The influence of international standards on the direction of insurance regulation in the United States has dominated public discussion about insurance regulation during recent years. Nowhere was that more evident than in Washington, D.C., last week. On May 5, the 6th Annual U.S.-EU Insurance Symposium was held at the U.S. Chamber of Commerce and on April 28 and 29 Congressional hearings focusing on international insurance regulatory issues and their impact on U.S. insurers were held in both the U.S. Senate and the House of Representatives. With the January 1, 2016, implementation date for Solvency II quickly approaching, we expect this focus will only increase.
This report provides an update on recent developments in key international regulatory standards that may be of interest to our clients, as well as notable highlights from this past week’s events.
A. 2015 FSAP Review of the U.S. Insurance Industry
B. International Capital Standards: Developments at IAIS, the Fed, the NAIC and on the Hill
C. Reduced Collateral: The European Council Supports a Covered Agreement
A. 2015 FSAP Review of the U.S. Insurance Industry
In April, the International Monetary Fund (IMF) issued its second Financial Sector Assessment Program (FSAP) assessment of insurance regulation in the United States. The Assessment found a reasonable level of observance in the United States of the International Association of Insurance Supervisors (IAIS) Insurance Core Principles (ICPs), but noted several areas for development and gaps in regulation. It is the gaps, rather than the overall assessment of observance, that will capture greater attention.
FSAP, which was established jointly by the IMF and the World Bank in 1999 in response to the financial crises of the late 1990s, is a comprehensive and in-depth analysis of a country’s financial regulatory sector. Currently, 29 major jurisdictions undergo an FSAP review every five years. For insurance, FSAP reviewers assess the extent to which regulators in the subject jurisdiction observe the international regulatory standards set out in the ICPs. The 2010 FSAP review urged the United States to further centralize and federalize insurance supervision. This finding, in conjunction with the 2008 financial crisis, led to many significant developments in U.S. insurance regulation over the last five years. The 2015 FSAP review will likely have further impact on the U.S. insurance regulatory landscape.
2010 FSAP Review
One of the most significant shortcomings noted in the 2010 FSAP review was with respect to the U.S. approach to group supervision. Historically, the U.S. approach to group supervision, as embodied in the NAIC’s Insurance Holding Company System Regulatory Act and accompanying model regulations (Holding Company Act and Regulations), has been described as a “windows and walls” approach: regulators have “windows” to scrutinize group activity and assess its potential impact on the ability of an insurer to pay its claims and “walls” to protect the capital of an insurer by requiring the insurance commissioner’s approval of material related-party transactions. However, the 2010 FSAP review found that U.S. regulators did not effectively assess the financial condition of the whole group of which a licensed insurance company is a member and that risk-focused examinations did not generally focus on group issues.
In response to this critique, the NAIC adopted amendments to the Holding Company Act and Regulations in 2010 and a new Risk Management and Own Risk Solvency Assessment Model Act (ORSA Model Act) in 2012. Notably, the 2010 amendments to the Holding Company Act and Regulations include a requirement that the ultimate controlling person of every insurer subject to registration must file an “enterprise risk report” (Form F) annually, which must identify, to the best of the ultimate controlling person’s knowledge and belief, the material risks within the insurance holding company system that could pose enterprise risk to the insurer. Form F reporting in some states began as early as April 2014. Similarly, the ORSA Model Act requires insurers to “maintain a risk management framework to assist the insurer with identifying, assessing, monitoring, managing and reporting on its material and relevant risks.” They must also perform an ORSA at least annually and at any time “there are significant changes to the risk profile of the insurer” or its insurance group. Insurers subject to the Act1 must also file an ORSA Summary Report with their insurance commissioner if requested (but not more often than annually). ORSA reporting began January 1, 2015, in those states that have adopted the ORSA Model Act.
