Annual checkup: the U.S. insurers' annual statement has evolved from a fraud detector into a critical tool for demonstrating solvency.

INSURANCE REGULATION was developed to guarantee the financial stability of insurance companies. To that end, the central requirement of each state's regulatory system has been the filing of an annual financial statement by insurance companies. These financial disclosures are regarded as essential to protect buyers of insurance. The state insurance departments verify the accuracy and completeness of the disclosures, through periodic examinations of insurers' books and records. The verified information is available to the financial community and insurance buyers so that each insurer's financial strength can be further assessed and factored into the true value of the coverages and services it provides as compared with its competitors.

The accounting methods and principles that apply to the annual statement are known as statutory accounting. They are based loosely on actual state statutes, but they are primarily the cumulative result of many decades of standardization by agreement among the state insurance commissioners. Statutory accounting has a generally conservative bias, so that the financial condition of insurers as reflected in their annual statements serves as a paradigm for the evaluation of a financial institution as a virtually "unsinkable ship."

This basic foundation of rigorous solvency regulation is fortified by regulating insurers' market conduct. Premium rates, advertising and underwriting methods, policy forms and benefit provisions, and various aspects of the performance of policy obligations, such as claim practices, are scrutinized. Rate regulation is intimately related to solvency in the longer run, and the other major aspects of market conduct regulation promote fair and equitable methods in the process of selling and delivering financial services, given the underlying premise that insurers are financially sound, so that they are capable of performing their contractual obligations, in full and indefinitely.

In the Beginning

Insurance regulation began in the mid-1800s, gaining hold in New York and Massachusetts. Superintendent William Barnes of New York is a memorable example of an official "sleuth," exceptionally alert to financial fraud and deception in their grosser forms.

As a young lawyer, Barnes was employed by the New York Comptroller's office in 1855 to examine several fire insurance companies located in the Wall Street area. He found, among other discrepancies, that one company's mortgages on "building lots" in Brooklyn, claimed as assets worth $102,000 on its statement, were on properties located entirely under the water of New York Harbor. He determined, apparently by personal observation, that the properties were below both the high and the low water mark, and he even conducted soundings and constructed a map to demonstrate that the depth of the high water was about 11 feet. The invested capital of another company examined by Barnes was found to consist of $150,000 in securities that had been borrowed for a daily fee of $1,000, solely for the purpose of being exhibited when the company had originally applied for its charter.

Barnes' investigations that summer led to the dissolution of six fire insurance companies and to the adoption by Comptroller James Cook of an annual statement "blank" for fire companies, which required each company to provide a detailed description of mortgaged premises, their value, and even the amount of insurance carried on the buildings.

Around this time, New York fire companies also were required for the first time to show the approximate equivalent of an unearned premium reserve as a liability, namely "the amount required to safely reinsure all outstanding risks." Barnes' discoveries also led to the establishment of a New York state Department of Insurance on Jan. 1, 1860.

The historical process in New York strongly reflects how annual statements became evidence that an insurer was adequately capitalized, that its claimed assets were real, and that they were invested appropriately. In the infancy of insurance regulation, government officials were not so much concerned with the long-term viability of companies as with their fundamental honesty and legitimacy. Fire companies were not engaged in a long-term business, and life companies were hot yet established according to actuarial principles that would even allow for the soundness of their long-term obligations to be evaluated. The primary focus, apparent from the historical records in New York, was to assure the public that insurance companies are generally reliable, legitimate financial enterprises.

New York was the first state to begin to regulate insurers on a systematic basis with an 1827 law requiring every bank or insurance company to file an annual sworn statement of its affairs with the state comptroller, setting forth the amount of its capital; the value of its real estate; the shares of stock held; debts owing to the corporation; debts owed by the corporation; claims not acknowledged as debts; and the amount for which the corporation is bound as surety.

New York's comptroller entered those companies' statements in a book open to public inspection. The comptroller was directed to report to the Legislature in the event that any reporting corporation appeared to be, or in danger of becoming, insolvent. Those general categories of disclosure included some specific requirements, such as a description of the stocks owned by the corporation, and the number and value of the shares of each stock, but in comparison with more modern disclosure requirements the statute is rudimentary. Also, it applied only to corporations "hereafter created" in New York.

In 1849, New York enacted the first general law allowing for the incorporation, without a special act of the Legislature, of marine, fire, and life insurance companies, and requiring them to file annual statements of their financial condition, similar to those required under the 1827 statute, with the Comptroller. Then in 1853, fire companies were required to file annual statements in an expanded format, consisting of five major parts: capital stock, property or assets, liabilities, income, and expenditures.

Each part was subdivided into more detailed items, such as par value and market value for stocks listed as property or assets and a breakdown of expenditures into losses paid, dividends paid, expenses (including commissions and fees), taxes, and other expenditures. In its more detailed aspects, this format at least began to resemble an itemized balance sheet and income statement, which are now the standard with regard to all financial statements.

The format for life companies' statements under this law was somewhat less extensive, consisting of 15 numbered items, including the number of policies issued during the year, amount of insurance effected, amount of premiums received, amount of interest and other receipts, losses paid and unpaid, expenses paid, amount of liabilities, and amount of assets, including the amounts invested in different categories such as real estate, bonds, mortgages, and other securities.

