Greetings!

In this edition of Insurance Perspectives, we discuss IFRS implementation, the outlook for NAIC and state regulatory reforms, and risk retention group capital adequacy tools. We also welcome a guest contributor who discusses changes to reporting on securities lending activities and present a series of upcoming speaking engagements.

As always, we welcome your feedback and invite you to share Insurance Perspectives with your colleagues and business acquaintances. If you do not currently receive our newsletter via e-mail, please subscribe at the left.

Tom Finnell
Managing Director

Jim Stangroom
Managing Director

In this Issue

1. IFRS Implementation? Don’t Forget About Controls!
2. Insurers Largely Unscathed From Regulatory Reforms at the Federal Level – Eyes Now Turned to the States and the NAIC
3. RRGs: Risk Governance Should Play a Role in Capital Adequacy Models
4. NAIC Mulls Changes to Securities Lending Accounting and Reporting
5. Upcoming Speaking Engagements

IFRS Implementation? Don’t Forget About Controls!
by Jim Morris

In February 2010, SEC Chairwoman Mary Schapiro resurrected the Commission’s consideration and discussion regarding the possible transition from GAAP to IFRS for registrants. While her comments did not offer a definitive timeline for the implementation and actually seemed to back off from the timeline previously announced by her predecessor, they did reestablish the likelihood that the transition may eventually become a reality.

There has been a maelstrom of activity within finance and accounting circles as corporate leaders have attempted to get a handle on the potential magnitude of the task that lies before them. Much has been said regarding the issues of immediate concern; however, there seems to have been little acknowledgement that this conversion will be implemented in the Sarbanes-Oxley era. This fact alone will add considerably to the complexity of the project.

Although it has been several years since the financial reporting world had to deal with implementing the requirements of SOX, it will be a long time before many of us will forget the resources that needed to be committed to ensure compliance. Only by considering the technical issues between the SOX and IFRS implementations can one truly get an understanding and appreciation for the complexity of the task that lies before us.

More specifically, consider that for many organizations the SOX implementation was mostly an exercise in creating documentation and formalizing evidence of financial reporting controls that were already in place. On the other hand, the earliest stages of the IFRS implementation will require that insurers re-train virtually every accountant and re-tool existing accounting and financial reporting software systems to be able to handle the changes. As if these tasks aren’t daunting enough on their own, the implementation plan will need to give consideration to the fact that the project must be performed without jeopardizing the control environment that has been built so carefully and engrained into the organization’s culture.

The combination of these and other considerations all point to the fact that it is in an organization’s best interest to begin laying the groundwork for its IFRS implementation project. The SEC has essentially presented the financial world with a “two-minute warning” that significant changes are around the corner. Prudent financial leaders will take this time to meet with their staffs and co-leaders to identify areas of concern and potential exposure and to lay out their implementation roadmap, mindful of the SEC’s evolving timeline for IFRS filing by registrants. By positioning their organizations to be ahead of the curve these leaders will be better situated to deal with the details as soon as they are revealed and ensure that implementation efforts are conducted within the framework of strong internal controls.

For more information, contact Jim Morris.

Back to top.

Insurers Largely Unscathed From Regulatory Reforms at the Federal Level – Eyes Now Turned to the States and the NAIC
by Tom Finnell

For months, many insurance professionals have been focused on the potential outcome of the Obama Administration’s plans for financial regulatory reforms in reaction to the recent economic crisis. However, based on the bill that passed in the House just before Christmas and another version that may be headed to the Senate floor for a vote within a couple of weeks, it is becoming increasingly clear that any impact of federal reforms on insurers will be relatively benign. What is now in play at the state level and at the NAIC may be quite another matter.

Recent action at the state/NAIC level has been robust. The industry is now beginning to wrestle with the vast scope and potential implications of changes that might be forthcoming as a result of the NAIC’s new Solvency Modernization Initiative (SMI). Indeed, discussions between industry representatives and regulators at the NAIC’s Spring National Meeting in Denver last month reflected different points of view as to the need for, and costs and benefits of, a number of proposals. Those range from how regulators assess group risk and capital, how they evaluate governance over insurers, and whether Solvency II should be adopted in the U.S., just to name a few.

