August 2011

Greetings!

The August edition of Insurance Perspectives discusses a range of topics that continue to move along the regulatory continuum to impact the industry as a whole, including increased scrutiny for the risk-focused examination process, proposed risk management standards, preparing for IFRS and a process that regulators will use to evaluate the need for additional requirements relating to corporate governance. 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. Implementation of the Risk-Focused Examination Process to Undergo Increased Scrutiny
2. NAIC Exposes Proposed Risk Management Standards; Industry Comments to be Aired at National Meeting in Philadelphia
3. Preparing for Accounting Change: What Should I Be Doing Now?
4. Regulators and Industry Agree on Process to Evaluate Requirements Relating to Corporate Governance
5. Upcoming Invotex Speaking Engagements

Implementation of the Risk-Focused Examination Process to Undergo Increased Scrutiny
by Les Schott

The risk-focused examination approach to insurance company examinations was adopted by the NAIC in 2006 and became a requirement for all states to follow effective January 1, 2010. While all states are following the risk-focused approach, the guidance pertaining to risk-focused examinations is subject to interpretation, and the implementation of the approach evidently continues in some ways to be a struggle.

In a recent meeting of the NAIC’s Financial Condition Committee, regulators were presented with several recommendations from the Chair of the Committee regarding risk-focused examinations. Rhode Island Superintendent Joe Torti noted that the notion of a risk-focused examination approach is not necessarily new but that there have been some fundamental changes from the previous examination approaches; unfortunately, some of those changes may not have been implemented as successfully as they could have been. In the meeting, Superintendent Torti unveiled his plan to ensure the success of the risk-focused examination process:

Development of a Supervisory Best Practices Program – There currently exists a program within the Financial Examiners Handbook Technical Group where states can voluntarily submit examination files to the NAIC staff for a critical review to determine if improvements can be made to their examination process going forward. Torti would like to take this process one step further, by setting up a process where states can learn directly from one another, and then push these best practices down throughout their respective states. The program envisioned by Torti would bring exam supervisors from the states together to review and discuss completed examination files with the objective of developing best practices and improvement suggestions to those states submitting the files. Initially, NAIC staff would educate the supervisors on the review process they have used, as well as best practices they have seen, but eventually, the supervisors would be in a position to return and teach the process to other states. This process would replace the staff review program the NAIC supports now. Such a program would not be without its costs, so the Committee voted to recommend that a fiscal impact study be undertaken.

Focus on Risk Mitigation Strategies to Reduce Financial Statement Verification Effort – One of the intended benefits of the risk-focused examination process is that through the identification, assessment and evaluation of an insurer’s strategies to mitigate both current and prospective risks, examiners could better direct their time and resources to areas of greatest risk. However, it appears that the implementation of the risk-focused examination process is not reducing the effort expended on financial statement verification to the extent intended. Superintendent Torti noted that the amount of time spent on financial statement verification of lower risk areas needs to be reduced to provide the time for examiners to focus on the most significant prospective risks that could impact a company’s future solvency. To address this, the Risk Assessment Implementation Working Group was asked to look into the issue.

Risk Assessment Implementation Working Group - Since the adoption of the risk-focused examination process, the implementation efforts have been overseen by the Risk Assessment Implementation Working Group, a subgroup of the Financial Examiners Handbook Technical Group. The Working Group has been meeting in regulator-only sessions to discuss the findings of the file review process, and to discuss feedback from examiners in implementing the approach. To emphasize the importance of the implementation oversight, the Working Group has been elevated to report directly to the E Committee, and has been renamed the Risk Focused Surveillance Working Group. Additionally it was suggested that the Group should meet more often. The Group will now be responsible not only for examination issues, but also for the financial analysis process.

Torti believes that the recommendations should be non-controversial as they represent a win-win proposition for all involved in the risk-focused examination process, and it is his hope that implementation of the recommendations will bring a heightened level of consistency and uniformity to the process.

