How to build a recovery: one company's successful financial turnaround shows that procedures in all aspects of operations have to be adjusted to make corporate collection efforts work.
* Underwriting, reinsurance, billing and collections, audit, legal, accounting and claims all affect collections.
* A specific date should be set to differentiate run-off business from start-anew business.
* Performance measurement tools must be used in all areas to motivate people and focus them on activities that drive the desired financial outcomes.
As of Dec. 31, 1988, the known state of the national account book of business in a major U.S. property/casualty insurance company was as follows:
* Combined ratio--114 and increasing,
* Cash flow--negative,
* Collection rate--unknown,
* Billable receivables--unknown,
* Overdue--$20 million and increasing, and
* Schedule F penalty--$25 million and increasing.
Later analysis would determine the situation to be more dire. Managers determined that once the problems began to arise, they were seeing only the tip of the iceberg. The national account business portfolio also was replete with loss sensitive programs and alternative risk transfer mechanisms, including self-insured retention programs, deductible programs, captive programs, paid loss retrospective programs, incurred loss retrospective programs, banking excess plans and fronting programs.
In April 1989, the chief executive officer, chief financial officer and chief underwriting officer established the financial services department. Its mission was to immediately stop the bleeding, identify and rectify areas that were creating the substandard results, and set the company on a profitable course. To that end, the new department was empowered to make whatever changes necessary and was given significant influence over all aspects of the operations.
In just two years, the financial services department had begun to reverse the downward trend, as follows:
* Combined ratio--104 and declining,
* Cash flow--positive,
* Collection rate--97%,
* Billable receivables--100% identified (previously unknown receivables identified and collected totaling $100 million),
* Overdue--$300,000 and stable, and
* Schedule F penalty--$500,000 and stable.
These results continued to improve over the next four years.
All of these results were achieved without a significant investment from the company or using outside consultants and collection agencies. The following shows how this was accomplished and the lessons learned.
Lesson 1. Recognize that all aspects of the operations impact collections. This includes underwriting, reinsurance, billing and collections, audit, legal, accounting and claims. It became clear to management that a knowledgeable central force would be needed to coordinate the efforts of these areas. The processes in each area needed to be adjusted and improved so that they complemented other areas and supported corporate collection efforts. This was critical to success.
Lesson 2. Resist the urge to mark off all open balances and unilaterally close out prior business written in an effort to "start anew." This push usually comes from the underwriting and accounting areas in an effort not to be held accountable for this business and to reduce expenses. The actual effect is to worsen the company's cash flow. Current and future receivables will be rendered uncollectible.
Instead, set a date after which new and renewal business written is the "start-anew" business and needs to be handled properly. All business written prior to that date is "run-off" and needs to be reconciled and collected.
Lesson 3. Educate people in all aspects of the operations on the program types being written. All areas need to understand their role in making the business profitable. They need to understand the consequences of not following procedures and guidelines. And this training needs to occur on a regular basis, not just once.
Lesson 4. Use performance measurement tools in all areas of the operations to motivate people and focus them on the activities that drive the financial outcomes the company desires. To properly affect corporate outcomes, the development and performance objectives need to be identified and adhered to for each area of the operations.
But make sure you use the correct measures or you may not get the results you desire.
For example, the collections unit was using as a performance measure overdue ratio (overdue dollars/outstanding dollars), thinking this would motivate staff to reduce overdues in order to meet the ratio target. Rather, the outcome was that staff was delaying in collecting amounts due thereby increasing the outstanding dollars and getting a lower ratio. The financial services department fixed this by scrapping that measure and implementing two new measures, overdues (dollar target) and collection ratio (dollars collected/total dollars due). This identified departmental training needs that, when addressed, achieved the desired results.
Lesson 5. Learn from the mistakes of the past.
Operations Areas Step by Step
The following issues were identified and addressed in some of the operational areas in order to reconcile the run-off business and handle the start-anew business properly.
* Be careful in depressing premiums when writing business. This can result in artificially low results regarding program and policy aggregates, maximum premiums, escrow/working funds and collateral amounts, as well as incorrect accounting ledgers. All of these outcomes will lead to bad underwriting results, poor cash flow and low collection rates. This was a serious situation that needed to be corrected and handled properly going forward.
* When business is bound, communicate clearly and timely to all operating areas impacted by the terms of the deal, including accounting, billing and collections, claims and reinsurance. Have a standardized reporting format so that the reporting for each deal is the same. Without this, confusion will reign and your results will suffer.
* Be selective regarding the form of collateral you accept. The form of collateral preferred by insurance regulators is a letter of credit using the New York State wording (that is, clean, irrevocable and evergreen). The financial services department believed the most secure form to be this type of letter of credit, especially in the case of a bankrupt insured. Not having the correct form of collateral caused significant problems for the company in bankruptcy, collection and overdue situations.
* Audit the contracts to make sure they accurately reflect the intent and working of each program type. To management's shock, the financial services department found that the contracts for the company's self-insured retention programs did not accurately reflect the workings of the program type. This oversight created an unfunded liability of $200 million for the company that needed to be addressed immediately and successfully. If possible, standardize the contracts so that there is predictability in the business written.
