Greetings!

In this edition of Insurance Perspectives, which marks the one-year anniversary of our newsletter, we discuss European risk management requirements that may be introduced to the U.S. insurance industry and the potential impact of derivatives reform on insurance company risk management. In addition, Invotex announces the addition of a former Maryland insurance regulator to its practice as well as an upcoming conference on Emerging Risks.

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. Own Risk and Solvency Assessments – Coming to the U.S.?
2. Derivatives Reform Could Significantly Impact Insurance Company Risk Management
3. Invotex Announces Senior Maryland Insurance Financial Regulator Les Schott to Join Firm as Managing Director
4. Save the Date: Invotex to Co-Sponsor 4th Annual Emerging Risk Forum
5. Upcoming Speaking Engagements

Own Risk and Solvency Assessments – Coming to the U.S.?
by Tom Finnell

An NAIC working group will soon discuss whether the risk management practice known as “Own Risk and Solvency Assessment,” or ORSA, should be adopted for application in the U.S. ORSA is one of the central elements of Solvency II, the regulatory regime that is being developed for application in Europe and that is currently scheduled to become effective in late 2012. Among the issues that will be discussed by the NAIC’s International Solvency Working Group later this month are whether an ORSA framework should be developed for the U.S., what elements might be included, and potential implementation issues that might be pertinent to its application in the U.S.

A key part of the NAIC’s Solvency Modernization Initiative has been to compare the various components of state-based insurance regulation in the U.S. to other regulatory regimes, such as those in individual countries including Canada, the United Kingdom, Switzerland and Australia, but also with international and regional frameworks such as the principles set forth by the International Association of Insurance Supervisors (IAIS) and Solvency II. An inevitable outgrowth of those efforts is the identification of areas where, by comparison, the U.S. system may appear to be lacking; the NAIC and the states would then evaluate the need, cost and benefits associated with closing those gaps and move forward to do so where deemed appropriate.

Despite the obvious benefits for U.S. insurers to engage in sound risk management programs, there has been no regulatory requirement that they actually do so – yet. Traditionally, U.S. regulators have embedded risk management aspects into various other compliance requirements, for example, relating to the diversification and limits on investments in certain types of securities. In that manner, regulators determined their own tolerance for risk and mandated it across all insurers rather than endeavor to understand and rely upon what any individual insurer may have done to determine its own risk appetite and establish risk mitigation strategies to assure that it operates within that limit.

More recently, risk-focused examinations have come into vogue, and they have prompted examiners to inquire about and understand an insurer’s risk management program. Nonetheless, the irony has been that examiners are now delving into risk management, an area that an insurer is not even required to maintain per se.

That irony was not lost on the International Monetary Fund, which recently completed a Financial Sector Assessment Program (FSAP) of the observance of IAIS Insurance Core Principles for the U.S. In the area of risk assessment and management, it gave the U.S. regulatory regime an acceptable score (“largely observed”), while also noting that in the U.S., “there is no requirement that an insurer have in place comprehensive risk management policies and systems capable of promptly identifying, measuring, assessing, reporting, and controlling their risks.”

That observation appears to have had some influence on the NAIC’s International Solvency Working Group in preparing its agenda for a conference call scheduled for June 30, 2010. A related discussion document prepared for the call observes that “an ORSA is an IAIS Standard that will be evaluated under the FSAP.”

Undoubtedly, there would be many benefits if an insurer were to perform an ORSA and share that information with its regulators. That said, an effort to move the ORSA initiative forward in the U.S. would apparently carry with it some of the same issues that were debated at length when changes were made several years ago to transform the former NAIC Model Audit Rule into an upgraded Annual Financial Reporting Model Regulation that included certain provisions from the Sarbanes Oxley Act of 2002. For example: Is there a deficiency in regulation, and what evidence indicates that? What is the proposed fix and its scope? Do its costs outweigh its benefits? Should some insurers be exempted and, if so, which ones?