For both kinds of company, the basic technique of using "interrogatories" or questions directed to insurers, and requiring sworn answers, rather than requiring them to submit organized financial statements as such, persisted.

Significantly, the state comptroller was authorized to examine the finances of lift companies if their solvency was doubted, and to appoint one or more persons to examine fire companies at any time at his discretion. The legislative grant, and actual use, of regulatory powers of examination made annual statements subject to direct verification and, therefore, much more effective as regulatory tools.

Life Reserves Set

About the same time in Massachusetts, Insurance Commissioner Elizur Wright was concerned with the subtler kinds of fraud or injustice that he detected in the mathematical practices of the life insurance business in particular.

During a long visit to London in 1844, Wright became intensely interested in life insurance and was appalled by some of the practices of the British companies in this field. In particular, he abhorred the plight of aging life insurance policyholders who could no longer afford to pay their premiums and were compelled either to forfeit their policies or to sell them to speculators--somewhat like a modern viatical settlement transaction--in an auction conducted weekly at the Royal Exchange. The auction impressed Wright as being similar to a slave auction in the American South, in that numerous old men (the insureds) were required to exhibit their persons to the speculators at the auction, but with the highest prices being paid for those policies on the lives of the men who appeared to be in worst health.

Returning to Boston, Wright undertook a journalistic and lobbying campaign to reform the American life insurance business, which at that time did not provide any guaranteed non-forfeiture benefits, although some companies voluntarily granted them on a case-by-case basis. First, working in effect as a consulting actuary, for a fee of $2,200, he developed reserve valuation tables for the New England Mutual and five other life insurance companies. The 200,000 computations needed to produce the tables were performed manually by Wright and his older children over a period of about a year. Not only did the tables provide guidance as to the fair amount needed to compensate a withdrawing policyholder, but coincidentally also gave precise directions as to the amount of reserve liabilities needed to be maintained to keep a life insurance company solvent.

Wright campaigned for legislative action to make his reserving technique a legal requirement, instead of just a guideline. The first reserving law for life companies was enacted by the Massachusetts legislature in 1858 and made mandatory for all companies in 1861. Apparently because no one could understand or, therefore, enforce the new law, except Wright himself, he was appointed an insurance commissioner in 1858 and remained in that capacity until 1867. Having the benefit of companies' annual statements that showed the amounts of life policy reserves, Wright was able to advise policyholders about their policy values even before nonforfeiture values were first required in 1860.

In the words of his descendants, Philip and Elizabeth Wright, who published a biography of Wright in 1937, "He kept a record of every policy of every company doing business in Massachusetts ... He invited policyholders to visit him, and they did so. Referring to his register, he was able to tell any policyholder who presented himself to what extent, if any, he was being swindled, how much he would lose by dropping his policy, and what cash surrender value the company in enquiry in equity ought to pay."

As of 1860, Massachusetts companies were required to provide "temporary insurance," what would now be called extended term insurance, automatically as a nonforfeiture benefit, and ultimately the law was strengthened in 1879 to provide for payment of a cash surrender value at the policyholder's option. Wright's zeal eventually offended certain companies, and he was eased out of office in 1867, after which he became the actuary of both John Hancock and Travelers.

State Regulators Convene

In 1871, Superintendent George W. Millet of New York, the immediate successor of William Barnes, invited all of the insurance regulatory officials then in office to attend, for the first time, a national insurance convention in New York City. Of the 31 such officials, 19 were present or represented by a delegate when the convention opened on May 24, 1871.

In his introductory remarks, Miller is reported to have said, "The true object and aim of governmental supervision should be to afford the fullest possible protection to the public, with the least possible annoyance or expense to, or interference with, the companies."

Setting out state regulatory responsibilities, Miller cited annual statement forms and matters subject to legislative approval, including the computation of reserves, deposits, taxation, investments and dividends. By the ninth day of the convention, the delegates bad hammered out a prototype of the first uniform annual statement blanks.

They reconvened in October, with representatives of 30 of the 31 states in attendance, and the permanent character of the National Convention of Insurance Commissioners was virtually assured. The blanks initially adopted, however, were not put into an enduring form until further action by the convention resulted in the fire and life company blanks of 1874.

A casualty blank, actually called "Miscellaneous," was adopted by the NCIC in 1903, based on a New York form dating back to 1871 that had been adapted from the life blank. The basic features of the blanks endured until a new, combined fire and casualty, or "Multiple Line," blank was adopted in 1950, followed by a completely revised life blank in 1951.

Electronic Statements

In 1967, A.M. Best Co. became the first company to computerize the print version of the NAIC Annual/Quarterly Convention Statement. The NAIC appointed A.M. Best as its statistical agency in 1971, to prepare, create and submit NAIC Solvency and Profitability Test Reports for U.S. property/casualty insurance companies.

In 1985, A.M. Best created Best ESP, a software program designed to enable all types of insurance companies to prepare and file their quarterly and annual financial statements electronically. This was prior to the NAIC requesting similar electronic filings of data from U.S. insurance companies on a voluntary, and later, mandatory basis.