For more information, contact Les Schott.

Back to top.

NAIC Exposes Proposed Risk Management Standards; Industry Comments to be Aired at National Meeting in Philadelphia
by Tom Finnell

The NAIC’s Group Solvency Issues Working Group last week exposed for comment a draft NAIC Own Risk and Solvency Assessment (ORSA) Guidance Manual. Written comments are due by August 25. It is expected that interested parties also will discuss their comments when the working group meets in Philadelphia at the end of the month.

Recent drafting efforts appear to have benefited to a significant degree from conversations between working group members and other regulators with representatives of the North American CRO Council at the NAIC’s ERM Symposium that was held in Jacksonville, Florida in June. The CRO Council is a professional risk management group that seeks to develop and promote sound practices in risk management throughout the insurance industry, and is represented by Chief Risk Officers of leading insurers based in North America. The interchange of ideas and discussion at the symposium made it clear that there is much interest on the part of the industry to provide ERM information to regulators and much interest on the part of regulators to access and use that information to better understand each company or group, the risks it faces and how they are addressed and managed and to improve the regulatory oversight process. Exactly how that will happen will be determined through the due process currently in play with respect to the draft Guidance Manual language.

We had earlier surmised that an important part of the guidance would be a discussion of the objectives to be achieved and how ORSA would be used by regulators. While working group members and other regulators seem to have come to better terms with that through their discussions at the Jacksonville ERM symposium and in almost weekly phone calls, the draft document speaks much more to what insurers will be required to do and provide rather than on how that would be used by regulators or why. Key points about the draft guidance include the following:

• The legal authority to require an ORSA will likely be accomplished through changes to be made to Form B, the Insurance Holding Company System Annual Registration Statement.
• The ORSA would be performed at least annually by the company or group, although how often it would actually be requested would be at the regulator’s discretion. For example, regulators could request the ORSA annually as part of their financial analysis process, every five years as part of their examination process, at other intervals, and/or on an as-needed basis.
• Individual insurers with less than $500 million in direct written and assumed premiums (including international premiums but excluding premiums reinsured with the Federal Crop Insurance Program and the Federal Flood Program) would be exempt from the proposed ORSA requirement. NAIC staff indicated that 570 insurers representing 12.3% of the total number of insurers and 82.4% of the total U.S. subject premium would be required to prepare an ORSA.
• For insurance groups, those with less than $ 1 billion of subject direct written and assumed premiums would be exempt from the proposed requirements. NAIC staff indicated that the $1 billion threshold would apply to 1,854 insurers representing 40.2% of the total number of insurers and 93.1% of the total U.S. subject premium.
• Nonetheless, the commissioner may require an insurer or group that is otherwise exempt to file based on unique circumstances or if it is considered a troubled insurer. Likewise, insurers may request a waiver from the requirement based on unique circumstances.
• The level of depth and detail is up to each insurer or group, and where extensive supporting documentation exists it can simply be referenced with the provision that it be made available to the regulator upon request.
• An internationally active insurance group that is required to prepare and file an ORSA to another jurisdiction that serves as the group-wide supervisor may be able to use that ORSA to satisfy the requirements of its U.S. domestic regulator.
• Section I of the ORSA would describe the insurer’s risk management policy, and “at a minimum” would include these principles: risk culture and governance; risk identification and prioritization; risk appetite, tolerance and limits; risk management and controls; and risk reporting and communication.
• Section II of the ORSA would describe quantitative measurements of risk exposure in normal and stressed environments.
• Section III of the ORSA would describe group economic capital and prospective solvency assessment.

The initial impetus behind efforts to develop a U.S.-based ORSA requirement has largely been attributed to international pressures emanating from standards of the International Association of Insurance Supervisors, from the European Union through Solvency II, and from the Financial Sector Assessment Program of the International Monetary Fund. However, working group members were careful to avoid simply copying requirements from around the globe that might not fit with the insurance regulatory scheme in the U.S.; rather, they were sensitive to industry input and developed a proposed requirement that has what the working group believes to provide necessary information while affording insurers and groups flexibility as to details and format.

