Grier, Waymond A. - Credit Analysis of Financial Institutions-Euromoney Books (2012) - 151-300

Exhibit 1.
22 continued
Balance sheet 2006 2007 2008
Stockholders’ equity
Capital stock 4,787 4,685 5,400
Reserves/Retained earnings 5,289 5,045 4,089
Total equity 10,076 9,730 9,489
Total liabilities and equity 230,643 216,986 216,922
Source: Author’s own
Exhibit 1.23
Case study 2: Credit Bank: common size statements, 2006–2008 (% of total assets)
Income statement 2006 2007 2008

Interest income 13.69 14.28 11.23
Interest expense –10.50 –10.97 –7.88
Net interest income 3.19 3.31 3.35
Other revenue 2.77 3.41 3.45
Provision for loan losses –1.09 –1.23 –1.79
Other operating expenses –4.20 –5.12 –5.12
Income before tax 0.66 0.38 –0.11
Income tax –0.45 –0.23 –0.31
Extraordinary items 0.00 0.06 0.21
Net income 0.22 0.21 –0.21

Assets
Cash and due from banks 8.73 6.75 5.54
Investments 9.69 8.36 8.88
Trading account assets 3.91 3.46 5.56
Gross loans 70.98 73.03 70.31
Loan loss reserve –2.05 –2.05 –1.52
Loans (net) 68.93 70.98 68.78
Premises and equipment (net) 1.45 1.85 1.69
Interest and fees receivable 1.84 1.75 1.34
Other assets 5.43 6.84 8.20
Total assets 100.00 100.00 100.00
Continued
Liabilities
Deposits 59.80 65.65 67.52
Purchased funds and other borrowings 18.26 10.81 9.58
Accruals 2.69 2.67 2.35
Long-term debt 8.98 9.19 9.26
Subordinated capital notes 1.41 1.50 1.50
Other liabilities 4.48 5.69 5.39
Redeemable preferred stock 0.02 0.02 0.02
Stockholders’ equity 0.00 0.00 0.00
Capital stock 2.08 2.16 2.49
Reserves/Retained earnings 2.29 2.33 1.89
Total equity 4.37 4.48 4.37
Total liabilities and equity 100.00 100.00 100.00

Exhibit 1.24
Case study 2: Credit Bank: DuPont chart, 2007–2008
14.28%
*
Interest income
Total assets
3.31%
11.23%
Net interest
income
Total assets
–10.97%
3.35%
Interest
expense
Total assets
0.21% –0.23% –7.88%
Net income Income tax
Total assets Total assets
–0.21% –0.31%
4.71% 0.06% –1.23%

Exceptional Loan loss
Return on items (net)
equity provision
–4.82% 4.48% 0.21% –1.79%
Equity
Total assets
–2.93% –5.12%
4.37%
Net operating Operating
costs expenses
–3.46% –5.12%
3.41%
2007 Other
* revenue
Total assets
2008 3.45%

Bank profitability: the DuPont model
This breakdown of the components of net operating costs is revealing. When operating
revenue and other expenses both increase, this may be the result of increased emphasis on
fee-based business such as service charges as opposed to asset-based business such as loans.
In fact, operating expenses minus other revenue decreased, which is good news. However,
the provision for loan losses increased by 56 basis points (due to a further decline in loan
quality), enough to neutralise the other gains and increase the net operating cost ratio by
53 basis points.
Next, we note that the tax rate increased significantly, which would have a negative
impact on ROA. Like capital requirements, taxes are difficult for managers to control except
through ‘creative’ accounting or other delaying tactics. The increase in the tax burden was
not offset by a large increase in net extraordinary items (restructuring charges and prior-year
accounting changes) and produced a negative ROA for 1998 as follows:
ROA = net interest income – net operating costs + net extraordinary items – taxes
2007: ROA = 3.31% – 2.93% + .06% – .23% = .21%
2008: ROA = 3.35% – 3.46% + .21% – .31% = –.21%
Exhibit 1.25
Case Study 2: Credit Bank: financial statements, 2010–2012 (US$ million)
Income Statement 2010 2011 2012

Interest income 23,811 23,813 22,963
Interest expense –16,121 –14,902 –13,012
Net interest income 7,690 8,911 9,951
Other revenue 8,385 7,837 8,727
Provision for loan losses –2,600 –1,881 –1,991
Other operating expenses –10,615 –10,256 –11,102
Income before tax 2,860 4,611 5,585
Income tax –941 –1,189 –2,121
Extraordinary items 300 –56
Net income 2,219 3,366 3,464
Continued
133
Exhibit 1.25 continued
Balance Sheet 2010 2011 2012
Assets
Cash and due from banks 11,585 13,332 14,751
Investments 15,831 27,698 28,180
Trading account assets 18,117 38,875 32,093
Gross loans 147,818 153,840 167,184
Loan loss reserve –4,379 –5,155 –5,368
Loans (net) 143,439 148,685 161,816
Premises and equipment (net) 3,842 4,062 4,339
Interest and fees receivable 2,552 2,654 2,914
Other assets 21,208 15,183 12,760
Total assets 216,574 250,489 256,853
Liabilities
Deposits 145,089 155,726 167,131
Purchased funds and other borrowings 20,660 44,729 36,167
Accruals 6,452 5,493 5,719
Long-term debt 7,992 8,249 8,576
Subordinated capital notes 2,150 1,397 1,337
Other liabilities 12,260 8,878 9,767
Redeemable preferred stock 27
Stockholders’ equity
Capital stock 7,224 8,208 7,391
Reserves/Retained earnings 14,721 17,810 20,766
Total equity 21,945 26,018 28,157
Total liabilities and equity 216,574 250,489 256,853

Exhibit 1.26
Case Study 2: Credit Bank: common size statements, 2010–2012 (%)
Income Statement 2010 2011 2012

Interest income 10.99 9.51 8.94
Interest expense –7.44 –5.95 –5.07
Net interest income 3.55 3.56 3.87
Other revenue 3.87 3.13 3.40
Provision for loan losses –1.20 –0.75 –0.78
Other operating expenses –4.90 –4.09 –4.32
Income before tax 1.32 1.84 2.17
Income tax –0.43 –0.47 –0.83
Extraordinary items 0.14 –0.02 0.00
Net income 1.02 1.34 1.35

Assets
Cash and due from banks 5.35 5.32 5.74
Investments 7.31 11.06 10.97
Trading account assets 8.37 15.52 12.49
Gross loans 68.25 61.42 65.09
Loan loss reserve –2.02 –2.06 –2.09
Loans (net) 66.23 59.36 63.00
Premises and equipment (net) 1.77 1.62 1.69
Interest and fees receivable 1.18 1.06 1.13
Other assets 9.79 6.06 4.97
Total assets 100.00 100.00 100.00
Liabilities
Deposits 66.99 62.17 65.07
Purchased funds and other borrowings 9.54 17.86 14.08
Accruals 2.98 2.19 2.23
Long-term debt 3.69 3.29 3.34
Subordinated capital notes 0.99 0.56 0.52
Other liabilities 5.66 3.54 3.80
Redeemable preferred stock 0.01 0.00 0.00
Continued
Stockholders' equity
Capital stock 3.34 3.28 2.88
Reserves/Retained earnings 6.80 7.11 8.08
Total equity 10.13 7.09 10.96
Total liabilities and equity 100.00 100.00 100.00

Exhibit 1.27
Case study 2: Credit Bank: DuPont chart, 2011–2012
9.51%
*
Interest income
Total assets
3.56%
8.94%
Net interest
income
Total assets
–5.95%
3.87%
Interest
expense
Total assets
1.34% –0.47% –5.07%
Net income Income tax
1.35% –0.83%
12.94% –0.02% –0.75%

Exceptional Loan loss
Return on items (net)
equity provision
12.30% 10.39% 0.00% –0.78%
Equity
Total assets
–1.72% –4.09%
10.96%
Net operating Operating
costs expenses
–1.70% –4.32%
3.13%
2011 Other
* revenue
Total assets
2012 3.40%
Leverage increased somewhat from an equity to total assets ratio of 4.48% for 2007 to
4.37% for 2008. This was before regulatory pressures were added for all banks in the subject’s
137
Credit Analysis of Financial Institutions
geographical area to increase capital requirements. Nevertheless, the increased leverage was
not enough to offset the negative ROA, so that ROE for Credit Bank was negative for the
year 2008. As indicated, relatively small changes in ROA and leverage combined to drive
ROE down sharply. This illustrates the extreme sensitivity of financial institution profitability,
and therefore the level of skill required by managers.
Three years later, the picture appears considerably brighter.
Again, the environment for interest rates was trending downwards, but the bank improved
spreads by two basis points:
2011: spread = 9.51% – 5.95% = 3.56% (NIM)

2012: spread = 8.94% – 5.07% = 3.87% (NIM)
Net operating costs were reduced – largely due to an increase in other income which offset:
(i) a slightly larger provision for loan losses as the bank continued to weed out mortgage
problem credits; and (ii) an increase in operating expenses which the bank indicated was due
to an increase in risk management staff and control related expenses. This led to a modest
decrease in net operating costs as shown by the following ratio (operating expenses plus the
provision for loan losses minus other revenue):
2011: net operating cost ratio = 4.09% + .75% – 3.13% = 1.72%

2012: net operating cost ratio = 4.32% + .78% – 3.40% = 1.70%
Note, however, that three years before the net operating cost ratio represented more than
3% of total assets.
The gain by the improved NIM and the modest decrease in net operating costs as a
percentage of total assets for 2012 was offset by a larger tax bite on overseas operations,
according to the bank. As a result, the bank’s ROA remained almost stable at 1.35% of
total assets (see Exhibit 1.27).
2011: ROA = 3.56% – 1.72% + .02% – .47% = 1.34%

2012: ROA = 3.87% – 1.70% + .00% – .83% = 1.35%
Management could not use leverage to improve the bank’s overall position as steeper minimum
capital requirements were implemented. Consequently, ROE declined somewhat but remained
significantly higher than the ‘crisis’ years 2007–2008.
2011: ROE = 1.34% divided by .1039 (10.39%) = 12.94%3

2012: ROE = 1.35% divided by .1096 (10.96%) = 12.30%
Verification
Recall that our initial DuPont formula can be used to confirm the ROE results. The formula
again is:
138
ROE = PM × AU × EM
where PM = Net income/Total revenue
AU = Total revenue/Total assets
EM = Total assets/Equity
As applied to Credit Bank:
PM ¥ AU ¥ EM = ROE
2007 .03139 ¥ .067226 ¥ 22.30072 = 0.04707 or 4.71%
2008 –.03098 ¥ .067997 ¥ 22.86036 = –0.04816 or –4.82%
2011 .20098 ¥ .066861 ¥ 9.62753 = 0.12937 or 12.94%
2012 .18546 ¥ .072719 ¥ 9.12217 = 0.12303 or 12.30%
1
For Part 2: see the section Statement of cash flows.
2
HLT: highly leveraged transactions; RRE: residential real estate; and CRE: commercial real estate.
3
Note that all figures in the DuPont example may show slight differences due to rounding. A computer spreadsheet
was used to generate all the sample figures.
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Appendix 1.8
IFRS – applications to banks1
There are no longer any bank-specific disclosure requirements. Currently, all International
Accounting Standards (IAS) and their successor standards, IFRS, are applicable to banks,
particularly IAS 32, IFRS 7 and IFRS 9 (replacement of IAS 39). The following is a summary
of the main components of these three standards.
IAS 32 – Financial Instruments: Presentation

Last amended in May 2012 (effective 1 January 2013), IAS 32 – Financial Instruments:
Presentation establishes principles for presenting financial instruments as liabilities or equity
and for offsetting financial assets and liabilities. IAS 32 is a companion to IAS 39 – Financial
Instruments: Recognition and Measurement and IFRS 9 – Financial Instruments. IAS 39 deals
with, among other things, initial recognition of financial assets and liabilities, measurement
subsequent to initial recognition, impairment, derecognition, and hedge accounting. IAS 39
is progressively being replaced by IFRS 9 as the IASB completes the various phases of its
financial instruments project.
Scope
IAS 32 applies in presenting and disclosing information about all types of financial instru-
ments with the following exceptions (paragraph – IAS 32.4):
⦁⦁ interests in subsidiaries, associates and joint ventures that are accounted for under IAS 27
– Consolidated and Separate Financial Statements, IAS 28 – Investments in Associates
or IAS 31 – Interests in Joint Ventures (or, for annual periods beginning on or after 1
January 2013, IFRS 10 – Consolidated Financial Statements, IAS 27 – Separate Financial
Statements and IAS 28 – Investments in Associates and Joint Ventures). However, IAS 32
applies to all derivatives on interests in subsidiaries, associates, or joint ventures;
⦁⦁ employers’ rights and obligations under employee benefit plans (IAS 19 – Employee
Benefits);
⦁⦁ insurance contracts (IFRS 4 – Insurance Contracts). However, IAS 32 applies to derivatives
that are embedded in insurance contracts if they are required to be accounted separately
by IAS 39;
⦁⦁ financial instruments that are within the scope of IFRS 4 because they contain a
discretionary participation feature are only exempt from applying paragraphs 15-32 and
AG25-35 (analysing debt and equity components) but are subject to all other IAS 32
requirements; and
⦁⦁ contracts and obligations under share-based payment transactions (IFRS 2 – Share-based
Payment) with the exception of contracts in IAS paragraphs 32-34.
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IFRS – applications to banks
IAS 32 applies to those contracts to buy or sell a non-financial item that can be settled net in
cash or another financial instrument, except for contracts that were entered into and continue
to be held for the purpose of the receipt or delivery of a non-financial item in accordance
with the entity’s expected purchase, sale or usage requirements.
Key definitions
Financial instrument: a contract that gives rise to a financial asset of one entity and a finan-
cial liability or equity instrument of another entity.
Financial asset: any asset that is:
⦁⦁ cash;
⦁⦁ an equity instrument of another entity;
⦁⦁ a contractual right;
○○ to receive cash or another financial asset from another entity; or
○○ to exchange financial assets or financial liabilities with another entity under conditions
that are potentially favourable to the entity;

⦁⦁ a contract that will or may be settled in the entity’s own equity instruments and is:
○○ a non-derivative for which the entity is or may be obliged to receive a variable number
of the entity’s own equity instruments;

○○ a derivative that will or may be settled other than by the exchange of a fixed amount of
cash or another financial asset for a fixed number of the entity’s own equity instruments.
For this purpose the entity’s own equity instruments do not include instruments that
are themselves contracts for the future receipt or delivery of the entity’s own equity
instruments; or
○○ puttable instruments classified as equity or certain liabilities arising on liquidation
classified by IAS 32 as equity instruments.
Financial liability: any liability that is:
⦁⦁ a contractual obligation:
○○ to deliver cash or another financial asset to another entity; or
○○ to exchange financial assets or financial liabilities with another entity under conditions
that are potentially unfavourable to the entity;

⦁⦁ a contract that will or may be settled in the entity’s own equity instruments and is:
○○ a non-derivative for which the entity is or may be obliged to deliver a variable number
of the entity’s own equity instruments; or

○○ a derivative that will or may be settled other than by the exchange of a fixed amount of
cash or another financial asset for a fixed number of the entity’s own equity instruments.
For this purpose the entity’s own equity instruments do not include: instruments that
are themselves contracts for the future receipt or delivery of the entity’s own equity
instruments; puttable instruments classified as equity or certain liabilities arising on
liquidation classified by IAS 32 as equity instruments.
141
Equity instrument: any contract that evidences a residual interest in the assets of an entity
after deducting all of its liabilities.
Fair value: the amount for which an asset could be exchanged, or a liability settled,
between knowledgeable, willing parties in an arm’s length transaction.
The definition of financial instrument used in IAS 32 is the same as that in IAS 39.
Puttable instrument: a financial instrument that gives the holder the right to put the
instrument back to the issuer for cash or another financial asset or is automatically put
back to the issuer on occurrence of an uncertain future event or the death or retirement of
the instrument holder.
Classification as liability or equity

The fundamental principle of IAS 32 is that a financial instrument should be classified as
either a financial liability or an equity instrument according to the substance of the contract,
not its legal form, and the definitions of financial liability and equity instrument. Two excep-
tions from this principle are certain puttable instruments meeting specific criteria and certain
obligations arising on liquidation (see below). The entity must make the decision at the time
the instrument is initially recognised. The classification is not subsequently changed based
on changed circumstances.
A financial instrument is an equity instrument only if: (i) the instrument includes no
contractual obligation to deliver cash or another financial asset to another entity; and (ii)
if the instrument will or may be settled in the issuer’s own equity instruments, it is either:
⦁⦁ a non-derivative that includes no contractual obligation for the issuer to deliver a variable
number of its own equity instruments; or
⦁⦁ a derivative that will be settled only by the issuer exchanging a fixed amount of cash or
another financial asset for a fixed number of its own equity instruments.
Example – preference shares

If an entity issues preference (preferred) shares that pay a fixed rate of dividend and that
have a mandatory redemption feature at a future date, the substance is that they are a
contractual obligation to deliver cash and, therefore, should be recognised as a liability. In
contrast, preference shares that do not have a fixed maturity, and where the issuer does not
have a contractual obligation to make any payment are equity. In this example even though
both instruments are legally termed preference shares they have different contractual terms
and one is a financial liability while the other is equity.
Example – issuance of fixed monetary amount of equity instruments

A contractual right or obligation to receive or deliver a number of its own shares or other
equity instruments that varies so that the fair value of the entity’s own equity instruments
to be received or delivered equals the fixed monetary amount of the contractual right or
obligation is a financial liability.
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Example – one party has a choice over how an instrument is settled

When a derivative financial instrument gives one party a choice over how it is settled (for
instance, the issuer or the holder can choose settlement net in cash or by exchanging shares
for cash), it is a financial asset or a financial liability unless all of the settlement alternatives
would result in it being an equity instrument.
Contingent settlement provisions

If, as a result of contingent settlement provisions, the issuer does not have an unconditional
right to avoid settlement by delivery of cash or other financial instrument (or otherwise to
settle in a way that it would be a financial liability) the instrument is a financial liability
of the issuer, unless:
⦁⦁ the contingent settlement provision is not genuine;

⦁⦁ the issuer can only be required to settle the obligation in the event of the issuer’s liquidation;
or
⦁⦁ the instrument has all the features and meets the conditions of IAS 32.16A and 16B for
puttable instruments.
Puttable instruments and obligations arising on liquidation

In February 2008, the IASB amended IAS 32 and IAS 1 – Presentation of Financial Statements
with respect to the balance sheet classification of puttable financial instruments and obliga-
tions arising only on liquidation. As a result of the amendments, some financial instruments
that currently meet the definition of a financial liability will be classified as equity because
they represent the residual interest in the net assets of the entity.
Classifications of rights issues

In October 2009, the IASB issued an amendment to IAS 32 on the classification of rights
issues. For rights issues offered for a fixed amount of foreign currency current practice
appears to require such issues to be accounted for as derivative liabilities. The amendment
states that if such rights are issued pro rata to an entity’s all existing shareholders in the
same class for a fixed amount of currency, they should be classified as equity regardless of
the currency in which the exercise price is denominated.
Compound financial instruments

Some financial instruments – sometimes called compound instruments – have both a liability
and an equity component from the issuer’s perspective. In that case, IAS 32 requires that
the component parts be accounted for and presented separately according to their substance
based on the definitions of liability and equity. The split is made at issuance and not revised
for subsequent changes in market interest rates, share prices, or other event that changes the
likelihood that the conversion option will be exercised.
143
To illustrate, a convertible bond contains two components. One is a financial liability,

namely the issuer’s contractual obligation to pay cash, and the other is an equity instrument,
namely the holder’s option to convert into common shares. Another example is debt issued
with detachable share purchase warrants.
When the initial carrying amount of a compound financial instrument is required to
be allocated to its equity and liability components, the equity component is assigned the
residual amount after deducting from the fair value of the instrument as a whole the amount
separately determined for the liability component.
Interest, dividends, gains, and losses relating to an instrument classified as a liability
should be reported in profit or loss. This means that dividend payments on preferred shares
classified as liabilities are treated as expenses. On the other hand, distributions (such as
dividends) to holders of a financial instrument classified as equity should be charged directly
against equity, not against earnings.
Transaction costs of an equity transaction are deducted from equity. Transaction costs
related to an issue of a compound financial instrument are allocated to the liability and
equity components in proportion to the allocation of proceeds.
Treasury shares
The cost of an entity’s own equity instruments that it has reacquired (‘treasury shares’)
is deducted from equity. Gain or loss is not recognised on the purchase, sale, issue, or
cancellation of treasury shares. Treasury shares may be acquired and held by the entity or
by other members of the consolidated group. Consideration paid or received is recognised
directly in equity.
Offsetting
IAS 32 also prescribes rules for the offsetting of financial assets and financial liabilities. It
specifies that a financial asset and a financial liability should be offset and the net amount
reported when, and only when, an entity:
⦁⦁ has a legally enforceable right to set off the amounts; and

⦁⦁ intends either to settle on a net basis, or to realise the asset and settle the liability
simultaneously.
Costs of issuing or reacquiring equity instruments

Costs of issuing or reacquiring equity instruments (other than in a business combination) are
accounted for as a deduction from equity, net of any related income tax benefit.
Disclosures
Financial instruments disclosures are in IFRS 7 – Financial Instruments: Disclosures, and no
longer in IAS 32.
144
The disclosures relating to treasury shares are in IAS 1 – Presentation of Financial

Statements and IAS 24 – Related Parties for share repurchases from related parties.
IFRS 7 – Financial Instruments: Disclosures

Effective 1 January 2007, IFRS 7 – Financial Instruments: Disclosure will replaced bank-
specific standard IAS 30 and incorporated disclosure requirements under IAS 32, so that all
financial instruments disclosures are located in a single Standard for all types of entities. This
includes amendments to IAS 32 issued in 2005 (the fair value option and financial guarantee
contracts). The disclosure requirements contained in IFRS 7 are less prescriptive than those
in the previous IAS 30 for banks.
All the disclosures required by IFRS 7, except for the risk disclosures, must be part of
the financial statements with minimum disclosure requirements subject to the materiality
requirements of IAS 1 – Presentation of Financial Statements. The qualitative and quanti-
tative risk disclosures required by IFRS 7 may be provided in the financial statements or
incorporated by reference from the financial statements to another statement (for example,
the management commentary or a risk report). IFRS 7 introduces:
⦁⦁ requirements for enhanced balance sheet and income statement disclosure by category, (for
example, whether the instrument is available-for-sale or held-to-maturity);
⦁⦁ information about any provisions against impaired assets;
⦁⦁ additional disclosure relating to the fair value of collateral and other credit enhancements
used to manage credit risk; and
⦁⦁ market risk sensitivity analyses.
Scope
IFRS 7 applies to all risks arising from all financial instruments, including those instruments
that are not recognised on-balance sheet. Consistent with IAS 30 and IAS 32, there is no
scope exemption for subsidiaries or, as yet, for small-and medium-sized entities, but the
International Accounting Standards Board (IASB) has agreed to consider this issue in its project
on financial reporting for small-and medium-sized entities. The application to subsidiaries
may present a challenge to entities that are members of a consolidated group as they often
manage risk on a consolidated basis. Furthermore, the requirement to provide the disclosure
for each entity may provide limited value to users of financial statements (compared with the
cost of compilation) when the information is already disclosed at the group level.
IFRS 7 disclosures must be presented based on the accounting policies used for the
financial statements prepared in accordance with IFRS, including consolidation adjustments.
It is possible that the internal information made available to management for risk manage-
ment purposes is not prepared using such accounting policies, in which case it will need to
be amended. A good example is when hedging transactions are economically effective but
do not qualify for hedge accounting.
145
Balance sheet
IFRS 7, as with IAS 32, does not prescribe the location of the required balance sheet
disclosures. An entity is permitted to present the required disclosures either on the face of
the balance sheet or in the notes to the financial statements. When the Standard requires
disclosure by class of financial instrument, the entity shall group instruments in classes that
are appropriate to the nature of the information disclosed and the characteristics of the
instruments. IFRS 7 requires additional detail in the disclosures for each category of financial
instruments such as financial assets held at fair value through profit or loss or available-for-
sale. In contrast, IAS 32 only requires separate disclosure of financial instruments carried at
fair value through profit or loss, although the level of detail required by IFRS 7 is not as
prescriptive as the requirements of IAS 30. The required core balance sheet disclosures for
each category of financial assets and financial liabilities in IFRS 7 are similar to those in
IAS 32 and include the carrying amount and related fair value, along with the amount and
reason for any reclassifications between categories.
Balance sheet disclosures include the following.
Loans and receivables at fair value through profit or loss: IFRS 7 contains the disclosure
requirements for loans and receivables at fair value through profit or loss introduced in IAS
32 as a result of the IAS 39 fair value option amendment. These include the maximum
credit exposure, the impact of credit derivatives on the credit exposure, and the change in
the fair value of the loan or receivable (or group of loans or receivables) and any related
credit derivatives due to changes in credit risk, both during the period and cumulatively
since designation.
Financial liabilities at fair value through profit or loss: IFRS 7 includes the requirement
in IAS 32 to disclose the change in the fair value of a financial liability due to credit risk,
that was introduced as part of the amendment to IAS 39 for the fair value option. IFRS
7 also requires disclosure of the method used to determine the change in fair value due to
credit risk. Entities are required to use the methodology described in IFRS 7, unless they
can demonstrate that an alternative method is a better approximation.
Other sundry balance sheet disclosures:
⦁⦁ derecognition: certain information is required to be disclosed when all or part of transferred

financial assets do not qualify for derecognition, or when there is ‘continuing involvement’;
⦁⦁ collateral given: disclosure is required of the carrying amount in addition to the terms
and conditions of financial assets pledged as collateral;
⦁⦁ collateral received: an entity must disclose the fair value and terms and conditions of assets
received as collateral which the entity has the right to sell or repledge in the absence of
default;
⦁⦁ allowance for credit losses: IFRS 7 requires disclosure of a reconciliation of the allowance
for credit losses for all financial assets, whereas IAS 30 requires a similar disclosure only
for loans and advances;
⦁⦁ compound financial instruments with multiple embedded derivatives: disclosure must be
made of the existence of multiple embedded derivatives whose values are interdependent
(for example, callable convertible debt); and
146
⦁⦁ defaults and breaches: disclosure is required of the details and carrying amounts of
liabilities that are in default.
Income statement
Similar to the minimum balance sheet disclosures, an entity is permitted to present the
required income statement disclosures on either the face of the income statement or in the
notes to the financial statements. The income statement disclosures required by IFRS 7 are
more prescriptive than those required by IAS 32, although not as detailed as the require-
ments of IAS 30. For example, IAS 32 only requires separate disclosure of the net gains
or net losses of financial instruments carried at fair value through profit or loss, whereas
IFRS 7 requires the disclosure of this information for all categories of financial assets and
financial liabilities.
IAS 32 disclosures retained in IFRS 7 include:
⦁⦁ total interest income and total interest expense from financial assets and financial liabilities
that are not measured at fair value through profit or loss;
⦁⦁ available-for-sale gains or losses recognised in equity, in addition to those amounts
reclassified from equity to profit or loss; and
⦁⦁ interest accrued on impaired financial assets.
Disclosure requirements introduced by IFRS 7 include:
⦁⦁ net gains or losses for each category of financial asset or financial liability;
⦁⦁ impairment losses for each category of financial asset;
⦁⦁ fee income and expense (other than amounts included in the determination of the effective
interest rate) for financial assets and financial liabilities not measured at fair value through
profit or loss; and
⦁⦁ fee income and expense from trust and other fiduciary activities.
Other disclosures
Accounting policies
IAS 1 already requires disclosure of an entity’s significant accounting policies but IFRS 7
prescribes specific disclosure of certain policies relating to financial instruments. The IASB’s
Application Guidance to IFRS 7 provides more specific guidelines for disclosure of accounting
policies than currently required by IAS 32. It introduces disclosure of the criteria for: (i)
designating financial assets and financial liabilities as at fair value through profit or loss; (ii)
designating financial assets as available-for-sale; and (iii) the use of an allowance account
(that is, bad debt reserve), including the criteria for writing off amounts charged to such
an account.
147
Hedge accounting
Exhibit 1.28 summarises the hedge accounting disclosures required by IFRS 7. IFRS 7 expands
on the requirements of IAS 32 in that the gain or loss on a hedging instrument in a cash
flow hedge that is transferred from equity to profit or loss must be analysed by income state-
ment caption. Additionally, IFRS 7 introduces the disclosure of the amount of ineffectiveness
recognised in profit or loss for cash flow hedges and hedges of net investments in foreign
operations, and the gain or loss on the hedging instrument and hedged item attributable to
hedged risk for fair value hedges.
Exhibit 1.28
Hedge accounting disclosures required by IFRS 7
Disclosure Fair value Cash flow Net investment

hedges hedges hedges
Description of hedged risk and hedging instrument X X X
with related fair values
When hedged cash flows are expected to occur X
Forecast transactions no longer expected to occur X
Gain or loss recognised in equity and reclassifications X
to P&L
Ineffectiveness recognised in P&L X X
Fair value
IFRS 7 retains the IAS 32 disclosures relating to the methods and significant assumptions
used to determine fair value for different classes of financial assets and financial liabilities.
Required disclosures include:
⦁⦁ whether the fair value is based on quoted prices or valuation techniques;

⦁⦁ whether the fair value is based on a valuation technique that includes assumptions not
supported by market prices or rates, and the amount of profit recognised; and
⦁⦁ the effect of reasonably possible alternative assumptions used in a valuation technique.
Although ‘whether’ could, arguably, be answered with a qualitative analysis, it is presumed

that this will require a quantitative analysis of the value of instruments that fall into the
various categories.
IAS 32 currently requires disclosure of the nature and carrying amount of financial
instruments whose fair value cannot be reliably measured, including an explanation of why
148
this is the case. IFRS 7 expands the IAS 32 requirement to include how the entity intends
to dispose of such financial instruments.
‘Day 1’ profit or loss

IAS 39 does not permit profits or losses to be recorded when a financial instrument is
initially recognised (a ‘Day 1’ profit or loss), unless the fair value of the instrument is based
on a valuation technique whose variables include only data from observable markets. IFRS
7 requires disclosure of any Day 1 profit or loss not recognised in the financial statements,
together with the change in the amount previously deferred, plus the entity’s policy for
determining when amounts deferred are recognised in profit or loss.
Qualitative risk disclosures

IFRS 7 retains the qualitative disclosures required by IAS 32 relating to risks (that is, credit
risk, liquidity risk, and market risk) to which an entity is exposed, including a discussion
of management’s objectives and policies for managing such risks. IFRS 7 expands these to
include information on the processes that an entity uses to manage and measure its risks.
Quantitative risk disclosures

IFRS 7 expands on the quantitative disclosures contained in IAS 32, which are intended to
provide information about the extent to which an entity is exposed to risks based on the
information available to key management personnel, in addition to an overview of finan-
cial instruments used by the entity. IFRS 7 requires disclosure of all risk concentrations to
which an entity is exposed, based on shared characteristics (for example, location, currency,
economic conditions and type of counterparts). Additionally, IFRS 7 requires a description
of how management determines such concentrations.
Credit risk
For each class of financial instrument, IFRS 7 requires disclosure of the maximum credit
exposure, net of any impairment losses, before consideration of collateral or other credit
enhancements received (for example, netting agreements), plus a description of collateral and
other credit enhancements available. IFRS 7 considers the maximum credit exposure for loans
and receivables granted and deposits placed to be the carrying amount and for derivatives
to be the current fair value.
New credit risk disclosures in IFRS 7 include:
⦁⦁ information relating to the credit quality of financial assets that are neither past due nor
impaired (for example, a rating analysis);
⦁⦁ a description and fair value of collateral available to the entity as security and other
credit enhancements; and
⦁⦁ collateral of which the entity has taken control.
149
The disclosure of financial assets that are past due but not impaired may present an opera-
tional issue for many entities. Overdue information may not be readily available or it may
not be captured by an entity’s credit system until such time that it becomes past due by a
critical period of time.
Liquidity risk
IFRS 7 eliminates the requirement to disclose contractual maturities of financial assets.
Financial liabilities must be disclosed by contractual maturity, based on undiscounted cash
flows, which may or may not agree with the internal information made available to manage-
ment. One of the difficulties in preparing a maturity analysis is the treatment of derivatives,
which normally involve a series of cash flows. IFRS 7 guidance states that net cash flows
should be included in the maturity analysis in the case of an interest rate swap, since
contractually only net cash flows are exchanged. However, a currency swap would need to
be included in the maturity analysis based on gross cash flows.
The Application Guidance of IFRS 7 suggests timeframes that may be used in preparing
the contractual maturity analysis for liabilities.
IFRS 7 expands the disclosure of liquidity risk to include a description of how liquidity
risks are managed.
Market risk
IFRS 7 requires the disclosure of a market risk sensitivity analysis which includes the effect
of ‘a reasonably possible change’ in risk variables in existence at balance sheet date if
applied to all risks in existence at that date, along with the methods and assumptions used
in preparing the analysis. Market risk is defined as ‘the risk that the fair value or future
cash flows of a financial instrument will fluctuate because of changes in market prices and
includes interest rate risk, foreign currency risk and other price risk’ (for example, equity
and commodity risk).
The Application Guidance of IFRS 7 provides some guidance on what is ‘a reasonably
possible change’ and includes:
⦁⦁ consideration of the economic environment in which the entity operates – remote or

‘worst-case’ scenarios or ‘stress tests’ are not included;
⦁⦁ the entity should consider what changes are reasonably possible over the next reporting
period; and
⦁⦁ the entity need not re-assess what is a reasonably possible change in risk variables if the
rate of change of the underlying risk variable is stable.
Essentially, entities should disclose similar sensitivities to those that would be used for
internal risk management purposes. For entities outside of the financial services industry,
such information relating to market risk may not be readily available and compliance with
the required disclosures may present a challenge.
150
IFRS 7 does not prescribe the format in which a sensitivity analysis should be presented,
although exposures to risks from significantly different economic environments should not
be combined. For example, an entity that trades financial instruments might disclose sepa-
rately sensitivity information for financial instruments held for trading and those not held
for trading.
IFRS 7 requires disclosure of the assumptions and methods, together with the objective
of the methods used in preparing the sensitivity analysis. Additionally, the reasons for any
changes from the previous period in the assumptions and methods used in performing the
sensitivity analysis must be disclosed.
IAS 1 amendment
Simultaneously with the publication of IFRS 7, the IASB issued an amendment to IAS 1.
The amendment covers capital disclosures which were originally proposed to be included
in IFRS 7. Similar to IFRS 7, the amendment applies to all entities that produce financial
statements in accordance with IFRS and is effective for annual periods beginning on or after
1 January 2007.
The amendment requires the following disclosures:
⦁⦁ what an entity regards as its capital and qualitative information on the entity’s objectives,
policies and processes for managing it;
⦁⦁ summary quantitative information about the capital the entity manages; and
⦁⦁ whether an entity has complied with any externally imposed capital requirements and
information on the policies and process for managing external capital requirements.
For more information, the analyst should consult the reference International Financial
Reporting Standards, published by the International Accounting Standards Board.
IFRS 9 – Financial Instruments (Phase 1: Classification and

Measurement)
According to one of the largest audit companies,2 the replacement of IAS 39 with IFRS
9 promises to be the biggest changes in banks’ financial reporting since the introduction
of IFRSs. IFRS 9 remains a work in progress as of this writing. Some parts are complete,
some parts previously considered complete are potentially being revisited and some parts are
still being developed. Following a two-year deferral of the IFRS 9 mandatory effective date
(agreed by the IFRS board, the IASB), what appears to be certain is that banks and other
entities that are required or permitted to apply IFRS will be required to apply IFRS 9 on
1 January 2015. For entities in the EU, there is the additional uncertainty over the timing
of EU endorsement.
As it stands, IFRS 9 – Financial Instruments introduces new requirements for classifying
and measuring financial assets and liabilities. Impairment methodology for financial assets
and hedge accounting will expand IFRS 9 in further steps.
151
Overview of IFRS – Financial Instruments

Financial assets are required to be classified into three categories: (i) amortised cost; (ii)
fair value through profit or loss (FVTPL); and (iii) fair value through other comprehensive
income), depending on the entity’s business model for managing its financial instruments and
the contractual cash flow characteristics of the instrument.
All debt instruments (loans, receivables and bonds) will be measured at amortised cost
only if the objective of the entity (business model) is to collect the contractual cash flows
and if these cash flows are only payments of principal and interest. All other debt instru-
ments will be measured at FVTPL.
All equity instruments will be measured at FVTPL except in case of irrevocable elec-
tion made at initial recognition for measurement at fair value through other comprehensive
income (provided these financial assets are net held for trading purposes and note measured
at FVTPL) without subsequent recycling through profit or loss.
Embedded derivatives will not be recognised separately when their host contracts are
financial assets and the hybrid instrument in its entirety will then be measured at FVTPL.
Requirements for the classification and measurement of financial liabilities contained in
IAS 39 have been incorporated into IFRS 9 without any modifications, except for financial
liabilities designated at FVTPL (using the fair value option). The amount of change in the
liability’s fair value attributable to changes in credit risk is recognised in other comprehensive
income without subsequent recycling through profit or loss.
Provisions related to derecognition of financial assets and financial liabilities have been
carried forward unchanged from IAS 39 into IFRS 9.
Fair value option

IFRS 9 contains an option to designate a financial liability as measured at FVTPL if:
⦁⦁ doing so eliminates or significantly reduces a measurement or recognition inconsistency

(sometimes referred to as an ‘accounting mismatch’) that would otherwise arise from
measuring assets or liabilities or recognising the gains and losses on them on different
bases; or
⦁⦁ the liability is part or a group of financial liabilities or financial assets and financial liabilities
that is managed and its performance is evaluated on a fair value basis, in accordance with
a documented risk management or investment strategy, and information about the group
is provided internally on that basis to the entity’s key management personnel.
152
Exhibit 1.29
Annex 1: phase-in arrangements
2011 2012 2013 2014 2015 2016 2017 2018 As of 1 January

2019
Leverage Ratio Supervisory monitoring Parallel run 1 Jan 2013 – 1 Jan 2017 Disclosure starts Migration
1 Jan 2015 to Pillar 1
Minimum Common Equity Capital Ratio 3.5% 4.0% 4.5% 4.5% 4.5% 4.5% 4.5%
Capital Conservation Buffer 0.625% 1.25% 1.875% 2.50%
Minimum common equity plus capital 3.5% 4.0% 4.5% 5.125% 5.75% 6.375% 7.0%
conservation buffer
Phase-in of deductions from CET1 20% 40% 60% 80% 100% 100%
(including amounts exceeding the limit for
DTAs, MSRs and financials)
Minimum Tier 1 Capital 4.5% 5.5% 6.0% 6.0% 6.0% 6.0% 6.0%
Minimum Total Capital 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% 8.0%
Minimum Total Capital plus conservation 8.0% 8.0% 8.0% 8.625% 9.25% 9.875% 10.5%
buffer
Capital instruments that no longer qualify Phased out over 10 year horizon beginning 2013
as non-core Tier 1 capital or Tier 2 capital
Liquidity coverage ratio Observation Introduce

period begins minimum
standard
Net stable funding ratio Observation Introduce
period begins minimum
standard
Shading indicates transition periods.

