Greetings!

In this edition of Insurance Perspectives, we discuss the AICPA’s new guidance regarding internal control reporting to insurance regulators, strategic options for the handling of troubled insurers, the SEC’s preliminary views on IFRS, and NAIC guidance to insurance companies and regulators about Federal laws on insurers’ hiring of felons. In addition, Invotex announces new alliances to assist with internal control reporting as well as a series of upcoming speaking engagements.

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Tom Finnell
Managing Director

Jim Stangroom
Managing Director

In this Issue

1. AICPA Issues New Guidance Regarding Internal Control Reporting to Insurance Regulators
2. Troubled Insurance Companies – Making the Best of a Bad Situation
3. The SEC Is Back On the Road to IFRS
4. Be Careful Who You Hire – NAIC Revises Guidance on Violent Crime Control and Law Enforcement Act
5. Max McGee and Interactive Solutions LLC Team up with Invotex on Regulatory Internal Control Reporting and More
6. Upcoming Speaking Engagements

AICPA Issues New Guidance Regarding Internal Control Reporting to Insurance Regulators
by Jim Morris

A new AICPA auditing publication, A Statutory Framework for Reporting Significant Deficiencies and Material Weaknesses in Internal Control to Insurance Regulators, released by the AICPA’s NAIC/AICPA Task Force on February 8, 2010, offers guidance to insurance companies and their independent auditors with respect to the reporting of internal control weaknesses identified during the course of an audit of an insurer’s statutory-basis financial statements. Since much of the previous guidance was issued on an informal basis, this publication formally addresses technical deficiencies in the prior NAIC Model Audit Rule (MAR) while also providing valuable advice on bridging the gap between its requirements and those of the NAIC’s new Annual Financial Reporting Model Rule (AFRMR), which is intended to become effective for statutory reporting periods ending during 2010. Due to the impending transition to the AFRMR, this guidance is intended to serve as a bridge for the reporting periods between MAR and the adoption of AFRMR; therefore, it applies to audits of 2009 financial statements and may apply in later years with respect to any states, if any, that have not adopted AFRMR by then.

For example, Section 11 of the MAR specifically references Statement on Auditing Standards (SAS) No. 60 for definitions and guidance on complying with its requirements relative to communicating internal control issues identified during the course of the statutory audit. However, SAS No. 60 was replaced in 2006 when the AICPA issued SAS No. 112 and then SAS No. 112 was in turn superseded in December 2008 by SAS No. 115. These superseded auditing standards were updated to ensure the guidance regarding communications of internal control issues conformed with the requirements of the PCAOB’s auditing standards. This new guidance clarifies references and definitions of significant deficiencies, material weaknesses and remediated deficiencies or weaknesses consistent with SAS No. 115.

The new publication also clarifies exactly what must be included in the communication to the domiciliary state insurance department. Section 11 of MAR instructs external auditors to report all significant deficiencies or material weaknesses identified during the audit, except for those that have no impact on statutory reporting. This auditor communication must include, or be accompanied by, information provided by the insurer’s management regarding the remediation activities that have been or will be implemented to mitigate those deficiencies or weaknesses. Perhaps the most important aspect of the new AICPA publication is that it codifies that only those significant deficiencies or material weaknesses at the insurance entity statutory reporting level that remain unremediated as of the reporting date should be included in the auditor’s communication to insurance regulators. The AFRMR also contains language specifying that only unremediated weaknesses need be reported, but the AFRMR is not effective until audits of 2010 financial statements. The new publication looks to step in to fill this void and provide a uniform set of interim guidelines.

The following is a summary of other guidance provided by the publication:

• The starting point for the evaluation of communicating control deficiencies should be the comprehensive list of significant deficiencies and material weaknesses prepared at the consolidated level.
• Those significant deficiencies and material weaknesses that do not have any impact on statutory reporting (i.e., are relevant to GAAP reporting only) can be eliminated from the listing.
• Those significant deficiencies and material weaknesses that do not relate to an insurance entity (i.e., are related solely to a banking or other non-insurance affiliate) can be eliminated from the listing.
• Any internal control weaknesses that were not classified as significant deficiencies or material weaknesses due to lack of materiality at the consolidated reporting level that are nonetheless material to the statutory insurance entity should be added to the listing for consideration.
• Any significant deficiencies and material weaknesses identified that were fully remediated at or before the statutory reporting balance sheet date do not need to be included in the communication. In these instances, the external auditor should use the appropriate form of report similar to that provided in SAS No. 115 but make appropriate modifications to indicate that the matters being reported are only those that existed as of the balance sheet date.

