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Lou Felice, Health and Solvency Policy Advisor NAIC

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1 Lou Felice, Health and Solvency Policy Advisor NAIC
Financial Analysis Lou Felice, Health and Solvency Policy Advisor NAIC

2 Presentation Overview
Overview of the Financial Analysis Handbook (Handbook) Financial Analysis vs. Financial Examiner Roles NAIC I-SITE Reports & Insurer Profile Summary As you all are aware there are many financial resources available to you through ISITE We are going to focus mainly on the FAH This is a free publication to regulators and is available both in hard copy and electronically We will also talk briefly on analyst v. examiner roles And lastly, we will talk a bit about the mysterious FAWG

3 NAIC Financial Analysis Handbook
Assists regulators in performing risk-focused financial analysis to identify companies that may have financial problems or that have the greatest potential for developing financial problems Provides guidance to evaluate particular areas of concern in troubled companies Consistent and uniform method Qualitative and quantitative analysis Updated annually Rooted in extensive data reported to NAIC and States Covered in accreditation program for consistency across States and for consolidated assessment. Ties to risk-focused exams. Confidential – Regulator Only © 2009 The National Association of Insurance Commissioners All Rights Reserved

4 Financial Analysis Handbook
Analyst Reference Guides Level 1 Procedures Level 2 Procedures Level 2 – Investments, Cash Flow & Liquidity, Reinsurance, Affiliated Transactions, MGA & TPAs, Risk-Based Capital, Income Statement and Surplus, Unpaid Losses and LAE Supplemental Procedures Management Considerations, Audited Financial Report, Actuarial Opinion, Management Discussion & Analysis, Holding Company Analysis

5 Handbook - Risk-Focused Financial Analysis
Depth of the analysis will depend on the complexity and the financial strength of the insurer and the existing or potential issues and problems found during review of the financial statements At a minimum the following must be analyzed: Annual and quarterly financial statements Actuarial opinion Management’s discussion and analysis Audited CPA report Holding company filings Financial ratios So this is what is required for accreditation The keys: Depth of review, documentation, follow-up The financial statements provide a good start, financial data, notes, interrogatories along with the financial profiles reports which provide both ratio and trend information. This is a good start in assisting you on where you need to focus The actuarial opinion provides an independent view of reserves The MDA provides managements view of the company The audit provides an independent view of the company’s financials With the new requirements on holding company, we also need to look at the entire holding company system

6 Handbook - Analyst Reference Guide Example - Investments
Overview - Discusses specific topics: investment income, asset and liability matching, diversification of a portfolio, key areas of consideration when reviewing a portfolio Discussion of Level 1, 2 and Supplemental Procedures – provides considerations and guidance for the procedures Additional Reference Sources - SVO Purposes & Procedures Manual, Accounting Practices & Procedures Manual, NAIC Annual Statement Instructions, etc. The Analyst Reference Guide offers discussions on the checklist questions which encompass both the annual statement general checklist and the supplemental checklists If there is one section an analyst would need to read in this book, the Analyst Ref Guide would be the one. The outline of each chapter offers background information on the topic, the purpose of each procedure and the additional sources. Detailed discussion on most financial topics is included in the analyst reference guide. At the end of each section is also a bibliography that will provide you additional sources of information.

7 Handbook - Annual Level 1 Procedures
Background Analysis Last priority designation, inter-department communication, regulatory actions, NRSRO rating Management Assessment Shift in management or philosophy Balance Sheet Assessment Operations Assessment Investment Practices Review of Disclosures Notes to Financial Statements, General Interrogatories, etc. Assessment of Latest Examination Report and Results As you all know, per accreditation, a level 1 or similar set of procedures is the minimum required. The level one checklist provides an overview of the insurance company and its operations. Some of the questions include information on the balance sheet, income statement and cash flow statement. There is also detailed information on the insurers interrogatories and notes to the financial statements. You will also determine if the Company is currently a priority company.


9 Handbook - Annual Level 1 Procedures
Overall high-level review of insurer At the conclusion of the Level 1, the analyst is directed as to whether greater analysis must be completed within the Level 2 procedures given risk discovered in Level 1 For example, does the insurer have complex affiliated agreements in place that would require further detailed review beyond discovery work completed within Level 1? Read slide After completing the Level One analysis, the analyst will decide whether to recommend that the insurer be considered a priority company, and the extent to which Level Two procedures should be performed and the areas to be covered.

