oversight

Insurance Regulation: The Insurance Regulatory Information System Needs Improvement

Published by the Government Accountability Office on 1990-11-21.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

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                                                          INSURANCE
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                                                          REGULATION
                                                          The Insurance
                                                          Regulatory
                                                          Information System
                                                          Needs Improvement
                                                                     -   _ .__   - ._..--   .- .. .__



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  f    United States
‘GAO   General Accounting Office
       Washington, D.C. 20548

       General Goverument Division

       B-236091

       November 21,199O

       The Honorable Doug Walgren
       Chairman, Subcommittee on Commerce,
         Consumer Protection, and Competitiveness
       Committee on Energy and Commerce
       House of Representatives

       Dear Mr. Chairman:

       This report responds to your Subcommittee’s request that we review the effectiveness and
       reliability of the National Association of Insurance Commissioners’ Insurance Regulatory
       Information System for early detection and warning of financially troubled property/
       casualty insurers.

       We note for your consideration that while we received generally good cooperation from the
       National Association of Insurance Commissioners, we did not have access authority to some
       information that we requested during the preparation of this report. The lack of access
       limited the extent of our analysis. Continued lack of access to all relevant data will adversely
       affect future work we undertake in this area.

       This report supplements our September 1989 report, Insurance Regulation: Problems in the
       State Monitoring of PrOperQ’/chW..Kdty  hX3.U.W Solvency (GAO/GGD-89-129, Sept. 29,1989), We
       are continuing our work in this area by evaluating regulatory actions that state insurance
       departments take following detection of a problem insurer.

       As agreed with your office, unless you publicly announce its contents earlier, we plan no
       further distribution of this report until 30 days from the date of this letter. At that time, we
       will send copies to interested parties and make copies available to others upon request.

       Major contributors to this report are listed in appendix VI. Please contact me on 276-8678 if
       you or your staff have any questions concerning this report.

       Sincerely yours,




        Craig A. Simmons
       *Director, Financial Institutions
          and Markets Issues
Executive Summq


                   From 1983 through 1989, approximately 106 multistate property/casu-
Purpose            alty insurance companies became insolvent. Losses from the recent fail-
                   ures of two large insurance groups alone may exceed $6 billion. In
                   addition, from 1983 to 1989, the number of property/casualty insurers
                   designated by the National Association of Insurance Commissioners
                   (NAIC) for closer state regulatory attention increased from 205 to 622.
                   These events have raised concerns about the timeliness, accuracy, and
                   effectiveness of state monitoring of insurance company solvency-and
                   thus about the safety of U.S. property/casualty insurers.

                   The Subcommittee on Commerce, Consumer Protection, and Competi-
                   tiveness, House Committee on Energy and Commerce, requested that
                   GAO review the effectiveness and reliability of the property/casualty
                   version of the Insurance Regulatory Information System (IRIS), a system
                   developed by the NAIC to help states detect potentially financially
                   troubled insurers as early as possible.


                   State insurance departments are responsible for regulating and moni-
Background         toring the financial condition of insurance companies that operate in
                   their states. The head of each state insurance department is a member
                   of the NAIC. NAIC helps states both regulate the insurance industry and
                   identify those insurers that require increased regulatory attention.
                   Early identification of troubled companies is essential to (1) help compa-
                   nies regain their financial strength or minimize the damage resulting
                   from insolvency and (2) help states focus their examination resources
                   on troubled companies and coordinate their activities with other states.

                   During this review, GAO studied IRIS’ purpose and process; determined
                   how state regulators use IRIS results; and obtained NAIC, state regulator,
                   and industry views on IRIS’ effectiveness and usefulness. GAO did audit
                   work at seven insurance departments. GAO could not quantitatively eval-
                   uate the predictive accuracy of IRIS results because the NAIC considers
                   the data confidential and, therefore, did not provide GAO with the data.


                   Although IRIS is intended to provide early warning of potentially
Results in Brief   troubled companies, insurance department regulators said that they
                   generally know about the financial condition of domestic companies
             I     (those headquartered in their states) before IRIS results become avail-
                   able. IRIS is used more often to obtain information regarding foreign
                   insurers (those operating but not headquartered in their state).



                   Page 2                                       GAO/GGD-91-20 Insurance Regulation
                              Executive Summary




                              State regulators and industry officials said that IRIS has several deficien-
                              cies, including a reliance on insurer-prepared financial statement data
                              that are sometimes unverified and untimely. Moreover, the system does
                              not consider other readily available sources of solvency information.
                              GAO believes that these problems, along with other deficiencies, impair
                              IRIS’ effectiveness and usefulness as an early warning system.




Principal Findings

IRIS’ Purpose and Process     IRISis intended to help states identify potentially troubled insurance
                              companies by providing preliminary indicators of an insurer’s financial
                              condition. State insurance regulators are still ultimately responsible for
                              determining an insurer’s true financial condition.

                              The IRIS process contains two major evaluation phases and a follow-up
                              component. During the first phase, a set of financial ratios is generated
                              for each insurer from data contained in the insurer’s annual statements.
                              The ratios address various aspects of insurer operations such as
                              liquidity, profitability, and reserves. During the second phase, a team of
                              experienced financial examiners analyze selected companies’ ratio
                              results and annual statements and select some companies for increased
                              state regulatory attention. The NAIC or its representative follow up to
                              determine if states are taking appropriate actions against those compa-
                              nies that IRIS examiners identified as requiring immediate state regula-
                              tory attention. (See pp. 13-19.)


States’ Use of IRIS Results   GAO  found that the seven state insurance departments use IRIS results
                              differently, depending on their opinion of the system, the level of
                              sophistication of their in-house evaluation systems, their resources, and
                              the timing of IRIS results. Regulators at all seven departments said that
                              they are generally aware of the financial condition of domestic compa-
                              nies before IRIS results are available. (See pp. 23-24.)

                              IRISexaminer reviews of companies’ IRIS ratios and annual financial
                              statements for the prior year begin in March, and some reviews are not
                              completed until June. Consequently, identification of potentially
                              troubled insurers may not happen until 15 to 18 months after the
                              problem occurred. (See p. 26.)



                              Page 3                                       GAO/GGD-91-20 Inmrame Regulation
                    Executive Summary




                    Regulators in five insurance departments said they use IRIS as an addi-
                    tional source of information to confirm the status of domestic insurers
                    and to determine if previously unidentified foreign companies may need
                    increased attention. These regulators explained that states generally
                    focus their examination resources on domestic insurers. Regulators in
                    the other two departments said they do not use IRIS at all because other
                    monitoring methods better satisfy their needs. (See p. 24.)


Views on IRIS,,       State insurance departments generally held different views on IRIS’
                      importance, reliability, adequacy, timeliness, and usefulness in evalu-
Effectiveness and   : ating the financial condition of insurers. NAIC officials, state regulators,
Usefulness            and industry officials said that it is difficult for a ratio-based surveil-
                      lance system like IRIS to accurately measure the solvency of all types of
                      property/casualty insurance companies. According to NAIC, it is impor-
                      tant that IRIS be used only as one part of a state’s overall solvency regu-
                      lation. (See pp. 23-33.)

                     Regulators and industry officials said that IRIS has deficiencies,
                     including the following: (1) it relies on insurer-prepared annual state-
                     ments, which are sometimes not independently verified and are subject
                     to significant time lags; (2) its financial ratios are of limited scope and
                     may not identify all troubled insurers; (3) it is not equally effective in
                     assessing all types and sizes of insurers; (4) it does not adequately
                     address some important aspects of insurer operations; (5) it does not
                     consider some readily available sources of solvency information; and
                     (6) it is identifying an increasing number of companies, some of which
                     may not warrant immediate regulatory attention. (See pp. 24-32.)

                     Five state regulators and four industry officials GAO interviewed said
                     that, by itself, IRIS is not effective or has become less effective in sepa-
                     rating financially troubled companies from sound ones. Such inaccurate
                     designation can cause state resources to be diluted and decrease the use-
                     fulness of IRIS as a mechanism for focusing regulatory attention. (See
                     pp. 32-33.)

                     GAO  believes changes to IRIS could increase its usefulness in detecting
         ,           troubled companies and targeting regulatory resources. In view of regu-
                     lator and industry concerns about IRIS effectiveness, GAO believes that it
                     would be worthwhile to test ways to incorporate supplemental sources
              Y
                     of information into IRIS. By selectively choosing supplemental informa-
                     tion, NAIC should be able to minimize requisite review time and resource
                     requirements.


                     Page 4                                         GAO/GGD-91-20 Insurance Regulation
,
                        Executive Summary




                        In June 1989, NAIC adopted new financial standards recommending that
                        each state require annual independent public accountant audits and
                        actuarial certifications of loss reserves. The concept of independent ver-
                        ification of financial data is commonly accepted as a primary means of
                        ensuring its validity. Because IRIS is totally dependent upon annual
                        financial data, GAO generally supports NAIC'S efforts. However, in
                        addressing NAIC'S comments on a draft of this report, GAO learned that
                        loss reserve certifications may be done by actuaries or loss reserve spe-
                        cialists employed by the insurance company. Given the importance of
                        sufficient reserves to a property/casualty insurer’s financial health, GAO
                        believes that, ideally, loss reserves should be independently verified and
                        certified. (See pp. 33-34.)


                             recommends that NAIC evaluate, on a test basis, the feasibility, effec-
    Recommendationsto   GAO
                        tiveness, and costs of expanding IRIS to incorporate other information on
    the NAIC            the financial condition, operations, and management of insurance com-
                        panies with the goal of improving the system’s usefulness.

                        GAO  also recommends that NAIC take the lead in working with state regu-
                        lators, the insurance industry, and professional actuarial organizations
                        to explore options and identify the most appropriate way to obtain
                        annual independent certification of loss reserves. (See pp. 33-34.)


                            provided a draft of this report to the NAIC for formal comment, In its
    NAIC Comments       GAO
                        response, NAIC acknowledged the need for improved financial analysis
                        and solvency surveillance. To this end, NAIC has formed a working group
                        to develop additional financial analysis techniques and systems. NAIC
                        said this work is intended to both complement and supplement IRIS,
                        which has been and continues to be the cornerstone of NAIC'S financial
                        analysis system. GAO addresses these general comments at the end of
                        chapter 3, on pages 33 and 34.

                        Additionally, NAIC pointed out various statements that they believed
                        were either incorrect or misleading. GAO made changes where appro-
                        priate. (NAIC'S comments and GAO'S responses are contained in app. IV.)




                        Page 6                                       GAO/GGD-91-20 Insurmce Regulation
Contents


Executive Summary                                                                                      2

Chapter 1                                                                                              8
Introduction               Recent Trends in Property/Casualty Insurer Insolvencies                     8
                                and Liquidations
                           State Insurance Regulation                                                  9
                           Insurance Regulatory Information System                                     9
                           Objectives, Scope, and Methodology                                         10

Chapter 2                                                                                             12
The   Development    and   The Evolution of IRIS                                                      12
                           IRIS Today                                                                 12
Status of IRIS for         NAIC Guidance for Using IRIS                                               18
Property/Casualty          NAIC’s Electronic Communication Networks                                   18
Insurers                   Recent Developments Concerning IRIS                                        18
                           Summary                                                                    20

Chapter 3                                                                                             21
There Are Questions        States’ Opinions of and Use of IRIS
                           Regulator and Industry Concerns With IRIS
                                                                                                      21
                                                                                                      22
Regarding IRIS’            Conclusions                                                                30
Effectiveness and          Recommendations to NAIC                                                    31
Usefulness                 NAIC Comments and Our Evaluation                                           31


Appendixes                 Appendix I: Description of IRIS Ratios                                     34
                           Appendix II: Questionnaire Results Concerning States’                      39
                               Views on IRIS
                           Appendix III: Regulatory and Industry Spokespersons                        41
                               Interviewed
                           Appendix IV: Comments From the National Association of                     44
                               Insurance Commissioners
                           Appendix V: Major Contributors to This Report                              56

Glossary                                                                                              57




                           Page 6                                      GAO/GGD91-20 Jnsurance Regnlation
Table                  Table 3.1: Percentage of Property/ Casualty Companies
                           Designated by NAIC for Increased State Regulatory
                           Attention, (1983-1989)

Figure                 Figure 2.1: Overview of the IRIS Process                                  13

Related GAO Products                                                                             60




                       Abbreviations

                       IRIS      Insurance Regulatory Information System
                       NAIC      National Association of Insurance Commissioners


                       Page 7                                     GAO/GGDOl-20 Insurance Regulation
Introduction


                       According to the Insurance Information Institute,’ over 90 percent of
                       US. homeowners and automobile owners have property/casualty insur-
                       ance policies. Since such policies are purchased to protect against future
                       losses, insurers must remain solvent to honor their commitment to their
                       customers to provide continuous service and promptly pay claims.


                       While the number of companies that operated in more than one state
Recent Trends in       (multistate property/casualty insurers) suffering insolvencies has been
Property/Casualty      relatively small and has remained fairly constant, there has been a sig-
Insurer Insolvencies   nificant increase in the size of insurer insolvencies during the 1980s. In
                       addition, there has been a substantial increase in the number of insurers
and Liquidations       identified by NAIC for increased state regulatory attention.

                       From 1983 through 1989, approximately 105 multistate property/casu-
                       alty insurers became insolvent. Although these insolvencies each year
                       represent less than 1 percent of all insurers, the size of the insolvencies
                       has significantly increased. Before 1981, the most that guaranty funds
                       assessed insurers for the liquidation of any single insurer was $85 mil-
                       lion;2 in fact, only two company liquidations required insurers to be
                       assessed more than $60 million. Since 1981, four liquidations have each
                       required assessments of over $100 million. Receivers estimate that the
                       ultimate losses resulting from two recently failed large insurance groups
                       may exceed $5 billion.

                       In addition, the number of property/casualty insurers NAIC designated as
                       requiring increased state regulatory attention through its Insurance Reg-
                       ulatory Information System (IRIS) increased from 205 in 1983’to 622 in
                       1989. This increase in the size of insurer insolvencies, coupled with the
                       increase in the number of insurers identified by NAIC as potentially
                       troubled, has raised concerns about the timeliness, accuracy, and effec-
                       tiveness of state solvency detection systems. This report focuses on
                       NAIC’S IRIS, one of the tools available for states to use to identify poten-
                       tially troubled insurance companies.




