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IV. CONDUCTING EXAMINATIONS

This section covers procedures and considerations that are important when conducting financial condition examinations. The discussion here is divided as follows:

A. General Examination Procedures B. Examination of Computer-Based Operations C. Sampling D. Using the Work of an Outside Specialist E. Reinsurance F. Uniform Accounting for Insurers G. Managing General Agents H. Custodial or Safekeeping Agreements I. Use of Independent Certified Public Accountants (CPA) on Multi-state Examinations

A. General Examination Procedures

Summary

Certain general procedures, many of which do not result from a SRA, should be considered on all examinations. The examination program should include a section that explains the nature and extent of these general examination procedures. This part of the handbook addresses the following subjects, which are applicable to most examinations:

1. 2 . 3. 4. 5. 6. 7. 8.

Review of General Ledger and Journal Entries Review of Minutes of Board of Directors and Committee Meetings Review of Subsequent Events Review of Affiliated Transactions Review of CPA Workpapers Working with Internal Auditors Letters of Representations Examination Review Responsibilities

1. Review of General Ledger and Journal Entries

The examination team should review the general ledger, all Significant nonstandard journal entries, and any company workpaper entries made solely to prepare the annual statement. This review's purpose is to identify any Significant or unusual postings from unfamiliar sources, and other unusual entries that might not have been identified through other audit procedures (e.g., the purchase and sale of a significant block of business in the same year).

This review should be performed by an individual sufficiently familiar with the recurring journal entries and other posting sources so that unusual items will be detected. It usually is beneficial to set a dollar limit below which entries need not be investigated.

2. Review of Minutes of Board of Directors and Committee Meetings

The examination team should read the minutes of all meetings of the Board of Directors, shareholders, and executive and other important committees for the entire examination period through the end of fieldwork. Matters affecting the annual statement should be cross-referenced to the appropriate workpapers .

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As to any recent meetings for which minutes have not yet been prepared, examiners should ask management about matters dealt with at such meetings and request and review written summaries of • actions.

3. Review of Subsequent Events

Some events or transactions that occur after the balance sheet date may have an important bearing on the financial statements. The "Review of Events Subsequent to the Balance Sheet Date" checklist (Exhibit G) covers the procedures that should be used in all examinations.

4. Review of Afflliated Transactions

There are two broad categories of affiliated transactions:

a. Transactions having implications as to potentially misleading presentation of the annual statement. Such transactions frequently have involved questionable dealings, including management fraud. This type of afflliated transactions occurs infrequently but constitutes a very difficult area.

b. Transactions occurring in the ordinary course of business are considered afflliated transactions only because of an existing relationship between the transacting parties.

This section provides guidance for identifying and examining affiliated transactions.

Generally, examiners are more concerned with detecting and disclosing those affiliated transactions in the first category than with those affiliated transactions that are transacted in the ordinary course of business. Even though the greatest exposure is focused on only a relatively few affiliated transactions, procedures are performed to encompass the broad definitions of afflliates and afflliated transactions .

a. Affiliates Defined

Afflliates exist when there is a relationship that offers the potential for self-dealing, transactions at less than arm's length, favorable treatment, or the ability to direct the outcome of events differently from what might result in the absence of that relationship.

Some examples of afflliates are:

• A company's affiliates • Principal owners • Management (including directors) • Entities for which investments are accounted for by the equity method • Pension and profit-sharing trusts managed by or under the trusteeship of

management

An affiliate also includes any other person with which the reporting entity may deal if one party controls or can significantly influence the management or operating policies of the other to an extent that one of the transacting parties might be prevented from fully pursuing its own separate interests. A third person also is affiliated if it can significantly influence the management or operating poliCies of the transacting parties or if it has an ownership interest in one of the transacting parties and can significantly influence the other to an extent that one or more of the transacting parties might be prevented from fully pursuing its own separate interests.