All dates are as of 1 January.
Acronyms: CET1 = Common equity Tier 1; DTAs = Deferred tax assets; MSRs = Mortgage servicing rights.
Exhibit 1.30
Annex 2: sample IFRS bank financial statements
Consolidated income statement

Year ended
31 December
2012 2011
Interest and similar income 7,882 6,346
Dividend income 87 33
Interest and similar expenses (6,183) (4,936)

Net interest income 1,786 1,443
Loan impairment charges (530) (196)

Net interest income after loan impairment 1,256 1,247
Fee and commission income 1,095 1,044
Fee and commission expense (298) (309)
Net fee and commission income 797 735
Net gains/(losses) on financial instruments classified as held for trading 56 (318)
Net gains on financial instruments designated at fair value 110 100
Hedge ineffectiveness 56 37
Net gains/(losses) on investment securities (66) 112
Personnel expenses (774) (832)
General and administrative expenses (248) (276)
Depreciation and amortisation expense (355) (352)
Other operating expenses (219) (151)
Operating profit 613 302
Share of profit of associates and joint ventures accounted for using the equity 7 7
method
Profit before income tax 620 309
Income tax expense (184) (84)
Profit for the year from continuing operations 436 225
Profit for the year from discontinued operations 15 0
Profit for the year 451 225
Continued
Consolidated income statement
Year ended
31 December
2012 2011
Profit attributable to:
Equity holders of the parent entity (total) 442 220
Non-controlling interests (total) 9 5
451 225
Earnings per share for the profit from continuing operations attributable to the
equity holders of the parent entity during the year (LCUs per share):
Basic 0.34 0.20
Diluted 0.34 0.20
Earnings per share for the profit from discontinued operations attributable to the
equity holders of the parent entity during the year (LCUs per share):
Basic 0.013 0
Diluted 0.013 0
Consolidated statement of comprehensive income

Year ended
31 December
2012 2011
Profit for the year 451 225
Exchange differences on translation of foreign operations 35 34
Net gains on available-for-sale financial assets 163 5
Unrealised net gains arising during the period, before tax 187 6
Net reclassification adjustments for realised net losses, before tax (24) (1)
Cash flow hedges (16) (40)
Net losses arising on hedges recognised in other comprehensive income, before (40) (40)
tax
Net amount reclassified to the income statement, before tax 24 0
Actuarial gains in defined benefit pension schemes 9 34
Share of other comprehensive income of associates and joint ventures accounted
for by the equity method (6) 13
Income tax relating to components of other comprehensive income (75) (19)
Other comprehensive income for the year, net of tax 110 27
Total comprehensive income for the year 561 252
Continued
Year ended
31 December
2012 2011
Total comprehensive income attributable to:
Equity holders of the parent entity (total) 550 247
Total comprehensive income for the year from continuing operations 534 247
Total comprehensive income for the year from discontinued operations 16 0
Non-controlling interests (total) 11 5
Total comprehensive income for the year from continuing operations 11 5
Total comprehensive income for the year from discontinued operations 0 0
561 252
Consolidated statement of financial position (balance sheet)*

Year ended
31 December
2012 2011
Assets
Cash and balances with central banks 5,080 3,315
Loans and advances to banks 9,167 6,145
Loans and advances to customers 60,513 52,950
Financial assets held for trading 6,479 8,305
Financial assets designated at fair value 2,520 1,102
Hedging derivatives 2,865 3,341

Investment securities:
Available-for-sale 2,321 1,577
Loans and receivables 1,212 0
Held to maturity 2,999 2,009
Assets pledged as collateral 1,004 1,083

Investments in associates and joint ventures accounted for using the equity 112 108
method
Investment properties 98 0
Property, plant and equipment 1,471 1,555
Intangible assets 213 275
Current income tax assets 54 48
Deferred income tax assets 273 255
Continued
Consolidated statement of financial position (balance sheet)*
Year ended
31 December
2012 2011
Other assets 1,917 2,016
96,298 84,084
Assets classified as held for sale and discontinues operations 20 0

Total assets 98,318 84,084
Liabilities
Deposits from banks 30,836 25,549
Deposits from customers 46,775 42,698
Financial liabilities held for trading 3,301 2,829
Financial liabilities designated at fair value 1,367 1,311
Hedging derivatives 2,738 2,848
Debt securities in issue 1,766 1,232

Retirement benefit obligations 237 221
Provisions 387 229
Current income tax liabilities 101 125
Deferred income tax liabilities 1,109 693
Other liabilities 875 523
Convertible bonds 162 161
Subordinated debt 4,022 2,018
93,676 80,437
Liabilities included in assets classified as held for sale and discontinued operations 17 0
Total liabilities 93,676 80,437
Equity
Capital and reserves attributable to equity holders of the parent entity
Share capital 1,200 1,150
Share premium 857 818
Treasury shares (47) (52)
Silent participation Government Protection Scheme 750 0
Revaluation reserve 223 127
Retained earnings 1,263 1,320
Cash flow hedge (13) (3)
Continued

Year ended
31 December
2012 2011
Other reserves 307 213
4,540 3,573
Non-controlling interests in equity 85 74
Total equity 4,625 3,647
Total equity and liabilities 98,318 84,084
All amounts are in thousands of local currency units (LCUs), except per share data.
Parentheses indicate negative amounts.
* Requirements for the balance sheet are set out in IAS 1 (revised), ‘Presentation of financial statements’. The
standard now refers to the balance sheet as ‘statement of financial position’. However, as this new title is not
mandatory, entities could elect to retain the better-known title ‘balance sheet’.
1
Deloitte Touche Tohmatsu Limited, New York and London, ‘Deloitte: IASPlus’, (iasplus@deloitte.com).
2
Deloitte Touche Tohmatsu Limited, New York and London, ‘Global IFRS Banking Survey – Q1 2012: A changing
landscape’, 29 March 2012, (iasplus@deloitte.com).
158
Chapter 2
Insurance companies
Insurance companies fared better than banks during the financial and sovereign debt crisis.
This was due to their conservative investment business model or investment policy state-
ments (IPS). Indeed, there were glaring outliers during the crisis (for example, AIG) but those
companies strayed from their normal and well-understood insurance activities.
Nonetheless, the insurance industry experienced unprecedented volatility during 2008–
2009. The large swings in insurers’ market valuations, and the significant role that financial
reporting played in the uncertainty surrounding insurance companies during that period,
highlight the importance of understanding insurers’ financial information and its implications
for the risk and value of insurance companies.
Insurance company business model

Insurance companies hold a majority of their assets in what are called general accounts.
Separate accounts support liabilities such as defined-benefit plans or variable annuities, whereas
the general account backs traditional insurance products, such as homeowner’s insurance and
whole life insurance. This section will focus on general account investing practices.
Insurance covers a wide range of ongoing customer relationships, everything from a single
payment to cover a specific loss to recurring premiums for the rest of an insured’s life. Many
of these payments are contractually required to continue the protection provided by the policy.
Health and many property/casualty products operate as a revolving door driven by the law of
large numbers, spreading risk over many policyholders while keeping most assets in short and
intermediate-term (that is, liquid) investments so claims can be paid quickly. Operating earn-
ings provided regular cash flow even during the financial and sovereign debt crisis. If incoming
and outgoing cash flows are considered separately, premiums can be thought of as an asset
that improves liquidity. Many products provide a savings element and cash values. Incentives
encourage policy persistency, allowing insurance companies to invest in longer-term assets. The
insurance industry did not experience a ‘run on the bank’ scenario during the crisis.
Financial and sovereign debt crisis: lessons learned

Some insurance companies struggled through the financial and sovereign debt crisis, but those
focused on general account products were in a better position to succeed.
Through a survey and discussions with industry participants, a recent research report1
reached a number of conclusions to enable insurance companies to weather the next crisis.
⦁⦁ Liquidity can go away very quickly, especially when everyone is counting on the same
tools for risk mitigation. This kind of systemic concentration risk is ongoing. Investors
who proactively develop multiple sources of liquidity will be rewarded during a downturn.
159
⦁⦁ Insurance companies should actively manage liquidity, credit, and interest rate risks using
specific stress scenarios and have the results reviewed with independent oversight.
⦁⦁ State guaranty funds should assess risk charges that are based on risk exposures. This
practice aligns incentives and reduces moral hazard.
⦁⦁ Insurance companies have advantages related to cash flows during a crisis relative to other
financial services companies – that is, they often have long-term contractual relationships
with customers.
⦁⦁ Regulatory investment constraints are conservative relative to other financial institutions,
which tends to drive the most entrepreneurial investors elsewhere. This provides a safety
net that makes it harder for insurance company investment professionals to threaten
company solvency through their investments.
⦁⦁ Insurance company regulatory filings require transparent reporting of all securities held.
This requirement is more stringent than the disclosure demanded for other types of financial
institutions and encourages Insurance companies to stay with standard asset classes. It also
seems to drive aggressive entrepreneurial personalities away from the industry.
⦁⦁ Expect non-life insurance companies to face oversight on securities lending, a market
deemed ‘shadow banking’ as there is no trade repositories for securities lent. The market
is therefore non-transparent at present. Stock lending by the insurer AIG helped contribute
to the run that led to its 2008 rescue by the US government.
⦁⦁ Financial leverage (borrowing) limits flexibility during a crisis. The market can stay
irrational longer than a company relying on leverage can stay solvent. Insurance companies
use low amounts of true borrowing, although their basic business model uses float (that
is, cash is collected today with promises to pay it back to policyholders at a later time).
⦁⦁ An IPS should evolve over time to reflect asset classes and liquidity tools available for
use during both normal and crisis scenarios.
Overall, insurance companies did seem to perform better than banks during the recent
crisis. A general business model that incorporates recurring premiums (along with regulatory
conservatism and internal credit analysis) led to these results. Insurance companies are not
known for their quick reactions to market changes, but the investment process they had in
place provided conservative consistency. The IPS was the key to this success for insurance
companies of all sizes and types. It provides a consistent process and plan that an investment
team can use to stay within conservative bounds in the event of future bubbles or during an
actual crisis – because such possibilities have been considered proactively and contingency
plans have been prepared in advance.
Scope of insurance business

Insurance concepts
Diversifiability is the essential concept underlying most insurance activity. Death may result
in financial hardship to a family. Since no one knows if he or she will die in the next year,
the family faces financial risk. This risk can be eliminated through a type of group diver-
sification. For example, one could get together with a group of other people of the same
160
Insurance companies
age and agree that each will contribute to a pool with the funds being divided among the
dependents of those who do die during the year. Under normal conditions, the percentage
of a particular age group that dies during a year remains quite stable (unless, for example,
the cooperating group were all serving on the same battleship in wartime). Therefore, one
could predict the amount his or her dependents would receive in the event of death, and
the individual risk would be converted to an expense.
In earlier times, associations such as burial societies did collect funds from their members
and redistribute the funds line an insurance company. However, this service is now provided
primarily by insurance companies who estimate the percentage of the population that will
suffer some particular financial loss. They then sell policies to individuals. An appropriate
price is set that will ensure benefits to those who suffer the loss, cover operating expenses,
and provide a reasonable profit.
While diversification is the key to most insurance, we should note that there are insur-
ance policies written in cases where the risk is not really diversifiable. Lloyds of London
frequently provides insurance in cases in which there may not be enough people facing the risk
to provide diversification. Wealthy individuals simply place large amounts of capital at risk,
betting on such things as the possibility of rain in a given desert on a particular day of the
year. However, this is a relatively small part of the total insurance picture. Even Lloyds does
most of its business in the more mundane field of marine insurance. Earthquakes and floods
represent more important areas in which diversification is difficult to achieve. Frequently, the
participation of government has been necessary in order to provide insurance in such cases.
As do all companies, the insurance companies wish to maximise return and minimise
risk. Income comes from premiums and from return on investment portfolio. The insur-
ance company’s risk is not that of an individual claim; this is a programmed expense. The
primary risks arise from possible loss in investment portfolio value and the possibility that
the company’s estimates of total claim payments for the population insured are too low.
If their estimates of the amount of claims paid out are wrong, the insurance companies
can suffer large losses. For example, a particularly severe winter combined with a rapid
inflation of health costs can cause a health insurance company to experience more claims
than predicted and a higher cost per claim. Since rising interest rates have caused the value
of some outstanding stock and bond issues to decline in severely in value in the past two
decades, the risk of portfolio loss is also great.
Types of insurance companies

Insurance companies can be classified according to the type of insurance provided. Some insur-
ance companies specialise, while others are willing to insure life, health, home, automobile,
and business. Multiple offerings are frequently handled through wholly-owned subsidiaries.
Universal banks in Europe are increasingly offering insurance products through their acquisi-
tion of or merger with insurance companies.
Whatever the type of insurance offered, a large number of private insurers are currently
doing business around the world – a number expected to grow as privatisation of financial
institutions gathers momentum. In terms of legal organisation and ownership, the major
types of private insurers can be classified as follows:
161
⦁⦁ stock (share) insurers;

⦁⦁ mutual insurers;
⦁⦁ Lloyd’s Associations; and
⦁⦁ health plans and organisations.
Stock insurers
A stock insurer is a corporation owned by stockholders who participate in the profits and
losses of the insurer. The stockholders elect a board of directors who appoint executive
officers to manage the corporation. The board of directors has the ultimate responsibility
for the corporation’s financial success.
The types of insurance that a stock insurer can write are determined by its charter.
In property-casualty (also called general business) insurance, the majority of stock insurers
are multiple-line insurers that write most types of insurance, with the exception of life and
health insurance.
A stock insurer cannot issue an assessable policy. As assessable policy permits the insurer
to assess the policyowners’ additional premiums if losses are excessive. Instead, the stock-
holders must bear all losses. But they also share in the profits: if the business is profitable,
dividends can be declared and paid to the stockholders based on the amount of common
stock ownership.
Stock insurers predominate in the property-casualty insurance industry, especially with
respect to commercial lines of insurance. Stock insurers account for a large proportion of the
property-casualty premiums written by private insurers and typically market their insurance
by using the independent or general agency system.
Mutual insurers
A mutual insurer is a corporation owned by the policyholders. The policyholders elect the
board of directors, which appoints the executives who manage the corporation. Since rela-
tively few policyholders bother to vote, the board of directors has effective management
control of the company.
A mutual insurer may pay a dividend or give a rate reduction in advance. In life insurance,
a dividend is largely a refund of a redundant premium that can be paid if the mortality, invest-
ment, and operating experience are favourable. However, since the mortality and investment
experience cannot be guaranteed, the dividends technically cannot be guaranteed by insurers.
Lloyd’s Associations
Insurance can also be purchased from a Lloyd’s Association. There are two basic types of
Lloyd’s Associations: (i) Lloyd’s of London; and (ii) American Lloyds.
Lloyd’s of London is a major worldwide ocean marine insurer that writes a wide variety
of risks and is extremely important as a professional reinsurer. Lloyd’s is also famous for
writing insurance on diverse exposures such as a pianist’s fingers, a winning racehorse’s legs,
and a hole-in-one at a professional golf tournament.
162
Insurance companies
Lloyd’s of London has several important characteristics. First, Lloyd’s technically is not
an insurance company, but is an association that provides physical facilities and services to
the members for selling insurance. Lloyd’s by itself does not write insurance; the syndicates
that belong to Lloyd’s write the insurance. In this respect, Lloyd’s is similar to a stock
exchange, which does not buy or sell securities, but provides a marketplace and other
services to members.
Second, the syndicates that actually write the insurance are managed by an underwriting
agent who is responsible for appointing a professional underwriter for each major type of
business. The syndicates tend to specialise in marine, aviation, automobile, and other property-
casualty insurance lines. The unusual exposure units that have made Lloyd’s famous account
for only a small part of the total business. Likewise, life insurance accounts only for a small
fraction of the total business and is limited to short-term contracts.
Third, pre-1990s individual members (called Names) who belong to the various syndi-
cates have unlimited liability with respect to insurance written as individuals. There remain
several hundred Names. Due to severe losses suffered by Names in the early 1990s (due
largely to natural disasters, asbestos liability claims, and mismanagement), many individual
Names could not pay their share of claims and were financially ruined. Subsequently, Lloyd’s
changed its structure. No new ‘unlimited’ Names can join.
Finally, corporate members with limited liability were permitted to join and underwrite
insurance. To prevent a recurrence of the disastrous losses of the 1990s, financial requirements
for underwriting were changed to prevent excess underwriting that was not backed by liquid
assets. Market oversight has significantly increased. Lloyd’s has since rebounded and started
to thrive again, but it has not regained its past importance as newly created companies, in
Bermuda for example, captured a large share of the reinsurance market.
American Lloyd’s
American Lloyd’s are US-based associations of private underwriters organised similar to
Lloyd’s of London. The American Lloyd’s associations, however, differ from the former in
many respects. First, the number of individual underwriters is smaller. Second, the liability
of an individual underwriter is limited. Each underwriter is responsible only for his or her
share of the loss and not that any insolvent member. Third, the personal net worth and
financial strength of an underwriter are considerably lower than that of a Lloyd’s of London
member. Fourth, an American Lloyd’s association does not operate through a syndicate, but
is managed by an attorney-in-fact. Finally, the financial reputation of an American Lloyd’s
association is not as good as Lloyd’s of London. Several associations have failed, and some
US states, such as New York, forbade the formation of new associations some years ago.
Health plans and organisations

In many developed countries, private organisations provide coverage primarily for medical
services. This coverage typically complements government-sponsored social security systems
and is optional. The organisations can be profit-oriented or non-profit and, like general and
life insurance companies, are usually heavily regulated. Prepayments by covered members
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allow the plans to provide broad, comprehensive healthcare services. Plans are frequently
sponsored by a business entity for its workers.
Agents and brokers

A successful sales force is the key to an insurance company’s financial success. Most policies
today are sold by agents and brokers.
Agents
An agent is someone who legally represents the insurer and has the authority to act on the
insurer’s behalf. An agent can bind the principal by expressed powers, by implied powers,
and by apparent authority. In many countries, however, there is an important difference
between a life insurance agent and a property-casualty insurance agent. A life insurance agent
usually does not have the authority to bind the company. He or she is merely a soliciting
agent who induces persons to apply for life insurance. The applicant for life insurance must
be approved by the company before the insurance becomes effective.
In contrast, a property-casualty insurance agent typically has the power to bind the
company immediately with respect to certain types of coverage. This is normally done by a
binder, which is temporarily evidence of insurance until the policy is actually issued. Binders
can be oral or written. For example, if a customer telephones an agent and requests insur-
ance on a motorcycle, the insurance can become effective immediately.
Brokers
In contrast to an agent who represents the insurer, a broker is someone who legally repre-
sents the insured. A broker legally does not have the authority to bind the insurer. Instead,
the broker can solicit or accept applications for insurance and then attempt to place the
coverage with an appropriate insurer. But the insurance is not in force until the insurer
accepts the business.
A broker is paid a commission from the insurers where the business is placed. Many
brokers are also licensed as agents, so that they have the authority to bind their companies
as agents.
Brokers are extremely important in property-casualty insurance at the present time. Large
brokerage companies have knowledge of highly specialised insurance markets, provide risk
management and loss control services, and control the accounts of large corporate insurance
buyers.
Types of insurance
Insurance business can be divided into three broad categories: life insurance, property-casualty
insurance, and health and disability insurance.
A comparison of the relative importance of these types of insurance can be made in
terms of assets held or premiums received. Life insurance dominates in terms of assets held
because life insurance business involves receipt of premiums during one year with payments
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Insurance companies
from those premiums to occur many years in the future. Many other types of insurance
involve collection of premiums during a year and payment of claims from those premiums
during the same year. A look at premiums received yields a different picture. Life insurance
premiums are far less than those for property-casualty insurance.
Life insurance
Life insurance policies can be broken down according to the method by which they were
sold. The categories are as follows.
⦁⦁ Ordinary: life insurance sold to an individual by an agent or employee of the life insurance
company, with premiums normally being paid monthly, quarterly, semi-annually, or
annually.
⦁⦁ Group: life insurance sold to cover all members of some group. The most common group
would be all employees of a company, who receive the insurance as a fringe benefit. The
group policy may still give some options to individual members of the group.
⦁⦁ Credit: life insurance sold in connection with a loan. The policy is normally for the
amount of the loan and is normally marketed to borrowers by lenders. The lender may
or may not own a captive insurance company for the purpose of selling these policies.
⦁⦁ Industrial: insurance sold in small amounts to relatively low-income buyers. Collection
of premiums is normally on a weekly basis with the agent calling on the insured rather
than relying on them to mail or electronically transfer premiums.
Probably more important than method of sale, life insurance differs in type of coverage and
pattern of payment. Whole life insurance is expected to remain in force for the life of the
insured and pay the contracted-for benefit upon death. Straight life, which represents the
bulk of whole life insurance in force, requires payment each period (year, quarter, and so
on) until death.
Limited pay life requires payment for a certain number of years and then continues to
provide coverage until the insured dies and benefits are paid. Of course, premiums are higher
for limited pay life than for straight life.
Since benefits are paid at eventual death, the payment of benefits from these policies is
a certainty unless the policy is cancelled. In the early years of the policy, when very few
people in the age group are dying, most of the premiums must be invested to provide funds
to pay claims as the insured people get older and the death rate for that group increases.
Total lifetime premiums are frequently less than death benefits because the life insurance
company has the premiums to invest for most of a century. Most of these policies have cash
values based on these savings that are being built up. The insured member can normally
either cancel the policy and receive the cash value or borrow against the cash value and
keep the insurance in force, with any amount borrowed being deducted from the benefit in
the event the insured person dies while the loan is outstanding. Many people who purchase
such policies keep them in force until retirement, when their dependents no longer need
protection from the financial loss of their death, and then cash them in. Thus these policies
serve as both insurance programs and savings programs. From the other side, these policies
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put the insurance company in the position of acting as a financial intermediary, accepting
funds that it must return to the insured persons at some later date and investing these funds
to earn a profit in the meantime.
Endowment policies also put the insurance company in the position of acting as a financial
intermediary. An endowment policy pays the insured a specific amount at a specified future
date. If the insured dies before this date, the same amount is still paid. These policies are
frequently sold as a combined savings program to help finance a son or daughter’s education
and insurance programs to guarantee that funds for education will be there in the event the
parent dies before the child reaches college or university age.
Term policies are pure insurance. If the premium is paid on a term policy and the insured
does not die during the year, there is no cash value, although the policy may frequently be
extended simply through payment of another premium. In brief, term insurance is similar to
automobile, health, and home insurance in that the only benefit received is insurance against
certain risks over the period covered by the premium.
From the buyer’s point of view, term and whole life insurance can be compared by
subtracting the cost of term insurance from the cost of whole life insurance to determine the
amount effectively being placed in a savings plan. The cash value at the time the policy will
likely be cashed in can be compared with the effective savings plan contributions embedded in
the whole life premium and the rate of return earned on the savings plan can be measured.
Variable life insurance

Variable life insurance addresses one of the competitive disadvantages of whole life insurance.
The life insurance company needs to guarantee certain cash values to the insured and cannot
count on interest rates remaining high. Therefore, the life insurance company must assume
a low return on invested funds in designing its policies. This means that in periods of high
interest rates the implied return on a whole life policy is well below that available on other
investments. The variable life insurance policy is a variation on whole life insurance that
addresses this problem by allowing the insured to participate in both risk and return. Like
whole life insurance, the variable life insurance policy has premiums based on a conservative
return assumption such as 4% or 5%. As with whole life, the insured’s annual premium,
after the cost of administration and the mortality cost (approximately equal to the cost of
one-year term insurance) is invested. At the end of each year, any excess return over the low
assumed return is used to purchase additional paid-in whole life insurance. Consequently,
the amount of insurance depends on the return earned by the company on invested funds.
From the buyer’s point of view, the problem with variable life is that it seldom fits
insurance needs. The returns earned by the insurance company’s investments are primarily
dependent upon the general level of interest rates. For most individuals, the amount of life
insurance needed is not determined by the general level of interest rates.
Universal life insurance

Universal life insurance is an attempt to allow policyholders to participate in higher returns
when they are earned, while packaging the form of participation to better fit the insured’s
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Insurance companies
needs. The universal life policy is like a straight life policy, except that returns earned in
excess of the low assumed return accrue to the benefit of the insured through adjustment to
the cash value of the policy. In addition, the insured may vary both the amount of insurance
and the amount of premiums from time to time. This type of policy allows the insured to
participate in market interest rates while also having the ability to alter insurance and cash
payments to fit changing needs. Universal life is a much newer type of policy than variable
life, having been introduced around the late 1970s.
Life insurance companies also offer annuity plans. The purchaser of an annuity makes
a single payment or a series of payments for which the life insurance company then agrees
to make monthly payments for the rest of the insured’s life. Annuities are used primarily as
a means of providing retirement income. They are purchased by individuals who want more
retirement income than that provided by their employers and/or the social security program
or, in some case, by small employers as a means of providing a pension (retirement) plan.
In addition to providing a regular savings program, the annuity may allow greater monthly
income than the individual could achieve by investing funds elsewhere.
Property-casualty insurance
The property-casualty insurance field provides protection against financial losses to property
and against lawsuits. Most things insured against in this category would be considered acci-
dental, though theft is certainly not accidental to the thief, and negligence of some type is
normally argued in liability cases.
Automobile insurance is the single largest category, accounting for a large portion of
total property-casualty insurance. Included is protection against damage to the policyholders
and their automobiles in an accident, as well as insurance against lawsuits arising from an
accident.
Multiple peril policies make up a group of insurance programs protecting owners from
financial loss from fire, theft, storm damage, and so on. The trend among these policies is
for writing single contracts providing combined coverage for storm, theft, and certain other
risks, as well as fire.
Workers’ compensation is insurance by the employer against claims for injuries by
workers. Benefits provided are determined by law, and employers are required to carry this
insurance in some countries.
Liability, including malpractice but excluding workers’ compensation and automobile, is
an important source of premium income. This includes personal liability insurance carried
by many professionals.
Marine insurance covers the risks its name implies. Protection against financial loss from
theft, storm damage, and other types of risk is provided for ships and their cargoes. Insurance
against political loss is covered separately by political risk policies.
Surety and fidelity insurance generally provides a guarantee that a certain course of
action will be carried out. This may be required when late or inadequate completion of work
would cause serious financial losses to one party to a contract. In such a case, insurance
may be required to protect one party to a contract from loss if the other party should fail
to complete work as agreed to.
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Health insurance
Health insurance covers medical expenses and income loss associated with accident and
illness. Insurance premiums in this field have increased rapidly in recent years, with increases
in the number of people insured and increases in medical expenses. Policies are often sold in
the form of group policies. ‘Special’ policies, such as cancer insurance, are more frequently
sold as individual policies.
Types of marketing systems

Insurance companies can also be classified according to how they market their services. Some
companies serve only a special group and promote their services only to members of that
group. Other companies have a group of agents that sell only insurance offered by them.
Still other companies market their insurance through general agencies that sell their insur-
ance plus that offered by other companies. This latter approach is particularly common for
companies that do not offer a full range of insurance. A growing amount of insurance is
sold through group sales, particularly to groups of employees. Some group sales are handled
by agents, and some are handled by employees of the insurance company involved. Group
sales lower the sales cost per insurance dollar (or other currency measure) and create the
opportunity to price insurance according to the characteristics of a particular group rather
than the general population. In short, an efficient marketing system is essential to an insur-
ance company’s survival.
Life insurance marketing systems

Life and health insurers use several basic marketing methods:
⦁⦁ general agency systems;

⦁⦁ managerial (branch office) system; and
⦁⦁ direct-response system.
General agency system

Under the general agency system, the general agent is an independent businessperson who
represents only one insurer. The general agent is in charge of a territory and is responsible
for hiring, training, and motivating new agents. The general agent receives a commission
based on the amount of business produced.
Most insurers provide some financial assistance to the general agent. The insurer pays all
or part of the expenses of hiring and training new agents and thus has considerable control
over the selection of agents and their training. The insurer may also provide an allowance
for agency office expenses and other expenses.
A considerable amount of new life insurance is sold currently by personal-producing
general agents. A personal-producing general agent is a variation of the agency system
by which an experienced agent is hired primarily to sell insurance under a contract that
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Insurance companies
provides both direct and overriding commissions. A personal-producing general agent typi-
cally is an above-average salesperson with a proven sales record. The agent is hired primarily
to sell insurance and not to recruit and train new agents. The personal-producing general
agent usually receives higher commissions than a typical agent. In return, the agent may
be expected to sell a certain amount of insurance for a particular insurer. In addition, the
personal-producing general agent may have contracts with more than one insurer. Finally,
the personal-producing general agent usually pays his or her expenses but may receive a
higher overriding commission to help pay expenses.
Managerial (branch office) system

The managerial system (also called the branch office system) is another distribution system
for selling life insurance, especially by larger insurers. Under this system, branch offices are
established in various areas. The branch manager has the responsibility for hiring and training
new agents. However, the branch manager is considered an employee of the insurer, who
typically is paid a salary and a bonus based on the volume and quality of the insurance
sold and the number of new productive agents added. Under this system, the insurer pays
the expenses of the branch office, including the financing of new agents.
Direct-response system
The direct-response is a marketing system where life and health insurance is sold without the
services of an agent. Potential customers are solicited by advertising in the mail, newspapers,
magazines, television, radio, and other media. Some insurers also use telemarketing (telephone
solicitation) and the Internet to sell insurance. The life and health insurance products that
are promoted usually are easy to understand and require relatively low premium outlays.
These products include accident policies, hospital indemnity policies, credit life insurance,
and basic forms of term insurance.
The major advantages of the direct-response system are that advertising can be specifi-
cally directed toward selected markets, acquisition costs can be held down, and new markets
can be penetrated. The disadvantages, however, are that complex products cannot be easily
sold by this method since an agent’s services may be required, the advertising promoting
the product may be misleading or deceptive, and the products generally are supplemental in
nature and may not be designed as a basic coverage.
Finally, substantial amounts of new individual life insurance, annuities, long-term care
insurance, and other insurance and financial products are now being sold in group insurance
plans in the developed markets.
Property-casualty insurance marketing systems

There are five basic systems for marketing property-casualty insurance:
⦁⦁ independent agency system;

⦁⦁ exclusive agency system;
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⦁⦁ direct writer;
⦁⦁ direct-response system; and
⦁⦁ mixed systems.
Independent agency system