                       ‘The Insurance Information Institute provides information to the public concerning the business of
                       property/casualty insurance.                                 I(

                       *Guaranty funds in each state pay in-state policyholder claims on liquidated insurers by assessing
                       property/casualty insurers doing business in the state. When a licensed insurer is liquidated, each
                       state’s fund is responsible for paying claims for policyholders residing in the state. However, some
                       lines of business are excluded.



                       Page 8                                                       GAO/GGD91-20 Jnsurance Regulation
                       chapter 1
                       Introduction




                       Property/casualty insurance is a major means by which individuals and
State Insurance        corporations protect themselves against the threat of economic loss
Regulation             resulting from damage to property or injuries to other people. In gen-
                       eral, state legislatures set the rules under which insurance companies
                       must operate. State insurance departments are responsible for moni-
                       toring the financial condition of insurance companies operating in their
                       states and for taking appropriate regulatory actions against troubled
                       companies.3 These departments license companies to sell insurance in
                       their states, sometimes set the rates insurers can charge, and periodi-
                       cally examine the records of domestic insurers (companies headquar-
                       tered in their state).

                       State insurance departments generally use similar methods to assess the
                       financial strength of companies licensed to do business in their states.
                       The states established the National Association of Insurance Commis-
                       sioners (NAIC) to encourage uniformity and cooperation among the
                       various states and territories as they individually regulate the insurance
                       industrys4

                       As pointed out in our 1989 report’on insurance regulation; some states
                       may not be allocating sufficient resources, including qualified exam-
                       iners, to analyze the financial condition of the numerous companies
                       operating in their states. States generally focus their resources on
                       domestic companies, and often need assistance in monitoring so-called
                       foreign companies-those that operate in their state but are headquar-
                       tered elsewhere. We concluded in that report that interstate cooperation
                       is an important part of solvency regulation. However, we also pointed
                       out that only a few states fully share information with other states or
                       provide regular updates to other states on financially troubled domestic
                       insurers.


                       The NAIC’S IRIS is a nationwide early warning system that is intended to
Insurance Regulatory   help states focus their examination resources on potentially troubled
Information System     insurance companies and provide states with information needed to
                       coordinate their activities with other states, Early identification of

                       3cOngresspassed the McCarran-Ferguson Act in 1946, which essentially gives the states primary
                       responsibility for regulating the insurance industry.
                       4NAIC consists of the heads of the insurance departments of the 60 states, the District of Columbia,
                       and 4 U.S. territories.

                       %surance Re ulation: Problems in the State Monitoring of Property/Casualty Insurer Solvency
                       (GAO/Go-&lZQ,      Sept. 29,198Q).



                       Page 9                                                       GAO/GGD-91-20 insurance Regulation
                        Chapter 1
                        Introduction




                        troubled companies is essential if the companies are to regain their
                        financial strength or to minimize the damage resulting from insolvency.

                        IRIS consists of two phases and a follow-up component. During the first
                        phase-the statistical phase- financial ratios are generated for each
                        insurer; these ratios are based on data contained in their annual state-
                        ments. During the second phase-the analysis phase-a team of experi-
                        enced financial examiners analyzes selected companies’ ratios and
                        annual statements to identify companies that, in their opinion, need
                        increased state regulatory attention. NAIC or its representative follows
                        up on IRIS results to determine if states are taking appropriate actions
                        against companies that IRIS examiners identified as having the greatest
                        potential for financial troubles.


                        The Subcommittee on Commerce, Consumer Protection, and Competi-
Objectives, Scope,and   tiveness, House Committee on Energy and Commerce, requested that we
Methodology             review the effectiveness and reliability of IRIS for early detection and
                        warning of financially troubled property/casualty insurers6 To deter-
                        mine the effectiveness and reliability of IRIS, we studied the overall IRIS
                        process; determined how state regulators use IRIS results; and obtained
                        NAIC, regulatory, and industry views on the effectiveness and usefulness
                        of IRIS. However, we could not independently evaluate the predictive
                        accuracy (effectiveness and reliability) of IRIS results because NAIC
                        would not provide us with records of the work of the examiner team or
                        a list of companies that mIs,examiners designated as requiring increased
                        state regulatory attention, According to NAIC, the information on the
                        records and the list is confidential.

                        During our review, we interviewed NAIC and IRIS officials, state regula-
                        tors, insurance company executives, and insurance trade association
                        representatives. In addition, we used the responses to our 1988 survey
                        of state insurance commissioners regarding financially troubled prop-
                        erty/casualty insurance companies to determine state views on IRIS.’ The
                        1988 survey is our most recent evaluation concerning state regulatory
                        views of IRIS.


                        “There is a similar IRIS process for life/health insurance companies, which we did not review for this
                        report.

                        7The survey and summarized state responses are contained in app. I of our report, Insurance Re ula-
                        tion: Problems in the State Monitoring of Property/Casualty Insurer Solvency (GA d /
                        Sept. 1989). Excerpts from the survey that relate to IRIS are contained in app. II of this report.



                        Page 10                                                      GAO/GGD-91-20 Insurance Regulation
chapter 1
IntroductSon




We did on-site audit work at the following insurance departments: Con-
necticut, Delaware, District of Columbia, Illinois, New Hampshire, New
York, and Texas. The departments were selected on the basis of ques-
tionnaire results and various criteria including geographic diversity, the
number of licensed companies, and the size of the insurance department.

We also did audit work at NAIC headquarters in Kansas City, Missouri,
where we obtained NAIC'S views of IRIS and interviewed several members
of the 1989 IRIS examiner team. We reviewed available literature on IRIS,
including articles published in periodicals, state insurance department
reports, and previous industry studies on IRIS. We provided copies of a
draft of this report to the NAIC for formal comment and review. NAIC'S
comments on our draft and our response can be found in app. IV, We did
our review between January and December 1989, in accordance with
generally accepted government auditing standards.




Page 11                                     GAO/GGD-91-20 Insurance Regulation
Chaoter 2

The Development and Status of IRIS for
Roperty/Casuaky Insurers

                        IRISis intended as a first line of review in the state insurance depart-
                        ments’ overall surveillance of insurers. IRIS has evolved into a multi-
                        phased process using financial ratios and evaluations by experienced
                        examiners. NAIC forwards IRIS results to state regulators and, until
                        appropriate actions are taken or planned, monitors the states’ actions
                        against insurers that IRIS examiners identified as requiring immediate
                        regulation.


                        In 1972, NAIC began calculating financial ratios from insurer-filed annual
The Evolution of IRIS   statements. NAIC developed the ratios to give the states a preliminary
                        indication of each insurer’s financial condition. Called the Early
                        Warning System, the ratios were intended to help regulators identify
                        companies that required regulatory attention sooner than would occur
                        in regularly scheduled examinations.

                        A second phase was added to the process in December of 1977. During
                        this phase, a group of state-employed financial examiners analyzed indi-
                        vidual companies’ ratios and annual statements for the NAIC. This exam-
                        iner team identified those insurers that they believed required
                        immediate regulatory attention. The team conducted detailed reviews
                        for all companies that failed four or more ratios, while ratios for all
                        other companies were scanned to note any unusual conditions. Examina-
                        tion results were distributed by the NAIC to the subject companies and to
                        the state insurance departments. In 1979, the system was re-named the
                        Insurance Regulatory Information System.

                        NAIC designed IRIS to be easy for regulators to understand and use. NAIC
                        believed that a simple system applied uniformly to all companies would
                        be more valuable than a slightly more effective but more complicated
                        system. Drawbacks of this type of universal system are discussed in
                        chapter 3.


                        Today’s IRIS process goes beyond financial ratios. IRIS is intended to be a
IRIS Today              multi-phased, year-round solvency surveillance tool. According to NAIC,
                        ongoing surveillance by qualified examiners and follow-up by the the
                        NAIC and state regulators play an invaluable role in solvency regulation.




                        Page 12                                      GAO/GGD-91-20 Insurance Regulation
                                                          Chapter 2
                                                          The Development and Statue of IRIS for
                                                          Property/Casualty IMurers




                                                          Figure 2.1 provides an overview of the IRIS process for insurers that
                                                          receive IRIS examiner reviews during March and April.’


Figure 2.1: Overview of the IRIS Process

                                   5 Selected annual




                                                                                                                                         I-
       March 1:                      statement data                                                        Is company identified
 NAIC receives annual                  entered into                                                          for examiner team             States follow normal
                                                              ___+       IRIS ratio5 produced    __)            review based        No     examination process
   statements from                      computer
      companies                      l Edit checks                                                         on selection criteda?
                                        performed




                        .

                                       fs company
                                                                         Synopses mailed to
                                                                          eubiect comoanies
                                                                                                          I    Yes


                                                                                                               March/April:
                                                                                                            5 Examiner team
  States follow up a5                                                    and iheir domlcillary                   reviews
   resource5 permit                 designated as first       t                                              *Designations
                                         priorlty?                               state
                                                                              insurance                         assigned
                                                                                                          *Synopses produced



                                       Yes
                                        1
                            *Domestic state must respond to NAIC                                       Mid-June:                            Zone coordinators
                                 concerning planned regulatory                       5IRIS management team reviews adequacy of              continue to review
                                            actlons                                                states responses                          adequacy of state
                            *Company must fife March, June, and                        l fdanagement team meets with NAIC and                    responses
                                September quarterly statement5                                 zone coordinator5 to report                      and request
                                          with NAIC                                                     finding5                           additional information
                             *Zone coordinator recefves synopsis                       *Zone coordinators assume responsibility                  as needed




                                                                                                                                                                    .
                                                                         Zone coordinators                                                    September 1:
                                         December:                                                             September:                   Zone coordinators
                                         Final report                        follow up to
                                                                        determine whether or                Zone coordinators               review first priority
                                   concerning follow up       f--                                         report status of follow   C-     companies’ quarterly
 End 01 IRIS Process              activities presented to                     not states
                                                                         actions are carried                   up to NAIC                       statements
                                            NAIC                           out as planned




                        Y



                                                          ’ Insurers that are not reviewed during this period-.-because of time constraints or because they filed
                                                          their annual statement late-receive their initial examiner review during June. These insurers are
                                                          then subject to the normal follow-up process applicable to other companies.



                                                          Page 13                                                          GAO/GGD-91-20 Insurance Regulation
                         chapter 2
                         The Development and Statue of IRIS for
                         Property/casualty Ineurera




IRIS Evaluation Phases   NAIC receipt and processing of annual statements is the initial step of the
                         IRIS process.Each March, NAIC receives standardized annual financial
                         statements from most insurers; these statements detail their financial
                         operations over the preceding calendar yeara Specified statement data
                         are input and stored in NAIC’S computerized data base. This is followed
                         by a detailed two-phase process comprised of a statistical phase and an
                         analytical phase.

                         According to NAIC, the statistical phase is the backbone of IRIS. During
                         this phase, NAIC’S computer, using insurance company-supplied data, cal-
                         culates 11 financial ratios for each insurer. The ratios address various
                         aspects of each insurer’s financial condition and stability. These ratios
                         fall into four major categories: overall, profitability, liquidity, and
                         reserve. Appendix I provides a detailed explanation of each IRIS ratio.

                         NAIC  has established a “usual range” for each ratio as benchmarks for
                         acceptable performance. When a company’s ratios fall within this range,
                         they are considered acceptable or normal. However, according to NAIC,
                         falling outside a ratio’s usual range is not considered a failing result. The
                         NAIC notes that in some years it may not be uncommon for financially
                         sound companies to have several ratios with results outside the usual
                         range.

                         According to NAIC, each usual range was developed from (1) studies of
                         ratios for companies that have recently become insolvent or have expe-
                         rienced financial difficulty in recent years and (2) general economic con-
                         ditions. NAIC said that the components of each ratio and the ratios’ usual
                         ranges are reviewed annually and are revised whenever necessary to
                         include the latest insurance industry information,

                         States have on-line access to each company’s annual statement data,
                         which are stored on NAIC’S computerized data base. States can access
                         individual company ratios the day after they are generated. NAIC pro-
                         vides state insurance departments with ratio reports that list the IRIS
                         ratios for each company that filed an annual statement with the NAIC.
                         Individual companies also receive a copy of their own ratios. Finally, the
                         general public can obtain individual company ratios and usual ranges.




                         21RISis technically a voluntary system. However, states require that most of their domestic insurers
                         file annual statements with the NAIC.



                         Page 14                                                     GAO/GGD-91-20 Insurance Regulation
    Chapter 2
    The Development and Statue of IBIS for
    Property/c&leualty lneurerl3




-
    The analytical phase follows. On the basis of certain characteristics,
    some of which NAIC considers confidential and would not divulge, com-
    panies are selected for analytical review. NAIC uses publicly-known cri-
    teria to select companies for review. A company might be selected if one
    or more of the following factors is present:

    The company has four or more financial ratios outside the usual range.
    During the prior year, IRIS identified the company.as requiring increased
    state regulatory attention.
    NAIC classified the company as qualified IRIS.3
    The company’s change-in-surplus ratio is outside the usual range.
    All three of the company’s reserve ratios fall outside the usual range.

    NAIC has published the complete set of mandatory criteria that were
    used in 1987. In addition to the above characteristics, companies were
    selected if they

    had impaired capital or negative surplus;
    had any other combination of ratios that appeared unusual;
    were in liquidation, rehabilitation, or conservatorship; or
    reported loss reserves at a discount (reported reserves at a lower
    amount than the estimated future liability due to the interest factor, or
    time value of money).

    The number of criteria NAIC uses has increased over time. Since 1985,
    the number of formal selection criteria, both public and confidential,
    increased from 6 to 13 as NAIC has attempted to strengthen the process.
    In addition, other criteria are sometimes used informally for a year or
    two while being considered for addition to the formal list.

    Beginning each March, during the analytical phase, a seven-member NAIC
    examiner team reviews each selected insurer’s ratios and annual finan-
    cial statements. State insurance departments representing all four of
    NAIC’S geographic zones provide financial insurance examiners to make
    up the property/casualty team.

