July 2011

Greetings!

The July edition of Insurance Perspectives examines prominent topics of current interest, including proposed rules for credit impairment on debt securities, the potential for waivers on proposed risk management requirements for smaller companies and groups, the NAIC's latest statement on the treatment of producer commissions in the MLR calculation, and possible changes to auditors' reports. In addition, we highlight upcoming Invotex speaking engagements at industry conferences.

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, Les Schott and Jim Stangroom
Managing Directors, Insurance Services

In this Issue

1. From “Books” to “Buckets” – FASB and IASB Change Course on Impairment of Investments in Debt Instruments
2. NAIC Discussions Reveal that Smaller Companies and Groups May Obtain Waivers from Proposed Risk Management Requirements
3. Latest MLR Development: NAIC to Seek Solutions to Insurance Producer Commissions that Do Not Involve Changing Federal Law
4. An End to Boilerplate? PCAOB Pondering Changes to Auditors’ Opinions
5. Upcoming Invotex Speaking Engagements

From “Books” to “Buckets” – FASB and IASB Change Course on Impairment of Investments in Debt Instruments
by Jim Stangroom and Qu Zhang

The FASB and IASB (collectively known as “the Boards”) have held joint meetings since November 2010 to discuss a methodology for recognizing credit impairments on debt securities. In January 2011, they issued a joint Supplementary Document on impairment issues. The Boards held a number of outreach meetings with constituent groups including financial statement users and preparers, auditors, standard setters and regulators during the comment period for this Supplemental Document. In response to the feedback received from these constituents, the Boards have recently changed course. In a joint meeting on June 15, they unanimously decided to pursue a “three-bucket” expected loss approach for the impairment of financial assets. This new approach replaces the “good book” and “bad book” methodology previously proposed in the Supplementary Document.

Under the previous proposal, “good book” assets would have required two impairment calculations, one to determine a floor based on expected losses in the foreseeable future and another to determine remaining expected losses recognized on a time-proportional basis. “Bad book” assets would have had the full amount of expected lifetime losses recognized immediately. Much criticism was received on the complexity of this previous proposal.

The newly proposed “three-bucket” approach was designed to reflect the general pattern of credit deterioration of loans. This approach would apply to all debt instruments except those measured at fair value with fair value changes recognized in net income. As agreed upon by the Boards, an impairment allowance will be based on debt instruments categorized into three “buckets”:

(click on chart to enlarge)

The Boards have charged their staffs with developing further guidance on criteria for classifying assets in each Bucket. Clear and well-defined indicators and guidance on transferring assets between Bucket classes are also a work in progress. With regards to Bucket 1 assets, the Boards have directed staff to pursue an “operational” approach to model such impairment allowances. A new proposed draft with detailed models is targeted to be released September 2011.

What does this proposal mean for insurers and regulators? The proposed “three-bucket” system will require significant management judgment, especially in the development of models and assumptions to estimate impairment losses at a portfolio level. We foresee further operational complexities in tracking initial and subsequent changes in loss expectations in Bucket 1 as portfolios turn over and in determining when assets should transfer between Buckets. Having more precise guidelines on asset qualifications, impairment allowance calculations and indicators for asset movements between Buckets will be essential to the success of this impairment model.

For more information, contact Jim Stangroom.

Back to top.

NAIC Discussions Reveal that Smaller Companies and Groups May Obtain Waivers from Proposed Risk Management Requirements
by Tom Finnell

The NAIC’s Group Solvency Issues Working Group is currently involved in a series of interim conference calls aimed at flushing out more details about the proposed Own Risk and Solvency Assessment requirement, dubbed “ORSA.” In a recent submission sent to interested parties, the proposal has taken on the form of a draft NAIC ORSA Guidance Manual, which now includes additional language that would permit state insurance regulators to grant waivers to insurers writing less than a stated threshold of premium annually and in certain other situations. Nonetheless, and as drafted, smaller insurers won’t be exempted from the proposed requirements per se; rather, they would qualify to apply for a waiver which may (or may not) be granted by the respective commissioner on a case-by-case basis.