Based on the agenda and discussion document that we have seen for the upcoming conference call, the working group anticipates addressing those kinds of questions and more. We will keep our readers apprised of new developments as we learn more about the working group’s deliberations about a potential ORSA requirement for the U.S. and its potential implications to insurers.

For more information, contact Tom Finnell.

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Derivatives Reform Could Significantly Impact Insurance Company Risk Management
by Jim Stangroom

The Restoring American Financial Stability Act of 2010 (the Act) was passed by the Senate in May 2010; a similar bill was passed by the House in December 2009. Both bills contain provisions related to derivative instruments that, if enacted, will significantly impact insurance companies actively engaged in the use of derivatives. This week, members of the House and Senate began the legislative process of reconciling the two bills, and there are indications that a final bill may be sent to President Obama by July 4th.

The derivatives reform provisions are not without controversy, and changes are likely during the Senate-House reconciliation process. The bills provide that nearly all derivatives transactions that are currently traded over-the-counter with bank counterparties would be conducted through central clearinghouses. Such an arrangement would result in greater transparency and real time reporting of prices but also could result in greater transaction costs and margin requirements. Insurance companies may find risk management and hedging more costly with the passage of these financial reforms, if they are enacted in their current form.

The tone coming from many legislators is that derivatives are the root cause of problems that led to the financial crisis; others do recognize that derivatives can be an effective risk management tool when used appropriately. Indeed, state insurance laws generally prohibit the use of derivatives for speculation and require that insurance companies establish derivative use plans and controls over the use of derivatives for risk management purposes. Interest rate derivatives, such as swap, caps, floors and collars, can be effective tools for managing duration mismatches between assets and insurance liabilities. Equity index derivatives can be effective tools for managing risks associated with indexed annuity guarantees. Credit default swaps were much publicized for their role in the sub-prime mortgage crisis; however, when appropriately used by insurers, they can be an effective hedge of corporate bond credit risk.

The key derivatives-related provisions of the Senate bill are as follows:

• No federal bail-outs for “swaps entities” – Banks would have to choose between maintaining their FDIC insurance coverage or being able to trade derivatives; they could not do both. This controversial provision was submitted by Senate Agriculture Committee Chairman Blanche Lincoln (D-Ark.); however, House Financial Services Committee Chairman Barney Frank (D-Mass.) has said this Senate bill requirement that would effectively force banks to spin-off their derivatives operations “goes too far.” This particular provision is expected to be the subject of much continued debate as the House and Senate work through the process of reconciling their respective versions of reform. Banks are the counterparties for insurance company derivatives transactions and, unless there are changes during the course of the House-Senate reconciliation conference, the legislation could result in fewer banks trading derivatives, fewer counterparties and, with fewer suppliers, possibly higher costs for insurers.
• The SEC and the Commodity Futures Trading Commission (CFTC) are given joint rulemaking authority – The Act requires the SEC and CFTC to draft rules for swaps dealers, swaps clearinghouses and major swap participants on risk practices, capital requirements, margin requirements, recordkeeping and reporting. The term “swaps” in the Act encompasses all types of derivatives, and many insurance companies that engage in derivatives transactions to any significant degree likely will come under the definition of a “major swap participant,” thus requiring them to register with the SEC and/or the CFTC. Compliance with SEC and CFTC rules, including periodic reports and filings, will only add to the cost of derivatives trading.
• Nearly all derivatives trading would be conducted through clearinghouses – The Act will require clearinghouses to register with the SEC or the CFTC, and these clearinghouses will need to submit any category or type of swap for pre-approval before clearing. If there is no clearinghouse established for certain types of swaps, then both counterparties will be required to report transactions to a registered swap repository. The SEC and CFTC are authorized to draft rules requiring clearinghouses to establish risk management practices and margin requirements. Existing commodity and financial futures exchanges have the infrastructure in place to most likely qualify for clearing many of the swap contracts currently traded over the counter. Insurance companies and other derivatives counterparties would likely be subject to clearinghouse transaction fees, swap dealer transaction fees, assessments and margin requirements, which will further add to the cost of derivatives trading.
• Registration of major swap participants – Entities that maintain a substantial position in swaps would be designated as “major swap participants.” The threshold of what might constitute a “substantial position” would be defined through SEC and CFTC rulemaking; however, it may be that insurance companies using derivatives as part of their routine risk management would be considered major swap participants. The Act subjects major swap participants to registration and ongoing reporting requirements to the SEC or CFTC.

