurance/GPW 50.26% 59.87%
UPR/NPW 26.60% 15.00%
Claims incured/NPW 17.09% 42.84%
Claims incured/Earned Premiums 23.29% 50.39%
Net Comm./NPW 7.86% -10.79%
Operating Expenses/GPW 13.73% 10.11%

38
 Operating Expenses/Earned Premiums 37.62% 29.63%
Combined Expenses/Earned Premiums 48.32% 16.94%
Underwriting Profit/NPW 20.84% 27.77%
Investment Income/GPW 0.14% 0.72%
Investment Income/NPW 0.28% 1.80%
Combined Expenses/NPE 48.32% 16.94%

CONCLUSION

As a result of the foregoing and probably more, managers and analysts cannot place absolute
reliance upon the results of financial ratio analysis. In general “window-dressing” practices
which will improve profitability in the short run may be utilised. Such practices include the
postponement of the maintenance of fixed assets, which will decrease costs and increase
profitability in the short run, but which will impact the firm severely when machine breakdowns
occur and production processes are interrupted. A policy of delaying the purchase of modern
equipment will decrease capital outlays and reduce depreciation expenditures in the short run.
However, failure to keep pace with competitors that are installing modern, efficient, and low-cost
machinery will adversely affect the ability of the company to compete in the global market place.

In addition, changing price levels and changes in the current values of assets can produce
distortions in accounting measures of performance and financial position. It is desirable,
therefore, to have on hand the kinds of additional information that are available regarding
current replacement values. Nevertheless, even with the supplementary information, financial
ratio analysis is not the complete answer to evaluating the performance of a firm. When
financial ratio indicates that the patterns of a firm depart from industry norms, this disparity is not
an absolutely certain that something is wrong with the firm. Departures from industry norms
provide a basis for raising questions and further investigation and analysis. Additional
information and discussions may establish sound explanations for the differences between the
pattern for the individual firm and industry composite ratios. Or the differences may reveal
forms of management calling for correction.

Conversely, conformance to industry composite ratios does not establish with certainty that the
firm is performing normally and is managed well. In the short run, many tricks can be used to
make the firm “look well” in relation to industry standards. The analyst must develop firsthand
knowledge of the operations of the firm and of its management to provide a check on the
financial ratios. In the same vein, the analyst must develop a sense, a touch, a smell and a feel
of what is going on in the firm. Sometimes it is this “sixth sense” that uncovers weaknesses in
the firm. The analyst should not be anaesthetised by financial ratios that appear to conform with
normality. Thus, financial ratios are a useful part of an investigative and analytic process, but
they are not the complete answer to questions about the performance of any firm.

39
2. QUALITATIVE ANALYSIS
a) Management and Directors profiles… you can analyse accomplishments of individual
members of management and the Directorate to check their previous track records and
past successes.

b) Branch network… you want an indication of the spread of the insurer in terms of
reaching out to the policyholders. This depends also on type of markets served and level
of automation and the strength of the service providers networks.

c) ICT capabilities… related to (b) above and you want to see how reliable is the data and
information from the insurer as well as the speed of delivery when it comes to products
and services.

d) Credit rating… you want to know the insurer’s international credit rating. You are better
off dealing with an insurer with a known claims paying ability rating.

e) Debtors Aged Analysis/Insurer’s Credit write-off policy… you want to know how
much debt makes up the insurers balance sheet and what their write-off policy is given
the market credit period agreement.
f) Treaty reinsurance spread… you want to know how well spread the insurer’s treaty
reinsurance programme is to determine over exposure and knock-on effects in the event
of catastrophe. Internationally the rule of thumb is that no one reinsurer should carry
more than 10% of a programme but in developing markets this can be relaxed to 40%
due to shortage of market participants.

g) Listing on the stock exchange… you want to know how easy it is for the insurer to
mobilize additional capital in the event of need. This is related to (f) above. You want to
assess the quality of shareholders as well.

h) Schedule of shareholders… related to (e) above. You want to assess the quality of
major shareholders in terms of their ability to inject additional capital in terms of distress.

i) Market share… you want to know how powerful the insurer is in terms of influencing
market practice; rating and developments. This is a measure of leadership.