The new language proposes alternative thresholds in the case of an individual insurer as opposed to a group of insurers. In both cases, the key measure is annual direct written and assumed premium, including international business but excluding premiums reinsured with the Federal Crop Insurance Corporation and the Federal Flood Program. Individual insurers that write less than $500 million of such subject premium would qualify to apply for a waiver. For a group, the subject premium of all insurance legal entities within the group would be combined; if it was less than $1 billion, the group would qualify to apply for a waiver. The proposed language goes even further to provide that any insurer “may also make application to the commissioner for a waiver from the requirements of the ORSA based upon unique circumstances. The commissioner may consider various factors including, but not limited to, the type of business entity, volume of business written, availability of qualified board members, or the ownership or organizational structure of the entity.”

It is important to note that the proposed waiver language is far from a done deal. The document in its current form is for discussion purposes, and much work remains before a revised proposal is brought forward to the Solvency Modernization Task Force. In the near term, the working group’s agenda calls for discussion about, among other matters, an industry suggestion to include within the ORSA a description of the insurer’s definition of solvency; its time horizon of risk exposure; the risks to model and how they are quantified; measurement metrics used; target level of capital; and how risk diversification is considered.

Next week in Jacksonville, Florida, the NAIC and its Solvency Modernization Task Force will be sponsoring an ERM Symposium where it is anticipated that insurers will describe their processes to evaluate capital adequacy. This includes the ERM framework, EMR quantitative assessments, insurer group presentations (in closed session) and the use of ERM in insurance regulation. It is anticipated that the symposium will foster more ideas for the working group to consider as it moves the ORSA proposal forward. Invotex will be there and will keep our readers posted on further developments.

For more information, contact Tom Finnell.

Back to top.

Latest MLR Development: NAIC to Seek Solutions to Insurance Producer Commissions that Do Not Involve Changing Federal Law
by Les Schott and Juhee Park

The treatment of insurance producer commissions continues to be the topic of ongoing debates and a sticking point among the MLR rules enacted under the Patient Protection and Affordable Care Act (PPACA). On June 30, the NAIC’s Professional Health Insurance Advisors Task Force voted to endorse federal H.R. 1206, proposed legislation that would exempt agent and broker commissions from the medical loss ratio calculation. This move was celebrated by insurance agents and producer groups who have complained about a significant drop in their commissions. However, when the NAIC Executive Committee discussed this issue during a conference call on Tuesday, July 12, a call for a vote never happened. Instead, Florida’s insurance commissioner and incoming NAIC president, Kevin McCarty, stated that they are “looking for solutions other than changing the federal law.” He added that they will “continue discussions with HHS to find a solution that addresses the issue” and that the earlier vote of the task force did not constitute endorsement by the entire NAIC membership on the issue.

Under the Patient Protection and Affordable Care Act (PPACA), the MLR rules require insurers offering individuals and small group health products to spend 80 percent - 85 percent for the large group - of their premiums on direct medical care and activities improving healthcare quality. This provision essentially limits administrative expenses, compensation, marketing expenses and other expenses and profits to the remaining 20 percent and 15 percent for those respective business segments.

Under current rules, agent and broker compensation is included in the administrative expense portion of the medical loss ratio formula. Producer groups have argued that the provision, set to ensure consumers have better value for their premium expenditures, is in fact having the opposite effect when agent and broker commissions is not excluded from the calculation.

According to a survey performed by the National Association of Insurance and Financial Advisors (NAIFA), insurance agents have experienced a significant decrease in their commissions since the MLR went into effect on January 1, 2011. Of the 520 agents in the poll, 75 percent responded that their commission has decreased. Fifty-three percent of the agents surveyed reported that their commission has decreased by 25 percent or more.

Furthermore, the study contended that the drop in agents’ commissions is affecting the insurance market and quality of customer service. The NAIFA survey found that 23 percent of the agents whose commissions have decreased have had to reduce non-sale services they provide to customers, and 11 percent have withdrawn from the individual market.