The independent agency system has several basic characteristics. First, the independent agency
is a company that usually represents several unrelated insurers. Agents are authorised to
write business on behalf of these insurers and in turn are paid a commission based on the
amount of business produced.
Second, the agency owns the expirations or renewal rights to the business. If a policy
comes up for renewal, the agency can place the business with another insurer if it chooses
to do so. Likewise, if the contract with an insurer is terminated, the agency can place the
business with other insurers.
Third, the independent agent is compensated by commissions that vary by line of insur-
ance. The commission rate on renewal business typically is the same as new business. If a lower
renewal rate is paid, the insurer would lose business, since the agent would place the insurance
with another insurer. A second commission called a contingent or profit-sharing commission
(also called a bonus) may also be paid to the agent based on a favourable loss ratio.
The commission method of compensating agents has been criticised on two grounds:
(i) it creates conflict of interest – when the agent places the business with the lowest-cost
company, the client benefits, but the agent’s commission is lower; and (ii) the commission
is not necessarily related to the service provided – a high-premium policy results in a high
commission even though it may require little effort by the agent.
To correct for these defects, a negotiated fee system is sometimes used. The company
quotes a premium net of commissions, and the agent then negotiates a fee with the insured
based on the amount of effort required.
The independent agents perform several functions. They are frequently authorised to
adjust small claims. The larger agencies may also provide loss control services to the insureds,
such as accident prevention and fire control engineers. Also, for some lines, the agency may
bill the policyowners and collect the premiums. However, most insurers have resorted to
direct billing, by which the policy owner is billed directly by the insurer and then remits
the premium to the company. This is particularly true of personal lines of insurance, such
as auto and home insurance.
Exclusive agency system

Under the exclusive agency system, the agent represents only one insurer group of insurers
under common ownership. The agent is general prohibited by contract from representing
other insurers.
Agents under the exclusive agency system do not usually own the expirations or renewal
rights to the policies. There is some variation, however, in this regard. Some insurers do not
give their agents any ownership rights in the expirations. Other insurers may grant limited
ownership of expirations while the agency contract is in force, but this interest terminates
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Insurance companies
when the agency contract is terminated. In contrast, under the independent agency system,
the agency has complete ownership of the expirations.
Another difference is the payment of commissions. Exclusive agency insurers generally
pay a lower commission rate on renewal business than on new business. This results in a
strong financial incentive for the agent to write new business and is one factor that helps
explain the rapid growth of exclusive agency insurers. In contrast, as noted earlier, insurers
using the independent agency system typically pay the same commission rate on new and
renewal business.
Also, exclusive agency insurers provide strong supportive services to the new agent. The
new agent usually starts as an employee during a training period; the agent becomes an
independent contractor who is paid on a commission basis.
The functions performed by exclusive agents vary among insurers. Some insurers limit
exclusive agents to selling insurance, while others permit them to adjust small claims as well.
Virtually all exclusive agency insurers use the direct billing method and are responsible for
issuance of the policy.
Direct writer
A direct writer is often erroneously confused with an exclusive agency insurer. A direct writer
is an insurer in which the salesperson is an employee, not an independent contractor. The
insurer pays all the selling expenses, including the employee’s salary and related benefits.
Similar to exclusive agents, an employee of a direct writer represents only one insurer.
Employees of direct writers are compensated on a salary arrangement while some compa-
nies pay a basic salary plus a commission directly related to the amount of insurance sold.
Others pay a salary and a bonus that represent both selling and service activities of the
employee.
Direct-response system
A direct-response system is an insurer that sells through the mail or other mass media, such
as newspapers and magazines, radio, or television. No agents are used to sell insurance.
The direct-response system has several advantages to property and liability insurers.
Lower selling expenses are incurred because market segmentation can be more precise, and
underwriting can be more selective. Mailing lists can be prepared to identify groups that
are likely to have fewer claims than average. However, the major disadvantage is that the
insurance sold must be limited to the simple lines of insurance, such as auto and home-
owners insurance.
Mixed systems
The distinction between the traditional marketing systems is breaking down as insurers search
for new ways to market their products. Many property-casualty insurers currently use more
than one marketing system. These systems are referred to as mixed systems. For example,
exclusive agency companies and direct writers find it easier to enter regional markets by
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contracting with independent agencies in those areas. The independent agencies are already
established, which minimises the heavy start-up costs of financing new agents in those areas.
Some insurers using the independent agency system also use the direct response system to
reach additional customers.
As the evolution in insurance marketing continues, insurers continue to seek new and
innovative ways to market their products. In particular, providing product information
to customers on the Internet is likely to receive greater emphasis. The Internet market is
too large, too sophisticated and has too much momentum to ignore. Insurance companies
that disregard the tremendous potential of this medium are ignoring what is clearly the
most efficient mechanism for explaining products and delivering fundamental information
to customers and prospects.
Life insurance companies

Investment policies
Life insurance companies have a large portfolio of assets that is used to fund their whole
liabilities. These liabilities are the benefits they ultimately must pay based on mortality rates.
These are easy to predict for large pools of people. However, the life insurance companies
have other problems that make asset/liability management crucial to their success.
⦁⦁ Policies might be surrendered when interest rates rise. This will cause assets to shrink.
⦁⦁ Policy loans may tend to rise when interest rates rise. Indeed, the high inflation and
interest rates of the 1970s had a great impact on the industry in most developed economies
because many persons exercised their policy loan privileges to borrow on their policies at
guaranteed rates that were below market rates.
⦁⦁ Life insurers sell an array of financial services other than the traditional whole life insurance
protection products. These other products include universal life and variable life policies
that combine insurance protection with an investment savings plan, as well as savings/
investment products, such as guaranteed investment contracts (GICs), single premium
annuities, and variable rate annuities. The growth of the savings/investment type plans
has caused most of the changes in the way life insurance company portfolios have been
structured over the past 30 years. Indeed, the entry into the savings/investment arena has
put life insurers in direct competition with banks and mutual funds.
⦁⦁ The capital surplus of the insurance company must be invested for growth, because it is
the basis upon which the financial stability of the companies depends on. Furthermore, the
ability to grow in the long run is determined by the growth rate of the capital surplus.
Return objectives
An insurance company has the primary objective of earning a positive spread between the
return on its investments and the actuarial return assumptions that were used in pricing its
products. If such a positive spread is earned, the company’s surplus will grow, and it can
write additional premiums. If a negative spread is earned, the company’s surplus will shrink,
and its ability to write additional insurance to earn more premiums will decline.
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Insurance companies
The current income requirement of an insurance company is usually determined by

liquidity requirements based upon sums that must be paid on policies, policy loans, working
capital needs, and so forth. Because cash flows from customer premium payments are more
than sufficient to cover these requirements, there is not much need for a life insurance
company’s investment portfolio to generate large amounts of current income.
Over the long term, the total return on the investment portfolio must be sufficient to cover
liabilities. For whole life policies, it is necessary that the investment portfolio earn at least
a return equal to the actuarial interest rate assumption that was used to price the product.
Annuities and guaranteed investment contract products guarantee that a certain return will
be paid on a customer’s investment for a fixed period of time. This means that the portfolio
backing these products must be invested to earn returns that at least match these guarantees
for the time that the guarantee was made. Bond portfolio techniques, such as immunisation to
guard against reinvestment rate risk will be employed to cover such contracts (see Box 2.1).
Universal life products, where the policyholder gets life insurance protection, plus a tax-
deferred (in many countries) high-return investment fund, must be invested so as to earn
returns that are high enough to cover the actuarial assumptions used to price the life insur-
ance product, and produce investment returns for the customer that are in line with those
available in a balanced portfolio of stocks and bonds.
Most life insurance companies use an actuarial rate that is set below the level of interest
rates that can be earned in the market when pricing their products, so as to be able to earn
a spread that covers operating costs and produces a profit margin. Two methods are used
to do this.
⦁⦁ Investment-year method, in which all products sold in a given year are priced according
to market interest rates earned in that year. This method enables a company to price its
products more competitively during a time of rising interest rates.
⦁⦁ Portfolio method, in which all products sold in a given year are priced according to the
yield earned on the entire portfolio, regardless of when the investments were made. This
method enables a company to price its products more competitively during periods of
declining interest rates.
It is essential that no significant mismatch occur between the return characteristics of the
assets in a life insurance company’s portfolio and the actuarial discount rate assumptions
on its liabilities. This asset/liability management requirement is the basis upon which the
portfolio management policies of a life insurance company must be determined.
From a current income viewpoint, different insurance products need different types of
stability. Pure life products require only a small current income. Therefore, long-term bonds
can be used to fund them. Annuity and universal life products require high yields that are
competitive with other companies, and a maturity schedule that matches the term of the
guarantees.
Because whole life policy contracts are state in monetary terms, the assets supporting
them do not need inflation protection. Protection-plus-savings products, on the other hand,
which are sold on the basis of providing long-run real returns need to generate real returns.
The emphasis is on earning a competitive return for this product class.
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Box 2.1
Immunisation
Immunisation is a technique that can be used to reduce interest rate risk. Therefore, it can
be used to guarantee with a high degree of accuracy that a predetermined horizon return
will be earned on a portfolio.
To see why immunisation is a desired portfolio strategy for fixed-income investing, consider
the case where an investor (an insurance company, for example) purchases a 15-year bond
whose yield-to-maturity is 8%. It is clear that if interest rates change, the value of the bond
will change also. This is a form of interest rate risk. This risk of capital loss can be avoided
simply by buying a bond that matures at the investor’s time horizon. Then the ending value
of the bond will be guaranteed to be par, enabling the investor to know for certain what
the capital gain (in case of discount bonds), or capital loss (in case of bonds bought at a
premium) will be.
It turns out, however, that this procedure will not completely eliminate interest rate risk
if one invests in coupon bonds. This is because there are two forms of interest rate risk. One
is the risk of the loss of capital because bond prices fall as interest rates rise; the other is
a risk that comes about because the future income stream generated from a fixed-income
investment is affected by the rate of interest that will be earned on reinvested coupons over
the investment horizon. This is easily seen from that fact that even if this bond is held to
maturity, there can be no guarantee that the 8% yield-to-maturity will actually be realised
over the investment horizon because of reinvestment rate risk.
If interest rates fall in the future, the coupon interest earned in subsequent years will have
to be reinvested at lower rates. This will cause the true realised return on the investment to
fall below the 8% yield-to-maturity of the bond that existed on the date it was purchased.
Similarly, if interest rates rise in the future, the coupon interest earned in subsequent years will
be reinvested at higher rates, enabling the investor to earn an actual return over the 15-year
time horizon that is greater than 8%. Because it makes the ultimate return on a fixed-income
investment difficult to determine in advance, reinvestment rate risk is an undesirable quality
of bond investing. The use of an immunisation strategy is a way of reducing this uncertainty.
The relationship between the horizon return on a bond and its holding period is as follows:
Horizon return = (D/H)(Spot rate of target year) + (1 – D/H)RR

where: D = Unadjusted duration of the bond
H = Time horizon of the investor
RR = Average reinvestment rate over the holding period
Spot = Spot rate of target year = Spot yield applicable to the ending year
of the investor’s time horizon
From this equation, it can be seen that if D/H = 1, the horizon return will always equal the
spot rate applicable to the ending year of the holding period, no matter what the average
Continued
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Insurance companies
level of the reinvestment rate turns out to be. This means that if the unadjusted duration
of the bond equals the investor’s time horizon, then the horizon return on the bond will
equal the spot rate applicable to the ending year of the holding period, no matter what the
average reinvestment rate is in the interim. Therefore, the principle of immunisation is clear:
to immunise a bond or a fixed-income portfolio against reinvestment rate risk, buy a bond
or a portfolio whose unadjusted duration equals the time horizon of the investor. Note that
when this is done, the return that is guaranteed over the holding period is not the initial
yield-to-maturity on the bond or the portfolio; rather it is the spot yield available in the market
that is applicable to the ending year of the holding period at the time investment is made.
To understand why this principle of immunisation works from a common sense viewpoint,
note that the unadjusted duration of a bond is generally less than the number of years until
its maturity. Therefore, if an investor purchases a bond whose unadjusted duration is equal
to his or her time horizon, the maturity of the bond will generally exceed the desired holding
period. Therefore, the investor will be selling the bond before it matures.
Example: if interest rise during the investment period, the bond will ultimately be sold
well below par. This will drag the actual yield down below the yield-to-maturity on the bond
that existed when it was purchased. However, because interest rates have been rising during
the holding period, the periodic coupon interest received during the investment period will
be reinvested at higher and higher rates. This will increase the horizon return on the bond.
It turns out that based upon the above formula, the effects of these two forces will cancel
each other out over the holding period, if the unadjusted duration of the bond equals the
investor’s holding period. The horizon return will then equal the spot yield available in the
marketplace for the holding period at the time the investment was made. The reinvestment
rate risk would thereby, be eliminated.
If interest rates fall during the investment period, the bond will ultimately be sold with
a large capital gain. This would raise the actual yield on the investment above the initial
yield-to-maturity on the bond that existed when it was purchased. However, because interest
rates were falling during the holding period, the coupon interest received could only have
been reinvested at lower and lower rates. This would drag the horizon return on the bond
down. Again, the effects of these two forces will cancel each other out over the holding
period if the unadjusted duration of the bond was set to equal the investor’s time horizon.
The horizon return will then equal the spot yield that was available in the marketplace for
the end of the holding period, at the time the investment was made. The reinvestment rate
risk would, therefore, be eliminated whether interest rates rose or fell.
In practice, portfolio immunisation is a more complicated procedure than has been outlined
above. Four conditions are required to immunise a portfolio against reinvestment rate risk.
∑∑ The unadjusted duration of the portfolio must equal the investor’s time horizon when there
is a single period payout; in the case of a multi-period payout schedule, the unadjusted
duration of the portfolio must equal the unadjusted duration of the stream of required
future portfolio payouts.
Continued
175
Box 2.1 continued
∑∑ The current value of the portfolio must at least equal the present value of the required
payout(s).
∑∑ The maturity variance of the portfolio must equal or be only slightly greater than the
maturity variance of the required portfolio payout(s).
∑∑ The distribution of the unadjusted durations of the assets in the portfolio must be wider
than the distribution of the unadjusted durations of the required payouts.
The fact that an immunisation procedure may not completely protect the horizon return of a
portfolio from changes in the slope of the yield curve is called immunisation risk. While this
risk may not be entirely eliminated, it can be minimised by setting the maturity variance of
the portfolio as closely as possible to that of its required payout stream.
Risk constraints
Life insurance companies have a low tolerance for the risk of loss of principal or the inter-
ruption of investment income. Life insurance companies are increasingly required to maintain
a mandatory securities valuation reserve, the size of which is a function of the risk charac-
teristics of their investments. As an example, for reserve purposes, bonds, preferred stocks,
and real estate might be carried at amortised cost, while common stocks might be carried
at market value. The maximum amount of the reserve may vary by the class of assets. For
example, bonds might require a 2% reserve, while common stocks might require a 33.3%
reserve. Such reserve requirements suggest that the life insurance surplus is vulnerable to
fluctuations in common stock portfolios, which would be carried at market value.
Liquidity constraints
Life insurance companies traditionally have needed only enough liquidity to fund working
capital needs. This usually is low because cash flow is positive. This means very long-term,
non-marketable investments can be purchased, such as private placements and real estate.
However, policy loans can rise sharply if interest rates rise rapidly. This can cause a cash
flow problem. This means that if interest rates rise, life insurers will need more liquidity.
Of course, the worst time to have to raise liquidity is when interest rates are rising. This
has caused life insurance companies to desire more liquidity, to write policy loans based on
floating interest rates, and to engage in better asset/liability duration matching. The latter is
especially true of annuity and guaranteed investment contracts.
Time horizon constraints

Time horizons have been traditionally long for life insurance; 40 years is typical. This is still
true for the conventional life insurance contract. Such long-term liabilities can be matched
with illiquid assets. But the newer annuity, universal life, and guaranteed investment contracts
176
Insurance companies
require shorter time horizons and more liquidity. The cost of having more liquidity is negligible
or non-existent only if the yield curve is inverted (often a rare event in developed economies).
Best policy
The focus of the investment management policy of most life insurance companies is on spread
management. This means that the investment portfolio must attempt to earn a total return
that exceeds the ‘guaranteed’ return that has explicitly or implicitly been given to customers.
For whole life insurance policies, the implied guaranteed return is the actuarial assumption
that is used to price the cost of the polices; for guaranteed investment contracts, it is the
rate that has been explicitly guaranteed by the contract. Of course, the whole life insurance
policy is based upon earning the actuarial return, on average, over a long number of years,
while the guaranteed contract yield must only be earned for the life of the contract (which
is usually a much shorter time).
One problem with positing a policy that is based on earning a high total return is that it
can increase the riskiness of a portfolio. For example, if very long-term bonds are employed
because their yields tend to be the highest, the volatility of the portfolio will increase as
interest rates fluctuate. If stocks are employed in order to earn higher returns in the long
run, the volatility is also increased. Therefore, insurance portfolios must be invested to earn
reasonable spreads over actuarial assumptions and explicit yield guarantees without taking
unwarranted risks.
A way of doing this is to have good asset/liability management, whereby the duration
of the assets in the portfolio are matched with those if the liabilities. Within the confines of
this constraint, an attempt is made to maximise the total return spread over the actuarial
assumptions that were used to price the various products. Most life insurance companies
segment their investment portfolio so as to group liabilities with a certain sensitivity to
interest rate and other risks together, and match these liabilities with assets that are expected
to behave in ways which will match the risk that can be tolerated by each liability group.
For example, long-term, high-quality bond portfolios are often employed to invest funds set
aside to pay whole life insurance products. This is because these products are liabilities that
are stated in nominal, rather than real, monetary terms. Usually, long-term bond rates will
be well above actuarial assumptions that are used to price the product so that a reasonable
spread can be earned. Furthermore, the safety of high-quality bonds is needed to satisfy
most regulators and rating agencies. Active management policies can be employed to take
advantage of anticipated changes in interest rates and sector yield spreads in order to enhance
the total return of the portfolio by generating capital gains.
Guaranteed income and annuity contracts often require lower duration portfolios than
whole life contracts because the duration of the liability stream is shorter. Because a guar-
antee is made, however, high quality investments are required. One way to earn a reasonable
spread over market rates is to invest in relatively illiquid, but still high quality, bonds whose
durations match those of the guarantee. This can be done by investing in private placements.
Universal life products require shorter-term, fixed-income portfolios and more equity
investments. Some fixed-income investments are required because of the partial insurance
character of the product, but much emphasis is based upon earning a competitive return via
177
equity investments. In some markets, it is possible to use some junk bonds (low-quality, high-
yield bonds) in this type of portfolio to get an additional return as long as the risks taken
are not substantial and the total return in the long run is still comparable to stock market
returns. Some additional return and inflation protection can be obtained by investing in real
estate and venture capital, in addition to common stocks. Because universal life products are
viewed by the consumer as equity-related investment vehicles, fluctuations in the portfolio
can be tolerated, which are in the same order of magnitude as the stock market.
The surplus of the company is often invested for growth using a variety of investment
vehicles that are expected to produce good returns. However, companies cannot tolerate large
fluctuations in their surplus lest it impair their ability to write additional insurance. Therefore,
a well diversified, balanced portfolio is used to invest surplus funds. This portfolio, however,
can contain virtually every sort of investment, including common stocks, private placements,
junk bonds, venture capital, real estate, foreign securities, and so forth. The overall portfolio
quality, however, is usually kept high.
It is prudent for the life insurer to set a maximum exposure in stocks as a percentage
of surplus, rather than as a percentage of assets. Low liquidity needs, high income require-
ments (for annuity products), and large professional staffs have enabled insurance companies
to participate in some risky investments, including derivatives, swaps, securities in emerging
market companies, junk bonds, venture capital, and so on. However, the exposure to these
kinds of investments should be prudently to 20% of assets because of the insurer’s inability
to take significant risks.
Life insurance companies should not forget other constraints relevant to its home market.
These include tax considerations and regulatory requirements. Tax regimes vary from country
to country and can onerous to life insurers in some states and liberal in others. Furthermore,
the insurance industry is heavily regulated in most countries and these regulations restrict
the investment activities and operating flexibility of insurance companies.
Investment policies of property-casualty insurance companies

Property-casualty insurance companies are operated, in effect, as two organisations: (i) an
insurance company that is in business to earn an underwriting profit and; (ii) an investment
company earning an investment income. The latter provides financial stability to the whole
organisation because investment income can offset extraordinarily large underwriting losses
that occur periodically (earthquakes, floods, tornadoes, and hurricanes). It also provides
a growing surplus that gives the company the ability to expand its underwriting volume.
Since an insurance company should try to maintain a premium-to-capital ratio of 3:1, more
underwriting business can be done as investment income adds to capital.
Return objectives and risk constraint profile

Return objectives
Current income is needed by a property-casualty insurer that has underwriting losses. If the
company has consistent underwriting profits, there is less need for current income. If companies
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Insurance companies
assume high investment incomes when quoting rates, the underwriting profits tend to fall or
turn negative. This would increase the reliance on current income to meet operating need
for cash.
Inflation protection is a must for property-casualty insurers, especially if their policies
require them to replace damaged property at its current market value. However, if policy
coverage periods are short, the need for inflation protection in the portfolio is lower, since
the protection is provided by raising quoted policy premiums.
Risk constraints
The cash flow of a property-casualty insurer can be erratic. Large losses can occur due to
storms, bad weather effecting automobile accidents, and so on. If a catastrophe should occur,
a large portion of the investment portfolio might have to be liquidated. That portion of the
portfolio relating to policyholder reserves has a low tolerance for risk of principal loss. The
purely capital surplus funds, however, may tolerate greater volatility.
Liquidity constraints
Liquidity is an important need of property-casualty insurers because of the unpredictability
of cash flows and necessity, in high tax regimes, of shifting the portfolio mix from high
taxability to low taxability, based on the underwriting performance. Because the time horizon
of a property-casualty company is shorter term, its liquidity needs are higher than those of
a life insurance company.
Time horizon
Time horizons tend to be long for many property-casualty companies because large claims are
only paid after a long period of litigation or administrative tie-ups. Some property-casualty
companies have ‘long-tail’ risks. This means that a long time can elapse between the time
a premium is paid for protection by the customer, and the time damages must be paid by
the company. For example, if a company insures a doctor for medical malpractice and the
doctor delivers a baby who later in life develops cerebral palsy, the doctor may be sued as
much as 18 years after the birth. Even then, the plaintiff gets paid only after a trial has
been completed and appeals are exhausted. In this case, the income earned on the assets may
accrue for a long time to offset the size of the claim. Other claims such as ‘fender bender’
automobile accidents are ‘short-tailed’ claims that are paid quickly.
Best policy
Property-casualty companies tend to have a liquid reserve of short-term bonds to stabilise
income. A large, long-term bond portfolio is also utilised. Thus, the overall portfolio tends
to be ‘dumbbell’ shaped with mostly short and long-term assets without intermediate term
securities. Capital surplus tends to be invested in stocks with an emphasis on long-term growth.
It is common for equities to be about 20% of the investment portfolio of a property-casualty
179
insurance company. If the company has underwriting profits, it is recommended that tax-
free bonds, preferred stocks, and common stocks be utilised in high tax regimes in order to
obtain some measure of tax shelter. If the company has underwriting losses, more emphasis
is placed on taxable bonds. High quality liquid assets are utilised.
Regulation of insurance companies

Like banks, insurance companies are heavily regulated financial institutions. Most insurance
companies operate under some form of government regulation due to the importance of
having a stable supply of insurance in the economy. Regulatory practices, however, vary
widely from country to country.
In the EU, for example, insurance companies are preparing themselves for Solvency
II, under an EU Directive (called Omnibus II) that codifies and harmonises EU insurance
regulation, in particular the approach to insurer solvency. Once the Omnibus II directive is
approved by the European Parliament, Solvency II will be scheduled to come into effect on 1
January 2014. The directive’s origin is the International Association of Insurance Supervisors
(IAIS) and the latter’s efforts to put in place a common structure worldwide for the assess-
ment of insurer solvency. Solvency II is a risk-based framework of quantitative requirements,
supervisory review, and market disclosure modelled on the three pillars of Basel III.
In the US, regulations can vary from state to state but are largely overseen by the National
Association of Insurance Commissioners (NAIC) which has a risk-based capital (RBC) formula
that generates the regulatory minimum amount of capital a company is required to maintain
to avoid regulatory action (see Box 2.2).
The overriding aim of regulators is the protection of policyholders, and this may be
achieved either through controlling company solvency or through policy, pricing, and
marketing controls. In short, insurers are regulated for the following reasons:
⦁⦁ to maintain insurer solvency;

⦁⦁ to compensate for inadequate consumer knowledge;
⦁⦁ to ensure reasonable rates; and
⦁⦁ to make insurance available.
Box 2.2
NAIC’s RBC
Among the greatest weapons against insolvency are the risk-based capital requirements formu-
lated by the National Association of Insurance Commissioners (NAIC) in the US. The risk-based
capital (RBC) system uses a formula that establishes the minimum amount of capital neces-
sary for an insurance company to support its overall business operations, considering its size
and risk profile. That amount is then compared with the company’s actual statutory capital to
determine whether a company is technically solvent. The formula results allow government
Continued
180
Insurance companies
regulators to intervene in a timely manner when a company fails to meet these minimum
standards. Companies failing to meet the minimum capital standard developed by the formula
are subject to increasingly stringent regulatory intervention, depending upon the degree to
which they fail the minimum standard.
There are five levels of action a company can trigger under NAIC’s RBC formula. The base
action level is the authorised control level (ACL). If a company’s actual capital dips below
its ACL risk-based Capital, the state insurance regulator has authority to place the company
under regulatory control. Therefore, the ACL is used as the base level, and the other regula-
tory intervention levels are defined relative to the ACL. The five action levels are:
∑∑ No Action, which means that a company’s total adjusted capital (TAC) is at least twice
its ACL;
∑∑ Company Action Level, which means that a company’s TAC is at least 1.5 times its ACL,
but less than twice its ACL;
∑∑ Regulatory Action Level, which means that the company’s TAC is at least equal to its ACL,
but less than 1.5 times its ACL;
∑∑ Authorised Control Level, which means that a company’s TAC is at least 0.70 times its
ACL but less than its ACL; and
∑∑ Mandatory Control Level, which means that the company’s TAC is less than 0.70 times
its ACL RBC.
Maintain insurer solvency

Insurance regulation is necessary to maintain the solvency of insurers. This goal is called
solidity, by which regulation aims at preserving or enhancing the financial strength of
insurers. Solvency is important for two reasons. First, premiums are paid in advance, but
the period of protection extends into the future. If an insurer goes bankrupt and a future
claim is not paid, the insurance protection paid for in advance is worthless. Therefore, to
ensure that claims will be paid during the policy period, the financial strength of insurers
must be carefully monitored.
A second reason for stressing solvency is that individuals can be exposed to great finan-
cial insecurity if insurers fail and claims are not paid. For example, if the insured’s home is
totally destroyed by a fire and loss is not paid, he or she may be financially ruined. Thus,
because of the possibility of great financial hardship to insureds, beneficiaries, and third-party
claimants, regulation must stress insurer solvency.
Insurer solvency is closely monitored by privately-owned rating agencies, notably insur-
ance specialist A.M. Best Company.
Compensate for inadequate consumer knowledge

Regulation is also necessary because of inadequate consumer knowledge. Insurance contracts
are technical, legal documents that contain complex clauses and provisions. Without
181
regulation, an unscrupulous insurer could draft a contract so restrictive and legalistic that
it would be worthless.
Also, most consumers do not have sufficient information for comparing and determining
the monetary value of different insurance contracts. It is difficult to compare dissimilar poli-
cies with different premiums because the necessary price and policy information is not readily
available. For example, individual health insurance policies vary widely by cost, coverage,
and benefits. The average consumer would find it difficult to evaluate a particular policy
based on the premium alone.
Without good information, consumers cannot select the best insurance product. This
can reduce the impact that consumers have on insurance markets, and can also reduce the
competitive incentive of insurers to improve product quality and lower price. Thus, regula-
tion is needed to produce the same market effect that results from knowledgeable consumers
who are purchasing products in highly competitive markets.
Finally, some agents are unethical, and government or official licensing requirements tends
to be minimal. Thus, regulation is needed to protect consumers against unscrupulous agents.
Ensure reasonable rates

Regulation is also necessary to ensure reasonable rates. The rates should not be so high that
consumers are exploited by being charged more than the value of the coverage. Nor should
the rates be so low that the solvency of insurers is threatened. Whether a rate is too high
or too low is often difficult for the regulators to determine. Rate regulation is an extremely
complex issue, even in countries with developed insurance markets.
Make insurance available

Another regulatory goal is to make insurance available to all persons who need it. Insurers
are often unwilling to insure all applicants for a given type of insurance because underwriting
losses, inadequate rates, adverse selection,2 and a host of additional factors. However, the
public interest may require regulators to take actions that expand private insurance markets
to make insurance more readily available. If private insurers are unable or unwilling to supply
the needed coverages, than government insurance programs may be necessary.
Specific areas of regulation

Insurance companies are subject to regulations in the following areas in most market
economies:
⦁⦁ formation and licensing of insurers;

⦁⦁ financial regulation;
⦁⦁ rate regulation;
⦁⦁ policy forms; and
⦁⦁ sales practices and consumer protection.
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Insurance companies
Formation and licensing of insurers

Although requirements vary from country to country, a new insurer is typically formed by
incorporation. Similar to banks in most countries, insurance companies seek licensing with
the relevant authorities which specify minimum capital and surplus requirements.
Financial regulation
In addition to minimum capital and surplus requirements, insurers are subject to other
financial regulations in most developed markets. These financial regulations are designed to
maintain solvency.
Admitted assets
An insurer must have sufficient assets to offset liabilities. Only admitted assets can be shown
on the insurer’s balance sheet. Admitted assets are assets that an insurer can show on its
statutory balance sheet (also called annual statement) in determining its financial condi-
tion. All other assets are non-admitted (see discussion of balance sheet items in the section
Reinsurance agreements and non-admitted assets).
Most assets are classified as admitted assets. These include cash, bonds, common and
preferred stock, mortgages, real estate, and other legal investments (see Box 2.3). Non-admitted
assets include premiums overdue 90 days or more, office furniture and supplies, and
certain investments or amounts that exceed statutory limits for certain types of securities.
Non-admitted assets are excluded because their liquidity is uncertain. As a result, policy-
holders’ surplus is decreased by an increase in non-admitted assets.
Box 2.3
Portfolio policy
Regulation of portfolio policy is aimed at protecting the insured by protecting the portfolio from
shrinkage in value. Life insurance companies (tend to be) are severely restricted with regard
to investment in equity securities, to direct investment in real estate, and to other investments
perceived to be risky. Non-life companies are usually allowed to invest in equity securities
up to the amount of their equity and surplus. However, the attractiveness of equity securities
is decreased by procedures the regulators use in computing the insurance company’s equity
and surplus. Equity securities are carried at their current market values; bonds can be carried
at their face value or original cost. If rising interest rates cause both stock and bond values
to decline, the company holding only bonds will not suffer a decline in portfolio value from
the regulators’ viewpoint, but losses will be recorded for the company with equity invest-
ments. The consequent reduction in recognised capital can impair the company’s ability to
sell additional insurance, since certain ratios of capital to insurance face value are required.
Non-life insurance companies hold 20% to 30% of their assets in equity securities, while life
insurance companies hold about 40% to 50% of their assets in this form.
183
Reserves
Reserves are liability items on an insurer’s balance sheet and reflect obligations that must
be met in the future. Life insurers maintain policy reserves to pay future policy benefits to
policyholders. Property-casualty insurers maintain two financial reserves: (i) unearned premium
reserves to pay for losses that occur during the policy period; and (ii) loss reserves or the
estimated cost of settling claims that have already occurred but have not been paid as of
the valuation date.
Surplus
The surplus position is also carefully monitored. Policyowners’ surplus is the difference
between an insurer’s assets and liabilities. The surplus of a capital stock insurer consists of
two items: (i) a capital stock account that represents the value of the shares issued to the
shareholders; and (ii) paid-in surplus that represents amounts paid in by shareholders in
excess of the par value of the stock. Both items together represent policyowners’ surplus.
Since a mutual insurer has no stockholders, policyowners’ surplus is simply the difference
between assets and liabilities.
In property-casualty insurance, policyowners’ surplus is important for several reasons.
First, the amount of new business an insurer can write is limited by the amount of poli-
cyowners’ surplus. One conservative rule used by insurance company analysts is the Kenny
ratio3 by which a property insurer can safely write LCU24 of new net premiums for each
LCU1 of policyowners’ surplus. Second, policyowners’ surplus is necessary to offset any
substantial underwriting or investment losses. Finally, policyowners’ surplus is required to
offset any deficiency in loss reserves that may occur over time.
In life insurance, policyowners’ surplus is less important because of substantial safety
margins in the calculation of premiums and dividends, conservative interest assumptions
used in calculating legal reserves, conservative valuation of investments, greater stability in
operations over time, and less likelihood of a catastrophic loss.
Risk-based capital
To reduce the risk of insolvency, insurers are increasingly required to meet certain risk-based
capital (RBC) standards. RBC means that insurers must have a certain amount of capital,
depending on the riskiness of their investments and insurance operations. Insurers are graded
by regulators in developed markets based on how much capital they have relative to their
RBC requirements. For example, insurers that invest in less-than-investment grade corporate
bonds (‘junk bonds’) must set aside more capital than if government bonds were purchased.
The RBC requirements are based on a formula that considers four types of risk – asset
default risk, insurance risk, interest rate risk, and general business risk. Asset default risk is
the risk of default of specific assets and a market decline in the insurer’s investment portfolio.
Insurance risk is the risk that premiums and reserves may be inadequate for paying benefits.
Interest rate risk reflects possible losses due to changing interest rates. Examples include a
decline in the market value of assets supporting contractual obligations and liquidity problems
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Insurance companies
arising from disintermediation because of changing interest rates. Finally, business risk refers
to other risks that insurers face, such as guaranty fund assessments and insolvency because
of bad management.
The insurer’s total adjusted capital (TAC) is then compared with the amount of RBC.
(TAC essentially is statutory capital and surplus with certain adjustments.) An ideal regulatory
approach would include the following: a ratio of 100% or above means that insurers have
met or exceeded their minimum RBC requirements. Insurers with ratios of at least 75% but
under 100% would have to indicate to the regulators how they plan to increase their RBC.
Insurers with ratios of at least 50% but less than 75% would be ordered to take specific
action. If the ratio falls below 50%, regulators would have the authority to take control of
the insurer and would be required to do so if the ratio falls to 35%.
The RBC standards give regulators a early warning with respect to insurers with finan-
cial problems. The standards also discourage insurers from investing too heavily in risky
investments (see Box 2.2).
Investments
Insurance company investments are regulated with respect to types, quality, and percentage
of total assets or surplus that can be invested in different investments. The basic purpose of
these regulations is to prevent insurers from making unsound investments that could threaten
the company’s solvency and harm the policyowners.
Life insurers typically invest in common and preferred stocks, bonds, mortgages, real
estate, and policy loans. Regulators generally place maximum limits on each type of invest-
ment based on a percentage of assets or surplus. For example, an authority may specify that
common stock investments are limited to a maximum of 10% of total assets.
Property-casualty insurers are subject to fewer restrictions in their investments than life
insurers. Restrictions, however, vary from country to country. First, in respect to minimum
capital requirements, the funds must usually be invested in government securities and high-
quality corporate bonds. Second, any excess funds over the minimum capital requirements
and reserve liabilities can be invested in the common stock of solvent corporations or in
real estate the company is permitted to hold. There may be restrictions, however, on the
proportion of assets that can be invested in any single corporation.
Limitation on expenses
In some countries, regulators place limitations on the amounts that can be spent in acquiring
new business and maintaining old business by life insurers. The purpose is to prevent wasteful
price competition that would result in life insurers competing with each other by offering
higher commissions to agents. The aim is to hold down the cost of life insurance to consumers.
Dividend policy
In life insurance, the annual gain from operations can be distributed in the form of dividends
to policyowners, or it can be added to the insurer’s surplus for present and future needs.
185
Many countries limit the amount of surplus a particular life insurer can accumulate to a
maximum, say, of 10% of policy reserves. The purpose of this limitation is to prevent life
insurers from accumulating a substantial surplus at the expense of dividends to policyowners.
Reports and examinations

