mmmm&mBm$m'v^'^^^^^ UC-NRLF B M 577 DbD ;r<:v Nir^ ."vy .-i ;';'7-;';:,ov<'-- ^^^^k;^^^^^,..^^^^^^^^^^^ nioersit^ of ^;^ 4^ California ^ /^ v^ THE EXAMINATION OF INSURANCE COMPANIES A Series of Talks to the Members of His Office Staff BY S. HERBERT WOLFE, F. S. S. Consulting Actuary Author of "Inheritance Tax Calculations," "Modified Premiums and Costs," Etc. NEW YORK THE INSURANCE PRESS 1910 t^&',1 <30 '/■/ ^cO Copyright, igio, by S. Herbert Wolfe J. B. LYON COMPANY PRINTERS AND BINDERS ALBANY, N. Y. PREFACE On numerous occasions the members of my office staff have evidenced a desire to consult reference books which would enable them to obtain information on points connected with their examining and their auditing work; my inability to direct them to proper sources of information led me to institute a system of brief talks upon the topics connected with their work. During the summer of 1910 I was asked by the New York State Civil Service Commission to participate in the oral examination of candidates for the position of Assistant Examiner of the Insurance Department of the State of New York. Many of the aitswers given by the candidates indicated the same need for informa- tion which had been expressed by my own assistants. Department and company officials to whom I hap- pened to mention these facts, suggested the advisa- bility of putting these talks in some permanent form, so that they could be of use not only to the members of my own staff, but to Departmental Examiners and to assist the accounting departments of companies in the solution of the numerous problems which arise in connection with their annual statement work. In conformity with that suggestion, I offer this book to those who may need it, and wish merely to state that it was not my intention to prepare a learned treatise on the practice and theory of supervision and accounts, but merely to give to my fellow-workers the [3] 211710 4 Preface benefit of the rules which I have found advantageous in the large number of examinations and audits with which I have been connected. It will be noted that it has been my attempt to impart the knowledge by sug- gestion rather than by direct statement. In this way, the reasons for the various treatments have been de- veloped and the logic of the situations has been shown more clearly. Whenever it became necessary in my talks to refer to specific statutes, the sections or parts of sections applicable were read ; I have reproduced them in this book in the form of appendices rather than to cumber the text with extensive quotations. S. Herbert Wolfe. 165 Broadway, New York, N. Y., December, 1910. TABLE OF CONTENTS PAGE Preface 3 CHAPTER I. The development of supervision — Personal attitude of the examiner — Qualities he should possess — His attitude towards ofl&cials of company under examination 9 CHAPTER II. Limitation on real estate holdings — Examination of title — Title insur- ance — Purchases from officers or interested parties — Methods of appraisal — Certificates of extension 16 CHAPTER III. Mortgages — Limited to percentage of value of property — Abstract — Appraisal — Fire insvu-ance poHcies — " Purchase money mortgages " — Notice to mortgagor — Guaranteed mortgages — Transfer of tax lien 22 CHAPTER IV. Bonds — Different forms of bonded indebtedness — Railroad bonds — Registered and coupon bonds — Directors not to be interested in sales or purchases — Evidence of ownership 30 CHAPTER V. Difference between bonds and stocks — Danger in stock investments — Preferred, common and guaranteed stocks — Collateral loans — " Win- dow dressing " — Collateral loans contrasted with poHcy loans 38 CHAPTER VI. Cash in ofiice and in bank — Percentage of cash to invested assets — Cer- tificate from banking institutions — Interest bearing and non-interest bearing accounts — Pohcy loans — Liens and their sources — Premium notes 46 CHAPTER VII. Miscellaneous assets — BiUs receivable — Furniture and fixtxires — Accrued interest — Rent paid in advance — Reinsurance due — Agents' balances — Deferred premiums — Uncollected premiums — "Paid for" and " written " bases — Uncollected assessments of fratemals 53 16] 6 Table of Contents CHAPTER VIII. PAGK Loading on uncollected and deferred premiums — Disallowed or non- admitted assets — Loans on capital stock — Supplies and printed matter — Commuted commissions — Cash advanced to officers — Excess credits — Depreciation in securities — Premiums outstanding more than ninety days — Appreciation 63 CHAPTER IX. Amortization of bonds piu-chased above par — Accumulation of bonds purchased below par — Incorrect methods of treating premiums and discounts — Necessary factors 70 CHAPTER X. Liabilities — Net value of life insiu-ance policies — Net terminal value — Mean reserve — Unearned premiums — Unearned premiums on marine policies — Perpetual poUcies — Reinsurance 80 CHAPTER XI. Surrender values claimable — Different forms of death claim liabilities — Resisted claims — Accident and health claims — Contingency reserve. . 89 CHAPTER XII. Fire losses — Plate glass losses — FideUty and surety policies or bonds distinguished — Inability to keep track of issues — Suggested remedies — Salvage — Co-surety — Depository bonds 97 CHAPTER XIII. Special liabilities — Credit policies — Definition — Methods of treating accounts with insolvent debtors — Liability poUcies distinguished from workmen's collective poUcies — New York and Michigan methods of computing reserves 104 CHAPTER XIV. Miscellaneous liabilities — Special or advisory board contracts — Taxes due or accrued — Borrowed money — Capital stock — Sale of stock in connection with life insurance forbidden 115 CHAPTER XV. Commissions on uncollected premiums — Dividend liabilities of life com- panies — Annual and deferred dividends — Restrictions placed on dividends by New York statutes — By Ohio statutes — Items of divi- dend hability in statement blank — Tontine poUcies — Sources of dividends 124 Table of Contents CHAPTER XVI. PAGE Departmental examinations not audits — The trial balance — Premium income — The two bases — " Pohcy holders' basis" — Various sources of^nterest — Other items of income — Premium on capital stock 133 CHAPTER XVII. Evidence of disbursements — Voucher-cheques — Losses — Payments in installments — Net losses, surrender values and dividends — Other dis- bursements — Profit and loss 141 CHAPTER XVIII. Development of schedules in annual statement blanks — Analysis and explanation of schedules A to Y, inclusive of Ufe blank 149 CHAPTER XIX. Additional schedule for fraternals — Schedules in blank used by fidelity, surety, credit and liability companies — Detailed classification of fidelity and surety risks 158 CHAPTER XX. Schedules and their application to financial portions of statement — Method of checking details shown in schedules with items in other por- tions of statement 167 CHAPTER XXI. Excise bonds — Special feature in New York State — Excise reinsurance agreement — Its method of operation — Guaranty of bills of lading — Other forms of guaranteed certificates 175 CHAPTER XXII. Limitation of risk — Logic of statutes — Limitation as applied to liability poUcies — To credit policies — Policies in hands of agents — Method of verifying unearned premium item 181 APPENDICES. Appendix A — New York Insurance Law relating to ownership of real estate 189 Appendix B — New York Insurance Law relating to disposition of real estate 190 Appendix C — Notice to be sent to mortgagors 192 Appendix D — New York Insurance Law relating to directors or officers being interested in purchases and sales of securities .... 193 Appendix E — New York Insurance Law relating to investments of com- panies, etc 194 Appendix F — New York Insurance Law relating to investmenji of capital 197 Table of Contents PAQB Appendix G — Certificate for verifying bank deposits 199 Appendix H — Sheet for determining excess credits 201 Appendix I — New York Insiu-ance Law referring to amortization and market value of securities 202 Appendix J — New York Insurance Law relating to the computation of the loss reserves for liability companies 203 Appendix K — Michigan Insurance Law relating to the computation of the loss reserves for hability companies 206 Appendix L — Reserve for unpaid UabiUty losses 207 Appendix M — New York Insurance Law providing for a contingency reserve 216 Appendix N — Ohio Insurance Law pertaining to the participation in surplus by policyholders of life insurance companies. ... 218 Appendix O — New York Insurance Law fixing the limitation of ex- penses of life insurance companies 220 Appendix P — New York Insurance Law pertaining to the annual reports of life insurance corporations 224 Appendix Q — Liabihty loss reserves 228 Index 241 THE EXAMINATION OF INSURANCE COMPANIES CHAPTER I The Development of Supervision — Personal Atti- tude of the Examiner — Qualities He Should Pos- sess — His Attitude Towards Officials of Company under Examination. It is my intention to discuss with you, from time to time, certain phases of your examining work and to lay down rules for your guidance; I think it proper that during this, my first talk, I should briefly trace the history of insurance examinations in this country and also lay down some general principles, rather than to deal with any particular phase of the exam- ining work. Supervision in this country really started with the idea that insurance corporations, like other corpora- tions, should render reports to the financial officers of the government so that taxes might be levied and a means for securing revenues for the State thereby created; the thought that they should be supervised for the benefit of the policyholders was an after- thought. The insurance departments of the various States in this country are gradual developments; origiaally started, as I have indicated, for the pur- pose of securing reports upon which taxe^ could be [9] 10 Examination of Insurance Companies levied, they became bureaus of licenses established not only for the purpose of securing revenue from agents' licenses, but also for the prevention of soliciting for unauthorized companies. That was probably the first step for the protection of policyholders by the various insurance departments. As the companies grew larger and became more vital factors in the financial world, abuses crept into their management, and of late years, probably within the past two decades, the supervision by the State authorities has taken more and more upon itself the question of eliminating these abuses and requiring the insurance companies to be administered for the benefit of the policyholders along lines not only sound from a financial standpoint, but in the case of life insurance companies, secure from an actuarial standpoint. There is one great difference between a depart- mental examination and an examination made by a firm of certified public accountants, for instance, and that is this : it was never intended that a departmental examination should be an audit. It is impossible for any group of examiners coming to a company's office for a brief period of several weeks, or even several months, to properly review each and every transaction which has taken place since the company was last examined. The form of examination, therefore, which you will have to follow, may properly be described as more of a scrutiny of the system and methods than of the details. At least, the first part of an examiner's work should be to familiarize himself with the sys- tems used in the office, to thoroughly trace the history of the various transactions in order that he may find out the course which every transaction or group of Examination of Insurance Companies 11 transactions takes in its progress through the office. This scrutiny will enable him to determine whether there is anything radically wrong in the way in which the various items are treated. Subsequently it will become necessary to ascertain whether those systems which have been prescribed by the superior officers have been properly carried out by the subordinates; no matter how perfect a system may be when it is outlined by the one in charge, it must be apparent that the results will not be accurate unless the man to whom has been entrusted the duty of making the entries, thoroughly understands the system and obeys his instructions. Any discrepancies which are found as a result of the examination of the details, must be followed to the very end and analyzed carefully. It will not do to dismiss apparent discrep- ancies on the theory that the amount involved is not large. A mistake of one dollar may indicate some- thing radically wrong with the entire system and lead to the discovery of errors of great magnitude. I think it but proper that I should refer briefly to something of great importance in the matter of exami- nations, and that is the personal attitude of the ex- aminer. A great deal of the success of any examiner is going to depend upon the way he comports himself in the offices which he is investigating. Tact is one of the primary necessities of an examiner; without that a man might as well make up his mind that he will never make any headway with his work. Above all, there must be no antagonism between you and the employees of the company, if for no other tlian selfish purposes ; this should be carefully observed, for unless you have the passive assistance, at least, of those in 12 Examination of Insurance Companies the oflBce, you are going to find your work exceedingly hard. Following the same thought, however, I think the two greatest faults that an examiner can possibly possess are bluster and self-importance. I know of no two things which are more to be condemned in his makeup than these two which I have just mentioned. They prevent him from obtaining the maximum good from the energy which he must devote to his examin- ing work. In connection with this it is well to call attention to the attitude which an examiner should take toward the oflScials of the company he is examining; at its best, an examination is an interruption to the routine work of an office, and in view of this fact an examiaer and his assistants should be courteous in asking for books, information and the necessary data. He should, of course, be firm and insist upon having his wants supplied, it being understood that he will not ask for any information other than that to which he is entitled. It is almost unnecessary for me to refer to the fact that no examiner should accept any favors from the officials of the company he is examining; no matter how innocent are the attentions which are accepted, there is a feeling of obligation created which must have a bad effect upon the work. I likewise deem it unnecessary to point out that all information which is obtained in the course of an examination must be con- sidered as strictly confidential and must not be dis- cussed with outsiders or communicated to anyone except your superior. To sum up the mental qualities which every ex- aminer should possess, I think I would say that he Examination of Insurance Companies 13 should attempt to have the combined qualities of a sponge and filter; the sponge, in order that he might be able to absorb all the information which comes to him, and the filter that he might be able to separate the valuable from the invaluable, retaining the former and allowing the unimportant details to rapidly pass from his mind. There is a great temptation on the part of examiners to be too suspicious. You should, of course, attempt to find a reason for every fact which is presented to you, and should insist upon knowing and understand- ing the underlying cause of everything that comes to your attention, but on the other hand you should not allow your suspicions to influence your judgment. Very frequently entries which appear wrong to you will turn out to be perfectly innocent. It is quite easy to appreciate that an entry which has been made by a man who thoroughly understands the system and has been studying it for years, may present a strange appearance to you; a thorough study of the system, however, together with explanations, for which you should never be ashamed to ask, will enable you to promptly determine the correctness of the process. There is another quality that an examiner should possess, but for the acquisition of it I can give no rules, viz., the power of instinct. I imagine that every good examiner at some time has had a fact presented to him which at the outset appears to have something wrong about it, but, if pressed for a reason^he cannot tell why his suspicions have been aroused ; it presents no features out of the ordinary, and yet he feels that there is something wrong about it. While it may be impossible to acquire this sense, a careful attention to 14 Examination of Insurance Companies the various details, and an analysis of the different methods, will unquestionably assist in the develop- ment of the mind along these lines. Those in charge of examining work should not disregard suggestions which come to them from sub- ordinates. It is extremely dangerous to assume that because one of your assistants is doing routine work, he is thereby prevented from seeing things which may be of extreme importance to you. Valuable sugges- tions are not always obtained from those who occupy positions of responsibility. Even an office boy may be able to give you valuable suggestions; in the case of one company it was the suggestion of an office boy relative to the unusually large consumption of stamps which led to the detection of the fact that the secre- tary of the company was in the habit of secreting in his private drawer a considerable number of stamps. I merely mention this to show that we may get in- formation in a perfectly proper way from those who occupy minor positions, and we should never disregard any information, no matter how humble its origin. As a final word I might point out that a good ex- aminer attempts to obtain his information by unusual methods whenever possible. By this I mean that you should not content yourself with employing and fol- lowing the methods which have been used by the clerks of the company; you should attempt to secure the information in a way differing from the one by which the entries have been made. You will thereby be enabled not only to satisfy yourself that you are securing the correct result, but you will be able to detect errors which would not be developed by simply following the work which has been outlined by the Examination of Insurance Companies 15 clerks in the office. I recall that in the case of one company, the unearned premium account in its burg- lary department appeared to be unusually low ; instead of simply confining our inquiry to tracing the entries which had been made in the office, we elected to treat the matter from the standpoint of cancellations instead of issues, and in this way we were enabled to detect the unusual, improper and abnormal cancellations which were being made in that office; by this means the amount of outstanding premiums in the burglary department had been reduced and the liabilities of the company correspondingly understated. CHAPTER II Investments — Limitation on Real Estate Holdings — Examination of Title — Title Insurance — Purchases from Officers or Interested Parties — Methods of Appraisal — Certificates of Extension. In order that a life insurance company may be suc- cessful it is necessary that the funds which it has collected from its policyholders, in excess of the cur- rent mortuary requirements, shall be invested in safe securities which bear a certain rate of interest; the underwriting departments of companies transacting other forms of insurance have not within the past few j^ears been uniformly profitable and in conse- quence the returns to stockholders and the increases in surplus funds have largely come from the investment profits. I cite these facts as an illustration of the importance from the examiner's viewpoint of the con- dition of the assets of the corj^oration which he is investigating. I shall therefore briefly refer to the points to be noted in the various forms of investment with which you will be brought in contact. Eeal estate is not regarded with favor by many statutes and supervising officers as a form of invest- ment for the funds of policyholders; the holdings in real estate of insurance companies in nearly all of the States are limited to that amount which is necessary for the transaction of their business and to those par- [16] Examination of Insurance Companies 17 eels which have been acquired in satisfaction of debts. (See Appendix A.) If, for instance, it becomes neces- sary for a company to foreclose one of its mortgages, it naturally must take title to the real estate which is involved. If one of its representatives should owe the company some money it would be a hardship to prevent it accepting real estate from the agent in liqui- dation of his debt. The examination of real estate parcels must be divided into two parts: first, the technical or legal aspects which are involved and, second, the considera- tion of the matter from the standpoint of an invest- ment. It is advisable to place the first part of this work in the hands of an attorney or real estate con- veyancer who is familiar with the local laws affecting the parcels under consideration, but as an examiner should always be in a position to tell his assistants exactly what is needed, I shall indicate the principal points which should be examined by one dealing with the legal aspects. The evidence of ownership in real estate is a deed of some kind, but the fact that a company possesses this deed is not absolute evidence of its ownership; it may have disposed of the property after the deed was signed and the title could be transferred without the deed being surrendered. In the company's possession should be ai abstract of title which shows the history of the parcel under observation. The usual starting point of an abstract is the patent which has been granted by some sov- ereign government or State and upon this abstract will be indicated the changes which have taken place in the title or any liens which may have been recorded 2 18 Examination of Insurance Companies against it. In some instances it will be unnecessary for the abstract to go back to the original grant, as some of the legislatures have passed acts which have for their purpose the curing of all defects in titles to real estate after a certain date. It is necessary that the abstract should be brought to the date of the exam- ination in order to show the ownership of the parcel at that time. In recent years there has been a development in the real estate field which to a certain extent does away with the necessity for an abstract. Companies have been formed for the purpose of issuing to purchasers of real estate, a policy of insurance guaranteeing the validity of the title of the real estate which has been acquired and promising to pay to the owner any loss resulting therefrom, not in excess of the face of the policy, should it develop that the title was not good and marketable at the time that the policy was issued. If the company under examination should possess a policy of this kind issued by a reputable and well- established title insurance company, it is the usual practice to accept that policy in lieu of an abstract, but particular attention should be paid to the excep- tions which are noted in the policy in order that we may observe if there is anything there referred to which would militate against the parcel appearing in the assets of an insurance company. Passing now to a consideration of those features to which the examiner should particularly address him- self, instead of entrusting them to an attorney. He should first ascertain the manner in which the title to the property was acquired, whether it was by fore- closure or bought in the open market. If the former. Examination of Insurance Companies 19 was the foreclosure the result of bad judgment exer- cised in the ordinary course of business or was it caused by making loans upon insufficient security to officers or mortgagors in whom the officers were inter- ested. If the real estate were purchased we should determine whether the vendor was in any way inter- ested in the company under examination. The question of the figure at which the real estate is to be allowed as an asset should now receive atten- tion. For this purpose it is well to employ two com- petent real estate appraisers, but it is well to caution them that in obtaining a fair value of a piece of prop- erty you do not wish to obtain a value which would result from a forced sale, for this would result in too low a value and thus do the company an injustice. On the other hand, it is equally advisable to caution the appraisers that you do not desire what may be termed a " boom " value for the real estate; ap- praisers are usually optimists who can see nothing but the most roseate future for property in their locality. Different methods are employed in arriving at the market value of large pieces of property. A record of the recent sales in the immediate neighborhood is sometimes taken as a test for current values, but this is open to the objection that the sales may have been affected by conditions which do not apply to the par- cel under observation; it may have been necessary to liquidate an estate and this might serve to lower the value, or the piece which has been sold may have had some strategic position or may have had some sentimental value which would not be duplicated in the piece in which you are interested. 20 Examination of Insurance Companies Large office buildings are usually appraised by either adding the cost of construction to the value of the land or by finding the net rental value of the avail- able space, which figure is then used as an income factor upon which the valuation is predicated. The cost of construction depends upon conditions, all of which are not properly related to the valuation of the property, and in considering the valuation on a basis of rental space it is necessary that all artificial con- ditions should be eliminated. My object in pointing out the weak points in each of these methods is to advise the careful examiner to rely upon no one method, but to obtain his results by using several methods, if possible. Should any wide discrepancy occur between them it may lead not only to the determination of the true value, but also to the existence of improper conditions which will be re- ferred to later. In examining the appraisal based upon rental values we must use the expenses of maintenance as an offset to the income. An analysis of the items entering into this calculation will enable the examiner to determine whether any disbursements for running expenses are being charged to the original investment account, for in this way it is a comparatively easy matter to in crease the apparent income from rentals until the asset has all the earmarks of an extraordinarily good investment. It is needless to point out that this is a temporary condition, the correction of which in the future will involve heavy charges to profit and loss. If the company is occupying any of the building for its own purposes, you should determine whether the rental which is charged against the space which it Examination of Insueance Companies 21 occupies is in proper proportion to similar rentals being charged to and received from other tenants. This phase of the investigation will also develoj) whether the company is allowing any of its tenants to pay less than a fair rental. The reason for such favoritism, if any exists, should be fully explained to the examiner. A careful scrutiny of the fire insurance policies which are held by the company should be made, for in the case of destruction by fire the value of the asset will depend largely upon the company's ability to recover upon its policies. Whether the policies have been placed in an admitted company is a phase of the question to which the examiner should devote some attention. In the beginning of this talk I referred to the fact that real estate is a form of investment which is frowned upon by the insurance laws in most of the States. This fact is emphasized by the requirement, now very general, that such parcels as are not required for the transaction of the company's business should be disposed of within five years from the time that they have been acquired. In order that the effect of this requirement might not be too harsh, tla^re is a provision that the supervising officer may grant an extension of time should he be satisfied that a strict compliance with this statute would result to the dis- advantage of the company. (See Appendix B.) If, therefore, you find that the real estate has been re- tained longer than the statutes permit, certificates of extension should be exhibited to you. CHAPTER III Mortgages — Limited to Percentage of Value of Prop- erty — Abstract — Appraisal — Fire Insurance Pol- icies — ' * Purchase Money Mortgages ' ' — Notice to Mortgagor — Guaranteed Mortgages — Transfer of Tax Lien. In some States (New York, for instance) a mort- gage is a lien upon a piece of property given to secure a debt. In other States (Massachusetts, for instance) a mortgage is a conditional transfer of property as security for a debt, and if the debt be paid no title to the property passes. In some jurisdictions the evi- dence of the debt is a bond signed by the owner of the property. In other States the form which the evidence of the debt takes is that of a note with coupons attached, and the mortgagee simply deposits these coupons in the bank as he would the coupons of a railroad bond. In some cases you will find that the owner has executed a deed of trust in favor of the mortgagee. As I pointed out in the case of a real estate deed, the mere presence of the mortgage is not an absolute evidence of the possession of anything of value. Until a short time ago in New York a mortgagor could pay his indebtedness and the mortgage be satisfied upon the record without the mortgage papers being sur- rendered. You can, therefore, see the danger of an examiner assuming that because the company has in [22] Examination of Insurance Companies 23 its possession a mortgage, it must, therefore, have an asset of value. In New York at the present time a mortgage cannot be satisfied unless the original mort- gage is deposited with the proper county officer at that time. This, however, may raise in you a false sense of security, since it is possible under that law for the mortgagor to make a partial payment and the mort- gagee is not required to surrender the original mort- gage. This is an important point to be borne in mind when the company that you are examining is not the original mortgagee, but has taken the mortgage from another party by assignment. You will recall that I divided the work on the real estate holdings of a company into two parts : the first to be undertaken by the attorney or conveyancer, and the second to be undertaken by the examiner. In the same way the work on mortgages may be advan- tageously divided. The attorney should determine the presence of all the necessary papers, such as the mort- gage, the bond and the application for the loan setting forth the details of the property which is to be mort- gaged. These details should show the true rental value, the value of the land, the value of the buildings, if any, how long the building has been constructed, and all of the other data which are necessary in order that the board of directors or the finance committee may pass intelligently upon the loan. He should also find in each case some evidence that the property has been appraised by disinterested, competent people. The margin of safety which must exist between the value of the property and the loan which is made thereon varies in different States. In some, the loan may not exceed 50 per cent, of the value of the prop- 24) Examination of Insurance Companies erty, while in others the loan may be 66% per cent, of the value, the law in the latter case requiring that the property shall be worth at least 50 per cent, more than the amount loaned thereon. In the case of a mortgage loan, there should be an abstract of title which will indicate that the title was in the mortgagor at the time that the loan was made, whether any prior mortgage has been given and recorded and whether there are any liens of any kind recorded against the property. The abstract should be brought down to show that the mortgage under consideration has been recorded by the proper county officer. There should also be some evidence of a search having been made in the proper office for evi- dence of unpaid taxes, unpaid water rents or any other liens of any kind, and these should of course be cleared up before the loan is made. The statutes do not permit insurance companies to invest in second mortgages, and in order to deter- mine whether the mortgage in which the company has invested its funds is a first lien on the property, you will of course realize the importance of ascertaining that there are no unpaid taxes or liens recorded against it. In some states there is a recording tax which must be paid at the time that the mortgage is recorded and it is important to observe that this has been properly attended to, for under the New York procedure, for instance, it is impossible to foreclose a mortgage without setting forth at some time that the recording tax has been properly paid. Now as to the examiner's work. He should care- fully observe that all the details of the mortgage cor- respond with the details set out in the schedule of Examination of Insurance Companies 25 mortgages which the company is compelled to file with Insurance Departments. Upon him also devolves the duty of determining the security behind the mortgage, and for this purpose it becomes necessary to employ an appraiser familiar with the local conditions sur- rounding the parcel upon which the mortgage has been placed; you will recall that in the case of real estate holdings I advised the employment of at least two competent appraisers ; in the case of mortgages I think that one should be sufficient. There is a greater neces- sity for determining the value of the property with great exactitude in the case of real estate holdings, for the company may properly claim that any excess of the appraised value of the property over the book value should be allowed as an asset. In the case of mortgages, however, the asset value remains station- ary, irrespective of any increase in the value of the property, and we are concerned only with determining whether the required margin of safety exists. The statutes of nearly all the states prohibit the loaning of the funds of an insurance company upon unimproved property, and the examiner will, therefore, be compelled to consider the value of the buildings as well as that of the land ; it becomes necessary for him, therefore, to scrutinize the fire insurance policies which the mortgagee holds for his protection in the event of the destruction of the buildings and the con- sequent reduction in his security. Observe that they are in solvent, admitted companies and that the poli- cies contain what is known as the '' mortgagee " clause, which not only provides that the loss or dam- age, if any, under the policy shall be payable to the mortgagee instead of to the owner of the property, 26 Examination of Insurance Companies but that the interest of the mortgagee shall not be invalidated by numerous acts of the mortgagor or owner over which he (the mortgagee) has no control and which ordinarily would void the policy. A mortgage calls for a definite rate of interest, pay- able upon certain dates ; it is advisable to note whether any discrimination has been shown by the company in making loans upon property owned by its officers or their friends at rates of interest not equal to the rate received from other borrowers. You should also note whether the interest is paid promptly, as this is one of the best negative indica- tions of the value of the property; I mean by this, that if the mortgagor does not pay his interest prompty, we naturally look with some suspicion upon the parcel and should scrutinize it more carefully in order that we may determine whether in the event of foreclosure, the investment and the expenses will be fully protected by the value of the property. On the other hand an examination of the history of the mort- gage may indicate that there is no necessity for having it appraised, for if we find that the mortgagor has reduced his loan by substantial payments it is a very good indication that the remainder is amply protected. If, however, the mortgagee in consideration of this partial payment has released any of the security which stood behind the original loan, it becomes necessary to carefully observe whether the part that remains is ample to secure the balance of the loan. In selling a piece of property which it owns, a com- pany is frequently required to accept part of the pur- <ihase money in the shape of a mortgage on the prop- erty; these are called '' purchase money mortgages,'* Examination of Insurance Companies 27 and it must be apparent to you that an appraisal is hardly necessary in these cases. Another important point to which I wish to direct your attention is the manner in which the mortgagor receives the notification of the amount of interest due upon the interest dates. If you find, for instance, that it is the practice of the company to send out notices periodically to its mortgagors notifying them that a certain interest payment is due, it is evident that this constitutes a notice to the mortgagor of the amount of the outstanding indebtedness; when he pays the amount called for by the notice, it is a tacit admission upon his part that the amount of the unpaid principal is the amount shown in the notice. If you should find, however, that the interest is not collected direct from the mortgagor, but is collected through the medium of some financial agent or trust company, it is advisable to communicate directly with the mortgagor for the purpose of obtaining from him an acknowledgment of the amount of his indebtedness to the company. Ap- pendix C is a form of notice which I have prepared for this purpose, and it aims to overcome the annoy- ances which have been experienced in the past by the companies as a result of these notices. Many mort- gagors were unable to appreciate the cause of the inquiry and imagined that their loans were being called; the reassuring sentences in the concluding paragraph in the notice are intended to meet this situation. You may have occasion to consider a form of invest- ment known as '' guaranteed mortgages." These are mortgages upon which some corporation, chartered for that purpose, guarantees that the interest will be paid 28 Examination of Insurance Companies when due and that the principal will be paid within eighteen months of the date of maturity, whether the mortgagor makes the payments to it or not. For these services it is the practice of the guaranteeing company to charge one-half of 1 per cent. ; that is, if the mort- gagor pays interest to it at the rate of 51/2 per cent., the mortgage is sold to you on a 5 per cent, basis. In these cases the guaranteeing company retains all of the incidental papers, such as the fire insurance policies and the abstract ; it usally gives to the purchaser a title policy or incorporates a title policy in its guarantee; the purchaser receives the bond, the mortgage and an assignment, the latter being recorded, if desired. The same rule applies here as in the case of title insurance policies in real estate, viz., if the guaranteeing com- pany is a solvent, responsible institution, the guarantee is an excellent thing. The examiner, however, should consider the guarantee merely in the nature of an addi- tional safeguard and should apply to that parcel the same tests which he would apply if no guarantee existed. Another form of investment with which you may possibly be brought in contact (whether it is a form of investment which may be made by insurance com- panies is not entirely clear in my mind and I do not know whether the question has ever been passed upon) is what is known as a " transfer of tax lien." If the owner of a piece of property in New York does not pay his taxes to the city, the taxing authorities after a certain number of years has elapsed, sell to the highest bidder the right to collect this tax with interest from the time of sale. The purchaser of Examination of Insurance Companies 29 these tax liens must pay these back taxes, of course, to the citj^ The basis upon which the city sells it, is that the purchaser who is willing to take it at the lowest rate of interest is awarded the lien. In other words, if two bidders want a lien, one being willing to accept 5 per cent, and the other 5l^ per cent., the city would sell it to the one willing to take it at 5 per cent. In this case the owner of the property would have to pay to the purchaser the amount he paid, together with interest at 5 per cent, for the period between the date of the tax sale and the date of the redemption, with an added penalty in the shape of interest for six months. These tax liens are prior to any first mort- gage or any other lien which may exist against the property, except of course city taxes which may be assessed after the date of the lien. The usual period which these liens must run before foreclosure can be made, is three years, although at the option of the purchaser foreclosure may be started after thirty days from the failure of the owner to pay the semi-annual interest on the tax lien, or six months after any failure upon the owner's part to pay subsequent taxes. CHAPTER IV Bonds — Different Forms of Bonded Indebtedness — Railroad Bonds — Registered and Coupon Bonds — Directors not to be Interested in Sales or Purchases — Evidence of Ownership. A bond may be briefly and generally described as a promise to pay a definite sum, at a definite time, with a definite rate of interest. You understand, of course, that this is not an inflexible definition, for in some cases it is subject to modification. The bonds issued by the British Grovernment, for example, known as " British Consuls " are perpetual, having no definite date of maturity. At least one of the railroad com- panies in this country has issued bonds which are per- petual, and the United States Grovernment in one of its 2 per cent, issues has provided that the principal may be paid at the pleasure of the government at any time after 1930. There are other bonds which are, strictly speaking, not perpetual, but run for very long terms : one of the issues of the West Shore Railroad, the nominal maturity date of which is 2004, is an instance of this kind. I shall briefly review this morning the different kinds of bonds with which you may be brought in con- tact in your examination of companies. Government Bonds Bonds of the United States Government are now held generally for sentimental purposes, their value [30] Examination of Insueance Companies 31 from an investment standpoint having disappeared; the bonds of other governments usually found among companies which transact business in this country are those of the United States of Mexico, the Provinces of Canada and the Imperial Japanese Government; companies transacting business in foreign countries are likely to have bonds of the countries in which they do business and you will therefore probably find in the course of your work the bonds of Germany, France and Russia, these being the most usual instances. State Bonds The bonds of the various states in this country have usually been issued at very low rates of interest, the credit of the states being very high; in fact some of the states have no outstanding indebtedness of any kind. m Municipal Bonds In this group are included the bonds of counties, cities, villages, townships, school districts, drainage districts and other political subdivisions; here the value largely depends upon the relation which the taxable value of the property in the political unit bears to the amount of outstanding indebtedness. As a usual thing, municipal bonds constitute an unim- peachable form of investment, and are sold and quoted on what is known as a rate basis. If, for instance, the bonds of a certain village are said to sell upon a 3.80 per cent, basis, it is understood that after taking the date of maturity and the rate of interest stated in the bond, into account, the purchaser will net 3.80 per cent, upon his investment. S'2 Examination of Insurance Companies Irrigation Bonds These are the bonds which have been issued against irrigation rights and of late have come into favor owing to the high rate of interest which they bear. Many of the lands in the western States are being reclaimed by means of irrigation projects, which are either operated by private capital or by governmental assistance and the value of the irrigation bonds de- pends very largely upon this factor. Public Service Bonds These are securities issued by street railways, gas companies, electric light companies, water companies and other corporations which deal