December 2011

Greetings!

The December edition of Insurance Perspectives offers a year in review as well as issues that continue to be debated, including medical loss ratios, the SEC on IFRS and a view of the European proposal for mandatory rotation of audit firms.

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. Invotex Insurance Practice – 2011 in Review
2. Final Rule Issued on Medical Loss Ratio Provisions; Brokers’ Last Prayer Rests with Congress
3. The SEC Takes Another Step in Its IFRS Work Plan, but a Decision is Not in the Offing
4. European Commission Takes Aim at the Public Accounting Profession with Mandatory Rotation and Other Proposals

Invotex Insurance Practice – 2011 in Review

With only a few short weeks until the New Year, it is a good time to reflect on 2011, to recognize how grateful we are for our achievements and to take a moment to thank those who have helped us along the way. First, some highlights from our insurance practice over the past year:

• First and foremost, we have enjoyed a diversity of interesting and complex assignments that are both challenging and stimulating; we’ve been involved in a number of situations involving the industry’s largest players as well as a variety of complex matters.
• We expanded our practice geographically and have been involved in engagements coast-to-coast.
• In addition to serving state insurance regulators and industry clients, Invotex’s insurance practice provided services to the federal government, assisting in developing audit plans and strategies to determine compliance by insurers with federal regulatory requirements implemented with healthcare reform.
• We continued to grow our staff and enhance the credentials and experience of the practice as a whole.
• We further complemented our access to technical resources through additional alliance relationships with actuaries, IT professionals and risk experts.
• Our highly-acclaimed Insurance Perspectives electronic newsletter continues to bring timely insights each month on industry and financial issues of interest to insurance professionals and regulatory communities.
• We increased our visibility through attendance at NAIC and industry meetings and through numerous speaking engagements involving topics such as International Financial Reporting Standards, risk management, governance, financial regulatory reform, health care reform and various other areas of financial/ insurance/ regulatory interest.

We are most especially thankful for the loyalty and support of our clients and the confidence they have placed in Invotex. Throughout the year, we were supported by feedback from our clients, business acquaintances and readers of our newsletter and by the comments shared by many in our travels on assignment and at industry meetings. We’re grateful for the opportunities that came our way and for all who lent their support, advice and well wishes throughout the year. To all of our clients, friends and readers, we offer our wishes for a safe and warm holiday season and the very best for the New Year.

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Final Rule Issued on Medical Loss Ratio Provisions; Brokers’ Last Prayer Rests with Congress
by Les Schott

A year after interim guidance was issued, the federal Department of Health and Human Services (DHHS) has issued its final rule on Medical Loss Ratio (MLR) requirements under the Patient Protection and Affordable Care Act. In prior issues of Insurance Perspectives (see January 2011, July 2011), we have discussed the basic concepts of MLRs . Effective in 2011, health insurers must meet MLR requirements designed to ensure that certain minimum percentages of premium dollars are spent on healthcare and certain qualifying expenses; in other words, there is now a cap on how much premium dollars can be used to cover overhead and profit. Health insurers will be required to spend at least a stated portion of the premiums they collect – 80% for individual and small group plans and 85% for large group plans – on medical care and activities that improve health care quality for patients. To the extent that an insurer’s MLRs fall short of those minimums, it will be required to rebate funds to subscribers.

The final rule issued by DHHS is effective January 1, 2012, and comes after consideration of nearly 100 comment letters received by DHHS. After consideration of those comments, DHHS made several amendments to the interim regulation — but not, as some had hoped, to respond to pleas by brokers that their commission costs be omitted from the calculation:

Rebates:
Under the interim final rule, insurers that have not met the applicable MLR standard would have been required to provide any owed rebate to the policyholder and each subscriber “in amounts proportionate to the amount of premium each paid.” While the insurer could enter into an agreement with the group policyholder to distribute rebates to the subscribers, the insurer remained liable for the accurate distribution of rebates to individual enrollees. However, DHHS received comments expressing significant concerns about the logistical and tax problems inherent in this requirement. The concerns related to insurers’ lack of access to the information needed to distribute rebates to individual enrollees covered under a group policy, the insurers’ liability even when the insurer enters into an agreement with a policyholder to distribute rebates and the potential tax implications to insurers, employers and consumers for rebates of premiums that would initially be paid with pre-tax dollars.