Annual reports and examinations are used to maintain insurer solvency. Regulators gener-
ally require that each insurer publish an annual report, preferably audited by independent
accountants, which provides detailed information with respect to assets, liabilities, reserves,
investments, claim payments, RBC, and other information.
Supervisory authorities in developed markets also periodically examine insurance compa-
nies. Examinations can occur every three to five years depending on the jurisdiction. The
purpose is to detect early warning signals, ensure compliance with regulations, and take
corrective action if problems surface.
Liquidation of insurers
Liquidation procedures differ among countries in the event of insurer insolvency. Some
countries have enacted laws that provide insurance guaranty funds similar to bank deposit
guarantee schemes. Insurance guaranty funds provide for payment of unpaid claims of insol-
vent insurers. The guaranty funds limit the amount that policyowners can collect if an insurer
goes broke. For example, in the US, life insurance guaranty funds typically place a limit of
US$100,000 on cash values and US$300,000 on the combined benefits from all policies.
Rate regulation
Rate regulation is designed for consumer protection and is carried out in varying degrees
in many developed markets. Generally, regulatory authorities like to see rates that are
adequate, reasonable (not excessive), and not unfairly discriminatory. Rate setting by regula-
tors, however, is highly controversial and often open to dispute by insurers.
Policy forms
The regulation of new policy forms is another important area of insurance regulation. Because
insurance contracts are technical and complex, the regulators generally have authority to
approve or disapprove new policy forms before contracts are sold to the public. The purpose
is to protect the public from misleading, deceptive, and unfair provisions.
Sales practice and consumer protection

The sales practices of insurers is also heavily regulated in most developed markets concerning
the licensing of agents and brokers, and the prohibition of twisting, rebating, and unfair
trade practices. Licensing attempts to ensure that agents have knowledge of insurance laws
and the contracts they intend to sell.
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Insurance companies
Twisting is the inducement of a policyowner to drop an existing policy in another

company due to misrepresentation or incomplete information. The objective in forbidding
twisting is to prevent policyowners from being financially harmed by replacing one insur-
ance policy with another.
Rebating is giving to an individual a premium reduction or some other financial advan-
tage not stated in the policy as an inducement to purchase the policy. Prohibition ensures
fair and equitable treatment of all policyowners by preventing one insured from obtaining
an unfair price advantage over another.
Asset and liability management

Liabilities and capital
An understanding of the liabilities of insurance companies is necessary to develop an appro-
priate approach to management of assets. The dominant liabilities for both life and non-life
insurance companies are reserves based on the fact that premiums are collected as much
as a year ahead for non-life insurance companies and most of a lifetime for life insurance
policies. The amounts expected to be paid out over the period covered by the premium are
carried as a reserve when that premium is first received. As claims are paid, both cash and
reserves are reduced. If claims exceed reserves, capital and surplus are reduced, and vice
versa. The long lives of many life insurance policies compared with those of non-life insur-
ance companies result in much larger policy reserves for life insurance companies.
In addition to the higher absolute amount of reserves, life insurance companies have a
much higher ratio of reserves to equity. The lower capital levels for life insurance companies
result from both management decisions and regulatory requirements. They are based on
recognition of the fact that life insurance obligations are easier to predict than the obliga-
tions of most other insurance companies. In addition, the accumulation of funds for certain
death benefits means that the currency unit value of liabilities per face value of insurance is
higher for life insurance than for other insurance. Therefore, a higher ratio of liabilities to
equity does not necessarily mean a higher ratio of insurance face value to equity. Accident
rates and the amount of settlement per accident have varied. This is particularly true during
periods of high inflation.
The size of the equity base has important implications for asset management. With a
limited equity base, the life insurance companies can endure less asset value erosion than
can non-life companies.
Assets
The primary assets of insurance companies are investment portfolios in the form of marketable
securities. Investment portfolios are held for two reasons. Because the insurance companies
collect premiums with insurance coverage provided for some time after collection, they have
these funds to invest until they are paid out as benefits. On the liability side, this shows up
as reserves.
187
The second category of funds is held as protection against losses due to factors such
as excessive benefit expense or shrinkage in the value of assets. On the liability side of the
balance sheet, these funds are represented by surplus and equity accounts. The investment
policy is determined by the two purposes the portfolio serves.
The liquidity needs from the investment portfolio are minimal. Most insurance companies
are continually expanding in size, with premiums received during any month being more
than sufficient to meet all cash outflows for that month. Actual sale of securities would
be necessary only if premium revenue declined. The company will add to its portfolio and
reserve accounts from month to month unless its volume declines or disintermediation occurs.
This is not to say that day-to-day cash management is not an important function in
an insurance company. A large insurance company will have cash flows of several million
a day. A company may be able to improve profit by reducing idle cash equal to one day’s
cash flow. Therefore, the companies follow cash flow over the week and month very closely
to keep as much cash as possible invested. If premiums for a particular company tend to
come in around the first of the month, with claims paid at en even rate over the month, the
company will have idle cash during the early part of the month. These funds will be invested
in money market instruments, with adjustments being made on a daily basis.
Because these day-to-day cash flows vary with such things as mail delivery, or the
speed of the local payments system, and are not totally predictable, there may be short-
term liquidity demand that requires the sale of money market instruments. This short-term
money management problem is linked to management of the investment portfolio only to
the extent that the company must decide how much to invest in money market instruments
for liquidity reserve purposes.
Liquidity demands of a more serious nature arise from disintermediation. Whole life
and endowment policies normally give a holder the right to borrow a large portion of
the reserve attributed to the policy at an interest rate state in the contract. When interest
rates rise, people find these policy loans to be a low-cost source of funds and borrow
heavily, either to meet credit needs or to invest at higher interest rates. In addition, if a
whole life or endowment policy is cancelled, the insured is paid most of the reserve asso-
ciated with the policy. This is the cash value spelled out in such policies. Cancellation of
whole life policies, to be replaced with term policies, has also occurred during periods of
high interest rates. Downturns in loan and cash surrender demand are in periods when
interest rates are falling.
The pressure to earn returns on portfolios comes from two sources. First, insurance
companies are clearly profit-seeking ventures, and portfolio return is an important source of
revenue. Unlike mutual savings institutions, even mutual insurance companies pay a profit-
based dividend to members who also elect directors. Thus, virtually all insurance companies
are overseen by directors elected by people who share in all the profits.
In addition to direct profitability to the owners, investment portfolio return indirectly
affects profitability through the ability of the company to price policies competitively. For all
insurance companies, and particularly for a life insurance company, the premiums depend on
an assumption about rates of return on the company’s investments, and on an assessment of
risks. For a LCU10,000 benefit payment 50 years in the future, the annual investment neces-
sary to accumulate this amount is LCU8.59 if the interest at which funds can be invested is
188
Insurance companies
10%, and LCU1.39 if the interest rate is raised to 15%. If a 20% rate of return could be
assumed, the payment would fall to LCU0.22.
Premiums required for some life insurance policies are therefore quite sensitive to the
return that can be earned on the investment portfolio. The assumption of a low long-term
investment return at a time when interest rates are high is one factor leading to the increased
portion of the life insurance premium going to term insurance.
For life and non-life insurance companies, the amount of new insurance which a particular
company can write is limited by the amount of equity and surplus. Return on the investment
portfolio increases the amount of surplus.
Risk
As with any other company, the insurance company cannot think of the riskiness of a single
security in isolation from the investment portfolio, nor can the investment portfolio be viewed
in isolation from the other aspects of the company’s business. An insurance company faces
four major types of risks.
⦁⦁ Excessive benefit costs are the first type of risk: they can occur because of a natural
disaster, because inflation drives average claim amounts to higher than anticipated levels,
or simply because the company’s original estimates of losses were wrong.
⦁⦁ Sales declines represent the second type of risk: they can occur because a severe economic
downturn eliminates either the ability to pay for premiums or the need for certain types
of insurance. Business insurance would be the most obvious example, as the need for it
decreases during a recession when business activity declines or businesses close. Demand
for life insurance, particularly whole life, may also decline in inflationary periods as people
look for investments that will provide some protection from inflation.
⦁⦁ Portfolio value loss is a risk that results from a similar set of factors: as inflation rates
rise, the general level of interest rates rises as well. A rise in the general level of interest
rates results in a decline in the market value of existing fixed-income securities. In addition,
common stock returns have been negatively correlated with the inflation rate in recent
history. An economic downturn can also have a negative impact on portfolio value through
defaults on bonds and mortgages, and through a reduction in common stock values as
profits decline. Default rates on the types of securities that insurance companies hold
have remained low even in economic downturns, but losses in market value have been
substantial. For example, a bond with an 8% coupon rate and twenty years to maturity
would be selling at 70% of its face value if the general level of interest rates for this risk
class were to increase to 12%. Likewise, but less surprisingly, the average value of a share
of common stock has been known to decline 40% or more. With their low ratios of equity
capital to total assets, the insurance companies cannot absorb large losses of this type.
⦁⦁ Cancellation and policy loan risks are primarily problems faced by companies offering
whole life or endowment policies: these withdrawals generally occur during periods of
high interest rates but could also occur in severe economic downturns. Of course, high
interest rate periods and economic downturns are both periods when the values of securities
may be low. For fixed-income securities, the maturity value is not affected by a decline
189
in current market value. The decline in market price is significant because: (i) it reflects
an opportunity loss in that higher-yielding securities are currently available; and (ii) if
the company should need cash, the bonds would have to be sold at a loss. As indicated
earlier, a loss in the value of equity can have an immediate negative impact on equity
and surplus ratios, even in the absence of a need to sell the securities at depressed prices.
The conditions which might lead to each of the various types of losses are summarised in
Exhibit 2.1.
Since inflation and economic downturn are factors influencing most types of losses,
particularly for life insurance companies, the investment portfolio does not provide significant
opportunity to diversify away risks from other aspects of the business.
Exhibit 2.1
Risks and causes of losses
Risks Causes
Excessive claim losses Inflation, natural disasters
Sales declines Inflation, economic downturn
Losses in investment portfolio Inflation, economic downturn
Policy loans and cancellations Inflation, economic downturn
Portfolio strategy
Because of this limited opportunity for diversification, insurance companies pursue a conser-
vative portfolio strategy. Long-term fixed-income securities are the primary investment for
both life insurance and non-life companies.
Within the investment portfolio, the normal principle of eliminating diversifiable risk is
followed to the extent possible. Unfortunately, legislation designed to ensure safety in some
countries may actually increase the difficulty of achieving proper diversification. Regulations
are based on the view that high-grade fixed-income securities are nearly risk-free. Restricting
insurance companies to heavy investment in these securities and restricting them from such
areas as direct investment in real estate, for example, have left them exposed to the full
effect of interest rate risk associated with inflation.
Portfolio managers have sought to diversify within these regulatory limits. The movement
to commercial mortgages with equity participations in some countries is one such example,
giving some of the diversification benefits of real estate ownership without violating restric-
tion of direct real estate ownership or direct common stock purchase. Convertible bonds are
another investment medium providing similar opportunities.
190
Insurance companies
To deal with interest rate risk, the life insurance companies base their premiums on
expected investment return. If management knew the policy would not be cancelled or
borrowed against, investment maturity could be based on expected eventual payment date,
thereby insuring a rate of return. This would not be entirely possible for payments expected
to be made 60 years in the future, but 40-year maturities are available in some markets and
would be sufficient to cover most commitments.
Portfolio strategy to deal with the possibility of excessive withdrawals through loans
and cancellations is primarily dealt with through a balancing of the maturity structure so
that any demand can be met through maturing securities rather than by selling securities at
a discount. This has been combined with some movement toward forward contracts to sell;
it can effectively convert some long-term government securities or mortgages to short-term
securities.
In summary, insurance companies face significant risks tied to the inflation rate and
economic conditions. These risks cannot be very effectively diversified away, but they are
problems of the short and intermediate term in which securities might have to be sold below
cost. If a company has its maturity structure designed evenly so that it can avoid the necessity
of selling securities before maturity, the risks are manageable. A poorly designed maturity
structure could quickly result in insolvency in the face of withdrawal demand.
Box 2.4
Insurance company hedging techniques: swaps
Corporations and financial institutions that desire to hedge market risks find that the use
of conventional, publicly traded derivative instruments, such as options and futures, do not
always meet their risk management needs. A market in swaps and other customised deriva-
tive instruments has developed to meet various needs of business and financial institutions
for risk modifying vehicles that can be tailored to meet specific requirements.
The most common type of customised derivative instrument is the swap. Swaps are
contractual agreements between two parties, in which each party agrees to exchange a stream
of cash for a stipulated period of time (called the tenor of the swap), based upon certain
agreed-upon parameters and the price fluctuations in some underlying specified commodity
or market index. Since at least one of the two streams of cash that are to be exchanged
depends upon the market price of a commodity or index, such as Libor, the exchange rate
between two currencies, or the level of a stock market index at the time a swap is initiated,
there is uncertainty regarding what the future size of a least one of the two cash streams
will be.
There are, generally, three types of swaps: interest rate, currency, and equity index swaps.
All exist because the markets for fixed-income securities, currencies, and equities are volatile
and involve risks that some entities active in the markets for business reasons are unwilling
to take, and which other, more speculatively oriented, parties are willing to accept.
Continued
191
Box 2.4 continued
For example, the most common use of interest rate swaps is to enable institutions to
obtain asset/liability risk matches that eliminate the risk of ‘borrowing short to lend long,’
and vice versa. Consider an insurance company has long-term liabilities in the form of death
benefits that being financed with long-term bonds. However, the insurance company carries
an average cash balance of US$100 million, earning Libor, when the actuarial assumption
that determines the financing cost of its life insurance policies is a fixed 6% rate. From the
insurance company’s perspective, it has an average of US$100 million invested in short-term
instruments when it has all long-term liabilities. This is an asset/liability mismatch that makes
the insurance company vulnerable to interest rate risk; its profit margin is impacted by the
spread between Libor and its 6% fixed actuarial cost applied to the US$100 million of cash
reserves. As Libor fluctuates, so will the company’s profit margin; this is interest rate risk.
In contrast, suppose a bond dealer who has a US$100 million inventory of long-term
bonds with an average yield of 7.5% financed with short-term borrowings at Libor. This
arrangement makes the dealer vulnerable to interest rate risk because the return on its inven-
tory is fixed at 7.5%, while the cost of financing it is Libor. If Libor increases or decreases,
the spread earned by the dealer (7.5% – Libor) will fall and rise. This could result in volatile
profit margins, which means the dealer is vulnerable to interest rate risk.
Both institutions can correct their asset/liability mismatches, thereby reducing their expo-
sure to interest rate risk, by entering into an interest rate swap agreement, in which the
insurance company agrees to pay a floating rate of interest on a notional amount of principal,
and the dealer agrees to pay a fixed rate of interest on the same notional amount of principal.
To see how such a swap would reduce the risk of both institutions, suppose that a swap
agreement is entered into with the following characteristics at a time when Libor is 5%:
Term …………………………………………… Five years

Insurance company pays floating rate …… Libor flat
Dealer pays fixed rate ……………………… 7.5%
Notional principal …………………………… US$100 million
With this swap agreement, every six months the transfer of funds takes place. Six months
after the initiation date, the cash flows will be as follows:
Fixed-rate payment = .075/2 x US$100,000,000 = US$3,750,000

Floating-rate payment = .05/2 x US$100,000,000 = US$2,500,000
A net payment would be made of US$1.25 million from the fixed-rate payer to the floating-
rate payer at the first coupon exchange.
Suppose that, for the next coupon exchange, Libor increase by 25 basis points (100 basis
points = 1%). This means that, at the next settlement date, cash flows will be:
Continued
192
Insurance companies
Fixed-rate payment = .075/2 x US$100,000,000 = US$3,750,000

Floating-rate payment = .0525/2 x US$100,000,000 = US$2,625,000
The net payment would be US$1.125 million from the fixed-rate payer to the floating-rate payer.
In effect, the swap stabilises the spread earned by both institutions on US$100 million
so that they no longer run interest rate risk on the amount of assets. The insurance company
receives an inflow of funds equal to 7.5% on US$100 million from the swap. If the insur-
ance company has an actuarially determined fixed cost of funds of 6%, this swap guarantees
it a 1.5% positive spread (negative cost) on its cash reserves, no matter what the level of
short-term interest rates happens to be. The payments that the insurance company makes
to the dealer, which are based on Libor applied to US$100 million, is simply an approximate
passthrough of its bank interest to the dealer. Therefore, the insurance company has swapped
away the risk (and potential profits) associated with the fluctuating spread between Libor
and its 6% fixed cost of funds for the relative safety of a fixed 1.5% spread no matter what.
Conversely, the dealer has an inflow of funds equal to Libor, which offsets the cost of
financing its inventory. The 7.5% return that it earns from its bond inventory is paid over
to the insurance company. Consequently, the net spread that the dealer earns on its bond
inventory is now zero at all times (no risk), rather than being the difference between 7.5%
earned on the bonds and the Libor cost of financing the inventory, which can fluctuate and,
therefore, is risky. The bond dealer’s income is now going to be determined by the bid/
asked spreads of its bond quotations, rather than by changes in the spread between Libor
and the fixed 7.5% rate on bonds. The bond dealer has swapped away the risk (and poten-
tial profits) associated with the fluctuating spread between short and long-term rates for the
relative safety of bid/asked spreads.
7.5%
Insurance
Dealer
company
Libor
Libor 7.5% 6% Libor
Bond Reserves
Bank Bank
inventory
Insurance company’s spread = Libor + 7.5% – 6% – Libor = 1.5%

Dealer’s spread = 7.5% + Libor – 7.5% – Libor = 0%
Continued
193
Box 2.4 continued
Before entering the swap, however, both the insurance company and the dealer should be
aware of the advantages and disadvantages facing them.
The following are advantages of swap agreements over conventional traded derivatives.
1 They are highly flexible and can be custom made to fit the requirements of the parties
entering into it.
2 The swap market is virtually unregulated, in contrast to the highly regulated futures market.
This could change, however, since regulators usually abhor a regulation vacuum and prob-
ably will, eventually, seek to bring the market under their ‘protection.’
3 The cost of transacting in the swap market is low.
4 Swaps are ‘private’ transactions between two parties. Often, swaps are ‘off-balance sheet’
transactions that can be used, for example, to enable a company to reposition its balance
sheet quickly without alerting competitors. This, too, may change as regulators and audi-
tors force more transparency on swap transactions and require that at least the credit
equivalency risk (essentially, the cost of replacing the swap contract if one of the original
counterparties defaults) be included in the balance sheet.
The disadvantages of swaps include the following.
1 Being agreements, a party who wants to enter into a particular swap must find a coun-
terparty that is willing to take the other side of the swap.
2 Swaps can be illiquid; once entered into, a swap cannot be easily terminated without the
consent of the counterparty.
3 Because there are no margin deposits or a clearinghouse that help ensure, or will guar-
antee, that the agreements will be honoured, the integrity of swaps depends solely upon
the financial and moral integrity of the parties that have entered into them. This means
that swaps have more credit risk than futures contracts.
Insurance company insolvency

Owning mortgages and junk bonds is not what creates an insolvent insurance company. The
assets of an insurance company embody two types of risks: interest rate risk and credit risk.
Although most companies limit interest rate risk through duration matching (see Boxes 2.1,
2.4 and 2.5), credit risk cannot be hedged. Generally, this will not be a problem because
an insurer can hold on to an asset long enough for the credit to improve. If this is not
possible, and a majority of the policyholders for varying reasons begin to let their policies
lapse, the insurance quickly exhausts its supply of liquid assets and is forced to liquidate
credit-impaired assets, normally at deep discounts to book value.
The most dangerous exposure for a life insurance company is the exposure to policy
withdrawals and surrenders. Policyholders’ propensity to surrender their policies tends to
194
Insurance companies
vary with the distribution source. Policies sold through general agencies are more likely to
lapse than policies sold through group (branch) agency networks. General agents have no
allegiance to any particular company and will often take advantage of a perceived problem
to create a new commission opportunity. Group agents, however, depend on a particular
company or group of companies for their livelihoods and will try to discourage policyholder
relationships from lapsing. A ‘run on the bank’ tends to be irrational, but it happens. Even
the most sophisticated institutional policyholder may get cold feet when it hears of a run
on the bank, because it does not want to be the last one at the window. Thus, runs tend
to feed on themselves.
Box 2.5
Insurance company hedging techniques: use of duration
Duration is the expected life of a fixed-income security, taking into account its coupon yield,
interest payments, maturity, and call features. Duration attempts to measure actual maturity,
as opposed to final maturity, by measuring the average time required to collect all payments
of principal and interest.
For example, the duration of a 6%, five-year bond selling to yield 9% is as follows:
Coupon rate = 6.00%

Term (years) = 5
Initial yield = 9.00%
Period (t) Cash flow PV of US$1 at PV if CF t x PVCF

(per US$100) 0.045
1 3.00 .956937 2.870813 2.87081
2 3.00 .915729 2.747190 5.49437
3 3.00 .876296 2.628890 7.88666
4 3.00 .838561 2.515684 10.06273
5 3.00 .802451 2.407353 12.03676
6 3.00 .767895 2.303687 13.82212
7 3.00 .734828 2.204485 15.43139
8 3.00 .703185 2.109555 16.87644
9 3.00 .673927 2.018713 18.16841
10 103.00 .643927 66.324551 663.24551
Total 88.130923 765.89520
Continued
195
Box 2.5 continued
Duration (in half years) = 765.89520 = 8.69

88.130923
Duration (in years) = 8.69 = 4.35

2
The above calculation is referred to as ‘Macaulay duration’, after Frederick Macaulay who
pioneered work in this field of bond maturities. The result of 4.35 years simply indicates
that given the cash flows of the bond, its effective maturity is shorter than the original five
years term.
Duration (and subsequent modifications) is a key concept in fixed-income portfolio
management for at least three reasons. First, it is a simple summary statistic of the effective
average maturity of the portfolio. Second, it turns out to be an essential tool in immunising
portfolios from interest rate risk. Third, duration is a measure of the interest rate sensitivity of
a portfolio. While the exploration of duration applications is beyond the scope of this book,
it can easily be seen the importance to reduce or hedge portfolio risk for insurance company
asset and liability management. For example, to reduce interest rate risk, an insurance company
may seek to match the sample bond’s maturity with a liability source with the same duration.
Increased need for bank funds

The magnitude of the life insurance business rivals that of retail banking, yet both are mutu-
ally dependent. Viewed exclusively from the life insurers’ side, one might ask why a life
insurance company would ever need to borrow from a retail bank. As types of insurance
and investments have continued to change, however, the need for bank funds has increased.
The most frequent form of borrowings has been through open lines of credit, which most
typically are used to fill gaps between premium inflows and investment purchases. Lines of
credit are also needed as backup for mortgage securitisation, note and bond issues. Life insur-
ance companies use bank loans as interim and long-term financing for acquisitions. As the
barriers between banking and insurance continue to erode, life insurers will make increasing
use of bank loans to diversify into property-casualty activities, real estate development, and
other investments – including banking itself.
Because of this increased reliance on bank loans, the credit analysis of life insurance
companies has picked up in importance. Although life and other insurers are highly regulated,
analysts cannot feel secure in the knowledge that insurance experts are performing their watch
dog function. Too many insurance company failures in recent history have highlighted the
need for vigilance and thoroughness when analysing insurance companies. The trend toward
the writing of less profitable lines of insurance, such as group and term, and the problems
experienced recently in other types of insurance, such as property-casualty lines, further
strengthens the case for complete analysis.
196
Insurance companies
Credit analysis
Although the presentation of insurance company financial statements may differ from those
of more familiar manufacturing companies, the basic elements of credit analysis are the same
as for any borrower. These elements can be concentrated into three key areas: the manage-
ment, the business, and the financial characteristics of the company.
Knowing management and the nature of the life insurer’s business

All too often, credit analysis becomes simply a juggling of all the familiar financial ratios
that can be put together. As a result, analysts may tend to overlook the people responsible
for those numbers and the business environment that fostered them. But the management
and business of the life insurer are as important as the figures. It is management that makes
the decisions that lead to those numbers.
The analyst, then, must determine the character of management, its experience, and its
overall plan for the future of the company. Is management determined to promote growth
or diversification? Are key numbers of management well known? What is management’s
view of the long-range course of the business?
Knowing the nature of the life insurer’s business is also important. The basics of the
business determine the financial characteristics to be analysed later. What types of insur-
ance are written? What kinds of margins can be expected? Does the company write types
of insurance other than life? Are there any new types of insurance products that affecting
the company’s market? Answers to these types of questions will provide a framework within
which to judge management’s performance in shaping the financial results.
Basic tools for credit analysis

Those financial results are the most clear-cut evidence of management’s ability and are easily
the most accessible indication of the nature of the company’s business. The framework of
financial analysis that follows is not designed to provide all the answers that the analyst
needs. What is intended, rather, is to provide the basic tools necessary to outline the impor-
tant aspects of the life insurance company’s performance and financial condition.
It should be evident that the three elements of credit analysis are closely interrelated,
and as a result, the financial analysis of a life insurer will readily reveal many answers to
questions about management and the business. For example, an integral part of the financial
analysis is an evaluation of the mix of the types of insurance written and a look at the
non-insurance-related subsidiaries which may not be included in the statutory balance sheet.
The difficulty of comparing life insurance companies

The diversity of the life insurance industry can make comparison between life companies
difficult. Rules of thumb may be useful, but if improperly used, they can often be misleading.
Differences in the mix of insurance in force, growth rate, and level of diversification are just
three characteristics that vary widely between companies, but at the same time, are important
determinants of margins, overall profitability, and financial strength.
197
Fortunately there are resources available that can provide some basis of comparison
and additional useful information for the banker’s own credit analysis. Perhaps the most
well-known source is Best’s Insurance Reports which provides background and analysis of
investment assets, policy reserves management, and overall operation of both stock and
mutual companies (see Exhibit 2.2).
Exhibit 2.2
Sample insurance company credit ratings
Secured ratings
A++ and A+ (Superior) Assigned to companies that have a superior ability to meet their ongoing
insurance obligations.
A and A– (Excellent) Assigned to companies that have an excellent ability to meet their ongoing
BB++ and B+ (Good) Assigned to companies that have a good ability to meet their ongoing
Vulnerable ratings
B and B– (Fair) Assigned to companies that have a fair ability to meet their ongoing
insurance obligations. Financial strength is vulnerable to adverse changes in
underwriting and economic conditions.
C++ and C+ (Marginal) Assigned to companies that have a marginal ability to meet their ongoing
insurance obligations. Financial strength is vulnerable to adverse changes in
underwriting and economic conditions.
C and C– (Weak) Assigned to companies that have a weak ability to meet their ongoing
insurance obligations. Financial strength is very vulnerable to adverse
changes in underwriting and economic conditions.
D (Poor) Assigned to companies that have a poor ability to meet their ongoing
insurance obligations. Financial strength is extremely vulnerable to adverse
changes in underwriting and economic conditions.
E (Under regulatory supervision) Assigned to companies (and possibly their subsidiaries/affiliates) placed
under a significant form of regulatory supervision, control or restraint –
including cease and desist orders, conservationship or rehabilitation, but
not liquidation – that prevents conduct of normal, ongoing insurance
operations.
F (In liquidation) Assigned to companies placed in liquidation by a court of law or by forced
liquidation.
S (Suspended) Assigned to rated companies when sudden and significant events
affect their balance sheet strength or operating performance and rating
implications cannot be evaluated due to lack of timely or adequate
information.
198
Insurance companies
Risk categories for life insurance companies

Life insurance companies are in the business of dealing with risk and uncertainty. These
risks fall into two broad categories, investment and underwriting. Since both investment and
underwriting are essential to insurance operations, poor management in one will directly
influence the other. Therefore, poor underwriting decisions may result in unusually large
losses causing erosion of reserves and the need to liquidate assets. Poor investment decisions
may cause shortfalls in investment income which is necessary to help build policy reserves.
The key to comprehensive credit analysis of life insurance companies is the evaluation of the
company’s ability to assume and manage these investment and underwriting risks profitably
and soundly.
Investment risk: what to look for

The investment assets of insurance companies consist primarily of bonds, mortgages, common
and preferred stocks, real estate, and policy loans. An analysis of the quality of these assets,
just like any other investment, can be centred on an evaluation of their risk, return, and
liquidity. Although regulatory authorities often specify the types of investments and asset
mixtures permitted, life insurers do have a certain degree of flexibility, and thus their ability
to invest funds to achieve appropriate returns for a given level of risk can be evaluated.
Quality of investment assets

A year-to-year breakdown of asset mix showing each investment category as a percentage
of total invested assets will give an indication of the nature of the risk and liquidity within
the investment portfolio. For example, the larger the percentage of equity investments the
higher the risk assumed, while the larger the percentage of government securities held, the
lower the risk assumed.
The liquidity of the portfolio is in part determined by the nature of the insurance written.
The long-term characteristics of life insurance contracts usually dictate that life insurers invest
in a large proportion of long-term assets such as bonds and mortgages. Property-casualty
insurance companies, on the other hand, generally have a larger proportion of stocks (equity
securities). The important consideration for life insurers is that investment assets assume a
level of risk appropriate to preserve the long-term stability of the portfolio, provide sufficient
income to fund reserves, and prove liquid enough to meet pending cash demands.
Companies experiencing portfolio difficulties often show fluctuations in their mix of invest-
ment assets as they channel funds from one investment type to another. If a life insurer has
not changed reserve assumptions or the mix of types of insurance in force, there is usually
no reason for significant changes in asset mix unless problems with asset management are
present.
An indicator of the stability of the investment portfolio is the average change in asset mix
during the year. After calculating the percentage investment assets of each asset category for
the current and prior years, take the difference between those percentages for each category,
add them together (ignoring sign), and then divide by the number of categories. The result
199
represents the average change in the percentage of total cash and invested assets for all
categories of assets. According to some regulators, results of 5% or greater are exceptional
values and should be further investigated.
Poor average yield

Investment return is one of the single most important measurements of the company’s ability
to manage investment risks. The average yield on the companies’ investment portfolio can be
compared with that of other life insurers and the industry average by dividing net investment
income by the average cash and investment assets held during the year.
In developed markets, the company’s yield is generally disclosed in its financial state-
ments, but can also be obtained from global rating agencies, such as Best. Poor average
yield is a sign that the portfolio is not managed properly or is not assuming enough risk.
Regulatory standards indicate that investment yields of less than 4% or greater than 9.9%
are exceptional values.
The percentage relationship of interest earned to interest required ties together invest-
ment and underwriting operations. This is a comparison of average investment yield to the
average reserve interest assumptions. This statistic demonstrates the ability of the company
to manage investment assets relative to its underwriting requirements. If yield is below the
reserve interest assumption, investment assets are not producing the income needed to increase
reserves under those assumptions, and a drain on earnings results. On the other hand, a
rate greater than the reserve interest assumption is a healthy sign for both underwriting and
investment management capability.
Policy loans
Policy loans have usually remained a small part of total assets. Traditionally, policy loans
are provided at very low interest rates so that in times of higher interest rates the number of
policyholders desiring loans increases. The effect of an increasing proportion of policy loans
at these lower interest rates is to reduce the average yield on the total investment portfolio.
The percentage of policy loans to total assets is an indicator of the yield-dampening
effect on the total portfolio. Therefore, a company with a higher percentage of such loans
may have a lower average investment yield despite management’s ability to effectively manage
the remainder of the portfolio.
Quoted market values versus original cost

In addition to specific measurements of yield and changes in asset mix, the comparison of
market value versus original cost of equity securities and the independent evaluation of bond
and mortgage portfolios will give insight into the general quality of a life insurer’s assets.
The equity portfolio of life insurers is generally valued at market in statutory financial state-
ments. A comparison of quoted market values versus original cost reflects, therefore, the
company’s ability to manage the portfolio during varying conditions in the market. Naturally,
higher market value relative to cost in times of market decline indicates an excellent ability
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to manage assets. On the other hand, the decline of market value in times of rising markets
is an unfavourable sign.
Underwriting risk: what to look for

Since management’s ability to handle insurance operations will significantly affect all phases
of the company, the second priority of consideration is underwriting. An overall picture of
the underwriting risk assumed by a company can be obtained by examining those aspects
of insurance operations not disclosed directly on the balance sheet such as the product mix
of insurance in force and the average policy lapse rate.
Profit margin
In general, each type of insurance carries a different profit margin. Whole life, annuities, and
industrial policies are most profitable, followed by term, group, credit life, and accident and
health. Thus a percentage breakdown of premium revenue of insurance in force is an indicator
of the general profit producing capacity of the underwriting operation. Those companies more
deeply committed to term insurance would generally be expected to have lower margins and
higher volume than those more committed to writing whole life. Life insurance companies
often break down revenue accounts by lines of business, but the product mix can also be
found in rating agency materials.
Change in product mix

