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In this edition of Insurance Perspectives, we take a look at the future of U.S. GAAP, discuss the adequacy of insurance company surplus, address changes in accreditation standards and put 2009 to rest.

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Tom Finnell
Managing Director

Jim Stangroom
Managing Director

In this Issue

1. U.S. GAAP: It's Not Dead Yet
2. Insurance Company Surplus: How Much is Enough, and How Can Insurers and Their Regulators be Sure?
3. Insurers and Investors Beware: States are Tightening Standards on Reviews of Company Licensing and Changes in Control
4. Requiem for 2009

U.S. GAAP: It's Not Dead Yet
by Tim Foley

The obituary for U.S. GAAP was written more than a year ago as the fate of those accounting principles was all but sealed with the anticipated adoption in the U.S. of International Financial Reporting Standards (IFRS). However, with new obstacles emerging and the SEC’s self-imposed deadline of next year to decide whether or not to adopt IFRS, it now seems more plausible that convergence with, rather than conversion to, IFRS will be the more likely outcome.

The standard-setters have made significant progress in their convergence efforts. Yet, more recently, they have encountered obstacles that make it apparent that complete convergence may not be feasible. Moreover, these obstacles stand as a serious challenge to the notion of outright conversion from U.S. GAAP to IFRS. These obstacles include:

• The ongoing struggle to develop a fair value standard that satisfies the needs of all financial statement users;
• Divergent views on fair value by the FASB and the IASB;
• The perception that fair value accounting standards contributed to the financial/credit crisis; and
• Political maneuvering by the European Union and U.S. Congress that threaten the independence of their respective accounting standard bodies, i.e., the IASB and the FASB.

It is clear that a single set of high quality accounting standards is a worthy goal embraced by governments, standard-setters, companies and practitioners around the world. The current lack of U.S. commitment to IFRS conversion remains the main obstacle to achievement of that goal. But what is also clear is that despite the espoused benefits of IFRS conversion, many concerns of U.S. policymakers remain that must first be addressed and reconciled.

The IASB and the FASB met in late October 2009, culminating in a joint statement reaffirming their commitment to convergence on major topics by June 2011. This statement was consistent with the approach called for by the G-20 nations and set forth how they planned to achieve converged solutions for financial instruments, including milestones to measure progress. The two boards will continue to meet monthly, and a new Monitoring Board will handle concerns regarding the potential that the FASB and the IASB may reach different conclusions on major projects.

Despite this harmonious appearance, signs of discord are developing. Concerns on both sides of “the pond” have been expressed by legislators and accounting standards-setters, including with respect to the following:

• Lawmakers in both the U.S. and Europe are intervening in the accounting standard-setting process thus threatening the independence of both the FASB and the IASB. Indeed, a proposal by Rep. Ed Perlmutter, D-Colo, would amend the Financial Stability Improvement Act of 2009 to remove responsibility for accounting standards and oversight of the FASB from the SEC and place that with other federal agencies.
• Whether there is adequate accountability and governance over the IASB, an issue of prime importance as the U.S. considers whether to move to IFRS.
• There are significant concerns over the role of current value accounting as a contributing factor to the economic crisis; moreover, some rifts are developing between the FASB and the IASB over what exactly the IFRS standards for current value accounting should be.

In the meantime, the silence from the SEC about its further plans with respect to the IFRS has been deafening. While further action by the SEC is anticipated early this year, there is much less assurance that conversion to IFRS and elimination of U.S. GAAP altogether will be the outcome.

For more information, contact Tim Foley.

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Insurance Company Surplus: How Much is Enough, and How Can Insurers and Their Regulators be Sure?
by Tom Finnell

The question of capital and surplus adequacy has hounded insurers as long as they have been in existence. The credit/economic crisis, recent international developments, and enhancements in modeling and supportive technologies are among the confluence of events that are bringing insurers and regulators toward a more certain answer to that age-old question. Moreover, the time-frame during which that may occur is shorter than many may realize.