The PPACA allows states to apply for a waiver if they believe that the MLR provisions will disrupt or destabilize the state’s insurance market. According to the U.S. Department of Health & Human Services, waiver requests for adjustments have been granted to Maine, New Hampshire and Nevada. Yet, several other states are still seeking waivers to keep their markets stable. Indiana has seen four insurers exit its individual market since the legislation passed, with more insurers indicating possible withdrawal at the absence of a waiver. Other states with similar requests include Kentucky, Florida, Georgia, North Dakota, Iowa, Louisiana, Guam, Kansas and Delaware.

The NAIC Executive Committee’s recent non-action and the Professional Health Insurance Advisors Task Force’s voted willingness to look at other options and solutions after previously publicly endorsing federal H.R. 1206, is an indication that the issue is far from a resolution and will be a topic of continuing debate at the upcoming NAIC Summer National Meeting to be held in Philadelphia. We will be there and will keep you posted.

For more information, contact Les Schott.

Back to top.

An End to Boilerplate? PCAOB Pondering Changes to Auditors’ Opinions
by Tom Finnell

For many who started their careers in public accounting and spent late hours cramming to pass the CPA exam, the independent auditor’s standard opinion ranks right up there with the Boy Scouts’ oath or Lincoln’s Gettysburg Address: it is short and to the point, easily committed to memory and stands the test of time. But if an idea currently under discussion at the Public Company Accounting Oversight Board (PCAOB) moves forward, carefully scripted boilerplate may soon yield to more interesting reading in audit reports.

Last month, the PCAOB issued a Concept Release on Possible Changes to the Auditor’s Report. Specifically, the PCAOB is considering any and all of the following ways to improve upon the meaningfulness of the auditor’s report:

• Inclusion of an “Auditor’s Discussion and Analysis” or “ADA” in which the audit report is supplemented by a narrative describing the auditor’s views on matters such as risks, audit procedures and results, the company’s financial statements, management’s judgments and/or other significant matters. The ADA would likely cover matters that the independent auditor currently shares only with the Audit Committee.
• Required and expanded use of emphasis paragraphs to highlight significant matters in the financial statements, e.g., with respect to management judgments and estimates, areas with significant measurement uncertainties and key audit procedures used in those areas.
• Providing auditor assurance on other information outside the financial statements such as in management’s discussion and analysis, non-GAAP information or earnings releases.
• Clarification of the standard auditor’s report about what an audit represents and the related auditor responsibilities, e.g., with respect to the auditor’s responsibility for the detection of fraud or for financial statement disclosures.
  

Through an outreach effort, the PCAOB has obtained wide support to move beyond the current pass/fail model for reporting by auditors to one that provides investors and other users of financial statements with more insight into the company, its financial statements and the audit itself. However, the PCAOB is also mindful that the proposed changes could increase the scope and cost of audits, impact the auditor’s relationship with client management and the Audit Committee, and give rise to liability and confidentiality issues for auditors. And, despite an effort to move away from boilerplate, the implementation of the proposed changes may simply give rise to different language that quickly becomes standardized itself.

At this juncture, it is too early to read the tea leaves as the concept that is under consideration is itself still being brewed. But we don’t presume that auditors will quickly become comfortable with the notion of providing juicy insights to investors when doing so may put at risk the relationship that they have with their clients. Indeed, the first comment letter that was posted on the PCAOB’s website was submitted by the Center for Audit Quality, which includes on its Governing Board the CEOs of the eight largest audit firms and of the AICPA. It states that “auditors should not be the original source of disclosure about the entity; management’s responsibility should be preserved in this regard” and that any additional disclosures by auditors be “objective and fact-based.”

The PCAOB is seeking public comment through September 30, 2011, and expects to hold a public roundtable to discuss the proposals during the third quarter of 2011.

For more information, contact Tom Finnell.

Back to top.

Upcoming Speaking Engagements

Back to top.