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In this edition of Insurance Perspectives, we discuss the financial regulatory reform debate on Capitol Hill, the impact of Chinese drywall claims on insurers, the importance of Medical Loss Ratios pursuant to the Patient Protection and Affordable Care Act and the NAIC’s evolving position on Accounting for Insurance Contracts.

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Tom Finnell
Managing Director

Jim Stangroom
Managing Director

In this Issue

1. Financial Regulatory Reform Debate Takes Center Stage on Capitol Hill
2. Drywall and Reopened Claims Pummel Insurers
3. Medical Loss Ratio: What's in a Number?
4. NAIC Mulling Positions on IASB/FASB Joint Project: Accounting for Insurance Contracts
5. Upcoming Speaking Engagements

Financial Regulatory Reform Debate Takes Center Stage on Capitol Hill
by Tom Finnell

If nothing else, the recent credit and economic crisis has made those on Main Street more knowledgeable, and perhaps, therefore, more loathsome of the practices of Wall Street. Politicians on both sides of the aisle are posturing to be seen as part of the solution while distancing themselves from what their constituents see as being the problem – greedy bankers. Indeed, nothing breeds bipartisanship like a common enemy. As a result, the future of financial regulatory reforms resulting from the crisis may soon be determined.

Both the House-passed bill and the Senate version currently under debate explicitly leave in place state-based regulation of insurers. Given that, and that it took the worst crisis in our lifetimes to develop the momentum to move these very significant reforms this far along, it seems that state insurance regulation is here to stay, certainly for the foreseeable future.

It has been almost a year since the Obama Administration released its blueprint for reforms. Since then, the proposal has taken shape through initial drafting by Treasury last summer and then through debate that culminated in passage by the House in December. However, and without bipartisan support at the committee level, the proposal of Senate Banking Committee Chairman Christopher Dodd (D-Conn.) proceeded to the Senate Floor for debate where it continues to face numerous potential amendments. Nonetheless, there is optimism that a bill will ultimately emerge from the fray; however, it will require some degree of bipartisanship as Democrats alone lack the necessary votes to get the job done.

One of the key elements of the Senate version was a proposal that large financial institutions contribute up to $50 billion to a resolution fund based on pre-need assessments. The idea was to create a pool of money that could be used to sop up problems if they were to emerge at some point down the road. As drafted, the initial resolution funding would come from federally-regulated financial institutions with more than $50 billion in assets, a definition that would seem to include a number of banks, but only one insurer. However, if the fund required replenishment, the door was left open to expose more financial institutions to assessments including, possibly, more insurers.

The notion of a pre-need resolution fund gave rise to concerns that, once established, politicians might subsequently be tempted to raid the cookie jar to cover other needs. It was also viewed as possibly tempting bad behavior on the part of financial institutions who would know that the fund could bail them out if things went wrong. Because of these and perhaps other concerns, Senate Democrats agreed recently to scotch pre-need assessments in favor of post-event funding. Recent amendments adopted by the Senate further clarified that taxpayers would not be on the hook in any event and that Treasury could lend funds to cover bailout costs that would then be recouped by selling off assets of the failed institution and by assessing other institutions.

Nonetheless, insurers remain concerned that they may be tagged with assessments relating to the failure of one or more large banks, yet they (the insurers) are already on the hook for insolvencies of other insurers through the state guaranty fund system. Insurers continue to argue that they should not pay to fix the problems of banks, especially since they didn’t contribute to their problems and won’t realize the resulting benefits. Interestingly, Senate Republicans counter that the reform proposal does little to increase federal oversight of large insurers and have challenged whether the state guaranty fund system is adequate to cover failures of large insurers.

Another contentious item with the Senate proposal relates to the so-called “Volcker Rule,” affectionately named after former Federal Reserve Chairman Paul Volcker, who contends that proprietary trading by banks contributed to the crisis and should be prohibited. As proposed in the Senate bill, it would apply to federally insured banks or thrifts and their affiliates, some of which are owned by large insurers and thus potentially ensnaring those insurers as well. The life industry is lobbying hard to release insurers from the Volcker Rule inasmuch as proprietary trading and use of hedging and derivatives is one of their necessary functions.