The creation of the electronic-copy version of the financial statements enabled the NAIC to retrieve U.S. statutory data and load it into its financial data relationship databases. It also eliminated the need for the NMC to convert or translate electronic filing specification formats unique to each third-party vendor to an electronic filing specification format unique to the NMC.

In defending the traditional role of state insurance regulation before a congressional committee, the NAIC testified in 1991 that the database was the "core of the solvency surveillance and other analysis activities of state insurance regulators and the NAIC" and would be available to the public in a variety of reports and studies.

This data is now submitted electronically by insurers directly to the NMC in most instances, in conjunction with their submissions to the various state regulatory agencies. The data is available free of charge to noncommercial users, to a limited extent, on the NAIC's Web site (www.naic.org), and can be obtained for a fee by others.

The current organizational structure of the NMC is set forth in its 1999 certificate of incorporation as a Delaware nonprofit corporation, and in its bylaws. Interestingly, only the actual insurance regulatory officials in office at a given time are members of the NAIC, but in the minds of most industry participants the NMC functions as an umbrella organization for the insurance departments themselves, and also as a public forum for the exchange of ideas, opinions and public-policy concerns about insurance regulation in general. A strong sentiment in favor of the preservation of the state system of regulation, as opposed to federal regulation, generally prevails both officially and unofficially in NMC forums.

The NAIC's agenda is parceled out to committees of regulators called task forces. The Blanks Task Force, like the other committees, meets regularly during one or more of the NMC's four annual national meetings. Proposed changes to the statement blanks are distributed to regulator members and NAIC subscribers, and interested parties are offered an opportunity to submit suggestions and comments. The interested parties are, most commonly, insurers and industry trade organizations. The usual result is that, over time, the evolution of the statement blanks and other NAIC developments are the product of a collective thought process and enterprise that accommodate different points of view and objectives, both governmental and business-oriented.

Key Points

* To guarantee insurers' financial stability, state regulators require each company to file an annual financial statement.

* In 1827, New York passed one of the first laws requiring every bank or insurance company to file, with the state comptroller, an annual sworn statement of its affairs.

* The first reserving law for life companies was enacted by the Massachusetts Legislature in 1858.

* In 1967, A.M. Best Co. became the first company to computerize the print version of the NAIC Annual/Quarterly Convention Statement.

STATEMENT BLANKS: In the late 1850s fire companies in New York were among the first insurers to be required to file an annual statement as proof that they had finances sufficient to cover all the losses they had underwritten.

1871-1899

Efforts to standardize the state-based regulation of insurance companies began in earnest with the inaugural meeting of the National Convention of Insurance Commissioners in New York City in May 1871. The NCIC, the precursor to the National Association of Insurance Commissioners, reached its initial goal of adopting statement forms for insurers to report their financial dealings annually to state regulators in 1874. A surplus reconciliation form, the Gain and Loss Exhibit, was introduced for life companies in 1895, and the reconciliation of assets form for fire companies was launched in 1899.

1900-1939

Committee on Valuation of Securities established in 1907. Model liability reserve law with minimum reserves of a company's average Iosses over a five-year period proposed in 1911. Workers' compensation Iosses segregated and amortized value of bonds approved for life companies in 1917. Exhibit of Changes in Surplus replaced Gain and Loss Exhibit for life companies in 1925. It was revamped in 1939 as a new Gain and Loss Exhibit.

1950

New Multiple-Line blank for fire and casualty insurers to accommodate the transition to combined property/liability coverages written by a single insurer. Casualty Actuarial Society comments: "From the standpoint of the general public, the blank has the advantage ... of providing exhibits of assets and liabilities in forms more comparable to those of other types of corporations with which an interested public is more familiar, and producing in concise form the year's operating results on a revenue basis and the accounting thereof in the capital and surplus account along conventional lines."

1951

New life company blank was completely revised in a modern format, the major parts consisting of Balance Sheet, Summary of Operations and Surplus Account, plus Exhibits. The Summary of Operations was patterned after the Gain and Loss Exhibit.

1969-1987

Schedule P of the property/casualty statement was changed from policy-accident year basis to calendar-accident year basis in 1969. The NAIC's Early Warning Tests were first applied in 1971. The tests were renamed Insurance Regulatory Information System (IRIS) in 1977. After a study conducted by McKinsey & Co., in 1976 the NAIC introduced the Financial Condition Examiners Handbook and Model Market Conduct Examination Handbook as guides for examiners. A major expansion of property/casualty Schedule P, from seven to 27 pages was accomplished in 1987.

Correspondent Peter M. Lencsis is assistant professor of finance at the Syms School of Business at Yeshiva University, New York. He previously taught at St. John's University School of Risk Management. His publications include Insurance Regulation in the United States.

Framing the Rules: In the mid-1800s Elizur Wright and William Barnes, working independently of each other, created the initial footprint of the rules contemporary insurers follow. Wright was concerned with subtle injustices that he detected in the mathematical practices of the life insurance business. William Barnes uncovered insurance fraud underwater in New York harbor.