    Individual examiner team members are not permitted to review compa-
    nies headquartered in their own state or companies that they reviewed
    during the previous year. Thus, examiners are expected to be objective
    “cold readers,” basing their analysis upon annual statement data only.

    3A company is characterized as qualified IRIS if its annual statement will not pass all edit checks in
    the data processing portion of the IRIS process.



    Page   16                                                     GAO/GGD-91-20 Insurance Regulation
                               Chapter 2
                               The Development and Status of IRIS for
                               Property/caimalty INmrerE




                               During their analyses of these data, the examiners attempt to determine
                               what caused the ratios to fall outside their usual ranges; they also
                               review other areas of insurer operations. Analysis focuses on sections of
                               a company’s current and prior-year annual statements, including pre-
                               miums written, assets, loss reserves, surplus, and historical trends.


Referral to State Review       On the basis of examiner reviews starting each March, NAIC categorizes
                               companies into one of three priority levels and refers them to state regu-
                               lators for regulatory attention. The following describes the three pri-
                               ority categories:

                           9 First priority-indicates  that an insurer’s problems may be very serious
                             or possibly threaten its short-term continuation.
                           l Second priority-indicates   that all or part of a company’s operations
                             appear to have long-term adverse effects on its financial condition.
                           l Third priority- indicates that a material (or significant) change or item
                             that the regulator should be aware of has been noted but does not indi-
                             cate an adverse effect on the insurer’s financial condition4

                               An examiner can also conclude that a selected company does not have
                               an adverse financial trend and that no material changes or irregularities
                               exist. If so, the company is designated either “no priority” or “no
                               synopsis required.” The reason why a company was originally selected
                               for review dictates which of these two designations is used. A synopsis
                               is required for each company that either had four or more financial
                               ratios outside the usual range, was identified during the prior year as
                               requiring first priority attention, or was classified as qualified IRIS.

                               After reviewing a company, the examiner prepares a synopsis, if
                               required, that summarizes the evaluation of the insurer’s financial con-
                               dition. According to NAIC, the synopsis text also reflects major statement
                               errors or omissions noted by the examiner team. However, we were
                               unable to verify this since we were not allowed to review these syn-
                               opses. The synopsis is then reviewed and approved by the IRIS manage-
                               ment tearnh The examiner team synopsis is initially distributed to the
                               home state insurance department, the appropriate zone examination

                               41RISpriorities were changed to numerical designations in 1989. The old designations were: imme-
                               diate attention, targeted attention, and targeted but no “adverse solvency trend.”
                               5The property/casualty management team consists of the IRIS director and assistant director and the
                               property/casualty coordinator and assistant coordinator. All of these individuals are state employees
                               on loan to NAIC.



                               Page 16                                                     GAO/GGDQl-20 Insurance Regulation
                   Chapter 2
                   The Development and Status of IRIS for
                   Property/Casualty Insurers




.--..-
                   coordinator,” and the subject company. A copy is also filed at NAG NAIC
                   distributes the synopsis to all other state insurance departments in late
                   May to early June of each year. The synopsis is confidential and is not
                   available to the public.

                   NAIC  requests that regulators determine what regulatory activities have
                   been or will be initiated to address the financial condition of first pri-
                   ority companies in their states and that they respond to NAIC by June of
                   that year.7 Further, NAIC requests that first priority companies file
                   March, June, and September quarterly statements with NAIC. NAIC does
                   not request state response concerning companies that were designated
                   as second or third priority.


Follow-Up Review   The IRIS management team reconvenes in June to review the adequacy of
                   state regulatory responses to first priority designations. The team then
                   meets with an NAIC representative and the zone coordinators to report
                   its findings. At this point, the zone coordinators assume responsibility to
                   follow up with states that do not respond to first priority companies or
                   that respond inadequately. In addition, the zone coordinators meet to
                   review first priority companies’ quarterly financial statements as
                   needed. A status report is submitted to NAIC during its national Sep-
                   tember meeting.

                   After October 1, zone coordinators follow up with states to determine if
                   regulators carried out the actions indicated in their June response
                   forms. The zone coordinators prepare a report concerning state follow-
                   up activities for NAIC’S December meeting.

                   Figure 2.1 provides an overview of the IRIS process for insurers that
                   receive IRIS examiner reviews during March and April. If a state does not
                   provide an adequate response and take appropriate regulatory actions,
                   a zone examination (where several states participate in and conduct a
                   single comprehensive financial examination) can be implemented for a
                   first priority company. Results of a zone examination are disseminated
                   to all states in which an insurer is licensed or doing business.

                   %one coordinators are responsible for following up with a state if it does not respond to a first
                   priority designation or if the response is inadequate. If responses remain inadequate, the zone coor-
                   dinators recommend multistate (zone) examinations to be carried out by examiners from the states in
                   which the companies do a large volume of business.

                   7Companies licensed ln only one state are excluded from the follow-up requirement, except those that
                   reinsure risks for other insurance companies or that write nonstandard coverage. These two activities
                   can be done across state lines without a separate license for each state.



                   Page 17                                                     GAO/GGDBl-20 Insurance Regulation
                          Chapter 2
                          The Development and Status of IRIS for
                          Property/Casualty Insurers




                          According to NAIC, while IRIS analyses are valuable in identifying compa-
NAIC Guidance for         rues likely to experience financial difficulties, the statistics are not in
Using IRIS                themselves indicative of an adverse financial condition. It further states
                          that not all of the companies IRIS examiners identify for priority atten-
                          tion will necessarily be troubled. IRIS results should only be part of the
                          states’ overall solvency surveillance process. NAIC also advises taking
                          the following precautions:

                      l No state should rely on IRIS as its only form of surveillance.
                      . Important decisions, such as licensing, should not be based on IRIS
                        without further analysis or examination of the company concerned.
                      l In interpreting ratios, states should note that ratios outside the estab-
                        lished usual ranges are not necessarily failing results. A company’s
                        ratios may be outside the usual range because of unusual accounting
                        methods, matters that have been corrected, or other circumstances.
                      . While the information contained in IRIS reports is compiled in a manner
                        and from sources believed to be reliable, states should be aware that the
                        information’s accuracy is not guaranteed.


                          State insurance departments have on-line access to IRIS results and
NAIC’s Electronic         annual statement information for all companies that file with NAIC. State
Communication             regulators can electronically access NAIC’S IRIS database to obtain com-
Networks                  pany-specific IRIS ratios, designations, and examiner team reports. In
                          addition, by using NAIC’S State Data Network, regulators have on-line,
                          interactive access to NAIC’S computerized annual statement database.
                          State regulators can access this database to produce standard reports
                          (e.g., direct premiums written and direct losses paid), verify IRIS data, or
                          conduct customized analyses and reports (e.g., additional ratios). Regu-
                          lators can also copy data from the State Data Network onto their state’s
                          computer to perform additional analysis. The most recent 5 years of
                          data are maintained on the annual statement database for direct access
                          by state insurance departments.


                          In 1988, NAIC instituted a quarterly financial ratio testing system to
Recent Developments       enhance the regulators’ early warning of significant changes in the
Concerning IRIS           financial position of insurers. Under this system, NAIC enters selected
                          data from insurer quarterly financial statements into one of its
                          databases and generates six basic financial ratios. The ratios measure
           Y              changes in the volume of business, assets, liabilities, and surplus. Two of
                          the six ratios-change in net premiums written and change in surplus-
                          are essentially the same as ratios calculated in the annual IRIS system.


                          Page 18                                      GAO/GGDBl-20 Insurance Regulation
Chapter 2
The Development and Status of IRIS for
PropeI%y/caeualty Insurers




State insurance departments and zone coordinators have access to the
quarterly data collected and to the ratios generated. However, according
to NAIC, because quarterly data may not be sufficiently detailed to
permit accurate rankings of insurers, companies should be prioritized on
the basis of their prior year-end IRIS test results. NAIC believes the useful-
ness of the quarterly system is uncertain at this time, given the limited
experience since its inception. In its comments on a draft of this report,
NAIC said it plans to collect more detailed quarterly data in 1991 and
establish a triggering mechanism for this data thereafter. This mecha-
nism would be a series of statistical analyses, conceptually similar to
IRIS, that would compare company data reported quarterly to some type
of standard. Companies with such variations would be marked for fur-
ther scrutiny.

In a second development, an IRIS Effectiveness Study done by the Illinois
Department of Insurance for NAIC recommended that three modifications
be made to the 1990 IRIS process concerning the ratios:

The ratios’ usual ranges should be changed for certain IRIS tests in an
effort to properly classify additional companies as requiring increased
state regulatory attention. The changes are designed to detect financial
difficulties in “bigger” companies.
A degree-of-test-failure methodology should be added to the selection
criteria. Using the degree-of-test-failure methodology, a company that
fails only one ratio- but by a large degree-may be designated by the
examiner team as needing increased state regulatory attention. This
would identify potentially troubled companies that would not have been
identified previously by IRIS because they had less than four ratios
outside the usual range.
Additional financial ratios should identify potentially troubled compa-
nies that might not be identified under the current system.

In its comments on our draft report, NAIC indicated that it plans to test
these recommendations during the 1991 IRIS cycle. An official who
worked on the study said that if NAIC judges that the recommendations
increase IRIS’ effectiveness, NAIC will adopt them as a permanent part of
the system.

In addition, the NAIC’S Solvency Policing Agenda for 1990 includes
enhancing NAIC solvency analysis support to states. NAIC’S comments
expanded on this point by stating that it has developed and is continuing
to refine additional computer analysis to enhance solvency surveillance.



Page 19                                        GAO/GGD-91-20 Insurance Regulation
          Chapter 2
          The Development and Statue of IRIS for
          ProPerty/Casualty Ineurers




          In a third development, NAIC released the IRIS ratios’ usual ranges to the
          general public in early 1990 through the publication of NAIC’S Using the
          NAIC Insurance Regulatory Information System (1989).* This will enable
          the public to determine how many ratios each company had outside the
          usual ranges. According to an NAIC official, pressure from consumer
          groups led to this decision. It is too early to tell how the insurance
          industry will be affected by the quarterly reporting system, ratio modi-
          fications, and the release of IRIS results.


               is intended to help states identify potentially troubled insurance
Summary   IRIS
          companies. IRIS ratios and examiner team designations are preliminary
          indicators of an insurer’s financial condition. The results are not neces-
          sarily indicative of an insurer’s actual condition. State insurance regula-
          tors are ultimately responsible for determining an insurer’s true
          financial condition.

          The IRIS process contains two major evaluation phases and a follow-up
          component. During the statistical phase, 11 IRIS financial ratios based on
          annual statement data are generated for each insurer. During the ana-
          lytical phase, a team of financial examiners analyzes selected compa-
          nies’ ratio results and annual statements. Following their reviews, some
          companies are identified for increased state regulatory attention.

          NAIC requests that states assess the financial condition of their domestic
          insurers that IRIS examiners identified as requiring first priority state
          regulatory attention. NAIC also requests that states notify NAIC about
          what regulatory actions, if any, they intend to take against these compa-
          nies. NAIC and the zone coordinators follow up on the adequacy of the
          state responses and determine if regulators carried out the actions as
          indicated on their response form.

          Over the years, IRIS has evolved from a set of financial ratios to a mul-
          tiphased evaluation process, NAIC has continued to refine IRIS and eval-
          uate its effectiveness to determine if additional improvements can be
          made.




          *This  publication also discusses the IRIS process, including the statistical and analytical phases. In
          addition, each ratio is described in detail, and a ratio calculation worksheet is provided.



          Page 20                                                        GAO/GGD91-20 Insurance Regulation
Chapter 3

There Are Questions Regarding IRIS’
Effectiveness and Usefulness

                      NAIC,  state regulators, and insurance industry officials have varied opin-
                      ions on the effectiveness and usefulness of IRIS. According to NAIC, IRIS
                      has been reasonably effective in distinguishing between troubled and
                      sound companies. However, as mentioned in chapter 2, NAIC cautions
                      that IRIS has limitations and should only be used as a part of a state’s
                      overall regulatory approach. While state insurance regulators reported
                      that they used IRIS results, the extent depended, among other things, on
                      their opinions of IRIS and on the sophistication of their in-house systems.
                      Regulators and industry officials have numerous concerns about the
                      current and future effectiveness and usefulness of IRIS as a tool for iden-
                      tifying potentially troubled companies and establishing regulatory
                      priorities.


                      The opinions of state insurance regulators regarding the effectiveness
States’ Opinions of   and usefulness of IRIS varied. Similarly, the regulators used IRIS in dif-
and Uses of IRIS      ferent ways. While individual opinions and uses varied, overall they
                      believed that IRIS should and could be improved.

                      Appendix II contains questions and state responses concerning IRIS taken
                      from our 1988 survey of state insurance commissioners regarding finan-
                      cially troubled property/casualty insurance c0mpanies.l Questionnaire
                      results indicated that most regulators believed that IRIS ratios and NAIC
                      examiner team reports are at least moderately important and reliable
                      indicators of insurer solvency. Further, regulators believed that the
                      examiner team reports are more important, reliable, and useful than the
                      IRIS ratios. Questionnaire results also indicated that regulators believed
                      that IRIS is more important to the individual states in providing informa-
                      tion about foreign companies than domestic companies.

                      On the basis of our audit work at seven insurance departments, we
                      found that individual states used IRIS results differently, depending on
                      their opinion of the system, the sophistication of their in-house systems,
                      their resources, and the timeliness of IRIS results. Regulators at five of
                      the seven insurance departments used IRIS ratios and examiner team
                      reports as one of their in-house methods to identify potentially troubled
                      companies. No state we visited or contacted used exclusively IRIS to pri-
                      oritize domestic companies for further review.



                      ‘The questionnaire and state responses can be found in our 1989 report, Insurance Regulation:
                      Problems in the State Monitoring of Property/Casualty Insurer Solvency (GAO/GGD-89-129, Sept.
                      d9,1989).



                      Page 21                                                  GAO/GGD-91-20 Insurance Regulation
                        Chapter 3
                        There Are Questions Regarding IRIS
                        Effectiveness and Usefulness




                        Regulators at all seven of the insurance departments said they generally
                        are aware of their domestic insurers’ financial condition, either from in-
                        house reviews or from other external sources, before IRIS results are
                        available. An NAIC official who oversees the IRIS process said that state
                        regulators should generally have more in-depth knowledge of the finan-
                        cial condition of their domestic companies than IRIS provides. The regu-
                        lators in five of these departments, however, said that they used IRIS as
                        an additional source of information to confirm the status of domestic
                        insurers and to determine if other previously unidentified companies
                        might need increased regulatory attention.