Other items under debate include:

• An amendment supported by the NAIC that would limit both Treasury’s authority to negotiate insurance trade agreements and its ability to preempt the authority of state insurance regulators.
• Whether life insurers should be exempted from the Financial Crisis Responsibility Fee, a.k.a. the “bank tax,” which would be used to repay the resulting debt from federal bailout efforts.
• Whether the federal government should have the ability to veto rate increases of health insurers.

It has been reported that a Senate vote may take place as early as this week and, if passed, it would begin a process to reconcile provisions with the version passed earlier by the House.

For more information, contact Tom Finnell.

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Drywall and Reopened Claims Pummel Insurers
by Phil Ermer

Homeowners’ insurers are reeling from recent developments involving claims liabilities relating to defective drywall in homes as well as an onslaught of hurricane-related claims that are being reopened years after the event. Both Louisiana and Florida are on the front lines, with activity before their courts and legislatures running fast and furious. In some cases, adverse claim developments resulting from these legal developments may have contributed to some recent insurer insolvencies. While this article focuses on drywall, both issues provide some perspective on the ability of insurers to anticipate claims trends and, therefore, adequately price business, which are significant aspects of an insurer’s risk management.

Since 2001, some 500 million pounds of drywall has been imported from China, much of that to supplement the domestic supply shortage that occurred in the wake of Hurricane Katrina. In recent years, there have been a growing number of insurance claims relating to Chinese drywall, which is asserted to contain and emit sulfur gases that cause physical discomfort to residents as well as corrosion of wiring, piping and other metal within their homes.

Over the past year, the connection between the harm occurring and the drywall has become more widely accepted and the remedy better defined. Lawsuits have gathered steam to determine which parties and their insurers are to be left with financial responsibility, and Louisiana appears to be at the epicenter of this issue and the resulting litigation.

Homeowners insurance denials based on exclusions for “pollution and contamination,” “latent defect” and “faulty, inadequate or defective planning” were dealt a setback in a March 2010 ruling by Lloyd Medley, Chief Judge of Civil District Court, Orleans Parrish, in Finger v. Audubon Insurance Co., No. 09-8071 (La. Dist, Ct. Orleans Parrish).  The ruling cited the “pollution and contamination” exclusion as inapplicable as the damage was not environmentally related; rather, it was due to substandard building materials. The “latent defect” exclusions also were deemed not applicable as there was neither gradual deterioration of the drywall nor wear and tear. Further, the damage to wiring and metal was the result of the bad drywall not another problem. Finally, “faulty, inadequate or defective planning” exclusions would not apply as the drywall was functioning as designed and would, therefore, not come under this exclusion.  The ruling is to be appealed, but it provides another rope for holding homeowner carriers to covering these damages.

Although the extent of cancellation or non-renewal of homeowner policies due to Chinese drywall concerns is disputed between state legislators and industry representatives, the Louisiana State Senate recently passed a bill, SB 595, that prohibits carriers from raising premiums, cancelling or not renewing homeowner policies because of concerns with Chinese drywall. The action incorporates not only the concern for a perceived improper practice by carriers but also the State’s desire to limit further mortgage defaults of homeowners whose coverage is cancelled and can’t be replaced. That bill now goes to the Louisiana House.

The liability train has not been completely lined up, but there is a strong desire for Louisiana’s legislature and courts to hold homeowners’ carriers at the front of the line. From there, the next in the subrogation line will be the builder’s commercial liability carrier, followed by the domestic supplier’s coverage, importers and eventually the manufacturer. Foreign manufacturers that, ultimately, should be held responsible may lie beyond reach and never be joined to the train, leaving the losses to be held by carriers here in the United States.