In December 2014, the NAIC adopted further amendments to the Holding Company Act and Regulations that authorize state insurance regulators to act as the group-wide supervisor for internationally active insurance groups (IAIGs). A state insurance regulator may serve as group-wide supervisor for an IAIG if: (1) the group has an insurer domiciled in the regulator’s state; (2) the group has premiums written in at least three countries; (3) at least 10% of the group’s gross written premiums are written outside the United States; and (4) based on a three-year rolling average, the group’s total assets are at least $50 billion or its total gross written premiums are at least $10 billion. The 2014 amendments provide that state insurance regulators may select the group-wide supervisor based on the following factors: (1) place of domicile of the largest insurer(s) in the group; (2) place of domicile of the top-tiered insurer(s) in the group; (3) location of the group’s executive offices or largest operational offices; (4) whether another regulator is acting, or is seeking to act, as the group-wide supervisor; and (5) whether another regulator provides reasonably reciprocal recognition and cooperation. A group-wide supervisor is authorized to:
Assess the enterprise risks within the IAIG;
Request, from any member of the group subject to the commissioner’s supervision, information necessary and appropriate to assess enterprise risk, including information regarding governance, risk assessment and management, capital adequacy, and material intercompany transactions;
Coordinate and compel development and implementation of reasonable measures designed to ensure that the group is able to timely recognize and mitigate enterprise risks;
Communicate with other state, federal and international regulatory agencies for members within the group and share relevant information;
Enter into agreements and obtain documentation providing the basis for or otherwise clarifying the commissioner’s role as group-wide supervisor; and
Other group-wide supervision activities, consistent with this authority.
2015 FSAP Review
The 2015 FSAP found various shortcomings with the U.S. regulatory framework for insurance, notwithstanding Federal and state activity since the last report. The 2015 report found 21 out of 26 ICPs were “Observed” or “Largely Observed,” but 5 ICPs are only “Partially Observed.”2 In particular, it noted as “Partially Observed”:
Objectives, Powers and Responsibilities of the Supervisor (ICP 1). The FSAP found state regulators’ objectives are not clearly and consistently defined in law. It further notes the Federal Reserve Board (FRB) does not include policyholder protection and there is potential conflict, in times of stress, between the expressed objective of the regulation of savings and loan holding companies and non-bank financial companies, and the interests of policyholders. As to state regulatory objectives, it states, in a fairly Delphic way, “states should ensure that the promotion of insurance business, and excessive focus on affordability of insurance rather than fair treatment of policyholders, are not a part of regulatory objectives, explicitly or otherwise, especially given states’ interests in promoting the growth of the insurance sector as a significant provider of employment and state revenues.”
Supervisor (ICP 2). The ICP requires the supervisor to be operationally independent, accountable and transparent and to have appropriate legal protection, adequate resources and meet high professional standards. The FSAP noted risks to independence. It found the process for appointment and dismissal of state insurance commissioners exposes the supervision of insurance to potential political influence, as does the high dependence on state legislatures for principal legislation and budget.
Corporate Governance (ICP 7). The ICP requires the supervisor to require insurers to establish and implement a corporate governance framework which provides for sound and prudent management and oversight of the insurer’s business and adequately recognizes and protects the interests of policyholders. The FSAP found that neither state nor Federal regulators have set formal broad-based, insurance-specific governance requirements. Significantly, in anticipation of the FSAP, the NAIC adopted the Corporate Governance Annual Disclosure Model Act and the Corporate Governance Annual Disclosure Model Regulation (Corporate Governance Models), which require that on each June 1, every insurer, or the insurance group in which the insurer is a member, submit a Corporate Governance Annual Disclosure (CGAD) to its lead state or domestic regulator. In the CGAD, insurers must document, in narrative form, information about their corporate governance framework, including the structure and policies of their boards of directors and key committees, the frequency of their meetings, and procedure for the oversight of critical risk areas and appointment practices, among other things. Insurers must also disclose the policies and practices used by their board of directors for directing senior management on critical areas, including a description of codes of business conduct and ethics, and processes for performance evaluation, compensation practices, corrective action, succession planning and suitability standards. In adopting this model, the NAIC explicitly rejected the concept of setting corporate governance standards based on its view that insurers are subject to varying corporate governance standards under state law and, for public companies, Federal Securities laws, and choosing to rely instead on risk assessment through reporting and onsite examinations. The FSAP found this falls short.