                        Two regulators we visited said that IRIS is useful in helping to focus state
                        examinations on specific areas of concern. Regulators in another two
                        states said IRIS is useful in helping states’ review foreign insurers, both
                        for determining which companies should be licensed to operate in their
                        state and for determining which licensed companies require increased
                        regulatory attention. An NAIC official who oversees the IRIS process said
                        that states with limited resources depend more on IRIS ratios and reports
                        when assessing the financial condition of companies, especially foreign
                        insurers, than do better-equipped states.

                        Regulators in two of the seven insurance departments we visited said
                        they do not use IRIS at all. They said that in-house solvency monitoring
                        methods, including continuous surveillance, satisfy their needs. One of
                        the two departments also does not receive IRIS results because it cannot
                        legally protect their confidentiality.


                        As indicated above, most regulators use IRIS as a part of their overall
Regulator and           solvency monitoring effort. However, all of the regulators and industry
Industry Concerns       officials we interviewed said that IRIS could be improved. Some of the
With IRIS               deficiencies cited were as follows:

                    l   The IRIS process relies on insurer-prepared annual statements, which are
                        sometimes not independently verified and can be untimely.
                    .   The scope of IRIS’ financial ratios may be too limited.
                    l   The system is not equally effective on all types and sizes of insurers.
                    l   IRIS does not directly address some aspects of insurer operations that
                        can contribute to a company’s insolvency (e.g., management and
                        pricing). In this regard, IRIS does not consider some readily available
                        sources of solvency information (e.g., prior state regulatory solvency
                        examinations and commercial rating service evaluations).



                        Page 22                                      GAO/GGD-91-20 Insurance Regulation
                               Chapter 3
                               There Are Questions Regarding IRIS’
                               Effectiveness and Usefulness




                           l   The number of companies designated for priority attention has grown
                               rapidly compared to the number of multistate insurer failures. Five
                               state regulators and four industry officials we interviewed said that by
                               itself IRIS is not effective or has become less effective in distinguishing
                               financially troubled from sound companies.


IRIS Data Are Not Always       Since the IRIS process relies upon the financial information contained in
Independently Verified         the insurers’ annual statements, it is important that this information be
                               accurate. Similarly, it is important that the information be submitted in
and Can Be Untimely            sufficient time to be analyzed during the examiner team review. NAIC,
                               regulators, and industry officials have expressed concerns over both of
                               these matters.

                               According to an Ernst and Young report, at the end of 1989,34 states
                               did not require that property/casualty insurers have financial audits
                               conducted by independent public accountants.2 In addition, 33 of the
                               48 departments that responded to the survey published in our Sep-
                               tember 1988 report said they did not require that the adequacy of
                               insurer reserves (funds set aside by insurers for future claim payments)
                               be certified by actuaries for domestic insurers.

                               According to NAIC, even though a particular state may not require its
                               domestic companies to be audited, those companies may be required to
                               be audited by another state in which they are licensed. NAIC estimates
                               that, using 1988 annual statement data, property/casualty companies
                               that were subject to independent audit requirements in 1990 accounted
                               for approximately 90 percent of the industry’s total premiums. How-
                               ever, the 10 percent written by unaudited companies would amount to
                               approximately $20 billion of the industry’s $202 billion in premiums in
                               1988.

                               In addition, the independent audit requirements do not necessarily
                               apply to the insurer annual statements used during the IRIS process. The
                               audits are performed on an insurer’s balance sheet, operations state-
                               ment, cash flows, and surplus reconciliation. They are not performed on
                               all of the information contained in the lengthy annual statement.3 Fur-
                               thermore, according to NAIC’S model rule requiring annual audited finan-
                               cial statements, the audit reports are not due until June 30 of each year,

                               %tate Audit Rules for Insurance Companies: New Rules for 1989, Ernst and Young, CPA’s (February
                               1990).
                               3The 1990 annual statement was 89 pages.



                               Page 23                                                  GAO/GGD-91-20 Inmrance Regulation
Chapter 3
There Am Questions Regarding IRIS’
Effectiveness and Usefulness




whereas the annual financial statements used during the      IRIS   process are
due by March 1 of each year.

In June 1989, NAIC adopted new financial regulation standards recom-
mending, among other things, that each state require annual indepen-
dent public accountant audits and actuarial certifications of loss
reserves. Several states have added or are considering adding such
requirements. Beginning in 1990, loss reserves on the property/casualty
annual statement must be certified by an actuary or qualified loss
reserve specialist. Accurate and complete financial data are vital to reg-
ulators in performing their oversight responsibilities, Therefore, we
endorse NAIC’S efforts to improve data reliability as a step in the right
direction.

Although NAIC does routine edit checks on each company’s annual state-
ment, it uses these statements without verifying their accuracy and does
not guarantee the accuracy of the data and IRIS results. We believe the
IRIS process very likely would not identify a misstatement of financial
condition or a statement not prepared in accordance with statutory
requirements, regardless of whether it was due to company oversight or
fraudulent activity. Thus, a troubled company might not be identified
by the IRIS examiner team for increased state regulatory attention.

NAIC, state regulators, and industry officials have also expressed con-
cerns about the timeliness of IRIS results. As we pointed out in our Sep-
tember 1989 report, insurer-submitted annual financial statements, and
consequently IRIS results, are subject to significant time lags. IRIS exam-
iner team synopses are initially distributed to the subject companies’
domiciliary state insurance department regulators in March to early
May each year. NAIC does not distribute the synopses to other state
insurance departments until late May to early June.

In this sequence of events, a company could have a problem for more
than a year before a state regulator is aware of it. For example, if a
company had developed a problem in January 1990, it would not show
up on an annual statement until the end of the year. State regulators
would not receive the examiner team results until 15 to 18 months after
the problem initially occurred. In addition, some initial examiner team
reviews do not occur until June.

According to NAIC, the use of diskette filing has substantially expedited
the processing of insurers’ annual statements. NAIC estimated that, in
 1990, approximately 90 percent of all insurance companies filed their


Page 24                                      GAO/GGD-91-20 Insurance Regulation
                          Chapter 3
                          There Are Questions Regarding IRIS’
                          Effectiveness and Usefhlness




                          annual statements with the NAIC on computer readable diskettes. This
                          could increase the number of statements that examiners review during
                          March and April.

                          In addition, as we pointed out in our September 1989 report, the NAIC
                          president expressed concerns about the timeliness of insurer annual
                          statements, saying that by the time state regulators are notified of a
                          problem, the situation may have become much worse or, conversely,
                          may no longer require state attention. One state regulator and two
                          industry officials we interviewed said that a company’s financial condi-
                          tion can change quickly. Thus, some IRIS users believe that serious
                          damage can be done to a company’s health before IRIS can detect the
                          problems.


IRIS Ratios Alone Are a   According to an NAIC official who oversees the IRIS process, IRIS by itself
Limited Indicator of      is not an effective regulatory tool. The official told us that, as an insurer
                          solvency monitoring method, the ratios, taken alone, have low reliability
Solvency Problems         because they are only the initial part of IRIS, which is itself only part of
                          the states’ overall surveillance process.

                          State regulators and industry officials said that IRIS ratios are limited
                          because they were designed to be uncomplicated, easy for regulators to
                          understand and use, and applied uniformly to all companies subject to
                          review. According to studies performed for NAIC, the IRIS ratios are not
                          equally accurate for all insurers.

                          To adequately reflect the current insurance market environment, the
                          ratios should be regularly updated. Four state regulators and five
                          industry officials said that additional and more sophisticated ratios
                          would be needed to adequately address all insurance operations,
                          including insurers’ product lines and mix of business. However, one of
                          the officials, who also oversees the IRIS process, added that more ratios
                          would make the process more complex, and the system would then
                          become more difficult to understand.

                          The official said that while the ratios are limited, the overall IRIS process
                          is “adequate” because it is heavily weighted to identify problems that
                          troubled companies generally experience, including income changes and
                          reserve adequacy. The examiner team analyses of insurers’ ratios and
                          annual statements help to verify the accuracy of the IRIS ratios and help
                          to overcome problems associated with using the ratios alone. However,
                          the IRIS ratios are important in determining which companies are


                          Page 26                                       GAO/GGD-9190 Insurance Regulation
                             Chapter 3
                             There Are Questions Regarding IRIS’
                             Effectiveness and Usefulness




                             selected for examiner team review. Consequently, the limited ratios
                             could prevent insurers’ annual statements from reaching examiner
                             review. This could result in IRIS not identifying troubled companies for
                             increased state regulatory attention.

                             In addition, 7 of the current 11 IRIS financial ratios rely on the accuracy
                             of the reported surplus. This figure is provided by individual insurance
                             companies and is sometimes not independently verified for accuracy. We
                             believe that lack of independent verification coupled with the difficul-
                             ties in accurately reporting and verifying assets, reserves, and conse-
                             quently surplus, would present problems for any ratio-based system.
                             NAIC said that it plans to continue examining the effectiveness of the IRIS
                             ratios. As discussed in chapter 2, NAIC plans to test some modifications
                             to the ratios during the 1991 IRIS cycle.


IRIS Does Not Work           State regulators and industry officials we interviewed said that it is dif-
Equally Well for All Types   ficult for any ratio-based solvency monitoring system to work equally
                             well for all insurance companies, According to one industry representa-
and Sizes of Insurers        tive, it is very difficult, if not impossible, to develop a “one size fits all”
                             approach to measuring the solvency and solidity of all 3,500 property/
                             casualty insurance companies. Companies vary in their mix of business,
                             position in the market, territorial coverage, specialization, marketing
                             strategies, and exposure (risk) to such an extent that no one standard on
                             any key issue -reserve adequacy, cash flow, or reinsurance, for
                             example-could ever be uniformly appropriate.

                             State regulators and industry officials we interviewed said that the
                             overall IRIS process is not well-suited to assess many different categories
                             of companies, including reinsurers, small or new insurers, and insurers
                             that concentrate in some commercial liability lines (e.g., medical mal-
                             practice). When companies engage in these lines of business, their finan-
                             cial ratios differ from those considered “normal” for most other
                             insurance companies. According to a 1989 IRIS effectiveness study,
                             between 1978 and 1988 over one-half of the insurers that went insolvent
                             concentrated in commercial lines of business, and most of the others
                             (categorized as personal lines) participated in commercial lines of
                             business.

                             An NAIC official who oversees the IRIS process said that some of these
                             concerns have merit. One official who worked on the IRIS effectiveness
                             study said that modifications to the 1990 IRIS ratios should address some



                             Page 26                                        GAO/GGD91%0 Insurance Regulation
                      Chapter 3
                      There Are Questions Regarding IRIS
                      Effectiveness and Usefulness




                      of these concerns and help in evaluating different types of insurers. The
                      effect these changes will have on IRIS is unknown at this time.


IRIS Examiner Team    IRISratios and subsequent examiner team reviews are based solely on a
Reviews Are Limited   company’s current and prior year annual statements. IRIS does not con-
                      sider examiners’ prior knowledge of companies or external, nonfinancial
                      sources of information. Therefore, IRIS cannot fully evaluate some
                      aspects of insurer operations that have contributed to insurer insolven-
                      cies but are not evident from annual financial statement data. These
                      areas could include poor management practices, poor underwriting,
                      inadequate pricing, poor claims management, changes in ownership/
                      management, and fraud.

                      In addition, three state regulators and five industry officials said that
                      IRIS could do more to evaluate other areas that often contribute to
                      insurers’ financial troubles, including quality of assets, loss reserves,
                      reinsurance, and parent/affiliate relationships.

                      To fully evaluate management practices and other areas of insurer oper-
                      ations mentioned above, state regulators generally review other sources
                      of solvency information in addition to annual financial statements. How-
                      ever, these sources of information are not a part of the centralized IRIS
                      process. These sources include prior state regulatory solvency examina-
                      tions, insurance rating service evaluations (e.g., Best’s, Moody’s, Stan-
                      dard and Poor’s), state regulator market conduct examinations,
                      reinsurance data, changes in ownership/management, interstate commu-
                      nications information, consumer complaints, and “street talk.”

                      An NAIC official said that, because it is NAIC’S goal to release IRIS results
                      as early as possible, it is not efficient to include other sources of infor-
                      mation that would slow down the evaluation of insurer financial condi-
                      tions. Another state regulator said that IRIS is not designed to perform
                      complete reviews and cannot evaluate external information at a central
                      site because of time, resource, and access to information constraints.

                      While we agree that IRIS results need to be timely, we are not convinced
                      that considering other information in addition to the annual financial
                      statements would necessarily prolong IRIS reviews. Although some
                      potentially useful sources, such as consumer complaints maintained by
                      the states, are not readily accessible for the centralized review process,
                      other data sources, such as rating service evaluations, would be rela-
                      tively easy to obtain and examine. By carefully selecting supplemental


                      Page 27                                        GAO/GGD-91-20 Insurance Regalation
                          Chapter 3
                          There Are CJuestions Regarding llUS’
                          Effectiveness and Usefulness




                          information, NAIC should be able to minimize the requisite review time
                          and resource requirements.

                          Moreover, nonfinancial information and other data sources could serve
                          to overcome limitations of annual financial statement data. For example,
                          company ratings by Standard and Poor’s and A.M. Best include types of
                          information, such as ownership/management practices and changes,
                          that are not available from annual financial data. Also, since insurance
                          rating services periodically update insurer ratings to reflect recent
                          events and economic changes, these ratings may provide a more current
                          indication of an insurer’s condition than a year-end financial statement.


IRIS’ Useful] ness as a   IRISwas initially designed to help regulators identify “priority” compa-
Priority-Setting System   nies that should be looked at by the states as soon as possible. Over the
                          years, the number of companies identified by NAIC for closer regulatory
May Be Decreasing         attention has grown significantly.