10 Handbook – Annual Level 2 Procedures
Detailed analysis focused on key risk areas Procedures are quantitative (benchmark oriented) and qualitative Investments Unpaid Losses and LAE Income Statement and Surplus Risk-Based Capital Cash Flow & Liquidity Reinsurance Affiliated Transactions MGAs & TPAs Level 2 may ask the analyst to consider: High risk investments, the level of loss reserves, a negative trend in liquidity or an more detailed understanding of a complex reinsurance transaction Read some of the chapter titles

11 Handbook – Supplemental Procedures
Management Considerations Audited Financial Report Statement of Actuarial Opinion & Actuarial Opinion Summary Management’s Discussion and Analysis Holding Company Analysis The supplemental reports can provide a wealth of information, lets look at some of the contents

12 Handbook – Supplemental Procedures Management Considerations
Procedures address: Assessment of corporate governance pertaining to the board of directors and management Compliance with state statutes, accounting and reporting Reputational risk Legal issues Business plans and projections Risk management Corporate Governance – Board of Directors Follow-up on issues from recent Examinations Review Board of Director meeting minutes Changes in Board of Director membership Concerns regarding the Board of Directors Corporate Governance—Changes in Management or Organizational Structure Management Turnover Changes in the Organizational Structure Operational Changes Mergers/Consolidations We do have procedures in Level One to look for compliance issues with regard to reporting or compliance with state statutes and also with news or ratings that impact the company, so again this chapter provides some additional procedures to help assess those risk areas. A few of the procedures cover  Compliance with State Statutes, Accounting, and Reporting Material Reporting Errors, Validation Errors Failure to comply with State Statutes Suspensions, Revocations, Consent Orders Reputational Risk Concerns about poor Financial Strength/Credit Ratings News, Industry Issues with potential negative impact Legal/Fraud Significant Litigation Understanding potential for Fraud/Legal risk IT issues are something that probably come from market conduct analysis – (examples include; claims handling problems due to IT issues, changes to I.T. systems that could cause a disruption in claims processing, reserve calculations or financial reporting. ) The Handbook includes a procedure in Level 1 to identify any potential market conduct concerns and this chapter provides some follow-up to that – for example, what is the financial impact of market conduct remediation, fines, & settlements. Level one asks the analyst to review the most recent Business plan if there is one available, and if warranted based on the review, to request one. The procedures here explain some things to consider in the review of the business plan such as whether any significant changes have taken place, have initiatives been accomplished, and a review of actual vs. projected variances. The Risk Management procedures ask if the Company does an Enterprise Risk Management assessment and to follow up on work performed by the examiners regarding assessment of risk management and any subsequent changes.

13 Handbook – Supplemental Procedures Management Considerations
Special Note: It may not be necessary to complete all procedures within this chapter. Procedures completed are based on the level of concern an analyst may have with management performance and the driving forces behind operations. In performing analysis of management considerations, the analyst should utilize the risk-focused surveillance examination work that has been most recently completed related to these risk areas. Where applicable, the analyst should follow up on the work performed by the examiners including any comments or recommendations made by the examiners. Read slide

14 Handbook – Supplemental Procedures Audited Financial Report
Procedures address: Overview of opinion Opinion issued and rationale Accounting basis and type of opinion (individual insurer or consolidated) Data cross-checking to annual financial statement Internal controls CPA’s Letter of Qualifications Change in CPA Audit Committee Read slide Model Audit Rule (Accred Standard) Letter of Qual. – independent, background & experience, filing and compliance Audit committee – oversight of internal and external functions of the company

15 Handbook – Supplemental Procedures Statement of Actuarial Opinion and Actuarial Opinion Summary
Procedures address: Identification and qualifications of the actuary Scope of the opinion The Opinion Relevant comments and exhibit disclosures Conclusions and recommendations Procedures related to the Actuarial Opinion Summary Read slide There is a major benefit to knowing the range of reasonable reserves through your confidential actuarial opinion summary and within this section, there are procedures for its review

16 Handbook – Supplemental Procedures Management’s Discussion and Analysis
Procedures address: Overview of filing in accordance with Annual Statement Instructions Non-consolidated basis? Results of operations Prospective information Material changes Assessment of balance sheet and liquidity Assessment of investment transactions Summary and conclusion So the MDA is from the managements prospective ! Use it for background and basic content, however, do your own investigative work when there are areas of concern ORSA will build on this.