exclusively in those things which are used for public service purposes. Their value is largely dependent upon the franchises which these companies enjoy, the bonded indebtedness and the density of the population of the localities which they serve. Industrial Bonds Some corporations dealing in public utilities, but which do not transact a public service business, have outstanding bond issues with which the examiner is frequently brought in contact. Such are the bonds, for example, of the Central Leather Company and the United States Steel Corporation. Railroad Bonds This class of securities probably constitutes the largest item in the bond holdings of insurance com- panies and it is my intention to briefly refer to some of the different forms of railroad bonds in order that Examination of Insurance Companies 33 you may become familiar with the terms employed. My designations are not intended to provide a defini- tion of the relationship of the various parties to the contract from a legal standpoint. This could only be furnished after an exhaustive investigation into the various agreements and contracts into which the rail- road companies have entered for the protection of each individual issue. Some of the most common issues of railroad bonds are: First mortgage. Debenture. Second mortgage. Convertibles. Consolidated. Equipment or car trust. Unified. Eefunding. General mortgage. Adjustment. Income. Sinking fund. Collateral trust. Prior lien. ■■ The mere title of a bond is not a safe index to either its value or its terms. Eailroad bonds may be broadly divided into two classes — first mortgage and all other. But even the designation of a bond as a '' first mortgage bond " may create a false impression. The first mortgage bonds of a holding company do not necessarily carry with them a first mortgage lien on the railroads, the stock of which is held by the holding company. A true first mortgage bond is a mortgage upon a definite mileage, and constitutes its first bonded lien. In former years a conservative railroad did not mortgage its system for more than $20,000 a mile. At the present time it is no unusual thing to find roads mortgaged up to $40,000 a mile, the necessity for a 3 34 Examination of Insurance Companies more substantial roadbed and heavier rails being fac- tors which have contributed to this condition. After the first mortgage bonds were issued, and before their maturity, the railroads found that it became necessary to secure more money and other bonds were issued. The name " second mortgage," for various reasons, was not popular with the investing public, and the railroad companies gave their issues other names. Consolidated, unified, general mortgage bonds are all second liens until the underlying mortgage bonds have matured or are paid off. As soon as the first mort- gage bonds are out of the way the subsequent issues become first liens upon the property. A debenture bond, in this country, has come to mean a bond secured almost exclusively by the credit of the road which issues it, without having any definite prop- erty behind it. While it is a definite promise to pay, and in that way differs from the capital stock, it is more in the nature of a note. There is another impor- tant point of difference between a debenture bond and the capital stock in that if the interest on the former be not promptly paid, the holders can obtain a judg- ment which, if not satisfied, can form the basis of a foreclosure suit. Income, convertible and in many cases collateral trust bonds are issues which are more in the nature of debenture bonds than of the others. An income bond may be broadly described as a promise to pay the principal, with interest at a definite rate, from the income earnings of the system. Convertible bonds provide that within a certain number of years the holder of them may exchange them for the common stock of the railroad. Collateral trust bonds are bonds Examination oe Insurance Companies 35 whicli have been issued against the deposit of a certain amount of bonds of the road or some of its systems and which have been placed in a fund for the protec- tion of this bond issue. Equipment or car trust bonds are usually issued for short terms for the purpose of paying for additional rolling stock, and it is the usual practice for the rail- road issuing these equipment bonds to place the title to the rolling stock in the name of some trustee, usu- ally a trust company, which receives from the railroad company a certain amount from the current receipts for the purpose of redeeming these equipment bonds at their maturity and paying the interest upon them in the meanwhile. Refunding and adjustment bonds are, as their names indicate, intended for the purpose of redeeming issues which are about to mature. Sinking fund bonds as a usual thing are securities, the maturity of which is provided for by the accumulation of a sinking fund. It is necessary for the examiner in scrutinizing the bond holdings of a company to observe the rate of interest, the date of maturity, and the general classifi- cation of the bond, for upon these factors will depend the market values. It is necessary to note whether the bonds contain an option of redemption, for if the issuing company retain the right to redeem a 50-year bond at its pleasure after ten years have expired, it is quite evident that this must not be considered as a 50-year bond. The effect which such a provision will have upon the market value is very peculiar. If a bond has been purchased at a premium, the redemp- tion option must be taken into account in determining the true value of the investment, but if the security 36 Examination of Insurance Companies has been purchased below par this option of redemp- tion must be disregarded. This phase of the question will be referred to more at length in my talk on amor- tization. Bonds are issued in two forms: registered bonds and coupon bonds. Registered bonds are those which are not payable to the bearer, but which provide that the principal or the interest or both shall be paid to some corporation, firm or individual, the name of which appears upon the bond and is registered in the books of the company. In the case of those bonds which are registered, as to interest, the investor re- ceives his interest payments in the form of cheques sent from the head office of the corporation issuing them, and these bonds, therefore, contain no sheets of coupons. Coupon bonds are payable to the bearer or holder, and the interest is payable in the shape of coupons which are detached upon their due dates and deposited in some banking institution. A bond may be regis- tered as to its principal, but its interest payments may be provided for by sheets of coupons. In the case of coupon bonds it is necessary in examining a com- pany to observe whether the unmatured coupons are attached to the bond and if not some adequate expla- nation should be offered for their absence. In outlining the development of departmental exam- inations, I indicated that methods had changed mate- rially in the past years. Within the past three years some of the States have enacted statutes which pro- hibit the directors and officers of insurance companies from being financially interested in the sale or pur- chase of the company's securities. Section 36 of the Examination of Insurance Companies 37 New York Insurance Law is an instance of this. (See Appendix D.) In order that you may be sure that the securities have not been borrowed for the purpose of exhibiting them to the examiner or for temporary purposes, it is well to satisfy yourself that the company's title to the securities is the result of an actual purchase. This evidence will be exhibited to you either in the shape of the receipted bills from the vendor or, if you desire more affirmative information, you can obtain it from an inspection of the entries in the cash book, supple- mented by an inspection of the cheques or vouchers themselves. CHAPTER V Difference Between Bonds and Stocks — Danger in Stock Investments — Preferred, Common and Guar- anteed Stocks — Collateral Loans — * * Window Dressing ' ' — Collateral Loans Contrasted with Policy Loans. In my talk to you the other day I pointed out that, although there might be some differences in the extent of security behind it, a bond was a definite promise to pay; to-day I wish to refer to this in order that you may realize the difference between a bond and a cer- tificate of stock. A certificate of stock is merely an evidence of the holder's equity in a corporation: it indicates that he is a partner in the business: there is no promise to pay any smu at any time and until the company is liquidated or the stock retired, there is no chance for an investor to receive the principal of his investment. An insurance company is a semi-public corporation and you can readily appreciate the danger to it of an investment in the capital stock of another corporation. If the funds of the policyholders are to be used for the purpose of purchasing a partnership in a different kind of business, the policyholder should be prepared to experience the penalties of a losing venture in the same way that he will benefit by a profitable one. I have in mind the case of a life insurance company which purchased a number of shares in a casualty [38] Examination op Insurance Companies 39 company. The latter 's business was not conducted along proper lines, and in consequence the stock- holders had to meet an assessment on their stock in order that the casualty company might remain solvent and be permitted to transact business in the various States. As the life insurance company was a stock- holder, it, with all the others, had to contribute to this additional payment. As a result the life insurance policyholders have invested many times the amount of their original purchase in the capital stock of the casualty company, and it is almost unnecessary for me to point out that this is an entirely improper channel of investment for the funds of the policyholders. You will appreciate this danger by stopping to con- sider the manner in which the stockholders of national banks are regarded. If for any reason the funds of a national bank become seriously impaired, not only do the stockholders lose all of their investment in the capital stock, but under the National Banking Law they are liable for an assessment equal to the par value of their stock holdings. If an insurance com- pany, for instance, had $100,000 of the capital stock of a national bank and through poor investments or defalcations the affairs of the bank became involved, the insurance company would have to protect the depositors not only to the extent of its original invest- ment of $100,000, but also to the extent of an addi- tional $100,000 if it were needed. It is pertinent that at this time I should call your attention to the fact that from our viewpoint there is a difference between a life insurance company and a company transacting other forms of insurance. The policy contracts of a life insurance company 40 Examination of Insurance Companies may run for a long term of years, and it is no imusual thing for policies to be in force forty, fifty or sixty years from their dates of issue. The continued suc- cess, therefore, of a life insurance company depends upon the safe investment of its funds in such a way that they will earn the rate of interest assumed in the calculation of the premiums. The contracts of other insurance companies run for shorter terms as compared with the policies of a life insurance company, and the premium rates are not predicated upon the investments earning a definite rate of interest. I mention this fact in order that you may see the direct bearing it has on the point to which I am now going to refer, viz., that if the corporation, the stock of which the insurance company holds, is not successful, no dividends are payable upon the stock and therefore the earning power of the investment is crippled ; while this might be a very serious matter to a life insurance company, you will see that it will not have the same effect upon companies transacting other forms of business. In the State of New York at the present time, life insurance companies are not permitted to invest in or loan upon the stock of any corporation (see Appendix E) ; the exception noted in the statute relates to the stocks of a municipal corporation, which are more in the nature of bonds, and the criticisms noted above cannot properly be applied to them. The two forms of stock which will probably come to your attention in the examination of insurance com- panies, are preferred and common, either of which may be guaranteed. The preferred stockholders of a corporation are Examination of Insurance Companies 41 entitled to a distribution of the earnings of the corpo- ration before any dividends are declared upon the common stock, and in some cases are entitled to prior- ity in the event of liquidation. After the interest on the bonded indebtedness and the other fixed charges have been met, the preferred stockholders are entitled to a dividend if in the judgment of the directors such a payment be advisable. A preferred stockholder's certificate does not entitle him to a definite payment, but merely to an equity in the earnings. As a usual thing, on preferred stocks the dividend is limited to a certain amount, althougib. the preferred stockholders in some corporations are entitled to an additional dividend after the common stockholders have received their dividend. The common stock of a corporation entitles its holder to the profits which are apportioned by the directors; it is quite evident that before the common stockholders can receive any dividends, the interest on the bonds, the fixed charges and the dividends to the preferred stockholders (if any preferred stock has been issued) must be paid. When a railroad corporation leases its lines to an- other corporation, one of the terms of the lease may provide that the lessee shall pay dividends at a certain rate upon the outstanding capital stock of the lessor. These shares thereby become " guaranteed stocks," but it must be evident to you that their security depends upon the earning power of the road which has assumed the operation of the leased lines. In examining an insurance company which holds certificates of stock among its assets, it is necessary to observe whether the certificates stand in the name 42 Examination of Insukanoe Companies of the company or in the name of some individual who has assigned them to the company in blank. The latter is a very dangerous condition, for it permits the certificates to be used by any person into whose hands they may fall. It is important, therefore, that stock certificates should be issued to the corporation, or, if indorsed, the name of the insurance company should be specifically set forth in the indorsement. There are cases where the entire stock issue of a corporation may be owned by an insurance company, in which case it is necessary that certain individuals should hold qualifying shares to enable /ilaem to act as directors, but in this case the rule for the indorsement just cited should be followed. In connection with the question of certificates of stock, you should know that section 16 of the New York Insurance Law permits surety companies to invest in and loan on the stock of a similar corpora- tion transacting business in other countries (see Ap- pendix F). You will, of course, observe whether the bonds and stock certificates of an insurance company are kept in a secure place. Unless a company is of a sufficiently large size to justify it in having a specially con- structed vault on its own premises, it is usual for companies to keep their securities in public safe deposit vaults ; caution requires that access should not be had to such vaults by less than two of the officers or employees of the insurance company, appearing at the same time. In some cases you will find that among the assets of an insurance company are loans on collateral ; these are loans which have been made to an individual or Examination of Insurance Companies 43 a firm or a corporation upon their note secured by the deposit of certain collateral. This collateral may con- sist of bonds or stock certificates or even the assign- ment of a mortgage, which assignment has not been recorded. In my opinion collateral loans are a form of invest- ment which belong more properly to banking institu- tions than to insurance companies. I think that an insurance company should not be burdened with the necessity of looking after the securities which have been pledged as a security for a loan. They may be of such a nature as to have a constantly fluctuating market value, in which case the company must keep in constant touch with the stock market. It goes without saying that in no case should a loan be made upon any kind of collateral in which the insurance company would not invest its own funds, for, should the bor- rower fail to pay his note upon its due date, the com- pany would have to take the collateral in satisfaction of its debt if it could not secure the repayment of its loan from the borrower. In consequence, any loans which are made upon securities in which the company is not authorized to invest its own funds should be disallowed in the calculation of its assets. The examiner should pay particular attention to the collateral loan, should determine whether the interest is paid promptly, and should also observe whether the note is past due. In the latter case some adequate explanation should be offered to account for the condition. It is also essential that the name of the actual bor- rower in each case should be known. The use of ** dummy borrowers " should be condemned, and their 44 Examination of Insurance Companies employment will undoubtedly be found to lead to con- ditions which should be discouraged. The funds of an insurance company should never be used for the pur- pose of personal aggrandizement or for the conveni- ence of the officers and their friends. The name of the actual borrower in many cases indicates whether the funds are being used for such purposes. I wish to briefly refer to a term with which you may be familiar in connection with collateral loans. " Window dressing " has been applied to that prac- tice in the past of some companies which have at- tempted to keep from the public and the supervising officials the evidence of the use of their funds for col- lateral loan purposes; as the companies are required to prepare their statements as of December 31st, any loans which were made on or after January 1st, and repaid before the close of business December 31st, did not appear in the schedule of assets. Realizing this, it was the practice of some companies to have those col- lateral loans which they wished to hide, paid on Decem- ber 31st, and two or three days afterward remake the same loan. A continuance of this practice accom- plished the purpose of keeping the knowledge of the loan from those who were entitled to the information and led to a reprehensible condition. The examiner should observe the collateral loan account in the ledger for the purpose of determining the existence of such a practice; if found, it should be condemned unscathingly. The annual statement blank now in use aims to disclose this situation, if it exists. I wish to contrast a collateral loan with a policy loan ; the latter, in my opinion, constitutes as good an investment for an insurance company as can be found, Examination of Insurance Companies 45 if the loan does not exceed the reserve which the com- pany is required to maintain. Not only is the invest- ment protected by the securities and operations over which the company has direct supervision, but it carries out the true intent and purposes of a legal reserve, which, you will recall, is nothing more or less than the payment which the policyholder has made to the company in excess of the cost of furnishing his insurance in order that his premiums may be kept level throughout the history of the policy. By loaning to its policyholder, the company is fulfilling the highest purposes of an insurance company, inasmuch as it is permitting him the use of his own money and not permitting the interest of the other policyholders to suffer thereby; he is paying an adequate rate of interest; and if he should not pay his loan when it matures, or the interest, his policy would be canceled, and the liability of the company would cease on that score. The care which should be exercised in making policy loans will be referred to in another talk. CHAPTER VI Cash in Office and in Bank — Percentage of Cash to Invested Assets — Certificate from Banking Institu- tions — Interest Bearing and Non-interest Bearing Accounts — Policy Loans — Liens and Their Sources — Premium Notes. It is safe to say you will find in every company which you are called upon to examine, cash in office or cash in bank. A verification of the cash in ofiice is, of course, a simple matter, and it will be sufficient to merely point out the necessity of determining that everything in the cash drawer is cash or its equiv- alent. You should not find any notes of officers or of employees or cheques which are post-dated or cheques which have been held for a long time without being cashed or cheques which have been returned protested. Should you find any of these items, you will request an explanation. Of course, in some cases you may find that the cashier has made temporary advances to clerks until the arrival of the next salary day, but these are matters which I feel can safely be left to your discretion. The bank deposits may be divided into two parts: first, those which are interest bearing, and second, those upon which the bank allows no interest. In well-managed companies the percentage which the cash in bank bears to the invested assets varies with the size of the company, special conditions and the form of insurance transacted ; the smaller the company [46] Examination of Instjkance Companies 47 the larger will be the proportion of its assets in this form. Among fire insurance companies, for instance, it is not unusual to find 10 per cent, of their admitted assets in the form of cash, while normally a life insur- ance company, operating only an ordinary department, would not have that amount, and if we should find more than 5 per cent, in such a company, we would be justified in carefully examining the cause. From an investment standpoint a large bank ac- count is to be discouraged, for no bank can aiford to pay as high a rate of interest as the company could realize from well-selected investments. Non-interest bearing accounts should not be found, except for cur- rent chequing purposes. The only exception which occurs to me is that which I have found in the exam- ination of some of the smaller life insurance companies which have left their deposits without interest in those banks which have discounted the insured's notes for the agent, the understanding being that while the company should in no way be held responsible for the note, it would leave the proceeds with the discounting bank until the note matured. For the purpose of ascertaining the amount of cash in the various banking institutions I have prepared a form of certificate (see Appendix G), which has for its purpose not only the securing of a statement from the officers of the banking institution relative to the amount of cash which the company has on deposit and subject to its cheque, but is also intended to develop whether the deposit exists for the purpose of securing a loan which the banking institution has made to any officer, director or employee of the com- pany under examination. In addition, this certificate 48 EXAMINATIOI^ OF INSURANCE COMPANIES will show whether the deposit is the result of the com- pany having discounted notes or borrowed any money from the institution. You will, of course, appreciate the fact that if a company has discounted notes with a banking institution in such a way that the bank can have recourse to the company in the event of the non- payment by the makers of the notes, a liability has been created for which suitable provision should be made. I wish to refer again to some of the improper con- ditions which may result from a company keeping too large a percentage of its assets in the form of cash in bank ; it may indicate that the officers of the insurance company are interested financially in the bank or the insurance company is under some obligation to the bank and is liquidating its indebtedness by carrying a large deposit there at a low rate of interest. In the case of newly-established companies (of which at the present time there are a great number in this country) you will probably find that the keeping of a large amount of cash in bank is intimately connected in some way with the underwriting of the capital stock of the company, and a clear and full explanation of all the circumstances surrounding this condition should be placed at your disposal. Yesterday I referred briefly to the advantages of policy loans from the standpoint of remunerative and safe investments for a life insurance company. I did not touch upon the methods which you should employ in verifying the schedule of policy loans which will be furnished to you. It goes without saying that every such loan should be upon the security of a policy which is in force and the reserve for which is being Examination of Insurance Companies 49 maintained by the company; the policy contract should be deposited with the company and you should also find a note evidencing the indebtedness and an assign- ment to the company as security for the debt, although in some cases the note and the assignment are in one instrument. The instrument just referred to should be signed by the insured and the beneficiary, although of recent years some insurance policies have contained a clause giving the insured the right, with the company's con- sent, to change the beneficiary if the policy has not been assigned. In those cases it has been held to be unnecessary for the beneficiary to join the insured in the assignment for the purpose of securing a policy loan. I do not recall that this is the result of any judicial decision (to my knowledge the point has not been adjudicated) or whether it is the result of com- pany practice. At all events it is a condition which we find at the present time and it has been very gen- erally accepted. A policy loan is a good investment only when it and the accrued interest upon it are equal to, or less than the reserve which the company is maintaining upon the policy; in a great many cases you will find that the policy becomes automatically cancelled when the outstanding indebtedness against it exceeds the maxi- mum loan value to which it is entitled. This provision is intended to guard against the dangerous condition which would result from a policy loan being in excess of the reserve liability which is being maintained upon it, for this latter quantity is the only thing which protects the company against loss in the event of lapse. It is important to bear this in mind in the case of 4 50 Examination of Insurance Companies those forms of policies on which the reserve decreases instead of increasing, the latter being the usual con- dition. On term policies which cover a long period, we find that the reserve increases at the beginning and then decreases until at the expiration of the policy the reserve is zero. Under such a policy you, of course, appreciate the danger of permitting the loan to remain as an asset after the maximum point of the reserve accumulation has been passed. In many cases it is the practice of companies to re- quire that the interest on its policy loans shall be paid in advance, and in consequence there will be a certain amount of the interest receipts of the company which have not been earned; proper provision for this con- dition should be made in the statement of liabilities. There is another form of policy loan which we may distinguish from the regular kind by calling it a ' ' lien. ' ' Liens arise in one of two ways: if an assessment com- pany reincorporate as a legal reserve company, it may give its policyholders the option of paying adequate premiums in the future either on the basis of their attained ages at the time of reorganization or on the basis of their ages at the time when their original assessment contracts were issued, and in the latter case the policyholder must pay to the company the amount of the reserve which would have been accumulated at the time of reorganization had he taken out a level premium contract from the start. If the policyholder does not wish to pay the amount of the reserve in cash, it will be safe for the company to accept a note from him for that amount, bearing interest at a rate not less than that assumed in the calculation of the reserve. Should the policyholder prefer to pay his Examination of Insurance Companies 51 premium at his attained age, no lien note is given, for each premium payment is sufficient not only to pay the current mortuary cost, but also to accumulate an ade- quate reserve. The second manner in which these liens may arise is illustrated by the case of a legal reserve company which has issued policies upon the yearly renewable term plan and wishes to give its insured the right to change to another form without medical examination and at the original age at issue. Let us suppose that the company is working on the basis of the American Experience Table of Mortality, with interest at 3V2 per cent, per annum, that the original policy was for $1,000, issued at age 30, ten years ago, upon the yearly renewable term plan, and that the policyholder now desires to change to a twenty payment life contract. If the insured desire to pay the twenty payment life premiums, as of age 30, and make only ten more pay- ments, it would be safe for the company to permit him to do this if he would pay to it $206.47 in cash or give a lien note for that amount. ,The change to any other form of contract (calling for a higher pre- mium rate than the original policy) could be safely made on the same basis, viz.: the giving of a lien note for the amount of reserve which should have been accumulated at the time of exchange. A thing to be noted, however, in the case of liens claimed by reorganized assessment companies as assets, is the nature of the lien. If the policyholder has signed the note, no question can arise as to his understanding of the placing of an indebtedness against his contract, but in some instances in the past these liens have been created by the enactment of a by-law, and the first 52 Examination of Insurance Companies knowledge the insured or the beneficiary had of such a lien was obtained at the time that the policy was sur- rendered or matured as a death claim. In such cases it is necessary to carefully determine the legality of the by-law and make certain that the policyholder is acquainted with the exact condition of affairs. The same limitation as to their admissibility as an asset applies to policy liens as to policy loans, viz. : they are good only when equal to or less than the reserve. A premium note is a note signed by the insured for his temporary accommodation in order that he may be enabled to pay the premiums called for by his policy contract. As a usual thing they run for short terms (within a year) and bear interest, for if they are given without an interest requirement, it will be apparent to you that a discrimination is being worked against the policyholder who pays his premium in cash when it becomes due. It is not necessary for the policy to be deposited with the company when a premium note is given by the insured. These remarks apply to the premium notes given by holders of life insurance con- tracts; as a usual thing, premium notes on other forms of insurance contracts are admitted as assets without reference to the reserve which is being maintained upon that particular policy. This treatment is con- sonant with the treatment of the uncollected pre- miums, which will be referred to more at length to- morrow. CHAPTER VII Miscellaneous Assets — Bills Receivable — Furniture and Fixtures — Accrued Interest — Rent Paid in Advance — Reinsurance Due — Agents' Balances — Deferred Premiums — Uncollected Premiums — " Paid for " and " Written " Bases — Uncollected Assessments of Fraternals. You may find some bills receivable among tbe assets of a company which you are examining; these are nothing more or less than notes, and being loans on personal security are disallowed as assets. An insur- ance company is not supposed to invest its funds in commercial paper. To attempt to appraise an asset of this kind would require the examiner to pass upon the financial responsibility of the maker of each note, and this is manifestly impossible. Furniture and fixtures are sometimes included by companies among their ledger assets, and if so are disallowed, it being impossible to properly appraise an asset of this kind. It is proper that at this point I should call your attention to the fact that it is the general practice of Insurance Departments to regard assets as valueless unless they are marketable so they may be used in the settlement of policy claims, if necessary. The accrued interest on the various kinds of securi- ties and the accrued rents on the property which the company owns, are items which require no explanation from me; their treatment is obvious. In some cases [53] 54 Examination of Insurance Companies you may be met by the claim of a company that it should be given credit for the rents which it has paid in advance. If, for instance, on December 31st, a com- pany should have sent its cheque for the January rent of an office which it is occupying it might properly claim credit for that payment ; there is no question but that the claim is logical. We charge the company with a liability for any rents (when it is the tenant) which are past due or accrued, and as this is simply the reverse of that situation, the company should be given credit for any rents which it has paid in advance. The same reasoning applies to fire insurance premiums which have been paid in advance, the company being entitled to credit for the unearned portion of the pre- mium, although it is not very usual for this claim to be made. In the course of your work you may find that a credit is claimed for reinsurance on losses due from other companies. These are cases where other com- panies have reinsured some part of the risk ; a loss has been sustained and the company which you are exam- ining has not had the opportunity to receive from the reinsuring company its share of the loss. In conse- quence, it is entitled to credit for any reinsurance due from solvent admitted companies, for either you are charging the full liability on any losses which have occurred or the company which you are examining has paid the claim. Agents' debit balances are of two kinds: one we find in the statement of life insurance companies and the other in statements of fire insurance companies. The terms have two different meanings: in the case of a life insurance company, an agent's debit balance ExAMIISrATION OF INSURANCE COMPANIES 55 refers to an advance wliich has been made to him (either in cash or by permitting him to retain pre- miums which he has collected) and which is unsecured in the sense that we understand it, although the ad- vance may be secured by the renewal contract of the agent. In the case of a fire insurance company the agent's balance represents the premiums for which he has not accounted. The cause of the difference in these two items arises from the fact that the two statements are on different bases. The statement of the life insurance company is upon a cash basis, and the only items that are con- sidered as premium income are the premiums which have been actually paid either in cash or in notes ; in the case of a fire insurance company every premium, as soon as it is written, is carried into the income account. According to the annual statement blanks used by departments the amount of the ledger assets must exactly equal the ledger assets of the previous year, plus the income of the year, less the disbursements which have been made during the year; in consequence, the treatment of the premiums in the case of the fire insurance company requires us to have some corre- sponding item in the ledger assets to represent the in- debtedness of the agent. In the case of a life insur- ance company the premiums are not carried into the income portion of the statement until they have been paid in cash, and the uncollected premiums, therefore are not iQcluded among the ledger assets. The agents' debit balances in a fire insurance com- pany when not more than ninety days past due are recognized as a good asset. The reason for fixing 56 Examination of Insurance Companies three months as a line of demarkation between a good asset and a bad asset is entirely arbitrary. Those who were charged with the duty of framing the stat- utes undoubtedly had to rely upon their past experi- ence, and it was probably felt that an agent should report premiums in his hands within ninety days after they had been written. Section 118 of the New York Insurance Law specifically provides for the allowances of this item when an examination is made by the authority of the Superintendent of Insurance into the affairs of a fire insurance company, or when a fire insurance company renders a statement to the Insur- ance Department, for the section states : '' There shall not be allowed as assets any in- vestments which are not held as prescribed by law at the date of such examination or rendering such statement ; but unpaid premiums on policies written within three months shall be admitted as available resources." I merely wish to call your attention to the fact that in the case of life insurance companies the debit bal- ances of the agents are really bills receivable, and the same rule applies for their disallowance as in the case of bills receivable. Accident and miscellaneous insurance companies have still a third form of statement. They are required to include at the present time among V the items of income all premiums which have been \>itten, but instead of charging them to the agents, the> carry them into the ledger assets as items of *' preml'^ms in course of collection;" the same rule applies here as in the case of fire insurance companies, viz., premiums which are not more than ninety days Examination of Insurance Companies 57 past due are admitted as assets. In the case of fidelity and surety companies this rule may work an injustice, as premiums which are perfectly good are sometimes by the very terms of the bond or the policy not collect- ible until the contract is finished or the estate has been wound up or until some court proceedings have been had which will render the premium due. It fre- quently happens, therefore, that these premiums are more than ninety days past due, and while perfectly good, are disallowed as assets. I wish to call your attention to a situation which I found in the case of a casualty company which had a great number of premiums more than ninety days past due; in order to obtain credit for some of them as an asset it asked its agents to give cheques to the com- pany, but the cheques were not dated until some con- siderable time after the annual statement date. In the mean time they were carried in the cash drawer as *' cash in office." It is unnecessary for me to point out the impropriety of this method of converting a nonadmitted asset into an admitted one, and, of course, these post-dated cheques were disallowed. In life insurance companies, items of deferred pre- miums require some explanation. A deferred premiimi is the semi-annual or quarterly installment due after the date of the examination for the balance of the pre- miums necessary to complete the policy year. In other words, if a policy be issued in December of one year on the semi-annual basis, the second installment of the premium will be due in June of the next year. If you are making an examination, therefore, as of December 31st, there will be one semi-annual premium deferred, viz., the premium which is due in the following June. 58 Examination" of Insurance Companies I have prepared a table which shows how the install- ments on both semi-annual and quarterly policies are deferred. At the top of the table is indicated the date of the examination. All of the premiums found to the right of the heavy line are the ones which will be de- ferred. For instance, by Table I, which is applicable to an examination made as of December 31st, you will see that on any policy with semi-annual premiums issued before July, there is no deferred premium, because the premiums for the entire policy year will have become due before the time of the examination. A policy, however, which is issued in July of that year, will have its second installment due in January of the next year, and in consequence there will be one semi-an- nual premium deferred. In the same way a policy issued in November on the same basis will have one deferred premium — the installment due the following May. In the case of quarterly policies, you will notice that policies issued in the months of January, February and March have no deferred premiums because all four quarterly installments become due before the date of the examiaation, December 31st; a policy which is issued during April, May or June will have one quarterly premium deferred; a policy issued during July, August or September will have two quarterly premiums deferred; a policy issued during October, November or December will have three quar- terly premiums deferred. Examination of Insurance Companies 59 TABLE I Examination as of December 31st Semi-annual Premiums Iseues of January July " " February August " " March September " " April October " " May November " " June December " " July " August " " September « " October " " November " " December January February March April May June Quarterly Premiums Issues of January April July October " " February May August November " " March June September December " " April July October . . . " " May August November " " June September December . " " July October " " August November. . " " September December. . January February March January April February May March June October I January April July " " November. ... I February May August " " December . . . . | March June September In order that you may see how this rule works in the case of an examination made at some other date, I have prepared Table II, which shows the deferred premiums which are to be found when an examination is made as of October 31st. You will note there that the months of issue (the months which appear on the left of the table) are arranged in a different order and all of the installments to the right of the heavy line are ones which will be deferred. For instance, any policy with semi-annual premiums issued between November 1st and April 30th, will have no deferred premiums, while semi-annual policies issued between May 1st and October 31st will have one semi-annual premium deferred. 60 Examination of Insurance Companies TABLE II Examination as of October sist Semi-annual Premiums Issues of November May " " December June " " January July " " February August " " March September " " April October " " May INovember " " June December " " July January " " August February " " September March " " October April Quarterly Premiums Issues of November. . . . February May August " " December. . . . March Jime September " " January April July October " " February May August. . . " "March June September " "April July Octo ber. . " " May August " "June September.. " " July October.... November December January November February December March January April " " August I November February May " " September I December March June " " October | January April July In preparing a schedule of deferred premiums it is important to note whether a policyholder has paid any of the installments before they became due, because if he has, it will be necessary to remove that installment from the schedule of deferred premiums. Uncollected premiums (premiums in course of collec- tion) may be either annual, semi-annual or quarterly. The term refers only to the premiums which have fallen due before the date of the examination and upon which the agent has not reported the collection or the cancellation to the home office. The uncollected pre- miums have nothing to do with the method of pay- ment, i. e., they may be either annual, semi-annual or quarterly installments. A policy may have credits for Examination of Insukance Companies 61 both an uncollected and a deferred premium, and I think you will be able to see that the uncollected pre- miums sometimes include those installments on semi- annual and quarterly policies which became due before the date of the examination, but which had not been reported by the agent. Annual statements are required in the different States upon two bases: one the '' paid for basis " and the other the '' written basis." The former requires companies to report only those policies in force which have had the first premium paid by the insured; the latter basis requires companies to report all policies as soon as they are written and which remain uncancelled upon their books. I mention this fact to you now be- cause it has a direct bearing upon the way in which the schedules of uncollected and deferred premiums are prepared. In the " paid for " States, the schedule naturally will not contain a number of items which will be found in the schedule prepared on the other basis. I wish to call your attention, however, to the fact that a statement may be prepared on the paid for basis, but contain a small amount of uncollected first year's premiums, although you would naturally expect that upon this basis no uncollected first year pre- miums would be included; the explanation may be found in the fact that the items in question are the second semi-annual or the second, third or fourth quarterly installments of first year premiums, and the company, of course, cannot cancel the policy until after the days of grace have expired; if those days of grace carry the policy beyond the date of the exam- ination, the schedule will show uncollected first year premiums. 