Along the same lines, the change in product mix during the year is a key to the stability of
underwriting operations. Problems with particular lines of business may be indicated when
a company begins switching emphasis significantly over short periods of time. Changing the
product mix may be prompted by large underwriting losses in certain lines, changes in long
range planning, or lack of marketing effectiveness.
In general, significant changes in the types of insurance written should be questioned.
The average percentage change of the product mix is calculated by summing the differences
in the percentage of premium of each line of business between the prior and current years
(ignoring sign) and dividing by number of lines of business. Results of 3% or greater are
considered exceptional values.
Lapse rate
The lapse rate, or rate of non-persistence, is that rate which insurance policies terminate
due to the policyholder’s failure to continue making premium payments. In general, the
company’s lapse rate is an indicator of underwriting or marketing effectiveness and abnor-
mally high lapse rates are signs of weakness in one area or the other. Since under statutory
accounting, all costs except claims are taken to income in the first policy year, the effect of
lapses on the income statement is to release the difference between cumulative reserves and
cash surrender values directly to revenue.
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The result of lapses can actually be a proportionate increase in revenues, and thus can
create income in the current period despite the fact that the company foregoes premium
revenues and may incur an economic loss on the policy. Lapse rates are included in reserving
assumptions and as such, should be provided for in premium revenues. However, a company
with a much higher lapse rate than its competitors with similar lines of insurance is, in
general, exhibiting weaker underwriting ability.
Profitability
The effectiveness of underwriting is most clearly revealed in life insurer profitability (see
also Box 2.6). Underwriting decisions affect premium growth, claim costs, expenses, and
additions to reserve which are the essential components that determine profit. Inaccurate
actuarial assumptions can result in higher than expected mortality and morbidity and thus
higher claim costs.
Lack of marketing effectiveness can, of course, result in loss of premium revenues. The
income statement should first be examined in relation to the previous period’s results to
generally determine the overall trends of revenues and expenses. Once trends are recognised,
the conditions or decisions resulting in those changes should be determined. Are premiums
up because of increased marketing effort? Are commission and expense increases due to rapid
growth in new business or lack of adequate controls? Are additions to reserves in line with
the general level of operations? Are claim costs abnormally high?
Box 2.6
Embedded value
Embedded value (EV) has become a popular measure of life insurance profitability as demands
increased from the analyst community for more consistent, transparent information that better
captures a company’s underlying business economics. While some insurance companies have
been content with simply reporting these metrics, insurers that learn how to successfully
manage through EV will find they have created a dynamic tool to improve performance.
EV measures a life insurance company’s economic value, as calculated by management,
and generally illustrates the value of new business separately from the in-force business. EV
is the present value of all future surpluses for the life insurer, taking into account reserve
releases. The company’s net asset value is added to this total. EV is a construct from the
field of actuarial science which allows these uncertain future cash flows to be valued, so that
a more realistic picture of the company’s financial position is possible, allowing for future
contingencies.
In other words, to value in-force business, EV is the sum of the following three elements:
1 net asset value (adjusted for market values);

2 present value of future expected premiums from existing contracts; and
Continued
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3 cost of ‘locking-in’ (difference between the net return earned on the assets covering the
solvency margin and the shareholders’ required rate of return).
While EV is well established in Europe and Asia-Pacific (through ongoing work by the European
Insurance CFO Forum), it continues to emerge slowly in North America, where some insurers
have adopted it mainly due to the demands from foreign parent companies. However, as
analysts continue to request EV measures it will become increasingly difficult for the remaining
companies to resist providing EV information in their statements. Note that EV in Europe is
now more commonly referred to as European Embedded Value (EEV).
Net losses
Net gain from operations as a percentage of total revenues can be used to examine trends or
compare one company with another. It is obviously a sign of weakness if the company shows
a net loss for the period. However, new companies, or companies writing large amounts of
new business, will often show losses on statutory statements due to large acquisition costs
being expensed in the current period. Such deficits may be ‘normal’ in such circumstances, but
are nevertheless a substantial drain on surplus. These companies should be watched closely.
Mature companies experiencing heavy losses that are not writing a great number of new
policies should cause concern. Such losses from new business are not ‘normal’ under gener-
ally accepted accounting principles (GAAP) procedures because acquisition costs are deferred
and expensed over the life of the contract (see also Box 2.7). The same is true under IFRS
4 Phase II: Insurance Contracts (see Box 2.11 in Appendix 2.1). If a company is showing
statutory losses due to new business, check GAAP earnings as well. Since GAAP earnings
are generally higher than statutory, a company experiencing GAAP losses should be watched
very closely. Those losses will not be due solely to new business but are probably due to
disproportionately high claim losses or ineffective control of general expenses.
Box 2.7
Deferred acquisition costs and related expenses
Deferred policy acquisition costs (DAC) are incurred in connection with acquiring or renewing
insurance policies. They are comprised of the costs necessary to sell and issue a policy
such as broker and agent commissions, underwriters’ salaries and benefits, and inspection
and examination costs. Under GAAP, DAC should only include costs that vary with and are
directly related to the acquisition of the policies, but in practice insurers also capitalise some
fixed costs. In addition, there is significant diversity in the identification and measurement of
DAC across insurers. As discussed below, in October 2010 the FASB issued a standard that
addresses both issues.
Continued
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Box 2.7 continued
DAC are paid early in the policy term while the benefits – premiums revenue – are
realised over the policy term. Under the GAAP matching concept, costs are expensed in the
same period in which the corresponding revenue is earned. Therefore, DAC is reported as
an asset and amortised over the estimated life of the policy.
In contrast, costs that do not vary with and are not primarily related to the acquisition
of new and renewal insurance contracts – such as those relating to investment management,
general administration, and policy maintenance – are charged to expense as incurred. In addi-
tion, DAC related to internally replaced contracts is immediately written off to expense and
any new deferrable expenses associated with the replacement are deferred if the contract
modification substantially changes the contract. However, if the contract modification does not
substantially change the contract, the existing DAC asset remains in place and any acquisition
costs associated with the modification are immediately expensed.
Property-casualty companies typically issue six month or 12 month policies, and so their
DAC represent a small portion of assets on the balance sheet (about 2% of total assets;
see Exhibit 2.6 in Appendix 2.2). In contrast, life insurance companies issue policies that are
expected to remain in force for many years, and so their DAC typically represent a significant
portion of reported assets (about 4% of total assets or 6% of adjusted total assets). Still, DAC
amortisation as a percentage of revenue is more than twice as large for property-casualty
insurers compared with life insurers (10% compared with 4%; see Exhibit 2.10 in Appendix
2.2). These statistics suggest that average DAC duration is significantly longer for PC insurers.
Life and health insurers often report the DAC asset combined with an intangible asset
called value of business acquired (VOBA) or ‘present value of future profits’. VOBA reflects
the estimated fair value of in-force contracts in a life insurance company acquisition, that is,
the value of the right to receive future cash flows from the business in-force. VOBA is based
on actuarially determined projections, by each block of business, of future policy and contract
charges, premiums, mortality and morbidity, separate account performance, surrenders, oper-
ating expenses, investment returns and other factors.
High spending levels

According to regulators, a high ratio of commission and general insurance expenses to
premium revenue (above 60%) should be closely examined. Comparisons of the company to
others of similar size and product mix will reveal their relative efficiency. If high spending
levels are not the result of high growth rates, they usually indicate poor budgeting or control.
Although they may not represent an immediate threat to solvency, they may indicate that
management decisions have not been consistent with the need for long-term stability. If the
underlying reason is due to high growth, then plans for the injection of additional capital
and management’s long range growth plans should be questioned.
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Rate of change in premium revenues

The company’s growth rate can best be measured by the rate of change in premium revenues.
If premiums are growing rapidly, it is important to ask some basic questions about manage-
ment’s ability to control expansion and whether it has the knowledge and experience to handle
operations under dramatically changing conditions. An increase in premiums of more than
50%, or a decrease of more than 10%, is considered exceptional. It is interesting to note
that as growth declines, expenses usually decline, often resulting in higher statutory earnings.
However, a levelling or decline of premium income will eventually require the liquidation of
assets to free reserves for payment of claim costs.
Other factors
There are other supporting indications of underwriting performance and stability including
the ratio of new premiums to total premiums, general insurance expense as a percentage
of premiums, and others. The specific directions that analysis takes should, of course, be
dependent on the particular strengths and weaknesses of the company’s underwriting.
Insurance regulators are primarily interested in life company solvency for the protection
of policyholders. Creditors are also interested in balance sheet strength, especially the cushion
provided by capital and surplus. The surplus account is affected most obviously by the net
gain from operations. However, there are several other factors that affect surplus, several
of which are peculiarities of statutory accounting.
Factors affecting surplus

The first of these surplus transactions is unrealised and realised capital gains and losses on
stock assets which are credited or charged directly to surplus in many of the developed
accounting systems. Any change in non-admitted assets will increase or decrease surplus, as
will the payment of stockholder dividends. Under statutory rules any changes in actuarial
assumptions on existing policies will affect surplus. For example, if reserves are strengthened
by assuming higher mortality rates or lower interest assumptions, reserves are increased
directly from the surplus account.
Some regulators require that life insurers set aside a portion of stockholder surplus in a
‘mandatory securities valuation reserve’ which is used to stabilise statutory surplus against
market ups and downs. None of these transactions is required to be flowed though the
income statement under statutory methods of accounting.
Change in the surplus account

The relationship between statutory capital and surplus and total assets of the company is a
rough measure of balance sheet strength. Perhaps a better indicator of condition, however,
is the change in the surplus account between periods. Steady increases are of course desir-
able, while decreases may be tolerable for short periods of time. If surplus decreases between
periods, and there is not a net loss from operations, further examination is needed to determine
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which of the previously mentioned transactions caused the problem. Are dividends exces-
sive or were there large net capital losses? Were reserves increased directly from the surplus
account, and if so, was the change in actuarial assumption made because of expected losses
or to help protect earnings that were weak for other reasons? A 10% or more decrease or
a 50% or more increase in surplus between periods is considered excessive.
The proportion of bank debt to equity in the life insurer’s balance sheet is not really
comparable to the debt ratio of industrial companies. The level of debt is normally much
lower for insurance companies. Any large amounts of long-term debt or an increasing trend
in this area should be questioned.
Reinsurance agreements and non-admitted assets

There are two factors to consider that are not disclosed on statutory balance sheets, reinsurance
agreements and non-admitted assets. Most insurance companies find it necessary to reinsure a
portion of their contracts with other companies. Generally, reinsurance is required for either
two reasons. One, the individual risk of a policy is not consistent with the company’s under-
writing assumptions (such as having a very large death benefit in relation to the rest of the
line). Or two, the company is seeking relief from the large expenses incurred from writing
substantial amounts of new business. In either case, the ceding company ultimately bears the
responsibility of death benefits. In the latter case, the reinsurer purchases a portion of the
risk on a block of business while the ceding company receives current income representing
recovery of acquisition costs and an element of profit.
Many of these ‘surplus relief’ reinsurance contracts are actually financing arrangements
in which the ceding company guarantees that the contract will not be terminated until the
assuming company recovers all advances and may provide that in the event of cancellation
the ceding company will return the advance plus interest. Thus, such a financing agreement
represents a liability to the ceding company. Statutory accounting in most markets does not
require the disclosure of such agreements; however, GAAP methods call for such disclosure,
and therefore GAAP statements are the best source of information concerning this type of
agreement. Such financing arrangements alone may not weaken a life insurer’s credit, but is
accompanied by other signs of underwriting problems, they do suggest further investigation.
Non-admitted assets are those assets that statutory methods prohibit from inclusion on
the balance sheet. Usually these assets consist of goodwill, furniture and fixtures, automobiles,
agent debit balances, accrued income on investments in default, and other items. They are
excluded in order to disclose the balance sheet as conservatively as possible. However, a rise
in the proportion of non-admitted to admitted assets is an indication that a company may
be investing in non-productive or risky assets.
Condition of subsidiaries
In some markets, statutory accounting also does not permit the consolidation of subsidiaries
on life company statements. During the analysis outlined here, it would be useful to examine
each company as it stands alone. IFRS and US GAAP practices do call for consolidation even
when subsidiaries are not involved with insurance-related businesses. To some extent such
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Insurance companies
consolidation can mask or distort the condition of the life insurance company. In recogni-
tion of that, IFRS and US GAAP suggest disclosure of consolidating as well as consolidated
statements in such cases. The analyst should be careful to note the condition of subsidiaries
and its effect on the parent company, especially since the loan may be downstreamed to
such non-insurance subsidiaries. Are these subsidiaries strong enough to stand on their own,
or is the insurance parent’s guarantee a necessarily?
Cash flow
Cash flow is perhaps the single most important factor in lending to life insurance companies.
It is both the beginning and the end of the borrowing relationship, for not only are fluctua-
tions in expected cash flow normally the reason for life company borrowing, but cash flow
is also the source of loan repayment.
Cash flow from operations is the source of repayment primarily because life companies
generally exhibit asset growth rather than the seasonal expansion and contraction of most
manufacturing companies. The effectiveness of both underwriting and investing come together
in the cash flow statement, and thus net cash flow can become the most comprehensive
measure of a company’s health.
Cash flow deficits

Although cash flow deficits filled by bank loans are usually short-lived, a trend toward such
deficits could be cause for concern. If a company continues to write a significant proportion
of new business each year, and therefore, incurs a large amount of commissions and other
acquisition expenses, cash flow will usually suffer. Likewise, if a company is unable to add
new business, premium revenues will decrease and assets will be liquidated with both effects
clearly evident within the cash flow calculation.
Evidence of changes in investment strategy will also surface if the size of investment
disposals and purchases increase dramatically from period to period. If this is occurring,
check the cash flow statement category ‘cash flows from investing activities’ and the effect on
investment income on the income statement. But, of course, the most important question to
answer is whether or not the company is experiencing enough cash flow to adequately cover
both bank loans and investment commitments. Investment needs must be covered because
the company’s responsibility is to maintain the flow of investment income to reserves for
the ultimate benefit of policyholders. It is therefore important to insure that both investment
commitments and credit lines are covered. The ability of the company to manage operations
so that the funds necessary to provide for such needs are generated is, of course, what a
comprehensive credit analysis is designed to measure.
Like a bank, most insurance companies publish a statement of cash flows which is
divided into three categories: (i) cash flows from operations; (ii) cash flows from investing;
and (iii) cash flows from financing.
Cash flows from operations include primarily net profit for the period plus or minus
any non-cash items, chiefly the reserves. Also included are changes in trading assets, prepaid
and accrual items. Cash flows from investing include the purchase and sale of the company’s
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main investment assets, such as stocks and bonds. Finally, cash flows from financing includes
the proceeds from debt issues (or their reimbursement) and new share issues.
Analysing the financial statements of life insurance companies

Solvency, in essence, is measured by a company’s capital and surplus – its statutory net
worth. Statutory accounting is designed to reflect the long-term nature of the life insurance
business. The following factors are critical in analysing the balance sheets and income state-
ments of life insurance companies.
Important factors
The mix of assets compared with industry averages is important, but a mutual company
should be compared against the mutual segment of the business, a stock company against
the stock segment, and so forth. The proportions of volatile and non-volatile assets are
important – specifically, non-investment grade (junk) bonds and problem mortgages compared
with the rest of the portfolio.
Reserves must be analysed. Insurance companies must set up various types of reserves,
and analysts should be able to get those figures from the companies on a quarterly basis,
although companies provide only annual data.
The revenue mix is the most important item on the income statement. Analysts should
determine what proportion are premiums, what proportion is net investment income, and
what ‘other’ income is. The sources of the other income figures are important. For example,
the company may have separate operations or subsidiaries that generate other income. For
many holding companies, just determining what they own is difficult; the information may
be buried in the other income category, and sometimes it is worthwhile to dig for it.
Premium mix is important. Analysts should determine the mix of ordinary life, annuities,
group, and individual policies. They should determine whether the health component is a
health maintenance organisation or traditional indemnity and to what extent it is experience
rated. A certain persistency factor relates to each of these lines of business, which should
provide some information about the consistency of the company’s revenue flow.
Analysts should examine both first-year and renewal premiums. The bulk of the premiums
for an insurance company are renewals. A drop-off in sales does not necessarily translate
into an immediate diminution in premiums. If people are pulling back in the marketplace
because they do not like the current pricing, that is not necessarily a negative. If, as they
are pulling back, they clean up and restructure their insurance plans, that could prove to
be positive if it enhances persistency.
Net investment income has become an increasingly important and sensitive factor because
it is a big number for most companies. Analysts should determine the average yields the
company is getting on the various types of assets in its portfolio. In addition, they should
look at the maturity of the bond portfolio. How much has come due or is coming due?
This is a particular problem when interest rates are volatile. For example, rating agencies
may express concern in such an environment, causing life insurance companies to keep a
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Insurance companies
bigger chunk of their asset base in short-term instruments. When short-term interest rates
drop, many of these companies suffer earnings decline.
Expenses are critical to the evaluation of an insurance company. Trends in expenses are
particularly revealing. Analysts should evaluate any successes companies may have had in
trimming their expenses and to what extent they could become more efficient.
Finally, pricing is an important factor in valuation of insurance companies. Is the price
of insurance going up, sideways, or down?
Property-casualty insurance
Property-casualty insurance companies are often referred to as short-term insurers due to
the nature of the risks they underwrite. The risks are primarily related to accidents and
property damage. Perhaps the best definition of property-casualty insurance is the insurance
of all non-life risks. The property-casualty insurance business can be broken-down into two
business lines: consumer (or personal) and commercial.
Consumer lines
The most common examples of consumer property-casualty insurance are automobile, house-
hold, travel, and fire and accident. Typically consumer property-casualty insurance policies
have a standard boilerplate wording and premiums are payable in advance, usually as a
single rate.
To be profitable, it is necessary to underwrite high volumes of policies (due to intense
price competition in this sector and to ensure the widest possible spread of risk). As a result,
efficient information-processing systems are vital. Consumer lines are also characterised by
active selling through agents.
Commercial lines
Rather than the extensive use of agents, brokers place most commercial property-casualty
insurance with underwriters. The major commercial markets are for fire (property), employers’
and professional liability, and automobile (vehicle fleets). Commercial lines business is char-
acterised by a smaller number of larger risks than found in consumer lines. In turn, this
increases the importance of reinsurance to protect the insurer against very large single losses.
Also included under commercial lines are marine, aviation, and transport insurance
(MAT). Policies insure against loss or damage (resulting from aircraft or water-vessel opera-
tions), or accidents, including those to third parties. MAT is usually written on a three-year
basis; at the end of each year a transfer to the income statement is made which is not related
to premiums written in any individual year (although a number of large insurers follow
different accounting methods). For other markets (automobile insurance, for example), the
standard basis is the one-year accounting period. Because of this fundamental difference in
the accounting period, MAT results are usually disclosed separately from other property-
casualty business.
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Credit analysis and primary risks of property-casualty insurers

Inflation and liquidity are the primary risks faced by property-casualty insurers. The first is
important because property damage is replaced at current costs and the second is important
because accidents are much more difficult to predict assets must be liquid enough to satisfy
claims within a reasonable period. The economic and social impact of these risks on under-
writing volatility and financial leverage requires thorough analysis of property-casualty insurers
as borrowers. A comprehensive review should include a close look at cash flow, premium
trends, underwriting and investment results, capital adequacy, and reserving practices.
Historically, bank borrowings of property-casualty insurance companies have not been
significant. However, greater cash flow volatility resulting from the impact of rapid inflation
almost two decades ago has led to a greater awareness of the flexibility offered by bank
credit facilities. Besides depending on credit lines to cover extraordinarily large claim payments
arising out of catastrophes or other emergencies, insurers have come to rely on bank loans
to fill other breaches in cash flow or liquidity that arise from time to time.
The greater use of bank credit is good reason in itself for analysts to intensify their
analysis of property-casualty companies.
Property-casualty insurance companies – interpreting the numbers

Property-casualty insurance has certain inherent elements that determine the manner in which
income and expenses and assets and liabilities are measured. The most basic of these factors
is the underlying nature of property-casualty insurance. Through the pooling of large numbers
of risks, property-casualty insurance permits the application of probability analysis to the
occurrence of specified events. In such a manner, insurers can absorb risks of financial loss
that would be too much for individuals acting alone.
Basic unpredictability of property-casualty insurance

An important characteristic of the ‘specified events’ or losses covered are their unpredict-
ability as to actual occurrence, frequency, and claim size. For property-casualty insurance,
this uncertainty determines the nature of the policy period and reserve structure and affects
cash flow and investment policy. The effects of uncertainty must be recognised if financial
statements of the insurer are to be fully understood.
Influence of regulation and statutory accounting

As is the case for all areas of insurance worldwide, property-casualty practices are dictated
by government regulatory agencies. The objective of these agencies is to maintain insurance
company insolvency or the protection of policyholders. Statutory accounting, which was
created to assist in achieving this purpose, emphasises the balance sheet over the income
statement and produces a conservative estimate of surplus. Besides requiring the use of statu-
tory accounting, regulatory agencies prescribe authorised investments and methods of security
valuation and set minimum standards for capital, reserves, and surplus.
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Insurance companies
IFRS and US GAAP accounting

Statutory accounting’s inherent problem is that the financial statements produced are not
germane to the analysis of a going concern. Lack of comparability with other businesses
makes evaluation of current profitability difficult, which is a matter of concern to present
and prospective creditors and shareholders. An answer to this difficulty was the development
of IFRS and US GAAP standards applicable to the industry (see Appendix 2.1).
Credit analysis of property-casualty companies

The common purpose behind most loans to the property-casualty insurance industry is that
of filling cash flow gaps that crop up intermittently. But it is the cash flow from operations
– the gaps in which cause the credit requests in the first place – that is the primary source
of loan repayments. The analyst must focus then on cash flow and make some attempt to
predict its trend despite the obvious difficulties involved.
Cash flow
Cash flow stems primarily from insurance operations and, as such, tends to reflect the
volatility of underwriting activities. This volatility is largely a function of the influence on
claims of such external forces as inflation, catastrophes or natural disasters, accident or crime
frequency, the size of liability judgments, and so on.
The other significant components of cash flow are investment income and sales and
maturities of investment portfolio holdings. The former, bond interest, for example, is very
stable from one period to the next and the latter is much less so because it is largely a
discretionary item.
The primary role of cash flow for property-casualty insurers is as a supplemental source of
liquidity that enables loss and loss adjustment expenses to be paid without having to liquidate
long-term investments that often are selling below cost. The secondary importance of cash
flow is that it represents the funds available for investment at current market rates. Uses of
cash for other purposes (including debt servicing) are usually much smaller proportionately.
With this kind of volatility, the difficulties involved in predicting cash flow and loan
servicing ability become obvious. Reasonable judgments in ascertaining trends can be made,
however, by considering the most important factors affecting insurance operations – namely:
premium growth, underwriting and investment insurance, capital adequacy, and reserving
practices.
Also important in making operating forecasts, of course, is knowledge of current economic
and industry conditions. Developments in these areas have a powerful impact on all partici-
pants. There is virtually no escape from such all-pervasive and profound determinants of
overall results as high inflation and excessive competition.
Premium growth
Constantly rising premiums resulting from greater unit volume, increased insurance values,
or higher rates are necessary to ensure that cash flow remains on an upward trend, certainly
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one of the basic signs of a healthy property-casualty insurance operation. Also, new business
placed on the books leads to loss reserve and unearned premium reserve additions – the
provisions for which are non-cash charges. The favourable impact on cash flow and invest-
ment income is thereby magnified in terms of the time lag between premium receipts and
claim payments. Insurers with ever-increasing premiums have positive cash flows even when
underwriting losses are incurred.
Besides boosting cash flow, increasing levels of premium are vital to the maintenance
of steady underwriting profitability. Appreciation in the underlying value of insurable risks
from real as well as inflationary growth requires that premium volumes rise faster than the
GDP if they are not to be outpaced by claim costs. Careful monitoring of an individual
concern’s overall premium trend is called for, then, to see that gains have at least kept
pace with the competition and that rate hikes, at least in recent years, have accounted for
a large part of the increases achieved. Greater unit coverages are hardly worthwhile if done
at unprofitable price levels.
Sudden surges in premium volume must be watched for, on the other hand, as they
might mean shifts in underwriting policy or marketing areas (with sometimes sorry profit
results) or the reaching of revenues through price cutting to cover unexpectedly large claim
payments. Temporary relief obtained in this manner could result in severe underwriting losses
at a later time. Meaningful changes in premium mix are also worth investigating, for they
could mean a fundamental movement in product line emphasis with possible ramifications
for profitability and leverage. A shift to more liability business, as an example, would in all
likelihood lead to more volatile underwriting experience and larger loss reserves.
Underwriting experience
Competence in assessing risk exposure and the level of compensation necessary to write
business at a profit is at the heart of any successful property-casualty insurance operation. A
company’s underwriting experience can best be interpreted through use of the combined or
trade ratio – a sum of the ratios of losses and loss adjustment expenses incurred to earned
premiums and of underwriting expenses incurred to written premiums.5 A combined ratio
of under 100% indicates an underwriting profit; one over 100%, an underwriting loss. The
advantage of this procedure is that by relating underwriting expenses to written rather than
earned premiums.
The combined or trade ratio enables the analyst to review underwriting trends and the
separate impact on overall results of losses and expenses. It can also be used in making
comparisons with the industry. Close examination of these figures and particularly the pure
loss ratio (losses alone as a percentage of premiums earned), provides an excellent overview
of management’s underwriting skills and the impact of this activity on overall profitability
and, ultimately, on financial strength and solvency.
The most highlighted element of the combined ratio is the proportion of losses and loss
adjustment expenses to earned premiums. However, the relationship of ‘other underwriting
expenses’ to written premiums should receive no less attention. Accounting for a sizable
part of the premium revenue, these expenses consist primarily of commissions and related
expenses, both of which vary directly with premium volume. Other costs in this category
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Insurance companies
such as field supervision and collection, general and administrative expenses are smaller
in magnitude as well as somewhat less variable. In periods of high inflation, a company’s
success or failure often depends on its ability to control operating expenses, and for this
reason, careful tracking of the expense ratio is called for. This index is generally accepted
among insurance company analysts as the most reliable measure of operational efficiency.
Underwriting cycles
Consideration of the industry’s well-known underwriting cycle is also a necessary part of the
evaluation process. Industry underwriting profits tend to go from one extreme to another
about every two to four years with premium rates rising faster than claim costs in the up
phase and vice versa on the downswing (these cycles are not necessarily correlated among
countries). The cycles are brought about by abrupt changes in capacity such as those that
occur when management teams collectively determine that favourable results justify the addi-
tion of sizable amounts of business.
Unfortunately, over-optimism and rapid inflation (if present) generally make the same
insurance management teams poor forecasters of future losses or the costs upon which the
price of the insurance product is based. This deficiency in combination with price competi-
tion – urged on by high profits and the wish to avoid market share loss – then causes an
acceleration of the swing from good to bad underwriting margins. Furthermore, resistance to
rate increases by regulators who, in many developed market, still hold rate adjustments or
‘prior approval’ powers, tends to exaggerate this movement. Once underwriting deficits occur,
of course, greater risk selectivity and higher rates eventually start a reversal of the cyclical
down trend. Knowledge of the various stages of the underwriting cycle as well as its current
phase enables an individual company’s underwriting record to be put in better perspective.
Reinsurance
Another important aspect of a company’s underwriting operation is its reinsurance program.
The cession of reinsurance or transference of a part or all of a given risk to another
company is undertaken to achieve greater risk distribution, to stabilise earnings (and cash
flow) by limiting the amount of risk retained, and to reduce the amount of required reserves.
Reinsurance is also used to increase or decrease written premiums in a particular business
line and to avoid loss of volume (through the exchange of business with another company).
Reducing the variability of underwriting results by limiting the size of potential losses is
especially important to relatively new concerns because their restricted cash flows make
careful planning a necessity. Also, reinsurance can lessen the liquidity requisites of a ceding
company’s investment portfolio.
The two basic methods of reinsurance are facultative and treaty. Facultative involves
reinsurance of individual risks at the option of both the ceding company and reinsurer.
Treaty reinsurance, on the other hand, provides for the automatic cession and acceptance
of a certain amount or proportion of a particular line of business.
There are also two basic forms of reinsurance, namely pro rata and excess of loss. Under
the former type, the reinsurer receives a percentage of the ceding company’s premium and,
213
similarly, is liable for the same portion of any loss. Under the excess-of-loss type, the reinsurer
is only liable for that loss portion exceeding a specified amount per event or per period.
Important to a company’s reinsurance plan is the retention limit which is defined as the
maximum amount of loss a company has determined it can absorb on any one risk or class
of exposures. With an outsized claim or series of claims having the potential of significantly
affecting a company’s financial condition, the importance of the decision setting this limit
should not be underestimated. No rules of thumb exist as to what the proper amount should
be, though in no case should any loss or series of losses be allowed to disproportionately
affect the balance sheet. As might be expected, it is the largest insurance companies that
tend to have the highest retention limits.
The use of reinsurance as indicated by the cost of reinsurance in relation to premiums
earned varies widely between companies. However, for the industry as a whole, reinsurance
has continued to increase due to the greater amount of casualty business being written. The
adequacy or success of a company’s reinsurance activities, on the other hand, is generally
measured by the proportion of reinsurance costs that are recovered from the reinsurer in the
form of loss and loss expense payments. Because over time reinsurers must earn a profit if
adequate markets are to be maintained, a ratio approaching but still less than 100% would
appear to be the optimum for both buyers and sellers of reinsurance.
Capital adequacy
Capital or surplus is important because it acts as a cushion to withstand severe losses from
underwriting and from declines in the value of investments. It also provides a base for the
writing of insurance or in another sense, as a limit on the amount of new business that can
be added.
The most commonly used measure of its sufficiency is the premium to surplus ratio: the
higher the ratio, the greater the risk the company bears in relation to the available cushion.
The normal limit for the premium to surplus ratio is about 3:1. Lines having a ‘long tail’ (rela-
tively lengthy settlement periods) and relatively volatile underwriting results, as an example,
should generally have a larger capital base. An abnormally high ratio is cause for careful
examination, especially if the surplus has been boosted through ‘pyramiding’ or inclusion
of surplus belonging to subsidiaries. Earnings stability, adequate reinsurance protection, and
writing more property than casualty or liability business can mitigate this kind of exposure,
however, and can allow a higher premium to surplus to be maintained without undue risk.
Capital as a cushion against miscalculation of loss reserves is a function, in part, of
the larger loss reserves required by liability coverage and the more rapid growth of this
line. Because of the increased importance of this capital cushion over the last two decades,
analysts now look to the relationship of loss reserves to surplus as perhaps an equally or
even more appropriate measure of leverage. Furthermore, this calculation is often adjusted
to eliminate the effect of pyramiding or intangible assets on surplus.
As to capital impairments from eroding equity markets, companies with high premium
to surplus ratios should be examined concerning the proportion of assets represented by
common stocks as opposed to other investments. The percentage of surplus represented by
stocks should be compiled (and compared with the industry) in order to better gauge the
214
Insurance companies
potential impact of market declines on solvency. Another important factor in this regard is
the degree to which the market value of, say, the bond portfolio is below cost. Liquidation
of discounted bonds could become a necessity in times of stress due to unusually large
claims or persistent negative cash flows. The losses experienced as a result could put severe
pressure on the capital position.
Investment income
Bridging the gap between underwriting profit (loss) and operating earnings is investment
income, an element that has surged upward over the past two decades due to rising cash
flows, relatively sustained economic growth, subdued inflation, and healthy capital markets
in the leading developed countries. What has further compounded the benefits for insurers
has been the rise in the rate of return on investments at a pace faster than the rate of infla-
tion associated with claim costs.
Investment holdings
Besides liquidity reserves, made up primarily of cash and short-term money market instru-
ments, investment assets of property-casualty insurance companies are made up primarily of
bonds and stocks, both common and preferred where available. Although mortgages, real
estate, and other investments make up a large part of the investments of life insurers, they
represent only a small percentage of the total investments for property-casualty companies.
The asset mix of companies should be looked at to assess the risks and liquidity of invest-
ment holdings as well as the year-to-year changes taking place. Portfolios having sizable
holdings of common stocks and real estate, for example, can generally be said to have greater
credit risk and less liquidity than those with a predominance of government securities and
corporate bonds.
Structuring of portfolios
How insurance companies structure their portfolio is determined to a large extent by the
nature of their cash flow patterns. Volatility characterises the cash flow of property-casualty
concerns due to the unpredictability of claims as to frequency and size and, therefore,
liquidity is a prime requisite of portfolios. A major portion of property-casualty company
investments, therefore, is readily marketable and available to cover any catastrophes or
unexpected increases in claims. Another factor influencing the nature of investments can be
the tax status of property-casualty insurers in various countries. A tax rate at or close to
the full corporate rate is an incentive for property-casualty insurers to seek tax-advantaged
investments.
Investments in other companies

Large commitments in affiliated companies or enterprises under the control of the company
should be carefully evaluated. The appropriateness and liquidity of these commitments should
215
be established, not to mention the valuations of these commitments which are carried on
the balance sheet.
Performance measures
Investment yield provides the best measure of investment performance as well as some idea
as to the general quality of the investment portfolio. Yield ranges, however, depend on the
market where the insurer holds most of its investments. In developed markets, investment
yields have been very low in recent years. Yields above the upper limit in those markets
may mean a sacrifice of liquidity and safety for high returns, and the ultimate worth of
such yields should be investigated. Inordinately low yields, on the other hand, may indicate
speculative investments offering large capital gains over the long run but producing nominal
current returns. If this is the case, attention should be paid to the stability, liquidity, and
proper valuation of these investments.
Reserving and reserve analysis

Few things are more important to the profitability, stability, and solvency of a company than
the consistency and conservatism of its reserving policies. The accuracy with which reserves
are established for claims is crucial to the integrity of an insurer’s entire business.
The adequacy of reserves is impossible to determine fully. But the analysis of reserving
practices and reserve changes and comparisons of current with aged reserves and the company
and the industry can reveal a great deal about reserve levels and policies. This analysis is
particularly important because of the wide range of estimates about the future that must be
made in establishing reserves, namely, the value of each reported claim in current money
(including incurred but not reported claims), the time it takes to settle claims, and the rate
of inflation (both economic and social) during this time. The accounting flexibility created
by this process enables boosting of earnings through understating losses and vice versa. And
while any misuse of this flexibility is not viewed favourably, it does allow ‘borrowing’ or
‘lending’ of future earnings.
One approach to this analysis is to monitor the trend of paid losses, incurred losses, and
loss reserves under the assumption that all three should move in concert, relatively speaking,
if reserve adequacy is to be maintained. Comparison of these trends is especially significant
because paid losses are a cash flow item difficult to manipulate while incurred losses (an
income statement item) and loss reserves (a balance sheet item) are largely estimates and,
therefore, reasonably controllable.
Incurred losses, paid losses, and loss reserves should be taken as a percentage of earned
premiums over a several year period with annual percentage changes then figured for each as
an aid in establishing relative movements. If the paid losses ratio (also called ‘claims ratio’)
moved up faster than the others, it could mean that inadequate reserving was taking place;
conversely, significantly slower gains could mean the occurrence of reserve strengthening. The
latter might suggest that underwriting profits were improving faster than they appeared to
be. However, such an observation should be made carefully since the situation could just be
an acceleration of unit growth. Adding substantial amounts of new business tends to depress
216
Insurance companies
the ‘paid’ portion of incurred losses because of the time lag between earning premiums and
settling claims. Another circumstance that might produce the same effect is increases in the
proportion of long tail liability business on the books.
Analysis of loss ratios over time can provide a reasonable evaluation of loss reserves.
Furthermore, this approach is made more useful by the availability of the appropriate figures
on a quarterly basis.
Other strength and stability factors