The new guidance includes illustrative reports for communicating control deficiencies to insurance regulators. We recommend that finance, accounting and audit professionals who work within the insurance industry become familiar with this updated guidance to ensure compliance with auditor and management requirements for internal control reporting to insurance regulators. We further recommend that audit committees be informed of this publication as part of their internal control oversight role.

For more information, contact Jim Morris.

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Troubled Insurance Companies – Making the Best of a Bad Situation
by Kerby Baden

While state insurance regulators have well-developed receivership statutes and practices to handle impaired and insolvent insurers, a new landscape has emerged with a growing number of troubled insurers looking to engage in run-off or restructuring mechanisms as an alternative to being placed in traditional receivership proceedings. With little existing guidance on the matter, in 2007, the NAIC’s Receivership & Insolvency Task Force initiated a study of alternative mechanisms and related best practices. A Restructuring Mechanisms for Troubled Insurers Subgroup (“Subgroup”), composed of regulators involved in the solvency monitoring process as well as the receivership process, was formed.

The Subgroup recently completed its study, which is documented in an NAIC white paper entitled, Alternative Mechanisms for Troubled Companies. The paper discusses approaches and concepts that are available within and outside the United States to assist regulators with assessing possible alternatives for handling troubled insurers. Currently, the Subgroup and the Committee have approved the white paper. The NAIC’s Executive Committee and the Plenary Group will meet at the March 2010 NAIC National Meeting in Denver to determine whether it should be formally adopted.

Several potential advantages discussed in the white paper for utilizing alternative mechanisms are that (1) they can potentially lead to a quicker resolution than a traditional receivership, (2) they typically allow for continuous claim payments and orderly claims processing without interruption, and (3) they can be less costly than receiverships, which, therefore, can result in larger payments to policyholders / claimants.

However, the white paper also mentions some potential disadvantages for these mechanisms, including that (1) these plans may be an option for solvent insurers to transfer value away from policyholders; (2) the cost of efficiency of an alternative mechanism may come at the expense of the policyholders or insurers; and (3) insurers may become insolvent even as they continue run-off or restructuring activities, which, in turn, could result in preferential payments being made at the expense of priority claims in liquidation.

As state insurance regulators consider whether an alternative mechanism scheme is appropriate for a particular insurer, care must be taken to ensure this approach stays within the context of the overall policy objective behind each alternative. The current regulatory system, which utilizes liquidation and guaranty fund protection, reflects a legislative policy that places the rights of policyholders and claimants over the interests of the investors and general creditors of the insurer. A plan that provides for a perceived quicker and less costly resolution to a troubled insurer must be balanced with maintaining the policy protections the policyholder expected when the policy was purchased from the insurer.

In this period of economic uncertainty and with a possible increase in federal oversight of the insurance industry being debated, it appears the NAIC and the states are taking a proactive step in getting ahead of potential problems by encouraging and working with troubled insurers to achieve an acceptable solution that can benefit the insurer while at the same time remaining true to the state’s mandate of keeping the interests of the policyholders front and center.

For more information, contact Kerby Baden.

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The SEC Is Back On the Road to IFRS
by Jim Stangroom, Tim Foley and Jenny Divver

On February 24, 2010, the SEC unanimously approved the release of a formal Statement reaffirming the Commission’s support for a single set of globally accepted accounting standards and acknowledging that IFRS is best positioned to be that set of standards. It seemed that during 2009 the SEC had taken a detour on the Roadmap it proposed in November 2008, but it now appears that the SEC has regained its bearing. The 2008 SEC Roadmap included a timeline for the Commission’s adoption of IFRS; however, almost immediately following the SEC’s release of the Roadmap, a new SEC Chairman took charge and there were questions about both whether and when the SEC might commit to IFRS. This recent SEC Statement takes an important step towards answering those questions.