17 Handbook – Supplemental Procedures Holding Company Analysis
Procedures address: Holding company structure Interstate coordination Evaluate financial condition of holding company Form A – Statement of Acquisition of Control of or Merger with a Domestic Insurer Form B – Insurance Holding Company System Annual Registration Statement Form D – Prior Notice of a Transaction Extraordinary Dividend/Distributions Really focused on Holding Company System KEY ELEMENT OF GROUP ASSESSMENT Knowing the risks in both the insurance and non-insurance segments Understanding who to communicate with Understanding the overall financial condition of the holding company system and what segments are driving the results Within this chapter we also may need to review forms A, B, D, or E

18 Handbook – Holding Company Analysis
Holding company analysis is a standard part of the financial analysis process as outlined in the NAIC’s Financial Analysis Handbook Includes reviewing the upstream and downstream holding company entities (both financial or non-financial entities) Understanding the structure, affiliated relationships, financial condition, management, etc. Utilizing public information, such as SEC filings, international filings, and/or requested information Read slide

19 Holding Company Analysis Considerations
NAIC has been conducting HC analysis training for state insurance departments Recently adopted amendments to accreditation program for Part B – Financial Analysis guidelines with regard to HC analysis effective 2012 GSIWG continues to create best practices and standards for HC analysis Focus on lead state report Maintaining the Holding Company Analysis Liaison List The Insurance Analysis and Information Services department of the NAIC has been conducting Holding Company analysis training for state insurance departments. As part of this training we look at the domestic companies in their state. We provide them guidance and feedback on what they should be including in their analysis. The first step and the foundation for good holding company analysis is to understand the holding company structure and to understand what types of relationships exist between the companies within the group. Once you know what those relationships are, then you can assess if there is enterprise risk and if other entities in the group pose a risk to your domestic or to the insurance operations within the group.

20 Link to SEC Filings

21 Lead State Report It is intended to facilitate efficiencies when one or more states coordinate the regulatory processes of all states involved So these are some of the groups MO is the lead state on, we select the lead state by looking at: A Lead State(s) may be determined using, but not limited to, the following criteria: * premium volume of legal entity; * net admitted asset size of legal entity; * reinsurance arrangements; * unique political considerations; * location of books and records; and * market exposure of business written within a state (sometimes with a state without a domestic in the group

22 Handbook - Quarterly Procedures
Level 1 and 2 procedures Focuses on Significant Changes from Quarter to Quarter and Quarter to Prior Year End Ratio calculations are automated NEW Quarterly Level 1 for Non-Troubled Insurers Adopted for First Quarter 2012 Significantly reduced procedures Procedures address key risk areas Background information Management assessment Balance sheet and operations assessment Review of disclosures and assessment of results from analytical tools More limited review Previously focused on following companies that had been flagged in the annual analysis / Expanded starting in 2012 Lastly, there are checklists on ISITE and in the bound version of the financial analysis handbook for the quarterly statement as well. It should be noted that the Level One checklist for quarterly analysis serves the same purpose as Level One for the annual analysis, even though not all the same tools are available.

23 I-SITE Categories Page
Collection of analytical tools designed to provide an integrated approach to screening and analyzing the financial condition of insurers Financial Analysis Solvency Tools (FAST) Analytical Financial Profile Reports, Financial Analysis Handbook, Summary Reports, Jumpstart Reports, Investment Snapshot, Form A, Etc. Prioritization Tools IRIS Ratios, ATS, Scoring System, Handbook Automated Yes, RBC, RBC Trend

24 Summary Reports Some of the key reports: FAH sum, RBC Trend, Lead state, IRIS sum, permitted practice, prioritization, and scoring reports We also have on the right side market share reports where you can pick an LOB and pull back data such as writings and loss ratios

25 Financial Profile Reports
The Financial Profile Report is a summary of key financial information for a company over the last five years Includes a Financial Summary page There are also detailed sections for: Assets, Liabilities, Capital & Surplus, Loss & LAE Reserve Analysis, Income Statement, Cash Flow and Exhibit of Business and Profitability