                          As shown in figure 3.1, the number of property/casualty insurers NAIC
                          has designated as requiring increased state regulatory attention
                          increased from 205 in 1983 (9 percent of the companies that filed
                          annual statements) to 622 in 1989 (23 percent of the companies that
                          filed annual statements). Similarly, the number of property/casualty
                          companies designated as first priority increased from 78 in 1983 (3 per-
                          cent of the 2,345 companies that filed annual statements) to 233 in 1989
                          (8 percent of the 2,746 companies that filed annual statements). During
                          the same period, the number of multistate insolvencies has remained
                          fairly constant, averaging 16.4 per year, with a range between 4 and 21.




                          Page 28                                     GAO/GGD-91-20 Insurance Regalation
                                      Chapter 3
                                      There Are Questions Regarding lItIS’
                                      Effectiveness and Usefulness




Table 3.1: Percentage of Property/
Casualty Companies Designated by                                                                             Designated for increased
NAIC for Increased State Regulatory                                                        Reviewed                  attention
Attention, (1983-l 989)                                      Total         Percent                by               All         First priority
                                      IRIS veafl             filing   desianatedb         examiners        companies            companies
                                      --1983         -___-   2,345                 9%           240                205   -                 78
                                      1984
                                      __----                 2,419                12            307                281                    124
                                      1985                   2.458                17            469                418                    215
                                      1986                   2,505
                                                               ___-               24            830                590                    271
                                      1987                   2,529
                                                                ________-         22            950                569                    234
                                      ii%---
                                      --..-_--.--~           2,654                21                   c           569                    221
                                      1989                   2,746                23                   c           622                    233
                                      aThe IRIS year reflects company information from the prior operating year
                                      bPercentages bre rounded.

                                      CNAIC did not provide us with totals for this category


                                      We recognize that since IRIS was intended to identify potentially troubled
                                      firms so that actions could be focused to prevent their failure, the
                                      number of failures that have occurred is not the best index with which
                                      to measure the effectiveness of the system. However, we also note the
                                      significant growth in the number of companies being identified in the
                                      first priority category. Should this number remain high, states will not
                                      find IRIS as useful as they might in helping them to focus their limited
                                      resources on those companies most needing regulatory attention.

                                      While the increased number of designated companies may include some
                                      that did not fail due to early identification and regulatory attention, our
                                      discussions with NAIC officials, state regulators, and industry represent-
                                      atives did not indicate that this number is significant. We did not have
                                      access to data needed to determine IRIS' effect. On the basis of our field
                                      work, though, we believe that the increase in designations occurred in
                                      part because of an expansion of the criteria used to determine which
                                      insurers are subject to IRIS examiner review and priority attention. Also
                                      according to NAIC, more companies are designated because the total
                                      number of insurers has increased and because increased resources and
                                      improved procedures have allowed the NAIC examiner team to review a
                                      greater number of company annual statements that were filed.

                                      We accept NAIC'S contention. However, we also note that state insurance
                                      regulators must respond to NAIC about each company designated as first
                                      priority. To the extent that the number of companies targeted for pri-
                                      ority attention increases both numerically and as a proportion of the
                                      industry, the usefulness of IRIS as a mechanism for focusing regulatory


                                      Page 29                                                          GAO/GGD-91-20 Insurance Regulation
                  Chapter 9
                  There Are. Questions Regarding IRIS’
                  Effectiveness and Usefulness




                  attention where it is most needed will be reduced. In d&cussing this
                  point, five state regulators and four industry officials we interviewed
                  said that by itself, IRIS is not effective, or has become less effective in
                  separating financially troubled from sound companies.


                       was originally intended and is still often described as an early
Conclusions       IRIS
                  warning system for identifying potentially troubled insurance compa-
                  nies. The principal regulator for each company is the insurance depart-
                  ment of the state in which the company is domiciled. As discussed
                  earlier in the chapter, these departments said they usually know about
                  their domestic companies’ financial condition before IRIS results become
                  available. Thus, IRIS does not usually provide early warning or first
                  notice of potential problems to the primary regulator. Regulators, how-
                  ever, said they use IRIS for providing information about foreign compa-
                  nies operating in their state. These states can follow up on IRIS results by
                  seeking additional information from an identified company’s domiciliary
                  state insurance department or by initiating an investigation on their
                  own.

                  While no ratio-based early warning system such as IRIS cam expect
                  100 percent predictive accuracy, an effective system could help states
                  focus their examination resources. Effective early identification of
                  troubled insurers can also serve as an impetus for, or an alternative to,
                  other forms of interstate coordination. This may be particularly impor-
                  tant as our earlier report showed that not all states have been equally
                  forthcoming with other states’ regulators about potential problems with
                  their domestic companies.

                  However, industry and regulatory officials have pointed out certain
                  weaknesses in IRIS that raise serious concerns about its effectiveness and
                  usefulness as a regulatory tool. These include the following:

              l      relies on insurer-prepared annual statements, which are sometimes
                  IRIS
                not independently verified and are subject to significant time lags.
              l IRIS financial ratios, which are the backbone of the system, may be lim-
                ited in scope and may not identify all financially troubled companies.
              . IRIS is not equally effective for all types and sizes of insurers.
              l IRIS does not adequately address some aspects of insurer operations that
                can contribute to company insolvencies.
              . IRIS examiners restrict their analyses to annual statement data and do
                not consider other potentially useful, readily available sources of sol-
                vency information.


                  Page 30                                        GAO/GGD-91-20 Inmrancc Regulation
                        chapter 3
                        There Are Questions Regarding IRIS’
                        Effectiveness and Usefulness




                    .      is identifying an increasing number of companies, some of which
                        IRIS
                        may not warrant immediate regulatory attention.

                        We believe that changes to IRIS could increase its effectiveness and use-
                        fulness as a regulatory tool. We believe it would be worthwhile for NAIC
                        to test ways to incorporate other sources of information, such as state
                        examination reports and rating service evaluations, into IRIS. While NAIC
                        has concerns about the time and resources needed to access other data,
                        we are not convinced that these constraints preclude exploring the use
                        of other data types and sources, given industry and regulator concerns
                        about the increasing number of insurers identified by IRIS. By selectively
                        choosing supplemental information, NAIC should be able to minimize the
                        requisite review time and resource requirements.

                        Since IRIS is totally dependent upon insurer-prepared annual financial
                        statements, we support NAIC’S efforts to ensure the validity of the data,
                        including requirements for actuarial verification and independent audit
                        of statement data. However, in addressing NAIC’S comments on our draft
                        report, we learned that NAIC’S required actuarial certification of reserves
                        against current and future claims may be done by actuaries or loss
                        reserve specialists employed by the insurance company. We commend
                        NAIC’S action to increase the reliability of loss reserve estimates, but
                        given the importance of sufficient reserves to a property/casualty
                        insurer’s financial health, we believe that, ideally, this loss reserve certi-
                        fication should be independently verified and certified. (See p. 54.)


                        We recommend that NAIC evaluate, on a test basis, the feasibility, effec-
Recommendationsto       tiveness, and costs of expanding IRIS to incorporate other information on
NAIC                    the condition, operations, and management of insurance companies,
                        with the goal of improving the system’s usefulness.

                        We also recommend that NAIC take the lead in working with state regula-
                        tors, the insurance industry, and professional actuarial organizations to
                        explore options and identify the most appropriate way to obtain annual
                        independent certification of loss reserves.


                        In its response to our draft report (app. IV), NAIC acknowledged the need
NAIC Comments and       for improved financial analysis and solvency surveillance. NAIC added
Our Evaluation          that it has formed a working group to develop additional financial anal-
                        ysis techniques and systems. It further stated that the group has devel-
                        oped an orderly approach for the analysis of insurance companies. This


                        Page 31                                        GAO/GGBBl-20 Insurance Regulation
Chapter 3
There Are Questions Regarding IRIS’
Effectiveness and Usefulness




approach is currently undergoing intense scrutiny to determine its effec-
tiveness. NAIC said that it hopes to develop this system to both comple-
ment and supplement IRIS, which has been and continues to be the
cornerstone of its financial analysis system.

We agree that IRIS has been a valuable tool in the monitoring and over-
sight of insurance companies. As we state in this report, it now provides
a means of interstate coordination. However, as currently structured, it
is limited and needs to be improved.

Our analyses of other types of financial institutions and their regulation,
specifically banks and thrifts, have shown the significance of poor man-
agement as a major factor contributing to insolvency. This factor is
explicitly measured in the bank regulators’ system for identifying
problem banks. We believe that including explicit measures of manage-
rial behavior would increase the effectiveness of IRIS. Because our
review of the IRIS system did not cover the states’ examination
processes, we do not know the extent to which information about mana-
gerial behavior is now collected by the states.

We view NAIC’S establishment of a working group to develop additional
financial analysis techniques and systems as a positive step. This group
should consider pertinent data from many sources, including regulators’
examination and market conduct reports and rating agencies’ evalua-
tions, so that the IRIS examiner teams can bring wider bases of knowl-
edge than they currently have available to them.




Page 32                                      GAO/GGD-91-20 Inmrance Regulation
Page 33   GAO/GGD-91-20 Insurance Regulation
Appendix I

Description of IRIS Ratios


                           At the backbone of IRIS are 11 financial ratios that address various
                           aspects of each insurer’s financial condition and stability. The ratios fall
                           into four major categories: overall, profitability, liquidity, and reserve.
                           NAIC has established a “usual range” for each ratio as benchmarks for
                           acceptable performance. A description of the IRIS ratios follows1


Ratio 1: Premium to        A company’s surplus provides a cushion for absorbing above-average
Surplus (Overall Ratio)    losses. The premium to surplus ratio measures the adequacy of this
                           cushion. The higher the ratio, the more risk the company bears in rela-
                           tion to the surplus available to absorb loss variations. The premium to
                           surplus ratio is net premiums written as a percentage of stated surplus.
                           The usual range for the premium to surplus ratio is up to 300 percent.


Ratio 2: Change 6-t        Major increases or decreases in net premiums written indicate a lack of
Writings (Overall Ratio)   stability in the company’s operations. A major increase in premiums
                           may signal abrupt entry into new lines of business or sales territories. In
                           addition, such an increase in writings may be a sign that the company is
                           increasing cash inflow in order to meet loss payments. The change in
                           writings ratio is the increase or decrease in net premiums written taken
                           as a percentage of net premiums written in the prior year.

                           If the net premiums written is zero or negative in both the current and
                           prior year, the change in writings ratio is given as zero. If the net pre-
                           miums written is positive in the current year but zero or negative in the
                           prior year, the change in writings ratio is given as 999 percent. The
                           usual range for the change in writings ratio is from greater than
                           -33 percent to less than 33 percent.


Ratio 3: Surplus Aid to    The use of surplus aid reinsurance treaties may be taken as an indica-
                           tion that company management believes surplus to be inadequate. In
Surplus (Overall Ratio)    addition, the continued solvency of companies with a large portion of
                           surplus ‘deriving from surplus aid may depend upon the continuing
                           cooperation of the reinsurer. The surplus aid consists of commissions on
                           ceded reinsurance unearned premium.




                           ‘The descriptive information was taken from NAIc’s publication Using the NAIC Insurance Regula-
                           tory Information System, Property and Liability Edition, 1988. The usual ranges cited refer to the
                           1988 version of the IRIS system.



                           Page 34                                                    GAO/GGD-91-20 Insurance Regulation
                                Appendix I
                                Deacrlptlon of IRIS Ratioa




                                Since this amount cannot be determined exactly from the annual state-
                                ment, it must be estimated. This estimate is made by multiplying the
                                ratio between ceding commissions and ceded premium for all reinsur-
                                ante ceded by the amount of unearned premium on reinsurance ceded to
                                nonaffiliated companies. This estimated surplus aid is taken as a per-
                                centage of stated surplus to obtain the ratio result. Unearned premium
                                on reinsurance ceded to affiliated companies is excluded from the calcu-
                                lation to avoid prejudicing the ratio against members of groups or fleets
                                with pooling agreements. The usual range for the ratio of surplus aid to
                                surplus is less than 26 percent.


Ratio 4: 2-Year Overall         The overall operating ratio is a measure of the profitability of an insur-
Operating Ratio                 ante company. Over the long run, the profitability of the business is a
                                principal determinant of the company’s financial solidity and solvency.
(Profitability Ratio)       *   The overall operating ratio is a combination of three ratios: the loss ratio
                                plus the expense ratio minus the investment income ratio.

                                The loss ratio is the total of losses, loss adjustment expenses, and policy-
                                holder dividends taken as a percentage of net premiums earned. The
                                expense ratio is equal to underwriting expenses (net of other income)
                                divided by net written premiums. The investment income ratio is equal
                                to the net investment income divided by net premium earned. The com-
                                bination of these three ratios indicates the profitability of a company’s
                                operation, with a ratio result below 100 percent signifying a profit and a
                                ratio result above 100 percent indicating a loss. The usual range for the
                                2-year overall operating ratio is less than 100 percent.


Ratio 5: Investment Yield       In addition to measuring one important element in profitability, the
(Profitability Ratio)           investment yield also provides an indication of the general quality of the
                                company’s investment portfolio. Investment yield is net investment
                                income as a percentage of the average invested assets during the year.
                                Invested assets is the amount of cash and invested assets plus accrued
                                investment income minus borrowed money. The average invested assets
                                during the year is determined by taking half of the following sum:
                                invested assets at the end of the prior year plus invested assets at the
                                end of the current year minus net investment income during the current
                                year. The usual range for investment yield is greater than 5 percent.




                                Page 36                                      GAO/GGD-91-20 Inmrance Regulation
                             Appendix I
                             Description of IRIS Ratios




Ratio 6: Change in Surplus   The change in surplus is, in a sense, the ultimate measure of the
(Profitability Ratio)        improvement or deterioration in the company’s financial condition
                             during the year. The change in surplus is the difference between surplus
                             at the end of the current year and surplus at the end of the prior year,
                             taken as a percentage of surplus at the end of the prior year. For this
                             ratio, stated surplus for each year is adjusted for deferred acquisition
                             expenses. This amount is calculated by multiplying the unearned pre-
                             mium reserve by the ratio of acquisition expenses to net premiums
                             written. Acquisition expenses include commissions, taxes, licenses and
                             fees, and half of all other underwriting expenses. The adjustment for
                             deferred acquisition expenses makes the change in surplus ratio some-
                             what more complex. However, it significantly improves the effective-
                             ness of the ratio for distinguishing troubled from sound companies.

