Risk-Based Capital - how the regulators look at P&I Clubs

According to MarineLog,

Standard & Poor's Ratings Services said yesterday (July 21, 2004) that it lowered its counterparty credit and financial strength ratings on American Steamship Owners Mutual P&I Assn. Inc. (American Club) to 'BB+' from 'BBB-' and then removed the ratings from CreditWatch.

The article makes a number of points about supplementary calls and other aspects of Club financials that should be familiar to most readers.  Toward the end of the article, however, some less familiar terms appear.

Standard & Poor's says the rating on American Club was placed on CreditWatch with negative implications on May 4, 2004, due to the delay of 2003 financial statements caused by implementation difficulties from the Club's new IT system. The Club has made substantial progress toward correcting the situation. American Club has now filed year-end 2003 statutory financials and has provided Standard & Poor's with draft GAAP financials.

Although statutory financials show the Club's risk-based capitalization to be slightly below authorized control levels, Standard & Poor's believes year-end 2003 GAAP capitalization will be substantially higher than statutory surplus because GAAP accounting allows the full amount of assessments announced in June 2004 to be booked in 2003--unlike statutory accounting. The Club is expected to substantially improve its statutory capitalization by year-end 2004, as revenue from the June 2004 supplemental call becomes recognized in statutory revenue and as improved operating performance helps to build retained earnings.

What do the terms marked in red mean?  They're not frequently seen in Club Annual Reports.

statutory financials

Statutory financials are the financial statements that all U.S. insurance companies, including the American Club, must submit to the insurance department of their domiciliary state at the end of every calendar quarter. At the end of every calendar year, each company must submit a comprehensive set of financial statements known variously as the "Annual Statement", "the yellow book", "the blank" or "the Convention statement".  These statements are due on March 1, and they are one of the special curses of doing P&I business in the United States.

The Annual Statement must be prepared in accordance with statutory accounting principles which are designed to show the value of the company, not as a going concern, but as if it had stopped doing business on the statement date. Regulators refer to "the liquidation basis" of their accounting principles, as opposed to "the going-concern basis" of GAAP. Accordingly, some of the rules concerning recognition of revenue are a little different from the rules governing other financial institutions.

GAAP financials

GAAP financials are financial statements prepared in accordance with generally accepted accounting principles.  Because the American Club has to comply with U.S.GAAP, its statements may look slightly different from those prepared by the European Clubs, but the rules are largely the same.  These are the financial statements that are distributed to members and brokers every year, and are the statements which the brokers use in preparing their reviews of the Club.

GAAP financials are based on the assumption that the company will continue in business for a "reasonable period", defined in SAS 59 as not to exceed one year from the balance sheet date. This going-concern assumption is fundamental to accrual accounting; among other things, it justifies the current and non-current classification within the balance sheet, the allocation of costs over periods benefited, historical cost accounting, and most aspects of the revenue recognition and matching principles.

statutory vs. GAAP accounting

The principal difference between statutory and GAAP accounting, as it affects a P&I Club, concerns the recognition of revenue from supplementary calls that were unbilled as of the statement date ("unbilled calls").  Such calls are not generally recognized under statutory accounting, because they are inchoate; the Club may have the power to levy them, and deficits in open years may show that they are necessary, but as long as they have not been billed, they will not be recognized as revenue as of the statement date.

GAAP is more liberal; as long as the Club plans to levy supplementary calls within a year of the statement date, and has a track record of collecting its calls, revenue from unbilled calls can be recognized, "with a haircut", as the auditors say.

This is the main reason that American Club's statutory financials as of December 31, 2003 are not as rosy as the GAAP financials.  The large supplementary calls (in the neighborhood of $30 million) announced in June 2004 can be booked as an asset as of December 31, 2003 in the GAAP financials. They cannot be fully booked in the statutory financials as of that date, although the regulators do permit the American Club to book unbilled calls to the extent they are, in effect, collateralized by the difference between the present and future value of the Club's loss reserves.  (That figure was about $8.5 million in the 2002 Annual Report, and is around $12 million in the 2003 Annual Report.) No wonder S&P believes that "year-end 2003 GAAP capitalization will be substantially higher than statutory surplus."  

The 2003 Annual Report is now available (1 Oct 2004) and the GAAP surplus is around $32 million compared to statutory surplus of $11.2 million. Look at footnote 10 to the 2003 Annual Report for the reconciliation.

The other reason has to do with reinsurance recoverables. Statutory accounting imposes a penalty ("the Schedule F penalty") for unsecured reinsurance recoverables and receivables that are more than 90 days old. Although the managers do their best to keep this penalty to a minimum, there are times when a substantial hit to surplus cannot be avoided. (It was around $4 million at the end of 2002.)

risk-based capital ("RBC")

Risk-based capital is a method developed by the National Association of Insurance Commissioners ("NAIC") to measure the minimum amount of capital ("the RBC amount") that an insurance company needs to support its overall business operations. RBC is used to set capital requirements considering the size and degree of risk taken by the insurer. Four major categories of risk are measured to arrive at an overall RBC amount. These categories are: Asset Risk - a measure of an asset's default of principal or interest or fluctuation in market value as a result of changes in the market. Credit Risk - a measure of the default risk on amounts that are due from policyholders, reinsurers or creditors. Underwriting Risk - a measure of the risk that arises from under-estimating the liabilities from business already written or inadequately pricing current or prospective business. Off-Balance Sheet Risk - a measure of risk due to excessive rates of growth, contingent liabilities or other items not reflected on the balance sheet.

authorized control level

This refers to the level of statutory surplus at which the regulators may step in and take action to restore the company's surplus to a satisfactory level. For property and casualty insurers, it is currently defined as 50% of the RBC Amount.

Although this sounds dire, all it means in practice to a P&I Club is that the regulators will recommend that the Directors levy supplementary calls to cure the deficits in the open underwriting years, if they have not already done so by the time the regulators realize it's necessary.  Clearly, S&P, secure in the knowledge that the Club had levied the calls the regulators would deem necessary, was not overly concerned that the Club's statutory surplus at year-end 2003 dropped below the authorized control level.

To put this in perspective, give the American Club a break. Would anyone care if Gard ran into technical problems with the Norwegian authorities?