26 Insurer Profile Summary
Insurer Profile Summary Sharing Best Practices Guide Adopted by the Financial Analysis Handbook (E) Working Group Outlines best practices for effective and efficient sharing of a domestic state’s Insurer Profile Summary with other interested state insurance regulators Highly Confidential Document Earlier this year the Financial Analysis Handbook (E) Working Group adopted a INSURER PROFILE SUMMARY SHARING BEST PRACTICES GUIDE It outlines best practices for effective and efficient sharing of a domestic state’s Insurer Profile Summary with other interested state insurance regulators. When to request an Insurer Profile Summary How to request a Summary – what is the process Suggested language to put in the request (i.e. you can hold it confidential) What the Insurer Profiles Summary should and should not be used for Accreditation Considerations Highly Confidential Document Posted to StateNet (under “Financial Analysis” Link)


28 Risk-Focused Exams Welcome to the
© 2009 The National Association of Insurance Commissioners All Rights Reserved

29 What is a Financial Examination?
A financial condition exam is an on-site regulatory review of an insurer’s key processes with the primary goal of assessing financial solvency of the company. An exam is risk-focused because the examiner focuses on areas of higher risk of an insurance company. © 2009 The National Association of Insurance Commissioners All Rights Reserved

30 Why Conduct Financial Exams?
Detect insurers with potential financial trouble; Picks up where analysis ends Determine compliance with state statutes and regulations; Compile information needed for timely, appropriate regulatory action; © 2009 The National Association of Insurance Commissioners All Rights Reserved

31 Why Conduct Financial Exams?
To provide a clear methodology for assessing residual risk and how it translates into examination procedures; To allow the assessment of risk-management processes in addition to those which relate to financial statement line items; and To utilize examination findings to establish, verify or revise company’s priority score. © 2009 The National Association of Insurance Commissioners All Rights Reserved

32 Financial Examiner Roles
Financial Analysis vs. Financial Examiner Roles

33 Roles of Examiner and Analyst
On-site and Off-site solvency monitoring involve roles and skill-sets that are different, but complement each other: Analyst Identifies risk by reviewing reported financial results Utilizes analytical review, (ratio analysis, benchmarking, inquiry) to identify solvency concerns and compliance Examiner Identifies risk by reviewing business processes Utilizes control & detail tests to identify solvency concerns and findings Focuses on Residual Risk Analysis = historic perspective on risk based on documentation - Establish initial priorities / foster further interaction. Support other regulatory functions (licensing) Examiner = Concurrent and prospective risks based on interaction with management

34 Roles of Examiner and Analyst
State Insurance Analysts typically perform the following functions: Collection and analysis of insurer and group financial information Desk audits to assess risk and compliance Review of non-financial information regarding insurance companies that is routinely collected by other department units Review of insurance company transactions Coordination with other department functions Determining regulatory courses of action regarding identified troubled insurance companies Evaluating and monitoring corrective plans Communicating results of regulatory actions Licensing and admissions 1 – analysts look at financial statements every quarter and are identifying risks as they happen every quarter. 2 – Through desk audits the analyst is identifying risk and determining if they company is out of compliance, be it mis-reporting or non-compliance with state statutes. 3 – You are talking to other departments each quarter – market conduct, rates and forms, licensing, actuarial. So you should have the most current information from those other departments on activities that may be going on that are not immediately financial but that could post a risk to the insurer’s solvency in the long run. Are there significant complaints that market conduct staff are investigating, or is the company requesting rate increases on large blocks of business. 4 – Classification of insurance company transactions. The analysts are going to be involved on some level in reviewing and understanding material transactions that the company is engaging in through review of Form D, annual review of From B or even Form A if there is an acquisition taking place. 5 – Coordination with other departments – it’s not just that you are taking a report that the market conduct staff hand you and sticking it in a file, but you are coordinating with them. For example if you have a troubled company that has material market conduct violations, you may be sitting down with the market conduct staff to understand what those violations are and what the financial impact will be on the insurer should they be required to remediate – reprocess claims, pay fines – or if their market conduct violations result in reputational damage and lost sales, what does that do to their financial solvency? So analysts are coordinating information sharing with other departments. 6 – Evaluating and monitoring corrective plans – if you have a company that has a RBC corrective action plan or some other corrective plan, it is the analyst that will be monitoring if those plans have been implemented and how successful they are. Did they receive the capital contributions they said they would? Did their expenses drop due to the cost cutting efforts they planned to make. If they were planning new marketing strategies or on the flip side planning to run-off on unprofitable block of business, what are the results of that – do you see the changes in premium?

