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Greetings!
In this edition of Insurance Perspectives, we wrap up an incredibly busy year for regulators and industry professionals alike by presenting important updates on internal control reporting and residential mortgage-backed securities as well as outcomes of this past week's NAIC meeting.
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Tom Finnell
Managing Director
Jim Stangroom
Managing Director |
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In this Issue |
- Lively Debate Precedes NAIC’s Approval of Changes to Accounting for Deferred Tax Assets
- RBC Changes for Residential Mortgage-Backed Securities Are on the Way
- Risk-Focused Exams and the NAIC’s Internal Control Reporting Requirements: An Integrated Approach for Efficiencies in Regulatory Compliance
- Epilogue: Proposed Change to Internal Control Reporting Guidance
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Lively Debate Precedes NAIC’s Approval of Changes to Accounting for Deferred Tax Assets
by Tom Finnell
In San Francisco this week, state insurance commissioners did some last minute sparring before approving a proposal to expand the ability of insurers to report deferred tax asset (DTA) amounts as admitted assets. The industry expects that the action will increase surplus of insurers by $11 billion at year-end 2009. The proposal has morphed somewhat since the fall of 2008 when the ACLI first proposed the change as one of several means of providing surplus relief in response to the financial pressures on insurers resulting from the credit and economic crisis.
The new guidance provides a GAAP-like recoverability test, and only amounts that meet that test can then be considered in determining admitted adjusted gross DTAs. In making that determination, the new changes increase the previous admissibility limitations on carrybacks and gross DTAs from the lesser of the amount expected to be realized within one year of the balance sheet date or 10% of statutory capital and surplus, to the lesser of the amount realizable within three years or 15% of statutory capital and surplus.
Those in support of the final proposal cited certain “guardrails” that had also been included, i.e., a sunset clause that will take effect after two years if further action is not taken to renew the guidance; the existence of an RBC charge that will be applied to any resulting higher admitted DTA amount; a provision that precludes companies with inadequate RBC results (generally amounts lower than 300% ACL RBC) from availing themselves of the revised DTA limitations; and increased disclosures. Furthermore, they contended that the change was necessary to reassert a national standard in light of numerous permitted practices that had been granted by some states over the past year.
Those against the final proposal argued that the aforementioned RBC charge has yet to be determined; that technical working group members and NAIC staff themselves see the need to further study the impact of the changes over the next two years; and that the change effectively is a loosening of regulatory standards.
In the end, the proposal passed. The revised guidance will take effect beginning with 2009 year-end reporting.
For more information, contact Tom Finnell.
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RBC Changes for Residential Mortgage-Backed Securities Are on the Way
by Jim Stangroom
The NAIC is well on its way to making changes to the manner in which risk-based capital charges are determined for insurers’ holdings of residential mortgage-backed securities (RMBS). The changes were prompted by the recent credit and economic crisis and the resulting wholesale downgrades by rating agencies of RMBS issues. However, it has been recognized that those actions by rating agencies are in response to their assessment of the likelihood of loss, but without a related assessment of the extent of total loss. As a result, it has been widely perceived by those in industry, and confirmed by regulators, that the current RBC methodology for RMBS results in punitive capital charges for many insurers in the current environment.
With assistance of consultants, the NAIC administered a proposal process that culminated in the selection of PIMCO Advisers to evaluate more than 21,000 RMBS issues and provide the necessary model and metrics that insurers are to use for year-end 2009 filings. A model will be used to determine the intrinsic price of each RMBS security, the NAIC designation, and the resulting RBC charge.
This is a significant effort on the part of the NAIC and its consultants, who are operating within a very narrow timeframe. The expectation is that values will be available for downloading by insurers just before the end of the year. Insurers are equally challenged in making necessary system changes necessary to automate the data feeds into their reporting systems so as to facilitate the production of timely and accurate year-end reports.
The NAIC has posted background, reporting and filing instructions, fees, and related information about this RMBS initiative on its web site.
For more information, contact Jim Stangroom.
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Risk-Focused Exams and the NAIC’s Internal Control Reporting Requirements: An Integrated Approach for Efficiencies in Regulatory Compliance
by Jim Morris
As the end of 2009 approaches, significant changes in the insurance regulatory arena are looming. Beginning in 2010, two key NAIC initiatives become fully effective: the revised Annual Financial Reporting Model Regulation (AFRMR), a successor to the NAIC’s Model Audit Rule developed by the NAIC/AICPA Working Group; and the Risk-Focused Examination (RFE) approach developed by the Risk Assessment Working Group (RAWG). Companies that implement the AFRMR in such a way as to incorporate the principles of the RFE approach can directly influence the efficiency of the ensuing regulatory examination process. Similarly, RFE approach guidance provides some important clues as to how insurers can tackle the task of complying with the AFRMR in a cost-effective manner.
Much has been written and discussed regarding regulators’ attempts to impose Sarbanes-Oxley (SOX) type internal control reporting requirements on insurance companies, including mutuals and privately-held companies. A substantial number of companies will fall under at least some of the AFRMR’s provisions due to the tiered structure of the rule, with the newer and perhaps more onerous requirements being applicable to insurers reporting direct and assumed written premiums exceeding $300 million. For larger companies with direct and assumed written premiums in excess of $500 million, the AFRMR’s SOX 404-like internal control reporting requirements are triggered, albeit in a manner that is in some respects more lenient than SOX. That said, efforts to comply with the AFRMR will still represent a significant undertaking for many companies, including some that are already compliant with SOX itself.