                             If the current year adjusted surplus is iero or negative, the ratio result
                             is given as -999 percent. If the current year adjusted surplus is positive,
                             but the prior year adjusted surplus is negative, the ratio result is given
                             as 99 percent. The usual range for the change in surplus ratio is from
                             less than 50 percent to greater than -10 percent.


Ratio 7: Liabilities to      The ratio of liabilities to liquid assets is a measure of the company’s
                             ability to meet the financial demands that may be placed upon it. It also
Liquid Assets (Liquidity,    provides a rough indication of the possible implications for policy-
                             holders if liquidation becomes necessary. The liabilities to liquid assets
                             ratio represents liabilities taken as a percentage of liquid assets. Liquid
                             assets are calculated as total cash, invested assets plus accrued invest-
                             ment income, and installment premiums booked but deferred and not yet
                             due minus any investments in affiliated companies and minus any
                             excess of investments in real estate over 5 percent of liabilities. Bonds
                             are included in this ratio at their annual statement value, which is not
                             necessarily equal to their “liquidation” or market value. The usual range
                             for the liabilities to liquid assets ratio is below 105 percent.


Ratio 8: Agents’ Balances    The ratio of agents’ balances to surplus measures the degree to which
                             solvency depends upon an asset that frequently cannot be realized in the
to Surplus (Liquidity        event of liquidation. In addition, the ratio is reasonably effective in dis-
Ratio)                       tinguishing troubled from sound companies. The ratio represents the
                             amount of agents’ balances in the course of collection taken as a per-
                ”            centage of stated surplus. The usual range for the agents’ balances-to-
                             surplus ratio is less than 40 percent.



                             Page 36                                       GAO/GGDSl-20 Insurance Regulation
                           Appendix I
                           Description of IRIS Ratios




Ratio 9: l-Year Reserve    In addition to measuring the accuracy with which reserves were estab-
Development to Surplus     lished 1 year ago, the ratio of l-year reserve development to surplus
                           provides an indirect indication of management’s opinion of the ade-
(Reserve Ratio)            quacy of surplus. The most up-to-date estimate of the losses that were
                           outstanding a year ago is the sum of the current reserves for those
                           losses still outstanding plus the payments on those losses made during
                           the past year. The difference between this current estimate and the
                           reserves that were established at the end of the prior year is the l-year
                           reserve development. If the current estimate is greater, the prior year’s
                           reserves were deficient, as judged by 1 year’s hindsight,

                           If the current estimate is less, the reserves were redundant. The ratio of
                           l-year reserve development to prior year’s surplus is this deficiency or
                           redundancy taken as a percentage of last year’s surplus. A positive ratio
                           result indicates a deficiency, while a negative ratio result indicates a
                           redundancy. For the property lines of business, the amount of salvage
                           and subrogation applicable to prior years’ losses received during the
                           current year is subtracted from the change in losses for prior years. For
                           liability lines, salvage and subrogation have already been netted out in
                           the annual statement. Loss adjustment expenses are included in a
                           manner similar to the treatment of losses. The ratio does not take into
                           account voluntary reserves or the excess of statutory over case basis
                           reserves. The usual range for the ratio of l-year reserve development to
                           surplus is less than 25 percent.


Ratio 10: 2-Year Reserve   The 2-year reserve development to surplus ratio is calculated in a
Development to Surplus     manner similar to the calculation of the l-year reserve development
                           ratio. The 2-year reserve development is the sum of the current reserve
(Reserve Ratio)            for losses incurred more than 2 years prior plus payments on those
                           losses during the past 2 years minus the reserves that had been estab-
                           lished for those losses 2 years earlier. The usual range for the 2-year
                           ratio is also less than 25 percent,


Ratio 11: Estimated        This ratio provides an estimate of the adequacy of current reserves. In
                           this ratio, the estimated current reserve deficiency or redundancy is
Current Reserve            taken as a percentage of surplus. This estimated deficiency is the differ-
Deficiency to Surplus      ence between the estimated reserves required by the company and the
(Reserve Ratio)            actual reserves maintained. The estimated reserves required is the cur-
            ”              rent net premiums earned multiplied by the average ratio between
                           developed reserves and earned premiums for the last 2 years. For each
                           of these years, the reserves as stated in that year are adjusted by the


                           Page 37                                      GAO/GGD91-20 Insurance Regulation
Appendix I
Deecription of IRIS R&km




l-year or 2-year reserve development as calculated in Ratios 9 and 10.
This total is then divided by the net premiums earned in the appropriate
year to obtain the developed reserve to premium ratio. The usual range
for the ratio of estimated current reserve deficiency to surplus is less
than 26 percent.




Page 39                                     GAO/GGDI)l%O Insurance Regulation
3 Appendix II

 Questionnaire Results Concerning States’ Views
 on IRIS

                I. Importance of IRIS ratios in alerting states to financial problems that
                may result in an insolvency of a domestic or foreign property/casualty
                insurer.


                                                           Domestic insurer             Foreign insurer
                Very great importance                                    10                _____-      11
                Great importance                                         17                            22
                Moderate importance  __-                                 15                 __-_---     9
                Of some imPortance                                        6                             4
                Little or no importance                                   0                       1 (INA)


                II. Importance of IRIS ratios and examiner team reports in helping states
                make a definitive judgment as to whether financially troubled property/
                casualty insurers need to be placed in conservation, rehabilitation, or
                liquidation.


                 IRIS ratios                               Domestic insurer             Foreign insurer
                Very
                ..~__ great importance                                    4                             5
                Great importance                                          9                            12
                Moderate importance                                      21                            17
                Of--....-__.
                     some importance
                                  -~.-                                    5         -                   8
                Little or no imDortance                                   9                       4 (2NA)



                Examiner team reports                      Domestic insurer             Foreign insurer
                Very great importance                 --                  9               ._____-~-~ 10
                Great importance                                         15                ..-___--_    18
                Moderate-.-importance
                              ___. -.                                    14 _-__---_          -         12
                Of some importance         .-~___--                       4                              4
                Little or no importance                                   6                        2 (2NA)


                These responses are from a 1988 GAO survey contained in our report,
                Insurance Regulation: Problems in the State Monitoring of Property/Cas-
                ualty Insurer Solvency (GAO/GGD-89-129, Sept. 29, 1989). Forty-eight
                states responded to the questionnaire.




                Page 39                                            GAO/GGDBl-20 Insure.nce Regulation
Appemdlx II
Questionnaire Results Concerning States’
Views on IRIS




III. Reliability of        IRISratios and examiner team reports as indicators of
property/casualty            insurer solvency.


                                                                             Examiner team
                                                         IRIS ratios                reports
Very greatly reliable                                               6                     12
Greatly reliable                                                   16                     17
Moderately reliable                                                17                     16
Somewhat reliable                                                   a                      3
Little or no reliability                                            1                      0


IV. Adequacy, timeliness, and usefulness of           IRIS   ratios and examiner
team reports.


                                                               IRIS ratios
                                                 Adequacy       Timeliness       Usefulness
Very satisfied                                            6              7                7
Generally satisfied                                      34             33               33
Neither satisfied nor dissatisfied                        5              4                6
Generally dissatisfied                                    2              3                1
Very dksaiisfiid                                          0              0                0
No basis to iudae                                         1              1                1



                                                       Examiner team reports
                                                 Adequacy    Timeliness    Usefulness
Very satisfied                                           10                  a            11
Generally satisfied                                      33         ---, 35              34
Neither satisfied nor dissatisfied                                        4
                                                          5_____~__~~~~~~~~~~~            2
Generally dissatisfied                                    0               1               1
Very dissatisfied                                         0               0               0




Page 40                                              GAO/GGD91-20 Insurance Regulation
gAppendix III

 Bgulatory and Industry
 SpokespersonsInterviewed

                      American      Insurance    Association
Associations
                      Phillip Schwartz

                      National   Association       of Independent     Insurers

                      Terrie E. Troxel

                      National   Association       of Insurance     Commissioners

                      Jim Bugenhagen
                      Glenda Channel
                      Robert Klein
                      Denise Matthews
                      David Simmons
                      Jim Rose
                      Jean Olson

                      Reinsurance      Association     of America

                      Sandra L. La Fevre
                      James M. Shamberger


                      American      Re-Insurance     Company
Insurance Companies
                      James Anastasio

                      Crum & Forster       Corporation

                      Leslie Cheek

                      E.W. Blanch Co.

                      Robert A. Bailey

                      State Farm Mutual         Automobile     Insurance     Company

                      Jean C. Hiestand (Retired)
                      Mike Olson




                      Page 41                                              GAO/GGD-91-20 Insurance Regulation
              Appendix III
              Regnlatmy and Industry
              spokespen3oM Interviewed




              District   of Columbia       Insurance      Department
Insurance
Departments   Margurite Stokes

              Illinois   Department        of Insurance

              James Schacht
              Kenneth E. Mrozek

              New Hampshire        Insurance         Department

              Robert Solitro

              New York State Insurance               Department

              Vincent Laurenzano
              Bernie Ganley

              Pennsylvania      Insurance      Department

              Del Oldham

              State of Connecticut          Insurance     Department

              Antone M. Cosme
              Peter F. Kelly

              State of Delaware          Insurance     Department

              John T. Tinsley III

              Texas State Board of Insurance

              Etti Baranoff
              Robert F. Crawford




              Page 42                                               GAO/GGD-91-20 Insurance Regulation
                  Appendix III
                  Regulatory and Industry
                  Spokespersons Interviewed




                  Moody’s     Investors       Service
Rating Services
                  Marvin L. Shulman

                  Standard     & Poor’s

                  Alan M. Levin




                  Page   43                             GAO/GGD91-20 Insurance Regulation
  Ppe

gzents   From the National Association of
Instance Commissioners

Note. GAO comments
supplementing those in the
report text appear at the                                                                                                                       120 wesr /Ah smer
end of this appendix.
                             NAIC                                                                                        816.471.7004   Main Fax
                                                                                                                                                Suire IIW
                                                                                                                                                Kanws Ciry, Missouri
                                                                                                                                                816-842.3600
                                                                                                                                                                          64105




                                                                                                                         816-842-9185   Financial Services   & Research    Fax

                             Narional
                             Associalion
                             of Insurance
                             Commissioners


                                   September          26,     1990



                                   Mr. Richard   L. Fogel
                                   Assistant   Comptroller     General
                                   U.S. General   Accounting     Office
                                   Washington,   D.C.      20548
                                   Dear      Mr.     Fogel:

                                   Thank       you      for     the     opportunity       to review     and comment on your          draft   report
                                                                  tiOn:       The     Insurance     Reeulatorv  Information         System     Needs
                                   &Jlprovemez&.             The NAIC is well          aware of the need for improved       financial      analysis
                                   and solvency             surveillance.

                                   The cornerstone           of financial        analysis       at the NAIC has long been the Insurance
                                   Regulatory         Information       System        (IRIS).        This     system,      instituted         years       ago,
                                   continues       to serve         as a useful          tool    to regulators,          the insurance           industry,
                                   the public,          and the NAIC.            Although       the IRIS        system    will      continue       to be a
                                   primary      analytical        tool  utilized        by the NAIC and regulators,                   it should       not be
                                   counted      on as the only analytical                  tool   of financial        analysis        for the NAIC and
                                   regulators.           The system       has undergone            considerable        evaluation        over     the last
                                   several      years      and even closer          scrutiny      in the last        few years.          However,        after
                                   all      the   scrutiny,         the   IRIS      system      continues        to be an effective                 tool       in
                                   identifying        needed regulatory           attention.

                                   The NAIC Examination              Oversight        (EX4) Task Force        has formed         a working     group
                                   specifically        to develop       additional        financial    analysis      techniques       and systems.
                                   Currently      the working       group,     with the assistance        of NAIC staff,         has developed     an
                                   orderly      approach      for     the    analysis        of insurance       companies.         The system      is
                                   currently     undergoing       intense      scrutiny      by the insurance      regulators       and NAIC staff
                                   to determine        its effectiveness.             In time we hope to develop            this    system to both
                                   complement       and supplement        the IRIS system.

                                   The draft     report      contains           several    valid    observations.        However,  the report   also
                                   makes numerous          statements              which    are     either     incorrect     or misleading.       Our
                                   specific     comments,        which           include      substantive       remarks    as well    as technical
                                   corrections,      follow.




                                                   Page 44                                                               GAO/GGD-91-20 Insurance Regulation
                                    Appendix N
                                    Comments From the National Association of
                                    InsuranceCommissioners




                           Letter to Richard L. Fogs1
                           September 26, 1990
                           Page Two

Now on D. 9.               1.   Page  12: While the number of companies designated       as requiring     increased
See comment 1                   state regulatory   attention   through IRIS has increased from 205 in 1983 to
                                622 in 1989 as stated in the report,      the number has been more static        over
                                the past five years.       In addition, the number of companies designated         as
                                first  priority  was 215 in 1985 and 233 in 1989. This actually       represents    a
                                docraase as a percentage of companies filing      from nine percent in 1985 to
                                eight percent in 1989.
                           2.   Pages 12, 28-30, and 37-39:          The report  implies    a lack of timeliness       in
                                providing     data to the state departments either by not providing          meaningful
                                interim    data or through delay in providing         IRIS data.      The report    does
Now on pp, 11,20-21, and        indicate    that diskette   filing  has speeded up IRIS processing.       It should be
25-27                           noted that IRIS ratios had been calculated         by April    15, 1990 on companies
See comment 2.                  representing      over 90 percent     of the industry     based on premium volume.
                                These ratio      results  are available    to the states     immediately   through the
                                State Data Network. Please also note the following          comments:

                                a. More detailed  quarterly data will be collected   by the NAIC in 1991. It
                                   is anticipated  that some type of triggering   mechanism for this quarterly
                                   data will be in place shortly  thereafter.
                                b. In discussing   the Examiner Team project,       the report  noted that some
                                   reviews   are not completed until      June.    In 1990, the Examiner Team
                                   completed its review of 88% of the total        companies it reviewed during
                                   the project   by May 4, 1990.     In addition,      as the report  notes, the
                                   Examiner Team designation  is available    to the states immediately   through
                                   the State Data Network.