35 Roles of Examiner and Analyst
Example: Investments Off-site analysis can monitor balance and composition of portfolio, benchmark the company’s investments against competitors and gather information from the insurer to explain significant changes. Help set priorities for examiner On-site examination can evaluate the process in place at the insurer to monitor investment performance and reporting; establish company specific risks; gain an understanding of the effectiveness of controls; and tailor substantive procedures to apply underlying transactions, reviewing reconciliations, obtaining confirmations, etc. Here is an example where we compare what the analyst does to what the examiner does. READ SLIDE Analyst is going to be looking for shifts in the investment portfolio, the impact of current economic conditions, which we just saw in the last couple years with huge write-downs and capital losses. The analyst is also going to be communicating with the insurer to get an explanation for why real estate holding jumped 15% or why they reported capital losses when the industry trend was the opposite.

36 Conducting Examinations
The NAIC Financial Condition Examiners Handbook provides guidance to assist state insurance departments to effectively plan, conduct, and report on the financial condition of insurers. Approach changed to a Risk-Focused Surveillance approach in 2007 Model Law and Accreditation Standard The NAIC Model Law and Accreditation guidelines specifically require state departments to conduct examinations in accordance with policies and procedures included in the NAIC Financial Condition Examiners Handbook. Variations to the methods and scope of exams are permitted to the extent that the variations reflect the financial strength and position of the insurer © 2009 The National Association of Insurance Commissioners All Rights Reserved

37 Model Law on Examinations
Exams must be conducted on each licensed insurer at least once every 5 years Some state statutes require more frequent exams Initial Priorities se through analysis process A state may accept an examination report on a company prepared by another state if: The state department performing the exam was accredited at the time of the exam; or The exam was performed under the supervision of or participation by an accredited insurance department The domestic state typically assumes responsibility for the exam and shares their report with other states.

38 Examination Classifications
Insurer Type Single-state insurer: A company that does not meet the definition of a multi-state insurer such as a Health Maintenance Organization. Multi-state insurer: A company that is domiciled or chartered in one state and licensed, registered, qualified or accredited, eligible or operating in at least one other state. HMO’s – are licensed by state and is a type of group insurance that entitles members to services of participating hospitals and clinics and physicians A single-state insurer is defined as any company that is licensed in only one state does not meet the definition of a multi-state insurer. • A multi-state insurer is defined as a company that is licensed in more than one state domiciled or chartered in one state and licensed, registered (for risk retention groups), qualified or accredited (for reinsurers), eligible (for surplus lines) or operating in at least one other state. For purposes of this definition, the term “state” is intended to include any NAIC member jurisdiction, including U.S.territories.

39 Examination Classifications
Exam Scope: Full-scope: An examination in which the scope of the control and substantive procedures to be performed during the examination is based on the implementation and documentation of the risk assessment procedures required under the NAIC Financial Condition Examiners Handbook. Review all areas of exam and focus on high-risk areas. Limited-scope: An examination which is limited to a review or examination of specific financial statement line items or particular risk areas. Full-Scope Examination - This should include 1) assessing the risks that an insurer's surplus is not materially misstated, and 2) assessing the quality and reliability of management to identify, control, assess, and manage its business and financial reporting risks. A full scope examination shall make an assessment of the insurer's financial condition. A full-scope examination meets the requirements of the NAIC Accreditation Program. Limited-Scope Examination – This could be determined on a basis other than the implementation and documentation of the risk assessment procedures within the NAIC Financial Condition Examiners Handbook. A limited scope statutory examination may result in a Report of Examination which may include a conclusion on the financial condition of the insurer based on work performed in the specific areas. Completion of limited-scope examinations does not satisfy the five-year examination requirements of the NAIC Accreditation Program.