b. Afflliated Transactions Defined

An affiliated transaction is any direct or indirect transaction between the reporting entity and an affiliate. Afflliated Transactions include transactions between:

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A parent company and its subsidiaries Subsidiaries of a common parent The reporting entity and: • Other affIliated businesses • Management (including directors) • Principal owners

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• Pension and profit-sharing trusts managed by or under the trusteeship of management

• Other parties having the ability to exert Significant influence

AffIliated transactions also may include other transactions in which the reporting entity may not appear to be involved. Identifying these affIliated transactions is frequently difficult, if not impossible, because (1) examiners ordinarily must rely on oral representations to obtain an awareness that a relationship exists and a transaction has occurred; and (2) the parties to the transaction may be adverse to disclosing the motives, facts, and circumstances surrounding the transaction.

Transactions that, after study, cannot be understood as to their apparent motivation or appear to be commercially unreasonable raise the presumption that affiliates exist.

Where subtle affIliated relationships are known or believed to exist, examiners should perform procedures to determine whether affIliated transactions classification is appropriate. Although oral representations of management or others often are required to understand the business purpose of the transaction, such representations should be evaluated in light of apparent motives and the weight of other evidence. Important oral representations should be confirmed in writing either in the letter of representations or in a separate letter .

There are a number of conditions that may create motivation for affiliated transactions, which are designed to alleviate or forestall circumstances management perceived would adversely affect the company. Some examples are:

• Lack of sufficient surplus to continue the business. • An urgent desire for a continued favorable earnings record in the hope of

supporting the price of the company's stock. • An overly optimistic earnings forecast. • Dependence on a single or relatively few products for the ongoing success of the

company. • Significant litigation, especially between shareholders and management.

Absent contrary circumstances, transactions with affiliates should not be assumed to be outside the ordinary course of business. However, affiliated transactions are occasionally deliberately obscured by using devices such as business structure or management operating style.

Circumstances such as these should increase the examiner's skepticism of a management that may be determined to attain its objectives regardless of the means required to do so.

c. Affiliated transactions with Partial or No Accounting Recognition

Transactions by or among affIliates are considered to be affiliated transactions even though they may be given partial or no accounting recognition. For example, an entity that provides significant services to an affiliate without charge, or at charges that do not appear normal, may be involved in an affiliated transaction.

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d. Affiliates But No Transactions

Sometimes two or more entities are under common ownership or management control, but do not • transact business between or among themselves. The mere existence of common control may result in operating results or financial position significantly different from what would have occurred if the entities were autonomous. For example, two or more entities in the same line of business may be commonly controlled by a party with the ability to increase or decrease the volume of business done by each (i.e., the ability to exercise significant influence over the operations of each entity).

e. Typical Examination Procedures

The following examination procedures typically are considered to identify afTtliates and afflliated transactions.

• The review and evaluation of internal accounting control and an understanding of the entity's business and operating environment should be sufficient to recognize whether significant transactions are occurring and are not being given accounting recognition. Examples: a company provides accounting and management services to an affiliate at no charge; a major shareholder absorbs corporate expenses.

• Determine and evaluate the entity's procedures for identifying and properly accounting for affiliated transactions.

• Determine and evaluate the entity's procedures, if any, that prohibit individual directors or other members of management from exercising significant influence over transactions in which that person is an affiliate.

One means used by many entities to preclude such significant influence is to prohibit a director or other member of management from voting or otherwise participating in any business decisions in which that individual is an affiliate.

In some cases, an affiliate may have participated in a business decision and it may not be practical for the board to reconsider a previously approved transaction solely so that person can abstain from voting. In these instances, it usually is acceptable to obtain written representation from appropriate management and the affiliate that significant influence was not exercised, provided that by reference to the entity's minutes or otherwise, the examiners are able to satisfy themselves that the affiliate's vote does not influence the outcome of the board's decision (e.g., the resolution was unanimously approved).