The NAIC’s Capital Adequacy Task Force is working on a number of items that would lead to a more definitive analysis of capital and surplus adequacy. These include the development of a standard for risk in terms of a confidence interval and time horizon that would establish a minimum regulatory capital standard; a description of all relevant and material risks and how they are incorporated into both reserving standards and the risk-based capital formula; how, if at all, regulatory capital would differ from economic/target capital; and the development of more advanced approaches that could include the use of internal models and company-specific assumptions.

While year-end 2011 has been mentioned as a possible date by which these initiatives will be completed by the Task Force, it is likely that at least some will take more time. Exactly when they will be completed is unknown; but the point remains that a stake has been placed in the ground, agenda items have been prepared, and we can anticipate tangible developments in the near term.

The relationship between the financial strength of an insurer and its ability to withstand both anticipated and unanticipated risks has long been recognized by the industry, its regulators, rating agencies, brokers, informed consumers, and others. The manner in which that relationship has been addressed has changed dramatically over time. In fact, risk management by insurers is still very much an evolving area for which many hard lessons are still being learned. For example, insurers have had to react to the adverse effects wrought by the recent credit crisis and ensuing recession and the efforts at the federal, state and NAIC levels to consider necessary marketplace, financial reporting and regulatory reforms.

For many years and through the 1980s, insurers were largely subjected to static minimum capital and surplus requirements. A flat amount typically would be required for an insurer to become licensed, and varying other flat amounts might be required, depending on the lines of business it was authorized to write. A more sophisticated regulatory requirement to evaluate surplus based on the unique risk profile of each company simply did not exist in those days.

Low and static capital and surplus requirements, combined with the effects of business practices of some insurers and other deficiencies in regulation resulted in a spate of insurer insolvencies in the late 1980s, initially related primarily to property/casualty insurers and then involving some larger life insurers in the early 1990s. These developments spawned investigations by the Federal Government. While a stronger federal role in insurance regulation was avoided, the result was increased activity by the states and by the NAIC to develop a stronger and more uniform system of state-based regulation.

The centerpiece of those efforts was the NAIC’s Financial Regulatory Standards Accreditation Program, an initiative that is still ongoing and evolving with further refinements to standards that are adopted and with which each accredited state is then expected to comply. Foremost among those regulatory standards at the time was the advent of risk-based capital requirements for insurers.

Risk based capital is a means by which the amount of capital and surplus of an insurer can be evaluated in large measure against its own risk profile. That profile considers the company’s size, the types of business it writes, its invested asset profile and other risk-related characteristics. For example, company-specific data for the reporting entity, such as the dollar value by classification of its investments in fixed maturities, are multiplied by various factors which have been determined and approved by the NAIC based on industry experience to derive an amount of capital deemed necessary to support the risks underlying those investments.

While RBC was a significant development in the financial regulation of insurers, it does have limitations which may be significant in interpreting the adequacy of capital and surplus for a particular company:

• While the RBC formula is based in part on company-specific reported amounts, they are applied against risk factors that are anchored in industry experience, which may prove to be quite different from the company’s ultimate experience.
• Although the RBC factors are based on past industry experience regarding adverse investment and underwriting cycles, there is no assurance that the industry’s future experience will be no worse than its past experience over relevant time frames. (Indeed, the recent credit crisis and recession has resulted in significant credit spread widening in late 2008, at unprecedented levels.)
• There are certain risks that do not necessarily lend themselves to modeling as part of a standard, industry-wide format and which therefore may not be adequately reflected in RBC, if at all. In particular, the following risks are currently not captured in the RBC formula: catastrophe risk, operational risk and the risk of spread widening for investments in bonds. Moreover, the NAIC’s RBC is not currently targeted toward a particular statistical level of safety (unlike Solvency II in Europe where the Solvency Capital Requirement would be defined as the amount of economic capital required to be held to limit the probability of ruin to 0.5%).