62 Examination of Insukance Companies In the case of fraternal organizations, another method is followed. You will not find credit allowed for uncollected or deferred premiums, but you will find that included among the non-ledger assets are ' ' assess- ments actually collected by subordinate lodges not yet turned over to supreme lodge." As the fraternals do not ordinarily issue certificates which provide for the payment for a longer period than the current month, there can be no such thing as a deferred premium, and the item which I have just quoted is the equivalent allowance which is made in order that the fraternal organization may receive credit for any premiums in course of transmission. " CHAPTER VIII Loading on Uncollected and Deferred Premiums — Disallowed or Non-admitted Assets — Loans on Cap- ital Stock — Supplies and Printed Matter — Com- muted Commissions — Cash Advanced to Officers — Excess Credits — Depreciation in Securities — Pre- miums Outstanding More than Ninety Days — Appreciation. I spoke yesterday morning of the credit which should be allowed a life insurance company for the uncollected and deferred premiums outstanding at the time of the examination; it is but proper to allow these as credits, for the calculation of the reserve is upon the assumption that all of the premiums are paid at the beginning of the policy years. It is not proper, however, to allow the entire amount of the uncollected and the deferred premiums as an asset, for the reserve is calculated upon the net pre- mium basis. You will recall that the premium which a policyholder is called upon to pay, is divided into two parts: first, the mathematical net premium which is sufficient to pay the current mortuary cost and accumu- late the reserve, and second, the loading which is added to the net premium in order that the expenses may be provided for, the fluctuations in market values taken care of, and to provide, in short, for everything except the mortality and the reserve. Since the re- serve is calculated upon a net basis (with no regard [63] 64 Examination of Insurance Companies for the loading) the asset which we are going to allow as an offset should be placed upon the same basis. In consequence, it becomes necessary to deduct from the uncollected and deferred premiums, the element to which I have just referred — the loading. Nearly all forms of legal reserve policies have their premiums computed upon one of three bases: the regular level premium, upon which the loading is the same through- out the entire history of the policy contract, or the full preliminary term, the premiums on which for the first year are for one year term insurance, or the modified preliminary term. The net premium for the first year of the second basis just mentioned — the full prelimi- nary term — is that of a one year term insurance, and the difference between it and the gross premium charged to the insured, is the loading, which is, there- fore, very heavy, amounting to about 75 or 80 per cent, of the premium charged, while the net premium there- after is uniform and dependent upon the form selected by the insured. The net premium for the first year of the third basis — the modified preliminary term — contains another factor which makes the net premium larger than the one just mentioned and the loading in consequence smaller, although in the subsequent years the loadings on this basis are larger than on the full preliminary term basis. All of these facts must be borne in mind when fixing upon the proper deduc- tion to be made from the uncollected and deferred premiums. Having mentioned practically all of the sources of a company's assets, I shall briefly refer to some of the items of disallowed or non-admitted assets, which in the case of Insurance Department examinations are always taken into account. Examination of Insurance Companies 65 The company under examination is never given credit for any of its capital stock which it may own or any loans which it has made upon it as the security. The reason for this is obvious; the capital stock is intended to serve as an additional investment for the protection of the claims of the policyholders: the in- vestment of the capital stock is hedged around with even greater restrictions than apjjly ordinarily to the other assets of a company, and you will, therefore, see the impropriety of permitting a company to invest its funds in its own capital stock. This is equivalent to a man trying to lift himself by his own boot straps. It may be pertinent for me at this point to call your attention to the fact that insurance companies and banking institutions are the only two classes of corpo- rations which are not permitted to use any of their capital stock for the purpose of establishing their busi- ness. In every other class of corporation, that occurs to me at the present time, the supposition is that the company will use its capital stock for the purpose of establishing itself and building up the plant which is necessary for the conduct of its business. In the case of an insurance company this is not permitted; all of the preliminary expenses of the organization, the establishment of agencies and the purchases of sup- plies must be met at first from the surplus which re- sults from the selling of the capital stock of the com- pany above par. This is a natural result of the practice of charging the capital stock of an insurance company as a liability without permitting it to consider its plant as an asset. If, for instance, an insurance com- pany should start and sell its capital stock at par only, 5 66 Examination op Insurance Companies the moment that it bought and used a postage stamp its capital would be impaired. Supplies, stationery and printed matter are in the same category as furniture, fixtures and safes. "While they may cost an insurance company a great deal of money they are not readily convertible into cash and are, therefore, not available for use in the payment of its losses. They are, therefore, disbursements which must be met from the surplus portion of the assets in order that the capital stock may remain unimpaired. Commuted commissions are really advances to agents or agents' debit balances in the case of a life insurance company. They are purchases of the future renewal interests of the agents, and we have no guar- antee that the renewal premiums will ever be paid by the insured ; as the payment of renewal commissions is based upon the receipt of the renewal premiums from the insured, it is manifest that the security behind this debt is not of the kind which can be recognized as an asset. Cash advanced to or in the hands of officers or agents is a form of asset which is always disallowed. You will readily appreciate that it does not differ from the loans on personal security or bills receivable to which I have already referred, and the examiner can- not be expected to pass upon the financial responsi- bility of the representative of the company in whose hands cash belonging to it has been placed. A very important matter (especially in the case of newly established life insurance companies) is the ex- cess over the reserve which results from the premium notes, policy loans, liens, uncollected and deferred pre- miums and other credits which are claimed by the company on account of its policy contracts. The Examination of Insurance Companies 67 proper way to compute this excess item is by the preparation of a schedule similar to the one with which you are familiar (see Appendix H), and which serves to bring out clearly the nature of this disallow- ance. Against each policy is placed the various credits which are claimed upon its account and the sum of these credits is compared with the liability which the company is maintaining to take care of this particular policy. The headings of the various columns, I am sure, are familiar to you and need not receive any fur- ther explanation from me. You will note, however, that in computing the total amount of credits claimed for any particular policy, I have included only the net amount of uncollected and deferred premiums; as we deduct the loading before computing the assets, it is but just to the company to charge it only with that portion of the uncollected and deferred premiums which is allowed. In the schedule described in the foregoing remarks you will note that each policy is treated separately, and it would be improper to allow the accounts of the various policies to be mingled. If, for instance, a company maintained upon one policy a reserve of $10 more than the sum of the credits which it claimed upon that policy, and upon anotlier policy claimed as an asset $10 more than the reserve which it main- tained against that contract, it would be improper to consider that one transaction offsets the other and that no deduction was necessary. An analagous situation would be created if we assumed that because the se- curity behind one mortgage was worth $10 more than the amount loaned thereon, and the security behind another one was worth $10 less than the amount 68 Examination of Insurance Companies loaned, the transactions counterbalance one another. The false reasoning contained in this proposition must be obvious to you. The book value of ledger assets over the market value is an item which is always deducted. The source of this deduction may be traced to one of many causes. If, for instance, the company own real estate which has depreciated from the figure at which it is carried on the books, the difference between the market value at the time of the examination and the price at which the parcel is carried upon the company's books would be deducted; if the company has loaned money on a piece of property which the reports of the appraisers show is not worth the amount loaned upon it, the dif- ference would appear here, and it is independent of any instructions which might be issued by the super- vising officer relative to the necessity for a reduction in the amount of the outstanding principal at some early date in the future; if the collateral deposited as the security for a collateral loan is insufficient to maintain the loan, the deficiency is taken care of in this item, and if the market value of the bonds and stocks is less than the amount at which those securi- ties are carried on the books of the company, the de- ficiency must be deducted. In a subsequent talk I shall refer more to the method of determining the proper book value at which the bonds of a company should be carried, and this will have a bearing upon the matter of depreciation which we are now con- sidering. In the case of fire insurance and companies trans- acting what is broadly termed " miscellaneous " busi- ness, I have previously called your attention to the Examination of Insukance Companies 69 fact that premiums in course of collection more than ninety days past due or agents' balances upon busi- ness which was written more than ninety days before the date of the examination, are disallowed as assets. It may not be amiss for me to call your attention to the fact that while I have referred to the necessity for deducting from the assets any excess which their book value has over the market value, the contrary situa- tion must, of course, be provided for, i. e., if we should find that any of the assets of the company are worth more in the market to-day than the figure at which they are carried in the books of the company, we should allow it credit for that excess value. CHAPTER IX Amortization of Bonds Purchased Above Par — Accu- mulation of Bonds Purchased Below Par — Incor- rect Methods of Treating Premiums and Discounts — Necessary Factors. In my talk to you yesterday I referred to the fact that the appreciation and depreciation in the book values of the ledger assets should be taken into ac- count when we are preparing a statement showing the financial condition of a company. It must be apparent to you that an investor who intends to hold securities until they mature is not concerned with any fluctua- tions in the market value of the securities ; he is inter- ested only in the income earning powers of his invest- ment. In other words, if an investor should buy a bond at par with the intention of holding it until the principal should become due, he would not be affected by any abnormal conditions in the stock market which might temporarily cause his bond to be worth 98 or 105; unless he sold his bond at the current market price, the temporary fluctuations would not affect him at all. A life insurance company is in the same situation as an investor such as I have just described. Its policy contracts run for a long term of years and the calcula- tion of its premiums is based upon its ability to earn a certain rate of interest on its invested assets; it is not desirable that an insurance company should con- [70] Examination of Insura.nce Companies 71 stantly change its investments, for that process leads to manipulation and the injection of the element of speculation into its operations, conditions which were responsible for many of the evils which were devel- oped in recent investigations of insurance companies. For these reasons a life insurance company should attempt to secure safe investments running for long terms, and it will, therefore, be concerned more with receiving the principal of its investments when they mature and receiving the proper interest rate in the meanwhile, than with any temporary changes in the market value of the securities. The question of the receipt of the par value of a bond at its maturity brings us face to face with the proper method of taking care of the bonds which have been bought on different bases. The three possible situations are, first, that a bond shall have been bought at par or, second, that it has been bought above par or, third, that it has been bought below par. In order to illustrate these different conditions let us assume that in each of the first two cases the bond is for $1,000, is purchased on June 1, 1910, bears inter- est at a rate of 5 per centum per annum, that the interest is payable semi-annually on June 1st and De- cember 1st, and that the bond will mature (its prin- cipal become due) on June 1, 1915. It will be apparent to you that if the bond be pur- chased at par, each of the $25 coupons will be interest on the investment and on June 1, 1915, the owner will receive the amount which he originally invested, $1,000. The second case is illustrated by a bond similar to the one described, being purchased at $1,044.91; in 72 Examination of Insura.nce Companies other words, at a premium of $44.91, or, to use the terms of the bond market, has been purchased " at " 104.491, or has been purchased ' ' on a 4^ basis. ' ' The latter designation is used in order to convey the infor- mation that an investor paying that price for the bond indicated, will receive only 4 per cent, on his invest- ment, instead of 5 per cent, as called for by the bond. The correctness of this statement will be shown later. The investor has paid $1,044.91, and on June 1, 1915, will receive only $1,000 for the surrender of the bond; it is quite evident, therefore, that if he is not to suffer some loss he must provide in some way for the gradual writing-off of this premium of $44.91 dur- ing the five years, from the interest receipts, i. e., he must use some part of each $25 which he receives, for the purpose of reducing the premium which he was compelled to pay on the bond, so that when it matures he will have only $1,000 invested. The scientific application of this process is called amortisation. In the past, some companies have used one of two methods to accomplish this, but both are incorrect, and yield improper results. I shall briefly refer to them in order that you may understand the nature of the errors. In the case of the bond just referred to, one of the methods was to charge the premium of $44.91 to profit and loss as soon as the bond was pur- chased; in consequence, the earnings for that year showed an apparent loss and the interest earnings of subsequent years were unduly inflated. The second method was the reverse of this, made no charge in the book value of the security until June 1, 1915, when it charged profit and loss with $44.91, the differ- ence between the book value of the bond and the Examination of Insurance Companies 73 amount which was paid, in the meanwhile considering each coupon of $25 as an interest receipt. I have indicated to you that the proper method of treating this situation is to divide each interest pay- ment into two parts, carrying one to the interest account and the other to a sinking fund which is to be used for the wiping out of the premium of $44.91. This method is required by a statute in the State of New York (see Appendix I), and while the statute would seem to be broad enough to include within its provisions companies transacting any kind of insur- ance business, it is apparently the intention of the Department to insist upon the rule being observed by life insurance companies only. In order that you may see the exact manner in which this process is worked out, I have prepared a chart which indicates the various steps in the bond under consideration. By reference to the bond tables in common use, it will be found that a 5 per cent, bond running for five years will, if purchased at 104.491, yield 4 per cent., and the following calculation proves that to be correct: 2 per cent, of $1,044.91 = $20.90. Each coupon of $25, therefore, must be divided into two parts, $20.90 representing the interest earning and $4.10 representing the semi-annual contribution to the sinking fund; the following table will enable you to trace the progress of the successive contributions of $4.10: Coupon due December 1, 1910 $4.10 Interest factor X 1 . 02 Value June 1, 1911 $4.18 Coupon due June 1, 1911 -f 4.10 $8.28 74 Examination of Insurance Companies Amount carried forward $8 . 28 Interest factor X 1 .02 Value December 1, 1911 $8.45 Coupon due December 1, 1911 + 4.10 $12.55 Interest factor X 1 . 02 Value June 1, 1912 $12 . 80 Coupon due June 1, 1912 -f 4 . 10 $16.90 Interest factor X 1 . 02 Value December 1, 1912 $17.24 Coupon due December 1, 1912 + 4 . 10 $21.34 Interest factor X 1 . 02 Value June 1, 1913 $21'. 77 Coupon due June 1, 1913 -f 4 . 10 $25.87 Interest factor X 1 . 02 Value December 1, 1913 $26.39 Coupon due December 1, 1913 -f 4.10 $30.49 Interest factor X 1 . 02 Value June 1, 1914 $31 . 10 Coupon due June 1, 1914 -\- 4. 10 $35.20 Interest factor X 1 . 02 Value December 1, 1914 $35.90 Examination of Insurance Companies 75 $35.90 + 4.10 $40.00 X 1.02 $40.80 + 4.10 $44.90 Amount carried forward Coupon due December 1, 1914 Interest factor Value June 1, 1915 Coupon due June 1, 1915 .... Premium on bond From this table you will see that if we accumulate the contributions to the sinking fund at the rate of 4 per cent, per annum, compounded semi-annually, we shall have a sufficient amount in the sinking fund to take care of the premium which was paid on the bond when it was purchased. The difference of one cent in the result is due to disregarding mills in the fore- going calculations. In order that you may note that by this result an investor is at all times receiving interest upon the book value of the bond at the rate of 4 per cent, per annum, we may put the foregoing calculations in another form, as follows: DATE (1) Coupon (nominal interest rate) (2) 4% of book value (effective rate) (3) Amorti- zation factor (4) Book value (5) December 1, 1910. Junel, 1911 December 1, 1911. Junel, 1912 December 1, 1912. Junel, 1913 December 1, 1913. Junel, 1914 December 1, 1914. Junel, 1915 $25.00 25.00 25.00 25.00 25.00 25.00 25.00 25.00 25.00 25.00 $20.90 20.82 20.73 20.65 20.56 20.47 20.38 20.29 20.19 20.10 $4.10 4.18 4.27 4.35 4.44 $1,040.81 1,036.63 1,032.36 1,028.01 1,023.57 1.019.04 1,014.42 1,009.71 1,004.90 1,000.00 Total. $44.91 76 Examination of Insurance Companies You will note that as a result of deducting $4.10 from the book value of the bond on December 1, 1910, the new book value is $1,040.81; 2 per cent, of that value is $20.82, which deducted from the proceeds of the coupon received on June 1, 1911, or $25, leaves $4.18, as the amount to be deducted in order to obtain the new book value. By reference to the original table you will see that the difference between the amount of the fund on June 1, 1911, $8.28, and the amount of the fund at the end of the previous period, $4.10=^. $4.18. If we take 2 per cent, of the new book value, $1,036.63, we shall have $20.73, which deducted from $25 gives us $4.27 as the amortization factor, which you will be able to identify on the first table as the difference between $12.55 and $8.28, etc. At the end of each six months, therefore, if we decrease the book value of the bond by the amount shown in column (4) at the maturity of the bond the amount which will be paid to us will exactly equal the book value, and the premium has disappeared. The weak point of this accounting is that we are compelled to assume that the sinking fund will earn the rate of interest assumed, in the above case 4 per cent.; it might be difficult to invest small funds in this way, but in actual practice the sinking fund will contain sufficient money to enable an advantageous investment to be obtained. For the purpose of illustrating the third condition — that of a bond which has been purchased below par — let us assume that the bond is for $1,000, is pur- chased on June 1, 1910, bears interest at the rate of 3 per centum per annum, that the interest is payable semi-annually on June 1st and December 1st, and that ExaminatiojSt of Insurance Companies 77 the bond will mature on June 1, 1915. The premises in this assumption have been changed from those in the preceding one to make them fit more nearly the actual conditions which we would expect in a security purchased by a life insurance company, for it is not to be expected that 5 per cent, bonds will normally sell below par. If the foregoing bond be purchased for $955.09, it will yield the purchaser 4 per cent, on his investment, although the nominal rate stated in the bond is only 3 per cent. A table constructed for this security, similar to the one just shown for the bond purchased at a premium, would be as follows: DATE (1) Coupon (nominal interest rate) (2) 4% on book value (effective rate) (3) Accumu- lation factor (4) Book value (5) December 1, 1910. June 1, 1911 December 1, 1911. June 1, 1912 December 1, 1912. June 1, 1913 December 1, 1913. June 1, 1914 December 1, 1914. June 1, 1915 Total, $15.00 15.00 15.00 15.00 15.00 15.00 15.00 15.00 15.00 15.00 $19.10 19.18 19.27 19.35 19.44 19.53 19.62 19.71 19.81 19.90 $4.10 4.18 4.27 4.35 4.44 4.53 4.62 4.71 4.81 4.90 $44.91 $959.19 963.37 967.64 971.99 976.43 980.96 985.58 990 . 29 995.10 1,000.00 You will note that the factors in column (4) are called in this case " accumulation factors " instead of *' amortization factors," for instead of reducing the book value to par by amortization, we are gradually advancing the book value to par by accumulations. I have assumed in this case a bond which would be pur- chased at a price to yield the same rate of interest as 78 Examination op Insurance Companies was yielded in the first case in order that you might note the fact that the amortization factors in one case are exactly the same as the accumulation factors in the other, but in the first case they are deducted from the book value, while in the second case they are added to the book value. The foregoing is the process which every life insur- ance company should apply to its bonds; it is not so important that companies transacting other forms of insurance should use it, because, as I have already pointed out, the calculations of the latter are not pred- icated upon the investments earning a definite rate of interest, but the process of amortization is one which should be used by every corporation which intends to hold its securities for investment purposes; in no other way can the premium on the bond be properly taken into account. An unscientific approximation is sometimes made by dividing the premium on the bond by the number of periods which it has to run and reducing the book value by the resulting quotient. In the case cited above, for instance, the premium of $44.91 would be divided by 10 and $4.49 deducted from the book value every six months. While this method brings the book value to the par value at the maturity of the bond, it does not properly distribute the decreases which should take into account the interest earnings of the sinking fund. It is hardly necessary for me to point out that no method of amortization can be applied to stocks or to bonds which have no definite date of maturity, for the factors which are necessary in order that we may properly amortize are as follows: Examination of Insurance Companies 79 1. A definite rate of interest stated in the bond. 2. A definite date of maturity. Having these two and the purchase price we are enabled to obtain the third factor, which is The effective rate of interest, and the employment of these three as in the preceding illustrations will enable us to treat securities in the scientific manner indicated. In one of my previous talks I indicated that I would again refer to the question of amortizing bonds which have a redemption privilege prior to the date of maturity. If, for instance, a bond maturing in thirty years contain a provision whereby it may be redeemed in ten years, it must be apparent to you that the holder of the bond, for his own protection, must con- sider the most adverse situation. If the bond has been purchased above par, therefore, the most un- favorable situation is the one which will require the entire premium to be provided for and eliminated at the end of ten years, instead of at the end of thirty years, when the bond would mature if the privilege of redemption had not been exercised. If the bond has been purchased below par, however, it will be apparent to you that the most adverse con- dition is the one which assumes that the bond will not be paid off until its date of maturity and, there- fore, that the accumulations (the difference between the purchase price and the par value) will not reach their maximum until the end of the thirty years. CHAPTER X Liabilities — Net Value of Life Insurance Policies — Net Terminal Value — Mean Reserve — Unearned Premiums — Unearned Premiums on Marine Pol- icies — Perpetual Policies — Reinsurance. In my previous talks I have briefly referred to the various items of assets to which your attention will be directed in your examination of insurance com- panies. In order to arrive at its surplus it must be obvious to you that a proper consideration should be given to the liabilities with which the company should be charged. Speaking in a broad sense, I should consider the lia- bilities of insurance companies under four groups, viz. : 1. Policy liabilities. 2. Claim liabilities. 3. Dividend liabilities. 4. Incidental (all other) liabilities. In the first group I place those liabilities affecting active policies and which are embraced in the items of '' net value " of life insurance companies and " un- earned premiums " of other companies. The second group will comprise the liabilities which should be maintained to provide for the claims and losses which have occurred prior to the date of the examina- tion, but which have not been settled in full. The third group, consisting of the dividend liabilities, is [80] Examination of Insurance Companies 81 found only in the case of life insurance companies and it is so important and differs so radically from the miscellaneous liabilities of insurance companies, that I have preferred to include them in a separate group. The incidental liabilities of insurance companies are found in all classes of insurance companies and include the unpaid taxes, unpaid commissions, unpaid medical fees, etc. In the case of companies transacting credit insur- ance, there is a special liability which cannot be referred to any of the foregoing subdivisions and which consists of 50 per cent, of the gross premiums on the credit policies which expired during the three months preceding the date of the examination. The reason for the inclusion of this item will be referred to when the subject of credit insurance is discussed more at length. The net value of life insurance policies is the result of an accurate mathematical computation which takes into account not only that portion of the premium known as the reserve, but includes another factor — that portion of the premium which represents the amount which will have to be paid for death losses during the balance of the policy year according to the table of mortality upon which the reserve is accumu- lated ; it is this factor which distinguishes the ' ' mean reserve " from the '' net terminal value," for it is the universal practice now of Insurance Departments to compute mean reserves instead of interpolating by months. I shall dismiss the subject of the reserves for life insurance companies with these few remarks, for it is a phase of the situation which is so closely allied with a thorough actuarial training, that a fur- 6 82 Examination op Insurance Companies ther discussion would be out of place in a general talk such as this is. The method of computing the liabilities on the pol- icies of companies transacting other than a life insur- ance business, is so entirely different from the policy reserve just referred to, that I might have been justi- fied in assigning it to a separate group. In contradis- tinction to life insurance reserves, the unearned pre- mium account is not scientifically computed. In an address which I delivered some years ago before the National Convention of Insurance Commissioners, I referred to the ' ^ reserve ' ' of miscellaneous companies as follows: '' What is the so-called ' reserve? ' Let us first consider this question from the negative view- point. It certainly has none of the functions of the reserve for life policies, which has for its purpose the accumulation of a sufficient amount in the early years of a contract to enable the de- ficiency of subsequent years to be met without an undue increase in rates. It is not intended for the reinsurance of a company's risks, for this contingency is to a certain extent a remote one, and, therefore, would hardly justify a provision of this kind. It does, however, occupy the same relation to a corporation which the governor and flywheel do to a complicated piece of machinery. As a steam engine would run wild did it not have some controlling mechanism, so would a corpora- tion indulge in equally extravagant operations if some check were not placed upon it so that it could be brought face to face with a realization that all of the premiums written by it are not earned the moment they are received, but a por- tion of them must be set aside for the purpose of meeting losses in the latter history of the contract.'* Examination of Insurance Companies 83 The unscientific nature of the computation must be apparent to you when you stop to consider that when two companies have issued similar policies on the same risk at different premium rates, the amount of the unearned premium differs in each case. The States have differed in fixing the rate at which the unearned premiums of fire and miscellaneous com- panies (the term ^' miscellaneous " has come to be applied to all companies which do not transact a life, a fire or a marine insurance business) shall be com- puted; some require that 50 per cent, of the gross pre- mium shall at all times be maintained; others require the unearned premiums to be computed upon a pro rata basis. The question of computing the pro rata basis, there- fore, is one to which I will now address myself, and I may mention at the outset that there are two methods of doing this; the more exact one, whereby each month's business is treated separately, I shall first discuss. It would be manifestly impossible to take each pol- icy contract and compute the exact number of days which it has to run before its termination ; it has been assumed, therefore, that all policies are issued on the fifteenth of the month, and if we were making an examination as of December 31,'' 1909, for instance, and we were dealing with one-year policies, i. e., policies that are to run for twelve months from the date when they were issued, we would find the following condi- tion of affairs: The policies which were issued dur- ing December, 1909, would have been in force on the average for fifteen days, or half a month; they would have earned, therefore, l/24th of the premium and the Tineamed portion of the premium with which they 84 Examination of Insurance Companies would be charged would be 23/24tlis; policies which were issued in November, 1909, have been in force one and one-half months, and, therefore, the unearned por- tion of the premium would be 21/24ths; in the same way policies issued in January, 1909, would have only one-half month longer to run before their termination, and the unearned portion of the premium chargeable against them, therefore, would be l/24th. Bearing in mind that the date of the examination is December 31, 1909, I can illustrate by the following table the frac- tions representing the unearned portions of the pre- miums on a two-year policy, i. e., a policy which had two years to run from its date of issue and which was in force at the time of the examination: Policy issued December, 1909, for 24 months has 47/48ths unearned « " November, 1909, " 24 " " 45/48th3 " January, 1909, " 24 " " 25/48ths " « December, 1908, " 24 « " 23/48ths " November, 1908, " 24 « " 21/48th3 " January, 1908, " 24 « « l/48th I have not used the intermediate months, but they are calculated in the same way; applying the same method to a three-year policy we have a Policy issued December, 1909, for 36 months has 71/72nd3 unearned " November, 1909, " 36 u " 69/72nds " January, 1909, « 36 a " 49/72nds " December, 1908, " 36 (( " 47/72nds " November, 1908, " 36 " " 45/72nds " January, 1908, " 36 u " 25/72nds " December, 1907, " 36 u " 23/72nds " November, 1907, " 36 ii " 21/72nd8 " January, 1907, " 36 u " l/72nd A similar method will be followed in other cases adjusted for the term of the policy and the same rule will apply to examinations made as of dates other than December 31st, it, of course, being necessary in these cases to make the proper adjustment. Examination of Insurance Companies 85 The other pro rata method which is more generally used, is based upon the assumption that the pol- icies of a company have been distributed uniformly throughout the year. In other words, that the same number of policies (or rather the same amount of pre- miums) have been written in January as in February, March and the other months of the year; this being so, it will be apparent to you that we will arrive at correct results if we assume that every policy was issued midway, or on July 1st. On December 31, 1909, one-year policies will upon this assumption have been in force six months, and will have one-half of their term complete, the unearned premium factor, there- fore, being %. Two-year policies issued during 1909 have been in force on the average six months, have eighteen months still to run and the unearned pre- mium factor is, therefore, %. The application of this rule results in obtaining the following fractions to represent the unearned premium factors, and in order to save a lengthy description, the date of the examina- tion is again assumed to be December 31, 1909, in each case: Policies issued in 1909 for 1 year have 1/2 of gross premium unearned « " " 1908 " 2 years " 1/4 " " " " " 1909 " 2 " " 3/4 " « « « 1907 " 3 " " 1/6 " " " " 1908 " 3 " " 1/2 " it « « 1909 « 3 « « 5/6 « " " " 1906 " 4 " " 1/8 " « « « 19Q7 « 4 « « 3/8 « « « « i9Qg « 4 u « 5/8 « « « " 1909 " 4 " " 7/8 " « " " 1905 " 5 " " 1/10 " " « " 1906 " 5 " " 3/10 " a « « 1907 « 5 .< « 1/2 « « " " 1908 " 5 " " 7/10 " " " " 1909 " 5 " " 9/10 " If this method be used policies mnning for less than one year, but still in force at the time of the examina- 86 Examination of Insurance Companies tion, are included with the one-year contracts, 50 per cent, of their gross premiums being carried. The second method inferring as it does that there is a uniform distribution of the company's business throughout the months of the year, should not be used in those cases where this assumption is clearly unjus- tified by the actual facts or in those cases where the financial condition of the company is such as to require an absolute determination of the unearned premium account. In the case of marine insurance companies, there is a different rule for calculating the unearned pre- miums ; on policies covering hulls and what are known as time cargoes, it is usual to consider that 50 per cent, of the outstanding premiums are unearned. On car- goes insured for a specific voyage (on a particular vessel for a voyage say from Liverpool to New York) it is usual to require that 100 per cent, of the gross premium shall be carried as a liability. In Massa- chusetts, for instance, this has become part of sec- tion 11, which, in stating the duties of the commis- sioner, provides that: ^' In respect to marine risks he shall compute the liability thereon by charging fifty per cent, of the amount of premiums written in its policies upon yearly risks, and upon risks covering more than one passage not terminated, and the full amount of premiums written in policies upon all other marine risks not terminated ; but in the case of foreign fire and marine insurance companies with less than three hundred thousand dollars capital, admitted to transact fire insurance only in this commonwealth, the full amount of pre- miums written in other marine and inland naviga- tion and transportation insurance policies shall ^ be charged as liability." Examination of Insurance Companies 87 The only other special form of unearned premium, account which occurs to me at this time is one that you may find in the examination of fire insurance com- panies located in the State of Pennsylvania and the southern part of New Jersey; these companies issue what are called '' perpetual " policies, whereby the owner of the property pays a sum to the insurance company when the policy is issued and no further premiums are required, the assumption being that the interest on the deposit will be sufficient to reimburse the company for its outlays in the matter of losses. Should the policyholder wish to surrender his policy he is entitled to receive a certain percentage (usually 90 per cent.) of the deposit, and upon these contracts the liability charged is the amount of the premiums which could be claimed by the policyholders if they elected to cancel their policies. In calculating the unearned premiums of an insur- ance company, credit should be given for the reinsur- ance which it has effected in other solvent,' admitted corporations. The credit which is allowed is to be calculated in the same way in which the unearned pre- miums are calculated. In the case of life insurance companies, the reinsurance credit is the reserve which the reinsuring company maintains upon the policy which it issues to the company which you are examin- ing. If, for instance, the compan.y you are examining has issued an endowment policy for $100,000, of which it has reinsured $50,000, not upon the endowment plan but as a one-year term policy, you would charge it with the reserve on the $100,000 endowment policy, and give it credit for the mean reserve on the term policy which has been issued in its favor. 