Liquidity
As previously noted, the possibility of catastrophes or unexpected increases in claims makes
mandatory the maintenance of substantial liquidity by property-casualty insurers. How well
a company can meet the potential demands placed on it by such events can be measured
to some degree by the ratio of liabilities to liquid assets. A ratio of around one to one is
considered normal though care should be taken to determine the trend for several years;
forewarnings of insolvencies have in the past come from a rising ratio.
Companies having high liability to liquid asset ratios should be further examined as to
the adequacy of claim and liquidity reserves. These reserves are the most important determi-
nants of the companies’ ability to meet the obligations of policyholders and other creditors.
Agents’ balances (premiums held by agents pending the premiums being forwarded to
the company) should be examined because they are receivables that often may be difficult
to collect in the event of liquidation. Taken as a percentage of surplus, agents’ balances can
indicate the degree to which solvency depends on these relatively high risk assets. This ratio
is generally less than 40%.
Change in surplus
One of the most important signs of year-to-year developments in financial condition is the
change in surplus. Annual increases or decreases roughly comparable to the net gain (or
loss) from operations are looked for with substantial divergences from this pattern cause for
further examination. The more important factors affecting surplus besides operating results
include unrealised capital gains (losses) on equity investments, changes in non-admitted assets
and surplus aid from reinsurance, surplus paid-in, and dividends to stockholders.
Non-admitted assets and non-insurance subsidiaries

Non-admitted assets are those excluded from the statutory statement for purposes of conser-
vatism in most developed insurance markets. They include: agents’ balances or uncollected
premiums over three months due; equipment, furniture, and supplies; past due bills receivable;
and so on. Any significant increase in these items should be questioned since a sizable expan-
sion could become a matter of concern given the relative risk or somewhat less productive
nature of these assets.
217
Close attention should be paid to non-insurance subsidiaries or affiliates because attempts

to improve overall returns through diversification have increased investments in these activi-
ties materially over the past two decades. The balance sheet and income statements of each
should be evaluated for profitability and financial strength with particular attention being
paid to the latter because infusions of new money in most cases would have to come from
the insurance parent or affiliate. The determination to be made is whether these entities are
making a meaningful contribution to overall corporate objectives or if they are a drain in
terms of earnings, capital, and management. GAAP statements are generally required for this
analysis, whenever possible, since it is only in these presentations that subsidiary or affiliate
financials are broken out separately as wells as consolidated with the insurance concern.
Management
The numerous technical requirements of property-casualty insurers and the difficulties of
determining costs that are not realised until after sale of the product are just two of the more
obvious reasons why managerial competence is so important in this industry. Such skill is
evidenced to a large degree by operating results which can be documented fairly easily in this
business due to the abundance of statistical data generated by regulatory accounting rules.
More subjective and, therefore, more difficult factors to assess include management depth;
the extent and sophistication of planning, budgeting, and control systems; and how well
developed are performance standards and long-term objectives. In a broader sense, too, there
is the matter of management’s ability to integrate the technical aspects of the business with
the strategies and policies dictated by the needs and demands of the external environment.
Box 2.8
Life business and property-casualty business: summary of risks
Competition
The life insurance business is mature and highly regulated so acquisition costs (such as agent
and broker commissions) are high in order to secure new business. Property-casualty insurers
are not as important in size compared with life insurers but are heavily regulated. Property-
casualty insurers are more sensitive to the stage of the underwriting cycle: when the cycle
is in a downward phase, competitive pressures can result in deterioration in the quality of
the underwriting taken on. The use of reinsurance to diffuse this risk is a standard feature
in the property-casualty sector.
Changes in government regulations

Precisely because of heavy regulation, any change in regulatory rules can have an adverse
impact on operations and profitability.
Continued
218
Insurance companies
Investment
Poor investment decisions may cause shortfalls in investment income which is necessary to
help build policy reserves.
Underwriting
Poor underwriting decisions may result in unusually large losses causing erosion of reserves
and the need to liquidate assets.
Policy surrenders
A significant increase in policy surrenders is the insurance industry’s equivalent of a run on
the bank.
Reserves
It is crucial that life insurers maintain a sufficiently high level of reserves to reflect a true and
accurate valuation of future liabilities.
Interest rates
During periods of high interest rates, mortgage-related endowment policies are in less demand
and the value of fixed income investment may fall.
Inflation
In an inflationary environment, there is a risk that operating expenses will exceed the expec-
tations built into product pricing. This will put pressure on profit margins, which is especially
dangerous if returns to policyholders have been guaranteed. For property-casualty insurers,
in particular, inflation’s impact can be significant as claims serve to replace historical cost
assets at current prices.
Currency risk
Although most insurers are primarily domestic companies, the globalisation of investment
portfolios and asset selection has increased insurer exposure to foreign currency fluctuations.
Hedging techniques, such as the use of forwards, futures, and swap contracts are an increas-
ingly important feature of insurance company risk management.
Management
Given the above, the main risk with life insurance companies, therefore, resides with invest-
ment and marketing performance, which is a function of management quality as opposed
to actuarial judgement.
219
Box 2.9
Life insurance – early warning signs: exceptional values
The following table lists several of the exceptional values used in an early warning system of
the National Association of Insurance Commissioners (US based regulatory body). If a company’s
test results are outside these values, closer investigation of their financial statements may be
necessary. The test has proved quite effective in giving early indications of impending financial
and underwriting problems.
Test Exceptional Values

∑∑ Change in surplus less than or equal to –10%
greater than or equal to +50%
∑∑ Net gain/total income less than or equal to zero
∑∑ Commissions + expenses/premium greater than or equal to 60%
∑∑ Investment yield less than or equal to 4.0%
greater than or equal to 9.9%
∑∑ Change in premium greater than or equal to +50%
less than or equal to –10%
∑∑ Change in product mix greater than or equal to +3%
∑∑ Change in asset mix greater than or equal to +5%
Ratio analysis
There are several specialised ratios used to analyse an insurance company’s financial condi-
tion. But, unlike corporate or bank analysis, the ratios selected depend on the type of insurer
being analysed. Claims ratios are more appropriate for property-casualty insurers, while
capital adequacy ratios are more revealing for life insurers. The main ratios are listed below,
segregated according to type of insurer.
Life insurer ratios

Growth in net premiums written
This percentage change measure indicates the growth achieved from one year to the next.
Rapid growth can put a significant strain on a company’s capital. Growth rates in various
premium categories may be influenced not only by the company’s marketing strategy, but
also by economic and investment market conditions.
Investment income/total investments

The ratio indicates the rate of return the company has been able to achieve over the year
under review. Though not an accurate figure, given the fluctuations in the market value of
220
Insurance companies
investments, it is a fairly good guide for comparison purposes with other companies in the
same line of business.
Payments to policyholders/total income

Similar to the claims ratio for property-casualty insurers, this ratio provides a guide to the
company’s ability to limit policy payments compared with revenues.
Surrenders/premium income
A significant increase in this ratio could represent the equivalent of a deposit run-on-the-
bank, namely a loss of confidence among policyholders. However, care should be exercised
when interpreting the ratio since a spike from one year to the next could be grounded in
economic conditions rather than loss of confidence in the company.
Expenses/premium income
This ratio describes the company’s overall ability to control its operating and commission
expenses (to brokers and agents) as a proportion of premium income.
Investment reserve/premium income

This ratio compares the investment reserve (the amount set aside to accommodate poorly
performing investments) with the level of business being written. A figure of less than 100%
may indicate insufficient prudence in matching reserves to the level of business.
Surplus/total assets
One of two important leverage ratios (the other one is surplus/invested assets) which tracts
capital adequacy for a life insurance company. Currently, a 5% relationship is considered
satisfactory for stock companies.
Property-casualty insurer ratios

Growth in net premiums written
The rate of change from period to period is an important indicator of what growth was
achieved or lack thereof. Over the long term, premium increases should reflect inflation and
loss experience.
Net premiums written/gross premiums written

This ratio breaks out the company’s use of reinsurance and the variations from year to year.6
Reinsurance protects a company’s capital from excessive losses, but in turn exposes it to
221
the risk of non-payment if the reinsurer defaults. Companies should not be over-dependent
on reinsurance.
Claims ratio: paid losses/earned premiums

This ratio indicates the company’s performance in limiting its claims experience against any
given level of premium income. For claims, the losses paid (or net claims incurred) figure is
used because it provides a much more accurate guide to claims experience during any year
than the variable claims paid figure. The claims ratio can be expected to vary from period
to period, in line with experience and the nature of the business written. A reinsurer can be
expected to show greater volatility in its performance than other insurers, since it assumes
the high-risk elements of the experience of the company that it reinsures. When information
is available, this ratio can be split in two: one covering fire, accident, and liability and the
other covering MAT, to compare claims/premiums performance in the two areas.
Total loss ratio

This ratio has two component ratios: (i) the claims ratio; and (ii) the reserve increase ratio.
The first is composed of paid losses to earned premiums; and the second is reserve increases
to earned premiums. When paid losses rise faster than earned premiums, illustrated by a rising
paid loss or claims ratio, the fundamental profitability of the company is under pressure.
For most property-casualty insurance companies, and for the industry as a whole, paid
loss ratios have been significantly more volatile than total loss ratios. In times when paid
loss ratios have risen, the tendency has been for reserve additions to be skimpier – and vice
versa – and thus reserve accruals have tended to cushion the impact of changes in paid
losses. Although legitimate reasons relating to the timing of loss payments explain some of
this phenomenon, too much of a cushion effect should make an analyst suspicious.
Significant changes in the reserve increase ratio can signal major changes in the nature
of the company’s business, requiring a higher level of reserves for each premium amount. It
can also indicate that past reserve accruals have been inadequate and that reserves must be
strengthened in order to be adequate to meet future claim payment requirements.
Expense ratio: commissions, underwriting and operating expenses/net

premiums written
This ratio indicates the company’s performance in limiting its net commissions paid, under-
writing expenses, and overheads while attaining a given level of premium income or net
premiums written (NPW).
The expense ratio is a basic measure of the company’s efficiency. As in other financial
businesses, cost control is getting increasing attention in the property-casualty business. If
property-casualty insurance can be considered a commodity, then the low-cost producer has
a significant competitive advantage. One problem is that some expenses are semi-fixed in
nature, which makes reducing expenses when volume is declining very difficult.
222
Insurance companies
When costs are broken down by type, the most important expense categories are commis-
sions and underwriting expenses. Commissions tend to be variable expenses. All else being
equal, commissions vary almost directly with volume, although changes in corporate policy or
business mix can bring the commission ratio down. Underwriting expenses are predominantly
fixed, and the key to reducing the expense ratio is lower underwriting expenses.
Combined ratio: total loss ratio + expense ratio

This ratio, also called ‘trade ratio’, combines the total loss ratio and the expense ratio. The
total loss ratio includes losses paid plus reserve increases, which together indicates the ratio
of losses and loss expense incurred to earned premiums. The expense ratio measures the
ratio of commissions/underwriting/overhead expenses to net premiums written.
Although the combined ratio is like comparing apples and oranges (since the denominator
of the two ratios being used differs by the amount of unearned premiums), it gives a good
approximation of the company’s overall underwriting performance. A combined ratio under
100% indicates an underwriting profit; a ratio over 100% suggests an underwriting loss.
Operating ratio: combined ratio – investment income/net premiums written

By factoring investment performance into the combined ratio, the operating ratio recognises
the increasing tendency to accept narrowing underwriting margins, and even losses, if invest-
ment income is strong. A figure higher than 95% may indicate a problem.
Paid losses/incurred losses

One common way of analysing reserves is to review the relationship between paid and
incurred losses and how that changes over time. Paid losses are actual loss amounts paid
out while incurred losses are losses which have occurred within a stipulated time period
whether paid or not.
Incurred loss ratio: incurred losses/earned premiums

This ratio is the proportion of losses incurred to premiums earned. It indicates the amount
of premium money which is being consumed by losses. Increasingly, analysts are looking
to capital as a cushion against miscalculation of losses and are now placing importance on
the relationship of loss reserves to surplus as perhaps an equally or even more appropriate
measure – especially of leverage (this calculation is often adjusted to eliminate the effect of
intangible assets on surplus or equity).
Unearned premiums reserve/net premiums written

This ratio demonstrates the company’s approach to reserving for premiums which have not
yet been earned but which have been paid. In the majority of cases, a straight-line method of
223
premium recognition is used and this ratio is valuable mainly in giving a clue to the nature
of the business that the company is writing.
Outstanding claims reserve/net claims incurred

Most insurance claims are not settled or even reported quickly. Accordingly, an insurance
company must provide liability reserves not only for ‘claims reported but not paid’, but
also for ‘claims incurred but not reported’. In comparing the figures calculated for this ratio
between different companies, it is important to be aware of the type of business the company
is underwriting. Thus, a company concentrating exclusively on automobile insurance will
almost certainly have a much lower claims reserve for a given level of incurred claims than
a company underwriting product liability policies.
Premium solvency ratio: net worth/net premiums written

This ratio indicates the level of equity cushion available to support the company’s under-
writing activities. For example, all insurance companies in the EU are required to meet a
minimum 16% solvency margin.
Reserves solvency ratio: outstanding claims reserves/net worth

This ratio indicates the level of equity cushion available to support any adverse development
impacting existing reserves. The important question is how much of an increase in reserves
could be support by net worth (owners’ equity) before it is exhausted. This is more of a
concern for those companies seeking longer-term property-casualty business, such as liability
insurance. The outstanding claims reserves should include the marine, aviation, and transport
insurance reserve if it exists.
Premiums surplus ratio: net premiums written/net worth

This is a commonly used ratio of capital adequacy. The higher the ratio, the greater the risk
the company bears in relation to the available cushion. Surplus here refers to the company’s
equity base or net worth.
224
Exhibit 2.3
Combined insurance statement of financial condition, statement of income and ratio
sheet
Assets YR1 YR2 YR3

1 Investments:
2 Debt securities
3 Equity securities
4 Mortgage loans
5 Real estate
6 Policy loans
7 Other
8
9 Total investments
10
11 Cash and cash equivalents
12 Short-term investments
13 Agents balances and premiums due
14
15 Other receivables
16 Accrued investment income
17 Other assets
18 Taxes recoverable
19 Sundry intangibles
20
21 Total assets
Liabilities and Equity

22 Liabilities:
23 Net policy reserves
24 Policy claims
25 Policyholder funds and deposits
26 Unearned premiums
27 Total insurance liabilities
28 Short-term debt
29 Long-term debt
30 Other payables
31 Current taxes
Continued
32 Deferred taxes
33 Other liabilities
34 Non-controlling interests
35
36 Total liabilities
37
38 Share capital
39 Capital surplus
40 Reserves (including OCI)
41 Retained earnings
42 Total equity
43 Total liabilities and equity
44 Contingent liabilities
Combined insurance statement of income
Statement of income YR1 YR2 YR3

45 Revenue:
46 Premiums1
47 Investment income
48 Fees and other income
49 Realised gains
50 Total revenue
51 Payments to policyholders:
52 Death benefits/claims paid
53 Matured endowments
54 Disability benefits
55 Surrenders
56 Annuities
57 Other
58 Total payments to policyholders
59 Commissions/acquisition costs2
60 Interest expense
61 General insurance expenses
62 Change in reserves
63 Other disbursements/income
64
Continued
65 Total benefits and expenses
66 Income before taxes and non-recurring items
67 Income tax
68 Extraordinary gains/losses
69
70 Net income
Combined insurance statement of comprehensive income
71 Foreign currency translation adjustments

72 Unrealised gains/losses financial derivatives
73 Unrealised gains/losses net investments
74 Other adjustments
75 Net gains/losses recognised directly in equity
76 Net income
77 Total other comprehensive income (OCI)
Combined insurance ratio sheet
Ratios3 YR1 YR2 YR3

Life insurer:
78 Growth in net premiums written
79 Investment income/total investments
80 Payments to policyholders/total income
81 Surrenders/premium income
82 Expenses/premium income
83 Investment reserve/premium income
84 Surplus/total assets
Property-casualty (general) insurer:

85 Growth in net premiums written
86 Net premiums written/gross premiums written
87 Claims ratio: paid losses/earned premiums
88 Total loss ratio
89 Expense ratio
90 Combined ratio
91 Operating ratio
92 Paid losses/incurred losses
93 Incurred loss ratio
Continued

94 Unearned premiums reserve/net premiums written
95 Outstanding claims reserve/net claims incurred
96 Premium solvency ratio
97 Reserves solvency ratio
98 Premium-surplus ratio
1 Less: reinsurance ceded for property-casualty insurers.
2 Less: claims income from reinsurers for property-casualty insurers.
3 Explanations for each ratio are given in the section entitled Ratio Analysis.
Conclusion
The analytical tools that have been discussed here are by no means designed to present a
‘cookbook’ approach to appraising the creditworthiness of life insurers and property-casualty
insurers. Rather, the tools are designed to provide a framework for probing the strengths
and weaknesses of company management. The bank and analyst should be able to choose
those tests that seem appropriate, and from them, evaluate the company’s ability to effectively
management investment and underwriting risks.
The most meaningful goal of an analysis is to compare the borrower with some standard
measure of performance. In the absence of industry studies, perhaps the most useful and
meaningful method of comparison is to relate the company’s financial strengths and weak-
nesses with similar companies in the industry and to track its own performance through time.
A comprehensive credit analysis should consist of an appraisal of management, the
industry, and the financial condition and performance of the company. By evaluating appro-
priate financial tests and ratios and examining the trends they exhibit, the analyst can compile
a composite picture of the potential borrower from which to base the credit decision. Thus
a combination of appropriate test, cash flow analysis, and a comprehensive appraisal of
the business and management should result in a much more meaningful view of insurance
companies.
Box 2.10
Analysis of the insurance market – internal and external factors
Industry structure
The basic dichotomy in insurance is the difference between life and non-life companies.
Although many people think of insurance as one homogeneous product, the two major
segments differ basically in structure and in the products they offer.
Continued
228
Insurance companies
Size
Comparisons of the relative size of the two segments depend on the measure used. Life insur-
ance and non-life insurance premiums differ significantly (54% and 71% of total revenues,
respectively, in the US, for example (see Exhibit 2.10 in Appendix 2.2). The two biggest lines
of insurance are health and automobile.
Measured in assets, the life business is much larger than the property-casualty business.
The asset spread reflects the fact that life companies are large money managers, and property-
casualty companies are not.
Measured in capital, non-life companies are larger than life companies. The life business
is much more leveraged on an assets-to-surplus basis than the property-casualty business.
Historically, this has been the case for good reason: life company liabilities were much more
predictable than those of property-casualty writers. Since the end of the 1970s – the dawn of
a revolution in the life insurance business in many developed markets – questions have been
raised as to whether these companies should remain as leveraged as they are. The press,
rating agencies, regulators, and legislators have also turned their attention to that concern.
Internal factors in valuation

Company valuation depends on a variety of internal conditions and considerations, including
competition, volume, surplus and return management, and loss reserves policies. For a property-
casualty company, the important considerations are what it writes, where it writes it, and how
it writes it – or put in another way, product, geography, and distribution.
Competition
Competition has two aspects: the type of company and the degree of concentration. Because
the life and non-life businesses are so different, they will be treated separately, beginning
with the non-life segment.
The first word that comes to most analysts’ minds when thinking about the property-
casualty insurance business is competition. This is an intensely competitive business since
the developed markets have so many (the US alone has some 5,000 non-life insurance
companies). Because it is a mature business and a commodity business, it is not a growth
business. There may be a few growth stocks, primarily among specialty companies, but by
and large this is a mature, commodity, fragmented, competitive business.
The most obvious form of competition in any business is market share. Most insurance
managers do not favour the term ‘market share’ and very few companies admit they want to
increase market share. In reality, however, most insurers want greater market share through
various pricing strategies, but in so doing find that other companies quickly match their efforts
and the strategies fall apart.
The importance of volume

The companies have several good reasons to pursue increased market share in what
might appear to be an unprofitable business. One is that they need volume so they can
Continued
229
Box 2.10 continued
reduce their exposure to loss from an individual policy; they need to spread risk over more
policies.
The US National Association of Insurance Commissioners (NAIC) has developed risk-based
standards for insurers. One of the many tests under the risk-based capital guidelines is a
credibility test: how credible are the company’s reserves? In this case, credibility is a function
of the size of the business. A company that writes US$1 million of premiums in any given
year has a zero credibility factor attached to its reserves because it does not have a large
enough book of business. A company that writes US$400 million of premiums a year has a
50% credibility factor. No one has it right all of the time, so no one gets a 100% credibility
factor. So an important way to define credibility in this business is through the law of large
numbers. This provides additional incentive for companies to get bigger.
The critical mass for an insurance company depends on what the company does. Does it
concentrate on one line of business, or is it a national writer of all major lines of business?
Critical mass includes maintaining an agency plant, branch office network, and data processing
(information technology) capability.
Surplus and return management

Another important internal factor is the company’s capital, or surplus. Obviously, the amount
of surplus (or net assets) determines to a great degree how much business a company can
write. If surplus goes up significantly, a company can write more business. If surplus goes
down, the company may have to write less business.
A number of factors determine a company’s surplus. On the asset side, property-casualty
balance sheets are dominated by publicly traded securities. A drop in the markets can have
a direct and negative impact on surplus. One thing for analysts to watch for is the way
companies handle bad markets.
Reserve policy
Reserve policy is another key internal consideration in the non-life business. Loss reserves
are estimates subject to change. Normal loss reserves can be about two-thirds of a property-
casualty company’s liabilities and amount to roughly four times surplus.
In the life business, companies go bankrupt because of problems on the asset side of the
balance sheet. In the property-casualty business, companies go bankrupt because of problems
on the liability side of the balance sheet – primarily inadequate loss reserves. Reserves are
easy to skimp on because the companies do not have to pay off losses for a couple of years.
Reserves obviously drive surplus, so skimping a little bit on reserves can have a significant
effect on surplus.
Product, geography, and distribution

Product, geography, and distribution define any insurance company. Some property-casualty
companies concentrate in personal lines, such as automobile insurance, rather than commer-
Continued
230
Insurance companies
cial lines. The economics, regulation, and consumer issues around personal lines are very
different from those surrounding such commercial lines as workers’ compensation and general
liability insurance.
Geography has been a factor in underwriting results. Historically, insurance companies
have tended to focus on geographic regions they know best, although this is changing as
competition in the industry, as a whole, becomes livelier.
Distribution varies by company. In the property-casualty business, most companies write
through independent agents, who often write business for as many as six other insurance
companies. The biggest companies have captive agents, who write only for their companies.
A growing trend is to be found in companies which write business without any people at all.
They write through the mail, television, radio advertising, and existing policyholder referrals.
The Internet is rapidly becoming a marketing forum for these and many of the established
companies.
Reinsurance
Reinsurance is insurance bought by insurance companies. Insurance companies do not bet
the company on any given risk, so to spread their exposure, they buy insurance. For example,
one of the largest catastrophes the industry has ever faced, Hurricane Katrina in 2005, cost
the industry some US$80 billion in claims, according to updated estimates. Very few compa-
nies went out of business as a result of the hurricane because they bought reinsurance. The
availability of reinsurance is cyclical, which is very important; this fact was not well understood
until the failure of a large property-casualty insurer (Mission Insurance) in 1985. Its problems
were inadequate reserves and poor-quality reinsurance. As a result, analysts began to look
more closely at who the company’s reinsurers are.
Management direction
Analysts must also evaluate the quality of management. In most companies, not just insurance
companies, top management want to be big. The definition of bigness in most businesses
is assets or revenues, rarely profits. Many chief executives in the insurance business want to
be well known. Running a big company, not necessarily the most profitable one in the busi-
ness, does this. Understanding what motivates a chief executive is critical to understanding
an insurance company. If it is the chief executive who is getting his picture in the newspaper,
the analyst may want to be careful.
External factors affecting earnings

The external factors can be as important as the internal factors in analysing an insurance
company. Financial analysts often claim that one needs to know two things to invest in
insurance company stocks – interest rates and premium rates: interest rates down, stocks
up; premium rates up, stocks up. Furthermore, if an investor is only allowed to know one of
those two things on a near-term basis, he or she should know the direction of interest rates
Continued
231
Box 2.10 continued
rather than the direction of premium rates. In addition to interest rates, insurance companies
are affected by regulatory activities, inflation, demographics, and globalisation.
Interest rates
The effect of interest rates shows up on the balance sheet, the income statement, and ulti-
mately the book value of an insurance company. Interest rates are important to investors
because changes have a direct impact on a insurance company’s market value. Mark-to-market
book value rather than a given year’s operating earnings drive most insurance company stocks
in developed economies. Marking to market essentially means marking securities to their
current market prices. When interest rates go down, investor wealth accumulates, because the
value of bonds – which often represent three-quarters of an insurance company’s assets –
goes up.
Insurance company managers, however, must concern themselves with how well they
are managing the money flowing in. They do not like to see lower interest rates, because
they would rather invest at 10% than 6%. This is a classic problem of the average versus
the margin. For example, at one point for property-casualty companies in certain markets,
the combined ratio (cost of funds) for bringing in new money was running at 113%; that is,
a 13% pre-tax cost. The companies were investing at 8% to 9%, which is a negative spread
and eventually hurts the balance sheet.
When stocks are up and bond prices are down, both investor and manager are correct.
Ideally, in such an environment, the analyst wants to find an insurance company that is not
writing any new business, one that is only collecting on what it has done in the past.
Return on equity (ROE) is another important consideration, but is hard to define because
analysts use different sets of numbers. The majority defines ROE as net income divided by
average equity. Some analysts and investors in the insurance industry define ROE as operating
earnings excluding capital gains divided by stated book value. Yet other analysts and inves-
tors define ROE as an increase in marked-to-market book value plus dividends paid divided
by average book value. The difference between the last two methods is not large, however.
Inflation
Inflation is important to this business because liabilities are cost-based, not currency unit-
based. If someone has a car accident, the insurance company pays the cost of fixing the car
minus a deductible amount. It does not pay a flat amount per accident. Therefore, as inflation
pushes costs up, claim amounts increase.
Spiralling medical costs and the growing propensity in some countries to sue each other
(social inflation) are other examples of an inflationary impact on insurance company costs.
Catastrophes
Another external consideration is the size, number, and type of catastrophes such as fires,
earthquakes, hurricanes, and tornadoes. Catastrophes are important to property writers, who
Continued
232
Insurance companies
specialise in writing property insurance rather than liability insurance. Obviously, reinsurance
is particularly important.
Regulatory activities
The insurance industry is regulated in various ways in most developed markets. Regulation is
designed primarily to maintain insurer solvency, to encourage adequate consumer knowledge,
to ensure reasonable rates, and to make insurance available for a more efficient economy. This
is good for investors who seek transparency and a certain degree of market certainty. Heavy
regulation, however, can act counter to investor desires by putting an undue burden on the
industry to achieve regulators’ goals. This adds to costs and therefore puts a drag on profits.
Other factors
A host of other external factors also affect the insurance industry. These include distribution
networks and product diversification to the economy and taxation.
As mentioned earlier, some companies have career agents who write business mainly
for one company; others use independent agents, general agents, personal-producing general
agents, and a few are direct writers. An important source of competition in the life insurance
business is other asset gatherers. By the early 1980s, this business redefined itself from one
that mainly provided protection for survivors in the event of premature death. It is now an asset
gatherer. As a result, it competes with banks, mutual funds, and other insurance companies.
Product diversification is another factor. Life insurance, annuities, pensions, health insur-
ance, and disability insurance all have very different cost structures. Property-casualty business
is highlighted mainly by level commissions. In life insurance, agents are paid to sell, not to
service.
Another factor is asset quality. Real estate is a concern in the life insurance business. Again,
external considerations are interest rates. This is as rate sensitive a group as the property-
casualty business. This is an industry in which asset/liability matching is a valid concept. If a
company is matched, it should be relatively insensitive to interest rate movements.
The economy is another factor, probably more so than in property-casualty insurance.
Buying many forms of life/health/pension policies is discretionary – it can be postponed.
Property-casualty insurance is a demand product. One must have it to drive a car or rent a
flat or buy a home. The more money people have, the more likely life insurance sales go
up. The economy is also important because a sluggish economy leads to more claims in
health insurance and disability insurance – despite well-developed state insurance schemes.
Taxation is important in this business because most countries tax insurance profits. Other
government action issues that affect the insurance industry are the level and quality of state-
provided health insurance, banking reform, and degree of regulation.
Demographics are a very pertinent consideration. An aging population wants retirement
income today more than death protection. The aging population has also put a strain on
even the best managed state-sponsored pension programs.
Lastly, the prevalence of self-insurance and whether a company operates captive insur-
Continued
233
Box 2.10 continued
ance companies also affect insurance providers. Captive insurance companies – an industrial
company owning an insurance company – are still in business, as are risk-retention groups.
Risk-retention groups can be looked upon loosely as group captives: several people get
together and collectively insure themselves (the insurance original developed from this idea).
But risk-retention groups are a growing threat to the traditional commercial carriers and a
threat in a period of high interest rates, when the opportunity to invest the premiums prior
to paying the claims is more valuable.
Conclusion
In summary, factors internal to the insurance industry to be considered by investors include
the observation that, overall, this is a fragmented and mature business. Growth prospects must
be analysed within that industry context. Key distinguishing characteristics among companies
include product (what the company sells), distribution (how the company sells its product),
and geography (where the regulatory and other characteristics of the company’s geographic
territory reside). Of overriding concern in this regulated financial service business is asset
quality: assets in the case of life insurers, and liabilities (reserves) in the case of property-
casualty insurers.
Key external concerns when investing in insurance stocks include interest rates, the overall
economy, regulatory policies, and social considerations such as changing attitudes toward
litigation, demographics, and life-styles.
1
Rudolph, CFA, Max J. and Rick Beard, CFA, CIPM. ‘Why US Insurers Fared Better Than Banks,’ CFA Magazine,
May-June 2012.
2
Tendency of persons with higher-than-average chance of loss to seek insurance at standard (average) rates, which,
if not controlled by underwriting, results in higher-than-expected loss levels.
3
The Kenny ratio was proposed by Roger Kenny, an insurance journalist, that in order to maintain the solvency
of a property-casualty insurance company, insurance premiums written should not exceed more than twice the
company’s surplus and capital. This historical measure is used by some regulators to determine a property-casualty
company’s capacity to make claim payments while maintaining its solvency.
4
LCU = local currency unit.
5
Written premiums are the total revenues received from the sale of policies. Earned premiums are the portion of
written premiums for which the term of coverage has elapsed.
6
A breakdown of reinsurance data may not be available in some markets.
234
Appendix 2.1
Insurance companies and IFRS
Since January 2005, all European Union exchange-listed companies publish their financial
statements in accordance with IFRS norms.1 This includes insurance companies and the
vast majority of the standards affect them in one way or another. Most notably, however,
are IAS 32, IFRS 4, IFRS 7, and IFRS 9 (phased replacement of IAS 39 to be complete by
January 2015).
Implementation of IFRS standards and their periodic updates result in much longer and
more detailed financial statements than before. Insurers will be required to do more work
on statement preparation and a potential re-engineering of data gathering and consolidation
procedures. However, it is the nature of disclosures, much of which has never been made
public before, that could prove the most difficult issue. Under IFRS 4, for example, the
International Accounting Standards Board (IASB) expects companies to provide ‘information
that helps users understand: (a) the amounts in the insurer’s financial statements that arise from
insurance contracts; and (b) the nature and extent of risks arising from insurance contracts’.
IFRS 4 also requires disclosure that identifies and explains the amounts in an insurer’s
financial statements arising from insurance contracts and helps users of those financial state-
ments understand the amount, timing and uncertainty of future cash flows from insurance
contracts. The standard is in the process of being updated and revised under its new title IFRS
4 Phase II: Insurance contracts. Expected implementation: late 2013, early 2014 depending
on development of the IASB exposure draft in progress. The credit analyst is advised to keep
abreast of developments in the revision project (see Box 2.11).
On the other hand, IFRS 7 tempers excess detail: ‘It is necessary to strike a balance
between overburdening financial statements with excessive detail that may not assist users of
financial statements and obscuring important information as a result of too much aggrega-
tion. For example, an entity shall not obscure important information by including it among
a large amount of insignificant detail. Similarly, an entity shall not disclose information that
is so aggregated that it obscures important differences between individual transactions or
associated risks.’ (From Appendix B.B3 of the IFRS 7 standard.)
Box 2.11
IFRS 4 Phase II: Insurance contracts
Summary proposals
IASB and its US counterpart, FASB, have formed a joint insurance contract project in an effort
to move towards global insurance accounting. The project to date produced the following
highlights.
Continued
235
Box 2.11 continued
∑∑ The two Boards decide that investment components that are distinct from an insurance
component should be unbundled from insurance contracts and the investment component
should be measured under the applicable financial instruments standard.
∑∑ IASB confirms that both risk adjustment and a residual margin should be used in measure-
ment.
∑∑ IASB introduces a fair value through other comprehensive income (FVOCI) classification for
the measurement of eligible debt instruments.
∑∑ The Boards decide to require the use of other comprehensive income (OCI) for recording
changes insurance liabilities (excluding liabilities that are contractually-linked to underlying
assets) arising from changes in discount rates.
∑∑ The Boards further discuss the presentation and measurement of acquisition costs. The
IASB confirms that acquisition costs should be included in determination of the insurance
liability rather than recognised as a separate asset.
Financial statement presentation

IAS 1: Presentation of financial statements (revised June 2011) sets the objectives prescribes
the basis for presentation of general purpose financial statements to ensure comparability both
with the entity’s financial statements of previous periods and with the financial statements
of other entities. It sets out overall requirements for the presentation of financial statements,
guidelines for their structure and minimum requirements for their content. The complete set
of financial statements is shown in Exhibit 2.4.
Exhibit 2.4
Complete set of financial statements
Pre-revision Post-revision
Balance sheet Statement of financial position
Income statement Statement of income
Statement of comprehensive income
Statement of changes in equity Statement of changes in equity – owners’ equity
Statement of other comprehensive income (OCI) –
non-owners’ equity
Cash statement Statement of cash flows
Other: minority interests Non-controlling interests (presented within equity)
236
Insurance companies and IFRS
IFRS 1: First-time adoption of IFRS (amended December 2010) sets out the guidelines
for the first-time adoption of the new standards. The key principle of IFRS 1 is the require-
ment for the full retrospective application of all standards in force at the closing balance
sheet date for the first IFRS financial statements. However, there is a series of optional
exemptions, which are designed to ease the burden of retrospective application, along with
further mandatory exceptions.
Optional exemptions
First-time adopters can elect to apply all, some or none of the optional exemptions:
⦁⦁ business combinations;
⦁⦁ fair value as deemed cost for property, plant and equipment and investment property;
⦁⦁ employee benefits;
⦁⦁ cumulative translation differences on foreign operations;
⦁⦁ split-accounting for compound financial instruments; and
⦁⦁ assets and liabilities of subsidiaries.
Mandatory exceptions
The three mandatory exceptions where retrospective application of IFRS is prohibited are
as follows:
⦁⦁ de-recognition of financial assets and financial liabilities;