Valuation (ICP 14). The 2015 FSAP focused on the current prescriptive, formula-based nature of life reserving requirements, noting the current valuation standard has features that do not give appropriate incentives for dynamic hedging for products where it would constitute appropriate risk management and that shortcomings of the current standards are circumvented through complex structures, including transactions with affiliated captive reinsurers. The review goes on to note, however, that principle-based reserving (PBR)—though its implementation date is uncertain—would mitigate some of these issues. At the NAIC’s most recent National Meeting in March, Superintendent Joseph Torti III (Rhode Island), Co-Chair of the Principle-Based Reserving Implementation (EX) Task Force, reported that 21 states have now adopted the revised Model Standard Valuation Law, which authorizes PBR, and that PBR is expected to “go live” in 2017. Nonetheless, the future of PBR remains uncertain, with both New York and California—two of the largest states in terms of direct life insurance premium—strongly opposed.3
Group-wide Supervision (ICP 23). The ICP requires supervision of insurers on a legal entity and group-wide basis. The 2015 FSAP review commends the significant improvements in group-wide supervision that have been made in the United States through adoption of the 2010 amendments to the Holding Company Act and Regulations and the ORSA Model Act, but notes the absence of group-wide capital standards, as well as group-wide investment, market conduct and disclosure requirements.
Two other notable shortcomings identified in the FSAP:
The state-based system of regulation—although improved with the introduction of Federal Insurance Office (FIO)—remains complex and presents risks from a lack of consistency between regulators and risks of failure to act on gaps or weaknesses in regulation with sector or system-wide implications.
FRB needs to build expertise in insurance regulation and supervision generally and would benefit from having more staff with understanding of insurance issues at senior levels.
B. International Capital Standards: Developments at IAIS, the Fed, the NAIC and on the Hill
The Financial Stability Board (FSB) and the IAIS continue their work on aCommon Framework for the Supervision of Internationally Active Insurance Groups (ComFrame), a set of international supervisory requirements focusing on group-wide supervision of internationally active insurance groups (IAIGs). ComFrame is built and expands upon the high-level requirements and guidance currently set forth in the ICPs and will include international capital standards. The IAIS’s Field Testing Task Force is currently engaged in a ComFrame field-testing process, which entails the review and assessment of qualitative and quantitative questionnaires that are being sent out to IAIG volunteers and their group supervisors to assess whether ComFrame promotes effective group-wide supervision of IAIGs and whether it leads to practical benefits without undue burden. ComFrame is currently scheduled for full implementation in 2019.
In July 2013, the FSB directed the IAIS to develop group capital standards applicable to global systemically important insurers (G-SIIs). These international capital standards are to include: (1) backstop capital requirements (now known as Basic Capital Requirement, or BCR) by 2014; (2) Higher Loss Absorbency (HLA) requirements in 2015; and (3) risk-based, group-wide global insurance capital requirements (ICS) in 2017 (although recent reports indicate that IAIS’s timeline for completion of ICS may be pushed back to 2020). Once these standards are finalized, they would be submitted to FSB for its consideration and international agreement, and ICS would become a component of ComFrame applicable to IAIGs.
In 2014, IAIS adopted BCR, which is the first global group capital standard for the insurance sector and provides a method to measure capital within an insurance group across jurisdictions. IAIS continues its work to refine BCR based on the results of data collected during field testing. Future refinements could include allocation of business lines to be used in BCR and revising BCR factors to more appropriately align capital requirements with the inherent risks of business activities. In 2015, G-SIIs will begin to report BCR on a confidential basis to group-wide supervisors. BCR will serve as the starting point for both HLA and ICS (the latter of which may ultimately surpass BCR as the starting point for HLA). An IAIS consultation paper on HLA is scheduled to be released in June 2015 and a consultation paper on ICS was released in December 2014. IAIS’s “ultimate goal” for ICS is that it will “include a common methodology by which ICS achieves comparable, i.e., substantially the same, outcomes across jurisdictions,” and its “key elements” will include valuation, capital resources and capital requirements.
Solvency II Capital Standards
Solvency II is a new regulatory framework in the European Union (EU) that will create a new insurance regulatory regime applicable to almost all EU insurers and reinsurers, including groups headed by non-insurance related parents. Solvency II requirements will apply on a group-wide basis, and thus will impact U.S. groups with EU insurance subsidiaries and U.S. subsidiaries of EU groups. In March 2015, Solvency II reached a significant milestone when the European Commission adopted the first set of Solvency II implementing regulations. Solvency II is currently scheduled for full implementation January 1, 2016.