For more information, contact Tom Finnell.

Back to top.

Preparing for Accounting Change: What Should I Be Doing Now?
by Tim Foley

From those looking to get a jump on the inevitable accounting changes that lay ahead, one question we often hear is, “What can I be doing now to ease the transition to IFRS?”

Our first response is always the same: Change is coming, with or without an SEC decision on a wholesale move to IFRS in the U.S. The U.S. GAAP/IFRS convergence projects now underway will result in significant changes that will most likely occur well before IFRS becomes a reality for U.S. companies.

That point aside, one response to the original question would be: stay on top of the deliberations at the FASB and IASB, and read the discussion papers, exposure drafts and other materials being released by the two standard setting boards at an unprecedented pace. By understanding the deliberations and opposing arguments on many key issues, one can appreciate some of the nuances often found in the final standards. Another option is to get involved; to make your voice or the positions of your organization heard before key decisions are made. In this way, one can affect change, not just react to it.

However, for those who wish to move beyond the standard setting process and begin preparations for IFRS convergence, conversion, or both, there are many technical areas where enough progress has already been made to allow for meaningful implementation planning and analysis now. One needs to look no further than IFRS 1, First-time Adoption of International Financial Reporting Standards, for specific topics that could be addressed immediately.

For example, IFRS 1 provides for 10 optional exemptions (optional exemption from retrospective application of a standard) as follows:

• Business combinations
• Fair value or revaluation as deemed cost
• Employee benefits
• Cumulative translation differences
• Compound financial instruments
• Assets and liabilities of subsidiaries
• Designation of previously recognized financial instruments
• Share-based payments
• Insurance contracts
• Changes in existing decommissioning, restoration and similar liabilities

The IASB has provided companies with choices with respect to each of these accounting standards or reporting issues. In many cases, the information required to retrospectively apply these standards may not be available. However, if the information is available, the company is then afforded the opportunity to assess the relative impact on the balance sheet of prospective and retrospective application of IFRS. For some of these optional exemptions, the impact may be immaterial. But for others the financial position of the company could be substantially altered depending upon the approach chosen. Consider a high-level review of the balance sheet to identify areas that will warrant study or strategic consideration.

Insurers need not wait for all deliberations on key standards to conclude before beginning to plan or even perform some of these analyses. Consider the “Big 4” projects that are currently the highest priority for the FASB and IASB:

• Financial Instruments
• Insurance Contracts
• Leases
• Revenue Recognition

These projects are considered by the standard setters to be the most critical in the context of U.S. GAAP and IFRS convergence. The successful completion of these projects could in large part determine if the goal of a uniform world-wide set of accounting and financial reporting standards is ultimately achieved. Let’s consider two of these standards that are critically important to insurers: Financial Instruments and Insurance Contracts. Note that both projects:

• Have been in development for several years
• Involve issues that are controversial, with differences of opinion between the two boards, and among individual members of the FASB and IASB
• Will result in significant change to existing practice
• Embrace fair value, yet retain use of amortized cost in limited situations
• Will result in new standards that likely will not take effect until 2015 at the earliest

Given the characteristics mentioned above, one might think these would be among the last standards to be addressed in an IFRS project plan. However, because of the significance of the proposed changes, these are the types of standards where work should begin sooner rather than later. While the boards continue debating issues like the expected loss model, impairment allowances and the unlocking of residual margins, insurers can be focused on those aspects of the new standards that are known.