* Placing facultative reinsurance is usually an area that does not receive much scrutiny. On a total placement basis, you may be ceding away too much profit. If so, you could self-fund this reinsurance and have a credit line and/or a stop loss cover to protect any unexpected overages. You may be able to do the same with your treaty reinsurance if you do not have catastrophe exposures.
* When placing reinsurance, it is important to use reinsurers that are stable with regard to financial results, capitalization and location. Perform a review of your reinsurers every year to determine their long-term viability. Otherwise, you may find years later that you have no protection and have to take a hit to your bottom line.
* When negotiating treaty and facultative reinsurance terms, get a portion of the ultimate expected reinsurance recoverables covered by a letter of credit. For example, using your loss experience, you can estimate the outstanding reinsurance recoverables at three years out and get collateral for that amount. This collateral can be used to reduce any schedule F penalties and possible default by the reinsurer.
* It is important that there be continual education for the underwriters regarding loss-development factors, incurred-but-not-reported losses and the accurate application of the actuarial pricing methodology. Not having this education in place caused significant problems for the company, especially given the high turnover of underwriters in the field. The outcome of such a lapse is bad pricing, insufficient collateral amounts and inadequate aggregate/maximum premium limits.
For example, the CFO asked the financial services department to reunderwrite an account that appeared to be delivering unsatisfactory results. The financial services department was to use only information available to underwriting at the time the business was written. It was an incurred-loss retrospective account, and it was determined that the underwriter used loss data that was a year old to price the account, set maximum premium limits and determine collateral amounts. He did not apply actuarial loss development factors to the incurred loss amounts. Nor did he take into account that the company was growing at a 30% rate every year. In the contracts, he made no provision for audits to be performed. He never had financial reviews performed. The outcome was disastrous.
Billing and Collections
* On start-anew business, billing and collections personnel need to communicate with brokers/agents and insureds on an underwriting basis and not an accounting basis. Sending copies of ledgers or speaking in terms of debits and credits will not work. Bills need to reflect the terms of the contracts (deposit premiums, retrospective adjustments, deductibles, service fees, aggregates, maximum premiums). If not, the brokers/agents and insureds will not pay. This change was important, enabling the financial services department to achieve a 97% collection rate in two years.
* Reconcile run-off business on an underwriting basis and not based upon what the ledgers show. Get the underwriting Files and determine what should have happened by way of contracts and endorsements. Compare this to what was actually booked and paid. Any difference on the ledgers can be marked off with confidence that you have the correct numbers. On this basis, the financial services department was able to identify and collect $100 million in previously unknown receivables and clear the ledgers.
* Internal audit needs to regularly audit underwriting for compliance on application of pricing methodology, depressing premiums and probable maximum losses, collateral and escrow/working fund amounts, financial reviews of insurers and contract wording.
Without this process, catastrophic outcomes can, and many times do, occur. For example, it came to the financial services department's attention that the company's international operation was writing an increased number of captives, but no one was seeing any meaningful information on the captives. Financial services contacted the head of the international operation and queried him on this. He was not aware of the situation and requested that financial services go to his offices and audit the captives. This was done and the situation was not good.
Five captives were putting the company at significant risk. In the worst case, the underwriter had artificially calculated a reduced probable maximum loss to avoid scrutiny. He had no backup for his estimated ultimate expected losses, saying that he just used what the broker told him. The policy limit per occurrence was $2.5 billion with a probable maximum loss of $20 million. Not much was excluded from the policy. The captive was responsible for the first $1 million of each occurrence. Much of the probable maximum loss was reinsured. However, it was largely assumed back by the company, thus leaving the company at significant risk with little protection. Needless to say, changes were implemented.
* To improve accuracy of the ledgers, the financial services department instituted a daily procedure to reconcile the previous day's entries against the policy information received from the underwriter. If information was not available, accounting made sure they received it. If incorrect entries were on the ledgers, they were sent back to entry for correction. Accounting also checked each day that the corrective entries made the previous day were correctly entered. Performance measures were used to make sure the company stayed on top of this situation.
* Unapplied cash resided in a number of accounts. It was imperative that these accounts be reconciled if the financial services department was to be successful in its collection efforts. Performance measures were used to drive success in this area.
The financial services department was given a veto of any business opportunities that were under its purview. The purpose was to prevent the company from being adversely impacted by inappropriate business decisions made by those with authority in the field. Only the CFO could override the financial services department's veto.
For example, in an effort to reduce reinsurance penalties, the head of reinsurance was planning to draw down on letters of credit supplied by good reinsurers for their business to pay for delinquent reinsurers where an LOC was not available.
Another example dealt with underwriting wanting to use back-dated insurance policies as a way to cover business losses for companies, thereby improving their financial results.
Of course, both are illegal and would have tremendously damaged the company's image.
Having a knowledgeable brain trust such as the financial services department, that responded intelligently and quickly to all operational issues, greatly improved the financial results of the organization and prevented the implementation of bad decisions that would have created a public relations debacle.
Contributor Ian MacDonald is chief executive officer of The Maitland Group, Montville, N.J.
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|Comment:||How to build a recovery: one company's successful financial turnaround shows that procedures in all aspects of operations have to be adjusted to make corporate collection efforts work.(Property/Casualty)|
|Date:||Oct 1, 2005|
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