88 Examination of Insueance Companies I pointed out to you that the method of computing the policy liability, except in the case of life insurance companies, was unscientific, and you will appreciate this the more if you stop to consider that although a company pays its commissions and all other expenses incident to the procurement of its business when the policy first goes into force, the unearned premium account is nevertheless calculated upon the basis of the gross premium. CHAPTER XI Installment Policies — Surrender Values Claimable — Different Forms of Death Claim Liabilities — Re- sisted Claims — Accident and Health Claims — Contingency Reserve. The second group of liabilities consists of the claims and losses. The claims (I have used this term to dis- tinguish the liability from a death loss liability) which you will find in your examination of life insurance companies are of two kinds, those arising from the unpaid installments on death claims and the unpaid surrender values which may be demanded on lapsed policies. Some policies provide that in the event of the death of the insured the beneficiary will receive the amount insured in a certain number of stated installments instead of in one lump sum. It will be clear to you that the present value of ten installments of $100 each is less than $1,000, for instance, and therefore this method of payment when applied to any form of insur- ance costs less than does the payment of the proceeds of the policy in one sum. Cheapness, however, is not the sole consideration, for it is felt by many policy- holders that they prefer to effectually provide for their beneficiaries receiving a definite income, rather than to trust to the uncertainties of investments which will be selected by the beneficiaries or their advisors. The interest rate which shall be used in determining [89] 90 Examination of Insurakcb Companies the present value of the instalhneiits is determined by the rates specified in the statutes or the policies for the valuation; if, for instance, the policies are valued according to some mortality table with interest at 3^2 per centum per annum, the coromuted value of the installments would be calculated at that rate. Install- ment policies provide that the first installment shall become due and payable upon the approval of proofs of death and the others upon the subsequent anniver- saries of the death of the insured. In the case of a policy, the proceeds of which are payable in ten install- ments, it will be apparent to you that The 1st payment is due immediately. ''2nd ' " in 1 year. ''3rd " "2 years "4th " " 3 " " 5th " " 4 " "6th " " 5 " "7th " " 6 " "8th " " 7 " "9th " " 8 " " 10th " " 9 " From this table you will see that all of the values which are payable will have been paid by the end of the ninth year, and a table of present values con- structed on a 3 Mi per cent, basis for a $1,000 policy payable in ten equal annual installments, would be as follows : Present value of 1st installment. . $100.00 << ( ( a 2nd <( 96.62 <( (( I i 3rd < i 93.35 <( < ( << 4th ii 90.19 n (< ii 5th i( 87.14 Examination^ op Insuraistce Companies 91 Present value of (I 6th installment . . $84 20 7th 81.35 8th 78.60 9th 75.94 10th 73.37 $860.76 In other words, at the tune of the death of the insured the present value of the liability on this policy would be $860.76, and if we are making an examina- tion as of December 31, 1909, and the death under the foregoing policy had occurred on July 1, 1909, we would charge as a liability the present value of $760.76 due in six months. These installment payments are sometimes called annuities certain; they involve no mortality factor, which factor is, of course, taken into account in any real annuity contract, as the term is understood in life insurance phraseology. The other form of claims arises from the right which a policyholder has to demand a surrender value within a specified time upon his policy contract which has lapsed and upon which the company is no longer main- taining a reserve. If the legal holder have the right to demand, a surrender value the company must, of course, be prepared to meet that demand. This car- ries with it the necessity for maintaining as a liability the amount of that demand, for in no other way can we reach a correct determination of the surplus re- maining for the protection of all the policyholders. This surrender value may be demanded in the form of a cash payment, a paid-up policy or extended insur- ance, the form not affecting the amount of the liability, 92 Examination of Insurance Companies for in the case of paid-up and extended values we should charge as a liability the single premium neces- sary to provide for the protection. In examining any insurance company it is important that you should realize that a liability should be main- tained for every loss or claim which occurred on or before the date of the examination, even if the com- pany has not been made aware of the fact until some subsequent date ; in arriving at a statement of the con- dition of a company, you are concerned not with the liabilities of whose existence the company was aware, but with the liabilities which existed, and you should, therefore, include all losses which were outstanding at the time of your examination ; if, for instance, a policy- holder, living in Seattle and insured in a life insurance company domiciled m New York, died on December 30, the company would in all likelihood receive no notice of that loss until some time in January, but if you were making an examination, that loss should be con- sidered as a liability outstanding on December 31st. The failure of the company to maintain this liability is not a legitimate source of criticism or condemna- tion, but many well-managed companies to-day are recognizing the correctness of this view and are main- taining a reserve necessary to provide for this item and based upon past experience or actual results. In the case of life insurance companies the liabilities on account of death claims are subdivided by the an- nual statement blank into a number of items, as follows : Losses due and unpaid. Losses in process of adjustment or adjusted and not due. Examination of Insurance Companies 93 Losses which have been reported and no proofs received. Matured endowments due and unpaid. Death losses and other policy claims resisted by the company. Due and unpaid on annuity claims involving life contingencies. The object of this subdivision is to enable the super- vising officer to observe whether the company is set- tling its losses promptly or is unduly litigious in the treatment of its policyholders. If, for instance, any unduly large amount was reported as unpaid on death losses which have become due, the supervising officer would be justified in ascertaining the cause for this condition. You will note that the last subdivision, * ' due and unpaid on annuity claims involving life con- tingencies, " is intended to provide not for the install- ment values, but for the annuity contracts of the com- pany ; annuities certain involve no life contingency, for the installments are payable at certain definite times either to the beneficiary or to some other recipient. With the exception of the resisted claims, the deter- mination of the amounts due in the other subdivisions of the foregoing classification, is a simple matter, for they will be the amounts due under the policy con- tracts; in the case of resisted claims we are required to use our best judgment in determining what the liability should be. Life insurance companies are unquestionably subject to claims which have no justifi- cation, and it would, therefore, be manifestly unfair to charge as a liability the face value of all the policies upon which actions have been brought. An examina- tion of the loss papers will soon develop whether the 94 Examination of Insurance Companies company is disposed to refuse payment upon claims which it should recognize, and I have found that in the case of honestly conducted companies it is a safe and equitable rule to charge as a liability one-half of the face value of the resisted claims. This will take into account not only the judgments which the company will have to pay on cases in which it is unsuccessful, but also the costs and expenses which are involved in defending claims in which it is successful. In the case of companies transacting the business of accident and health insurance, there are different methods employed by the companies for the mainte- nance of the loss reserve items. It is the usual custom (and I think one which may be characterized as safe and sane) to divide the outstanding losses on Decem- ber 31st into three classes: first, the specific losses, i. e., those upon which the company has received notice that a death has occurred or an insured has lost a hand or a foot, upon which class of accidental injuries the policies provide for a definite payment, irre- spective of the ultimate effects of the injury. The second class takes into account other serious injuries and includes all of those claims which give evidence in the loss notice that the insured will be dis- abled for a considerable time. The third class em- braces the non-serious losses or those upon which the approximate period of disability cannot be determined. The proper method of treating the second and the third classes is based upon the experience of the com- pany; an inspection of its experience for five or ten years (the longer the period of observation we have, the more correct will be our estimates) will enable us to obtain the average settlement which the company Examination of Insueancb Companies 95 lias made on its serious cases and a corresponding figure for its non-serious cases. The application of these factors to the number of cases outstanding at the time of the examination will form a basis for the liability which should be maintained; the methods of settlement may vary, the increasing liberality in policy contracts which competition has forced the various companies to adopt and the varying conditions sur- rounding the insured, are all responsible for a greater liability than has been maintained by insurance com- panies in the past. It has been my experience that the reserves in the past have not been sufficient to meet the losses, but I wish to make it clear that this has arisen in most cases from no intentional desire upon the part of the managers to understate their liabilities, but from an honest failure to appreciate the conditions which I have just mentioned as affecting this liability. Conservative managers are beginning to realize these changed conditions and it is this mental attitude which probably accounts for the item which you will find in a number of the statements of well-managed com- panies, viz.: *' contingency reserve " or ** voluntary reserve " sometimes amounting to $50,000, $100,000 or even $250,000. One of the contingencies which the underwriters have in mind and which this fund is sup- posed to cover, is the settlement of claims at higher figures than the ones at which they have been carried in the annual statement. I hardly deem it necessary to call your attention to the fact that in any statement of losses, due allowance must be made for reinsurance in solvent, admitted companies, but care must be exercised lest double credit be given, first, in the deduction from outstanding 96 Examination of Insurance Companies losses, and second, as the allowance of the claims against reinsuring companies as an asset. It is likewise important in the case of every com- pany to ascertain how the actual settlements under its losses have compared with its estimates. It requires some time for losses to be settled and it is advisable, therefore, to select some date sufficiently far back to indicate the effects of actual settlements of the losses. The application of this test will show whether the departments charged with the duty of furnishing esti- mates of the outstanding losses have appreciated the true import of the notices which have been received. CHAPTER XII Fire Losses — Plate Glass Losses — Fidelity and Surety Policies or Bonds Distinguished — Inability to Keep Track of Issues — Suggested Remedies — Salvage — Cosurety — Depository Bonds. In the case of fire insurance companies the unpaid losses are divided into three divisions only: those which are adjusted and due, those which have not been adjusted and those which are resisted. From the ex- aminer's standpoint the treatment accorded losses in fire insurance companies is characteristic of the methods to be followed in the examination of compa- nies transacting the other forms of insurance, with such exceptions as I shall note hereafter. In companies transacting plate glass insurance, the treatment of losses is peculiar, inasmuch as the way in which the business is conducted requires that losses shall be settled not only promptly, but by the agency in the locality in which the loss occurs. It would never do, for instance, for a Home Ofl&ce in New York to attempt to arrange for the replacement of a broken pane of glass in Chicago. Such matters of adjustment are usually handled by the agency in the place in which the loss occurs and the first notice that the Home Office gets of a loss is usually accompanied by some evidence of its settlement. In consequence it is neces- sary to take this fact into account in calculating the [97] 7 98 Examination of Insurance Companies liabilities for the losses in plate glass insurance. Inci- dentally I may call your attention to the fact that this bears upon the matter to which I called your attention yesterday, viz. : that in preparing the financial state- ment of a company we should charge as a liability the losses which had occurred at the date of the examina- tion, whether they had been reported to the Home Office by that time or not. As a usual thing companies which transact a fidelity business also issue surety bonds, and it may be well for me to define these two classes of business. A fidelity policy is a contract entered into between an insurance company and an obligee, whereby the former guarantees the faithful performance of a duty by some third party; it does not require that the third party shall even be aware of the existence of the policy. The forms used for this contract are those prepared by the company and are not fixed by statute. It is the practice of fidelity and surety companies to classify only the foregoing as '' fidelity " risks, all other forms being considered as " surety;" the latter classification includes appeal bonds (given to protect litigants in appeal cases) — guardians', referees' and administrators' bonds (forms of guarantee usually required by the courts) — contractors' bonds, guaran- teeing that they will complete their work in accordance with specifications — maintenance bonds, given to a city, for instance, to guarantee that the asphalt streets will be maintained in a proper condition for a certain number of years — excise bonds, providing for a pen- alty in the event of the violation of the statutes by a liquor dealer — supply bonds, covering the quality of supplies to be furnished, and the various other forms Examination of Insurance Companies 99 for which modern civilization has created a demand. Broadly speaking a fidelity policy may be said to involve the integrity of some person who is to perform a duty, while in surety bonds this element is absent. It must not be understood that this distinction is inflexible, for it will be apparent to you that some of the bonds which I have just characterized as ' ' surety ' ' do involve the element of integrity to a certain extent. There is one matter, however, to which I wish to draw your attention in the treatment of fidelity poli- cies or bonds; it is the usual practice of companies issuing them to provide that the obligee shall have a certain time after the expiration of the bond in which to discover evidences of peculation or wrongdoing. If, for instance, a fidelity policy has been issued to an employer guaranteeing the honesty of his employee for twelve months from January 1, 1909, it is usual to include in the policy form a provision that the em- ployer has until July 1, 1910, in which to report any dishonest acts which were committed during the twelve months from January 1, 1909. You will of course recognize the justice of this privilege. For that reason I have raised the point (and I think the correct- ness of it is now generally admitted) that it is incor- rect for a company to consider that the bond which I have just mentioned expired on January 1, 1910. Some provision should be made for the losses which may be reported to the company during what I may term the ' ' period of discovery, ' ' viz. : the six months which have elapsed since the bond or policy ter- minated. In the case of fidelity and surety bonds (and you will note throughout this talk that I have used the 100 Examination of Insurance Companies terms " policies " and '* bonds " interchangeably) there are numerous points to which I wish to direct your attention. In the first place, I wish to point out the dangerous situation which is prevalent at the pres- ent time owing to the way in which the bonds are issued. In a subsequent talk I shall refer to the proper way of ascertaining whether the agents of other mis- cellaneous companies who have the privilege of issuing policies from their own offices are reporting the issues to the Home Office. That method of checking, how- ever, will not be applicable to fidelity and surety com- panies, for the nature of the business prevents the use of printed and numbered forms furnished from the Home Office. The language employed in bonds is dis- similar and has to be adapted to each particular case, so the use of a printed form is practically an impossi- bility. I have, therefore, suggested that the remedy for this condition might be found in one of three ways, and I wish to refer to them here in order that j^ou will have them in mind. I suggested first that the various Legislatures or the Insurance Commissioners (if they have the power) shall require that all court bonds be either executed on printed forms furnished by the Home Office and authenticated by the proper officers, or that they be written upon sheets of paper furnished by the Home Office and registered there in some way. The second remedy that I proposed was that all bonds, such as maintenance and general surety, be written only upon sheets of paper furnished by the Home Office and re- corded as previously suggested. In lieu of the fore- going I suggested that statutes should be enacted in the various states requiring that every bond issued by Examination op Insueance Companies 101 any agent shall have attached to it a certificate from the Insurance Commissioner of the State where the agency is located certifying to the fact that the com- pany is authorized to transact business. If this were done the company could have a complete record of the certificates which Jiave been used by any agency and it would be a simple matter to verify the data of the bonds to which the certificates have been attached. At the present time to properly check the court bonds, for instance, which have been issued, an auditor from the Home Office is compelled to visit every court, examine the records and ascertain the bonds upon which his company is bound. The question of salvage has more bearing upon surety matters than upon almost any other form of indemnity, although in the case of fire insurance com- panies and marine companies we find that salvage items exist ; we do not find them, however, to the same extent as we do in surety companies. At the present time companies are not permitted to take credit for salvage (doubtless owing to the peculiar nature of the various items which are claimed) and it would be a matter of some difficulty to lay down any rule for the proper allowance of salvage as an asset. At the same time we must not close our eyes to the fact that equity requires us to admit that salvage has some value, and while in the case of a company with a substantial sur- plus the question of salvage is unimportant, the sub- ject has considerable weight and importance in the case of a smaller company not possessed of a large working surplus; in the former case it is the usual practice to disregard the salvage and simply consider it as so much profit when it is disposed of. 102 Examination of Insurance Companies Co-surety is a term applied to an agreement whereby- one surety company agrees to become liable on any particular risk with another. For instance, in some court proceedings two sureties are required, no matter how strong financially one of them may be; in conse- quence it is the usual practice for a surety company to become co-surety with another in consideration of an almost insignificant premium. I have in mind one case where on a bond of $200,000 Company A received only l/42d of the premium which Company B received, and the latter executed an agreement whereby Com- pany A was to become liable for only l/42nd of the losses. While this agreement may have been binding upon the two companies, it did not affect the court or the person to whom the bond was given, as Company A was liable for the full amount of the bond, $200,000, if for any reason Company B could not have met the liability. Depository bonds are bonds issued by surety com- panies guaranteeing that a deposit in a bank or a trust company will be paid upon demand. It is the usual custom for municipal bodies (a State or a city) to require that a bank in which their funds are deposited shall furnish a depository bond. In times of financial stress and panic these bonds may become a serious menace to the surety companies issuing them. While the percentage of losses which the depositors of banks in this country have sustained is commendably small, and therefore the question of ultimate loss may not be a vital one, a surety company may be seriously embar- rassed by the necessity of paying out large sums of money at one time and being compelled to wait until the liquidation of various banking institutions pro- Examination" of Insurance Companies 103 vides funds for repayment. The law of average does not work here as in the case of other forms of insur- ance, for it must be apparent to you that there will be an uneven distribution of losses ; panicky times affect all of the depositories upon which a company has issued its bonds, while in the case of other forms of indemnity, sources of losses do not affect all of the policyholders at the same time. CHAPTER XIII Special Liabilities — Credit Policies — Definition — Methods of Treating Accounts with Insolvent Debtors — Liability Policies Distinguished from Workmen's Collective Policies — New York and Michigan Methods of Computing Reserves. If we examine the schedule of liabilities in the annual statement blank which miscellaneous insurance companies are required to file with the various Insur- ance Departments, we find that there are two kinds of business for which special items are provided — credit insurance and liability insurance.* The special items applicable to credit insurance are of two kinds, one being " special reserve for accrued losses on policies expiring in October, November and December," the other being ^' special reserve for accrued losses on credit policies in force." In order that these special items may be thoroughly understood, it will be necessary for me to explain the theory upon which credit insurance is founded. A credit insurance policy may briefly be described as an agreement upon the part of an insurance com- pany to indemnify its policyholder against losses arising from the insolvency of his customers in excess of Ms average experience; you will note, therefore, that he is not protected against all of the losses which * See chapter XXI. [104] Examination of Insurance Companies 105 he may sustain, but only against those which are in excess of his usual experience. This average experi- ence or '' initial loss " or " own loss " (these being the terms usually applied) is found by taking an aver- age of the losses which the merchant has sustained from the insolvency of his customers during the pre- ceding five years. You will find that the policy re- quires that the insured shall protect himself and the company against abnormal bad debts by selling only a limited amount of merchandise to those customers who are not financially strong, the amount of the sales which the merchant is permitted to make being based upon the rating given the customer by the recognized commercial agencies ; you will also find that the policy provides that the company shall not be liable for more than a certain amount on any one risk (irrespective of the rating) , and that its total liability under the policy is limited to a certain figure. For instance, the policy may be what is called a $25,000-$100,000 policy, which means that after the initial loss has been sustained by the insured, the maximum amount for which the com- pany is liable on any one of the merchant's customers is $25,000, and the maximum amount for which the company is liable on any number of insolvent cus- tomers is $100,000. I know of no other form of insurance which is like credit insurance in the particular which I am now about to describe, viz., that no loss can be collected by the assured under a credit policy until it has expired. The policy provides that the protection shall cover a certain period, in nearly every case a year ; at the ex- piration of that period an accounting is made between the assured and the company, and if the initial loss, 106 Examination of Insurance Companies has been exceeded, then the company is liable for the excess. While the assured has to give the company notice of every loss as soon as it occurs, no settlement or adjustment can be made until the policy has ex- pired. The assured has thirty days after the expira- tion to file his claim with the company, and the com- pany has sixty days after that to investigate the accounts and make its settlements with the policy- holder. Under these circumstances you will see the wisdom of requiring that a company shall carry as a liability the unearned premium on the policies expiring in the three months preceding the date of the examination, less, however, any amount which has been paid to the assured on account of those policies. If, for instance, a policy expired in October, and the company were able to adjust the account in November, it would be manifestly unfair to the company to give it no credit on December 31st in this item for the payment which it had made. Credit companies have different methods of treating the accounts with insolvent debtors which remain open at the time of the settlement. A credit company may take an assignment of the claim of its assured in such accounts and rely for its repayment upon the settlement which the insolvent debtor makes with his creditors. In other cases the assured may be willing to allow a claim against one of his customers at a figure satisfactory to the company, and the company then is required to pay only the difference between the amount owed and the figure at which the account is taken over. A third method is by the making of an agreement between the company and the assured Examination of Insurance Companies 107 whereby in the case of doubtful accounts the matter is permitted to remain open, the company assuming its liability for settlement to be made in the future. In some cases which have come to my attention recently it has been the practice of companies to disregard such agreements in a statement of their liabilities and to consider that the loss has been adjusted and the inci- dent closed. It will be apparent to you that this method of treatment is incorrect, for some liability does exist on account of these unadjusted items. I pointed out to you in my first talk that supervision in this country was largely a matter of gradual devel- opment, and this method of charging a liability for the expirations of the three months preceding the examination is an instance, for this requirement was not enforced until about seven years ago, when the first real examination of a credit insurance company in this country was made. Until that time only 50 per cent, of the gross premiums were charged as a liability, the item being treated in exactly the same way as the unearned premium account of a fire or an accident company was. During that examination it developed that some provision ought to be made for the policies expiring in the preceding three months. That method was followed until 1909, when the New York and the Massachusetts Insurance Departments made an examination of a credit insurance company and developed the fact that the charging of 50 per cent, of the gross premiums was not a sufficient allow- ance, for the reason which I have indicated, viz., that owing to the peculiar nature of credit insurance, none of the losses could be paid until the expiration of the policy, and, therefore, none of the premiums could be 108 Examination of Insurance Companies earned until that time. These two Departments, there- fore, established the rule that on all unexpired policies 75 per cent, of the gross premiums written should be carried as a liability instead of 50 per cent, as hereto- fore. This extra 25 jDer cent, is the amount to be car- ried in the '' special reserve for accrued losses on credit policies in force ' ' mentioned before, the remain- ing 50 per cent, being included in the calculation of the unearned premiums. I think the reasoning is eminently sound and it is in line with the idea which I had in mind as expressed in the paper which I read before the National Convention of Insurance Commis- sioners in September, 1907, in outlining what, in my opinion, should be considered the proper reserve on surety bonds: * ' I believe then that no surety company should consider a premium or fee earned until all possi- bility of risk thereon has passed away. To give this idea concrete form I would say, that, in my opinion, a company should carry as an unearned premium charge the gross premiums which it has received upon risks still open, less any payments which have been made to agents, or brokers, for securing the business. I am willing to admit what must be apparent to all who have considered this problem, viz., that this proposition will be in- effectual unless a sufficient premium or fee be charged. This criticism must apply to any lia- bility charge based upon the premium received, and without this adequacy it will be impossible to prevent the inequality between companies which I pointed out in a previous paragraph. ' ' The two departments just referred to, have assumed that the procurement expenses (the agency expenses) Examination of Insueance Companies 109 will amount to 25 per cent, of the gross premiums, hence they have charged the balance, 75 per cent., as the representation of the unearned premium; whether this amount is correct or not depends largely upon the business conditions of the country. In times of great prosperity the losses of a credit company will never equal that figure, and I think the reverse is true, viz.: that in times of depressed business conditions it is not unlikely that the figure will be exceeded. The table to which I referred the other day as com- paring the actual settlements with the estimates, is particularly useful in the matter of credit insurance, for it shows the adequacy of the estimates which have been made in the past. It is well not to lose sight of the general practice of Insurance Departments in this matter and the theory upon which the liabilities for annual statement purposes are prepared. It is assumed that companies will provide for the most adverse con- dition of affairs and that the liabilities which they will carry will be sufficient to meet such conditions. Should it become necessary for a credit company to reinsure its business it is not unlikely that the company which takes over its policies would require its unearned pre- mium account to be computed on the basis of 75 per cent, of the written premiums, and the requirement of the Departments, therefore, is justified. In order that you may understand the special item referring to liability companies " special reserve for unpaid liability losses " it will be necessary for me to make a more extended explanation. You will recall that a liability policy is an agreement made by an in- surance company to indemnify the assured against loss from the liability imposed hy law upon the assured for 110 Examination of Insurance Companies damages which are the result of bodily injuries (both fatal and non-fatal) which are suffered by certain other person or persons. There are various forms of liabil- ity policies ; employers ' liability, covering the accidents to employees — elevator liability, covering the liabili- ties resulting from accidents due to elevators — teams* liability, covering accidents caused by teams — physi- cians ' liability, protecting the assured against claims of malpractice, error or mistake, and various other forms. A distinction must be drawn between a liability policy and a workmen's collective policy, for under the former the company is not liable for any indemnity or any payments made by the assured for ivhich he cannot be legally held responsible. If, for instance, a work- man should be injured and the injury be not the result of negligence upon the part of the employer, or be one for which he (the employer) is not legally liable, there could be no recovery under the liability policy, even if the employer should wish to pay the injured work- man his wages during the time of his disablement. Under a workmen's collective policy, however, the contingency which I have just mentioned would be covered. The difficulty in estimating the future losses under liability policies arises from two causes. Different companies have different methods of handling their losses; one may feel that it is its duty to contest every claim which is made against one of its policyholders, and, therefore, its losses will not be settled for a great many years ; another company may feel that the proper method of handling its losses is to make prompt set- tlements. The second cause is the more serious and Examination of Insurance Companies 1.11 important one, viz.: that the relation between the em- ployer and the employee, which is the basis upon which liability insurance is predicated, is changing day by day. The limits of the liability incurred by the employer are being broadened and widened in such a way as to make it more difficult for the employer to escape the results of any accident. In fact, there seems to be a tendency to compel the employer to figure the wear and tear on his employees in the same way that he does the wear and tear on his machinery, and to figure that the cost of accidents occurring during the manufacture of any article should be included among the legitimate costs of production. It would appear that we are rapidly approaching a Workmen's Com- pensation Act in this country similar to the one in vogue in some of the European countries,* whereby the workman receives compensation for injuries sus- tained during the course of his work, whether they be caused by his negligence or not (intentional injuries or the wilful disregard of safety devices, being the only bars to recovery). In Germany this feature of work- men's compensation has probably received more at- tention than in any other country. In England the changes have served rather to modify the relationship between the employer and the employee rather than to place the indemnity upon the basis of a compensation act; it would appear, however, that these modifications in England have not resulted in the satisfactory con- dition hoped for by their sponsors. All of the aforementioned reasons made it necessary to devise some method of arriving at a proper reserve * The State of New York now has one which applies to eight hazardous occupations. 112 Examination of Insueance Companies for future settlement of losses which had accrued on liability policies. In New York the rule for the calcu- lation of this particular liability is found in section 86 (see Appendix J) ; this method provides for the di- vision of the data for the loss reserve into two parts: first, the ascertainment of the number of notices of injury which have been received within eighteen months, and second, the number of suits outstanding upon notices received more than eighteen months be- fore the time of rendering the report. In the case of companies which have been in the business for ten years or longer, the experience of each company is examined in order to find out what is the average amount which it has paid on its suits and also what amount it has paid on notices which were settled with- out litigation. These factors having been determined, they are multiplied by the number of each of the appropriate items, and from the product is deducted the amount of all payments which it has made on ac- count of the injuries reported within eighteen months. It is difficult in a few words to properly express all of the terms of this law, and you are referred to the statute itself in order that you may learn all of its provisions. In Michigan, the law is based upon a different theory. The number of notices and suits is disregarded and the company is required to carry as a liability 50 per cent, of the premiums received and earned, which result is adjusted by such an amount as in the opinion of the Insurance Commissioner is necessary (see Appendix K). It is the consensus of opinion that neither of these laws gives satisfactory results, and at the present time Examination of Insurance Companies 113 (November, 1910), the subject is receiving the careful attention of liability underwriters; it seems desirable from many standpoints to base the estimate of future losses upon the experience of the past, both as to the amount of payments and the length of time which will elapse between the date of loss and the date of pay- ment. In connection with this I wish you to read an article on this subject which appeared in the *' Weekly Underwriter " in February, 1908, and of which you have received copies (see Appendix L). I also wish to direct your attention to a paper which I read before The Liability Association in October, 1910 (see Ap- pendix Q), outlining a different method for arriving at the loss reserve. In California, Connecticut, Illinois and Massachusetts the statutes governing the calcula- tion of the loss reserve item are practically the same as the one on the statute books in New York. Before concluding this talk on the subject of lia- bility and credit insurance, I desire to briefly refer to the question of the " limits of risk." Under a liability policy the limitations are usually expressed in a simi- lar manner to the method outlined for credit insurance ; a policy issued on a $5,000-$100,000 basis would mean that while on any particular accident the company's liability is limited to $100,000 on all persons, it does not hold itself responsible for more than $5,000 on any one life. The limit on this policy would be $100,000. In the case of a credit insurance policy, however, a vital distinction exists, and the limit is considered to be the amount which the company will be required to pay upon the insolvency of any one debtor; in the illus- tration before mentioned, a $25,000-$100,000 policy, the limit would be $25,000. 8 114 Examination of Insurance Companies There is another distinction to which your attention should be directed between these two forms; under a credit policy the company can never be compelled to pay out more than the maximum limit, while under a liability policy the maximum limit as stated applies only to one accident, and the liability of the company, therefore, continues upon subsequent occurrences. CHAPTER XIV Miscellaneous Liabilities — Special or Advisory Board Contracts — Taxes Due or Accrued — Borrowed Money — Capital Stock — Sale of Stock in Connec- tion with Life Insurance Forbidden. Before taking up the question of the liabilities re- sulting from the dividends on life insurance policies, I shall refer to the miscellaneous liabilities which are found in the statement of life insurance companies. After disposing of the reserves and the policy claims, you will find in the annual statement blank, Convention edition of 1909 (which means the form of annual statement blank which was adopted at the 1909 session of the National Convention of Insurance Commissioners, and which is now generally used throughout the United States), an item of Due and unpaid on supplementary contracts not in- volving life contingencies You will note that this is similar in wording to the item referring to the amounts not yet due on install- ment contracts, with the exception that this item calls for the amounts which are due and unpaid, while the former item referred to the present item of amounts not yet due. The present item is also intended to cover another form of liability which you will find in your examination of the smaller and the more recently [115] 116 Examination of Insurance Companies formed life insurance companies. I refer to the item of amounts due on what are called " Special " or ^'Advisory Board " contracts. These are supplemen- tary agreements which have been entered into by the insurance company with a certain number of its policy- holders, whereby a definite amount (usually $1 per thousand of insurance in force) is set aside each year and a special fund thereby created, the proceeds from which are shared annually by the policyholders com- posing these special groups. It is usual to limit these groups to 100 or 200 or 500 shareholders, and each man who takes a policy for a certain amount (usually $5,000) is entitled to one of these shares. It has been the custom of companies in the past to form various series of these Advisory Board contracts. For instance, a company will form one group which it will call the United States group, and agree to set aside each year $1 on each $1,000 of insur- ance on all policies written and in force in the United States ; another group will be formed called the State of Indiana group, and $1 or $.50 will be set aside each year for each $1,000 of insurance written and in force in that State. It will be apparent to you that this system entails a serious drain upon the company, but it has been objected to for another reason ; it apparently creates a discrimination between the policyholders, and a recent summary prepared by the representative of a number of companies indicates that in reference to Advisory Board contracts 28 States have statutes expressly forbidding them. 9 States have forbidden them by rulings of their Insurance Departments. Examination of Insurance Companies 117 1 State has a departmental ruling which forbids them unless offered to all policyholders alike. 1 State has a decision by its Supreme Court de- claring them to be illegal under the anti-dis- crimination statute. In dealing with Advisory Board contracts the exam- iner should realize that the liability under them arises from two sources : first, the amounts which remain in the fund and are undistributed at the time of the examination (as a usual thing the policyholder does not receive his share of the fund until he pays his re- newal premium), and second, the amount which has accrued in the fund between the time of the last ascer- tainment and the date of the examination. Premiums paid in advance, including surrender values so applied This refers to the practice which some policyholders have of paying their premiums before they become due, in which case the entire premium so paid in ad- vance is chargeable as a liability. The reserve on a company's policies is calculated on the basis of the length of time which has elapsed between the date of issue and the date of the examination; it follows that if any premiums have been paid in advance of their due dates, they have not been taken into account in the calculation of the reserve. It becomes necessary, there- fore, to charge the gross amount collected from the insured, as in the event of his death before the pre- mium becomes due, it must in the absence of any special agreement be returned to his beneficiary. 118 Examination of Insurance Companies Unearned interest and rent paid in advance You will recall that wlien considering the assets of a company we gave it credit for the accrued interest on its policy loans and also for the rents which were due and accrued on the real estate which it owned. It is the practice of some companies to insist upon the payment of interest in advance by the policyholders who effect loans upon their policy contracts. If a policy loan were made on July 1st and interest col- lected for a year in advance from the borrower, you would (if your examination were being made as of December 31st of that year) charge six months' un- earned interest on the policy loan. This is consonant with the way in which we treated accrued interest. In the same way if any tenant on any of the property owned by the company has paid his rent for a period beyond the date of the examination, the unearned portion of that payment is properly chargeable as a liability. Commissions due to agents on premium notes when paid We allow the premium notes as an asset and do not provide for any deduction for commissions as we do in the case of uncollected and deferred premiums ; it is but proper, therefore, that the company should maintain as a liability the commission which it will have to pay when the policyholder liquidates the in- debtedness represented by the premium note. * ' Cost of collection ' ' on uncollected and deferred pre- miums in excess of the loading thereon You will recall that when we were dealing with the subject of uncollected and deferred premiums, I Examination of Insurance Companies 119 pointed out that we deducted the loading in order to bring these items to the net basis which was used in computing the reserve liability upon the policies. In the same way if the amount which the company will have to pay in the future on its uncollected and de- ferred premiums exceed the loading, a correct state- ment of the assets and liabilities requires that we should take cognizance of this condition and charge as a liability the difference between the amount which the company will have to pay out for collecting this asset and the loading which represents the expense fund available for that purpose. Salaries, rents, office expenses, bills and accounts due or accrued Medical Examiners' fees and legal fees due or accrued I have combined these two items for they deal with practically the same classes of items. They are almost self-explanatory, and I shall therefore confine my dis- cussion of them to pointing out one or two unusual items which should nevertheless be included. If the taxes on the real estate which the company owns have not been promptly paid they should be charged as a liability. If the company has ordered merchandise, printed matter or supplies which it has received before the date of the examination, the bills for them are properly chargeable as a liability, even though the bills have not been rendered or if they bear a date subse- quent to the date of the examination. You can readily see that it would not be proper for us to take any cog- nizance of any arrangement which had been entered into between the company and the one who furnished the supplies as to when the bill should be dated. 