With a growing number of websites related to legal representation, testing and repair of Chinese drywall problems, more claims are sure to follow. Further, with repair costs in recent judgments estimated to exceed $81 per square foot with entire houses needing remediation, the extent of coverage payment could equal a major portion of the actual house value.

It may be too early to foresee the geographical spread of claims and the full extent of future liability to carriers, but it is known that Louisiana and Florida are the hot beds of these issues. Carriers local to these regions will need to closely evaluate their risks, monitor the developing trends and be ready for additional regulatory scrutiny.

For more information, contact Phil Ermer.

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Medical Loss Ratio: What's in a Number?
by Kerby Baden

The answer: a lot more than many were aware of just a few months ago. A financial term, the genesis of which was the reporting by health insurers of arcane financial data to state insurance regulators, “Medical Loss Ratio,” or MLR, is suddenly on the minds of insurance executives, legislators and regulators alike.

The commotion is the result of the recent enactment of the Patient Protection and Affordable Care Act (PPACA), Sec. 2718 of the Public Health Service Act. The new federal requirements provide that, effective in 2011, a health insurer is to rebate funds to its subscribers to the extent that its MLR for a plan year is below 85% for large group business or 80% for individual and small group business. That is, admittedly, an over-simplification of what the law actually says. However, it is the fine print and interpretation of what is said in the law as well as what is not said that has many scratching their heads and working hard to meet deadlines for action.

The NAIC has quickly ramped up a number of working groups that are addressing various aspects of the new health care reform legislation. Their mandate includes addressing various issues raised by the new federal MLR requirements, understanding their implications, establishing guidance for states and responding to inquiries by federal agencies such as the Department of Health and Human Services. The issues that have been raised include the following:

• How would MLRs calculated pursuant to PPACA compare to how insurers have traditionally reported their loss ratios to state insurance regulators in Annual Statements and other filings?
• What changes to state filings would be needed to enable regulators and others to monitor MLRs calculated under the federal guidelines? The PPACA-prescribed MLR calculation provides that allowable claim costs can include costs for activities that improve the quality of care; but which activities comply? Which would not? (Indeed, recent action of some insurers to reclassify expenses in their financial statements has been the target of scorn by some on Capitol Hill and the subject of much publicity.)
• Could the application of the PPACA-mandated MLR limits result in market disruptions? How severe might that be? How might that be anticipated, and what actions could mitigate those adverse consequences? (It has already been announced by at least one insurer that it will withdraw from the health insurance market, albeit a relatively small segment of its total business.)
• Are loss adjustment expenses, as that term is used for statutory reporting by states, different than how used in the PPACA?

These are just a few of the challenges with which the NAIC and its working groups, the states, industry trade groups and federal regulators are wrestling, with the goal of having guidance in place well in advance of the January 1, 2011, effective date of the MLR provision.

The implications of the MLR issue are potentially significant. If perceived as too onerous, the MLR caps could detract from the ability of insurers to attract needed capital. Likewise, and given alternatives to deploy capital, insurers might reallocate capital to other business lines. In some states, the new federal MLR caps are quite different than those that have been enacted at the state level, which could further amplify market disruption. In time, these impacts will be known. For now, there is much for insurers and regulators to be concerned about as they prepare to implement the new law’s provisions.

For more information, contact Kerby Baden.

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NAIC Mulling Positions on IASB/FASB Joint Project: Accounting for Insurance Contracts
by Tim Foley and Jim Stangroom

The June 2011 deadline for the convergence of IFRS and U.S. GAAP accounting rules, a deadline put forth by the G20 leaders late last year, has the IASB and FASB working overtime to address changes to a number of key standards. The mutual goal of these two accounting standards boards is to complete work on the convergence of 11 standards in a little more than a year.

One highly visible and controversial standard is the update to IFRS 4, Insurance Contracts. The IASB and FASB are scheduled to release an exposure draft by the end of June 2010. The NAIC is working with a sense of urgency to ensure the views of its members are adequately considered before the exposure draft is released. The NAIC’s International Accounting Standards Working Group (IASWG) is coordinating with other NAIC Task Forces and Working Groups with the goal of forming a position by May 17th as a basis for discussions with the International Association of Insurance Supervisors (IAIS) and to facilitate the NAIC’s submission of comments to the IASB and FASB.