For example, the new insurance contacts standard will embrace a probability-weighted present value of future cash flows approach, and there will be some form of margin(s) applied to factor in risk and to account for the profitability of the contract. The assumptions used within this model will be current, as of the valuation date. As a result, a good portion of the reserve balance will be stated at an estimated fair value. In the original proposal, the residual margin was to be determined at policy inception, with no updates based upon new or more current information. Assuming for a moment that this principle does not change, this portion of the reserve can be viewed as fixed or valued based on original cost. There are scenarios under debate that could result in other reserve components being valued at original cost as well. In short, there are competing forces that will change the size and make-up of an insurer’s liabilities. How much they change will depend upon many factors, including the nature of the business in force.

Despite these changes on the liability side of the balance sheet, the end game has not changed. Insurers will update their ALM processes to continue to align asset and liability values, and their associated cash inflows and outflows. Such processes serve to minimize income statement volatility, optimize cash flow and maximize efficiency. Thus, when implementing IFRS 4 Phase 2, the new insurance contracts standard, insurers will want to simultaneously assess the impact of IFRS 9, the standard on financial instruments. They will want to consider the classification requirements and make effective use of the option to designate financial assets at fair value through profit or loss. This combination of required change and optional designation will provide alternatives that can be managed to the insurer’s benefit. The fair value option is irrevocable; therefore, careful and forward-looking analysis must be performed. An effective date of no earlier than 2015 for both standards seems likely. This should allow adequate time for planning and analysis, provided those activities begin soon.

Back to top.

Regulators and Industry Agree on Process to Evaluate Requirements Relating to Corporate Governance
by Tom Finnell

The NAIC’s Corporate Governance Working Group held an interim meeting in Jacksonville Florida last month to discuss its work plan and project time line and to determine a way forward. The project timeline had envisioned that a set of corporate governance principles would be developed for use in U.S. insurance regulation and that efforts would be expended into 2012 to develop a Corporate Governance Model Law. That goal had been met with much resistance from industry representatives who contended that doing so could cause conflict with other corporate laws, that the NAIC and the states already have comprehensive corporate governance requirements in place and that a new model law would solve a problem that simply doesn’t exist, if not create new problems. But conflict quickly gave rise to harmony as the working group agreed with an industry suggestion as to an alternative way forward.

Like some other current NAIC initiatives, the catalyst for the foray into corporate governance was the need to respond to recommendations from the International Monetary Fund’s Financial Sector Assessment Program (FSAP) review last year of the state-based insurance regulatory scheme in the U.S. Among other findings, the review noted that “… the NAIC and/or departments should consider issuing more guidance on good and bad practices in corporate governance for insurers.”

The working group has recognized that corporate governance guidance and requirements currently exist in numerous sources. NAIC sources include the model act pertaining to hazardous financial condition, the model audit rule (now formally known as the Annual Financial Reporting Model Regulation), the Model Insurance Holding Company System Regulatory Act, pertinent sections of the Financial Condition Examiners Handbook, and requirements with regard to biographical affidavits that insurers are required to file. Other information discussed includes guidance and requirements of the SEC, the PCAOB and Stock Exchanges.

In Jacksonville, the discussion between working group members and industry representatives quickly gravitated towards consensus that while there is much guidance within the U.S. insurance regulatory regime as to governance, it is not centrally housed in one place. As a result, it is difficult for FSAP reviewers, and even regulators and insurers, to easily understand what is there and how it might be used. Discussion centered on the need for a framework, an overarching corporate governance document that would discuss the various corporate governance requirements and tools singularly as well as how they interact together. Such a framework would summarize the corporate governance requirements that currently exist in one place; compare them to those of the International Association of Insurance Supervisors; and would provide a ”gap analysis” to determine if something was missing and, if so, suggest a remedy. Meeting participants appeared to be of a common mind and agreed that such a framework would provide long-term benefits to insurers and regulators alike, allowing all to “connect the dots” between the various needs and requirements as they pertain to corporate governance.

As a result, we expect debate about corporate governance at the NAIC to quiet down at least until the proposed framework is drafted and any deficiencies in corporate governance guidance or requirements are identified.

For more information, contact Tom Finnell.

Back to top.

Upcoming Speaking Engagements

Back to top.