120 Examination of Insurance Companies State, county and municipal taxes due or accrued In considering this item it will be necessary to con- sider it under two headings. The taxes which a life insurance company is called upon to pay may either be in the nature of a penalty which the State exacts for transactions of the past, or they may be in the nature of a franchise or occupation tax for its future trans- actions. Taxes which can be referred to the first class are surely a liability at the time of the examination, but taxes answering to the latter description are not, in my opinion, to be considered as liabilities outstand- ing at the time of the examination, even though they be calculated upon the basis of premium collections in the past. Advances by officers or others on account of expenses of organization or otherwise In the case of newly established companies you may find that some agreement has been made with its ofl&cers or organizers whereby certain sums are to be paid to them after the company has started to transact its business. In these cases the amounts so promised are liabilities of the corporation and should be so considered. Borrowed money and interest thereon I consider it almost unnecessary for me to discuss the question of the liability arising from this source, but I merely wish to call your attention to it as in some cases the presence of an item of borrowed money may render the balancing of the statement difficult. In former years the blanks provided for a deduction Examination of Insurance Companies 121 from the " ledger assets " in order that the statement might be brought in balance with the result which was obtained by adding or deducting the difference between the income and the disbursements to or from the ledger assets of the previous year. The present form of blank disregards the question of *' ledger liabilities," and in the case of a company which has borrowed money the statement will not balance unless the amount so borrowed is included in the income. Some question exists as to the propriety of consider- ing borrowed money as a source of income, and I think in every properly kept set of books the '* bills payable " should receive the same treatment as the '* bills receivable." Unpaid dividends to stockholders If a company has declared a dividend payable to its stockholders on a certain date it is customary to charge the total amount of the dividend declaration as a liabil- ity, even though the date of payment may fall beyond the date of the examination. You will also find that in a number of corporations it is impossible to locate some of their stockholders or fractional shares of stock are outstanding and dividends are payable thereon. In those cases the unpaid dividends are charged as a liability. Capital stock All of the capital stock which has been issued is a liability of an insurance company. The proper way in which to ascertain the amount of the outstanding stock is not by accepting the statement of the controlling 122 Examination of Insueance Companies account in the general ledger or even the statement as it appears in the stock ledger of the company; we should work directly from the stubs in the stock cer- tificate book. When a certificate of stock has been re- turned for cancellation it should be attached to its stub; the stubs, therefore, which have no certificates attached to them, should indicate the number of shares outstanding and the liability can be computed directly therefrom. Of course, in the case of companies which have been established for a great many years, it is not unusual that some of the old certificates should be missing. You will be able to decide, however, whether these exceptional cases are the result of error or of design. Among some of the recently established companies you will find that the stock has been sold to investors and to policyholders by stock salesmen who have in most cases used estimates of future earnings which will never be realized and which have awakened false hopes in the minds of those who purchased the stock. This has been frowned upon by practically every In- surance Commissioner, and a circular similar to the one which I quoted in the matter of Advisory Board contracts has been issued, from which the following in- formation relative to the sale of stock in connection with life insurance has been taken: 26 States have expressly forbidden it by statute. 7 States have Insurance Department rulings for- bidding it. 1 State has a departmental ruling forbidding it unless offered to all policyholders alike. 1 State has an Attorney-General's opinion de- claring it to be illegal. Examination of Insurance Companies 123 1 State has an Attorney-General's opinion de- claring it to be illegal unless the option for the purchase of the stock is contained in the policy contract. In these cases you may find that the purchasers of the stock have made partial payments on account, and if the certificates have not been issued it will be neces- sary to charge these advance payments as a liability. XJnassigned funds (surplus) are, of course, the balance between the sum of all the liabilities and the admitted assets ; the admitted assets you will recall are the result of deducting the non- admitted assets from the gross assets. In previous years the annual statement blanks referred to this item as '' gross divisible surplus." I mention this lest the different designation may cause some confu- sion in your minds. CHAPTER XV Commissions on Uncollected Premiums — Dividend Liabilities of Life Companies — Annual and Deferred Dividends — Restrictions Placed on Dividends by New York Statutes — By Ohio Statutes — Items of Dividend Liability in Statement Blank — Tontine Policies — Sources of Dividends. An examination of the liabilities charged against companies which transact other than a life insurance business will indicate that there are no additional points which require our consideration, with the pos- sible exception of the commissions or brokerage which are charged against the premiums in course of collec- tion. As we gave the company credit only for those premiums which were less than three months past due, we must be careful to charge as a liability the com- missions which will have to be paid, on only those pre- miums which have been allowed as an asset. You will recall that in separating the liabilities into four groups I referred to the dividend liabilities ; this group applies only to life insurance contracts. Life insurance policies are issued either upon the non-participating or the participating plan; as the pol- icyholder is not entitled to any share of the profits on non-participating policies the premiums charged are naturally lower. Participating policies are subdivided into two divisions — those providing for annual divi- dends and those providing that the apportionment, or [124] Examination of Insurance Companies 125 rather payment, of proj&ts shall be deferred until some date in the future. The question of dividends assumed considerable im- portance during the investigation of life insurance companies about five years ago. It was felt that the holding of large surpluses, without the necessity of an accounting between the time that the policies were issued and the time that the deferred dividend periods matured, was responsible in a large measure for the evils which existed. Until that time companies felt at liberty to use that form of dividend distribution which they felt was most desirable. Some have always issued annual dividend contracts, while others have discouraged the issuance of anything but deferred dividend contracts. As a result of the investigation just referred to, statutes were enacted in a number of States which have had the effect of abolishing the deferred dividend method of distribution. In New York, for instance, two statutes were placed upon the books which have a bearing upon this ques- tion. We find that section 87 (see Appendix M) speci- fies the amount of the contingency reserve which a domestic life insurance corporation may hold, limiting the amount to certain definite figures dependent upon the size of the company. As the contingency reserve indicates the maximum amount which the companies may hold in excess of their liabilities, it follows, of course, that the balance must be distributed (except in the cases of emergency referred to in the statute) in the form of dividends. The New York Insurance Law by section 101 pre- scribes the standard forms of policies which may be 126 Examination of Insurance Companies used by domestic life insurance companies in the State, and you will find that one of the conditions in these standard forms is that the policy shall participate each year in the surplus of the company. The effect of these requirements, you will see, is to provide for a system of supervision over the funds which the com- pany may accumulate in excess of the reserve require- ments and the necessity for other definite forms of liability. Formerly large sums of money, amounting in some cases to millions of dollars, had been accumu- lated for the purpose of distribution some time in the future, and no form of supervision over them had been exercised ; the officers had a free hand in the matter of the investment of these funds and their subsequent distribution. The adoption of the standard forms of policy in the State of New York, was followed by a similar action in a number of the other States. In Ohio, for instance, the General Assembly passed an act requiring the use of standard forms, or if any company did not care to use them, it could issue any other form provided it contained certain standard provisions and did not con- tain certain other prohibited conditions. Among the standard conditions which every life insurance com- pany issuing participating policies in Ohio must have in its contract, is the one which provides that the policy shall participate annually in the surplus, begin- ning at a time not later than the end of the third policy year (see Appendix N). The two exceptions to this form of distribution are, first, the policies which by their terms provides for a distribution made at the end of the fifth policy year and quinquennially there- after, and second, renewable term policies of ten years or less. Examination op Insurance Companies 127 These two exceptions were made, I believe, because it was felt that in the cases of five year dividend poli- cies the amount which could be accumulated without an accounting being made to the policyholder, was lim- ited in amount ; in the same way the premiums on term insurance policies do not usually contain a suflficiently large surplus factor to render the dividend question important. Until 1907 all of the surplus profits belonging to policyholders were carried in the general surplus of the company and included in the item of unassigned funds. After 1907 the separation was insisted upon and we now find in the annual statement blanks which are used by life insurance companies four items refer- ring specifically to the matter of dividends. The first one '' Dividends or other profits due policyholders, including those contingent on payment of out- standing and deferred premiums " refers to those dividends which have already been de- clared, but which have not been paid to the policy- holder at the time that the statement was made. The second " Dividends declared on or apportioned to annual dividend policies payable to policyholders during 1910, whether contingent upon the pay- ment of renewal premiums or otherwise " is self-explanatory, but you will note that it applies to annual dividend policies only. The year 1910, which has been inserted here will change each year, and I have used the figure which appears in the annual state- 128 Examination of Insurance Companies ment blank showing the condition of the company as of December 31, 1909, in order that the time of the application of the liability may be clear to you; these remarks apply with equal force to the date used in the next item. The third item '' Dividends declared on or apportioned to deferred dividend policies payable to policy- holders during 1910 '* is the item which corresponds to the one just referred to, but it is applicable to the deferred dividend con- tracts only. The fourth item ** Amounts set apart, apportioned, provisionally ascertained, calculated, declared or held awaiting apportionment upon deferred dividend policies, not included in item 33 " is probably the most important one and marks the radical change in the manner of treating dividends, to which I have referred previously, as a result of the investigations which have been made. Item 33 refers to the preceding item (designated by me as the third item), and the numbering is the one employed in the 1909 convention edition. A proper consideration of this item will require a brief description of the devel- opment of deferred dividend business in this country. The first issues of deferred dividend or tontine (this word is derived from the name of an Italian banker, Lorenzo Tonti, who in the seventeenth century sug- gested to the King of France that a number of indi- viduals should each contribute to a fund, the annual Examination op Insubance Companies 129 income of wliich was to be divided among the sur- vivors of the original contributors and when no sur- vivors remained, the fund was to revert to the State) policies provided for the payment of the face of the policies to the estates of those policyholders who died before the completion of the tontine period; the entire profits were divided among those policyholders who were alive at the completion of their dividend periods, and who had persisted in the payment of their pre- miums until that time. Those policyholders who through choice or necessity did not continue their pre- mium payments, forfeited not only their share in the profits, but also the reserve which had been accumu- lated on their contracts. The iniquity of this method was apparent and the policy contracts were then changed to provide that if a policyholder lapsed after making a certain number of premium payments, his equity in the reserve which had been accumulated on his policy, should be recog- nized; he was, therefore, given the right to receive a certain amount of paid-up insurance depending upon his age, amount of reserve which had been accumu- lated and the surrender charge which was exacted by the company. Subsequently nearly all of the States passed statutes requiring companies to grant these values in the case of lapsed policies, section 88 of the New York Insurance Law being typical of this class of enactments. The fourth item before referred to, you will see requires the company to set aside the amounts which it is holding for its deferred dividend policyholders; in this way these become specific liabilities of the com- 9 130 Examination of Insurance Companies pany and cannot be included in its general surplus or the unassigned funds. Although the computation of the dividends is a mat- ter which you will probably refer to your actuarial adviser, it is but proper that you should have a gen- eral idea of the manner in which the dividends on life insurance policies are obtained. The sources from which policyholders derive their dividends are 1. Savings from mortality. 2. Excess interest earnings. 3. Savings from loading. I have already explained to you that one of the factors upon which the calculation of premiums is based, is a mortality table. This mortality table as- sumes that during the year a certain number of in- sured lives will die. If in the particular company the agents have been careful to select policyholders in- volving no moral hazard and the examining physicians have been careful to approve the applications of those applicants only who have no marked iDhysical defects, the company will experience a mortality less than that assumed by the table upon which its premiums were calculated. It must be apparent to you that a profit will arise from such a condition of affairs; in a well- managed, active company, the actual mortality ought to be between 60 per cent, and 80 per cent, of the ex- pected mortality, in some years rising and in others falling, through no traceable cause. The second source of dividends arises from the ex- cess interest earnings, and you will recall that the in- terest factor is one which is taken into account in the Examination of Insurance Companies 131 calculation of the premiums. A company bases its premiums upon a certain mortality table and upon a definite rate of interest, 3 per cent, or 31/2 per cent, or 4 per cent. K the premium receipts and the reserve funds of the company are in«^;^ested in such a manner as to earn a net rate of interest in excess of the one assumed in the premium calculation, the excess over that rate is a source of profit. I have referred to the net rate in order to call your attention to the fact that we must take into account the investment expenses and the investment losses in determining the rate of interest earned. The third source is the saving in loading. You will recall that the insured pays a gross or office premium, which is divided into two parts, the mathematical net premium and the loading; the object of the first part is to pay the current death losses and to provide for the accumulation of the reserve necessary to pay each policy at its maturity; the loading is the difference between the mathematical net premium and the gross premium and is added to the net premium for the pur- pose of taking care of all of the expenses and contin- gencies not provided for by the net premium portion. If, therefore, a company should be able to so admin- ister its affairs as to effect a saving in the expense loading, it will be apparent to you that such saving will constitute a source of profit. From these three factors are derived the dividends payable to policyholders, but the factors themselves and the manner of applying them, are matters of opin- ion which vary according to the wishes of the actuary in charge of the company. There is another factor which I have not deemed it 132 ExAMiNATioisr OF Insurance Companies necessary to discuss as one of the sources of dividends. I refer to the profit which naay accrue to a company through the failure of its policyholders to continue their premium payments. In former years, the profit from lapses was considerable, but the stress of com- petition and the passage of laws in the various States affecting this question, have reduced these profits to almost a negligible quantity. The initial cost of plac- ing business on the books is so heavy that the loading factor is not sufficient to provide for it. If, therefore, a lapsing policyholder leaves any of his reserve in the hands of the insurance company, it is but proper to use it as an off-set to the procurement expenses. It is the practice of some actuaries in computing the sav- ings in mortality to take into account this lapse factor. CHAPTER XVI Departmental Examinations not Audits — The Trial Balance — Premium Income — The Two Bases — *' Policyholders' Basis " — Various Sources of Inter- est — Other Items of Income — Premium on Capital Stock. It is my intention to refer briefly to the various items in the income and the disbursement portions of the annual statement blanks in order that you may get a proper idea of the relation which these items bear to the other portions of the blank. As I have previously stated, an examination by an Insurance Department is not an audit in the sense that the term is usually understood; at the same time the examiner is vitally interested in feeling sure that the books shown to him can be relied upon as containing a true exhibit of the various transactions. In this, as in the other talks which I have made, you will notice references to the misleading methods which have sometimes been followed by the companies under examination; it must not be assumed from this that the examiner should be prepared to find improper con- ditions in every office visited by him, but did he not take all possible precautions to satisfy himself that the books were properly kept, he would be valueless for the work which he is undertaking. He is somewhat in the position of a physician making an examination of an applicant for life insurance: the doctor does not [133] 134 Examination of Insueance Companies expect to find an impaired risk, but his duty to his employer requires that he shall be alert and that his eye shall be constantly on the lookout for imperfec- tions; in fact, no one but the wrongdoer objects to a hypercritical attitude upon the part of the examiner. Before taking up the matter of the items of income, however, I desire to refer briefly to some of the gen- eral rules for examining the books of record. It is almost unnecessary for me to call your attention to the fact that we should be satisfied that the footings in all books submitted to us have been correctly made. In some cases it will be necessary to verify everything, while in other cases adequate tests can be made which will serve to answer all purposes; if the books of the corporation are audited periodically by competent ac- countants and auditors, the work of the examiner is much simplified, for if the methods of investigation which have been pursued by these outside auditors commend themselves, he may feel safe in accej^ting their certificate. As a general proposition it may be stated that every debit balance indicates either an item of disbursements or an item of assets, while every credit balance indi- cates an item of income or an item of liabilities. This rule, however, may be modified by the peculiar methods followed in some particular companies. Some books, for instance, are kept in such a way as to re- quire the use of each side of the account instead of the balance ; in other words, we may find that accounts are not closed out at the end of each financial period, and in those cases we must use the increase or decrease in the account for the corresponding items in the annual statement. If the general system of accounting, how- Examination of Insurance Companies 135 ever, is understood by the examiner and kept con- stantly in his mind, he will have no difficulty in apply- ing these general principles to each particular system. The most important item of income for insurance companies is naturally the premium income, and the treatment accorded this item varies with the different kinds of insurance transacted. I think I have already mentioned to you that in the case of life insurance companies the assets are computed upon the basis of the cash which has been received, and in consequence the premium income portion of the statement is upon the same basis; in the case of other forms of insur- ance, the assets are computed on the basis of the premiums which have been written, even though they have not been received in cash, and we therefore pre- pare the income portion accordingly. To bring the distinction clearly before you let me assume the case of two insurance companies, one transacting a life business and the other a fire busi- ness, both starting in December of any year and before the close of that year each has issued one policy upon which the premium of $100 has not been collected. For the sake of illustration we will assume that no moneys have been paid out for expenses and that no other transactions of any kind have taken place. In the case of a life insurance company the premium income would be zero, the disbursements would be zero and the ledger assets would be zero ; in the non- ledger assets, however, we would find the uncollected premium scheduled as a credit, the deduction made for loading, and in the liabilities we would find the reserve. In the case of a fire insurance company, however, the premium income would show $100, the disburse- 136 Examination of Insurance Companies ments zero, and among tlie ledger assets we would find a credit of $100 for " agents' balances not more than three months past due," thus making the statement balance; among the liabilities we would find the un- earned premium and the commission or brokerage due the agent charged in their appropriate places. In some fire offices it is the practice to give the agent credit for the commission as soon as he is charged with the premium, and in that case the premium in- come would be $100, the commissions would appear in the disbursement portion as $30 (if that be the rate allowed), and among the ledger assets we would find the agents' balances stated at the net figure, $70, the balance being thus maintained; in this case, however, you will note that the only item of liabilities to be charged is the unearned premium. It is important that we should bear in mind the manner in which unscrupulous officers or employees can profit by incorrect entries in the books; the most usual method is the overstatement of disbursements, the peculator profiting by the use of sums of money which are charged to other and more innocent ac- counts ; it must be apparent to you, however, that the same results can be accomplished by understating the receipts. That this is not merely an academic question can be realized when I explain to you that the use of large sums of money for legislative purposes by one of the large insurance corporations was accomplished by failing to report as an item of income, the policy fees which had been received, thus saving itself the necessity of setting forth the outlay in the disburse- ment portion of this statement. It is important, there- fore, that we should take the necessary steps to ascer- Examination op Insurance Companies 137 tain that all of the items of income have been correctly set forth in the books and the statements. In the case of all insurance companies, the premium income is stated on the policyholders' basis. By the use of the term ' ' policyholders ' basis ' ' I wish to con- vey the idea that the reports show the premiums writ- ten or received (as the case may be) after deducting the reinsurance, the return premiums and the pre- miums on not taken policies; I use this term to distin- guish these disbursements from the other deductions which are made and which are purely of an agency or managerial nature. In the case of life insurance com- panies, the deduction which is made is for reinsurance only, i. e., for the premiums which the company under examination has had to pay to some other company for having the latter assume part of the risk; in the case of life insurance companies, we do not have return premiums as a usual thing, or any of the other deduc- tions which you will find are made in the case of com- panies transacting the other forms. The reason for this is apparent when we consider that a life insurance contract may not be canceled by the company which has issued it except for fraud ; if the person who has been insured has made proper representations to the company at the time that the policy was issued and he continues to pay his premiums, there is no way in which the company can void the contract or escape carrying the risk. On the other hand, if a company transacting other forms of business should desire for any reason to get off a risk, it can do so by serving the proper notice upon the legal holder of the policy and returning the portion of the premium which has not been earned. 138 Examination of Insurance Companies As a result of the foregoing condition it is necessary for the statement blanks relating to companies other than life insurance companies, to contain items which show definitely how much has been returned to the in- sured in the manner which I have just described, and as their statements are on a " written " basis instead of a '* received " basis, it is necessary for the pre- mium exhibit to contain an item of the premiums on '' not taken " policies, i. e., the premiums on the pol- icies which have been issued but which for some reason or other have not been paid for by the insured and have been returned by the agent for cancellation. You will, of course, see the propriety, in fact the necessity, of this treatment if we are to account for all the pre- miums written. In a previous talk I referred to the two bases upon which life insurance companies in this country were required to report their condition, one the written and the other the paid for. These terms apply to the un- collected premiums and the reserve calculations of life insurance companies, and must not be confused with the " written basis " and '' received basis " which refer to the methods of treating premiums. The other item of importance in the income state- ments of insurance companies is the matter of interest, and this is subdivided into the various sources — real estate, mortgages, bonds and stocks, collateral loans, etc. There is no necessity for any extended comment by me upon the method of verifying this item, for it is merely a question of ascertaining the correctness of the entries which have been made. The annual state- ment blanks are now prepared in such a way as to include schedules showing the various forms of in- Examination of Insukance Companies 139 vested assets, and these schedules contain calculations which exhibit very clearly the amount of interest which has been collected during the year; the sum of these items in the schedules will agree with the interest items in the income portion of the statement. There are other items of income which are unusual, but which may be found from time to time in a com- pany's statement. For instance, if a company has some time in the past marked off an item to its profit and loss account, having considered it valueless, and a subsequent recovery in part or in whole has been made, the amount so recovered must appear among the income items in order to make the statement balance. If any invested assets have been sold or have ma- tured during the period covered by the statement, and as a result have shown a profit, we would naturally expect to find such items of profit in the income por- tion of the statement. You will recall that when I dealt with the proper method of amortizing bonds, I called your attention to the fact that if a security were purchased below par, it would be necessary to in crease the original book value each year in order that the book value at the time of maturity should be par; these various items of accumulation are proper sources of income and should be so scheduled. In the same way, if any security not subject to the process of amor- tization (real estate or stocks, for instance) should have its book value increased, the amount of such in- crease should be included among the income items. I desire to refer to another item which may be met frequently in the case of newly established companies, and that is the premium which has been paid by the rr "HE \ I'NIVr.RSITY !j OF Jr' 140 Examination of Insurance Companies stockholders upon any capital stock which has been sold during the period covered by the statement. If, for instance, the capital stock of the company has been increased by $100,000, and the newstock has been sold at the rate of $150 per share (par value $100), the difference between the par value and the price paid by the purchaser — $50 — must be carried as an item of income. The par value becomes part of the capital stock and is charged as a liability, but there is no liability attaching to the surplus portion which has been contributed by the stockholders ; it is, therefore, an item of income which may be used for managerial expenses in contrast with the capital stock portion, which at all times remains a liability and must not be impaired by disbursements. CHAPTER XVII Evidence of Disbursements — Voucher-cheques — Losses — Payments in Installments — Net Losses, Surrender Values and Dividends — Other Disburse- ments — Profit and Loss. For every item which appears among the disburse- ments of an insurance company (with the exception of the profit and loss entries) we should find some evi- dence of payment. This evidence may take the form of a receipt or a cheque, and the tendency among com- panies to-day is toward the use of a combination voucher-cheque, which when properly indorsed by the payee becomes a cheque which can be deposited in a bank. We should not be content, however, with finding merely a receipt for a disbursement; we should sat- isfy ourselves that the total amount claimed has been disbursed for the purposes stated. I can best illus- trate this by calling your attention to the case of an insurance company which entrusted the settlement of a number of its claims to an adjuster, giving him a certain amount of cash for the purpose; it subse- quently developed that it was the practice of this ad- juster to take a receipt from the claimant with the space for the amount paid left blank, and at some later [141] 142 Examination of Insurance Companies time figures were inserted which enabled the adjuster to make a handsome profit from the transactions. The first disbursements shown in the blank relate to the payment of losses. In the case of life insurance companies, the losses are divided into three groups — death losses, matured endowments and additions. The third division arises from the payment of the addi- tional insurance which is the result of the insured choosing to use the dividends which have been declared on his policy for the purchase of paid-up insurance instead of receiving them immediately in cash. In examining a life insurance company, you will satisfy yourself that not only has the proper amount been paid on each policy, but also that the proceeds have been paid to the proper person; companies require that at the time of paying a claim the policy shall be deposited with the company, and if for any reason the policy be absent, a satisfactory explanation should be offered. In the case of annuities, we should find that the company has in its possession satisfactory evidence that the annuitant was alive at the time that the pay- ment became due. Should the policy which provides for the payment of its proceeds in a certain number of installments, mature as a death claim or as an endowment, the com- muted value of the installments at the date of maturity, should be considered as a disbursement, and the dif- ference between such commuted value and the first actual pa>Tnent made to the beneficiary, should be car- ried into the income portion of the statement; when the subsequent installments are paid they should not Examination of Insueance Companies 143 be included among the losses, and we find a separate item in the disbursements '' paid for claims on supple- mentary contracts not involving life contingencies " for the accommodation of such payments. In the case of all insurance companies, the payments for losses are stated on a net basis, i. e., the amounts which have been received from reinsuring companies or which have been recovered in the shape of salvage, are deducted. A burglary insurance company, for in- stance, may pay a loss and subsequently recover some of the stolen articles; the amounts which it realizes from such recoveries are to be deducted from any statement of losses paid. If a fire insurance company has paid a loss on a stock of merchandise partially destroyed, any amount which it receives from the sale of the damaged stock, should be deducted in order that the net amount which has been paid to claimants may be properly shown. Life insurance companies are required to make returns to their policyholders in two other ways besides the payment of losses — surrender values and dividends. In the case of policies surrendered for cash, we should find the policy on file together with a receipt showing the amount paid, and a release from the insured and the beneficiary; an examiner should satisfy himself that surrender values have been allowed in accordance with the terms of the policy contracts, and that no discrimination has been per- mitted. Dividends are usually authorized by the Board of Directors of the company, and if the insured has received his dividends in cash, there should be on file some evidence of the pajonent. Dividends may be 144 Examination of Insurance Companies paid in cash, applied to the payment of renewal premiums, applied to shortening the endowment or the premium paying period, used for the purchase of paid-up additions or annuities, or may be left with the company to accumulate at interest; if the last named method has been selected by the insured, it devolves upon the examiner to see that a proper liability is being maintained by the company for such deposits. I have now mentioned practically all of the pay- ments which are made by insurance companies to their policyholders, and will now briefly refer to those dis- bursements which an examiner might expect to find, and which are not self-explanatory. Paid for claims on supplementary contracts not involv- ing life contingencies This is the item to which I have previously referred, and my object in bringing it to your attention again is to point out that the payments which newly established life insurance companies make to the holders of their Advisory Board or Special contracts should be in- cluded here. Commissions to agents Companies which transact other than a life insur- ance business are required to state the commissions or brokerage which have been paid to their agents (after deducting the commissions which have been repaid to them on return premiums and reinsured policies) but are not required to separate the commis- sions on first year premiums from the commissions on Examination" of Insurance Companies 145 the renewal premiums, for the same rate is allowed on both classes of premiums. In the case of life insur- ance companies, however, you will find that the sepa- ration is called for, owing to the fact that the initial cost of procuring the business is many times as great as the renewal commissions which are paid to the agents; for statistical purposes, therefore, it is im- portant that we should be able to separate the dis- bursements applicable to new business from those items of disbursement which have been incurred for the renewal of the business. Your attention is directed to section 97 of the New York Insurance Law (see Appendix 0) which limits the amounts which may be paid for the expenses of the first year, and it therefore becomes important for us to be able to separate the commissions in the case of a company to which this section is applicable. Commuted renewal commissions It is the practice of some companies to purchase from a retiring agent at an agreed figure, the value of future renewals which will have to be paid to him under his contract; if these payments were included with the other renewal commissions, and a comparison made with the renewal premiums collected, it would appear that an unduly large percentage had been dis- bursed and we therefore have this separate item. An examiner should carefully scrutinize the payments charged to this account in order that the general agency methods of the company may be clearly under- stood. 10 146 Examination of Insurance Companies Compensation of managers and agents not paid by commission for services in obtaining new insur- ance Agency supervision and traveling expenses of super- visors (except compensation for home office super- vision) Branch office expenses, including salaries of managers and clerks not included in Item 21 Item 21 is the second of the above items, and the object of requiring the separation of disbursements in this way is for statistical and statutory purposes. Rent, including $ for company's occupancy of its own buildings In order to obtain an idea of the true earning power of a piece of real estate owned by a company, it is necessary to know the " rental earnings;" by this term I mean the sum of the actual rental receipts and an allowance for any occupancies, for which, however, no actual rental is paid. If, for instance, a company's Home Office should occupy a certain number of square feet, it is but just in estimating the rental earning of the property to assme that the company is paying the same rental as another tenant occupying the same space would pay. It will be equally clear to you, how- ever, that the application of this theory may lead to abuses, for it would be a simple matter to inflate the apparent earning power of a piece of property by assuming the receipt of rents disproportionate to the space occupied. If, therefore, it be the practice of a company to charge itself with a certain amount for its Examination of Insurance Companies 147 own rent in a building which it owns, the amount so charged should be indicated in this item. Furniture, fixtures and safes As the moneys expended for these purposes are not recognized as an admissible asset, it is the usual prac- tice of companies to consider that all sums expended for these purposes are disbursements and not assets; it merely becomes necessary for me, therefore, to call your attention to the fact that the account of furniture and fixtures should not appear both as an asset and as a disbursement. Gross decrease by adjustment, in book value of ledger assets This item you will recognize as similar to the one which appeared in the income portion of the state- ment, but which referred to the increase by adjust- ment. We should find here all items which as a result of the application of the process of amortization have decreased the book value of the bonds. We should also find here the amounts which have been written off from the book value of other securities not subject to amortization, such as real estate, stocks, etc. Other disbursements During the course of the year the company may have some items of disbursements which cannot be con- veniently referred to any of the items appearing in the annual statement blank, and it is for the accommo- dation of them that this flexible item has been created. 