The final rule streamlines the rebate process for those enrolled in group policies. In particular, the final rule directs insurers to provide rebates to the group policyholder (usually the employer) through lower premiums or in other ways that are not taxable. The group policyholder must ensure that the rebate is used for the benefit of subscribers. The final rule also requires that insurers provide notice of rebates to enrollees and the group policyholder. All enrollees must be given information about the MLR and its purpose, the MLR standard, the issuer’s MLR and the rebate provided.

Expatriate and Mini-med Policies:
The interim rule provided special treatment for expatriate (generally group policies covering employees working outside of their country of citizenship and outside the employer’s country of domicile) and mini-med policies (policies with annual benefit limits of $250,000 or less). Specifically, for 2011, incurred claims and activities that improve healthcare quality would be multiplied by a factor of 2.0 in calculating the MLR. The interim final rule also directed insurers writing expatriate and mini-med policies to submit a report for each of the first three quarters of the 2011 MLR reporting year.

After analyzing the data filed by issuers on expatriate and mini-med policies and considering public comments, in the final rule DHHS continues the multiplier of 2.0 for expatriate policies. This adjustment acknowledges the higher administrative costs and volatility of these policies compared to typical insurance plans. For mini-med plans, the final rule phases out the special circumstance adjustment multiplier from 2.0 for 2011 to 1.75 for 2012, 1.5 for 2013 and 1.25 in 2014. In 2014, annual dollar limits on coverage will be banned and it is expected that mini-med policies will cease to exist.

ICD-10 Conversion Costs:
DHHS has mandated the replacement of the ICD-9-CM code sets used by medical coders and billers to report health care diagnoses and procedures with ICD-10 code sets, effective October 1, 2013. ICD-10 implementation will radically change the way coding is currently done and will require a significant effort to implement. ICD-10 conversion costs were excluded from quality improvement activities (QIA) in the interim rule; however, DHHS indicated that it would examine the reported conversion costs of ICD-10 to determine whether the policy to exclude these costs from QIA should be revisited. In addition, the interim final rule specifically requested comments on whether ICD-10 should be included as a QIA.

In response to the comments DHHS has considered the impact of ICD-10 on improving data collection for diagnoses and medical procedure coordination, patient safety, health outcomes and medical research and concluded that some of the impact of ICD-10 costs is a QIA. However, they recognized that ICD-10 has some claims processing functions as well. The final rule recognizes the dual nature of ICD-10 and includes as QIA ICD-10 conversion costs incurred in 2012 and 2013 up to 3/10 of 1% of an issuer’s earned premium in the relevant state market in each of those years.

Brokers’ Compensation:
Obvious by its absence in the final rule was any discussion or amendment to eliminate agents and brokers commissions from the MLR. The issue of agents and brokers commissions has been a hotly contested issue before the National Association of Insurance Commissioners (NAIC). On a November 22, 2011, conference call, the NAIC membership, by a slim 26 to 20 margin (with five Commissioners abstaining), passed a resolution calling on the U.S. Congress and DHHS to loosen the MLR requirement to ensure that agents and brokers commissions are excluded from the calculations. The resolution said the “Congress should expeditiously consider legislation amending MLR provisions of the PPACA in order to preserve consumer access to agents and brokers.”

The final rule, which does not take into account any of the proposed changes put forward by the NAIC resolution, was met with immediate criticism by the agent and brokers trade groups. Some agents and brokers claim to have seen up to a 50% reduction in their commissions as insurers attempt to comply with the MLR requirement and, as a result, they contend that the services agents and brokers provide to both consumers and employers of all sizes are being reduced. In May, a NAIC task force released a national study of producer compensation that backed up the producer community's position, finding “a significant number of companies have reduced commission levels, particularly in the individual market.”

It is unclear at this point whether the recent DHHS action spells an end to the agent and broker commission discussion. Congress has recently begun holding hearings on H.R. 1206, which would exclude producer compensation from MLR calculations. Perhaps the Administration is leaving the final decision on the sensitive issue of agents and brokers commissions in the hands of Congress. Stay tuned…

For more information, contact Les Schott.