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 j) Service Standards… you want to analyse how the insurer’s actual service delivery fares
against their promises on service delivery. You want to deal with a consistent insurer
who delivers on time all the time.

k) Innovation… you want to deal with an insurer who is market responsive and who can
develop products wanted by the market.

l) Policies… you require to know the Insurer’s policies on such items as IBNR, UPR, URR
and when uncollected premiums are reversed.

m) Reinsurance… you also need to know if premiums for non-proportional treaty cover
have been paid and also if the Insurer is settling proportional treaty reinsurance balances
and facultative reinsurance within the agreed credit period.

THE IMPORTANCE OF ASSESSING THE

FINANCIAL STRENGTHS OF INSURERS FOR THE
BROKER
There are three main factors which may endanger the security of life and general insurers:

• inadequate premiums charged and reserves

created, resulting from inadequate statistics or technical information, or changes such as a
gradual worsening of claims experience and the failure to take prompt corrective action;

• chance accumulation in the number or size of claims

against which adequate arrangements, usually by way of reinsurance, have not been
made;

• losses on investments and other assets in particular

circumstances.

IPEC has the responsibility of monitoring the situation, largely through the statutory returns
made to them by Insurance Companies.. However, even these controls are not foolproof and all
brokers have to be aware of the issue of the security of the insurers they deal with.

Whilst in most circumstances brokers are not liable for the failure of an insurer, there are several
reasons why they should monitor constantly the financial security of the companies with whom
they do business, namely:

• even if the broker is not liable for the insolvency,

they could face considerable problems with clients should they place a large volume of
business with an insolvent company;

• as a result of the above, the broker may be sued by

disappointed clients;

41
• it is possible that, as a prelude to an insolvency,
problems with claims will be experienced and this again could lead to problems for the
broker with his/her clients;

• business that has to be replaced as a result of an

insolvency may be at punitive terms, which may be unacceptable to or cause problems
with a client, and will increase the broker’s costs;

• the broker’s reputation could be permanently

damaged by association with an insolvent insurer;

• the broker itself may face financial loss as a result

of, for example, uncollected brokerage or return premiums.

(A South African legal case, that of Osman v J Ralph Moss Ltd (1970) confirmed the broker’s
responsibility in an insolvency situation where the broker advised the client to take out insurance
with a particular company notwithstanding the fact that he had knowledge that that insurer was
experiencing some financial strain.)

The depth of this assessment is of course dependent upon the size and resources of the broker.
Many small and medium sized firms have neither the staff nor the skills to carry out detailed
security reviews and therefore have to rely upon:

published data;

knowledge gleaned from regular contact with other brokers;

the “rule of thumb” methods described below.

BALANCE SHEET TESTS: GENERAL BUSINESS

In general business, most danger to an insurance company usually relates to inadequate

premiums charged and reserve created.

The charging of inadequate premiums over a period of years can more easily go unrecognised
by an insurer if proper provisions for unearned premiums and for outstanding claims are not
created at the correct time. Fundamentally, the continuing solvency of an insurer of general
business depends upon its shareholders’ funds in relation to the premium income. Since the
shareholders’ funds are, in the final analysis, the difference between the insurers’ total assets
and its sources of finance, excluding shareholders’ funds, it follows that any overstating of asset
values or understating of its liabilities will have the effect of increasing the stated amount of
shareholders’ funds.

In analysing an insurance company’s balance sheet, therefore, attention should be paid to any
signs of weakness in these balance sheet values.

Balance sheet assets

42
To obtain a realistic value of the asset side of the balance sheet it is suggested that the
following steps are taken.

Certain items may be discounted in whole or in part in the assessment:

• discount entirely goodwill, and unsecured debts of

an associated or dependent company;

• goodwill is the premium paid representing the

excess over the value of net assets when a business is acquired. As such the “asset” does
not exist and in extreme cases, (for instance solvency) will probably have no value.

Unsecured debts are of lower value than secured loans and as, technically, the parent can
exert little control over an associate, assets of this nature are of questionable value.

• discount fixed assets (other than real property) by

two-thirds;

Fixed assets are the property of the company and can include land, buildings, office
equipment, vehicles, plant and machinery. Most assets of this nature are valued on the
basis of the business as a going concern and in the event of urgent disposal may not
realise the sums shown in the accounts.

• discount real property by one-third;

Real property is land and buildings owned or on long leasehold. The lower discount
reflects the more tradeable nature of these assets.

• discount shares in associated companies by one-

third;

As the parent can exercise little or no control over the activities of an associate the
valuation may often be subjective.

• Check that the value shown in the balance sheet of

quoted investment is not greater than their current market value. If it is, the current market
value figure should be used.