40 Examination Classifications
Examination Type Individual exam: A financial exam over one insurer. Group exam: A financial exam over more than one insurer. This type of exam is typically conducted when multiple companies in a holding company group have similar key processes, systems and/or management. Exams can also be coordinated between regulators from multiple states. © 2009 The National Association of Insurance Commissioners All Rights Reserved

41 Key Examination Participants
The following individuals from a state insurance department are the key participants that conduct and oversee the examinations of domestic insurance companies: Chief Examiner (or designee): Schedule examinations, assign staff, coordinate with other state and zones examiners, and approve exam plan Examiner-in-charge: Coordinate review of company and examination testwork. Coordinate meetings with company and personnel. Staff Examiner: Conduct examination testwork and become knowledgeable of company operations. Financial Analysts: Interpret key financial and operational ratios, provide examiners with insight on company management, operating results, current events, etc. The chief examiner is the person who the head of the examination department of a particular state. Their ultimate responsibility is to take part in the planning and coordination between other states / examiners in those states. The examiner in charge oversees more of the day to day activity within the exam of a single company. This is slightly different than the Chief Examiner, who oversees the companies within their state. The examiner in charge does a lot of coordination between the company and the examination team. Staff Examiners actually do the testing and perform work to understand the operations of a company. A lot of the actual examination steps that are located in the Examiners Handbook are performed by the Staff Examiner. Financial Analysts look at the company’s financial data and perform review procedures on ratios. These ratios are reviewed by the analysts for reasonableness and so they can identify possible trends within the company that the examiners may want to be aware of. Other participants not mentioned on this slide are specialists which include actuaries, who look at the reserves reported by the company. In addition IT specialists may be used to review the company’s IT environment.

42 Risk-Focused Exam Approach
Examination methodology included within the NAIC Handbook is a ‘risk-focused’ approach. Required by Accreditation Standards for exams commencing on or after Jan. 1, 2010. Under this approach, examination fieldwork will emphasize the review of an insurer’s current or prospective solvency risk areas and the fair presentation of surplus. Examiner will focus work and resources on identified risk areas and focus less on areas with less risk. Risk-focused surveillance process includes identifying risks and assessing those risks to determine the ongoing monitoring and surveillance of an insurer.

43 Risk-Focused Surveillance
The risk-focused surveillance process requires examiners to prospectively consider the company’s financial condition by assessing whether the company’s current processes provide indications of future solvency concerns. Examples of items considered for prospective assessments include: Corporate Governance Future Business Plans Rate of Company Growth Liquidity of Assets On a higher level, the risk-focused surveillance process is designed to be prospective and to encourage the examiner to continually assess the financial health of the insurance company. It encourages the examiner to evaluate the company on a higher level, regarding their business, leadership and growth of the company.

44 Risk-Focused Surveillance
In accordance with the risk-focused surveillance guidance, examination work will shift so that more time is spent during the planning and risk assessment processes of the examination. Efficiencies should be gained as examiners utilize knowledge from prior exams as well as information provided through on-going monitoring by analysts to stay aware of risks within insurer operations. Some last thoughts: The risk-focused surveillance method will encourage examiners to spend more time focusing on planning and really understanding the company itself, rather than on the testing. It also encourages ongoing monitoring of the companies to identify future risks within the insurers operations.

45 Risk Assessment Matrix
© 2009 The National Association of Insurance Commissioners All Rights Reserved

46 Seven Phase Examination Process
Understand the Company and Identify Key Functional Activities to be Reviewed Identify and Assess Inherent Risks in Activities Identify and Evaluate Risk Mitigation Strategies/Controls Determine Residual Risk Establish/Conduct Exam Procedures Update Prioritization and Supervisory Plan Draft Exam Report and Management Letter Based on Findings Phase 1 Phase 2 Phase 3 Phase 4 Phase 5 Phase 6 Phase 7 Planning Phase 6 is the analysis modification and impacts future analysis focus © 2009 The National Association of Insurance Commissioners All Rights Reserved