                           3.   Page 17:     The report indicated      that insurers  that are not reviewed during
Now on p. 13                    March and April,     because of time constraints       or because they filed     their
See comment 3                   annual statement late,        receive their   initial examiner review during June.
                                This is true, however, it should be noted that all statements,             other than
                                late filers,    selected     for review based on non-discretionary     criteria     are
                                ravieved during March and April.          There may be years when time constraints
                                result  in certain    discretionary    reviews being performed in June.

                           4.   Page 18: The report     indicates    that the insurers      detail  their    financial
Now on p. 15.                   operations   on standardized      annual    financial   statements     covering      the
See comment 4                   preceding year which is generally      a calendar year.     All insurers    file on a
                                calendar year basis.

                           5.   Pages 19 and 30: The report               states that the usual ranger for the IRIS
                                ratios will be available         following     the 1990 IRIS process.         The unual ranges
Now on pp. 15 and 21,           for the IRIS ratios             were made available           early   in 1990 through          the
See comment 5.                  publication       of &,QI~ the NAIC w&&&orv                              Information      Svea
                                1989.        This publication      also discusses       the IRIS process         including     th;
                                statistical      and analytical     phases.      In addition,     each ratio is described in
                                detail      and a ratio calculation      worksheet is provided.




                                   Page 45                                                       GAO/GGD-91-20 Insurance Regulation
                                                                                                                                             I



                                                  Appendix N
                                                  Comments From the National Association of
                                                  insurance Conuniseioners




                                 -

                                     Latter to Richard L. Fogs1
                                     September 26,199O
                                     Page Three

Now on   p.    18.                   6.    Page  23:       The          report notes   that the zone coordinators    plan multi-state
See comment 6.                             examinatione.               The zone coordinators   8CtU8lly recommend such examinations.
                                     7.    Page     29,   40 and 42:     'Ibe report    discusses recommendations     made by the
Now on   pp.    20,27, and 28.             Illinois      Department as 8 result      of  an IRIS Effectiveness    Study and notes
See comment 7.                             that the NAIC plans to test these recommendations                during the 1990 IRIS
                                           cycle.       Bacause of additional    work on the study, the recommendations will
                                           be tested during 1991.
Now on   p.    21.                   8.    Page     30:          The      report      indicates     that    the NAIC will     evaluate     the
See comment 8.                             effectiveness               of additional          computer     analysis to enhance       solvency
                                           surveillance.                The NAIC has developed              and is continuing     to refine
                                           additional      computer          analysis.
Now on p. 21.                        9.    Page 30: The            report  refers to the NAIC's Solvency Policy Agenda for 1990.
See comment 9.                             Tha reference           should be to the NAIC's Solvency Policing   Agenda for 1990.
                                     10.   Pages 35 and 45-46:           The report     comments that the financial        ratios are
Now on   pp.    24,30 and 31.              limited   in scope and may not identify             all troubled  insurers  and that IRIS
                                           is identifying        nn increasing   number of companies, some          of which may not
                                           warrant     immediate      regulatory    attention.        We would like     to make the
                                           following    comments    in response:

                                           a. The failure      of an insurance company          Is not always directly      related    to
See comment 10                                items that can be discovered          by enalysis      or examination.      For example,
                                              it   is inherently       difficult      to discover      fr8Ud or misreprOSent8tion
                                              through analysis      or examination.         In addition,    regulators,    as well 88
                                              CPAs. do not have as their                primary    purpose during       an audit,    the
                                              detection   Of fraud.        Rather, they seek to verify         that controls      are in
                                              pl8Ce t0 proVent     fraudulent     activity.

                                           b. BeC8USa of the selection        criteria    used by the Examiner Team, many
See comment 11                                insurers'  statements   are reviewed which are not chosen because of the
                                              number of exceptional     values.      Some of these criteria      have been quite
                                              predictive   and have resulted     in a significant  number of companies which
                                              hAVe been deemed to need some degree of priority        attention.

                                           c. Basing its figures      on the project years 1983 through 1989,                      the report
See comment 12.                               h8s stated     that the number of companies needing immediate                         regulatory
                                              attention   (first  priority)  has been increasing.   In reality                     the number
                                              of first   priority   companies has decreased from 271 in 1986                         to 201 in
                                              1990.

                                           d. Internal,   informal NAIC studies have indicated   that IRIS has identified
                                              moat insurers which have become insolvent     as having problems.   In these
See comment 13.                               cnsea both exceptional    ratios  and Examiner Team recognition   have been
                                              present.




                                                  Page46
                                               Appendix N
                                               Comments  From the National Association of
                                               Insurance Commlseioners




                                 Letter to Richard L. Fogel
                                 September 26, 1990
                                 Page Four

Now on   pp.    24,30, and 31.            e. The selection      criteria    utilized  by the Examiner Team brings  moat
See comment 14.                              troubled  insurers      into the Examiner Team review process. Team members
                                             are able to aseess all types and sizes of insurers.
                                 11.      Pages 36 and 37:    The report    includes     references   to the credibility of
                                          data, lack of independent verification         of data, and use of data without
Now on   pp.    25 and 26.                verifying accuracy.   The following     points     should be noted with regard to
                                          these comments:

                                          a.   As  noted in the report a number of states do currently require audits by
See comment          15.                       certified    public  accountants.  Because most of these states   require
                                               reports   from foreign    as well as domestic insurers, mronertv       d



                                          b. It would be difficult    and expensive for all insurers      to have statutory
See comment 15.                              audits prior to the annual statement filing       date, March 1, of each year.
                                             In addition,      the audits  relate   to the balance       sheet,  operations
                                             statement,   cash flows, and surplus reconciliation     and not to all of the
                                             information   contained in the 89 page annual statement.
                                          c. All    property      and liability      insurers,     subject  to certain      possible
See comment 16.                              exemptions,     will    be required    to include     a loss reserve certification,
                                             completed by an actuary or qualified            loss reserve specialist,    with their
                                             1990 annual statements.            Presently      a number of states     require    such
                                             filing    for both domestic and foreign insurers.
See comment 17.                           d. While the NAIC makes no representations         or warranties   with regard to the
                                             accuracy of the       IRIS    ratio  results,  insurers'    annual statements  are
                                             processed through an extensive          series of computer crosschecks designed
                                             to identify     inconsistencies     in the data submitted.       Errors noted as a
                                             result    of this crosscheck process are corrected          on the data base.    In
                                             addition,    major statement errors or omissions noted by the Examiner Team
                                             in its review process are noted in a company's synopsis of review.

                                 12.      Page 40:      The   report,   in addrcesing     the limited   IRIS ratios,     states that
Now on   p,    27.                        the ratios       are important    in identifying      companies selected     for examiner
See comment 18                            team   review and that      the limited   ratios   could prevent potentially         troubled
                                          insurers'    annual statements from reaching examiner review.             It should again
                                          be noted that the IRIS ratios              are only one of thirteen          criteria       for
                                          selecting    companies for examiner team review.

                                 13.      Pages 42-43 and 49:         The report     recommends the evaluation        of the
                                          feasibility and effectiveness    of including   other supplementary    information
Now on   pp.    29,30, and 33             in the IRIS process.    While the NAIC welcomes any suggestions     for improving




                                               Page 47                                                   GAO/GGD-91-20 Insurance Regulation



                                                                         .,
                                                                        ,,‘I/
                                                                        ry
                                      Appendix IV
                                      Commenti From the National Association of
                                      Inmwauce Commissioneri




                           Letter to Richard L. Fogel
                           September 26, 1990
                           Page Five


                                 the effectiveness         of   the   process,     the   following        comments appear        to     be
                                 appropriate:
See comment 19.                  a. Other readily   available      solvency sources may be less timely than IRIS.
                                    All ratings   services     are dependent upon the same sources of financial
                                    data as the NAIC. At least one of these services currently           obtains its
                                    data from the NAIC. tit's            wance     Reoorta are not available    until
                                    Autumn and Best's       ratings     are not completed until   late summer.       It
                                    should also be noted that these rating              services do not cover all
                                    companies.

                                 b. The NAIC annual statement                 blank     contains      much information        on the
                                    operations       of an insurer which is not limited               solely to financial       data.
See comment 20                      The first        page of the statement           contains     information      on officers     and
                                    directors.          Interrogatories      and schedules,       as well as the notes to the
                                    financial      statements,        provide additional       operations     information.       Some
                                    areas      of       operations,       such as poor           management practices,           poor
                                    underwriting          and inadequate pricing,        may  be discerned from an insurer's
                                    annual statement            by skillful     analysis     and may often be noted in the
                                    Examiner     Team       phase of IRIS.
                                 c.   While the Examiner      Team may be able to add some additional             areas to its
                                      review process, such aa reviewing examination              reports and market conduct
See comment 21                        reports,    it would appear that reviewing         reinaurance    contracts    during the
                                      Examiner Team project          would be entirely           too time consuming.          It
                                      generally     requires  a specialist   to review these contracts          and requires a
                                      significant      amount of time for each contract.             The Examiner Team does
                                      review the reinsurance       schedule in the annual statement and includes any
                                      problems noted in its synopsis.             The review of such contracts             is a
                                      necessary part of each state's        surveillance      procedure and is a part of
                                      the NAIC's support         to the states        but would be most difficult             to
                                      accomplish within the IRIS process.
Nowon pp. 57 and 59. See   14.   Pages 64 and 66:         In the definitions       of "casualty         insurance" and "property
comment 22.                      insurance",      plate     glass, burglary,        and robbery          should be included      as
                                 property    lines.
Now on p. 57. See          15.   Pages 64:    A more appropriate   definition   of                   "foreign   insurer"    is        "any
comment 22.                      insurer incorporated or organized in a different                     state".
Now on p. 58. See          16.   Pages 65:    The definition     of "liquidation"              may be appropriate    in the
comment 22.                      context of this report;    however, liquidation             may be voluntary and not court
                                 ordered.
Now on p, 58. See          17.   Page 65:      Direct  written     premiums      are the amounts actually      paid by the
comment 22.                      policyholders     or recorded as paid.           The definition  on this page does not
                                 take into consideration       that written       premiums are not necessarily     collected
                                 premiums.




                                      Page 48                                                         GAO/GGD-91-20 Insurance Regulation
                                   AppendixIv
                                   CommentsFromtheNationalAssociationof
                                   fnsurance&nnmiesioners




                             Letter to Richard L. Fog81
                             September 26, 1990
                             Pago six

Nowonp.59.                   18.   Page 66: The definition   of *resoaves* as reported   on this       page should be
                                   amended to read "funds set aside by insurers       for future        loss and loss
See comment 22.                    adjustment expense payments".
Nowonp.59.                   19.   Page 66: 'Ibe definition     of "surplus"  should probably read "the difference
                                   between assets and liabilities       in a property  and casualty    insurer  and is
See comment 22.                    often    called  'surplus   as regards policyholders'.       Surplus     as regards
                                   policyholders   includes capital   in the case of a stock insurer".

                             We hope that these comments are helpful      to you in finalizing    the report.   Please
                             let us know if we can be of any further      assistance  to you.

                      J;y7



                             Earl R. Pomero




                             Vice President




                  Y




                                   Page49                                              GAO/GGD-91-20InsnranceRegulation
               The following are GAO’S comments on the National Association of Insur-
               ance Commissioners’ letter dated September 26, 1990.


                1. We agree with NAIC that the number of insurers identified as requiring
GAO Comments   increased state regulatory attention between 1986 and 1989 has
               remained relatively stable. (See fig. 3.1, p. 3 1.) However, our concern is
               that the total number of insurers identified, as well as the number desig-
               nated first priority, is high when compared to the number of multistate
               insolvencies during the same period. In addition, NAIC has noted in the
               past that the number of companies designated for regulatory attention
               has not been a good indicator of the number of potential insolvencies
               because only a small proportion of designated companies are either
               insolvent or in imminent danger of insolvency.

               2, We did not intend to imply a lack of timeliness in providing IRIS results
               to the state insurance departments. We commend NAIC for their efforts
               in speeding up the IRIS process through diskette filing and for making
               IRIS ratios and examiner team designations immediately available to the
               states through the State Data Network. However, as we have previously
               reported, annual financial statement reporting-the     basis for IRIS-is
               subject to significant time lags. Insolvencies may develop over a long
               period of time; however, some insolvencies can develop in a matter of
               months. As stated on page 27, complete IRIS results are not available
               until 16 to 18 months after the beginning of the reporting year. We
               expanded the text to reflect NAIC’S plans to expand the quarterly data
               collection and analysis. (See p. 20.) Furthermore, in its comments NAIC
               pointed to statistics related to the 1990 examiner team process. Since
               our field work was completed prior to the 1990 IRIS process we had not
               included these 1990 statistics or information in our draft report.

               3. NAIC’S statements confirm the process described in the report. (See
               p. 13.)

               4. We changed the text to reflect that all insurers file on a calendar year
               basis. (Seep. 16.)

               6. We changed the text to reflect that the usual ranges for the IRIS ratios
               were made available early in 1990 through the publication of Using the
               NAIC Insurance Regulatory Information System (1989). We expanded the
               text to describe other information contained in NAIC’S IRIS publication.
               (See p. 21.)



               Page50                                       GAO/GGB91-2OInsurmceRegulation
-                                                                              -
    .Appen~ TV
    Comments From the National Association of
    insurance Commissioners




    6. We changed the text to reflect that the zone coordinators recommend
    multistate examinations. (See p. 18.)

    7. We changed the text to reflect that the recommendations made by the
    Illinois Department as a result of an IRIS Effectiveness Study will be
    tested during the 1991 IRIS cycle and not during the 1990 cycle as previ-
    ously planned. (See p. 2 1.)

    8. We changed the text to reflect that NAIC has developed and is contin-
    uing to refine additional computer analysis to enhance solvency surveil-
    lance. (See p. 21.)

    9. We made the suggested change. (See p. 21.)              /

    10. We agree with NAIC’S comment that the cause of insurance company
    failures can be hard to identify, especially fraud and misrepresentation,
    It is precisely because of this difficulty that we believe NAIC should
    expand the information base on which it relies for IRIS. For example,
    state regulator examination results and market conduct reports could
    provide much useful information that may not be present in the finan-
    cial statement.