It has yet to be determined if converged GAAP or conversion to IFRS will impact statutory accounting for insurers here in the U.S. The NAIC’s degree of involvement with the IAIS, IASB and FASB in the standard setting process could give a glimpse into the future of statutory accounting standard setting. Invotex professionals have commented in past articles and industry presentations about the future of statutory accounting if IFRS becomes generally accepted. The insurance contracts proposal is an example where the NAIC has a voice in the IASB/FASB standard setting process; however, the NAIC’s statutory accounting working groups will likely evaluate whether to accept, reject or modify the new standard. Borrowing terminology from the IAIS, the NAIC is conducting a “fatal flaws review” of certain specific positions that will form the basis for the proposed standard and that are in many instances at odds with current U.S. statutory accounting and, likely, NAIC positions going forward.

It’s been nearly three years since the IASB released its discussion paper on “phase 2” of the insurance contracts standard; however, there are still many contentious issues. For example, the Boards remain split on the issue of risk and residual margin components of the insurance liability. The FASB remains strongly committed to a single “composite” margin, while the IASB has voted narrowly (8:7) in favor of separate risk and residual margins. The IASWG specifically requested input from the Casualty Actuarial and Statistical Task Force (CASTF) on the question of risk margins. In a CASTF conference call on May 11, there was significant discussion about the complexities and vagaries of determining risk and residual margins. There was similar discussion about the differences between separate risk and residual margins versus a composite margin approach. Significant concerns were raised about whether and how such margins should be released into earnings over either the coverage period or the expected claims paying period. Regardless of the risk margin approach, significant concerns were also raised about the lack of precision and reliability in determining such margins and whether such estimates would result in any useful information from a regulatory perspective. While there was much debate, there was nothing close to a consensus developed amongst the members of the CASTF. It is unclear what, if any, specific input the IASWG may ultimately receive from the CASTF.

The IASWG has seemingly conceded that certain joint IASB/FASB positions are unlikely to change and that their efforts are better served by weighing-in on the expected positions of the Boards even though they may not reflect the NAIC’s preferred accounting model. Among the expected IASB/FASB positions upon which the IASWG is deliberating are:

• A single measurement model for all types of insurance contracts (as opposed to the separate life and non-life models preferred by the NAIC).
• A discounted, unbiased, probability-weighed, future cash flows model.
• Inclusion of a “risk adjustment” or “risk margin” reflecting uncertainty about the amount and timing of the future cash flows.
• A model that will be calibrated to eliminate any gain at the contract inception date.

In addition to the question of risk margins, some of the other proposals under debate within and between the two Boards, and that the NAIC will be considering as it develops its positions include:

Unearned Premium Reserve (UPR) – this approach was tentatively approved by the IASB late last year. It would be used only for “pre-claims” liabilities. The liability would initially equal the premium received, thus preventing a gain at inception. This would represent a temporary approach at the initial contract recognition date, before application of the building-block approach.

Revaluation of Expected Cash Flows – the proposed guidance is clear that should expected cash flows develop in an adverse way, losses should be immediately recognized. But such proposed guidance is not clear as to the accounting treatment in a situation where favorable development is present.

Acquisition Costs – both Boards seem committed to the concept of immediate expensing of policy acquisition costs (though the terminology and definitions may change). Thus the concept of an explicit DAC would no longer exist. However, still under debate is how the incidence of those costs would impact insurance liabilities and cash flows.

It appears that many decisions need to be made in a relatively short period of time. We would expect that many of these open issues will remain when the exposure draft is issued in June. Competing proposals on a number of topics will likely be put forth for comment.

For more information, contact Tim Foley or Jim Stangroom.

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Upcoming Speaking Engagements

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