To definitively answer those questions of whether and when, the SEC directed its staff to develop and execute a Work Plan to consider the comments received from investors, issuers, accounting firms, regulators and others regarding the Roadmap. The 2008 Roadmap established 2011 as the timeframe for the SEC to decide on whether to require adoption of IFRS in 2014. This recent Statement reaffirms 2011 as the target timeframe for the SEC’s decision; however, the SEC acknowledged the magnitude of the task involved for U.S companies to convert to IFRS and stated that 2015 or 2016 would likely be the earliest that U.S companies would report under IFRS. As part of the Work Plan, this timeframe will continue to be evaluated.

The Statement indicates that the success of the ongoing FASB and IASB convergence projects are critical factors in allowing the SEC to make its decision regarding U.S adoption of IFRS in 2011. In past editions of Insurance Perspectives, we have described some of the controversy surrounding both the insurance contracts and financial instruments projects of the FASB and the IASB. Serious conceptual differences exist between the two Boards on these projects which are of most importance to insurers, and convergence will not be easy to achieve.

The Work Plan notes that IFRS lacks broad guidance for certain industries, such as insurance. Some fear that this lack of guidance could result in an increase in shareholder lawsuits regarding their use of judgment in the application of the standards. The SEC plans to identify areas where additional IFRS guidance may be needed to help alleviate the concern that individual companies, applying their own interpretation of the standards, could lead to a lack of comparability among financial statements of different companies. It bears watching whether or not any such additional accounting guidance emerges from the SEC Work Plan. If so, it could be the first inkling that the supposed principles-based concept of IFRS could, over time, develop into a rules-based body of accounting standards resembling the U.S. GAAP framework.

Further compounding the issue of comparability among financial statements is the concept of “dual-GAAP” whereby financial statements could be prepared under a different basis for private companies (U.S. GAAP) than for public companies (IFRS). A potential third method of reporting is the recent development of a separate set of IFRS for application specifically to small and medium sized entities (“SMEs”). These SME standards were issued in 2009 and contain simplified rules for the recognition and measurement of account balances and fewer disclosures than full IFRS. Understanding three methods of financial reporting is confusing enough for those experienced in accounting and reporting, not to mention investors attempting to extract and compare information from financial statements. The potential for three financial reporting methods appears to be a shift from the concept of transparency and comparability, which shareholders and other users of financial statements have demanded in the wake of recent accounting scandals. Another issue affecting comparability is the concept of jurisdictional variations among countries in the application of IFRS. Local historical approaches and cultural differences among the many countries using or adopting IFRS will inevitably result in financial statements which may be incomparable. As part of the Work Plan, ways to improve comparability of the financial statements prepared across borders will be considered.

The Work Plan indicates that these issues and many more will be further analyzed with the hopes of making the transition to IFRS as smooth as possible. The SEC staff will provide public progress reports on the Work Plan beginning no later than October 2010 and frequently thereafter until the work is complete. We have expressed our views in past editions of our Insurance Perspectives newsletter that implementation of IFRS will be an enormous effort, and companies are wise to stay abreast of these developments and monitor the SEC’s progress. Even non-SEC registrants will likely be affected if IFRS becomes the predominant set of accounting standards, and if so, there will likely be repercussions for insurance statutory accounting.

For more information, contact Jim Stangroom or Tim Foley.

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Be Careful Who You Hire – NAIC Revises Guidance on Violent Crime Control and Law Enforcement Act
by Jim Gordon

The NAIC is proposing amended guidance on federal legislation passed in 1994, the Violent Crime Control and Law Enforcement Act (the Act) which included several insurance-related fraud provisions now contained in 18 USC Section 1033 and 1034. In addition to creating five classes of insurance-related crimes, Section 1033 prohibits an individual who has ever been convicted of a felony involving dishonesty or breach of trust or any of the crimes identified in Section 1033 from willfully engaging in the business of insurance unless he or she first obtains the approval of the insurance commissioner of the state with regulatory control over his or her activities. This Section provides for penalties, both civil and criminal, including incarceration for the felon but also subjects the insurer or other individuals if they knowingly employ or engage the felon in the business of insurance.