When evaluating potential improvements, it is not uncommon to consider best practices by other companies, organizations, or industries. Indeed, in the past the NAIC has made such comparisons to the regulatory regime in place for U.S. banks at the federal level. That exercise had prompted a number of ideas for the NAIC’s consideration on the one hand, while confirming that the NAIC and the states were satisfied with other aspects of their own regulatory regime on the other.

In the wake of the financial and economic crisis, performance of such comparisons have continued to improve upon the system of state-based regulation with the help and coordination of the NAIC. Interestingly, such comparisons are increasingly being made across borders. For example, the NAIC is considering positions taken by the International Association of Insurance Supervisors, by the International Accounting Standards Board, and by individual countries that have sophisticated insurance regulatory schemes in place. While those studies continue, a number of areas have surfaced that could result in very fundamental changes to insurance regulation in the U.S. in the future:

• The possibility that the EU’s proposed Solvency II system could be replicated in the U.S.
• Increased use of sophisticated modeling techniques to evaluate capital or to supplement risk-based capital calculations, including the possibility that regulators might review such modeling on a centralized basis through assistance of the NAIC.
• The possibility that statutory accounting as we now know it in the U.S. may be replaced by International Financial Reporting Standards (IFRS), possibly with some differences at the behest of insurance regulators.
• Enhanced supervision of groups, including better coordination between other functional and country regulators.
• New guidance for regulators to evaluate an insurer’s adherence to certain high-level corporate governance principles, which are yet to be determined.

The foregoing list is just a small taste of what lies ahead for the SMI Task Force and provides an indication of the span and significance of just some of its activities.

As to potential changes to SAP resulting from IFRS, such was the topic of an earlier article in the Invotex Insurance Perspectives newsletter. In Denver, it was announced that the NAIC would appoint a commissioner-level subgroup to evaluate the matter and recommend policy decisions by 2011.

As evidenced in the financial regulatory bills making their way through Congress, the NAIC has apparently succeeded in making their case to Capitol Hill that whatever problems prompted the crisis, they were not the result of lapses in state-based regulation of insurers. Nonetheless, some industry representatives found it ironic that the states and the NAIC are now taking on an aggressive SMI agenda with a wide range of potential reforms that could result in very fundamental changes.

Our view is that the process underway by the NAIC to thoughtfully compare and evaluate other regulatory regimes and practices and suggest improvements is a necessary response to the crisis. The debate that will certainly ensue between regulators and the industry will likely be robust, even contentious at times and, hopefully, result in changes that are appropriate, cost-effective and that will make a meaningful and positive impact both on prudential regulation over insurers as well as on the future of the industry itself.

For more information, contact Tom Finnell.

Back to top.

RRGs: Risk Governance Should Play a Role in Capital Adequacy Models
by Elise Brenneman

Growth in new captive and Risk Retention Group (“RRG”) formations has been slow in the past several years, largely due to soft market conditions. This is bound to change, however, as many believe alternatives are poised to grow with increased tax burdens on businesses and anticipated hardening of pricing in certain lines. As capital adequacy assessment tools for RRGs are pursued by the NAIC, so too should the linking of these tools with corporate governance and risk management practices, since good governance has the potential for risk-reduction. A methodology which combines enterprise risk management (“ERM”) governance effectiveness with a flexible platform that addresses unique program design elements would be a powerful capital adequacy assessment tool for RRGs and regulators alike.

The NAIC’s Risk Retention Group Task Force recently formed the RRG Technical Subgroup to develop a regulatory tool to assess the capital adequacy of captive RRGs. Heightened attention on capital adequacy framework effectiveness certainly comes at a good time in the aftermath of the financial crisis. Good risk governance can be a strong risk mitigant and could be considered in a cost-effective manner in the tool ultimately developed. Furthermore, the assessment should extend to those service providers to the RRG organization as they provide the day-to-day back office operational support. This would also serve as an enhancement to the corporate governance assessment that would be performed by state examiners pursuant to the NAIC Examiners Handbook. The handbook is currently being evaluated for possible supplemental guidance in light of special considerations that may apply for RRGs.