Solvency II requires European insurers to calculate both a Minimum Capital Requirement (MCR) and a Solvency Capital Requirement (SCR), where SCR is more risk-focused than MCR. Supervisory action is required if an insurer’s financial resources fall below SCR with an aim of restoring capital to meet SCR as soon as possible. If resources fall below MCR, then “ultimate supervisory action” will be triggered (i.e., the insurer’s liabilities will be transferred to another insurer, and the license of the insurer will be withdrawn or the insurer will be closed to new business and its in-force business will be liquidated). Any additional capital charge will be applied to insurers that fail to adequately match their investments and capital to their liabilities.
On April 28 the Senate Committee on Banking, Housing, and Urban Affairs held a public hearing on “the State of the Insurance Industry and Insurance Regulation.” During this hearing, witnesses were pressed on the international capital standards being proposed by the IAIS and whether it would be appropriate to adopt those requirements in the United States. A number of senators took issue with U.S. regulators allowing the IAIS to dictate capital standards for U.S. insurers. This same sentiment was echoed on April 29 during a public hearing of the House Financial Services Subcommittee on Housing and Insurance entitled “The Impact of International Regulatory Standards on the Competitiveness of U.S. Insurers.” Commissioner Kevin McCarty (Florida), Michael McRaith, Director of FIO, and Mark Van Der Weide, Deputy Director, Division of Banking Supervision and Regulation for the Board of Governors of the Federal Reserve, testified at both the Senate and House hearings, with the Honorable S. Roy Woodall, Jr., the independent member with insurance expertise of the Financial Stability Oversight Council (FSOC), also testifying during the Senate hearing.
During his testimony, Mr. Woodall expressed concern that international regulators may be attempting to exert “inappropriate influence” on the development of U.S. insurance policy and that state insurance regulators are not represented at the FSB. Commissioner McCarty echoed this sentiment, noting that the U.S. insurance regulatory framework focuses on protecting policyholders, while the EU models focus more on protecting insurers’ creditors, and that these two approaches may be at odds. Commissioner McCarty also expressed concern about the IAIS’s “aggressive timeline of developing a global capital standard given legal, regulatory, and accounting differences around the globe.” All of the witnesses acknowledged, however, that any standards adopted by the IAIS would not be binding on U.S. regulators until adopted in the United States.
SIFIs and the Collins Amendment
At the Federal level, FRB is focused on constructing a domestic regulatory capital framework for non-bank systemically important financial institutions (SIFIs). In 2014, insurers won a much-anticipated concession concerning the enhanced supervision that the Dodd-Frank mandates FRB apply to insurers that have been designated SIFIs by FSOC. The Insurance Capital Standards Clarification Act of 2014 (known as the Collins Amendment), which became law on December 18, 2014, exempts insurance companies from the minimum leverage capital requirements and minimum risk-based capital requirements applicable to bank holding companies and other non-bank financial companies supervised by the FRB. The Act garnered widespread bipartisan support in an atmosphere where some representatives have accused the FSOC of acting without sufficient transparency and not publishing rules tailored to non-bank SIFIs.
To date, FSOC has designated four non-bank SIFIs: MetLife Inc., American International Group Inc., Prudential Financial Inc., and General Electric Co.’s finance unit; however, on January 13, 2015, MetLife Inc. filed suit seeking to overturn its designation—the first such company to do so—on the basis that FSOC’s conclusion was arbitrary and capricious.
NAIC Position on International Capital Proposals
The NAIC continues to closely monitor the development of proposed international capital standards, with an eye toward ensuring that such requirements do not undermine legal entity capital requirements in the United States. In 2014, the NAIC formed the ComFrame Development and Analysis (G) Working Group (CDAWG) to provide ongoing review and input on ComFrame and developments on international group capital requirements. Earlier this year, CDAWG reviewed and coordinated comments from state insurance regulators on IAIS’s first consultation paper on ICS, and in April, the NAIC issued Position Statements on ComFrame and International Capital Proposals.
The NAIC’s Position Statement on International Capital Proposals states that state insurance regulators continue to have concerns about the time, role and complexity of developing global group capital standards, given legal, regulatory and accounting differences around the globe. The Position Statement summarizes the general views that “guide U.S. state insurance regulators’ overall approach and expectations towards the development of capital standards and the various international proposals,” including:
Capital Standards. A single uniform capital standard is not a “silver bullet,” but rather should be seen as one of many tools used to achieve more effective regulation and/or greater financial stability.