Nonetheless, the NAIC’s RBC initiative has enhanced the regulatory monitoring of the financial condition of insurers.

What others may do to evaluate an insurer’s surplus – the NAIC or rating agencies, for example – is quite important. However, what is far more important in our view is what a company and its board do to evaluate the adequacy of capital and surplus, to monitor changes in conditions that might impact that over time and to assure that the insurer remains not only viable but sustainable over the long haul.

In such evaluations, there is much more involved than simple reliance on regulatory or industry measures of capital and surplus. Enterprise Risk Management, or ERM, encompasses a wide range of activities and involves the board and key financial and operating personnel throughout the company. Key aspects of ERM include the following:

1. Risk identification and monitoring
2. Risk assessment and prioritization
3. Risk mitigation
4. Risk appetite determination
5. Risk aggregation, measurement and reporting
6. Overarching governance through senior-level committees and board involvement

ERM is very much an evolving practice and different insurers are at different places along the learning and experience curve.

Our view about the need for such company-specific models from a general perspective is that they are useful if not necessary, and increasing in prominence within the industry. Moreover, they are increasingly being considered as an integral part of the ongoing process to enhance state insurance regulation – as seen in the Working Agenda for the NAIC’s Capital Adequacy Task Force.

Note: Portions of this article are from the report by Invotex to the Maryland Insurance Administration relating to the surplus of the nonprofit health service plans of the CareFirst BlueCross BlueShield group.

For more information, contact Tom Finnell.

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Insurers and Investors Beware: States are Tightening Standards on Reviews of Company Licensing and Changes in Control
by Don Sirois

At the NAIC’s Winter National Meeting in San Francisco, the Financial Standards and Accreditation Committee (Committee) voted to release for comment proposed implementation guidance regarding new accreditation standards relating to company organization, licensing and changes in control that were adopted by the Committee earlier in 2009 to become effective in 2012. The implementation guidance includes revisions to existing documentation and new guidance related to these accreditation standards. Taken together, the goal of the new standards and implementation guidance is to make the state reviews of licensing and change in control filings a more thorough and rigorous exercise.

In 2000, the U.S. Government Accountability Office (GAO) issued a report entitled, “Insurance Regulation: Scandal Highlights Need for Strengthened Regulatory Oversight.” The GAO’s report criticized state insurance regulatory oversight and inadequate sharing of information amongst states with regard to the massive fraud perpetrated by Martin Frankel involving seven insurers in the 1990s. The scandal revealed a weakness in the program of solvency regulation in that there was an inadequate review process over the chartering and change in ownership of insurance companies. In response, the NAIC determined that state insurance departments should be required to exchange information with regard to requests for changes to the ownership and control of insurers. A second GAO report in 2001 entitled, “The NAIC Accreditation Program Can Be Improved” found that the program could be enhanced by adding licensing of insurers to the accreditation standards.

Prior to these standards being added to the accreditation program, the NAIC needed to finalize the development of the Company Licensing Best Practices Handbook, a process that was completed in 2005. The NAIC also developed a Form A Database to allow for the codification and sharing of insurers’ change of control information by the states. With these tools in place, the Committee could then consider potential standards to address the issues raised by the two GAO reports.

Once implemented, the new standards will close a weakness in the accreditation program by allowing NAIC accreditation review team members the ability to challenge the oversight applied by insurance regulators regarding company licensing and review and approval of changes in ownership of insurers. Detailed reviews of such filings are the key to assuring that only responsible and qualified individuals gain control of insurers.

For more information, contact Don Sirois.

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Requiem for 2009
by Tom Finnell

As one year lapses into memory and the sun rises on a New Year, it is an apt moment to reflect on what has been and what may portend for the future. When 2009 is finally etched into the history books, it may ultimately be viewed either as just a bad dream or a turning point that began the long journey toward a new age. On which side of that fencepost one sits may likely depend upon how well they fared throughout the credit and economic crisis.