⦁⦁ hedge accounting; and
⦁⦁ estimates.
Combining retrospective application with optional exemptions and mandatory exceptions is

clearly a challenge. However, the exemptions could offer a degree of potential flexibility,
as long as companies recognise that these are one-off choices that will affect valuation and
presentation in subsequent years.
For example, a company can recognise all cumulative pension actuarial gains/losses from
the inception of the pension plan at first-time adoption, even if its accounting policies under
IFRS involve leaving some later actuarial gains and losses unrecognised. These gains and
losses are recognised in the opening IFRS statement of financial condition (balance sheet).
The alternative option could produce the recognition of gains and losses in the statement
of income at a later stage.
Indeed, presentation could pose the biggest challenge for most insurers as the market may
penalise inadequate disclosure. Companies need to tackle a number of critical issues including
making the most appropriate choices for their organisation and judging these against stake-
holders’ expectations and the standards set by their competitors. They also need to ensure
they collect, present and explain the necessary data in a coherent and compelling manner.
Exhibit 2.5 provides a sample IFRS presentation for life and non-life insurers.
237
Exhibit 2.5
Combined insurance statement of financial condition (balance sheet), statement of
income and statement of cash flows – IFRS sample presentation1
Assets YR1 YR2

Property, plant and equipment
Investment property
Intangible assets including intangible insurance assets
Investments in associates
Financial assets
Equity securities:
available for sale
at fair value through income
Debt securities:
held to maturity
available for sale
Loans and receivables including insurance receivables
Derivative financial instruments
Deferred income tax
Reinsurance contracts
Cash and cash equivalents
Total assets
Equity
Capital and reserves attributable to the company’s equity holders:
share capital
premium over par (additional paid-in capital)
reserves (including accumulated other comprehensive income – OCI)
retained earnings
equity component of discretionary participation features (‘DPF’)2
Non-controlling interests
Total equity
Liabilities
Insurance contracts
Financial liabilities
Continued
Investment contracts:
with DPF
at amortised cost
Borrowings
Derivative financial instruments
Provisions for other liabilities and charges
Trade and other payables
Deferred income tax
Retirement benefit obligations
Current income tax liabilities
Total liabilities
Total equity and liabilities
The notes are an integral part of these consolidated financial statements.
Income statement
Insurance premium revenue
Insurance premium ceded to reinsurers
Net insurance premium revenue
Fee income:
insurance contracts
investment contracts
Investment income
Net realised gains on financial assets
Net fair value gains on assets at fair value through income
Other operating income
Net operating income
Insurance benefits
Insurance claims and loss adjustment expenses
Insurance claims and loss adjustment expenses recovered from reinsurers
Net insurance benefits and claims
Investment contracts benefits
Expenses for the acquisition of insurance and investment contracts
Expenses for marketing and administration
Expenses for asset management services rendered
Other operating expenses
Expenses
Continued
Results of operating activities
Finance costs
Share of (loss)/profit of associates
Profit before tax
Income tax expense
Profit for the year
Attributable to:
equity holders of the company
equity component of DPF
non-controlling interests
Earnings per share for profit attributable to the equity holders of the Company
during the year (expressed in Euros per share):
basic
diluted
Statement of comprehensive income

Foreign currency translation adjustments
Unrealised gains/losses financial derivatives
Unrealised gains/losses net investments
Net gains and losses recognised directly through shareholders’ equity
Profit for the year
Total other comprehensive income
Attributable to:
equity holders of the company
non-controlling interests
Cash flow statement

Cash generated from operations
Interest paid
Income tax paid
Net cash from operating activities
Cash flows from investing activities

Acquisition of subsidiary, net of cash acquired
Continued
Purchases of property, plant and equipment
Proceeds from sale of property, plant and equipment
Loans granted to related parties
Loan repayments received from related parties
Net cash used in investing activities
Cash flows from financing activities

Proceeds from issuance of ordinary shares
Proceeds from issuance of redeemable preference shares
Purchase of treasury shares
Proceeds from borrowings
Repayments of borrowings
Proceeds from issuance of convertible bond
Dividends paid to company’s shareholders
Dividends paid to non-controlling interests (minority interests)
Net cash used in financing activities
Net (decrease)/increase in cash and bank overdrafts

Cash and bank overdrafts at beginning of year
Exchange (losses)/gains on cash and bank overdrafts
Cash and bank overdrafts at end of year
1 These are in addition to a required ‘consolidated statement of changes in equity’.
2 Investment contracts containing a discretionary participation feature.
1
International Financial Reporting Standards (IFRS); norms published prior to 2001 are termed International
Accounting Standards (IAS).
Appendix 2.2
Sample comparison of insurance

companies
Using common-size financial statements for a sample of US insurance companies, Exhibits

2.6 to 2.10 summarise the economic significance of financial statement line items.
Statistics are presented for all insurers (All) as well as for the following five sub-industries:
life and health (LH), property and casualty (PC), multiline (ML), reinsurers (Re), and insur-
ance brokers (IB).
Note that Exhibits 2.6 to 2.10 present time series averages (2001–2011) of aggregate
common-size balance sheet data, according to the author’s own study.
Exhibit 2.6
Primary asset categories
All LH PC ML Re IB
Cash 2% 2% 3% 1% 4% 2%
Investment assets (short-term) 56% 57% 62% 44% 70% 26%
Accounts receivable (including premium) 3% 1% 6% 2% 5% 37%
Reinsurance assets 5% 2% 9% 7% 11% 0%
Intangible assets (other than DAC) 2% 1% 4% 1% 0% 20%
Deferred policy acquisition costs (DAC) 4% 4% 2% 35% 0% 0%
Separate account assets 20% 28% 2% 35% 0% 0%
Other assets 7% 5% 12% 5% 5% 12%
Total assets 100% 100% 100% 100% 100% 100%
242
Sample comparison of insurance companies
Exhibit 2.7
Primary asset categories, excluding separate accounts
All LH PC ML Re IB
Cash 3% 3% 3% 1% 4% 2%
Investment assets (short-term) 71% 79% 63% 69% 70% 26%
Accounts receivable (including premium) 4% 2% 6% 4% 5% 37%
Reinsurance assets 7% 3% 10% 11% 11% 0%
Intangible assets (other than DAC) 3% 2% 4% 1% 0% 20%
Deferred policy acquisition costs (DAC) 4% 6% 2% 6% 4% 3%
Other assets 9% 7% 12% 8% 5% 12%
Total assets 100% 100% 100% 100% 100% 100%
Separate accounts: contract assets and liabilities that are legally insulated from the
insurer’s general account assets and liabilities are reported separately on the balance sheet.
Separate account assets are subject to general account claims only to the extent that the
value of such assets exceeds the separate account liabilities. The performance of investments
in separate accounts, net of contract fees and assessments, is passed through to the contract
holders. Separate accounts are used primarily for variable universal life contracts and variable
deferred annuity contracts. Separate account assets are diversified funds – similar to mutual
funds – which are managed by the insurance company. Contract holders select portfolios
consisting of those funds, and their claims on the investments are reflected in the balance
of separate account liabilities.
243
Exhibit 2.8
Primary liabilities and equity categories
All LH PC ML Re IB
Insurance reserves 48% 53% 45% 41% 56% 11%
Unearned premiums 4% 0% 9% 4% 7% 9%
Reinsurance liabilities 1% 0% 1% 0% 2% 0%
Debt 6% 5% 9% 4% 6% 8%
Separate account liabilities 20% 28% 2% 35% 0% 0%
Other liabilities 8% 7% 10% 5% 4% 56%
Non-controlling interest and preferred stock 1% 0% 1% 1% 1% 1%
Common equity 13% 7% 24% 9% 24% 19%
Total liabilities and equity 100% 100% 100% 100% 100% 100%
Separate account assets are reported on the balance sheet at fair value. Separate account
liabilities are generally reported at the same amount, because the contract holders own these
assets and the income (or loss) that they generate. Consistent with the fact that insurers have
limited or no exposure to separate account assets and liabilities, regulatory capital calcula-
tions exclude these items and require no supporting capital for these accounts. The balance
sheet is, therefore, reformulated to exclude separate account assets and liabilities.
Exhibit 2.9
Primary liabilities and equity categories, excluding separate accounts
All LH PC ML Re IB
Insurance reserves 60% 73% 46% 63% 56% 11%
Unearned premiums 5% 0% 9% 6% 7% 9%
Reinsurance liabilities 1% 0% 1% 1% 2% 0%
Debt 7% 7% 9% 6% 6% 8%
Other liabilities 10% 9% 10% 8% 4% 56%
Non-controlling interest and preferred stock 1% 0% 1% 1% 1% 1%
Common equity 17% 10% 25% 15% 24% 19%
Total liabilities and equity 100% 100% 100% 100% 100% 100%
244
Sample comparison of insurance companies
Unlike the balance sheet, the income statement does not report investment income, gains
or losses on separate accounts. Instead, it reports the revenues earned on separate accounts,
which include investment management fees, mortality and other risk charges, policy adminis-
tration fees, and surrender charges. Although the investment performance of separate accounts
is omitted from the income statement, it is relevant for evaluating the insurer’s prospects. In
particular, high investment returns increase account balances, which in turn boost fee income,
decrease the value of minimum benefit guarantees, and may attract additional investments.
The opposite occurs when returns are negative or lower than expected.
Exhibit 2.10
Common-size income statements
All LH PC ML Re IB
Insurance premiums 64% 54 71 65 86 26
Investment income 19 35 11 18 14 5
Fee income 8 12 5 8 0 72
Realised investments gains (losses), net 0 –2 1 –2 0 0
Other revenue 9 2 12 11 0 0
Total revenue 100% 100% 100% 100% 100% 100%
Benefits and claims 54 59 51 55 64 14

Amortisation of deferred acquisition costs 8 4 10 12 11 0
Other operating expenses 26 24 26 23 13 76
Investment expense 1 2 0 1 1 0
Interest expense 2 2 2 2 1 2
Total pre-tax expenses 90 91 89 92 90 89
Special pre-tax items 0 0 0 –1 0 –1
Pre-tax income 9 9 10 7 10 10

Incomes taxes 2 2 3 2 2 3
Special after-tax items 0 0 0 1 0 1
Non-controlling interest and preferred dividend 1 1 0 1 0 0
Net income available to common equity owners 6 5 7 5 8 8
245
Also, unlike the balance sheet, which explicitly reports reinsurance assets and liabilities,
premium revenues are reported net of ceded premiums, and benefits and claims are reported
net of expected recoveries from reinsurers.
246
Chapter 3
Investment banks
Investment banking is a cyclical business with more frequent ups and downs over the past
decade than previous decades. As markets grow then turn highly volatile, investment banks
swing from hefty profits to meagre profits, resulting in hiring binges to dramatic cutbacks
in staff. The only constant seems to be huge bonuses for the industry stars.
The global financial and debt crises since 2008 have changed all that. From a near
meltdown following the failure of Lehman Brothers, one of the industry stars, to a series
of trading losses, accounting shenanigans and sheer destructive disregard for the safety of
investor funds and ethical market conduct, the investment banking industry now sees itself
confronted by re-regulation, crippling returns, and bonus oversight. Some investment banks
transformed their legal structure to avail themselves of easier access to financing and greater
flexibility to buy retail banks (Morgan Stanley and Goldman Sachs) while others are ques-
tioning the merits of the stand alone investment bank model.
Diversification is the current buzzword. With investment bank units taking big write-
downs during the credit crisis, banks have been forced to reconsider the merits of universal
banking, which spans retail banking, insurance, mortgage lending, fund management and
investment banking. Some big universal banks such as Citigroup are still seen as too complex
and unwieldy, but others such as HSBC and JPMorgan Chase are benefiting from a strong
retail deposit base and are better placed with regulators.
Whatever the trend, the regulatory tide has moved against the investment banking industry,
bringing with it lower leverage ratios and greater scrutiny on what investment banks do.
Small investment banks have so far coped with the credit crisis better than big players
thanks to a more robust capital base and lesser involvement in the sub-prime mortgages
market, at the root of the crisis to begin with, and insignificant sovereign debt exposure.
Within universal banks, the appetite for investment banking will depend on the bank's
experience in the aftermath of the financial and debt crises. This chapter assumes an ongoing
investment banking activity albeit following a somewhat different business model compared
with the past. Whether the investment bank is big or small, the importance of following
their activity by credit analysts is greater than ever.
How investment banks make money

Investment banks make money by servicing clients through a variety of capital and money
market activities. Although the world’s largest retail banks are now heavily involved in
investment banking activities, the principal focus on the securities business is what sets a
true investment bank apart.
The main constituents of the world’s major investment banking companies are the practice
of investment banking itself (see Box 3.1 for a traditional definition), principal transactions
(trading and investment), commissions, asset management, and advisory fees. Currently, a
247
typical investment bank might earn 15% of its revenue from investment banking (compared
with more than 20% some years ago), 30% to 35% from principal transactions, 15% from
commissions, 20% from asset management, and the remainder in interest and dividend income.
The industry as a whole, however, has been under severe profit strain, the result of the
sub-prime market collapse and the liquidity crisis that ensued (Lehman Brothers’ failure
in 2008 was the culmination of loss of confidence – especially in investment banking).
Furthermore, investment banks’ cost-income ratio (operating expenses divided by net revenues,
a key measure of efficiency) has ballooned recently to 80% or more compared with 60% in
2007); this was due to declining revenues but also to an insistence on maintaining large and
expensive staff – the essential component of operating expenses. Other factors include tighter
regulatory capital requirements and lower leverage eating into returns while costs for back-
office functions such as risk management and information technology have been on the rise.
By nature, investment banks make impressive profits by taking on heightened risk. The
financial crisis has brought falling revenues to the industry and, coupled with trading losses
in volatile markets, a cap on risk-taking is the trend today in investment banking. Regulators
are more than ever attentive to the industry’s activities. Despite that, greater scrutiny in credit
analysis is warranted as investment bank fortunes tend to ebb and flow with economic and
market cycles.
Box 3.1
Definition of an investment bank
Traditionally, the investment bank is a company that acts as underwriter or agent, serving as
an intermediary between an issuer of securities and the investing public. To underwrite is to
assume the risk of buying a new issue of securities and reselling them to the public, either
directly or through dealers. This is termed a firm commitment. The underwriter or investment
banker makes a profit on the difference between the price paid to the issuer and the public
offering price, called the underwriting spread.
Under a conditional arrangement called ‘best effort’, the investment bank markets a new
issue without underwriting it, acting as agent rather than principal and taking commission for
whatever amount of securities the banker succeeds in selling.
Where a client relationship exists, the investment bank’s role begins with pre-underwriting
counselling and continues after the distribution of securities is completed, in the form of ongoing
expert advice and guidance, often including a position on the board of directors of the issuing
company where permitted by law. The direct underwriting responsibilities include preparing for
official registration (usually with the securities markets regulatory agency); consulting on pricing
of the securities; forming and managing a syndicate; establishing a selling group if desired;
and pegging (stabilising) the price of the issue during the offering and distribution period.
In addition to new securities offerings, investment banks handle the distribution of blocks
of previously issued securities, either through secondary offerings or through negotiations;
maintain markets for securities already distributed; and act as finders in the private place-
ment of securities.
248
Investment banks
Types of activities
Post-financial crisis, today’s investment banker is involved in an array of activities which
have become standard features of the one-stop investment bank. These activities include
underwriting and advisory services, corporate finance and financial engineering, securities
trading, mergers and acquisitions, fund management, venture capital, asset securitisation,
emerging markets, and international markets. Other activities performed by the large global
companies also include research reports, securities clearing and recording-keeping services,
standard banking and trust services, insurance sales and insurance underwriting services. The
following is a brief explanation of the main activities.
Investment banking
Through its services, the traditional investment bank: (i) helps corporations design securi-
ties with features that are currently attractive to investors; (ii) buys these securities from
the corporation; and (iii) sells them to investors. Although the securities are sold twice, this
process is really one primary market transaction, with the investment banker acting as a
broker to help transfer capital from savers (investors) to businesses. More technically, these
services are called underwriting and involve a significant amount of advisory services to the
client as well.
Corporate finance and financial engineering

In addition to lending to clients for the purchase of securities, investment banks are called
upon to provide sophisticated financial advice and specialised financial products to help clients
in their hedging, funding, arbitrage, and yield enhancement needs and activities. For the
investment bank this includes arranging or entering into as counterparty to forwards, futures,
options, and swap contracts. Other forms of financing include long-term loans to clients
on a select basis and bridge or temporary financing until permanent financing is obtained.
Securities trading
For many global investment banks, securities trading is the major activity – if not the
major asset and liability item on the balance sheet. Also called ‘market-making,’ principal
or brokerage transactions, securities trading involves the purchase and sale of corporate and
government securities traded on securities exchanges or in the over-the-counter markets. Such
trading, either for the customer’s account or for the company’s account (proprietary trading)
generates commissions and trading profits which often represent a significant portion of the
investment bank’s revenues. Trading activities also include taking positions in derivative
products such as futures, options, and swaps.
However, the 2010 Dodd-Frank Wall Street Reform Act in the US (and the ‘Volcker rule’
therein) has placed heavy restrictions on proprietary trading and has put a damper on invest-
ments in hedge funds and private equity. Some major investment banks, such as Goldman
Sachs, have acted to end trading on their own account and have reduced hedge fund and
249
equity holdings to 3% of the bank’s capital well ahead of the Volcker rule implementation
in 2014. Similar action is expected among the large UK banks as the Vickers Commission
has recommended that retail and investment banking activity be ‘ring fenced’ or separated.
Mergers and acquisitions

The major investment banking companies have merger and acquisition groups which operate
within their corporate finance departments. Members of these groups strive to identify compa-
nies with excess cash that might want to buy other companies, companies that might be
willing to be bought, and companies that might, for a number of reasons, be attractive to
others. Also, if an oil company, for instance, decided to expand into coal mining, it might
enlist the aid of an investment banker to help it locate and then negotiate with a target
coal mining company. Similarly, dissident stockholders of companies with poor track records
might work with investment bankers to oust management by helping to arrange a merger.
The stakes are high, mistakes are made, questions of legality are raised – but the mergers
and acquisitions activities have proved extremely profitable for the major investment banks
over the past several years. According to the author’s own research, investment banking fees
totalled US$80 billion in 2011, of which merger and acquisition fees reached almost US$30
billion. Total fees were down from their peak of almost US$120 billion in 2007, including
merger and acquisition fees of some US$50 billion.
Fund and asset management

Fund and asset management has become an integral part of the investment banking busi-
ness and, what is more according to some major houses, the income stream is less volatile
than that of underwriting, trading, or mergers and acquisitions activities. Fund management
includes mutual funds (unit trusts), pension funds, and portfolio management for clients
ranging from large companies to individuals. This business segment is part of an ongoing
process by which:
⦁⦁ an investor’s objectives, preferences, and constraints are identified and specified to develop
explicit investment policies;
⦁⦁ strategies are developed and implemented through the choice of optimal combinations of
financial and real assets in the marketplace;
⦁⦁ market conditions, relative asset values, and the investor’s circumstances are monitored; and
⦁⦁ portfolio adjustments are made as appropriate to reflect significant change in any or all
of the relevant variables that make up investment choices.
Although fund management is performed largely by independent investment companies,

which outnumber investment banks and exceed the latter’s managed assets by a wide margin,
investment banks’ presence in the field is significant.
A related service of fund management is an ‘asset management account’. An asset manage-
ment account combines banking services such as current account, credit and debit cards;
250
Investment banks
brokerage features like buying securities and making loans on margin; and the convenience
of having all financial transactions listed on one monthly statement.
Venture capital
Venture capital typically provides capital and strategic guidance to companies that may have
been recently formed and are rapidly growing, but not yet large enough to access the public
equity markets. Venture investing includes start-ups, growth stage, buyouts, consolidation, and
company turnarounds. An important feature of venture capital is the use of valuation meth-
odologies, highly skilled activities with which the investment banker should be very familiar.
Asset securitisation
Securitisation is one of the asset-backed innovations that has taken hold in the past several
decades in the US and which is now practised globally. Securitisation is the selling of securities
backed by the cash flows from a pool of financial assets. Common candidates for securitisation
are residential mortgages, commercial mortgages, auto loans or credit card debt obligations.
They are then packaged and sold to investors in the form of bonds, pass-through securities,
or collateralised debt obligations (CDOs). The principal and interest on the debt, underlying
the security, is paid back to the various investors regularly. Securities backed by mortgage
receivables are called mortgage-backed securities (MBS), while those backed by other types
of receivables are called asset-backed securities (ABS). The involvement of investment banks
in securitisation is logical given their expertise in the valuation and placing of securities for
a broad spectrum of issuers.
Critics, on the other hand, have suggested that the complexity inherent in securitisation
and the ‘over-the-counter’ nature of the market can limit investors' ability to monitor risk,
and that competitive securitisation markets with multiple securitisers may be particularly prone
to sharp declines in underwriting standards. The leading ratings agencies did not provide
assurances as they were accused of misunderstanding the risk and, thereby, assigning inac-
curate credit ratings. Private, competitive mortgage securitisation is believed to have played
an important role in the US sub-prime mortgage crisis, root of the subsequent financial and
debt crises.
Risk management
An investment banker readily admits that their business units, by their nature, do not produce
predictable earnings, and all of their businesses are materially affected by conditions in the
global financial markets and economic conditions generally. A well-run, relatively safe institu-
tion is not immune to such risks; witness JPMorgan Chase – a model of risk management
– and its spectacular trading loss in early 2012.
Investment banks are exposed to risks similar to those of other financial intermediaries
but to varying degrees. The main risk categories for the investment bank are market, credit,
operating, and liquidity risks. Proper management of these risks helps reduce the likelihood
of earnings volatility and erosion of capital. A well-managed investment bank will have in
251
place various controls such as corporate governance policies and procedures that require
individual business units within the company to identify, assess, and mitigate those risks on
an ongoing basis.
Proper risk management also revolves around the following principles:
⦁⦁ the most important tools in any risk management process are experience, judgement, and
constant communication with risk takers;
⦁⦁ vigilance, discipline, and an awareness of risk must be continuously emphasised throughout
the company;
⦁⦁ management must provide a clear and simple statement as to what can and cannot be
done in committing capital;
⦁⦁ risk management must consider the unexpected, probe for potential problems, test for
weaknesses, and help identify potential for loss;
⦁⦁ the process must be flexible to permit adaptation to changing environments, including the
evolving goals of the company; and
⦁⦁ the key objective must be to minimise the possibility of incurring unacceptable loss.
Such losses usually arise from unexpected events that most statistical model-based risk
methodologies cannot predict.
Although it is difficult for an external analyst to ‘get a feel’ of the company’s philosophy
and policies concerning control procedures, it is essential to obtain clues through personal
contacts with the investment bank or through market checks. Investment banking is above
all a ‘people’ business and the reputation of the company and of its staff is usually common
knowledge in a particular market.
Market risk
Market risk is the potential change in a financial instrument’s value caused by fluctuations
in interest and currency exchange rates, equity and commodity prices, and credit spreads.
Risk management in this area is responsible for the measurement, monitoring, and control
of market risk on trading positions, including the establishment of trading limits throughout
the company.
Over the past several years, measuring market risk with mathematical models has become
the focal point of many risk management efforts worldwide, with the term ‘risk manage-
ment’ becoming almost synonymous with ‘risk measurement’. A prudent investment banker
will view the primary risk of a product as not being in the product itself, but in the way
the product is managed. Breaches of discipline or lapses in supervision can result in losses
irrespective of the products involved or the mathematical models used. Nevertheless, for a
brief discussion of the most popular models, see Appendix 3.1.
Credit risk
Credit risk represents the loss that the company would incur if a counterparty or issuer
failed to perform its contractual obligations. The investment bank should have in place
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Investment banks
policies and procedures with the objective of protecting against such losses. The policies
and procedures might include:
⦁⦁ reviewing and establishing limits for credit exposures;

⦁⦁ further limiting counterparty credit exposures through various techniques, including
maintaining collateral and obtaining the right to terminate transactions or collect collateral
in the event of a credit default or downgrade (either by external or internal credit rating
systems); and
⦁⦁ continuously assessing the creditworthiness of counterparties and issuers.
Operating risk
Operating risk focuses on the company’s ability to accumulate, process, protect, and commu-
nicate information necessary to conduct its everyday activities, either in a domestic or global
environment. This includes the execution of legal, fiduciary, and agency responsibilities. A
well-organised investment bank manages operating risk in many ways, including maintaining
back-up facilities, using technology, employing experienced personnel, and maintaining a
comprehensive system of internal controls. Because ‘accidents’ do happen the investment
bank continually reviews its framework of internal controls, taking into account changing
circumstances, and initiates corrective actions to address control deficiencies and opportuni-
ties for improvement.
From a legal standpoint, risk arises from the enforceability of clients’ and counterparties’
obligations to and from the investment bank. This risk should be mitigated by:
⦁⦁ developing policies that enhance enforceability of transactions;

⦁⦁ monitoring compliance with internal policies and external regulations; and
⦁⦁ consultation with internal and external legal advisers.
Fiduciaries and agents have obligations to act on behalf of others. Such risks are inherent in
brokerage and investment management activities. Again, the prudent investment bank has in
place policies to ensure that obligations to clients are met and the company is in compliance
with applicable legal and regulatory requirements.
Liquidity risk
Liquidity risk arises in the course of the company’s general funding activities and in the
management of the balance sheet. It includes both the risk of being unable to raise funds
with appropriate maturity and interest rate characteristics and the risk of being unable to
liquidate an asset in a timely manner at a reasonable price. The investment bank’s main
objective is to assure liquidity at all times. The company’s liquidity management strategy
should include the maintenance of alternative funding sources and the diversification of those
sources, for example, credit lines with other financial institutions. The object is to make
sure that debt obligations maturing within, say, one year can be funded when due without
issuing new debt or liquidating assets.
253
Other risks
Other risks the investment bank encounters include political, tax, and regulatory risks.
These risks revolve around the impact that changes in local laws, regulatory requirements,
or tax statutes would have on the viability, profitability, or cost-effectiveness of existing or
future transactions. To help mitigate the effects of these risks, the investment banker should
constantly review new and pending legislation and regulations by employing professionals in
the jurisdictions in which the company operates to actively follow these issues.
Credit analysis of investment banks

Several characteristics of the investment banking industry affect the way a company analysis
should be conducted. For example, earnings comparisons are best made on a quarter-to-
quarter basis rather than a year-to-year basis. Such an approach is virtually impossible in
most markets given the lack of quarterly financial data – but it represents the ideal. Why?
Because situations in the investment banking field change so much from one year to the
next that annual comparisons may not be germane. The analyst, however, must contend
with that inability to gather quarterly data and factor in the drastic changes that could
occur between years.
In another example, the analyst should focus on net rather than gross revenues. Gross
revenues can be too high if the bank has significant interest expense. Therefore, similar to
the analysis of retail banks, interest expense should be deducted.
The analyst should try to determine the source of the revenues and how persistent or
stable they are. This applies especially to trading income. Banks that have very persistent
trading income tend to outperform the industry and the market.
The analyst should also examine where the revenues go. The key element is the propor-
tion of revenue used for employee remuneration. Investment banking is a highly profitable
business when markets are up and star staff members are primary beneficiaries along with
support staff in most cases. Although the level of remuneration varies from company to
company, the industry average for remuneration in recent years has been between 40% and
50% of net revenues. Beyond remuneration, between 30% and 35% of revenues usually
goes to suppliers – to pay the rent, telephone bills, outside consultants and auditors, and so
on. However, because this part of the expense burden is relatively small and more or less
fixed it is much less important than employee compensation.
The most important asset an investment bank has on its balance sheet is its securi-
ties inventory. The analyst should find out what that inventory consists of and whether it
contains securities or trading positions that will create problems for the company, such as
an over-concentration in equities or emerging market securities, or too much in junk bonds.
The company’s asset inventory should also be compared with its equity base. A dispropor-
tionate share compared with the company’s peers could put a strain on equity in depressed
market conditions.
Finally, the analyst should look at the relative importance of other asset categories,
because often there may be potential disasters. For example, investments may appear small
compared with the securities held for principal transactions (especially proprietary trading
254
Investment banks
for the bank’s own account) but they may contain a number of problem investments that
are large relative to the bank’s equity base. Although proprietary trading should cease to
be a problem when most regulators in major financial centres agree to prohibit the practice
altogether or spun-off to a fully capitalised separate entity. Prohibition in the US was effec-
tive from July 2012 with full compliance by 2014.
The statement of financial condition (the balance sheet)

The balance sheet of a typical investment bank is less complex than that of a retail bank.
While structure indicates a greater degree of liquidity, it also shows a more highly leveraged
situation than for most retail banks. The following balance sheet items are the most common.
Cash and equivalents

This item consists of cash on hand for daily operations and cash and securities segregated
for regulatory purposes or deposited with clearing organisations.
Customer and broker receivables

Amounts owed by customers to the bank for securities purchases and orders, as well as
amounts due on cash and margin transactions. For example, the investment bank extends
credit for a portion of the market value of the securities in the customer’s account up to
limits imposed by internal policies and/or applicable margin rules and regulations. These
receivables are stated net of the allowance (reserve) for doubtful accounts.
Securities brokers and dealers borrow from banks on a short-term basis in order to
finance the securities positions of their clients. This balance sheet item also includes receiv-
ables from any clearing organisation.
Financial instruments owned

Financial instruments owned (also known as trading assets) are stated at fair market value
in accordance with international accounting standards, and include securities held by the
bank for proprietary trading purposes where still permitted. The securities purchased are
said to be ‘long’ positions. Many investment banks act as market makers in many securities
and therefore keep a significant amount of securities in their trading inventory to facilitate
customer transactions.
Resale agreements
Technically, these are reverse repurchase agreements (also called reverse RPs or reverse
Repos). The agreements involve a loan between two parties, with one typically either a
securities dealer or retail bank. The lender or investor buys securities from the borrower
and simultaneously agrees to sell the securities back at a later date at an agreed-upon price
plus interest. The transaction essentially represents a short-term loan collateralised by the
255
securities because the borrower receives the principal in the form of immediately available
funds, while the lender earns interest on the investment. If the borrower defaults, the lender
obtains title to the securities.
In this case, the investment bank is the lender who is obligated to ‘resell’ the securities
back to the borrower. When the bank is the lender the transaction is called a reverse repo.
In a regular repurchase agreement, a bank or securities dealer sells securities under an agree-
ment to repurchase at a later date and thus represents the borrower. Every RP transaction
involves both a regular RP and a reverse RP, depending on whether it is viewed from the
lender’s or the borrower’s perspective.
Bank loans
On the liability side, the investment bank borrows from other financial institutions to support
its activities. These are short-term loans and are often complemented by borrowings in the
money markets in the form of commercial paper or other short-term debt instruments with
maturities of less than one year.
Repurchase agreements
As a liability item, these agreements represent the investment bank as borrower, having
provided securities as collateral for the loans with the agreement to repurchase the securities
at a later date, in effect paying off the loan (see Resale agreements above). For the large
global investment banks, recourse to repurchase agreements is a significant source of funding
in support of trading activities.
Payables
This item groups customer and broker/dealer payables. Securities trading may lead to various
customer or broker/dealer balances. Broker/dealer balances, for instance, may result from
recording trading inventory on a trade date basis rather than on a settlement date basis.
Payables to brokers and dealers also represent securities loaned to them backed by cash
collateral received, which ultimately must be returned when the loans are paid off.
Customer payables are largely margin balances held by the investment bank for customers’
securities purchases (a close corollary is customer deposits held by retail banks). Margin
balances are normally interest-bearing accounts.
Trading liabilities
Trading liabilities consist mainly of ‘short’ positions in securities, that is, securities that were
borrowed and then sold for cash in support of trading activities where still permitted within
the investment bank entity. At a later date the securities must be repurchased in the market
to retire the position.
256
Investment banks
Long-term debt and equity

Although less significant than short-term borrowings, long-term debt is used to support the
bank’s general business activities. Equity accounts for an even lesser support source compared
with retail banks, for instance. Equity classifications are the normal shares outstanding,
premiums over par (paid-in surplus), reserves, retained earnings, and now the ubiquitous
‘accumulated other comprehensive income (loss)’.
The statement of income

An investment bank’s income statement may be divided into two main categories: revenues
and expenses. Revenues have four categories: (i) commissions and fee income; (ii) trading
profits or gains; (iii) investment banking income; and (iv) net interest income. The chief
expense is staff remuneration which, as indicated earlier, is usually very large relative to
revenues and compared with other types of financial institutions.
Ratios
Unlike in retail bank analysis, the number of ratios used for investment bank analysis is fewer
and encompass only three categories: capital (leverage), profitability, and liquidity. Since the
bulk of an investment bank’s assets are securities (securities that are shown at fair value),
asset quality is less a concern than it is for retail banks’ quality of their loan portfolios.
See Exhibit 3.1 for typical ratios used to analyse an investment bank. The results are from
the author’s sampling of the largest global investment banks for the 2nd and 3rd editions
of this publication. Note that profits for the sample banks have fallen dramatically while
compensation remained almost stable. Leverage has dropped significantly and liquidity is up
as higher regulatory capital and liquidity requirements are the norm. Like retail banking,
profits will probably rarely reach pre-crisis levels anytime soon.
Exhibit 3.1
Ratios used for investment bank analysis
2nd edition 3rd edition

Profitability
Pre-tax profit margin* 27.8% 20.2%
Net profit/net revenues 19.7% 10.7%
Compensation/net revenues 47.8% 46.5%
Net profit/total assets (ROA) 1.0% 0.5%
Net profit/equity (ROE) 15.5% 5.1%
Continued
257

2nd edition 3rd edition
Leverage
Total assets/equity 17.9¥ 11.9¥
Long-term debt/equity 3.8¥ 2.6¥
Liquidity
Liquid assets**/total liabilities 62.6% 83.9%
Short-term debt/total liabilities 79.0% 76.3%
* Earnings before income taxes to net revenues.