• Check that not more than 20% of total assets (after

any discounting from the points mentioned above) is held in agents’ or companies’
balances.

Agent balances: agent balances are simply the amounts owing to the company from its agents,
and in most cases the amounts will fall due quite quickly. In a long established company, agent
balances will be one of a diverse range of assets. However, a new company will be more
dependant on new premiums and therefore this figure will be correspondingly higher as a
proportion of total assets.

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Other reasons for paying attention to this figure are:

• where the agents’ balance figure has started to rise

this may indicate weakness in the company’s credit control systems which could be
symptomatic of other problems;

• although the agent’s balance will be spread over a

wide range of intermediaries and thus the failure of any single intermediary should not
cause a great impact.

If there are general doubts about the insurer’s security, agents” balances may suddenly be
eroded by policy cancellations and this will affect the company’s cashflow;

• check that cash, bank balances and money on short

term deposit is not less than 6% of the total assets.

Cash: all companies need cash to meet short term demands, the payment of a series of
unexpected claims for example. Cash underpins the balance sheets and protects the company
against short term fluctuations. A number of recent public company (not insurer) insolvencies
have shown that despite the apparent quality of assets, if there is no cash to pay the bills, the
company will founder.

• Check that quoted investments at market value plus

cash, bank balances and money on short deposit covers the amount of the insurance
funds including outstanding claims as shown on the liabilities side of the balance sheet.

This is an indication of this company’s liquidity in that the availability of current assets to
meet current liabilities basically means that it has the resources to meet debts as they fall
due.

• Be aware of the need for the company to follow a

sound and broad based investment policy which will take the strain of both short term and
longer term cash requirements.

The importance of paying attention to a company’s investment mix is demonstrated by the

problems and failures of a number of US life companies.

Their problems stemmed from over-high investments in “junk bonds” (high yielding but
high risk bonds issued by commercial companies) and real estate, which both suffered a
spectacular slump in the recent past.

The investments of individual companies will necessarily differ and this in itself need not
cast doubt upon the insurer’s security, but if there is a fundamental difference in one
company’s investment portfolio it is sensible to consider whether or not it will take care of
the immediate cash needs of the company to pay those claims which are quickly settled,
as well as those which are slow to mature to settlement stage and remain uncertain as to
amount.

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Balance sheet liabilities

For most companies the largest single item on the liabilities side of the balance sheet is the
provision for outstanding claims, often followed by other insurance funds which comprise
unearned premiums for general business and the funds for marine and aviation business. It is
thus essential for an insurer to have set aside the correct amount for unearned premiums. Its
marine and aviation funds need to be adequate and its provisions for outstanding claims,
especially on third party and employers’ liability business including IBNR amounts, must also be
adequate.

Under-reserving over a period of years can finally undermine the resources of a company. It is
only possible to check the adequacy of these provisions with a detailed knowledge of the
premium income in each separate class of general business and the outstanding claims at the
year end for each class. This information is not available from published accounts and, if doubts
exist, the figures can only be obtained from the company.

When the company’s assets have been examined and, if necessary, recalculated and reduced,
and the total of the company’s liabilities (other than to shareholders) assessed, the latter total
should be taken away from the former to give a margin of solvency. One would normally expect
this margin of solvency to be not less than 25% of the general business premium income net of
outward reinsurance.

The comments above should be read in conjunction with the calculations for the minimum
solvency margins required by law. The solvency margin is one of the best guides to a
company’s solvency but it is a historic figure and needs to be compared with the other tests
mentioned below.

Other tests available

Balance sheet tests suffer from two weaknesses, namely:

• the information is often out of date when it becomes

available (although many companies do publish brief quarterly statements which may be of
some help); and

• it may not be sufficient to make a complete

judgement.

It also requires time and a certain degree of expertise to carry out the analysis and this will be
compounded by the number of companies a broker deals with. In addition to balance sheet
tests, therefore, the broker should be aware (and beware) of the following:

• long delays in the settlement of claims, although this

may be a reflection of administrative inefficiency rather than a deep seated problem;

• speed at which return premiums and other credits

are repaid by the insurer;

45
• the general quality of insurer statistical information,
particularly claims experience, so as to provide indications of inefficiencies within the
business which may lead to under-reserving;

• willingness to pay above average commissions and

other inducements may indicate a need to generate cash flow in order to keep up with
losses.

“Rules of Thumb”

The following “rules of thumb” can be used by the broker in assessing security.