148 Examination of Insurance Companies All items of profit and loss, other than those covered by the regular items, will appear here, and it is but proper that I should bring to your attention the neces- sity for the careful examination of all profit and loss entries. I know of no more fertile field for the growth of improper practices than the profit and loss account in a company's system of accounts. CHAPTER XVIII Schedules — Development of Schedules in Annual Statement Blanks — Analysis and Explanation of Schedules A to Y, Inclusive of Life Blank I have determined this morning to speak to you about the schedules which appear in the annual state- ment blanks and which contain valuable information for the examiner. Their importance justifies me in devoting some time to their consideration. Schedules, like many other matters connected with insurance supervision, have been largely a matter of development. Until five or six years ago, the sched- ules in the annual statements which Insurance Depart- ments required companies to file with them were rather primitive and were intended merely to list certain assets of the company. They were four in number; a schedule showing the real estate owned by the company at the close of business December 31st of the year for which the statement was rendered, one showing the bonds and stocks owned at that time, one containing information about the collateral loans out- standing on December 31st and, finally, one containing information about the mortgage loans. This was the extent of the schedule requirements. By reference to the annual statement blank in use at the present time, you will see that a great many more schedules are required from the companies and the additional requirements may be divided into two [149] 150 Examination of Insurance Companies parts: first, those schedules which will enable the supervising official to verify some of the more impor- tant items of liabilities and, second, the schedules per- taining solely to methods of management, details of administration and facts not connected in any way with the financial solvency or insolvency of the com- pany. Considering for the present the statement which life insurance companies are required to file with the New York Department, you will find that Schedule A is now divided into three parts, the first listing all the real estate owned at the time of making the statement and giving a great number of details, such as the original cost, the book value, the earnings, the expenses and other matters pertaining to each item; the second part of the schedule deals with the real estate parcels which have been acquired during the year to which the statement applies, the object of this additional information being to develop the method by which the real estate was acquired (by purchase or fore- closure) and from whom it was acquired, in order to indicate whether any improper factors have entered into its purchase or whether the foreclosures indicated that lax methods prevailed when the mortgage loans were made; the third part of the schedule relates to the real estate which has been sold during the year and is intended to develop not only any loss or profit which the company may have realized from each sale, but also the name of the purchaser, in order, as I pointed out when dealing with the second part of this schedule, to determine whether any improper motives have entered into the sales. In addition to these three parts there is also a classification, intended solely for Examination of Insurance Companies 151 statistical purposes, which shows the way in which the real estate is geographically divided, apportioning the various holdings between the different States and countries. Schedule B, while retaining practically the same form that it has had for a number of years, now shows not only the mortgages which are owned by the company at the time that the statement was made, but also includes a statement of the acquisitions, in- creases, reductions and those mortgages which have been disposed of. A classification similar to the one indicated in Schedule A is also found here. Schedule C is the one relating to collateral loans and is one of the most important schedules in the blank. It, like Schedule A, is divided into three parts, the first showing all collateral loans outstanding at the time the statement was made, the second showing the loans which were made during the year, and the third list- ing the loans which were discharged in whole or in part during the year. In former years, the only sched- ule relating to collateral loans which was required of companies was one similar to the first part of the present schedule, but even this part in the present schedule is very much amplified and requires the filing of such additional information as a detailed statement of the collateral which has been released and the sub- stitutions which have been made, if any. The name of the actual borrower is likewise insisted upon, and the use of these three subdivisions during successive years will enable a supervising ofiicial to determine whether any '* window dressing " has been indulged in; in other words, whether on December 31st of one vear loans were ostensibly paid off and remade on 152 Examination of Insurance Companies January 1st of the next year. This you will recall was one of the evils which was developed by the recent investigation. Schedule D, relating to bonds and stocks, is divided into four parts, the first showing all bonds owned by the company on December 31st, the second showing the stocks owned, the third showing the bonds and stocks acquired during the year, and the fourth show- ing the bonds and stocks sold, redeemed or otherwise disposed of during the year. In the past the first and second parts alone were required, but the present form of these parts indicates great enlargement, and we now have columns which develop whether there has been any increase or decrease by adjustment in the book values during the year. In addition to this infor- mation, companies reporting to the New York Depart- ment are required to furnish additional information which will enable the Department to judge of the methods of amortization used by the company. The object of requiring the names of the purchasers and the names of the vendors in the third and fourth parts of this schedule is to furnish the Department with full information relative to these details. Schedule E is one which shows the bank balances which were outstanding on December 31st of the state- ment year, and in addition thereto contains columns for each month in order that the company may show the largest balance which existed during those months in each of the banking institutions. There is likewise a column showing the amount of interest received dur- ing the year on these balances, and it is hardly neces- sary for me to devote much time to an explanation of the object of this schedule. I may say briefly that Examination of Insurance Companies 153 it is intended to develop whether the company is per- mitting an abnormal amount of its assets to take th'e form of cash in bank, whether any of the banking institutions are being favored at the expense of the policyholders owing to the connection with such insti- tution of any of the company's officers or directors, and whether any of the banks are being used as an adjunct to any of its other financial operations. This schedule is the first of what I. may term the new series, the first four constituting the original schedules which were formerly required by Insurance Departments. Schedule F shows the claims for death losses and for other policy claims resisted or compromised during the year, and also shows all policy claims which were resisted and unpaid at the end of the year covered by the statement. Schedule G shows all salaries, compensation and emoluments received during the year by the officers and directors, and also the amounts received by any other person, firm or corporation when such payments were in excess of $5,000; this schedule is intended to enable the Department to ascertain whether there have been any improper disbursements and also enables it to ascertain by whom the disbursements have been authorized. Section 103 of the New York Insurance Law (see Appendix P) sets forth the information which must be furnished to the Insurance Department and some of the foregoing information as well as the facts which some of the subsequent schedules are intended to de- velop have been inserted in compliance with that sec- tion. Schedule H, for instance, which is intended to show the payments for agency supervision, is of this 154 Examination of Insubance Companies nature and is for the purpose of ascertaining whether the company is complying with those statutes limiting the amount which may be expended for procurement purposes. Schedule I, showing all commissions paid on loans or on the purchase or sale of any property during the year, is self-explanatory, and the purposes of this in- formation will require no further explanation upon my part. Schedule J pertains to the legal expenses; it must be apparent to you that a Department is interested in knowing whether the companies under its supervision are litigious or are settling their just claims without requiring their claimants to resort to law. In the past some improper disbursements have been hidden under the guise of " legal expenses " and the object of this schedule is to prevent the repetition of such conditions. Schedule K, showing the expenditures in connection with matters before legislative bodies, officers or any branch of the government, is intended to develop whether the company has paid anything for the pur- pose of securing or defeating legislation, to whom such payments have been made, if any, and also whether any contributions have been made to campaign funds. Schedule L shows the proceedings of the last annual election of the corporation, the names of the candi- dates for directors or trustees or any corresponding office, the number of votes cast for each candidate and whether the votes were presented in person, by proxy or by mail. The object of this schedule is for the pur- pose of ascertaining how thoroughly the members of the corporation or the policyholders enter into the Examination op Insurance Companies 155 active management of affairs and how vitally inter- ested they were in the election of directors. The abuse of proxy voting will likewise be indicated by this schedule. Schedule M is intended to develop facts relating to the payment of annual dividends and to enable the Insurance Department to observe how these have been running for a number of years in comparison with the premiums which have been charged. For this pur- pose the schedule is divided first into four parts, giv- ing the facts relating to the typical ages, 25, 35, 45 and 55. Each one of these four parts is so subdivided as to indicate the premiums and dividends which have been paid during the nineteen years which immedi- ately precede the statement year upon the various kinds of policies which have been issued. The sched- ule, therefore, contains a record of the annual divi- dends which have been paid in each of the past nine- teen years on the various forms of policies issued at these typical ages, and in this way it is very easy to make comparisons between the various plans, between the various forms and to ascertain whether any glar- ing injustice has been done. Schedule N relates to the payments which have been made during the year on deferred dividend policies and the premiums charged (Schedule M dealing with annual dividend policies only) and uses the same typical ages and the same forms of insurance as does Schedule M, but instead of referring the policies to the year of issue, uses dividend periods for the pur- pose of ascertaining the relative returns. The infor- mation for policies using a five-year distribution period, is required for each of the past five periods: 156 Examination of Insurance Companies a five-year distribution policy, therefore, issued at age 25 and which has been in force for twenty-five years, will show the amounts received upon it at the end of each of the five periods; the 10, 15, 20, 25 and 30-year distribution periods are not so subdivided, the blank contenting itself with one distribution only. Schedule shows the amounts which have been set apart, provisionally ascertained, calculated or held awaiting apportionment on policies with deferred divi- dend periods longer than one year, together with the annual premiums charged for the insurance. The same arrangement of ages and forms of insurance is used in this schedule as in Schedule N. Schedule N refers to the deferred dividends which were paid dur- ing the year; Schedule refers to the amounts which have been set apart for future payments. The infor- mation given by this schedule on five-year deferred dividend policies, for instance, enables a Department to ascertain how much was set aside on an ordinary life policy issued at age 25 in each of the years 1905 to 1909, inclusive; similar subdivisions are made for the other dividend periods. Schedule P is in reality a summary of Schedule 0, in that it shows the total amount set apart on all the deferred dividend policies, while Schedule 0, you will recall, refers only to the four typical ages. Schedule X deals with the unlisted assets of a com- pany which do not appear in any of its schedules showing the property owned at the time of the state- ment was made. It must be apparent to you that if a security, take for instance, a share of stock, is con- sidered valueless and is charged to profit and loss, it disappears from the financial books and records of the company. In subsequent years the value of that stock Examination of Insurance Companies 157 may be re-established and if no record be kept it could be sold and its proceeds diverted into improper chan- nels. By means of Schedule X, the property owned by the company but not included in its annual finan- cial statement, is set forth and by comparing Sched- ule X of one year's statement with the corresponding schedule of the previous year, it can at once be deter- mined whether any particular item has disappeared, and if so whether proper credit has been given the corporation for it. Schedule Y is divided into two parts, the first relat- ing to purchases which have been made during the year and which have not been shown in Schedules A, B, C and D and in the furniture, fixture and supply accounts. The second part relates to property sold during the year, except that shown in Schedules A, B, C and D. Primarily the object of inserting this sched- ule is to comply with section 103 of the Insurance Law. I can easily appreciate, however, that the first part might be used for the purpose of determining whether the company has invested any of its funds in securities unauthorized by the Insurance Law. CHAPTER XIX Additional Schedule for Fraternals — Schedules in Blank Used by Fidelity, Surety, Credit and Lia- bility Companies — Detailed Classification of Fidel- ity and Surety Risks. In my talk the other morning T took for my subject the schedules which appear in the annual statement blank which life insurance companies reporting to the Insurance Department of the State of New York, are required to file. The blank which fraternal organiza- tions are required to use, while not as elaborate as that required from legal reserve life insurance companies, contains one schedule which we do not find in the other blank — the schedule of membership, showing the number of members at the time the annual state- ment was made, the amount of insurance, the amount received in mortuary assessments during the year and the number and amount of death losses incurred dur- ing the year, all arranged according to the attained age of the membership. This schedule is of particular use only when the members of the fraternals have yearly renewable term insurance, for if used by an Order, the premiums of which are calculated upon a correct, scientific basis, there will be no relation between the assessments collected and the claims in- curred at the attained ages. To illustrate: a member who was 49 years of age when he entered a year ago, has now the same attained age as the member who was [1&8] Examination of Insurance Companies 159 40 when he went in ten years ago. In consequence their mortuary assessments are, or should be, entirely different, and without the data necessary to calculate the funds which should be on hand for the protection of the second member, the figures given are valueless and meaningless. An inspection of the forms required from companies transacting other forms of business, indicates that with the exception of fidelity, surety, credit and lia- bility companies, no special schedules requiring our attention are required. Eeferring then to the blank which miscellaneous stock companies are required to file, we find that it contains similar schedules to the ones in the life blank, referring to the five principal forms of assets only — real estate, mortgages, collat- eral loans, bonds and stocks; Schedule D, however, the one relating to the bonds owned by the company, is not quite as elaborate as in the case of life insurance companies, for we find none of the columns pertaining to amortization. The first schedule which requires our attention is Schedule H (the schedules in the blank are not ar- ranged alphabetically and I shall take them up in the order in which they appear in the printed form), con- taining a statement of the salvage received during the year on account of losses and claims paid prior to the close of the year covered by the statement. There is nothing of special importance to which I need direct your attention in this schedule; its headings are self- explanatory and my only object in referring to it is to point out that it is an indication of the growing desire upon the part of supervising officials to ascer- tain the exact nature of every item entering into the annual statement. 160 Examination of Insurance Companies Schedule G relates to fidelity, surety and credit losses and claims only; its object is to ascertain how much has been paid in each of the past ten years on claims which remained unpaid on December 31st of the various years. A specific case will make this clearer. If on December 31, 1900, there were claims on fifty fidelity policies unpaid, the blank calls for the payments which have been made on account of those fifty claims in 1901, 1902, 1903, etc., up to and includ- ing 1910, and if any of these fifty claims remained unpaid on December 31, 1910, the company is required to state what liability it is carrying on account of such claims in the 1910 annual statement. By its use, the supervising official is enabled to ascertain whether the amounts carried in the annual statement for the vari- ous years as representing the liability on unpaid claims is approximately correct, or whether the company has uniformly adopted a system of under-estimating its liabilities. The unpaid losses for each of the past ten years are arranged on the lefthand side of this sched- ule and the payments during the various years are arranged on horizontal lines so that the payments of each year are referred to each of the outstandings. In order to prevent confusion, I desire to call your attention to the fact that the years indicated on the lefthand side of this schedule are not years of issue, but refer to the outstanding losses on December 31st of the various years. A loss, therefore, which was outstanding on December 31, 1900, and not settled until some time in 1903, would appear in each of the 1900, 1901 and 1902 totals. Schedule is divided into two parts. Part 1 refers to the following forms of insurance: Examination of Insurance Companies 161 1. Accident. 2. Health. 3. Fidelity. 4. Surety. 5. Plate Glass. 6. Steam Boiler. 7. Burglary and Theft. 8. Credit. 9. Sprinkler. 10. Title. 11. Fly Wheel. 12. Auto Property Damage. 13. Workmen's Collective. 14. Live Stock. The information which it sets forth shows the man- ner of arriving at the items of *' net unpaid claims except liability claims " and '' special reserve for credit losses on policies expiring in October, November and December " contained in the liability portion of the statement. For the purposes of this schedule, losses are divided into two parts: first, those which were outstanding December 31st of the previous year and, second, those which were incurred during the year of the statement and which remained unpaid on December 31st of that year. The second column of this schedule shows the increase or decrease which was made in the estimated liability as it stood Decem- ber 31st of the previous year. This column, taken in conjunction with the payments which were made on account of such claims during the current year and the amount which is being carried as a liability for those still remaining unpaid, furnishes an excellent index of the estimating ability of the underwriters of the companies who have in charge the fixing of an 11 162 Examination of Insurance Companies adequate liability for unpaid losses; in fact, the object of Schedules G, (Parts 1 and 2), J, K and M, is the verification of this important item of liability by the old test of proving the value of the pudding by; eating it. You will note that liability claims have been omitted from Part 1 of Schedule 0, and Part 2 of that schedule is devoted to liability claims only. It separates the unpaid losses into three groups (and in order to make the subdivisions clearer, I shall use the figures con- tained in the statement upon which the companies will report their operations for 1910) ; first, those issued prior to 1900, second, those issued between 1901 and 1905, inclusive, and third, those issued between 1906 and 1910, inclusive. The issues of each year are kept separate and the final objects of the schedule may be stated as an attempt to find the ratio which exists between the earned premiums on the one hand and the loss payments, plus the statutory reserve, on the other. The fact that this schedule contains a column headed ' ' additional liability for unpaid losses and claims and expenses of settlement as computed by the company," is a tacit admission that the statutory method of com- puting the value of unpaid liability losses in New York State is insufficient. Schedule J refers only to fidelity and surety losses or claims which were unpaid on January 1st of the year covered by the statement; it does not take into account the year in which the loss occurred or the year in which the policy was issued. Using again the 1910 statement as a basis, a company would be required to include in Schedule J all of the losses which were out- standing on December 31, 1909. Claims are here Examination of Insurance Companies 163 arranged consecutively by claim number, so that they may be easily followed from statement to statement, and you will notice that the arrangement of the col- umns is such as to bring in close proximity, the pay- ments which were made during 1910 with the esti- mated value of the loss on December 31, 1909, or if no payment was made during 1910, then the amount of the estimated liability on December 31, 1910, is shown. If a company honestly tabulate all of its outstanding claims. Schedules J and K furnish an absolute index to the sufficiency or insufficiency of its loss reserve. Schedule K is similar to J, but refers to those fidelity and surety losses or claims of which the company received notice during 1910 and which remained unpaid at the close of business December 31, 1910. I need not devote much attention to this schedule, and I merely desire to call your attention to the fact that the losses which this year are scheduled in K will appear in J next year, whether they were settled during 1911 or not. Like J and K, Schedule M applies only to fidelity and surety risks. An attempt here has been made to classify the different forms of policies and bonds referring to the fidelity and surety business. You will recall that in a previous talk I attempted to distin- guish between a fidelity and a surety risk, and in order to supplement that distinction, I shall here read the detailed classification of risks required by the Insur- ance Departments from companies preparing their data for Schedule M. This classification was arrived at after conferences between underwriters and repre- sentatives from the Insurance Departments, and is brought to your attention as constituting the best 164 Examination of Insurance Companies available classification which we have been able to obtain without making the details too cumbersome for practical use. Class No. 1. Fidelity.— Executives, Agents, Clerks, etc., of Financial Institutions, Public Service Corporations, Mercantile, Manufacturing, Fraternal, Labor Organizations, et al. Class No. 2. Fiduciary. — Administrators, Executors, Guardians, Trustees, Assignees, Re- ceivers, Committees, Conservators, Curators. Class No. 3. Public Officials. — State, County, Mu- nicipal Officials, Accounting Officers, Judges, Court Clerks, Notaries, Po- licemen, et al. Class No. 4. U. S. Gov't Officials. — Includes every risk covering any official or employee running to the U. S. Government. Class No. 5. Customs — Internal Revenue. — In- cludes all bonds given to the Customs or Internal Revenue Department of the U. S. Government and other financial guarantee running to the Federal Government. Class No. 6. Contract — U. S. Government. — Con- struction, Furnishing of Supplies. Class No. 7. Contract — General. — Construction, Furnishing of Supplies, All Con- tractor Risks other than running to the Federal Government. Class No. 8. Judicial or Court. — Refunding, Appeal, Bail, Attachment, Costs, Replevin, etc. All bonds required in or termi- nated by a judicial proceeding. Class No. 9. Depository. Class No. 10. License — Franchise, Examination of Insueance Companies 165 Class No. 11. Excise. Class No. 12. Indemnity — Miscellaneous. — Includes all financial guarantees not reported in classes 7 to 11, inclusive, guar- anteeing payment of rents, lost se- curities, etc. Schedule M is, in reality, divided into four parts as follows : Experience of 1909 on business written in 1909. Experience of 1910 on business written in 1909. Experience of 1910 on business written in 1910. Experience of 1911 on business written in 1910. It is manifestly impossible to fill in tbe figures for the last of the four subdivisions, as the statement con- taining this schedule will have to be filed during Janu- ary or February of 1911; the object of giving this fourth part is to give timely warning to the company of the future requirements. Concerning this exhibit the blank states : '* It is proposed to extend this schedule to show each year's experience on the business written in 1909 and subsequent years until such business has been terminated, and all claims thereunder set- tled." The distinguishing feature of this schedule is that it disregards entirely the premiums which have been charged by the companies and attempts to make all of its comparisons with the gross penalty written in the bond or policy. It is an attempt to derive some method of computing the present value of future loss payments on the basis of the face of the bond or policy 166 Examination of Insueance Companies — ''face" here being used as synonymous with ** penalty." Some underwriters have declared that no such determination can be made, and statisticians con- nected with Insurance Departments and insurance companies will watch the figures developed in Schedule M with a great deal of interest. Schedule N, referring to the bank balances carried in each banking institution, and Schedule X, relating to the unlisted assets, are similar to the corresponding schedules in the life blank, and need no further explanation upon my part. Schedule P exhibits the details of the calculation made in accordance with Section 86 of the New York Insurance Law, and applies only to companies trans- acting a liability business. Section 86, you will recall, deals with the present value of future liability loss payments. It is now generally admitted by under- writers that this method laid down by the statute, yields too low a reserve, and well-managed companies do not rely solely upon its provisions when stating their liabilities, but carry an additional voluntary re- serve to cover the payments which they feel will have to be made in the future. In connection with this I desire to recall to your mind the paper dealing with the question of liability loss reserves (see Appen- dix L). CHAPTER XX Schedules and Their Application to Financial Portions of Statement — Method of Checking Details Shown in Schedules with Items in Other Portions of State- ment. In my previous talks I outlined briefly the forms which the schedules in the life and the miscellaneous blanks have taken, outlined in a general way the reason for asking for the information therein con- tained, and indicated that the schedules showed the increased interest which supervising officials were tak- ing in the operations of the companies reporting to them. I desire in a very brief manner to call your attention to certain uses to which the schedules may be put in the way of ascertaining the correctness of the income, the disbursement, the asset and the lia- bility portions of the financial part of the annual state- ment blank. An observance of these rules will enable companies to prepare their annual statement blanks in such a way as to render unnecessary a great part of the correspondence which now finds its way into the offices of the Insurance Commissioners of the various States. In order that we may have a definite basis upon which to go, I shall refer to the blanks used by the New York Insurance Department for the purpose of having companies report their condition as of Decem- ber 31, 1910. [167] 168 Examination of Insurance Companies LITE BLANK Schedule A — Part 1 The total of the ' ' book value ' ' column should agree with item 1 of assets, '' book value of real estate." The *' market value " column should be used as a basis for item 22 of assets, " market value of real estate over book value," or part of item 42 of assets, *' book value of ledger assets over market value." Should the market value of the real estate owned be in excess of the book value, the difference will be car- ried in item 22, while if there be a depreciation the loss will be carried under item 42. The total of the ^' increase, by adjustment, in book value during 1910 " column, when added to the total in a similar column in part 3 of this schedule, should be the same as item 42(a) of income, " gross increase, by adjustment, in book value of real estate. ' ' The total of the " decrease, by adjustment, in book value during 1910 " column, when added to the total in a similar column in part 3 of this schedule, should be the same as item 47(a) of disbursements, " gross decrease, by adjustment, in book value of real estate." You will find that this schedule contains an exhibit of the gross rental and expenditure for taxes, repairs and expenses of each parcel for each of the last three years. The total of the " gross rental during 1910 " column, when added to the total of the '^ gross rental during 1910 " column of part 3, should equal item 32 of income, '' gross rent from company's property." The total of the " expended for taxes, repairs and expenses during 1910 " column, when added to the total of the " expended for taxes, repairs and expenses Examination of Insurance Companies 169 during 1910 " column of part 3, should equal items 30 and 31 of disbursements, which are '' repairs and expenses (other than taxes on real estate)" and '* taxes on real estate " respectively. Schedule A — Part 3 The total of the ^' profit on sale " column should agree with item 41(a) of income, " gross profit on sale of real estate." The total of the ' ' loss on sale ' ' column should agree with item 46(a) of disbursements, " gross loss on sale of real estate." Schedule B The total of the *' amount unpaid December 31st, 1910 " column should agree with item 2 of assets, '* mortgage loans on real estate." In the " interest " subdivision the total of the '' amount past due December 31, 1910 " column should agree with the first part of item 13 of assets, ^' interest due on mortgages." In the same subdivision the total of the " amount past due December 31, 1910 " column should agree with the second part of item 13 of assets, '' interest accrued on mortgages." In the same subdivision the total of '* gross amount received during 1910 " column should agree with item 23 of income, " gross interest on mortgage loans," although there is no way of verifying the deduction which companies are asked to make in this item for the accrued interest on mortgages acquired during 1910. 170 Examination of Insurance Companies Your attention is directed to the fact that the present form of Schedule B contains a record of not only the mortgages in the company's possession at the time that the statement was made, but also all acquisitions and sales during the statement year. Schedule C — Part 1 The total of " amount loaned thereon " column should agree with item 3 of assets, ' ' loans secured by pledge of bonds, stocks and other collateral. ' ' In the interest subdivision the total of '' amount past due December 31, 1910 " column should agree with the first part of item 15 of assets, '^ interest due on collateral loans." In the same subdivision the total of '' amount accrued December 31, 1910 " column should agree with the second part of item 15 of assets, *' interest accrued on collateral loans." In the same subdivision the total of '' amount re- ceived during 1910 " column should agree with item 24 of income, *' gross interest on collateral loans," when increased by the total of the amount of ' ' amount received during 1910 " of the interest subdivision in part 3 of this schedule. Schedule D — Part 1 The total of the '^ book value " column should agree with the first part of item 6 of assets, " book value of bonds." The total of " market value " column when added to the total of the similar column in part 2 of the schedule should form the basis for either the addition under item 23 of assets, '* market value of bonds and stocks over book value," or part of item Examination of Insueance Companies 171 42 of assets, '' book value of ledger assets over market value." In the interest subdivision total of '' amount due and accrued December 31, 1910 " column, should agree with item 14 of assets, ^' interest due and accrued on bonds." Your attention is directed to the fact that in this schedule the past due interest is not separated from the accrued interest. In the same subdivision the total of " gross amount received during 1910 ' ' column when added to the total of " amount received during 1910 " column in the dividend subsection of part 2, and the total of ''in- terest or dividends received during 1910 " column of part 4 should equal item 25 of income, " gross interest on bonds and dividends on stocks. ' ' The indented figure in item 25 of income, " accrued interest on bonds acquired during 1910 ' ' should agree with the total of " paid for accrued interest on bonds acquired during 1910 " column in part 3. The total of " increase, by adjustment, in book value during 1910 " column should agree with item 42(b) of income, " gross increase, by adjustment, in book value of bonds," when increased by that portion of the similar column in part 4 of this schedule applying to bonds. The total of " decrease, by adjustment, in book value during 1910 " column should agree with item 47(b) of disbursements, " gross decrease by adjust- ment in book value of bonds," when increased by that portion of the similar column in part 4 of this schedule applying to bonds. The total of " increase in amortized value during 1910 " column should agree with the indented figures 172 Examination of Insurance Companies in item 42(b) of income, "including $ for accrual of discount." The total of the '* decrease in amortized value dur- ing 1910 " column should agree with the indented figure in item 47(b) of disbursements, " including $ for amortization of premiums. ' ' Schedule D — Part 2 The total of ' * increase by adjustment in book value during 1910 " column should agree with item 42(c) of income, " gross increase, by adjustment, in book value of stocks " when added to the portion of the similar column in part 4 applying to stocks. The total of " decrease by adjustment in book value during 1910 " column should agree with item 47(c) of disbursements, '' gross decrease by adjustment in book value of stocks " when added to the portion of the similar column in part 4 applying to stocks. Schedule D — Part 4 The total of " profit on sale " column should agree with items 41(b) and 41(c) of income, " gross profit on sale or maturity of bonds " and '* gross profit on sale of stocks." The total of " loss on sale " column should agree with items 46(b) and 46(c) of disbursements, " gross loss on sale or maturity of bonds " and *' gross loss on sale of stocks." Schedule E The total of " balance December 31, 1910 " column should agree with items 8 and 9 of assets, '' deposits in trust companies and banks, not on interest " and ** deposits in trust companies and banks, on interest." Examination of Insurance Companies 173 The total of '' amount of interest received during 1910 " column should agree with item 27 of income, *' gross interest on deposits in trust companies and banks. ' ' Schedule F The total of " amount resisted December 31st, 1910 ' ' column should agree with item 15 of liabilities, ** claims for death losses and other policy claims resisted by the company." Schedule J The total of '' amount paid " column should agree with the indented figure in item 15 of disbursements, together with item 28 of disbursements, being the ** legal expenses in connection with the investigation and settlement of policy claims ' ' and * ' legal expenses not included in item 15, ' ' respectively. Schedule P The total of '* total '' column should agree with items 33 and 34 of liabilities, '' dividends declared on or apportioned to deferred dividend policies payable to policyholders during 1911 " and " amounts set apart, apportioned, provisionally ascertained, calcu- lated, declared or held awaiting apportionment upon deferred dividend policies not included in item 33." Schedule X The total of '* gross income during 1910 " column should equal item 34 of income, '' from other sources (give items and amounts)." 174 Examination of Insurance Companies The total of '' outlays made during 1910 " column should agree with item 38 of disbursements, " other disbursements (give items and amounts)." MISCELLANEOUS BLANK The annual statement which the miscellaneous com- panies are required to file requires no special treat- ment in so far as schedules A, B, C and D are con- cerned. The facts connected with the special sched- ules, however, are as follows : Schedule H The total of " value of property received as sal- vage " column should agree with item 16 (3) of dis- bursements, being the amount of the salvage deducted from the payments to policyholders for losses. Schedules J and K The totals of the *' estimated liability December 31st, 1910, per annual statement " columns of these two schedules when added together should equal item 4 (4) and item 5 (4) of liabilities, being the sum of the adjusted, in process of adjustment and resisted fidelity and surety losses. CHAPTER XXI Excise Bonds — Special Feature in New York State — Excise Reinsurance Agreement — Its Method of Operation — Guaranty of Bills of Lading — Other Forms of Guaranteed Certificates. In one of my previous talks I stated to you that the only forms of insurance which required the insertion of special items of liability in their annual statements were credit insurance and liability insurance. I pur- posely omitted any reference to the excise bonds which are issued by some surety companies and for which you will find in the blank used by the New York Insur- ance Department a special item in the liabilities refer- ring, however, not to all of the excise risks, but only to those that are written on liquor dealers in New York State. I desired to refer to this matter in a separate talk and the reason for the special treatment of the New York State excise risks can be seen from the following: You will recall that excise bonds are issued in order that the liquor dealer may be enabled to obtain his license from the State, and the companies guarantee that in the event of any conviction for viola- tion of the excise laws upon the part of the dealer, the penalty of the bond or such part of it as may be demanded, will be paid. Formerly these bonds in New York State were issued in May of each year; in later years and at the present time all of the bonds are issued on October 1st of each year and run to [175] 176 Examination of Insurance Companies September 30th of the next year. You will, therefore, see that on December 31st of any year these bonds have been in force only three months, and, therefore, the New York Insurance Department requires the com- panies to maintain not 50 per cent, of the gross pre- miums as an unearned premium account, but insists upon 75 per cent, being set aside as a liability. This treatment is in accordance with the actual conditions and is, therefore, not a special item such as were the liabilities applicable to credit insurance and liability insurance, but is simply the logical treatment of the item, and follows the general rule indicated in my treatment of the unearned premium account. Bear in mind, however, that this applies only to excise bonds issued for liquor dealers in New York State; in other localities the bonds are issued at vari- ous times throughout the year, and in consequence the usual 50 per cent, rule will be applicable in those cases. Attached to the excise business in New York State are one or two special features to which I would like to direct your attention at this time; the business there is done by means of an association, to which at the present time, I think, ten surety companies are sub- scribers. In other words, these ten companies have formed a pool and between them handle all of the New York excise business, both State and city. Repre- sentatives of these companies have met and have ap- portioned the business among themselves according to certain agreed ratios. Companj'' A, for instance, has agreed to assume 10 per cent, of the excise risks, will receive 10 per cent, of all of the premiums which will be collected (after deducting the expenses) and Examination of Insueance Companies 177. will pay 10 per cent, of all of the excise losses which are sustained in the State of New York. Company B, being smaller desires only to be a participant to the extent of 5 per cent., will receive 5 per cent, of the premiums and be responsible for 5 per cent, of the losses. The bonds are issued in the names of the indi- vidual companies, i. e., in the interior towns, for instance, the agent of Company A will issue bonds binding his company, but if a loss should result under that bond. Company A would not be required to pay the entire loss, but would be responsible for only its proportion as determined by the excise association, and the balance would be met by the other subscribers according to their respective proportions. While a company is liable for that percentage of the total losses which it has agreed to underwrite, you will find that it does not at once receive that percent- age of the premium receipts. All of the premiums which are collected go to the executive committee of the association, are deposited in some bank, and the committee, before distributing them between the vari- ous subscribers, sets aside a reserve fund in order to take care of the losses which may be claimed by the State at any time within three years after the bond has been issued, although the year for which the bond ran expired some time before. In other words, if a bond were issued on October 1, 1910, it would cover the liquor dealer for the year expiring September 30, 1911, but the State could at any time within two years after September 30, 1911, sue upon this bond to recover a penalty for any violation which occurred prior to that date. While this is the broad, general purpose of the reserve fund, it is aimed to pay all of the losses 12 178 Examination of Insurance Companies out of the other funds. Let us suppose, for instance, that Company A is compelled to pay a loss of $1,000 and that its share of participation in the excise asso- ciation is 10 per cent. When the loss is to be paid. Company A sends its cheque for $1,000 to the proper State officer and receives at the same time a cheque from the executive committee for $900, the share of the other subscribers. This payment is made by the executive committee, not from the reserve fund just referred to, but from a fund intended to provide for current losses, and which it aims to always keep at a certain figure. These funds are deposited in the bank not in the names of the individual companies, but in the name of the association, and in consequence some question has arisen as to the right of the company to include its share of the current loss fund and the reserve fund among its deposits in preparing the annual statement for filing with the various Departments. The usual tests which we apply to determine the admissibility of a bank deposit are, first, is the deposit to the credit of the corporation, and second, is it subject to with- drawal by its cheque. The result of applying both of these tests would seem to indicate that these deposits could not be included among the bank deposits, but should be scheduled as a separate and distinct asset. This is a technical matter which is usually passed upon by each Department according to its own judg- ment, and mention of it is made here merely to account for the presence in the annual statement blank of what may at first glance appear to be an unusual entr^\ There is another form of guaranty which may come into prominence in the course of the next year, and Examination of Insurance Companies 179 that is the guaranty of bills of lading for cotton ship- ments from the South. The owners ship their cotton and the foreign banks have been in the habit of ad- vancing money on the bills of lading which shippers presented. Owing to the fact that bills in the past have been forged, the foreign bankers have become less willing to accept these bills and have insisted upon some sort of a guaranty. Quite recently it was decided to form a corporation for the purpose of guar- anteeing the bills of lading for the foreign bankers. A company of this kind would in all probability be required to conform to the insurance laws relating to surety companies, for there seems to me to be no dis- tinction between this form of guaranty and forms of warehouse receipts, which are not unusual at the pres- ent time. I think it not unlikely that the business which I have just described may eventually be taken up by the surety companies now established and simply run as a branch of their business. When the time comes, it will be necessary to formulate laws for the proper regulation of the business, as it will present certain features which are not found at the present time in the usual transactions of the companies. I also wish to call your attention to the fact that you may be brought in contact with a form of ' ' guar- anteed " certificates which are not issued by surety companies and which have no relation to them. Some life insurance companies in the past have been formed, and in lieu of capital stock, have received contribu- tions from the organizers for the purpose of meeting the initial expense of organization; in exchange for these contributions, certificates have been issued pro- viding for the payment of interest at a certain rate, 180 Examination of Insurance Companies and the payment of the principal at some time in the future. These payments are to be made out of the expense fund or loading of the jDremiums, and the question has arisen in a number of the States as to the necessity for charging these certificates as liabili- ties in the annual statements of the companies in the same way that we charge capital stock at the present time. They provide, you will notice, not for a par- ticipation in the assets or from any source of interest income, but are payable out of the expense funds only. For this reason, the legal officers of the States to which the question has been referred, have in a number of cases decided that these outstanding guaranteed cer- tificates are not liabilities. CHAPTER XXII Limitation of Risk — Logic of Statutes — Limitation as Applied to Liability Policies — To Credit Policies — Policies in Hands of Agents — Method of Verify- ing Unearned Premium Item. Some of the topics which I wish to take up with you this morning are either collateral to some of the mat- ters about which I have already spoken to you, or have been briefly referred to in my previous talks. We find, for instance, that one of the points to which we should direct our attention in examining a com- pany or auditing its books, is to ascertain whether it has kept within the limits which are prescribed for it by the law in relation to the amount which it is per- mitted to carry on any one risk. It must be clear to you that the basic idea of insur- ance is the distribution of the losses which the few sustain in such a way that the shock will be felt over as large an area as possible and, therefore, with diminished effect upon each participant. Bearing this in mind, it must be equally clear to you that if an insurance company is to retain its solvency, it must so distribute its risks as to permit the law of averages to operate; otherwise its transactions will be in the nature of a gamble or a matter of chance. Take the case of a fire insurance company that confined its operations to the risks in one building only; you can readily see that a fire in that building might destroy [181] 182 Examination of Insurance Companies the company. As long as no fire occurred, all of the earned premiums not needed for expense purposes would be profit, but such a condition would be very unsafe. The proper distribution of a company 's risks, therefore, is an important matter and one upon which its continued solvency will depend. For this reason we find on the statute books of a number of the States, laws limiting the amounts which a company may write on a single risk. In the Com- monwealth of Massachusetts, for instance, we find that a portion of section 20 of the Insurance Law is as follows : '' No insurance company authorized to transact business in this commonwealth shall insure in a single risk, wherever such risk is located, a larger amount than one tenth of its net assets, unless it has provided for reinsurance of the excess over said limit, to take effect simultaneously with the original contract; and if any foreign insurance company violates this provision, the insurance commissioner may revoke its authority to trans- act business in this commonwealth; but a mutual boiler insurance company of this commonwealth may insure in a single risk an amount not exceed- ing one fourth of its net assets." The wording of this section is so clear as to prac- tically require no further explanation upon my part. I desire, however, to call your attention to the fact that you must use considerable care in applying the limitations of this section. No question will arise in its application to a life or a fire or a personal accident company, for there the question of the risk which is covered is quite clear, Examination of Insueance Companies 183 although in the case of a fire insurance company care- ful underwriters impose an additional restriction upon their operations by limiting the amount which they will carry in any one block. You will find that fire insur- ance companies keep a very accurate record of the way in which their risks are distributed, and do every- thing possible to prevent the " conflagration hazard." When you come to apply the law to liability and credit companies, the application becomes more in- volved and presents some unusual features. You will recall that when I talked about liability policies, I pointed out that a policy is sometimes designated as a $5,000-$50,000 policy. By this is meant that the company is liable only to the extent of $5,000 on any one life, but is liable to the extent of $50,000 as a result of any one accident. If the next day another accident occurred so that the same insured would have to pay damages, the liability company would again be in a position where it would have to furnish protection within these limits. It would seem, therefore, that the wording of the statute " shall insure in a single risk " would mean in this case that $50,000 is the measure of the amount involved in a single risk. In the case of credit companies you will recall that a similar designation is used, but the meaning is different. For instance, a $5,000-$50,000 policy would mean that after the insured's initial loss had been exceeded, a credit company would be responsible or liable to the extent of $5,000 for any one insolvent customer, and its total limit would be $50,000. Once that limit has been reached, the credit company could never be called upon to pay more than $50,000. Here it must be manifest to you that the limit on any single 184 Examination of Insurance Companies risk is not $50,000, but $5,000, because there is no reason to assume that any event which causes the insolvency of one customer is going to cause the insol- vency of another customer. There is another matter to which I have referred, and that is the method of checking the outstanding policies. In the case of fire, accident and some other forms of insurance, the policies are not issued at the home office of the company, but forms are placed in the hands of the agents and the policies are issued directly by them, notification being sent to the home office of the company either in the form of daily reports, lists of policies or some other similar way. In the case of personal accident companies we find a great many forms of policies issued, and in conse- quence the agents have in their hands a number of sets of policies. It is necessary, therefore, to check up the policy forms in their hands to ascertain whether all of the policies which have been issued have been reported to the home office; this is important in that we are interested, first, to ascertain whether the com- pany is carrying the proper amount of unearned pre- mium as a liability on its outstanding risks, and second, whether the company is receiving the pre- miums represented by all of the policies which have been issued by the agents. An agent, you will see, has the opportunity, should he be so inclined, to issue a policy, fail to report it at the home office, and put the premium in his pocket. Such a condition would never be revealed unless a loss were reported on such policy or unless the policy forms remaining with the agent are checked with the record at the home office. We should find that for every policy which has been placed in his hands, the agent has either reported its Examination of Insukance Companies 185 issuance, has returned the policy as spoiled, or still has the form in his possession. It is important both from the standpoint of the auditor and the examiner that this phase of the company's transactions should be closely guarded. I also wish to refer briefly to the proper method of determining the unearned premium account of a fire insurance company or any company which lists its premiums by expirations. A recent case of falsifica- tion of its annual statement by a fire insurance com- pany has received some attention, and I think the best way to make this clear to you is to take this specific case and show the steps which led to the determination of the falsification. The company in question reported that the gross premiums which it had written during the year 1909, less reinsurance and return premiums, amounted to $1,505,073. The recapitulation of its fire risks and premiums which purported to analyze its unearned premium account, was shown in its sworn statement as follows: Gross premiums charged, Year less Fraction Premiums written Term reinsiu-ance unearned ' unearned 1909 One year or less $602,075.10 1-2 $301,037.55 1908 It, f 5,465.16 1-4 1,366.29 1909 /^^°y^^" \ 9,295.62 3-4 6,971.72 1907] f 200,469.20 1-6 33,411,53 1908 I Three years -j 193,865.46 1-2 96,932.73 1909 J I 286,720.87 5-6 238,934.06 1906] ( 2,716.98 1-8 339.62 1907 ! ^„,„ „„„^ ] 5 , 007 , 71 3-8 1 , 877 . 