** Liquid assets include: cash and equivalents, marketable securities, resale (reverse repos) agreements, and
financial instruments owned (trading assets).
Source: Author’s sampling of data from the largest global investment banks
Financial statements: a hypothetical example

The returns in the investment banking industry depend on the interaction of the product
and market cycles. Exhibit 3.2 shows the relationship between the balance sheet and income
statement for the industry. Using figures from the 10 largest companies, the amounts have
been indexed to create a hypothetical, ‘average’ company with US$100 million in assets. The
returns are a function of competition in the marketplace, and what happens in the market
is a function of a number of factors, including interest rate conditions.
The product cycle in the industry is, indeed, a phenomenon. Thirty years ago, the mort-
gage-backed bond business was very profitable for global companies, but competition made it
less profitable 10 years later. During the 1990s and 2000s, derivatives business, securitisation
packaging and similar structured finance were all the rage because of very high returns. Those,
too, have fallen due to competitive pressures but most strikingly due to a near meltdown
in financial markets with the bankruptcy of Lehman Brothers in 2008. Currently, emphasis
is more evenly distributed among market-making and customer trading, asset management,
equity and bond underwriting, mergers and acquisitions, hedge fund servicing, and private
banking. Whether investment banks will benefit from these areas depends greatly on the
level of competition which will drive down margins and force a review of business strategy.
Economic and market cycles are, of course, just as important but most large investment
houses have learned to diversify their sources of revenues in the face of a severe economic
downturn following the financial crisis of 2008. The object is to dampen the negative impact
of product and market cycles in a post-crisis climate of re-regulation and volatile markets.
Some types of income can be traced to specific assets. Interest income is generated by
securities investments, customer receivables, margin accounts with individuals, or resale
agreements. Most of the important sources of income, such as investment banking fees,
do not flow from specific assets on the balance sheet. People are an important asset in the
258
Investment banks
industry, although that never shows on the books, per se. Staff members have relationships
with companies and work on the trading desks. The sum of their knowledge and expertise
is what makes one company different from another. In essence, investment banking fees
represent the productive capacity of the work force.
The primary sources of revenue, comprising about 80% of net revenues, are commissions,
trading profits, and underwriting fees. The remaining 20% of net revenues are generated
by net interest income, asset management, and so forth. The large global companies have
made a transition away from transaction revenues, that is, from one-at-a-time revenues. The
industry has moved toward recurring revenues. Commissions and trading profits are two
more reliable, renewable sources of income – despite an uncertain market outlook.
259
Exhibit 3.3
The balance sheet and the income statement inter-relationship
Assets
Cash and equivalents 1,453 Revenues
Marketable securities 3,106 Commissions 2,472
Customer receivables 20,779 Trading profits 1,720
Broker receivables 5,735 Investment banking 1,110
Resale agreements 35,299 Interest income 3,099

Interest expense 2,913
Financial instruments
owned: Net interest income 186
Securities inventory 29,930
Other investments 131 Other revenues 1,546
Net revenues 6,710
Plant and equipment 1,539
Goodwill and other 2,028 Expenses:
Total 100,000 Compensation 3,483
People — Floor costs 292

Off-balance sheet Occupancy and
items — communication 835
Advertising 146
Liabilities Other 1,082
Bank loans 3,045
Total non-interest
Repurchases 51,506 expense 5,838
Payables 15,639
Trading liabilities 15,447 Pre-tax income 871
Long-term debt 4,970 Income tax 248

Deferred
compensation and Net income 623
taxes 5,264
Sub-total 95,872
Equity 4,128
Total 100,000
Flows of revenue and expenses, year-end (US$ thousand).

Investment banks
Conclusion
Diversification and better management may help to smooth investment banking revenues
through product and market cycles but this has yet to be certified. Better risk management
has been strengthened by advances in technology and risk measurement techniques such as
value at risk (VaR), a statistical measure of the potential loss in the fair value of a portfolio
due to adverse movements in underlying risk factors. But VaR alone is not the panacea (see
Appendix 3.1).
Retail banks are aware that trading is a cyclical business and is not immune to down-
turns. Investment banks, on the other hand, argue that improvements in technology have
allowed them to open new markets and manage risk more efficiently, increasing their chances
of weathering downturns better than in the past. The financial crisis of 2008 disproved that
position and has convinced even investment bankers of the importance of diversification,
risk management, and common sense to preserve their existence.
However, investment banks’ financial statements can still be opaque because of the rapid
growth and shift in product to product. Only a decade and a half ago, these companies
placed emphasis on standard investment banking services such as underwriting, brokerage,
and merger advisory. After a period of rapid growth in operations – such as proprietary
trading, derivatives, brokerage for hedge funds, swapping operations – post-crisis regula-
tory constraints have dampened further growth in those areas. The credit analyst, therefore,
should exam the financial statements of an investment bank with an eye towards the degree
of revenue diversification, expense control (notably staff compensation), risk control measures
and volatility results through more stringent VaR or similar models.
261
Appendix 3.1
VaR analysis
Risk can be defined in terms of the probability of incurring a loss on an investment and
what the severity of that loss might be. Losses occur because the future values of factors
that determine asset prices are not predictable. These unpredictable factors that are the
ultimate sources of risk include variables such as the level of interest rates and the shape
of the yield curve, GDP growth, the rate of inflation, the level of equity risk premiums, the
magnitude of liquidity premiums, changes in the basis that links prices in one market to
prices in another market, and similar factors that are often included in arbitrage pricing or
any other fundamental factor model. Other factors can also cause asset prices to be other
than expected, including:
⦁⦁ a mis-specified valuation model that does not generate correct asset price forecasts, even
when the values of the variables in the model are forecast correctly;
⦁⦁ defaults that cause anticipated cash flows to evaporate; and
⦁⦁ the occurrence of catastrophic events such as war, pestilence, famine, and other disasters
(for example, an asteroid hits the Earth) that investors never took into consideration
when pricing assets but that, once recognised as possible, can have a profound impact
on asset values.
While the actual losses that might be incurred on an investment are unpredictable, it is
possible to estimate what the probability and severity of the losses might be if the prob-
ability distribution of all possible returns from the investment can be specified. To do this,
however, an investment manager must be able to specify all the possible expected losses and
the frequency (or probability) of their occurrences. Since the future value of every asset will
depend on future economic scenarios and other events, in order to specify the probability
distribution of investment returns over a given holding period the investment manager must
do the following:
⦁⦁ list all the possible scenarios and events that could unfold over the holding period during
which an investment risk is being assessed;
⦁⦁ estimate the probability of each scenario or event occurring during the period; and
⦁⦁ determine what the value of the investment would be if each scenario or event occurs.
It should be clear that this process is itself a probabilistic endeavour. Thus, the process of
assessing risk is, itself, risky. VaR analysis is a sophisticated approach that attempts to tell an
investment manager, top management of investment organisations, and regulators of financial
institutions and markets how much of the value of a portfolio, company, or market could
be lost if a reasonably serious event occurred, that is, how much of a portfolio’s, company’s,
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or market’s current value is at risk. Clearly, this is an important endeavour, because only
with such knowledge can:
⦁⦁ portfolio managers understand the risk that is inherent in their portfolios, so they can
avoid exceeding acceptable risk limits;
⦁⦁ top management be in a position to manage the total risk of their companies and prevent
the company from taking on so much risk that the viability of the company would be
put in jeopardy; and
⦁⦁ regulators be certain that the capital requirements imposed on financial institutions are
sufficient to cover the risks that are being taken.
In the light of heavy trading losses suffered by a large global banking company early 2012,
the Basel Committee on Banking Supervision – once an avid supporter of VaR – has launched
a review of the model’s use. The Committee’s consultative document1 includes proposals
to strengthen capital standards for market risk through a comprehensive review of the
overall design of the market risk regulatory regime. The review will also place emphasis on
the weaknesses in risk management under the Basel III framework internal models-based
and standardised approaches. For example, the Committee proposes moving from VaR to
expected shortfall, a risk measure that better captures ‘tail risk’, the Committee feels. Once
the Committee has reviewed responses, it intends to release for comment a more detailed
set of proposals to amend the Basel III framework (see Box 3.2).
Box 3.1.1
VaR’s decline?
After two decades of acting as the model for financial risk management and being embedded
in Basel capital rules, VaR credentials are being challenged. In the face of JPMorgan Chase’s
huge trading losses of early 2012, VaR seems to be on the decline. This is somewhat ironic
as no other company did more to promote VaR than JPMorgan.
VaR models, which became ubiquitous in the run-up to the financial crisis, were largely
invented in the back-office of JPMorgan in the early 1990s. They were believed to be an
elegant solution to the problem of measuring market risk in an ever complicated global
financial institution.
As Appendix 3.1 indicates, the models pulled together the thousands of positions taken
on by a big bank, ran them through a set of mathematical formulas peppered with probability
assumptions, and spat out a single number. The number represented the amount of money
a bank stood to lose from daily trading operations.
The larger the VaR number the bigger the potential daily trading loss. But the models
were based on many spurious assumptions and relied sometimes on out-dated or no longer
relevant historical data. During the financial meltdown starting in 2008, banks were bombarded
Continued
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Box 3.1.1 continued
by extreme market moves resulting in actual trading losses that far outpaced the numbers
predicted by their VaR models. Subsequently, regulatory authorities and the Basel committee
requested banks to ‘tighten’ their assumptions through more rigorous stress testing.
Four years on, JPMorgan restated its VaR figures to reflect more closely the actual losses
suffered in early 2012. The bank admitted that a change to a more sophisticated model was
being scrapped for a return to their old model. Soon after the Basel committee of banking
regulators said it was planning to strip VaR models out of calculations made to determine
the amount of regulator capital banks must hold.
Banks and the markets are awaiting anticipated changes by regulators to the use or
non-use of VaR models in calculating the market risk component of Basel III capital adequacy.
The definition of VaR

VaR is defined using statistical terminology. It is the maximum potential loss, measured in
currency units (such as dollars) likely to be incurred on an investment or a portfolio over a
specified holding period and confidence interval. To illustrate what VaR means, consider an
investment the possible returns of which over a defined period of time, such as one year, are
distributed as shown by the probability distribution illustrated in Exhibit 3.3.
Exhibit 3.3
Probability distribution
10% r
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VaR analysis
This is the usual way in which an investment in a stock fund indexed to the S&P 500
index is represented.
Suppose a portfolio manager wanted to determine how much value was being put at risk
if US$1 million were invested in the S&P 500 index for one year. Note that, simplistically,
it could be argued that US$1 million is at risk, since it is possible for the S&P 500 index
to decline to zero. This is not a good way of defining risk, however, since any investment
could result in a 100% loss but not all investments are equally risky.
Instead of defining risk as what could possibly be lost under the most adverse circum-
stance, VaR analysis defines risk as how much of an investment’s value could be lost under
a very adverse (but not the worst possible) circumstance. The question now becomes, how
bad a circumstance is bad enough to be considered a reasonable ‘outer limit’ to the value
of an investment, portfolio, company, or market that is put at risk?
Note that different investments have different probability distributions for their returns.
Exhibit 3.4 shows the return distributions of an investment in a bond (left) and in a common
stock (right). Clearly, the stock investment is the most risky, because its return distribution
is more dispersed (‘wider’). This is because the standard deviation of the return distribution
for stocks is larger than for bonds.
Exhibit 3.4
Return distributions of a bond and a stock
Bond returns rB Stock returns rB
265
Taking advantage of this concept, a risk analyst might ask the question ‘How much
investment value would be lost over a period of one year if the actual return on an invest-
ment turns out to be that return that equals the lowest one percentile of all possible returns,
when they are arrayed from lowest to highest?’ Returning to the return distribution for the
indexed investment, if S&P 500 index returns are normally distributed with an expected
return of 10% and a standard deviation of +/–20% per year, the lowest percentile return
would be represented by r.01, depicted in Exhibit 3.5.
The value of r.01 can be easily computed from ‘normal curve arithmetic’ and parameters
found in a table of areas under a normal curve:
ra – E(r)
Z.50 – a =
sr
Z.50 – .01 = Z.49 = –2.325 (from Normal Curve Table)
r – 10%
–2.325 = .01
20%
r.01 = –36.5%
This means that the lowest percentile return for an investment in the stock market for one
year is a loss of 36.5%. If this should occur, a US$1 million portfolio invested in an index
fund would suffer a loss of US$365,000. This is viewed to be the value that is at risk (VaR),
over a one-year time horizon, when US$1 million is invested in the S&P 500 index:
VaR = –ra Vp
= –(–.365) (US$1,000,000)
= US$365,000
In this example, which helps define and illustrate the basic VaR analysis technique, the value
at risk was measured in US dollars, over a one-year time horizon, using the lowest percentile
return as the risk measure (a = .01). In practice, VaR:
⦁⦁ can be measured in any currency unit;

⦁⦁ usually assumes an investment horizon equal to the amount of time it would take to
liquidate portfolio positions or to hedge an exposure. For a trading desk, this is normally
one day. However, for an investment manager, the VaR might be equal to the time over
which his or her performance is measured, which normally is one-quarter of a year. The
investment horizon used to calculate the VaR for two or more portfolios must be the
same if it is to be a valid measure of their comparable risks; and
⦁⦁ allows a choice of a to be either the first or the fifth percentile of possible returns (a is
set equal to either .01 or .05, at the discretion of the VaR analyst).
If VaR analysis is to be used as the basis for setting minimum capital requirements for
financial institutions engaging in international finance and trading, the methodology must be
standardised. Otherwise it would not be possible to measure risk of international investment
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VaR analysis
institutions on a comparable basis. Therefore, it has been proposed that VaR analysis be
performed in accordance with the following standardised practices:
⦁⦁ the VaR methodology employed by the regulated companies to be validated by independent

auditors;
⦁⦁ the data used as inputs to the model to be closely controlled and deemed appropriate by
independent auditors;
⦁⦁ the risk management function to be independent of the operating function of the companies;
⦁⦁ the model to be used to effectuate risk management;
⦁⦁ senior management to oversee and be informed of the risk management process;
⦁⦁ the investment time period applicable to the VaR analysis to be two weeks;
⦁⦁ the a to be set at 1%; and
⦁⦁ minimum capital requirements of financial companies to be set at three times the company’s
VaR.
There have been several criticisms of these regulatory proposals, with critics claiming that:
⦁⦁ a two-week holding period measurement is too long for some volatile investments,
particularly those involving derivative instruments;
⦁⦁ a two-week holding period, combined with a 1% a, tends to safeguard against events that
might only occur once in four years. This makes it difficult to validate a VaR model; and
⦁⦁ there is no consensus about the best way to perform a VaR analysis, how it should be
used, or how it should be adapted to fit unique circumstances. Without such consensus,
the use of VaR in setting minimum capital requirements could be overly restrictive in
some cases and overly lax in others.
267
Exhibit 3.5
Return distribution of the indexed portfolio (expected return: 10%)
α = 1%
r.01 10% rg
VaR methodologies
The example given above illustrated the basic principles behind VaR analysis. However, it
was a simple example that does not include many of the complexities faced by VaR analysts
when they attempt to assess the risks associated with real portfolios that include a variety
of investments, including illiquid assets (real estate, private placements) and complex assets
(derivatives, bonds with imbedded options, CMOs). Indeed, there are at least five different
ways of performing a VaR analysis.
Parametric (statistical) analysis (also called the variance/covariance

method)
The example above was a simple kind of parametric VaR analysis. This most popular of all
the VaR methodologies is based upon the following assumptions:
⦁⦁ investment returns are normally distributed;

⦁⦁ investment returns are serially independent;
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VaR analysis
⦁⦁ a one-day investment holding period is the appropriate time period over which to measure
the value at risk; and
⦁⦁ portfolio return distributions can be computed, using the Markowitz mean-variance
approach, based on the expected returns and standard deviations of the individual assets
that comprise the portfolio, the correlations between all of the paired combinations of
the assets, and the individual asset weightings of the portfolio.
To illustrate the parametric approach, suppose a portfolio contains 50 assets, each of which
has a known expected return and standard deviation of returns. Furthermore, the correlation
matrix depicting all of the 1,225 possible paired combinations that can be constructed with
50 assets and the correlation of all of these pairs is known. This information, together with
the way the assets are weighted in the portfolio, will enable the analyst to determine the
expected return and standard deviation of the portfolio, using the conventional relationships
that apply if all of the asset returns are normally distributed:
RP = w1R1 + w2R2 + … + w50R50

2 = w21d21 + … w250d250 + r1, 2d1d2 + … r50,49d50d49
Once the expected return and standard deviation of the portfolio is determined in this manner,
the distribution of portfolio returns can be constructed. To illustrate this, suppose that the
distribution of portfolio returns has an expected return of .05% per day, with a standard
deviation of +/–10% per day. As indicated in Exhibit 3.6, the lowest percentile return on
the portfolio would be:
ra – RP
Z.50 – a =
dP
r – .05%
–2.325 = .01
.10%
r.01 = –.1825%
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Exhibit 3.6
α = .01%
r.01 .0 6 % Return per day
For every US$1 million invested in this portfolio, the VaR for a one-day holding period is:
VARday = –ra VP
= –(–.001825) (US$1,000,000)
= US$1,825
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VaR analysis
If the analyst wanted to determine the VaR over a holding period of one week (five trading
days), this can be done using the serial independence assumption:
RPweek = n RPday
= 5 (.05)
= .25% per week
d2Pweek = n d2Pday
= 5 (.10%)2
= .05
dPweek = ÷.05
= .2236%
ra – RP
Z.50 – a =
d2P
r.01 – .25%
–2.325 =
.2236%
r.01 = –.26987% per week
For a US$1 million investment, the VaR for a one-week holding period is:
VARweek = –ra VP
= –(–.0026987) (US$1,000,000)
= US$2,698.70
The variance/covariance approach to calculating the VaR of a portfolio is an extension of

this modern portfolio theory (MPT) methodology. It breaks down the individual assets in
the portfolio into their elemental component parts, each of which is affected by only one
risk factor. For example, a UK bond held by a US investor can be decomposed into a series
of zero-coupon UK bonds with various maturities, plus an exposure to the British pound
sterling. Each zero-coupon bond component is affected by one risk factor: the British spot
rate for that component’s maturity. In addition, the US investor is exposed to another risk
factor: the exchange rate between the UK pound and the US dollar. Once the UK bond is
‘mapped’ to all of its component risk factors, its overall risk can be determined using rela-
tionships that resemble Markowitz’ mean/variance analysis:
d2A = w2xd2x + w2yd2y… w2id2i + 2wxwyrxy dx dy + … + 2wiwhrhidhdi

where: wi is the exposure that the asset has to the ith risk factor
di is the risk associated with the ith risk factor
rhi is the correlation between the hth and ith risk factors
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Entire portfolios can be mapped in this way by breaking all of their assets into their compo-
nent parts, so that the portfolio becomes nothing more than a conglomeration of elemental
component assets, each of which is exposed to an elemental risk factor. The variance (risk)
of the portfolio can then be calculated by using the variance formula shown above. If a
one-day holding period is chosen for the VaR measure, and it is assumed that the expected
return on a portfolio is negligible over such a short time interval, the probability distribution
of one-day portfolio returns can be drawn once the standard deviation of the portfolio has
been calculated, as shown in Exhibit 3.7.
Exhibit 3.7
rα 0 RP
Once this is done, the risk analyst simply defines the level of significance of the analysis
and calculates the VaR in the normal manner:
ra – 0
Z.50 – a =
dP
VaR = –raVP = Z.50 – a dPVP
The strengths of this method of VaR analysis are:
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VaR analysis
⦁⦁ the standard deviations and correlations needed to perform the analysis for individual
elemental components of assets are readily available from standard sources;
⦁⦁ the VaR calculations are relatively easy to perform. The method is straightforward and
does not require a large amount of computer power; and
⦁⦁ there is no need to value the individual assets in a portfolio; all that is required is to
determine the standard deviations (degree of volatility) of the assets or the elemental risk
factors that affect them and the correlations between asset or risk factor pairs.
However, the method is not perfect. It has several weaknesses, some of which are shown
below.
⦁⦁ The analyst must know the standard deviation of the returns of every elemental component
of every asset in the portfolio, as well as the correlation matrix for all elemental component
pairs. While these are available from standard sources, such as Ibbotson Associates,
normally these sources provide the long-term average values of these parameters. This
begs the question: how long should the ‘look back’ period be in order to determine the
standard deviation and correlations for a one-day holding period? It may be that long-
term averages of these parameters (Ibbotson Associates calculate the standard deviation
and correlations of and between assets over various periods ranging from 1 to over 70
years of market history) might not be appropriate when measuring daily VaR.
⦁⦁ A more serious weakness of the parametric approach is that it requires the analyst to
measure the correlations between the paired assets or risk factors that comprise and
affect the portfolio. These correlations are usually based on long-term historical data or
exponential moving averages of relatively recent past data. However, correlations can
change quickly, and there is no guarantee that future correlations will be the same as those
observed in the past. For example, most of the time, there is not much correlation between
various pairs of national stock market index returns. However, when Asian currency and
stock markets suddenly collapsed in late 1997, all of the global markets suddenly declined
together. During times of crisis, correlations between asset classes can change significantly.
This is important for VaR analysis, because it is usually assumed that if the correlation
between the returns on two asset classes is low, holding both assets will reduce the risk
of a portfolio, even if the two assets are inherently risky if held alone. However, if the
correlation between two asset returns suddenly rises substantially under the stress of a sharp
market decline, what had been viewed as a relatively riskless situation may actually turn
out to be quite risky. Unless this concept is factored into the analysis, the VaR analysis
could underestimate the true portfolio risk. If a variance/covariance analysis is performed
on individual risk factors to which the portfolio is exposed, the same types of problems
exist. Unfortunately, most parametric VaR analysis do not incorporate this tendency for
correlations to increase during times of crisis.
⦁⦁ As the number of assets or risk factors to which a portfolio is exposed increases, the
number of terms in the portfolio variance equation increases geometrically. This means
that portfolios that are exposed to a large number of assets or risk factors might be
cumbersome to evaluate.
273
⦁⦁ The usual calculations that are used to compute a VaR with this methodology require that
the individual asset returns be normally distributed. If they are not, advanced statistical
techniques are required to perform the calculations.
⦁⦁ The risk characteristics of some assets (such as assets with imbedded options) may change
with economic conditions (such as a change in interest rates). If this is the case, the VaR
calculations become very complex. This means that the variance/covariance or parametric
method of performing VaR analysis is most suited for portfolios that are comprised of
assets with linear risks. The risk of portfolios that contain assets that have non-linear risk
(that is, derivatives or securities with imbedded options) are not easily measured using
the variance/covariance method.
Historical analysis
The parametric approach usually assumes that asset returns are normally distributed. This is
necessary in order to employ the simple equations that are used to calculate the variance of
a portfolio from the variance of the individual assets or risk factors. However, most research
has found that investment returns are not normally distributed. Rather they tend to exhibit
platykurtosis (that is, there tends to be a higher than normal probability of abnormally
low or high returns) and skewness that is, the return pattern tends not to be symmetrical).
When return distributions cannot be assumed to be normal, the parametric approach must
be abandoned in favour of some other approach to analyse VaR.
The historical approach is a relatively simple solution to the non-normality problem. For
example, suppose that a risk manager wants to know the one-day, lowest-percentile VaR
of an investment. Using a ‘look-back’ period of, say, the past 100 days, the manager can
observe the percentage change in the value of the investment in each of those days. These
historical daily observations can then be put into a histogram, as shown in Exhibit 3.8. The
lowest-percentile return for a one-day holding period can then be determined directly from
the historically generated daily price changes by simply finding that return that corresponds
with the 1% area under the curve in the left tail of the empirically determined return distri-
bution, as indicated in Exhibit 3.8.
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VaR analysis
Exhibit 3.8
Historical daily observations
r.m RP r
The strengths of the historical approach are:
⦁⦁ the method is understandable and easily explained to clients and company management
who are not familiar with the technical details of the VaR method;
⦁⦁ unlike the parametric approach, it does not require the analyst to make any assumptions
about how the prices of the investment are determined. Therefore, no valuation models
are employed, nor is there a need to know the expected return of assets, their standard
deviations, or their correlation with other assets, since the Markowitz mean-variance
methodology is not used;
⦁⦁ there is no need to assume that asset returns are normally distributed; and
⦁⦁ serial independence does not have to be assumed.
The weaknesses of the historical approach are:
⦁⦁ it assumes that the distribution of daily returns in the future will be the same as in the
past. As a result, it only takes into consideration the effects of market forces on the assets
in the portfolio, plus those unique factors that happen to have been the focal point of
investors’ attention during the ‘look-back’ period. To the extent that these factors may
be less important in the future, the method will produce biased and erroneous results;
275
⦁⦁ it requires that the investment portfolio being analysed remains unchanged in the future
as in the past. Therefore, it is not flexible enough to take portfolio changes into account
on a real-time basis;
⦁⦁ it requires a large database of historical return data that is costly to maintain;
⦁⦁ it does not permit the analyst to perform sensitivity tests, that is, to determine how the VaR
would be impacted by assumed changes in certain key parameters of assets that comprise
the portfolio (standard deviations, correlations, asset weightings, and so forth); and
⦁⦁ because serial independence is not assumed, it is not possible to easily convert daily VARs
to weekly VARs. If a daily VaR is desired, the empirically constructed histogram must be
generated from daily data; if weekly VARs are desired, the histogram must be generated
from historical weekly data.
Historical simulation analysis

Portfolio managers often employ assets in their portfolios the historical performance of which
is unknown either because there has been no active market for the securities (for example,
private placements and swaps) or because the asset did not exist in the past (for example,
new issues). However, the performance of these kinds of assets can often be linked to the
performance of other assets that do have a well-known price and return history. For example,
the performance of all bonds is linked to the performance of interest rates. While a particular
bond in a portfolio may be a private placement or a new issue without a past history of
performance, examining the past pattern of interest rates and using the duration, convexity,
imbedded options and other characteristics of the bond, the probable past performance of
the bond can be simulated with the use of a bond valuation model. Similarly, knowing the
historical returns and volatility of a stock, the probable past performance of an option on the
stock with a known strike price and maturity can be simulated by using the Black-Scholes
or other potion-pricing model to determine how its price would have performed in the past,
given the price movements of the underlying stock and interest rates during the ‘look-back’
period. A histogram of the simulated returns can then be constructed to determine the
lowest-percentile return and VaR for a given investment in the simulated asset in the same
way as is done using the historical approach.
The historical simulation method has the following strengths:
⦁⦁ it does not require the distribution of returns of assets or risk factors to be normal.
Therefore, it can be used to measure the VaR of portfolios that contain derivatives or
assets with imbedded options; and
⦁⦁ it does not require the standard deviation and correlation of returns to be stable.
Although the approach is useful for these reasons, it has many of the same weaknesses as
the historical approach.
⦁⦁ The ‘look-back’ period may not be representative of the period over which the VaR is to
be measured. For example, suppose historical simulation is used to assess the risk of an
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VaR analysis
interest-only (IO) mortgage-backed security. Suppose further that the one-year ‘look-back’
period was one of stable interest rates. From this information, the standard deviation of
the IO was +/–.0042% per day. This might be used as a volatility parameter in a one-day
VaR analysis. However, if the Federal Reserve unexpectedly announces a sharp reduction
in interest rates, the price of the IO might decline much more than its historical volatility
would suggest, based on the standard deviation computed in the ‘look-back’ period. Because
one important underlying factor that had been stable during the period over which the
standard deviation parameter was measured suddenly changed, the VaR analysis turns out
to underestimate the risk substantially. This kind of problem is a particularly unfavourable
trait of some VaR methodologies.
⦁⦁ Historical simulation requires the VaR analyst to be able to construct a valuation model
that correctly links the probable performance of the asset being analysed to the performance
of the underlying factor whose past price history is well known (interest rates, the stock
market index, and so forth). It is not certain that good valuation models can always be
constructed to adequately perform this linkage in a way that would truly reflect how the
asset’s price would have actually behaved in the past. This is particularly true for exotic
investments, such as CMO structures, complex swap agreements, options contract, and
so forth.
Stochastic (Monte Carlo) simulation analysis

Stochastic, or Monte Carlo, simulation is similar to historical simulation in that it requires
the VaR analyst to develop valuation models for the individual assets that comprise a port-
folio. These models will specify the parameters that determine each asset’s value. However,
instead of basing the values of these parameters on the historical price movements of known
underlying factors, such as interest rates and stock price movements, a computer is used to
generate thousands of randomly selected values for these parameters in order to generate a
simulated return distribution for individual asset returns. The VaR analysis is then based on
these simulated distributions. For example, suppose a VaR analyst is attempting to deter-
mine the one-week VaR at the 5% probability level for a call option on a highly volatile
stock. From the Merton option pricing model, the analyst knows that the key parameters
in valuing the option are:
⦁⦁ the price of the underlying stock;

⦁⦁ the risk-free rate;
⦁⦁ the strike price on the option;
⦁⦁ the dividend on the underlying stock to be paid during the time until the option expires;
⦁⦁ the volatility of the underlying stock; and
⦁⦁ the time until the option expires.
The only parameters in this model that are known for certain and, therefore, can be speci-
fied in advance are the strike price and the time until expiration. All of the other parameters
that determine the value of the option from the Merton model are stochastic, that is, they
277
can only take on any one of a number of values, and there is uncertainty about what their
values will be during the forecasting period required by the VaR analysis. However, the
continuum of possible values that these parameters can take on during the next week can
be described by probability distributions. Therefore, based on his or her experience, the
analyst will define the probability distributions describing the array of possible values for
these stochastic variables. In doing this, the analyst is free to assume either normal or non-
normal probability distributions as well as the parameters of those distributions (expected
value, standard deviation, and so forth). Therefore, the analyst might make the following
specifications for the stochastic variables of the Merton model.
⦁⦁ The price of the underlying stock one week hence might be described by a normal
probability distribution of returns, with a stated mean and standard deviation as determined
by the analyst.
⦁⦁ The risk-free rate one week hence might also be described by a normal probability
distribution, with a stated expected value and standard deviation as determined by the
analyst.
⦁⦁ The dividend might be described by a skewed probability distribution (dividends are usually
raised and seldom cut), with a relatively small width. If there is some uncertainty about
the date on which the stock will go ex-dividend, the ex-dividend date will also have to
be modelled with an assumed stochastic model.
⦁⦁ The volatility of the underlying stock would be determined in conjunction with the price
of the underlying stock, as indicated above.
⦁⦁ Since the Merton model is known to be an imperfect model for valuing options, the
analyst might also assume some distribution of model error, with a mean of zero and a
standard deviation for the error that is based on the analyst’s experience with using the
model as a forecasting tool in the past.
These probability distributions for the parameters of the Merton model are input into a Monte
Carlo computer program, together with the Merton model itself. The computer program then
randomly selects a set of parameters (a risk-free rate, dividend, ex-dividend date, price of
the underlying stock, and so forth) and computes the value of the option in one week by
inputting these randomly selected parameter values into the Merton model. It then applies
a randomly selected error term to the result, based on the modelled error function input by
the analyst. This produces one possible value for the option in one week that corresponds
to one possible return on the investment in one week.
The computer then repeats the process by randomly selecting another set of parameter
values and computes another possible value for the option in one week and a corresponding
possible return on the investment. This process is repeated perhaps 100,000 times, each
iteration generating a possible return. When finished, the computer arrays all of the possible
returns from lowest to highest. Since the analyst wants the 5% VaR, the computer selects
the 5,000th return in the array (5,000/100,000 = 5%). This is the fifth percentile return.
This (probably negative) return, multiplied by the value of the investment in the options,
produces the VaR for the option.
The strengths of the stochastic (Monte Carlo) simulation approach are as follows.
278
VaR analysis
⦁⦁ It is more flexible than the other methods of determining a VaR, because it enables the
analyst to specify the valuation models and the probability distributions of every stochastic
parameter in the model. These specifications include both the numerical parameter values
(mean, standard deviation, and so forth) and the type of distribution (normal, binomial,
Poisson, and so forth). In addition, these parameters can be based on the analyst’s
judgement about what is likely to occur in the future, rather than being ‘locked’ into
historical scenarios.
⦁⦁ It can be used to analyse non-linear as well as linear risks. Therefore, it can be used to
compute the VaR for portfolios that contain derivatives and assets with imbedded options.
⦁⦁ It is more likely to generate outlier possibilities than would be included under a historical
analysis or historical simulation. This is important, because it is the outlier possibilities,
which human analysts often dismiss as being too far-fetched for serious consideration, that
are the primary cause of the kinds of disasters that risk management should avoid at all
costs. For example, historical analysis of the past 100 weeks, historical simulations, and
the parameter approach are unlikely to include disaster scenarios, such as the emergence
of war, famine, pestilence, or an asteroid hitting the earth. The Monte Carlo method may
not include these types of scenarios either, but because there is a finite possibility that
the computer simulation could randomly select ‘far left tail’ scenarios, it is as open to
the emergence of these disasters as is their probability of occurrence. Therefore, Monte
Carlo simulation is generally regarded as being a useful approach.
The weaknesses of Monte Carlo simulation are as follows.
⦁⦁ Its ability to measure VaR accurately relies on the analyst’s ability to develop adequate
valuation models for assets in a portfolio and to specify realistic probability distributions
for the stochastic variables in those models (garbage in, garbage out). Therefore, this
method requires a great deal of mathematical modelling capacity.
⦁⦁ The more variables there are in the models that value assets, the more simulations have
to be run.
⦁⦁ Often there are alternative models that can be used to determine the price of securities.
For example, options can be valued using a Black-Scholes, Merton, Hull, or White model,
and the results of each model could differ. This means that two companies with the same
portfolios could generate different VaR measures.
⦁⦁ It requires more computer power than other methods. Also, it requires a large historical
data base of historical returns and risks that can be used as a reference for analysts
that have to set the parameters on the probability distributions that define the return
probabilities for various assets.
Stress simulation analysis

Stress simulation requires the investment manager to specify some ‘worst-case’ scenario and
then determine how an investment would perform based on the theoretical relationships
believed to impact the value of the investment.
279

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Exhibit 1.

Source: Author’s own

Income statement 2006 2007 2008

Balance sheet 2006 2007 2008

Source: Author’s own

4.71% 0.06% –1.23%

Source: Author’s own

Income Statement 2010 2011 2012

Source: Author’s own

Income Statement 2010 2011 2012

Balance Sheet 2010 2011 2012

Source: Author’s own

12.94% –0.02% –0.75%

Source: Author’s own

2011: spread = 9.51% – 5.95% = 3.56% (NIM)

2011: net operating cost ratio = 4.09% + .75% – 3.13% = 1.72%

2011: ROA = 3.56% – 1.72% + .02% – .47% = 1.34%

2011: ROE = 1.34% divided by .1039 (10.39%) = 12.94%3

As applied to Credit Bank:

IFRS – applications to banks1

IAS 32 – Financial Instruments: Presentation

that are potentially favourable to the entity;

of the entity’s own equity instruments;

classified by IAS 32 as equity instruments.

Financial liability: any liability that is:

that are potentially unfavourable to the entity;

of the entity’s own equity instruments; or

Classification as liability or equity

Example – preference shares

Example – issuance of fixed monetary amount of equity instruments

Example – one party has a choice over how an instrument is settled

Contingent settlement provisions

⦁⦁ the contingent settlement provision is not genuine;

Puttable instruments and obligations arising on liquidation

Classifications of rights issues

Compound financial instruments

To illustrate, a convertible bond contains two components. One is a financial liability,

⦁⦁ has a legally enforceable right to set off the amounts; and

Costs of issuing or reacquiring equity instruments

The disclosures relating to treasury shares are in IAS 1 – Presentation of Financial

IFRS 7 – Financial Instruments: Disclosures

⦁⦁ derecognition: certain information is required to be disclosed when all or part of transferred

Disclosure requirements introduced by IFRS 7 include:

Disclosure Fair value Cash flow Net investment

Source: Author’s own

⦁⦁ whether the fair value is based on quoted prices or valuation techniques;

Although ‘whether’ could, arguably, be answered with a qualitative analysis, it is presumed

‘Day 1’ profit or loss

Qualitative risk disclosures

Quantitative risk disclosures

⦁⦁ consideration of the economic environment in which the entity operates – remote or

IFRS 9 – Financial Instruments (Phase 1: Classification and

Overview of IFRS – Financial Instruments

Fair value option

⦁⦁ doing so eliminates or significantly reduces a measurement or recognition inconsistency

2011 2012 2013 2014 2015 2016 2017 2018 As of 1 January

Liquidity coverage ratio Observation Introduce

Shading indicates transition periods.

Consolidated income statement

Interest and similar expenses (6,183) (4,936)

Loan impairment charges (530) (196)

Consolidated statement of comprehensive income

Consolidated statement of financial position (balance sheet)*