47 Risk Assessment Cycle INSURER PROFILE SUMMARY Examination
Supervisory Plan Risk-Focused Examination Seven Phase Process: Identify Functional Activities Identify/Assess Inherent Risk Identify & Evaluate Controls Determine Residual Risk Establish Procedures and Conduct Exam Update Supervisory Plan Exam Report//Mgmt Letter Develop Ongoing Supervision That Includes: Frequency of Exams Scope of Exams Meetings with Company Management Follow-Up on Recommendations Financial Analysis Monitoring INSURER PROFILE SUMMARY Priority System Financial Analysis Company Priority Score Determined By: Priority System Based on Dept. analysis and NAIC financial Analysis tools: Scoring System ATS Results IRIS Ratios Exam Results Analysis External information (somewhat related to analysis) Exam planning / procedures Exam results can modify the analysis results Follow-up Financial Analysis includes: Risk Assessment Results Financial Analysis Handbook Process Ratio Analysis (IRIS, FAST, Internal Ratios) Actuarial Analysis Update with internal/external changes Internal/External Changes Consider Changes to: NRSRO Ratings Ownership/Management/ Corporate Structure Business Strategy/Plan CPA Report or Auditor Legal or Regulatory Status

48 Steps to Phase 1, Part 1 Understanding the Company Step 1 Step 2
Gather necessary planning information Review the gathered information Perform Analytical and Operational Reviews Consider Information Technology Risk Update the Insurer Profile Summary Step 1 Step 2 Step 3 Step 4 Step 5 1 Note: Portfolio Analysis would be completed in conjunction with Phase 1, Part 1. © 2009 The National Association of Insurance Commissioners All Rights Reserved

49 Assessing the Adequacy Functional Activities
Parts to Phase 1 Understanding the Corporate Governance Structure 2 Assessing the Adequacy of the Audit Function 3 Indentifying Key Functional Activities 4 Consideration of Prospective Risk Once we have gained a general overall understanding of the company, the second part of Phase 1 is to understand the corporate governance structure. Part 3 involves assessing the audit functions, both internal and external. Part 4 is identifying the key activities within this specific company that need to be examined. And Part 5 is considering prospective risks that may affect the company. 5 © 2009 The National Association of Insurance Commissioners All Rights Reserved

50 Phase 2 – Identify and Assess Inherent Risk
Inherent risk – Risk of economic loss or inaccurate financial reporting before considering internal controls Inherent risk is the risk of material error before considering the function of internal controls. Risk is both financial reporting risk and other than f/r risk. © 2009 The National Association of Insurance Commissioners All Rights Reserved

51 Phase 2 – Identify and Assess Inherent Risk
Identify inherent risk Other than financial reporting inherent risk Items not directly related to a current f/s line item Generally related monitoring, policies, BOD interaction, strategic type risk, etc. Financial reporting inherent risk Typically directly related to a current f/s line item Risk During Phase One the examiner obtained a thorough understanding of the company and identified the key activities and sub-activities requiring examination. As a starting point to identifying inherent risk, the examiner may rephrase examination objectives into a risk statement for the related activity/sub-activity. The examiner is considering the question of, “What could go wrong?” in a key activity. The inherent risk assessment will be conducted based on this risk statement. The process is risk-driven or risk-focused due to the examiner’s consideration of the inherent risk identified by the risk statement. examples To rewrite or rephrase an examination objective such as “The value of investments is overstated in the financial statements” to a risk statement, the risk statement might be that “Securities are overstated.” In this instance, the key activity would be Investments, and the Sub-activity would be Valuation. Another example might be an examination objective of “Calculations of gains or losses on sales of investments reviewed” would be translated into the risk statement “Gains and losses are miscalculated.” The key activity would be Investments and the Sub-activity would be Gains/losses. © 2009 The National Association of Insurance Commissioners All Rights Reserved

52 Phase 2 – Identify and Assess Inherent Risk
Assess inherent risk based on: Likelihood of Occurrence Magnitude of Impact To reach overall inherent risk levels of: High Moderate Low © 2009 The National Association of Insurance Commissioners All Rights Reserved

Magnitude of Impact Likelihood of Occurrence Threatening Severe Moderate Immaterial High Moderate- high low Low

54 Phase 3 - Control Identification & Evaluation
Identify and understand internal controls that the insurer has in place for each risk Document Understanding Consider whether the controls appear to be designed appropriately to mitigate each risk If not, no need to test controls If so, test the controls for operating effectiveness Not required if testing will be inefficient Conclude whether the internal controls effectively mitigate each inherent risk Strong, Moderate or Weak © 2009 The National Association of Insurance Commissioners All Rights Reserved