1. Credit ratings
Rating agencies are not without their limitations as the ratings are to some extent in
themselves historical.

2. Paid-up capital
Particular attention should be paid to cases where the paid-up capital is less than 50% of
issued or authorised capital.

3. Trading history
How long has an insurer been trading? Although not an absolute guarantee, a long
period of successful trading should be an indication of future solvency.

4. Growth
Has the company grown rapidly in the recent past, particularly in a more exotic class of
business? This can be an indicator of overtrading, inexperienced or misguided
underwriting or an attempt to obscure problems with expenses or claims reserves.

5. Ratio of gross to net written premiums

Where a company is excessively dependent on reinsurance it can itself be exposed to
the insolvency of one or more reinsurers.

6. General underwriting style

A company with too relaxed an attitude to underwriting terms (although perhaps a
broker’s dream) may be awkward when large claims are presented.

7. Excessive capacity
A small company which offers capacity which is comparable to that available from a
larger insurer may be taking excessive risk to its net account, or again may be unduly
reliant on reinsurance.

Long term business

46
The test of solvency for a company’s long term business lies in the certificate signed by an
actuary and annexed to the balance sheet stating whether or not the aggregate amount of the
liabilities at the end of the financial year, following actuarial valuation, exceeded the aggregate
amount of those liabilities shown in the balance sheet. The balance sheet figure is normally the
life insurance fund plus current liabilities, the fund being the accumulated balance of income
over expenditure in the life revenue account over the years during which the company has
transacted business.

Most potential danger to a life company lies in losses on investments and other assets. Serious
investment losses are likely to occur only when sales have to be made at a time of a severe fall
in stock market prices. Such sales, however, need not endanger or seriously affect the security
of a life company so long as the invested assets are reasonably matched by length of term to
the company’s contractual liabilities to its policyholders.

It is the life office which has given guaranteed policy surrender values to its policyholders that
may find itself in a position of not having such liabilities matched by investments and may
therefore need to sell investments at depressed prices in order to meet its guaranteed surrender
values. In these circumstances the actuary may find it increasingly difficult to certify that the
calculated liabilities do not exceed the amount of the fund shown in the balance sheet.
Contracts that are advertised as having “valuable guarantees” on discontinuance are worth only
as much as the company which issues them.

Embedded value

The use of the embedded value concept for long term insurers has seen considerable growth in
the past few years.

Embedded value in the complex intangible world of life insurance is a similar measure to the
concept of “economic value” with other companies. It is calculated by taking the adjusted capital
and surplus of the insurer and adding to it the discounted value of future distributable profits on
in-force business (effectively the cost of capital required to support the in-force business). Any
increase in the embedded value over and above what could be expected in the assumed
projections would then be seen as “value added during the period”.

Whilst this tool has uses for management as well as outsiders wishing to better assess the
standing of the insurer, it is still not the perfect solution because of its complexity and the natural
use of assumptions, such as the discount rate used.

47
 INSURANCE COMPANY KEY PERFORMANCE
INDICATORS

1. RATIO ANALYSIS
a) Solvency Margin (Section 24 of the Insurance Act)

Shareholders Funds to exceed –

The greater of ZW$200 000 or 25% of Net Written Premiums in previous year x 100

b) Solvency Margin (International Basis)

48
 Shareholders Funds / Net Premiums written in current period x 100 (minimum acceptable
level for this environment would be 40%)

c) Financial Base ratio

Net written premium / (share capital + UPR) x 100

NB: This ratio measures overtrading and the erosion of capital. The lower the ratio the
bad the situation will be and the higher the ratio the better. Ratios above 100% are
preferable.

d) Combined ratio (ei + eii) below: Add the two ratios below. A ratio below 100% shows
profitability.

e)i Claims Incurred / Net Earned Premiums x 100

This shows the loss ratio on earned premiums.

e)ii Expenses (Operating and Commission) / Net Earned Premiums x 100

This shows the expense ratio on earned premiums

NB: 100% - combined ratio = profit/loss ratio

f) Claims cash coverage

Cash & short term deposits/claims incurred x 12

NB: This ratio shows how many months the Company can carry on paying claims
without having to resort to borrowing if the average claims ratio is maintained.

g) Times cover ratio

Shareholders net Assets/deductible on major business class

NB: Ratio shows how many claims on the main class equivalent to the deductible that
the insurer can pay before exhausting its shareholders funds. This is a good indicator of
the level of capitalization.

49