    11. We indicate in the report that insurers’ statements are selected for
    examiner team review on the basis of criteria other than just excep-
    tional ratio values, (See p. 16.) However, as elaborated on in our com-
    ment 20, the financial ratios are the backbone of IRIS.

     12. As the report shows, the number of companies NAIC has designated
    as requiring immediate state regulatory attention (first priority)
    increased between 1983 and 1989, both in absolute terms and as a per-
    centage of the number of companies filing. We also note that the rela-
    tively small reduction in the number of first priority designations that
    has occurred since the depths of the industry’s insurance cycle in 1986
    (271 to 234 in 1989 and 201 in 1990) may mean that the industry could
    enter the next downturn in relatively poor condition.

    13. Although we requested information and studies concerning IRIS’s
    effectiveness, with the exception of the Illinois Insurance Department
    study mentioned in 7 above, NAIC did not provide the internal, informal
    studies mentioned in its comment, nor were we informed of their exis-
    tence. Therefore, we cannot substantiate NAIC’S claim that IRIS has identi-
    fied most insurers that have become insolvent as having problems. (See
    pp, 30-3 1).


    Page 5 1                                     GAO/GM%91-20 Insurance Regulation
Appendix Iv
Comments From the National Association of
Insurance   Cmuuiseionera




 14. As discussed in the report, the IRIS ratios do not work equally well
for all types and sizes of insurers. We recognize that to the extent that
the examiner team is able to assess all types and sizes of insurers, the
review phase may be able to compensate for the limited ratios. Still, the
IRIS process overall does not work equally well for all types and sizes of
insurers. (See pp. 28-29.) Because NAIC denied us access to the names of
companies identified for priority attention, we can not substantiate
NAIC’S claim that the existing selection criteria brings most troubled
insurers into the examiner team review process.

16. We expanded our report to indicate that while 90 percent of total
industry premiums are written by insurers subject to independent audit
requirements, the 10 percent written by unaudited companies would
amount to approximately $20 billion of the industry’s $202 billion in
premiums in 1988. (See p. 25.)

We also modified our report to clarify that the independent audit
requirements do not necessarily apply to the insurer annual statements
used during the IRIS process. In addition, we expanded the text to indi-
cate that according to NAIC’S model rule requiring annual audited finan-
cial statements, the audit reports are not due until June 30 of each year,
whereas the annual financial statements used during the IRIS process are
due by March 1 of each year. (See pp. 26-2’7.)

As we stated in testimony on April 19, 1989, before the Subcommittee
on Oversight and Investigations, House Committee on Energy and Com-
merce, we believe that NAIC and state regulators can not afford not to
require audits.1 We recognize that requiring all insurers to have indepen-
dent audits of their annual financial statements completed by March 1
of each year may be burdensome. However, because IRIS is totally depen-
dent on the data contained in these statements, accurate and complete
financial information is vital to regulators in performing their oversight
responsibilities. Furthermore, it is important that the data contained in
the annual statements be reconciled to those financial statements
reviewed by independent auditors. Reconciliation is particularly impor-
tant when one considers that the accounting procedures allowed by the
states vary, with some companies using Generally Accepted Accounting
Principles and others using some variation of Statutory Accounting
Practices.


‘Insurance Failures: Property/Casualty Insurer Insolvencies and State Guaranty Funds (GAO/T-
AFMM39-7).



Page 62                                                   GAO/GGD-91-20 Insurance Regulation
    Appendix IV
    Chnmentll From the National Association of
    Insurance Ckmn&3sionere




    16, We expanded the text to clarify that this certification must be com-
.   pleted by an actuary or qualified loss reserve specialist. However, in
    exploring this issue further, we noted that NAIC will not require that
    those certifying the reserves be independent of the companies and that
    the states will have the option of accepting the certifications made by
    company employees. We are concerned with the latitude that NAIC is pro-
    viding to the states in this matter and the relationship between the
    actuary or qualified loss reserve specialists and the insurance compa-
    nies. Maintaining sufficient reserves to meet all future claims is the
    single most important element ensuring the financial health of property/
    casualty insurers. We believe that the commonly accepted concept of
    independent verification of financial data is a primary means of
    ensuring its validity, and this independence will be threatened if the
    states and the companies are provided too much latitude in obtaining
    actuarial certifications. (See p. 26.)

    17. We expanded the text to indicate that major statement errors or
    omissions noted by the examiner team in its review process are to be
    noted in a company’s synopsis of review. We were unable to verify this
    since we were not allowed to review any synopses. (See p. 18.)

    18. According to NAIC’S IRIS handbook and reflected in our report, “The
    financial ratios are the backbone of IRIS.” We believe NAIC'S assertion
    that IRIS ratios are only one of the 13 criteria is inaccurate. As can be
    seen on page 16, three of the five selection criteria NAIC permitted us to
    release directly involve one or more of the 11 IRIS ratios. While we know
    that other selection criteria are also based on IRIS ratios, we are unable
    to be specific since we were not informed of all the criteria used.

    19. NAIC is correct that rating services, to the extent that they use the
    same annual financial statement data as IRIS, are subject to the same
    reporting time lags. (See our response 2.) NAIC also is correct that the
    rating services do not cover all companies. However, insurers evaluated
    by rating services tend to be large companies and key market players
    whose failures would likely have significant impact upon policyholders,
    the guaranty funds, and the insurance industry.

    Since rating services do different types of analysis of an insurer’s
    annual financial statement, we believe that these sources could provide
    a broader perspective for the examiner team review. Moreover, while
    the IRIS ratios and examiner team review are based solely on year-end
    financial statements, rating services sometimes update company ratings
    to reflect deterioration in operating results, ownership or management


    Page 53                                      GAO/GGB91-20 Insurance Regulation
                                                                        .
Appendix Iv
Comments JTromthe National Association of
Insurance Cknnmissioners




changes, and the impact of changing economic conditions occurring after
year end. The important point, however, is not whether IRIS should use
rating service data, but rather that all sources of information-of  which
rating services may be one- that give a more complete picture of an
insurer’s condition should be evaluated for inclusion in the process.

20. We agree with NAIC that the annual statement blank contains some
information on the operations of an insurer which is not limited solely to
financial data, such as information of officers and directors, interrogato-
ries and schedules, and notes to the financial statements. However,
based on interviews with examiner team officials and documentation on
the IRIS process, we do not believe that the examiner team process is
required to review these areas.

Further, we are not convinced that poor management practices, poor
underwriting, and inadequate pricing can be discerned from an insurer’s
annual statement. Because insurers prepare and file their own annual
statements, it is highly unlikely that indicators of poor management
would be disclosed. In addition, the relationship between an insurer’s
products, underwriting, pricing, and profits is generally very complex.
The aggregate nature of information contained on an annual statement
does not generally provide details that are necessary for an examiner to
assess the adequacy of underwriting and pricing. We are unable to spe-
cifically comment on the frequency or effectiveness of examiner team
efforts to note these areas of operations because NAIC did not give us
access to examiner team synopses or working papers.

Our analyses of other financial institutions, specifically banks and
thrifts and their regulators, have shown the importance of poor manage-
ment as a major factor contributing to insolvency. This factor is explic-
itly measured in the bank regulators’ system for identifying problem
banks, known as the CAMEL rating system. The letters refer to capital,
asset quality, management, earnings, and liquidity. We feel that
including explicit measures of managerial performance would increase
the effectiveness of IRIS.

2 1. We are encouraged that the examiner team may be able to add exam-
ination reports and market conduct reports to its review process. We
agree that reviewing actual reinsurance contracts would be too time-
consuming and difficult. We changed the text to clarify that analyses of
reinsurance data reported in the annual statement is another type of
information that could be added to the IRIS process. (See p. 29.)



Page 64                                     GAO/GGD-91-20 Insurance Regulation
.
    Appendix lV
    Commenta From the National Association of
    Insurance C4nmissloner8




    As we reported in May 1990, NAIC has required increased disclosure of
    reinsurance activitym2 For example, as of 1989, an insurer must disclose
    the age of amounts recoverable from its reinsurers. This information
    will provide regulators with insight on potential problems with uncol-
    lectible reinsurance. NAIC pointed out that the reinsurance schedule in
    the annual statement is to be reviewed by the examiner team-the
    second phase of the IRIS process. However, computer-generated analyses
    of reinsurance data, such as the ratio of overdue reinsurance to surplus,
    could readily be incorporated into the first IRIS phase.

    Also, NAIC is developing an Alien Reporting Information System (ARIS)
    to determine how much business US. insurers are ceding to foreign rein-
    surers. NAIC will be able to calculate the amount of reinsurance ceded by
    country. IRIS analyses of an insurer’s dependence on reinsurers based in
    countries with lax regulation could be incorporated into the IRIS process.

    22. We made the suggested descriptive changes. (See pp. 57-59.)




    21nsuranceRegulation: State Reinsurance Oversight Increased, but Problems Remain (GAO/
        _ 0_113, May 4,lQQO).



    Page 55                                                  GAO/GGb91-20 Insurance Regulation
Appendix V

Major Contributors to This Report


                         Lawrence D, Cluff, Assistant Director, Financial Institutions and
General Government       Markets Issues
Division, Washington,    MaryLynn Sergent, Evaluator
D.C.

                         Alfred R. Vieira, Regional Manager Representative
Boston Regional Office   Lyle H. Lanier, Jr., Evaluator-in-Charge
                         Robert E, Erdman, Evaluator
                         Kelly Cecil, Evaluator




                         Page 66                                    GAO/GGD91-20 Insurance Regulation
4       .




    Glossary


    Actuary              One whose business or profession is to calculate insurance reserves and
                         premiums.


    Annual Statement     A statement of the year-end financial condition submitted in the fol-
                         lowing year by an insurer to the insurance regulator in each state in
                         which the insurer is licensed.
                                                                                                      c

    Casualty Insurance   Insurance concerned primarily with the insured’s legal liability for inju-
                         ries to others or for damage to other people’s property; casualty insur-
                         ance also encompasses such forms of insurance as plate glass, burglary,
                         robbery, and workers’ compensation.


    Claim                A request to recover under an insurance policy for a loss covered by
                         that policy.


    Conservation and     Proceedings in which an insurer experiencing financial or other
    Rehabilitation       problems is placed under court-ordered regulatory control. Generally,
                         the purpose of conservation is to conserve company assets and maintain
                         the status quo pending a final determination of the company’s status. In
                         the rehabilitation process, steps are taken to resolve the cause and con-
                         dition underlying the company’s problems so that it can be returned to
                         normal operations.


    Domestic Insurer     An insurance company incorporated under the laws of the state in
                         which it is doing business.


    Field Examination    An on-site examination of an insurance company conducted by one or
                         more state regulators.


    Foreign Insurer      An insurance company incorporated or organized in a state other than
                         one in which it is doing business.


    Guaranty F&d         An association established by state law to pay certain claims made
                         against an insolvent insurance company.



                         Page 57                                      GAO/GGD-91-20 Insurance Regulation
                                                 1.‘.
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                     Glossary




Insolvency           A state or financial condition in which a company is unable to pay obli-
                     gations as they fall due in the usual course of business.


Insurance            A system under which individuals, businesses, and other organizations
                     or entities are guaranteed compensation for losses resulting from certain
                     perils under specified conditions in exchange for payment of a sum of
                     money (a premium).
e’

Insurance Company    An organization chartered to operate as an insurer.


Insured              A person or an organization covered by an insurance policy, including
                     the “named insured” and any other parties for whom protection is pro-
                     vided under the policy terms.


Liquidation          A formal, court-ordered or voluntary process in which an insolvent com-
                     pany’s assets are converted to cash and applied towards its outstanding
                     indebtedness.


Policy               A contract of insurance.


Policy holder        A person who or organization that pays a premium to an insurance com-
                     pany in exchange for protection provided by an insurance policy.


Premium              The sum paid for an insurance policy. Net premiums written represent
                     premium income retained by insurance companies, directly or through
                     reinsurance, minus payments made for business reinsured. Direct
                     written premiums are the amounts actually paid by the policyholders or
                     recorded as paid.
          e

Property Insurance   Insurance providing financial protection against loss of, or damage to,
                     real and personal property caused by such perils as fire, theft, wind-
                ”    storm, hail, explosion, aircraft, motor vehicles, vandalism, malicious
                     mischief, riot, civil commotion, smoke, burglary, and robbery.



                     Page 68                                     GAO/GGDZ)l-20 Insurance Regulation
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                Glossary




Receiver        An appointee of a court to collect rents and manage and protect the
                interests of the lender or creditors during foreclosure or other litigation.


Reinsurance     Assumption by one insurance company of all or part of a risk under-
                taken by another insurance company.


Reserves        Funds set aside by insurers for future loss and loss adjustment expense
                payments.


Surplus         The difference between a property/casualty insurer’s assets and liabili-
                ties is often called surplus as regards to policyholders. Surplus as
                regards to policyholders includes capital in the case of a stock insurer.


Surplus Lines   Insurance of a risk for which there is no normal insurance market avail-
                able and is therefore provided by unlicensed insurers.




                Page 59                                       GAO/GGDSlSO I.nmrmce Regulation
~ Related GA8 Products


                Insurance Regulation: Problems in the State Monitoring of Property/Ca.s-
                ualty Insurer Solvency (GAO/GGD-89-129, Sept. 29, 1989).

                Property and Casualty Insurance: Thrift Failures Provide Valuable Les-
                SonS(GAO/T-AFMD-89-7, Apr. 19, 1989).

                Insurance Failures: Property/Casualty Insurer Insolvencies and State
                Guaranty Funds (GAO~~GD-87-100, July 28, 1987).




 (228240)       Page 60                                    GAO/GGD-91-20 Insurance Regulation
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     l(Jtvlrrt~sl.s for twpiw   of’   (;A0 rtyorts   should be serll. to:




     ‘I’ht~ first, five copiths of each report, are frtw. Additional        copies are
     $2.00 teach

     ‘lWrt* is a 25% discount, on orders for 100 or mort~ copies mailed to a
     sillglth address.

     Ortlt*rs must. be prepaid by cash or by check or rnont~y ordw              made
     out t 0 the Sti~,t~rint.~~~tit~~lt,of Documents.
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