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The SEC Takes Another Step in Its IFRS Work Plan, but a Decision is Not in the Offing
by Jim Stangroom

In November, the SEC issued two more staff papers as part of its work plan to make a determination about whether, and if so how, to incorporate IFRS into the U.S. financial reporting system. The papers are entitled A Comparison of U.S. GAAP and IFRS and Analysis of IFRS in Practice. These were preceded by a staff paper in May on Exploring a Possible Method of Incorporation of IFRS. These recent papers reflect the SEC’s progress along the road toward reaching its decision, but it is not clear that the SEC is any closer to actually making that determination.

At the December AICPA National Conference on current SEC developments, SEC Chief Accountant James Kroeker indicated that SEC Staff was in the final stages of completing field work related to its formal work plan and needed just “a few additional months” to produce a final report for consideration by the Commission.

That said, the global accounting community is anxiously awaiting the SEC’s decision on IFRS, which still may be months away, perhaps more than just a few. A decision had been expected by the end of 2011, a milestone date that had been set by the SEC some time ago. It is now clear that will pass, and other than a vague reference to “a few additional months” there now is no firm revised target date.

Some feel that U.S support of IFRS through the SEC is critical to the future acceptance of IFRS globally. Others believe the U.S will not cede authority for accounting rule making to an international body. As we have reported in previous editions of Insurance Perspectives, as the FASB and IASB continue to make progress towards new standards on accounting for insurance contracts and financial instruments, insurance companies should anticipate significant changes in accounting and financial reporting regardless of the SEC’s decision.

One aspect of the SEC work plan published in February 2010 called for the SEC staff to inventory areas where IFRS guidance differed from U.S. GAAP. In the paper, A Comparison of U.S. GAAP and IFRS, SEC staff summarizes its results of a review of 29 accounting topics, identifying many differences; however, the paper did not state any judgments as to which accounting standard was better from the SEC’s perspective. The paper stated that the elimination of such differences was not a prerequisite for SEC consideration regarding the incorporation of IFRS into the U.S financial reporting system.

Not surprisingly, one general observation made in this paper is that IFRS contains broad principles while U.S. standards often contain industry or transaction-specific guidance. The SEC Staff excluded from their analysis of differences those topics that were active on-going convergence projects of the IASB and the FASB, including the insurance contracts and financial instruments projects. The staff acknowledged uncertainty in whether the IASB and FASB will be able to reach convergence on all projects and specifically referred to the financial instruments project as an example. It is unclear whether the SEC will need to see more substantive progress on the IASB and FASB joint convergence projects before making a final determination on IFRS.

In the paper, An Analysis of IFRS in Practice, SEC staff presented observations on disclosure, compliance with accounting standards and comparability of financial statements for 183 companies that prepare financial statements in accordance with IFRS. Staff identified two themes as a result of its analysis: that the transparency and clarity of disclosure could be enhanced and that diverse application of IFRS across countries and industries “presented challenges to the comparability of financial statements....” In addition, this paper summarized frequent areas of comment from the Division of Corporation Finance as part of its disclosure review program of foreign companies that are SEC registrants.

Both of these SEC papers state that the observations made were not intended to be determinative as to whether or not IFRS should be incorporated into the U.S. financial reporting system. The papers form part of the SEC’s work plan set forth in February 2010. While the SEC staff may be winding up its work plan activities, a final report is now not expected for at least several more months, and then the SEC commissioners will need more time to deliberate before making a final decision. Although these two papers do not contain any major new insight into the SEC’s direction on an IFRS decision, they at least represent another step in the SEC’s formal work plan that has now been completed so that the SEC’s decision making process can proceed.

For more information, contact Jim Stangroom.

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European Commission Takes Aim at the Public Accounting Profession with Mandatory Rotation and Other Proposals
by Tom Finnell

It was only a few months ago that we reported that the Public Company Accounting Oversight Board (PCAOB) had issued a Concept Release soliciting public comment on the pros and cons of mandatory audit firm rotation and whether such a practice would enhance auditor independence (see article). In fact, the comment period relating to that Concept Release ends on December 14, 2011; more than 175 comment letters are currently posted on the PCAOB’s website.