The increased transaction and compliance costs for insurance companies actively engaged in derivatives trading could have far reaching consequences. Such costs can either be passed on to policyholders, or companies can accept lower profit margins or take more risk. Some combination of these alternatives is a likely outcome if this derivatives reform is enacted.

For more information, contact Jim Stangroom.

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Invotex Announces Senior Maryland Insurance Financial Regulator Les Schott to Join Firm as Managing Director
by Tom Finnell

Lester C. Schott, Associate Commissioner of Examination and Auditing for the Maryland Insurance Administration (MIA), retired from public service last month after a 30-year career working in various state government positions in Maryland. After a short break, he will begin another chapter in his career by joining Invotex as a Managing Director in the firm’s Insurance Practice.

Les' career with the State of Maryland included key roles with the Office of Legislative Audits, and more recently with the MIA where he has served since 1993. At the MIA, Les managed a staff of 35 and was responsible for assuring the continued solvency of the insurance industry in the state by overseeing financial examinations, the MIA’s financial analysis function, the licensing of authorized insurers and other entities, as well as the collection of premium taxes, retaliatory taxes and surplus lines taxes. He was directly involved in and responsible for the review of the most complex transactions related to insurers regulated by the MIA, and served as the Commissioner’s primary advisor on financial issues.

At Invotex, Les will be a key member of the firm’s Insurance Practice, where his responsibilities will include marketing, sales and delivery of advisory services to state insurance regulators, insurers as well as other clients. His extensive background in statutory accounting, examinations and in working with troubled insurers in restructuring situations is well suited to the firm’s client base and core services.

Les is a CPA as well as a Certified Financial Examiner. He has been active for many years in the Society of Financial Examiners including having served as its President in 2005-2006. He has also been quite active in proceedings of the National Association of Insurance Commissioners and has participated actively in numerous of its task forces and working groups.

For more information, contact Tom Finnell.

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Save the Date: Invotex to Co-Sponsor 4th Annual Emerging Risk Forum

Invotex Group and Interactive Solutions LLC will again co-sponsor the Insurance Industry Emerging Risk Forum, the 4th of such annual events to be held September 22-23, 2010 at the Kimmel Center in downtown Philadelphia.

This year’s Forum will focus on the very significant and profound changes facing insurers as they emerge from the crisis. These include the need to implement health care and financial regulatory reforms, the pressures to conform to international regulatory and solvency standards, and the challenges posed by preparing for an entirely new accounting model – International Financial Reporting Standards.

Beth Sammis, Acting Commissioner for the Maryland Insurance Administration, George Brady, International Counsel for the NAIC, and other speakers will address the drivers behind these fundamental changes facing the industry. Speakers from companies such as CIGNA will take a deeper dive into their experiences to date in grappling with these reforms and share their perspectives on longer term business implications and practices. Industry representatives and professionals will then address emerging practices and pragmatic ways forward for companies to consider in preparing for and implementing necessary changes.

The Forum is targeted towards insurance company executives and staff in the areas of finance and accounting, risk management and internal audit. It is also relevant for insurance company directors who may benefit from perspectives on emerging risks facing the industry.

Please mark your calendars for September 22-23, 2010. For more information and to register, visit the conference website at http://www.rmconference.com.

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Upcoming Speaking Engagements

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