Greetings!

This edition of Insurance Perspectives lends insights into the report of the Financial Crisis Advisory Group, upcoming changes to the NAIC’s accreditation program and more. The release of the Advisory Group report adds to the momentum for the eventual convergence of U.S. GAAP and International Financial Reporting Standards, and its recommendations will have important implications for the future of insurance company financial reporting. The NAIC Accreditation Program is a key aspect of insurance solvency regulation, and both regulators and industry will need to be aware of upcoming changes to the program. Finally, an article about construction contract funds management will be of interest to insurance professionals involved in the unique and challenging world of contract surety.

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Tom Finnell
Managing Director

Jim Stangroom
Managing Director

In this Issue

1. Financial Crisis Advisory Group Report Offers Important Recommendations to Insurance Companies
2. NAIC Accreditation Program Announces Changes
3. Contract Funds Management Enhances Risk Mitigation for Sureties
4. Invotex Director Don Sirois Named to NAIC Accreditation Review Team
5. Upcoming Speaking Engagements

Financial Crisis Advisory Group Report Offers Important Recommendations to Insurance Companies
by Jim Stangroom and Marylee Robinson

The Financial Crisis Advisory Group (the “Advisory Group”) recently completed its study about the accounting and financial reporting standard setting implications of the financial crisis. The study focused on financial institutions because of their central role in the crisis as well as on insurance companies. Their report, released July 28, 2009, provides additional impetus to the drive for convergence of international and U.S. accounting and financial reporting standards. Of importance to insurance companies, the Advisory Group recognized the linked missions of accounting standard setters and insurance regulators to serve the public interest, and they recommended that the accounting standard setters give the financial instruments project the highest priority.

The key points made by the Advisory Group may affect U.S. insurance companies in various ways. First, this is a high profile group with the influence to continue the momentum towards the convergence of U.S. generally accepted accounting principles and International Financial Reporting Standards. There are at least two major accounting policies that are high priorities in the convergence efforts: accounting for insurance contracts and for financial instruments. Second, by advising that the financial instruments project be given highest priority, it is more likely that we could see further changes in accounting for investments, including measurement, valuation, impairment and disclosure. The work of the Advisory Group has not necessarily concluded with their issuance of this report as they have committed to review the progress made by the Boards before year-end 2009.

The Advisory Group was established by the International Accounting Standards Board (the “IASB”) and the U.S. Financial Accounting Standards Board (the “FASB” and collectively the “Boards”) to advise both Boards “about the standard setting implications of the global financial crisis and potential changes in the global regulatory environment.”  Its members include senior leaders with broad international experience in the financial markets who have been joined by official observers representing key global banking, insurance and securities regulators, including the International Association of Insurance Supervisors.

In its report, the Advisory Group identified four principles that financial reporting must meet if it is to fulfill the critical role that general purpose financial reporting plays in the financial system.

1. Effective Financial Reporting

The Advisory Group found that the global financial crisis exposed the following weaknesses in accounting standards and their application: “(1) the difficulty of applying fair value (“mark-to-market”) accounting in illiquid markets; (2) the delayed recognition of losses associated with loans, structured credit products and other financial instruments by banks, insurance companies and other financial institutions; (3) issues surrounding the broad range of off-balance sheet financing structures, especially in the U.S.; and (4) the extraordinary complexity of accounting standards for financial instruments, including multiple approaches to recognizing asset impairment.”  In their report, the Advisory Group made 10 recommendations to address these weaknesses. The recommendations included giving highest priority to the simplification and improvement of the Boards’ standards on financial instruments. In addition, they recommended that the Boards reconsider the appropriateness of recognizing gains or losses on financial instruments caused by changes in the reporting entity’s own creditworthiness.

In a segment of the report subtitled “Intersection of Prudential Regulation and Financial Reporting,” the Advisory Group stressed the importance of continued communication between regulators and accounting standard setters. The report also stressed the importance of transparency and disclosure of regulatory requirements that may restrict a company’s financial flexibility, for example its ability to pay dividends, issue debt, sell assets or repurchase stock.

2. Limitations of Financial Reporting

The most notable limitation identified by the Advisory Group was that the quality of underlying financial reporting data depends on the use of proper processes for price verification and other valuation information. The Advisory Group made four recommendations including that price verification should be independent of sales, trading and other commercial functions.

3. Convergence of Accounting Standards

The Advisory Group concluded that “the financial crisis has made the case for global convergence of accounting standards even more compelling than before.” They followed-up with four recommendations in this area, all urging the Boards, governments and the business community to achieve convergence of accounting and financial reporting standards.

4. Standard Setter Independence and Accountability

The Advisory Group emphasized that accounting standard setters must be independent from political pressure and that policymakers must respect this need for independence. They cited examples in October 2008 when, under pressure from European Union members, the IASB waived its due process procedures to amend IAS 39 investment classification standards, and in April 2009 when the FASB accelerated its normal due process to amend fair value guidance under pressure from the U.S Congress. Five recommendations were made, including again recommending that the financial instruments project now underway should be the focus and chief priority of both Boards for the balance of 2009. Policymakers were encouraged to voice concerns and provide input to accounting standard setters but were urged to refrain from legislating specific accounting standards.

For more information, contact Jim Stangroom.