The Act provides a mechanism for an insurer to seek the written consent of the state insurance commissioner for a “waiver” so that the company may hire a “prohibited person.” The burden is upon the applicant to establish that written consent is warranted. The purpose of the waiver procedure is to provide such a prohibited person an opportunity to demonstrate that he or she is fit to participate in the business of insurance without constituting a risk to consumers or insurers.

In 1994 the NAIC adopted guidelines for state insurance regulators to assist in their efforts in interpreting the Act. It is clear from these guidelines that insurance agents, brokers, third party administrators and reinsurers, whether foreign or domestic, are deemed subject to the Act so long as their activities affect interstate commerce. What is not as clear is which felonies are crimes involving dishonesty or breach of trust. The NAIC is proposing some revisions to its guidance on this issue which suggests that states should use the definitions used by the FDIC. The courts seem to have adopted a “you know it when you see it” test.

The Act does not provide for a “safe harbor” for prohibited persons hired prior to its effective date. Insurers should have procedures in place to seek this information when they hire any employee or enter into a business relationship with any agent, broker, third party administrator or reinsurer. Failure to do so can result in serious penalties.

For more information, contact Jim Gordon.

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Max McGee and Interactive Solutions LLC Team up with Invotex on Regulatory Internal Control Reporting and More
by Tom Finnell

Invotex is pleased to announce that Max McGee and Interactive Solutions LLC have teamed up with Invotex to assist insurers in meeting regulatory requirements pertaining to reporting on internal controls as well as other regulatory risk exposure areas for insurers. Together, we provide an integrated service offering that is steeped in industry knowledge, regulatory insight, and proven expertise in internal controls across financial and IT operations.

For more than 35 years, Max McGee held a variety of posts at Prudential Insurance Company, culminating in roles overseeing this leading insurer’s statutory accounting reporting operations as well as its relationships with state insurance departments and the NAIC with respect to financial matters. For years he has also served as one of the lead industry representatives before NAIC working groups as they have addressed various key issues. Such issues have included changes to the NAIC’s Model Audit Rule that culminated in the new Annual Financial Reporting Model Regulation (AFRMR); Risk-Based Capital requirements relating to Securities Lending activities; risk-focused examinations; various statutory accounting issues; and much more. Now President of Max McGee Consulting LLC, Max will provide his extensive industry experience in helping clients address regulatory issues, particularly as they relate to the new AFRMR.

Interactive Solutions LLC is a Philadelphia-based consulting firm that specializes in controls and risk management, particularly with regard to Information Technology operations. In the insurance space, the firm has provided services to more than 15 insurers including BlueCross BlueShield plans in helping to prepare for compliance with the AFRMR’s new requirements and has partnered with Invotex in providing IT support on risk-focused examinations.

Invotex also has experience with the AFRMR, in assisting insurers with its requirements, as well as in assisting state insurance departments in incorporating changes to examination procedures in light of an insurer’s efforts to comply with the AFRMR. In 2005, Tom Finnell was engaged by the National Association of Mutual Insurance Companies to prepare a cost-benefit analysis of the then-proposed changes to the NAIC’s Model Audit Rule as the NAIC had proposed changes comparable to the Sarbanes-Oxley Act of 2002 pertaining to financial reporting and controls. Benefiting from Tom’s study, NAMIC and other industry representatives were successful in obtaining key changes to the final rule that helped to mitigate concerns of the industry over implementation costs, saving tens of millions of dollars. Those changes were to (1) eliminate the need for an independent auditor’s attestation relating to management’s assertions about internal controls; (2) increase the threshold for application of the internal control reporting requirements to insurers from $25 million to $500 million of premiums; and (3) allow management discretion as to the manner in which existing documentation is used to support their assertions regarding internal controls.

For more information as to how our team can help your company with regulatory internal control reporting requirements and more, contact Tom Finnell.

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Upcoming Speaking Engagements

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