ERM is not easily measurable as a quantitative or factors-based model (i.e. RBC) approach does not address the effectiveness of ERM. However, risk practices and risk governance can be observed and assessed, e.g., through risk-focused examinations performed by regulators. As the Task Force position begins to take shape, an optimal capital adequacy assessment tool would be one which properly diagnoses – early on – the potential for capital deterioration. With built-in flexibility (based on program design specification) and a method for factoring in good overall risk governance in the capital adequacy tool, the alternative market should respond with enhancements to risk governance practices. This could prove to be a big winner for capital regulation of captives and RRGs and for the growth prospects of the market.

For more information, contact Elise Brenneman.

Back to top.

NAIC Mulls Changes to Securities Lending Accounting and Reporting
by Max McGee

During the height of the financial crisis in 2008, insurance regulators were concerned about securities lending practices that caused liquidity issues for some insurance companies. At the time, some regulators questioned whether insurance companies should be permitted to engage in securities lending transactions at all given the small profit margin compared to the assumed risks.

As a result, the NAIC formed a subgroup comprising regulators and industry representatives to address the concerns of regulators, which included balance sheet treatment of collateral, the non-admission of collateral and the need for greater transparency. Recent guidance drafted by the working group will result in more consistent and transparent accounting for collateral, and enhanced disclosures that will improve the ability of regulators to monitor insurers’ securities lending activities.

At the Spring 2010 National Meeting, the Statutory Accounting Principles Working Group exposed for comment changes to SSAP No. 91R, Accounting for Transfer and Servicing of Financial Assets and Extinguishments of Liabilities, which aspired to address regulators’ concerns. In addition, the Blanks Working Group exposed for comment changes to the statutory blank that complemented the accounting changes and added increased disclosures. The suggested changes to 91R and Blanks were largely the result of industry recommendations.

The initial focus of the industry efforts was to educate regulators on how the securities lending business operates and to highlight the nature and extent of related risks. The major risks in a securities lending transaction are counterparty risk and liquidity risk. Counterparty risk is the risk that one or more counterparties will not be able to return the securities to the lender when called. The collateral received from counterparty by the lender must be maintained at all times between 100-102% of the fair value of the securities borrowed. If the lender is properly monitoring the collateral requirements, counterparty risk is very low. The changes to SSAP No. 91R clearly outline the requirements for maintaining collateral and when collateral should be treated as a non-admitted asset. For example, if the fair value of the securities borrowed is $100,000 but the value of the collateral received is only $90,000, the company would record $10,000 as a non-admitted asset.

The second risk is liquidity risk, the risk that the lender may not have sufficient liquidity to return the collateral to the borrowers when the securities borrowed are returned. In most cases, lenders receive cash collateral which is reinvested by the lender. Additional disclosures will be required to illustrate the timeframes within which the collateral is due to be returned and the duration of the reinvestment of the collateral. In most instances the duration of the investment will not exactly match the timeframe in which the collateral will be returned. Companies will be required to explain in the footnotes to the financial statements how they manage such duration mismatches.

One of the contributing factors to the lack of transparency is that in many cases the collateral received under the securities lending agreement was not reflected on the balance sheet. The existing statutory guidance was not clear and, under certain circumstances, allowed companies to keep the collateral off-balance sheet. The recommended changes include the adoption of FAS 140 guidance, which requires collateral that can be sold or repledged to be reported on the balance sheet. This will now require all cash collateral received to be reported on the balance sheet.

The outcome of these recommended changes to SSAP 91R will greatly enhance the information that regulators have to monitor securities lending activities of insurance companies.

Max McGee is President of Max McGee Consulting LLC, which operates, in part, through a joint marketing and service relationship with Invotex Group. For more information, contact Max McGee.

Back to top.

Upcoming Speaking Engagements

Back to top.