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NAIC Accreditation Program Announces Upcoming Changes
by Don Sirois

The NAIC Accreditation Program began as a response to a spate of insurance company insolvencies in the mid-to-late 1980s. During this period it became apparent that a system of effective solvency regulation could provide the safeguards needed to protect insurance consumers. The Financial Regulatory Standards and Accreditation Program was created to ensure that all insurance departments have a system of effective solvency regulation in place comprising the following basic components:

• Adequate statutory and administrative authority;
• Necessary resources to carry out that authority; and
  
• Organizational and personnel practices designed for effective regulation.

In June 1990, the NAIC, in an effort to provide guidance, adopted the baseline standards to achieve effective regulation and established a formal certification process to recognize those insurance regulatory agencies that had established an effective system of regulation. As the insurance industry evolves, the regulatory procedures must also change to keep pace, and the NAIC anticipated that these baseline standards would be dynamic and change over time. As part of the NAIC’s ongoing efforts, the following changes are scheduled to take effect January 1, 2010:

1. Property and Casualty Actuarial Opinion Model Law

The model law will be included as a new required standard. The model creates an Actuarial Opinion Summary document to be submitted March 15 with the insurers’ state of domicile and allows for other states in which the insurer is licensed to request the summary.

2. Risk Focused Examinations

Examination of insurance companies that begin on or after January 1, 2010, must follow the new risk-focused approach. This applies to all insurers with the exception of risk-retention groups that are licensed as captives.

3. Adoption of the Annual Financial Reporting Model Regulation

In 2006, the NAIC adopted several changes to the model regulation requiring annual audited financial statements by regulated insurance companies that previously had been referred to as the Model Audit Rule. Key components included that insurers comply with certain practices related to auditor independence, corporate governance and internal controls. The first management report on internal controls will be due in 2011 for the reporting period ending 2010.

Certain standards are scheduled to become effective January 1, 2011, with regard to regulating captive risk retention groups:

1. Law and Regulation Standards for Risk Retention Groups

In past years, risk retention groups have been exempt from the law and regulation standards because of their unique operating procedures. The newly adopted laws and regulation standards for risk retention groups are similar to those required for traditional companies but do have some distinct differences in areas such as accounting methods, risk based capital and reinsurance standards.

2. Risk Focused Examinations to Risk Retention Groups

Examinations of risk retention groups licensed as captives that start after January 1, 2011, must follow the risk focused approach.

For more information, contact Don Sirois.

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Contract Funds Management Enhances Risk Mitigation for Sureties
by Phil Ermer

Construction operations are ultimately funded by cash flows from projects, but they often rely in large measure on bank lines and the contractor’s personal resources. With construction spending estimates exceeding $960 billion in 2009 alone, protecting and managing project funding and cash flows is no small undertaking. Accordingly, potential conflicts can arise between the contractor’s cash needs for a specific project and their general corporate and even personal cash needs. A litany of problems arising from such conflicts have resulted in states enacting trust fund statutes, which are requirements by sureties for joint checking arrangements and other Contract Funds Management tools. While tools such as project-dedicated escrow accounts and joint contractor / surety accounts have existed for many decades, their growth and evolution has improved in response to sureties’ underwriting concerns and their needs for claim handling loss mitigation.

Historically, the surety’s role in construction was initially seen as a pre-qualifier of a construction entity, adding its own good name to that that of the contractor. In recent decades, sureties have taken on more of the risk of construction defaults as demand for bonding has grown, as new sureties have entered the market and as bond obligations are being more broadly interpreted by the courts. The resulting shift toward increased risk retention has prompted changes both in underwriting standards and claim procedures throughout the surety industry.

Contract Funds Management can be designed to respond to a surety’s concerns about a specific project or to respond more generally to the surety’s needs to monitor a contractor’s overall performance across a number of projects. Under either scenario, it can provide greater assurance to the surety that potential obligations under its bonds are being appropriately discharged.

Claim administrators have also used Contract Funds Management to establish control accounts for the direct deposit of contract payments from an owner and for advances a surety may make to its troubled contractor. Timing, convenience in handling, segregated job accounting and security are major benefits in the use of Contract Funds Management.

Contract Funds Management can also take on other forms, depending on the position of the parties and their objectives. Such formats can include joint accounts, escrow accounts or single-titled accounts, each of which can serve similar purposes; however, the roles of the parties in each format differ. For example, the account administrator’s role can vary from that of a representative of the surety to an escrow agent acting in accordance with, and guided by, a fund management agreement.

Also, each format can be designed to be either more focused or more comprehensive in processing, accounting and execution as defined by the parties’ desires. The mechanics of requesting disbursement, execution of checks and reporting are usually negotiated during the drafting of the fund management agreement.

Other issues an administrative agreement may need to address include the competing rights of subcontractors and vendors, banks and secured creditors and Indemnitors of the Principal. Concerns with bankruptcy, dominance and indemnification should also be considered when drafting the agreement.

For more information, contact Phil Ermer.

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Invotex Director Don Sirois Named to NAIC Accreditation Review Team

Don Sirois was recently appointed by the National Association of Insurance Commissioners (NAIC) as a member of the accreditation review team for the purpose of reviewing state insurance departments’ financial analysis and examination files for compliance with the NAIC standards. The accreditation program is one of the NAIC’s premier programs in that it ensures that accredited state insurance departments are complying with the NAIC’s Financial Regulation Standards. The NAIC utilizes independent consultants to perform certain aspects of these reviews. A typical accreditation review of a state insurance department will be conducted by a review team comprising three to six members who will spend an average of one week on-site at the department. Don’s career experience within the insurance industry includes serving both as chief financial regulator for the Maine Insurance Department and as a member of insurance company management.

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Upcoming Speaking Engagements

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