89 1908 f *°"^y®*" I 2,375.21 5-8 1,484.51 1909 1 [ 3,251.58 7-8 2,845.13 1905 1 f 93,644.35 1-10 9,364.43 1906 I 106,412.56 3-10 31,923.76 1907 I Five years ■! 100,404.40 1-2 50,202.20 1908 I 95,878.74 7-10 67,115.11 1909 J [ 127,044.24 9-10 114,339.81 $1,834,627.18 $958,146.34 186 Examination of Insurance Companies From the above table you will see that the premiums outstanding on December 31, 1909, on business written during 1909, was as follows: One year or less $602,075.10 Two years 9,295.62 Three years 286,720.87 Four years 3,251 . 58 Five years 127,044. 24 $1,028,387.41 It would appear, therefore, that if this recapitula- tion were correct, the difference between the net writ- ings as shown in the income portion of the statement, $1,505,073, and the 1909 issues in force on December 31st, $1,028,387.41, or $476,685.59, represented the -pre- miums upon business which had been issued during 1909, but which had expired before the end of that year. That a company should have issued one-third of its total writings on a short term basis of this kind is so absurd as to at once indicate that something is wrong. This condition once having been ascertained, there is only one safe way to compute the unearned premium account, and that is to disregard the books of the company entirely and work from the daily re- ports, which should show the policies still in force, the premiums received, the reinsurance which has been effected and all other data necessary for the computa- tion. I might add a word of caution, however, to this effect — do not fail to make an occasional check on the daily reports, in order to make sure that none has been taken from the files. This can, of course, be done by noticing if any serial numbers in any agency are miss- ing, and if so, what explanation of this condition can be offered. APPENDICES [187] APPENDIX A The restrictions placed on the ownership of real estate by the New York Insurance Law are as follows : * ' § 20. Every insurance corporation transacting business in this state may purchase, hold and con- vey real property only for the following purposes and in the following manner : *' 1. The building in which it has its principal office and the land upon which it stands. ' ' 2. Such as shall be requisite for its convenient accommodation in the transaction of its business. " 3. Such as shall have been acquired for the accommodation of its business. '* 4. Such as shall have been mortgaged to it in good faith by way of security for loans previously contracted or for moneys due. ** 5. Such as shall have been conveyed to it in satisfaction of debts previously contracted in the course of its dealings. * ' 6. Such as shall have been purchased at sales upon judgments, decrees or mortgages obtained or made for such debts. '* 7. Such as shall have been acquired under sections thirteen and fourteen of the general cor- poration law. ' ' [189J 190 Examination of Insueance Companies APPENDIX B The requirements relative to the disposition of real estate in New York are illustrated by the following quotation from section 20 of the Insurance Law: ''All such real property specified in subdivi- sions three, four, five, six and seven of this sec- tion, as shall not be necessary for its accommoda- tion in the convenient transaction of its business, shall be sold and disposed of within five years after it shall have acquired title to the same, or within five years after the same shall have ceased to be necessary for the accommodation of its busi- ness, and it shall not hold such property for a longer period unless it shall procure a certificate from the superintendent of insurance that its in- terests will suffer materially by the forced sale thereof, in which event the time for the same may be extended to such time as the superintendent shall direct in such certificate. If it is a domestic marine insurance corporation, it may also acquire and hold such real property within the state or upon or in its waters as is or may be adapted to or available for use in protecting, storing and caring for wrecked vessels or cargoes, or in pro- tecting, storing and caring for such vessels and appliances as are or may be employed for assist- ing the same, or is or may be adapted to or avail- able for other purposes of or incident to marine salvage service, and may manage and dispose of such real property in the same manner and with like effect as if it were an unincorporated owner thereof. No real property shall be acquired by any domestic life insurance corporation under subdivisions one or two hereof or under section fourteen of the general corporation law and no Examination of Insurance Companies 191 real property within the state shall be acquired by any foreign life insurance corporation under subdivision two hereof, except with the approval of the superintendent of insurance. No real prop- erty shall be disposed of by any domestic life in- surance corporation and no real property within the state shall be disposed of by any foreign life insurance corporation, by exchange for other real property, wherever situated, as the consideration for the transfer in whole or part, unless the acqui- sition of the latter shall be requisite for the con- venient accommodation of the corporation in the transaction of its business and shall be approved by the superintendent." 192 Examination of Insurance Companies APPENDIX C Office of S. H. Wolfe, Consulting Actuary, 165 Broadway, New York. New York, , M Dear : The Insurance Department., of the State., of is (are) now conducting an ex- amination of the Company of , and find among its assets a mortgage executed by upon property owned by you and located According to the books of the company on 19.., the unpaid principal of the mortgage was $ Will you please inform me if this amount is correct? Answer yes or no If not correct what is the right amount ? $ The examination now being made is required under the laws of the State and this notice does not affect your loan in any way. It does not mean that the com- pany desires you to pay it or that any objection has been made to it. This information is asked for only to enable the examiner to verify the entries in the com- pany's books and by signing this notice below and re- turning it in the enclosed stamped envelope you will aid the work. Very respectfully. > Examiner. Owner please sign here Examination of Insurance Companies 193 APPENDIX D '' § 36. No director or officer of an insurance corpo- ration doing business in this state shall receive any money or valuable thing for negotiating, procuring, recommending or aiding in, any purchase by or sale to such corporation of any property, or any loan from such corporation, nor be pecuniarily interested, either as principal, co-principal, agent or beneficiary, in any such purchase, sale or loan; provided that nothing herein contained shall prevent a life insurance corpo- ration from making a loan upon a policy held therein by the borrower not in excess of the net value thereof. Any person violating any provision of this section shall be guilty of a misdemeanor." 13 194 Examination of Insurance Companies APPENDIX E " § 100. No domestic life insurance corporation, whether incorporated by special act or under a general law, shall invest in a loan or upon any shares of stock of any corporation, other than a municipal corpora- tion, nor, excepting government, state or municipal securities, shall it invest in, or loan upon, any bonds or obligations which shall not be secured by adequate collateral security or where more than one-third of the total value of the collateral security therefor shall con- sist of shares of stock. Every such corporation which on the first day of June, nineteen hundred and six, owned any shares of stock other than public stock of municipal corporations, whenever the same were ac- quired, or any bonds or obligations of the kinds above described where said bonds or obligations were ac- quired after the first day of March, nineteen hundred and six, shall dispose of said shares of stock and of said bonds and obligations within five years from the thirty-first day of December, nineteen hundred and six, and in each year prior to the expiration of said five years shall make such reduction of its holdings of said securities as may be approved in writing by the superintendent of insurance. No investment or loan shall be made by any such life insurance corporation unless the same shall first have been authorized by the board of directors or by a committee thereof charged with the duty of supervising such investment or loan. No such corporation shall subscribe to or participate in any underwriting of the purchase or sale of securi- Examination of Insurance Companies 195 ties or property, or enter into any transaction for such purchase or sale on account of said corporation jointly with any other person, firm or corporation ; nor shall any such corporation enter into any agreement to withhold from sale any of its property, but the dispo- sition of its property shall be at all times within the control of its board of directors. Any such corpora- tion, in addition to other investments allowed by law, may invest any of its funds in any duly authorized bonds or evidences of debt of any city, county, town, village, school district, municipality or other civil di- vision of any state and may loan upon the security of improved unincumbered real property in any state worth fifty per centum more than the amount loaned thereon. Provided, however, that nothing in this sec- tion contained shall be construed as prohibiting a life insurance company from entering into an agreement for the purpose of protecting the interests of the com- pany in securities lawfully held by it, or for the purpose of reorganization of a corporation which issued securi- ties so held, and from depositing such securities with a committee or depositaries appointed under such agree- ment ; but such agreement and the deposit of securities thereunder must first be approved in writing by the superintendent of insurance with a statement of his reasons for such approval. Nor shall this section be construed as preventing such company from accepting corporate stock or bonds or other securities, which may be distributed pursuant to any such agreement approved as aforesaid or to any plan of reorganiza- tion approved in writing by the superintendent of insurance with a statement of his reasons for such 196 EXAMHSTATION OF INSURANCE COMPANIES approval. But if any securities so received shall con- sist in whole or in part of stock in any corporation or of bonds or obligations which shall not be secured by adequate collateral security or where more than one- third of the total value of the collateral security there- for shall consist of shares of stock, then any stock and any such bond or obligation so received shall be dis- posed of within five years from the time of their acqui- sition or before the expiration of such further period or periods of time as may be fixed in writing for that purpose by the superintendent of insurance. Examination of Insurance Companies 197 APPENDIX F '* § 16. The cash capital of every domestic insurance corporation required to have a capital, to the extent of the minimum capital required by law, shall be invested and kept invested in the kinds of securities in which deposits with the superintendent of insurance are re- quired by this chapter to be made. The residue of the capital and the surplus money and funds of every domestic insurance corporation over and above its cap- ital, and the deposit that it may be required to make with the superintendent, may be invested in or loaned on the pledge of any of the securities in which deposits are required to be invested or in the public stocks or bonds of any one of the United States, or except as in this chapter otherwise provided, in the stocks, bonds or other evidence of indebtedness of any solvent insti- tution incorporated under the laws of the United 'States or of any state thereof, or in such real estate as it is authorized by this chapter to hold ; but no such funds shall be invested in or loaned on its own stock or the stock of any other insurance corporation carry- ing on the same kind of insurance business, except that any such company engaged solely in business as a surety company under subdivision four of section seventy of this chapter may invest such funds in, or loan such funds on, the stock of any other corporation carrying on solely the same kind of business outside of, but not within, the United States. Any domestic insurance corporation may, by the direction and con- sent of two-thirds of its board of directors, managers or finance committee, invest, by loan or otherwise, any 198 Examination of Insurance Companies such surplus moneys or funds in the bonds issued by any city, county, town, village or school district of this state, pursuant to any law of this state. Any corpora- tion organized under subdivision one-a, section one hundred and seventy of this chapter, for guaranteeing the validity and legality of bonds or other evidences of indebtedness issued by any state, or by any city, county, town, village, school district, municipality, or other civil division of any state, may invest by loan or otherwise any of such surplus moneys or funds, as provided in section one hundred of this chapter. Every such domestic corporation doing business in other states of the United States or in foreign coun- tries may invest the funds required to meet its obliga- tion incurred in such other states or foreign countries, and in conformity to the laws thereof, in the same kind of securities in such other states or foreign countries that such corporation is by law allowed to invest in this state. Any life insurance company may lend a sum not exceeding the lawful reserve which it holds upon any policy, on the pledge to it of such policy and its accumulations as collateral security. But nothing in this section shall be held to authorize one insurance corporation to obtain, by purchase or otherwise, the control of any other insurance corporation." Examination of Insueance Companies 199 APPENDIX G Office of S. H. Wolfe, Consulting Actuary, New York, N. Y. Examination of for the Insurance Department of New York, N. Y., ,19.. Gentlemen : Among the assets of the on 19 . . is a deposit in your institution. For the sole purpose of verifying its books will you please fill out the attached certificate and return it in the en- closed stamped envelope. Very respectfully yours, (Perforated.) (Location) (Date) This is to certify that at the close of business 19 . . , the books of the showed a balance of $ due the and subject to its cheque and withdrawal; there were also cer- tificates of deposits outstanding for $ due 200 Examination of Insurance Companies On the same date, the was not indebted to this institution for borrowed money, discounted notes or under any other form of agree- ment, or are any of the aforementioned deposits held by this institution as security for any loan made to an officer, director or employee of said By Cashier, President or Treasurer. [Printed in Copying Ink.] Examination of Insurance Companies 201 XI Q < ►a oZ 3^ HO Mean reserve maintained Hi Other credits claimed Net deferred premium Net uncollected premiima a i3 Amount of policy loan ii 202 Examination of Insurance Companies APPENDIX I ** § 18. If any domestic insurance corporation shall have invested any of its funds in or loaned any of its funds upon the stock, bonds or other evidences of debt of other corporations or of any nation, State, county, city, town, village, school district, municipality or other civil division of any state, pursuant to the laws of this state, and the superintendent shall have reason to believe that such stock, bonds or other evidences of debt are not amply secured or are not yielding an in- come, he may direct it to report to him under oath the amount thereof, the security therefor and its mar- ket value. No stock and no bonds or other evidence of debt if in default as to principal or interest, or if not amply secured, shall be valued as an asset of the cor- poration above its market value. All bonds or other evidences of debt shall, if amply secured and if not in default as to principal or interest, be valued as follows : if purchased at par, at the par value; if purchased above or below par, on the basis of the purchase price adjusted so as to bring the value to par at maturity and so as to yield meantime the effective rate of inter- est at which the purchase was made ; provided that the purchase price shall in no case be taken at a higher figure than the actual market value at the time of pur- chase, and provided further that the superintendent of insurance shall have full discretion in determining the method of calculating values according to the fore- going rule, and the values found by him in accordance with such method shall be final and binding; provided, also, that any such corporation may return such bonds or other evidences of debt at their market value or their book value, but in no event at an aggregate value exceeding the aggregate of the values calculated ac- cording to the foregoing rule." Examination of Insurance Companies 203 APPENDIX J * ' ' There shall also be charged as a liability to each company which undertakes or writes insurance under subdivision three of section seventy of this act, whether organized under this or any other state or country, a further reserve as hereinafter provided. For the pur- pose of computing said reserve, each such company which has been engaged in liability underwriting for ten years or more, shall, on or before the first day of October in each year, state in writing to the superin- tendent of insurance its experience in the United States, under all forms of liability policies, each year separately according to the calendar years in which the policies were written, during a period of five years commencing ten years previous to the thirty-first day of December of the year in which the statement is made, in the following particulars, namely: the num- ber of persons reported injured under all the forms of liability policies, whether such injuries were reported to the home office of the given company or to any of its representatives; the amount of all payments made on account or in consequence of injuries reported under such policies; the number and amount, separately, of all suits or actions against policyholders under such policies which have been settled, either by payment or compromise; both of the above amounts to be ascer- tained as of date of the thirty-first day of August of the year in which the statement is made, and to include in the case of suits all payments made on account or in consequence of the injury from which the suit arose, * Part of §86. 204 Examination of Insurance Companies whether prior to or later than the date at which the suit was brought. Each such company shall thereupon reserve upon all said kind of policies, irrespective of the date at which the policies were issued (1) for each suit or action pending, on injuries reported prior to eighteen months previous to the date of making the statement, whether such injuries were reported to the home office of the given company or to any of its rep- resentatives, and which is being defended for or on account of the holder of any such policy, and the aver- age cost thereof as shown by said experience, and (2) for injuries reported under such policies at any time within eighteen months, whether such injuries were reported to the home office of the given company or to any of its representatives, the average cost for each injured person as shown by said experience. From the sum so ascertained the company may deduct the amount of all payments made on account or in conse- quence of said injuries reported within eighteen months, this amount to be taken as of the date at which the statement is made. Any company which now issues or shall hereafter issue, liability policies as aforesaid, and which has not been engaged in liability underwriting for ten years, shall nevertheless, until such times as it may be able to state its experience of the period hereinbefore required, make and maintain a reserve upon all said kind of policies, irrespective of the date at which the policies were issued, determined as follows: (1) for each suit or action pending, on in- juries reported prior to eighteen months previous to the date of making the statement, whether such in- juries were reported to the home office of the given Examination of Insurance Companies 205 company or to any of its representatives, and which is being defended for or on account of the holder of any such policy, the average cost thereof as shown by the average of said experience of all other companies stated as required by this section, and (2) for injuries reported under such policies at any time within eighteen months, whether such injuries were reported to the home office of the given company or to any of its representatives, the average cost for each injured per- son as shown by the average of said experience of all other companies stated as required by this section: which average costs for suits and for injured persons shall be furnished by the superintendent of insurance to each such company on or before the first day of December, in each year. From the sum so ascertained each such company may deduct the amount of all pay- ments made on account or in consequence of said in- juries reported within eighteen months, this amount to be taken as of the date at which the statement is made. ' ' 206 Examination op Insurance Companies APPENDIX K (436) § 512. Sec. 3. ** The commissioner of insurance shall compute the reserve fund to be held by such companies or asso- ciations by taking fifty percentum of the premiums received upon all risks not expired at the time of mak- ing such computation. And in addition thereto in the case of corporations doing an employers' liability in- surance, the commissioner of insurance shall compute the liabilities for unsettled claims in said employers' liability insurance business at not less than fifty per cent of the premiums received and earned during each and every year less the amount paid for losses and ex- penses incidental thereto, upon claims brought under policies issued during said year: Provided, That such reserve shall not be compute*d for more than the five years previous to the time of making such computa- tion: Provided further, That to the amount of the reserve so ascertained, there shall be added such amount as is necessary to provide for claims of earlier date, not liquidated." Examination of Insurance Companies 207 APPENDIX L Reserve for Unpaid Liability Losses By S. H. Wolfe. The managers of properly conducted insurance com- panies are anxious to ascertain the present value of their future liabilities, for in no other way can they determine the soundness of their underwriting methods. The method now in vogue of computing the present value of future losses under liability policies, as prescribed by the laws of New York, Massachusetts, Dlinois and California, and other States, is inadequate, is based on incorrect premises, and is an aid to that destructive and delusive process know as '^ fooling one's self." The truth of both of these propositions is evidenced by the fact that many companies voluntarily charge themselves with a greater loss reserve than they are required to do under the afore-mentioned statutes. This statement must not be construed as an attack upon the ideas of the devisers of the laws which now seek to establish adequate estimates. Proper prin- ciples, especially in the insurance field, cannot be se- cured in one day, and perfected results can only be accomplished by gradual development and reformation as the weak points in our system are revealed. With no idea, therefore, that I have devised a method original either in its conception or in its method of application, I nevertheless submit the fol- lowing facts in order that they may induce a line of thought which may lead to the promulgation of a rule 208 Examination of Insurance Companies of law wliicli will more adequately represent this item of the company's liabilities. In the early summer of 1907 I was requested by an insurance department to examine a company trans- acting a number of kinds of business, among them lia- bility insurance. The application of certain tests soon indicated that the statutes of the various States were not requiring sufficient reserve on unpaid liability losses, a conclusion which was verified by discussions with the officers and the fact that this particular com- pany was charging itself with an amount greater than any statutory requirement in order to take care of these losses as they might be paid. The rule set down by the various insurance departments had been faith- fully adhered to, and it became evident that the fault was not with its application but with the rule itself. It is unnecessary for me to recite the methods speci- fied for the computation of this reserve, and I shall therefore merely point out those features which will indicate the incorrectness of the premises. The liability insurance policy probably gives greater play for the exercise of individual methods and judg- ment on the part of the underwriters than any other form. Even after the premium is fixed and the policy issued, the greatest latitude in the method of carrying out the terms of the contract is allowed. One under- writer may consider it good business policy to settle his claims promptly and before they are brought to suit; another underwriter equally honorable may be of the opinion that the best interests of the policyholders and stockholders are served by uniform resistance to and deferring of loss payments until avoidance is no Examination of Insurance Companies 209 longer possible. It is not the function of this discus- sion to decide upon the correctness or advisability of one of these attitudes over the other. But the fact remains that any method for computing loss reserves under such contracts which is based upon the number of suits filed or number of notices received must lead to erroneous conclusion, for not only will such a method be affected by the divergent underwriting opinions just referred to, but it takes into account the mental calibre of the insured. To illustrate: One policyholder may feel it his duty to notify the company whenever one of his employees receives a scratch on the hand; some other policyholder may con- sider that he will be amply protected if he notifies the company only of such cases as give evidence of prob- able loss. The actual disbursements of the liability company under both of these contracts may be the same, but under the New York law, for instance, the reserve for losses which the company would be re- quired to maintain on the first policy would be many times the loss reserve required on the second policy. It is not an unusual experience for a liability company to be required to maintain as a loss reserve an amount in excess of the gross premium received, notwithstand- ing the fact that it can be conclusively shown that the ultimate loss under such a policy is well within the underwriter's expectations. The Michigan law is based upon a different idea, and seeks to establish as a minimum charge an arbi- trary percentage of the gross premiums received, with the further provision that this amount shall be in- creased if the experience of the particular company 14 210 Examination of Insurance Companies shows that such a course is necessary. The objections to this method are so numerous and apparent that it will be unnecessary to discuss it, although in justice it may be said that in many cases the Michigan re- quirements come more nearly and closely to a correct approximation of future results than do the other stat- utes referred to. With the idea, therefore, of employing some method which would eliminate the objectionable feature of the two methods referred to, which would furnish re- sults independent of the mental make-up of the in- sured, and at the same time take into account the underwriting methods of the management, the follow- ing method was followed: From the company records were obtained the earned premiums applicable to the policies of the various years of issue. Referring to the table hereto attached it will be seen, for instance, that during the first year of the policies issued during 1896 the earned premiums amounted to $222,599.06. The second year the earned premiums, without additional premiums received as the result of pay roll audits, had increased to $483,- 102.83; while the third year indicated that additional premiums had amounted to the insignificant sum of $700, and it subsequently developed that all additional premiums were practically received during the first three years of the existence of the policy. In excep- tional cases the additions received after that time might be safely disregarded. In the same way the losses paid during the various years were resolved into various groups representing the years of issue. It was found, for instance, that $20,182.21 had been paid during the first year of the Examination of Insurance Companies 211 policies issued during 1896, $106,132.54 during the second year, $68,142 during the third year, $45,750.09 the fourth year, $26,017.29 the fifth year, $16,850.37 the sixth year, $10,725.03 the seventh year, $2,795.69 the eighth year, $1,993.86 the ninth year, $111.87 the tenth year and $226.86 the eleventh year. In order to provide a reasonable period of conclu- sion it was determined that for the purpose of this estimate it could safely be assumed that all losses would be settled within ten years of the issuance of the policy, and such exceptional cases as ran beyond that period would serve to offset the interest factor, which will be referred to later. With these facts in our possession it was an easy matter to determine the ratio which the losses during the first series of years bore to the earned premiums of the first series of years, and in the same way similar ratios were determined for the second to the tenth years, inclusive. The application of these ratios to the various years became equally simple, and the results of such application are shown in the table, being indi- cated by the numbers contained within the brackets. There are certain additional features of the table to which it is advisable at this time to call attention. It will be seen, for instance, that in 1905 and 1906 it became necessary to estimate the earned premiums as well as the losses, for it follows that it is but just to allow a comj)any credit for its probable future receipts as well as for its probable future disbursements. These estimated premiums were calculated in a similar man- ner as the losses. It will be noted that the space for the earned premiums for the second year of the 1906 business is blank, the reason for this being that as the 212 Examination of Insurance Companies company will be allowed full credit for the total of the unearned premiums at the end of the third year, it is unnecessary to use an intermediate year. By this means the accomplishment of our purpose by one step is made possible. In order to arrive at the value of future losses on liability business, therefore, I summed the loss figures shown in the brackets in the table, and deducted from this amount the estimated additional premiums as shown in the table (less the cost of col- lection). This resulted in a slightly larger liability than was assumed by the company, but as I felt it would have been unjust to charge for examination purposes this item as computed in this new and un- tried way, I determined to wait until others with more experience at their command could show the correct- ness or incorrectness of the idea and suggest such modifications as may be necessary. So much for the theory. Quite recently the com- pany in question completed its distribution of the losses paid during 1907, and the following table shows the results of my estimates by years, and alongside of the actual payments that the company made: Estimates Actual shown payments PouciES Issued in in Table during 1907 1906 $254,138.40 $268,444.21 1905 122,718.74 105,230.61 1904 75,265.48 64,142.59 1903 50,578.06 33,972.25 1902 38,549.74 45,937.67 1901 13,953.59 20,811.24 1900 5,692.80 7,599.91 1899 3,450.91 4,401.16 1898 3,025.71 7,185.47 Totals $567,373.43 $557,725.11 The company, in addition to the foregoing, paid losses during 1907 of $6,417.44 on policies issued prior Examination of Insurance Companies 213 to 1898, and for which the table makes no charge. It will be seen, therefore, that my estimate differed from the actual payments by about $3,000. One of the reasons for not discounting the future payments was that this factor could be relied upon to take care of those extraordinary disbursements such as the $6,417.44 just referred to, and any other for which it would be impossible to make allowance in so general an estimate as the foregoing. The object of this explanation is not to announce any new or unusual method or discovery, but to bring to the attention of practical underwriters and statis- ticians a plan which seems to me to get rid of the objectionable features of the present laws and to pro- vide a method which will enable corporations to re- serve according to the merits of their own experience. If it should become necessary to provide for the reserve of a company which has not been in existence long enough to figure this liability on its own experi- ence, it goes without saying that a satisfactory way would be to require such a company to reserve on the basis of others which have been established for a longer period. It will likewise be noted that this pro- posed method, by using the experience of a number of years for the attainment of ratios, exclusively deals with the temporary or unusual fluctuations which might be found in any one year ; as the experience of one year disappears each year, it must follow that we will deal only with the newest experience of the com- pany. Furthermore, it will be noted that the losses paid after the fifth year are small in amount, and therefore as the experience becomes ' ' stale ' ' its effect upon the total result becomes smaller. 214 Examination of Insurance Companies experience table for computing probable future LIABILITY LOSSES Policies Policies Policies written written written in 1893 in 1894 in 1895 Earned premiums, first year $128,716.51 $178,952.65 Losses, first year $3,597.60 16,452.61 16,828.04 Earned premimns, second year 131,111.33 293,746.21 411,554.77 Losses, second year 37,209.82 51,936.46 75,561.02 Earned premiums, third year 130,415.65 295,081.10 411,862.79 Losses, third year 16,600.92 44,290.72 69,897.92 Losses, fourth year 13,601.64 33,741.97 50,964.96 Losses, fifth year 12,866.87 13,816.26 20,907.21 Losses, sixth year 14,506.11 9,799.29 14,822.49 Losses, seventh year 2,341.54 8,051.46 7,872.35 Losses, eighth year 2,072.65 3,279.43 631.44 Losses, ninth year 562.00 2,155.07 2,520.70 Losses, tenth year 281.65 1,627.10 1,126.93 Losses, eleventh year 729 .06 1 ,934 .39 Losses, twelfth year 191 . 10 50.00 Losses, thirteenth year 66 .90 Policies Policies Policies written written written in 1896 in 1897 in 1898 Earned premiums, first year $222,599.06 $295,793.83 $284,368.07 Losses, first year 20,182.21 37,579.17 32,666.49 Earned premiums, second year 483,102.83 586,291.94 594,604.25 Losses, second year 106,132.54 107,088.75 100,440.84 Earned premiums, third year 483,829.65 590,330.41 605,141.42 Losses, third year 68,142.00 66,565.30 63,869.17 Losses, fourth year 45,750.09 45,686.41 63,112.33 Losses, fifth year 26,017.29 12,876.94 30,906.79 Losses, sixth year 16,850.37 4,989.56 10,996.67 Losses, seventh year 10,725.03 9,243.83 4,032.34 Losses, eighth year 2,795.69 4,842.58 1,170.10 Losses, ninth year 1,993.80 4,515.46 840.14 Losses, tenth year 111.87 6,487.66 [3,025.71] Losses, eleventh year . 226 .86 Policies Pohcies Policies written written written in 1899 in 1900 in 1901 Earned premiums, fiirst year $311,425.63 $343,045.60 $359,952.16 Losses, first year 41,956.85 47,861.66 69,569.61 Earned premiums, second year 675 , 136 , 3 1 750 , 392 . 7 1 840 , 355 . 93 Losses, second year 110,953.37 153,299.99 201,144.34 Earned premiums, third year 690 , 182 . 99 769 , 297 . 08 888 , 763 . 98 Losses, third year 97,913.93 106,996.01 78,186.93 Losses, fourth year 44,429.69 56,646.75 48,465.18 Losses, fifth year 39,493.91 39,634.16 41,313.17 Losses, sixth year 45,924.76 18,625.36 38,285.92 Losses, seventh year 4,698.13 15,480.01 [13,953.59] Losses, eighth year 8,810.90 [5,692.80] [6,576.85] Losses, ninth year [3,450.91] [3,846.48] [4,443.82] Losses, tenth year [3,450.91] [3,846.48] [4,443.82] In the above tables the figures enclosed in brackets, [1, are the estimates which have been derived by the methods set forth. Examination of Insurance Companies 215 EXPERIENCE TABLE FOR COMPUTING PROBABLE FUTURE LIABILITY LOSSES Policies Policies Policies written written written in 1902 in 1903 in 1904 Earned premiums, first year $442 , 924 . 4 1 $450 , 5 1 6 . 06 $426 , 455 . 79 Losses, first year 95,826.19 81,167.41 80,244.32 Earned premiums, second year .. . 1,015,873.50 1,006,676.77 973,278.28 Losses, second year 223,820.84 181,980.79 181,774.41 Earned premiums, third year 1,073,809.69 1,076,129.44 1,028,216.56 Losses, third year 96,778.83 81,336.44 80,213.41 Losses, fourth year 48,356.05 62,509.26 [75,265.48] Losses, fifth year 41,092.29 [50,578.06] [48,326.20] Losses, sixth year [38,549.74] [38,633.03] [36,912.99] Losses, seventh year [16,858.80] [16,895.23] [16,143.01] Losses, eighth year [7 , 946 . 19] [7 , 963 . 35] [7 , 608 . 81] Losses, ninth year [5 , 369 . 05] [5 , 380 . 65] [5,141. 09] Losses, tenth year [5,369.05] [5,380.65] [5,141.09] Policies Policies written written in 1905 in 1906 Earned premiums, first year $470,591 .39 $554,324.77 Losses, first year 84,097.77 98,439.31 Earned premiums, second year 1,086,715.48 Losses, second year 195,400.68 [254,138.04] Earned premiums, third year [1,133,137.01] [1,334,758.61] Losses, third year [122,718.74] [144,554.36] Losses, fourth year [82,945.63] [97,704.29] Losses, fifth year [53,257.44] [62,733.63] Losses, sixth year [40,689.73] [47,917.81] Losses, seventh year [17,790.25] [20,955.70] Losses, eighth year [8,385.21] [9,877.21] Losses, ninth year [5,665.68] [6,673.79] Losses, tenth year [5,665.68] [6,673.79] "" In the'above'tables the figures enclosed in brackets, [], are the estimates which have been derived by the methods set forth. 