If examiners have been unable to satisfy themselves as to the absence of significant influence, or conclude that a relationship or transaction merits attention of the board of directors, they may recommend subsequent reconsideration of an issue by the board of directors, with any affiliates abstaining from voting.

The following procedures provide an approach for detecting abuses that sometimes result from holding company or affiliated relationships.

Potential abuses:

(1) Misuse of insurance company assets through:

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Shifting assets (particularly securities) from one affiliate to another for window-dressing purposes during examinations or at the fmancial statement date; Making unsecured loans or advances to afflliates;

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Maintaining compensating bank balances for the benefit of an affiliate; Making inappropriate loans to affIliates or purchases of affIliate securities; or, Pledging assets to secure loans for affiliates.

(2) Siphoning of insurance company funds through:

i. Dividends; ii. Management or service fees; iii. Payment of exorbitant reinsurance premiums to affiliates; iv. Inappropriate payment of the expense of affiliates; or, v. Misdirection of premiums or commissions to affIliate insurance

companies or agencies.

(3) Other forms of misrepresentation:

i. Creating nonexistent receivables due from affIliates for window-dressing purposes during examination, or at the financial statement date;

ii. Assuming the liabilities by/for an affiliate.

Techniques for deterring abuses:

(1) (2)

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Examine affIliates simultaneously; Appoint an affiliate coordinator for large or diffIcult examinations. The coordinator should be an experienced examiner and capable of supervising others. The coordinator may be either the examiner-in-charge or, in the case of a very large group, an examiner appointed by the examiner-in-charge; The coordinator's duties include: i. Reviewing and verifying the propriety of all legal documents (supplied

by management) supporting inter affIliate agreements or transactions (e.g., management or service contracts, guarantees or pledges of assets, intercompany loan agreements, agency contracts, inter affIliate reinsurance contracts, and current reports to the Securities Exchange Commission) ;

ii. Where necessary, coordinating the investigation of intercompany transactions with the teams that are examining other affiliates;

iii. Compiling a list of all entities that are affiliated with the company -together with an organization (intercompany) chart - including:

• Any company holding a controlling interest in the company being examined;

• Companies that are controlled by a common holding company; • Companies in which a director or offIcer has a substantial

interest; and, • Companies controlled by the company being examined.

iv. Supervising the examiners in the investigation of inter affiliate relationships.

(4) Define the duties of the examiners which include:

i. Develop a list of all significant inter affiliate transactions or balances encountered during the selection and evaluation of data used in the examination of the individual balance sheet accounts and evaluate compliance with appropriate insurance laws.

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The list should show:

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Nature of the transaction (or balance); Amount; Date of transaction; and, Record (and page number) from which the sample was taken.

If many transactions of a particular type occur - e.g., premium transactions between the company and an affiliated agent - select sample transactions to be included in the inter affiliate transaction list.

(5) Investigate the propriety of inter affiliate transactions and balances that have been identified.

Guidelines for investigating inter affiliate relationships affecting individual balance sheet accounts:

(1) Cash:

(2)

i. Determine whether transfers to affiliate bank accounts and cash disbursements to affiliates are supported by legitimate arm's length transactions. Many of the abuses listed above can be detected through careful examination of inter affiliate cash transactions.

ii. If the company maintains large balances in banks that also serve affiliates, verify that the company is not supplying compensating balances for the benefit of the affiliate.

Securities:

i. Check for illegal transfers. Possession of bearer bonds or securities registered in the name of any entity other than the company is a possible indication of the illegal transfer of securities for window-dressing purposes. To detect illegal transfers:

• Examine logs to determine who had access to company and custodian-held securities;

• Confrrm registration with issuing entities; • Check securities transaction records for the period immediately

preceding the examination; and, • Compare transfer prices with prevailing market prices of the

transfer date.

ii. Investigate all securities that may represent pledges of assets for the benefit of an affiliate.

(3) Dividends:

i. Evaluate the effect of dividends paid to a holding company on the fmancial condition of the affiliate.

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