In the meantime, lurking in the background is a significant change to the way that state insurance examiners will conduct the financial examinations of all insurers, regardless of size. The new RFE approach has brought some fundamental changes to the manner in which examinations will be conducted, including: a more direct focus on risk – not just those related to financial reporting, but also prospective risks that may adversely impact the company going forward; a more holistic view of the audit function at the company, including internal audit, the independent audit and oversight by the audit committee; and a clearer distinction between enterprise-wide controls and those that pertain at the level of key functional activities.
Financial examinations will likely become a more integrated and significant component of the overall ongoing surveillance process. Examiners will now spend a larger portion of their examination time gaining an understanding of the company by performing a top-down risk assessment and evaluating the effectiveness of the company’s entity-level controls and risk management processes and activities. While this may seem like a dramatic change in the exam approach, it really isn’t. The predecessor approach was risk-focused in its own right, but its execution in practice too often led to standardized procedures being applied from one company to the next. With a stronger focus on examiner training and backed by the leadership of senior financial regulatory staff of key states during the roll-out phase, the new RFE approach appears more likely to deliver on its objectives than was the case with the predecessor approach. In fact, examiners should be able look at a company through the same lens as its management; each may see a different image, but there should more of a common understanding around which examination-related dialogues with management can progress.
The RFE approach begins with the examiners gaining an understanding of the company as well as factors such as its environment, its products and its competition. This information will be utilized by the examiners to identify the inherent risks the organization faces on both a current and prospective basis. Unlike SOX and the AFRMR, the RFE approach does not limit the scope of its risk classifications to financial reporting risk alone. The examiners will also be interested in identifying and evaluating the credit, market, pricing/underwriting, reserving, liquidity, operational, legal, strategic and reputational risks facing the company.
The next phase of the examination will be to assess the risks to determine their likelihood and potential impact on the organization. Upon completion of the quantification phase, the examiners will seek to identify the controls the company has implemented on an entity-wide and/or process specific basis, make an assessment of the effectiveness of the controls’ design and validate the controls to ensure they are functioning. The results will be utilized to determine the nature and extent of substantive testing procedures considered to be necessary, if any.
Since the RFE approach’s risk assessment process closely resembles the traditional risk assessment models that have historically been utilized throughout the industry, the change should present companies with an opportunity to participate more actively in the exam process by sharing their knowledge of risk management and internal controls with examiners. By sharing their risk assessments, controls documentation, internal audit workpapers and reports and other similar information, insurers can proactively demonstrate to examiners that management understands the risks their companies face and that they are being actively managed. Since much of this information already exists, or will soon be prepared or gathered in order to comply with the AFRMR, most of this can be done with little additional demand on the company’s resources, especially if a company effectively builds and aligns its documentation with examiners’ needs in mind.
For more information, contact Jim Morris.
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Epilogue: Proposed Change to Internal Control Reporting Guidance
by Tom Finnell
In our October issue of Insurance Perspectives, we reported that a last-minute proposed change was posed to throw a wrinkle into insurers’ efforts to comply by 2010 with new internal control reporting standards. The issue related to the NAIC’s Annual Financial Reporting Model Regulation (AFRMR) and, more specifically, to related guidance contained in the supplemental Implementation Guide. The proposed change would have required management to report on all controls deemed significant to each individual legal entity within a group of insurers. In response, Invotex submitted its comment letter to the NAIC for consideration.
At the NAIC’s winter 2009 meeting held in San Francisco this past week, a consortium of industry interested parties brought forward a revised proposal for consideration by the NAIC/AICPA Working Group. The revised proposal was accepted and appears to alleviate much of the concern that had been expressed about the working group’s earlier proposal.
The subject language in the Implementation Guide, with the change adopted in San Francisco (in marked text) is as follows:
“Group of insurers,” as intended for use in the Model is to recognize the variety of structures that may exist. Companies within a holding company structure, or other set of insurers identified by management, may often share common management, systems or processes. Consequently, when management asserts to the effectiveness of their internal controls, it is appropriate to make such an assertion for those companies based upon the organization management determines to be most relevant to meet the reporting requirements. Because holding company structures, and other groups of insurers, can be complex and organized to meet corporate objectives, that structure may not align with the organizations that are responsible for managing and preparing the financial statements of the insurer. The Model provides flexibility to insurers to identify a “Group of insurers” for purposes of evaluating the effectiveness of their internal control over financial reporting. In determining the appropriate scope and level of testing for systems that are shared by a group if insurers, management is not required to expand the scope or perform additional testing that would be redundant for each legal entity included within the group of insurers. To the extent that a specific internal control or system is unique to and has a material impact on the preparation of the audited statutory financial statements of a legal entity included in a group of insurers and the legal entity exceeds the premium thresholds contained in Section 16, that control or system is to be included in management’s evaluation of internal controls.
A “Group of insurers” that has been granted approval to file audited statutory consolidated or combined financial statements of a group of insurers (as described in Section 8) may set the scope and level of testing for purposes of determining effectiveness of internal controls over financial reporting consistent with the basis on which the audited statutory financial statements for the Group are prepared, i.e., at the combined or consolidated level.
While these changes must be studied and considered in light of a group of insurers’ unique circumstances, our view is that the revisions better preserve the intended flexibility that was an explicit part of the initial AFRMR effort.
For more information, contact Tom Finnell .
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