216 Examination of Insurance Companies APPENDIX M '' § 87. Any domestic life insurance corporation may accumulate and maintain in addition to an amount equal to the net values of its policies com- puted according to the standard adopted by it under section eighty-four of this chapter a contingency re- serve not exceeding the following respective percent- ages of said net values, to wit : When said net values are less than one hundred thousand dollars, twenty per centum thereof or the sum of ten thousand dol- lars, whichever is the greater; when said net values are greater than one hundred thousand dollars, the percentage thereof measuring the contingency reserve shall decrease one-half of one per centum for each one hundred thousand dollars of said net values up to one million dollars; one-half of one per centum for each additional one million dollars up to ten million dollars ; one-half of one per centum for each additional two million five hundred thousand dollars up to twenty million dollars; one-half of one per centum for each additional five million dollars up to fifty million dol- lars; one-half of one per centum for each additional twenty-five million dollars up to seventy-five million dollars ; and if said net values equal or exceed the last mentioned amount, the contingency reserve shall not exceed five per centum thereof; provided that as the net values of said policies increase and the maxi- mum percentage measuring the contingency reserve decreases such corporation may maintain the contin- gency reserve already accumulated hereunder, al- though for the time being it may exceed the maxi- Examination of Insurance Companies 217 mum percentage herein prescribed, but may not add to the contingency reserve when the addition will bring it beyond the maximum percentage. Provided, however, that nothing herein contained shall be con- strued to affect any existing surplus or contingency reserves held by any such corporation save that when- ever the existing surplus and contingency reserves, exclusive of said net values and of all accumulations held on account of existing deferred dividend policies or groups of such policies, shall exceed the limit above mentioned it shall not be entitled to maintain any additional contingency reserve. Provided, further, that for cause shown the superintendent of insurance may at any time and from time to time permit any corporation to accumulate and maintain a contingency reserve in excess of the limit above mentioned for a prescribed period, not exceeding one year under any one permission, by filing in his office a decision stating his reasons therefor and causing the same to be pub- lished in his next annual report. This section shall not apply to any corporation doing exclusively a non- participating business." 218 Examination of Insurance Companies APPENDIX N Provision (6) of section 5 of Act regulating the con- ditions and provisions to be contained in policies (other than the standard forms) of life insurance com- panies doing business in Ohio. ''(6) A provision that the policy shall participate in the surplus of the company and that, beginning not later than the end of the third policy year, the com- pany will annually determine and account for the por- tion of the divisible surplus accruing on the policy, and that the owner of the policy shall have the right each year to have the current dividend arising from such participation paid in cash or applied to the pur- chase of paid-up additions, and if the policy shall pro- vide other dividend options, it shall further provide that if the owner of the policy shall not elect any such other options the dividend shall be applied to the pur- chase of paid up additions. " In lieu of the foregoing provision the policy may contain a provision that the policy shall participate in the surplus of the company, and that, beginning not later than the end of the fifth policy year, the com- pany will determine and account for the portion of the divisible surplus accruing on the policy, and that the owner of the policy shall have the right to have the current dividend arising from such participation paid in cash, and that at periods of not more than five years such accounting and payment, at the option of the policyholder, shall be had. '' Eenewable term policies of ten years or less may provide that the surplus accruing to such policies shall Examination of Insurance Companies 219 be determined and apportioned each year after the second policy year and accumulated during each re- newal period and that at the end of any renewal period on renewal of the policy by the insured, the company shall apply the accumulated surplus as an annuity for the next succeeding renewal term in the reduction of premiums. " These provisions shall not be required in non- participating policies." 220 Examination of Insubance Companies APPENDIX *' § 97. Limitation of expenses. No domestic life insurance corporation shall in any calendar year, after the year nineteen hundred and six, expend or become liable for, including any and all amounts which any person, firm or corporation is permitted to expend on its behalf or under any agreement with it (1) for commissions on first year's premiums, (2) for com- pensation, not paid by commission, for services in obtaining new insurance exclusive of salaries paid in good faith for agency supervision either at the home office or at branch offices, (3) for medical examinations and inspections of proposed risks, and (4) for advances to agents, a total amount exceeding in the aggre- gate (a) the loadings upon the premiums for the first year of insurance received in said calendar year, (calculated on the basis of the American experience table of mortality with interest at the rate of three and one-half per centum per annum) and (b) the present values of the assumed mortality gains for the first five years of insurance on the policies in force at the end of said calendar year on which the first premium, or instalment thereof, has been received during said cal- endar year, as ascertained by the select and ultimate method of valuation as provided in section eighty-four of this chapter; and (c) on policies issued and termi- nated in said calendar year the full gross premiums received, less the net cost of the insurance for the time the insurance was in force, computed by the American experience select and ultimate table, three and one- half per centum. No such corporation shall make or Examination op Insurance Companies 221 incur any expense or permit any expense to be made or incurred upon its behalf or under any agreement with it, except actual investment expenses (not exceed- ing one-fourth of one per centum of the mean invested assets), and also except taxes on real estate and other outlays exclusively in connection with real estate, in excess of the aggregate amount of the actual loadings upon premiums received in said year calculated ac- cording to the standards adopted by the company under section eighty-four of this chapter, and the pres- ent values of the assumed mortality gains hereinbefore mentioned. No such corporation, nor any person, firm or corporation on its behalf or under any agreement with it shall pay or allow to any agent, broker or other person, firm or corporation for procuring an applica- tion for life insurance, for collecting any premium thereon or for any other service performed in connec- tion therewith any compensation other than that which has been determined in advance. All bonuses, prizes and rewards, and all increased or additional commissions or compensation of any sort based upon the volume of any new or renewed business or the aggregate of policies written or paid for, are pro- hibited. No such corporation shall pay commissions upon renewal premiums received upon policies issued after the year nineteen hundred and six, in excess of five per centum of the premium annually for fourteen years after the first year of insurance in the case of endowment policies providing for less than twenty an- nual premiums, nor in excess of seven and one-half per centum of the premium annually for the first nine years after the first year of insurance and five per centum of the premium annually for the next ensuing 222 Examination of Insurance Companies five years in the case of other forms of policies; pro- vided that an amount found to be equivalent to the aggregate amount so payable by a calculation ap- proved by the superintendent of insurance and based upon mortality, interest and lapse rates, may be distributed through three or more years, or through a period exceeding fourteen years, but not more than two-fifths of such amount shall be payable for any one year; provided further that in any agency district subject to the supervision of a local salaried representative the renewal commission payable to agents of such district shall not exceed two-thirds of the foregoing rates annually for fourteen years, sub- ject to the calculation as aforesaid; provided fur- ther that any such corporation may condition the allowance or payment in whole or in part of any of the renewal commissions allowed to be paid as afore- said upon the efficiency of service of the agent receiv- ing the same or upon the amount and quality of the business renewed under his supervision; and also pro- vided that a fee not exceeding three per centum may be paid for the collection of premiums which shall be received for any year after the fifteenth year of insur- ance. If any such corporation shall compensate its agents, or any of them, after the first insurance year, in whole or in part, upon any other plan than commis- sions and collection fees, the aggregate sum so paid shall in no year exceed the limitations herein imposed and the schedule and plan of such compensation shall be submitted to and approved by the superintendent of insurance. No such corporation, nor any person, firm or corporation on its behalf or under any agree- ment with it, shall make any loan or advance to any Examination op Insurance Companies 223 person, firm or corporation soliciting or undertaking to solicit applications for insurance without adequate collateral security, nor shall any such loan or advance be made upon the security of renewal commissions, or of other compensation earned or to be earned by the borrower except advances against compensation for the first year of insurance. A foreign life insurance corporation which shall not conduct its business within the limitations and in accordance with the re- quirements imposed by this section upon domestic cor- porations shall not be permitted to do business within the state. This section shall not apply to expenses made or incurred in the business of industrial in- surance nor, except as to the limitation of expenses for the first year of insurance and as to compensation of and loans and advances to agents or solicitors, to stock corporations issuing and representing them- selves as issuing non-participating policies exclu- sively. 224 EXAMINATIOIT OF INSURANCE COMPANIES APPENDIX P Annual Reports of Life Insurance Corporations. ' ' § 103. In addition to any other matter which may be required by law or pursuant to law by the superin- tendent of insurance to be stated therein every annual report of every life insurance corporation doing busi- ness in the state of New York, made pursuant to sec- tion forty-four of this chapter, shall contain an ac- curate, concise and complete statement of the follow- ing matters, to wit: (1) All the real property held by the corporation, the dates of acquisition, the names of the vendors, the actual cost, the value at which it is carried on the company's books, the market value, the amounts expended during the year for repairs and im- provements, the gross and net income from each par- cel, and if any portion thereof be occupied by the com- pany the rental value thereof, a statement of any cer- tificate issued by the superintendent extending the time for the disposition thereof, and all purchases and sales made since the last annual statement, with par- ticulars as to dates, names of vendors and vendees, and the consideration. (2) The amount of existing loans upon the security of real property, stating the amount loaned upon property in each state and foreign country. (3) The moneys loaned by the corporation to any person other than loans upon the security of real property above mentioned and other than loans upon policies, the actual borrowers thereof, the maturity and rate of interest of such loans the securi- ties held therefor, and all substitutions of securities in connection therewith, and the same particulars with Examination of Insurance Companies 225 reference to any loans made or discharged since the last annual statement. (4) All other property owned by the company or in which it has any interest, includ- ing all securities, whether or not recognized by the law as proper investments, the dates of acquisition, from whom acquired, the actual cost, the value at which the property is carried upon the books, the market value, the interest or dividends received thereon, during the year; also all purchases and sales of property other than real estate made since the last annual statement, with particulars as to dates, names of purchasers and sellers, and the consideration; and also the income re- ceived and outlays made in connection with all such property. (5) All commissions paid to any persons in connection with loans or purchases or sales of any property, and a statement of all payments for legal ex- penses, giving particulars as to dates, amounts and names and addresses of payees. (6) All moneys ex- pended in connection with any matter pending before any legislative body or any officer or department of government, giving particulars as to dates, amounts, names and addresses of payees, the measure or pro- ceeding in connection with which the payment was made, and the interest of the corporation therein. (7) The names of the officers and directors of the company, the proceedings at the last annual election, giving the names of candidates and the number of votes cast for each and whether in person, by proxy or by mail. (8) The salary, compensation and emoluments re- ceived by officers or directors and where the same amounts to more than five thousand dollars that re- ceived by any person, firm or corporation, with par- 15 226 Examination of Insurance Companies ticulars as to date, amounts, payees, and the authority by which the payment was made ; also all salaries paid to any representative either at the home office, or at any branch office, or agency, for agency supervision. (9) The largest balances carried in each bank or trust company during each month of the year. (10) All death claims resisted or compromised during the year, with particulars as to sums insured, sums paid and reasons assigned for resisting or compromising the same in each case. (11) A complete statement of the profits and losses upon the business transacted during the year and the sources of such gains and losses, and a statement showing separately the margins upon premiums for the first year of insurance ascertained according to the select and ultimate method of valua- tion as provided in section eighty-four of this chapter and the actual expenses chargeable to the procure- ment of new business incurred since the last annual statement as enumerated in section ninety-seven of this article. A foreign corporation, issuing both par- ticipating and non-participating policies, shall make a separate statement of profits and losses, margins and expenses, as aforesaid, with reference to each of said kinds of business, and also showing the manner in which an}^ general outlays of the company have been apportioned to each of such kinds of business. (12) A statement separately showing the amount of the gains of the company for the year attributable to policies written after December thirty-first, nineteen hundred and six, and the precise method by which the calculation has been made. (13) The rates of annual dividends declared during the year for all plans of in- surance and all durations for ages at entry, twenty- Examination of Insurance Companies 227 five, thirty-five, forty-five and fifty-five, and the pre- cise method by which such dividends have been cal- culated. (14) A statement showing the rates of divi- dends declared upon deferred dividend policies com- pleting their dividend periods for all plans of in- surance and the precise methods by which said divi- dends have been calculated. (15) A statement show- ing any and all amounts set apart or provisionally ascertained or calculated or held awaiting apportion- ment upon policies with deferred dividend periods longer than one year for all plans of insurance and all durations and for ages of entry as aforesaid, together with the precise statements of the methods of calcula- tion by which the same have been provisionally or otherwise determined. (16) A statement of any and all reserve or surplus funds held by the company and for what purpose they are claimed respectively to be held. (17) A statement showing all sums of money expended in, or in any way connected with, the elec- tion of directors or trustees, with a statement when ex- pended, by whom expended, to whom paid and for what purpose." 228 Examination op Insurance Companies APPENDIX Q Liability Loss Reserves By S. H. Wolfe I have been asked by the Executive Committee of this Association to read a paper on the subject of '* Liability reserves and the effect of the new Com- pensation Law on the question of reserve, with par- ticular reference to the method of calculating the latter." The program of this meeting owes its existence to the enactment of certain laws bearing upon the pay- ments which employers are compelled to make to their employees in the event of injuries to the latter from accidental causes during employment. A diligent search among these statutes fails to reveal any men- tion of the word ' ' reserves. ' ' The lengthy title of the subject upon which I have been asked to address you, indicates, however, that there is some intimate con- nection between the two matters. An idea which is more or less prevalent (not only among those engaged in the liability business, but also among other underwriters) is that the reserve is in the nature of a penalty prescribed by the State or is an arbitrary test created by the same power as a measure of solvency. In reality, both of these viewpoints are wrong. If no supervising officer existed, if the State took no interest in the progress of insurance com- panies and if no laws designed to reveal the solvency or insolvency of an insurance company had ever been enacted, there would still exist the necessity for the Examination of Insurance Companies 229 creation and maintenance of a reserve fund. It is to the insurance business what the governor is to the steam engine — a control to prevent self-destruction from abnormal and undistributed operations. And as the governor on the steam engine is primarily in- tended for the preservation of the engine, so is the re- serve fund an absolute necessity for the insurance company. The recognition and admission of this idea will con- vince one of the intimate relation between the reserve fund and the future history of the corporations en- gaged in the business. I care not how effectively or how adroitly a company may have delayed the enact- ment of proper legislation or may have failed to prop- erly make the returns called for by existing statutes, the fact remains that unless a proper reserve liability be maintained, no company can hope to escape the action of natural laws and the penalty prescribed for their violation. A great deal of attention has been directed to the formation of some effective means of calculating that elusive item — the reserve for unpaid losses. A com- mittee of underwriters connected with the different companies has been collecting data upon which to predicate a law, and has submitted a number of plans, the application of which in most cases yields results so widely at variance as to lead to the conclusion that the basis of some of them does not rest upon proper scientific foundations. In the case of one company the application of three of these plans showed that the loss reserve should be as follows: Plan 1 $136,444 Plan 2 224,038 Plan 3 209,974 230 Examination of Insurance Companies In the case of another the figures were: Plan 1 $4,097,150 Plan 2 3,229,880 Plan 3 3,555,461 Thus indicating widely divergent results. The great danger in a discussion of this kind is that our earnest- ness and zeal and attempt to be absolutely correct and scientific, may cause us to lose sight of certain essen- tials. '* If once, the shadow to pursue, We let the substance out of view '* we shall certainly fail to arrive at a satisfactory result. Kemoving then, from the question of liability loss reserves any reference to a State enactment or of a penalty, and regarding them as they should be, simply in the light of an intimate and necessary adjunct to a company's affairs in much the same way that we would regard its premium income or its interest ac- count or its officers' salaries, we find that the question of future losses is directly affected by each of the fol- lowing factors: (a) The inherent worth of the business — which may also be called the underwriting factor, since it re- flects the skill and acumen of the men in charge of the business. (b) The methods of settlement — which may also be called the adjusting factor, since it represents the at- titude of the officers who are in charge of the adjust- ing department. (c) The results of court decisions — which may be called the litigation factor. Examination of Insurance Companies 231 (d) The general attitude of the law makers — which may be called the legislation factor. Before discussing, however, the relative effect which each of these factors has upon the total result, it will be advisable to refer briefly to the present methods of calculating the loss reserves required by the statutes of the different States, with particular reference to their merits and demerits; it will likewise be in- structive to notice to what extent the different methods take cognizance of the foregoing factors. Upon the statute books of New York and some of the other States, will be found a method which for the sake of brevity we may designate as '' the New York law;" the underlying principle here is the division of all future loss payments into two broad subdivisions: first, those claims upon which suit has been brought and notice of the occurrence of the accident has been in possession of the company more than eighteen months, and second, those claims, the notices for which the company has received within the preceding eigh- teen months. It is difficult to find any merit in this method and its defects are so glaring and so well recognized that it is unnecessary for me to consume your time in pointing them out. As long ago as Feb- ruary, 1908, the writer prepared a paper which ap- peared in one of the insurance journals, pointing out the insufficiency of this method ; the active co-operation of the Insurance Department of the State of New York with liability underwriters in an attempt to obtain a better basis, is an indication of the general recognition of the insufficiency of this method of computing the liability. The second method is in use in one of the States and 232 Examination of Insurance Companies is based upon the assumption that a company will ulti- mately have to pay a certain percentage of its pre- miums to policyholders and the unpaid portion should, therefore, be maintained as a liability. The merit of this method lies in that it recognizes the necessity for the subdivision of the premiums and the enforced segregation of those portions of the premium income which will be used for the payment of losses. Mani- festly, however, such a method fails to visit upon the head of the incompetent underwriter a sufficient penalty for the charging of too low a premium and the attempt of the statute to guard against this by placing in the hands of the Insurance Commissioners the right to increase the percentage in certain cases, is an at- tempt to correct the evil by the use of a more objec- tionable one, viz.: the clothing of an official with dis- cretionary power without requiring that he be scien- tifically equipped to handle the situation. From the foregoing we may conclude that neither of the two methods is satisfactory, and we are strength- ened in our belief by the fact that the question of lia- bility reserves is receiving so much attention at the present time with no attempt to defend the two methods or to base future statutes upon them. The companies have realized this and in a frank, open way have asked the supervising officials of the various States to co-operate with them in devising some method of meeting this situation. The effect of the new workman's compensation law will be far reaching; we know that it will affect the losses which will be incurred, but we cannot say at this moment to what extent; we know that it has affected the premiums which the assured will be required to Examination of Insura.nce Companies 233 pay for their protection. It will naturally follow, therefore, that the loss reserves must be modified if they are to reflect the new conditions. Manifestly, the ideal method of computing this new liability will be the one which will take into account as many of the four factors which I have previously mentioned as pos- sible, and which will assign to each its relative weight. Let us examine them in the reverse order in which they have been stated: > The Legislation Factor Who can say what the next day will bring forth in legislation? We are able, however, to observe fairly accurately the trend of legislation and gauge the ideas which seem uppermost in the minds of legislators. The defences upon which the employer formerly relied in meeting an action brought by an employee are one by one disappearing and the new law on the statute books of New York is undoubtedly an entering wedge to a system of compulsory compensation, similar to the one now in force in certain European countries. This is in line with the advance of socialistic ideas, so notice- able in every avenue of human activity in this country as elsewhere. New York has placed on its statute books definite enactments to this end; a number of other States have appointed commissions to consider the matter and it is but to be expected that their re- ports when presented will be largely influenced by the completed action of New York. It would be the worst kind of self-deception upon the part of underwriters to assume that this tide can be stemmed. The part of wisdom is to drift with it and to assume that at this moment it has not yet reached its flood. The present 234 Examination of Insurance Companies New York Compensation Act applies to eight hazard- ous occupations only. Who among us believe the ap- plication will not be extended to other fields of activity? The Litigation Factor The legislators place upon the statute books certain acts dealing with the relations between the employer and the employee; the courts construe these acts. Hand in hand with the tendency of Legislatures to make it more difificult for the employer to escape the results of accidents to his workmen, will be found the decisions of the courts. Awards for larger amounts have a direct bearing on the subject of loss reserves and this phase of the situation must unquestionably be affected by the definite amount of the recoveries speci- fied in the new compensation act. The Adjusting Factor In the same way that judicial awards are influenced — unconsciously, perhaps — by the arbitrary stand- ards prescribed by the present workman's compensa- tion act, so will the question of adjustments be like- wise affected. Formerly there existed no basis upon which an adjustment could be made; to-day the law sets forth certain standards applicable to the eight hazardous occupations, and although not applicable to other cases, it enables the injured employee and his at- torney to find some official figure upon which to base his demand for a settlement. In considering this phase of the question, it should likewise be borne in mind that methods differ among the various companies transacting liability insurance. In the opinion of Examination of Insurance Companies 235 some underwriters the best results are obtained from prompt and early settlements, the others believe in forcing a large number of claims to litigation. If, therefore, we attempt to calculate the loss reserve upon the basis of periods of settlement, we shall find that we are introducing an error which will seriously affect the scientific integrity of our calculations. The Underwriting Factor Since the premium is the basis for all insurance, I think I am justified in assigning to this factor the place of chief importance. The consideration for a liability policy, the pre- mium, may be properly divided into two parts: first, that portion intended to pay losses and loss expense, and second, the portion intended to cover all of the necessary disbursements of the company — salaries, rents, dividends, etc. With the exception of the in- terest on its invested assets, an insurance company has no other source of income. In order to facilitate this discussion, I shall refer to the first portion of the premium as '' the pure premium " and to the second as " the loading." The five possible situations which we can then have are: First. — That the pure premium is just sufficient to pay the losses (irrespective of the date of settlement) and the loading just sufficient to meet all of the ex- penses; in this case the underwriting department will show that it is self-sustaining and the surplus will be increased by the interest received on the investments. Second. — That the pure premium is insufficient to pay the losses, but the loading is sufficient to meet the 236 Examination of Insurance Companies expenses, in which case the underwriting department will show a loss, and the increase or decrease in the surplus will depend upon the ability of the interest income to overcome the underwriting deficiency. Third. — That the pure premium and the loading are both insufficient to meet the needs for which they are intended, and the increase or decrease in the surplus in this case will depend, as in the second case, upon the amount of interest received. Fourth. — That the pure premium is in excess of the amount necessary to pay the losses and the loading larger than the expenses incurred, in which case the surplus will be increased not only by the interest re- ceipts, but also by the excess in these two factors. Fifth. — That the pure premium is in excess of the amount required to pay the losses, while the loading is insufficient to meet the expenses; in this event if the underwriting profit and the interest income are suffi- cient to overcome the deficiency in the loading, the surplus will be correspondingly increased. In the foregoing five cases I have referred to the underwriting profit not as it is commonly understood in the underwriting and investment exhibit required by Insurance Departments, but rather with particular reference to the profits resulting from a comparison of the losses sustained with the pure premium charged. I have referred to these five possible conditions in order that we may be led gradually to the idea which I have in mind, viz.: the derivation of the '' pure premium." The '' loading " presents no great diffi- culty, for the expenses of a company are at all times within its control, and are not subject to the same dis- turbing causes that affect the other factor. Examination of Insurance Companies 237 Is it possible to obtain a pure premium? The law of averages applies to liability insurance as it does to every other field of activity; the practical operations of insurance companies would be rendered impossible without it. It will require no demonstra- tion upon my part to prove that the larger the number of happenings exposed to observation, the more re- liable will be the resulting statistics, and it seems to me that therein lies a solution for this problem; in other words, that a careful observation of the practical operations of the companies will enable us to derive the actual cost for the various forms of policies, i. e., the pure premium for the particular hazard. I imagine that no company in this country has been able by its own operations solely to accurately fix the cost for each particular class; individual companies have in- dividual underwriting and adjustment ideas. If we were able, therefore, to obtain the experience of all the companies and correctly tabulate it, we would have not only the benefit of an extensive field of ob- servation, but in addition thereto we would be able to eliminate those conditions which I have just pointed out, may be peculiar to any one company. Attempts in the past to get the companies to co- operate in the preparation of statistics of this kind have not been successful. It is not my intention to attempt to find out why the movement has not been a success. I am convinced, however, that failure must inevitably result from an attempt to secure the figures by mere company agreement. In this emergency it would appear that the State could profitably and properly step in and require the tabulation to be made under its supervision. Under these circumstances all 238 Examination of Insurance Companies companies would doubtless be glad to contribute their experience with a full realization that the details of their business would not be exposed to the gaze of competitors, but would be used solely for the purpose of deriving a factor which they need for their own pro- tection. I am fully aware that an objection against the use of '' pure premiums " derived from the experiences of the past will be urged. I recognize fully that the changes in the laws and in the attitude of the courts, which I have pointed out a few moments ago, will operate to render those premiums more or less insuffi- cient, but ways exist for correcting this condition. In the first place the calculation would be a continuing process, and each year, therefore, there would be in- troduced a correcting factor. In the second place it would be possible in my opinion to provide tempo- rarily for an arbitrary constant which would repre- sent the necessary addition to the pure premium ac- cording to the best judgment of competent under- writers. Having derived the pure premium, the procedure to obtain the reserve would be as follows: The business of any calendar year would be arranged by classes and opposite each class would be placed the pure premium (plus the constant) which should have been received on the basis of the standard experience. From such net premium receipts would be deducted the pay- ments which have been made to policyholders in each of the tabulated classes. The difference between the premiums and the payments would be the amount which the company should hold as a reserve to take care of the future losses of that class. As the claims Examination of Insurance Companies 239 of each year are disposed of the reserve would auto- matically disappear. It will be noted that the application of this method for a number of years will yield results which will not require the use of the arbitrary constant referred to, and it seems to me that among the advantages which it possesses is the one which removes from the con- sideration of the loss reserve, the premium which was charged to the insured; rates made in competition, therefore, cease to be a disturbing factor in this method of calculation. I have attempted to show that the premium is the substance and the loss reserve is the shadow; if the premium be once derived by safe, sane methods, loss reserves will take care of themselves. The derivation of the premium in the manner outlined will enable the State to insist that no premium lower than the recog- nized minimum rate shall be charged by any company. Similar action is now enforced by the State in its super- vision of life insurance companies, for if one of these companies should use premiums less than those pre- scribed by the tables of mortality and interest fixed by the State as a minimum standard, it is visited with a penalty in the shape of additional reserves and the penalty has proven to be severe enough to deter any company from following a course which in the opinion of the State would be unsafe. The method suggested above would entail no hard- ship upon the well managed company; if the minimum rate should be higher than that required by its careful underwriting, the difference would be temporarily car- ried in its loss reserve and ultimately find its way into its surplus. 240 Examination of Insurance Companies To summarize, I would say that in my opinion the new compensation law will have a decided effect upon the loss ratio of the companies, and therefore, upon the question of reserves which should be maintained for the unpaid losses. For the method suggested above, no originality is claimed, for the idea must have been in the minds of practical underwriters for some time. If, however, I have succeeded in making the necessity for concerted action in this direction more apparent to you, I feel that I have accomplished the purpose of my talk. INDEX [241] INDEX PAGE. Accident companies, method of treating outstanding losses in ... . 94 Accounts of insolvent debtors in credit companies 106 Accrued interest 53 Accumulation factors 77 Administrators' bonds 98 Advance premiums 117 Advisory Board contracts 116, 144 Agents' balances in fire companies 55 Agents' balances in life companies 54 Agents' debit balances 54 Amortization 70 Amortization of bonds with redemption privileges 79 Amortization, unscientific approximation of 78 Annual statements, paid-for basis 61 Annual statements, written basis 61 Annuities certain 91 Annuity claims unpaid 93 Annuity payments 142 Appeal bonds 98 Application of schedules to annual statement 167 Appreciation in assets allowed 69 Assets, appreciation in, allowed 69 Assets, non-admitted 64 Attitude of examiner 11 Bills of lading, guaranty for 179 Bills receivable 53 Bonds 30 Bonds, amortization of 70 Bonds, coupon 36 Bonds, depreciation in 68 Bonds, government 30 Bonds, industrial 32 Bonds, irrigation 32 Bonds, municipal 31 Bonds, public service 32 Bonds, railroad 32 Bonds, registered 36 Bonds, state 31 [243] 244 Index PAGE. Bonds, with redemption privileges, amortization of 79 Book value of ledger assets over market value 68 Borrowed money 120 Capital stock 121 Capital stock may not be used for establishing business 65 Capital stock owned 65 Cash advanced to officers 66 Cash, certificate for checking deposits of 47 Cash in bank 46 Cash in office 46 Cash, percentage which should be held 46 Classification of fidelity and surety risks 163 Collateral loans 42 Collateral loans, insufficiency of collateral deposits protecting. ... 68 Commuted commissions 66 Companies' own occupancy 20 Contingency reserve 95, 125 Contractors' bonds 98 Co-surety 102 Credit companies, accounts of insolvent debtors in 106 Credit companies, unearned premiums of 107 Credit insurance policy, definition of 104 Credit insurance, special liabilities applicable to 104 Credit policies, limitation of risk on 183 Credit policies, limits of risks 113 Death claims, liabilities on account of 92 Death losses resisted 93 Deferred dividend policies 128 Deferred premiums 57 Deferred premiums, loading on 63 Depository bonds 102 Depreciation in bonds 68 Depreciation in mortgages 68 Depreciation in real estate 68 Depreciation in stocks 68 Directors not to be interested in sales or purchases 36 Dividend liabilities of life insurance companies 124 Dividends 143 Excess credit 66 Excess interest earnings 130 Excise bonds 98, 175 Excise Reinsurance Association 176 Index 245 PAGE. Fidelity policies, method of checking issuance of 100 Fidelity policy, definition of 98 Fidelity risks classified 163 Fire insurance premiums paid in advance 54 Fire losses 97 Fraternal organizations, uncollected premiums in 62 Fraternals, additional schedule for 158 Furniture and fixtures 53 General rules for examinations 134 Guaranteed certificates 179 Guaranty of bills of lading 179 Guardians' bonds 98 Health companies, method of treating outstanding losses in 94 Installment payments 142 Installment policies 89 Interest accrued 53 Interest, effective rate of 79 Interest on policy loans paid in advance 50 Investments 16 Ledger assets, book value of, over market value 68 Liability companies, loss reserves of 112 Liability companies, special reserve for unpaid losses 109 Liability losses, different methods of settling 110 Liability policy, definition of 109 Liability policy differs from Workmen's Collective policy 110 Liability policies, limitation of risk on 183 Liability policies, limits of risks 113 Liens given when policies are changed 51 Liens of reorganized assessment companies 50 Liens, sources of 50 Life insurance companies, liabilities on account of death claims of. 92 Life insurance losses 142 Life insurance policies, net value of 80 Life insurance policies, reinsurance credits on 87 Limitation of risk 181 Limitation of risk on credit policies 183 Limitation of risk on liability policies 183 Limits of risk 113 Loading on uncollected and deferred premiums 63 Loans on collateral 42 Loans on policies 44 Losses due and unpaid 92 246 Index PAGE. Losses in life insurance companies 142 Losses in process of adjustment 92 Losses, reinsurance on 95 Losses reported, no proofs received 93 Losses under liability policies, different methods of settling 110 Loss reserves for liability companies 112 Maintenance bonds 98 Marine companies, unearned premiums of 86 Matured endowments due and unpaid 93 Mean reserve 81 Miscellaneous liabilities 115 Mortgagee clause, fire policies on mortgaged property should contain 25 Mortgages 22 Mortgages, abstract of title of 24 Mortgages, appraisal of 25 Mortgages, depreciation in 68 Mortgages, guaranteed 27 Mortgages, margin of safety in 22 Mortgages, notice of interest due on 27 Mortgages on unimproved property 25 Mortgages, partial payments on 23 Mortgages, purchase-money 26 Mortgages, recording tax on 24 Mortgages, second mortgages not permitted 24 Mortality savings 130 Net terminal value 81 Net value of life insurance policies 80 New York excise risks 175 Non-admitted assets 64 Non-participating policies 124 Officers not to be interested in sales or purchases 36 Over- statement of disbursements 136 Paid-for basis 138 Participating policies 124 Perpetual policies 87 Plate glass losses 97 Policies in hands of agents 184 Policyholders' basis 137 Policy loans 44 Policy loans, interest on, paid in advance 50 Policy loans, unearned interest on 118 IiTOEX 247 PAaE. Policy loans, verifying schedule of 48 Premium notes , 52 Premium on capital stock 139 Premiums deferred 57 Premiums in course of collection 56 Premiums on bonds, improper method of treating 72 Premiums paid in advance 117 Premiums, semi-annual and quarterly 58 Premiums uncollected 60 Profit and loss account 148 Quarterly premiums 58 Real estate 16 Real estate, abstract for 17 Real estate, appraisal of 19 Real estate, deed for 17 Real estate, depreciation in 68 Real estate, division of examination of 17 Real estate, fire insurance policies protecting 21 Real estate, limitations in regard to owning 16 Real estate, may only be held for limited time 21 Real estate, method for arriving at market value of 19 Referees' bonds 98 Reinsurance credit for life policies 87 Reinsurance on losses 95 Reinsurance on losses due 54 Reinsurance should be taken into account in calculation of un- earned premiums 87 Rents paid in advance 54 Resisted claims, method of treating 93 Resisted death losses 93 Sale of capital stock to policyholders forbidden 122 Salvage 101, 143 Savings from loadings 130 Schedules 149 Semi-annual premiums 58 Sources of dividend earnings 130 Special contracts 116, 144 Special liabilities 104 Special liabilities applicable to credit insurance 104 Special reserve for unpaid losses of liability companies 109 Standard forms of life insurance policies 126 Stock of similar corporation may be bought by surety companies . , 42 Stocks 38 248 Index PAGE. stocks, common 40 Stocks, depreciation in 68 Stocks, guaranteed 41 Stocks, life insurance companies not permitted to invest in 40 Stocks, preferred 40 Supervision, history of 9 Surety bonds, definition of 98 Surety bonds, method of checking issuance of 100 Surety risks classified 163 Supplies, stationery and printed matter 66 Supply bonds 98 Surplus 123 Surrender values 143 Surrender values claimable 91 Tax lien, transfer of 28 Title insurance 18 Tontine policies 128 Unassigned funds 123 Uncollected premiums 60 Uncollected premiums in fraternal organizations 62 Uncollected premiimis, loading on 63 Under-statement of receipts 136 Unearned interest on policy loans 118 Unearned premium account not scientifically computed 82 Unearned premiums of credit companies 107 Unearned premium of fire company, method of verifying 185 Unearned premiums of marine companies 86 Unearned premiums on pro rata basis 83 Unpaid annuity claims 93 Voluntary reserve 95 Voucher-cheques 141 Window dressing 44 Workmen's Collective policy diflFers from liability policy 110 Workmen's Compensation Act, probability of Ill Written basis 138 CFTME \ UNIVERSSTY ) OF JJ THIS BOOK IS DUE ON THE LAST DATE STAMPED BELOW AN INITIAL FINE OF 25 CENTS WILL BE ASSESSED FOR FAILURE TO REn"URN THIS BOOK ON THE DATE DUE. 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