In the meantime, more far-reaching proposals to shake up the accounting profession have surfaced across the pond. The European Commission (EC) floated legislative proposals last week that would require mandatory rotation of audit firms after six years (with some exceptions); that public companies have a mandatory and transparent bid process to procure audit services; that audit firms be prevented from offering non-audit services to audit clients; and that large audit firms be required to separate audit activities from non-audit activities. The proposals were met with the expected resistance by many audit firms as well as by many in industry and by individual country regulators as well.

The EC’s proposed requirement to mandate auditor rotation after six years is coupled with a requirement that there be a four year cooling-off period before the former audit firm can again be engaged by the company. Some countries in the Euro zone have had joint audit requirements in the past, i.e., where the overall audit effort is shared by two firms. The EC’s current proposals do not include the requirement that joint audits be performed, but in recognition that there may be voluntary situations where two sets of eyes are looking at the books, the proposals allow joint audit participants to perform their part of a company’s audit for up to nine years before rotating off. The EC’s proposals would have to be approved by European Union states and the European Parliament before they could take effect.

Here in the U.S., the Sarbanes-Oxley Act of 2002 (SOX) put in place a number of reforms, including independence requirements for audit committees, a stronger role for audit committees in overseeing the audit firm’s relationship and services, a five-year rotation period for the lead partner on an audit, a ban on certain key non-audit services to audit clients, as well as requirements to audit and report on internal controls. Several years later, the NAIC included a number of SOX-like provisions in the amendments to the former Model Audit Rule, now known as the Annual Financial Reporting Model Regulation (AFRMR). But neither SOX nor the AFRMR went so far as to call for mandatory audit firm rotation. While the PCAOB’s Concept Release seeks input on that notion (as opposed to just rotation of the lead partner), the EC has made audit firm rotation the centerpiece of its proposals.

As just one example of how the Big Four are reacting to the EC’s proposals, Ernst & Young issued its statement, indicating that “several of the key proposals…, should they come into effect, would damage audit quality and provide little or no added value while increasing the cost of audit at a time of economic uncertainty.”

A number of insurers and/or their audit committee chairs have spoken up on the PCAOB’s Concept Release and on the point of mandatory audit firm rotation. All of those letters take the position that the potential costs and risks of mandatory audit firm rotation would outweigh the benefits. For example, in a letter signed by the chair of its audit committee and by its senior vice president of finance and controller, New York Life put forth the following concerns about audit firm rotation:

• “The auditor… [has] deep knowledge and insight into the Company's business activities and financial processes. The full turnover of audit firm personnel will create risk until the firm has developed enough knowledge of the Company's management and operations.
• We are in a very specialized industry, in which there are a very small number of audit firms with deep industry expertise. A lack of specialized industry knowledge increases the risk that audit quality will decline, which far outweighs the perceived benefit of a rotation requirement.
• Companies will need to invest substantial time, effort and money in selecting and educating new auditors on a rotating basis. The time spent by senior management and other employees within our organization could best be directed to focusing on corporate governance, internal controls and financial reporting.”

New York Life’s letter also stated that, “we also believe that it is important that the Audit Committee continue to have the autonomy to choose the right auditor, based on the audit firm's experience and industry knowledge, instead of being forced to choose an auditor due to a mandated requirement.”

At the Audit Quality Symposium sponsored by the Canadian Public Accountability Board on December 1, 2011, PCAOB Chairman James R. Doty expressed interest in the EC’s proposals, stating: “I applaud Commissioner Barnier of the European Commission for his leadership in engendering an essential reexamination in Europe of the audit and its role in investor protection. He unveiled a new set of proposals yesterday. I look forward to studying and discussing them.” Nonetheless, Mr. Doty mentioned the notion of rotation only once in his presentation and only then in the context of the PCAOB’s Concept Release. His comments instead focused on what he sees as two “great impediments” to investor confidence in financial reporting:

• The “bias of the payment model,” i.e., “the auditor is hired and fired by the company itself.”
• “[Dealing] with the global nature of the audit, when notwithstanding what auditors’ marketing materials say, audit firms and audit regulators are, as with politics, local, and the auditor has a client to keep.”

With respect to its Concept Release, the PCAOB has requested that comments be received by December 14, 2011. The SEC plans to hold a public “roundtable” meeting in March 2012 to discuss the topics of auditor independence and mandatory firm rotation.

For more information, contact Tom Finnell.

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