55 Phase 3 – Risk Mitigation Strategies
Assessment of Controls The Overall Risk Mitigation Strategy/Control Assessment ratings to be indicated in the Risk Assessment Matrix are: Strong risk management Moderate risk management Weak risk management © 2009 The National Association of Insurance Commissioners All Rights Reserved

56 Phase 3 – Risk Mitigation Strategies
Control Testing Intended to provide assurance that control procedures are operating as prescribed Each of these methods may provide the examiner with examination evidence regarding the effectiveness and reliability of the control procedures utilized by the company, and the ultimate choice of which method to use is based on the professional judgment of the examiner, the nature of the control procedure, and the planned reliance the examiner wishes to place on that control Based on the evaluation of the control environment, the examiner will test those controls on which he or she intends to place reliance and use those results in determining the nature and extent of substantive testing. In general, if reliance is placed on a specific control and the testing supports this reliance, the extent of substantive testing the examiner is required to perform relating to that account balance may be reduced. Example: Although control testing may be performed for any accounting area, control testing by examiners frequently will be relevant to the following areas: Premium Recording and Collections Claims Expenses and Cash Disbursements Control testing is generally performed using one of the following methods Walkthrough Corroborative inquiry Observation Re-performance Examination of Documents © 2009 The National Association of Insurance Commissioners All Rights Reserved

57 Phase 3 - Utilization of Existing Work
Existing Control Documentation SOX Workpapers Internal Audit Workpapers External Audit Workpapers Utilize where relevant to exam © 2009 The National Association of Insurance Commissioners All Rights Reserved

58 Phase 4 – Determine Residual Risk
Residual risk is determined by how well the risk mitigation strategies/controls mitigate the inherent risk. © 2009 The National Association of Insurance Commissioners All Rights Reserved

59 Phase 4 – Residual Risk Grid

60 Phase 5 – Establish/Conduct Exam Procedures
Phase 5 Handbook Guidance: Detail examination procedures should be selected to correspond with the level of residual risk determined for each identified risk. High Residual Risk Detail procedures required. Moderate Residual Risk Fewer detail procedures performed (i.e. tests of details of transactions), including more utilization of analytical procedures. Low Residual Risk Limited or no detail procedures performed, which may be limited to analytical procedures. © 2009 The National Association of Insurance Commissioners All Rights Reserved

61 Phase 6 – Update Prioritization & Supervisory Plan
Created/updated at least yearly by domiciliary state Based on recent exams and analysts’ reports Lead state concept with multi-state companies Outline type of surveillance planned, resources, and how coordination planned Part of Insurer Profile Summary Supervisory Plan Created/updated at least yearly by domiciliary state Based on recent exams and analysts’ reports Lead state concept with multi-state companies Outline type of surveillance planned, resources, and how coordination planned Part of Insurer Profile Summary © 2009 The National Association of Insurance Commissioners All Rights Reserved

62 Phase 7 – Draft Examination Report & Management Letter
Table of contents Salutation Scope of examination Body of report Company history & corporate governance Financial statements Findings & recommendations Here is a brief overview of Phase 7 – Exam report and management letter. The exam report will be covered in more detail later. © 2009 The National Association of Insurance Commissioners All Rights Reserved

63 Phase 7 – Draft Examination Report & Management Letter
Part of exam workpapers Used for results or observations that are not material to public report Optional © 2009 The National Association of Insurance Commissioners All Rights Reserved

64 Phase 7 – Draft Examination Report & Management Letter
Examination Report- Common Findings Additional Reserves Needed Asset Valuation- OTTI Items not recorded in accordance with SAP Management Report- Common Findings Proprietary Company Issues Prospective Risk Discussions Internal Control Deficiencies Notes: Exam Reports findings: Notes to the financials DTA Valuation Reinsurance credits Management Report: The company would be at risk if the control weakness was exposed in the public arena. Example- IT firewall weaknesses. The company can have issues involving portfolio diversifications- Asset Liability matching. © 2009 The National Association of Insurance Commissioners All Rights Reserved

65 Post Examination Procedures
The following activities should be performed after the examination report is issued and prior to the next examination: Follow up on examination findings Communication with financial analyst between examination dates Supervisory Report The goal is to continually monitor the companies under examination, rather than to only perform examinations. © 2009 The National Association of Insurance Commissioners All Rights Reserved

66 Questions © 2009 The National Association of Insurance Commissioners All Rights Reserved

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