As 2008 drew to a close, the U.S. had just witnessed the worst market performance in a century. The S&P 500 dropped 45% in 2008 before showing signs of an upward turn at the end of the year. But any hopes of recovery were quickly dashed; as calendar pages turned to 2009, the index took another 25% hit before bottoming out in early March. Since then, the markets have clawed their way back to levels not seen since October 2007. Nonetheless, the S&P 500 is still 25% below those highs and there remain many naysayers and pundits who insist that troubles still lie ahead.

The havoc created at many insurers was intense, fueled not just by declining equity portfolios but also by historically low interest rates, significantly widened credit spreads, severely limited access to new capital for months, seemingly over-conservative valuations of residential mortgage-backed securities, ratings downgrades, significant increases in the cost of hedging programs and much more. The somewhat unique and sweeping problems of AIG aside, it was otherwise the specialty insurers with ties to housing and credit markets that bore the brunt of the damage, including mono-line credit insurers, private mortgage insurers and title companies.

While P&C companies did not fare too badly, reserve redundancies for many have disappeared. Life and annuity writers operate with surplus that is much more highly leveraged than their P&C brethren and, as a result, they were hit harder with several deciding to accept TARP funds.

The problems wrought by the crisis led to the inevitable search for its causes, numerous allegations, investigations, and incessant calls for reforms. At the federal level, potential reforms include those relating to systemic risk oversight; changes to the powers of the Federal Reserve and other federal regulatory agencies; a proposed Consumer Federal Protection agency; an Office of Insurance Information; and more. Nonetheless, bills are stuck in Congress as partisan ambushes continue. And while the cries for reforms were deafening a year ago, with every day that passes there is increasing concern that the proposed reforms will be ineffective or too costly to taxpayers and businesses alike.

In the meantime, and with the worst of the crisis apparently in the rear-view mirror, financial regulatory reforms have now taken a back seat to healthcare reforms, with Democrats determined to move a bill forward within the next couple of months. The outcome (if any) of the debate over both financial and health care reforms will likely seal the fate of each party in the elections that will take place later this year.

At the state/NAIC level, the year began with the defeat of an industry “wish-list” of surplus relief measures at the hands of the NAIC’s Executive Committee. Nonetheless, many state insurance commissioners granted permitted practices to provide relief to their key domestic insurers. Then, at year end, the NAIC gave its blessing over two key measures. Changes to statutory accounting standards will ease the limitations on reporting of deferred tax assets with an estimated industry-wide increase to surplus of $10 billion, effectively converting prior permitted practices to NAIC-prescribed practices; and changes to the manner in which RMBS portfolios are evaluated will result in a reduction of capital requirements by approximately $6 billion.

To the credit of the insurance industry and its regulators, insurers were spared the worst of the crisis. While surplus dropped, it nonetheless did its job in serving as a sufficient backstop to fend off the worst of prospective risks. There have been few new insurance receiverships, certainly of any size. And while concerns lie ahead – for example, with respect to the valuations of holdings in commercial real estate and mortgages – there seems to be growing confidence that the situation is now more manageable.

Insurers are close to having achieved a year of relative stability and sanity since the devastating slide that ended last March. They have survived the most daunting, real-life stress test imaginable for their risk management programs. They are making needed improvements, reducing costs, managing through their issues, even raising capital in some cases, all accomplished through a very difficult period. As leaner and more focused players, they hope to receive their just rewards as market conditions continue to further stabilize and improve.

Our prognosis is that neither our economy nor our insurers are out of the woods yet and that 2010 will see some further improvement but not without some volatility of its own. As we recover, risk managers will have to be increasingly diligent as financial engineers develop new products; weave their way through new regulatory and accounting rules; deal with increasing complexity; and seek a risk tolerance that is appropriate and commensurate with their strategies and financial profile.

For more information, contact Tom Finnell.

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