Fungibility. U.S. state insurance regulators are concerned with a reliance on the assumption that capital can be freely moved within an insurance group. Whatever capital requirements are implemented at the group level should be supplemental to jurisdictional capital requirements. For the United States, group capital requirements would supplement U.S. risk-based capital (RBC) that applies at the legal entity level.
Accounting and Valuation. There remain major differences among jurisdictions in accounting systems and approaches to valuation of assets and liabilities. The development of ICS, BCR and HLA will need to take this into account.
The NAIC is separately working on its own proposal for a group capital standard for IAIGs. In December 2014, the NAIC circulated an initial draft “concepts” paper entitled “U.S. Group Capital Methodology Concepts Discussion Paper.” The paper sets out three basic approaches. The first is labeled “RBC Plus” and would follow the same base methodology used for risk-based capital analysis of individual insurance companies, but would use consolidated GAAP financial statements and additional factors pertinent to internationally active groups. The second approach is labeled “Cash Flow” and assesses the adequacy of cash flows over the lifetime of a portfolio. The third approach is a hybrid of RBC Plus and Cash Flow testing. The reaction from industry has been mixed and it remains to be seen which of these proposals the NAIC will ultimately adopt.
C. Reduced Collateral: The European Council Supports a Covered Agreement
One week before Tuesday’s U.S.-EU Insurance Symposium, the European Council announced that it would direct the European Commission to negotiate an agreement with the United States on reinsurance collateral requirements for non-U.S. reinsurers doing business in the United States.
Dodd-Frank authorizes FIO and the U.S. Trade Representative (USTR) to negotiate jointly with one or more foreign governments, or their regulators, “covered agreements” on certain prudential measures, and authorizes the preemption of state insurance law if the FIO Director determines that the law: (1) results in less favorable treatment of a non-U.S. insurer domiciled in a foreign jurisdiction that is subject to a covered agreement than a U.S. insurer domiciled, licensed, or otherwise admitted in that state; and (2) is inconsistent with the covered agreement.
Historically, U.S. insurance laws governing credit for reinsurance have required non-U.S. reinsurers to post 100% collateral in the United States for risks reinsured from U.S. ceding insurers. In 2011, the NAIC adopted amendments to its Credit for Reinsurance Model Law and Regulation (Reinsurance Models) that allow certain highly rated, non-U.S. reinsurers domiciled in a “qualified jurisdiction” to reinsure U.S. ceding insurers with reduced collateral. Critics of state law requirements for reinsurance collateral have pointed out that the reduced collateral provisions of the revised Reinsurance Models are optional and that unless states are required to adopt these provisions, the lack of uniformity among states with regard to reinsurance collateral requirements will persist, inviting federal action.
The issue of a covered agreement was front and center during a session of the U.S.-EU Insurance Symposium on the EU-U.S. Insurance Regulatory Dialogue Project, which included representatives from industry, the NAIC, FIO, the European Insurance and Occupational Pensions Authority (EIOPA) and Insurance Europe. Industry representatives expressed interest in a covered agreement that would provide a level playing field for U.S. and non-U.S. reinsurers, as well as recognition of the U.S. system of insurance regulation as equivalent under Solvency II. However, they also left the door open to a state-based solution, by agreeing that obtaining mutual recognition and equivalence was far more important than how these results were obtained. Speaking on behalf of the NAIC, Director John Huff (Missouri) reported that states are making significant progress in adoption of the revised Reinsurance Models, and emphasized that a state-based solution provides greater certainty of implementation than pursuing a covered agreement (which would be the first of its kind). Director Huff also reported that 26 states representing more than 60% of direct insurance premiums have adopted the revised Reinsurance Models, and that another 11 states are expected to adopt the revised Reinsurance Models during 2015, which would raise the total direct insurance premiums of adopting states to 93%.
At the federal level, in December 2014, FIO issued its long overdue report, entitled “The Breadth And Scope Of The Global Reinsurance Market And The Critical Role Such Market Plays In Supporting Insurance In The United States” (Reinsurance Report). In the Reinsurance Report, FIO indicates that reinsurance collateral continues to be at the forefront of its thinking with regard to potential direct federal involvement in insurance regulation. Specifically, the Reinsurance Report argues that “federal officials are well-positioned to make determinations regarding whether a foreign jurisdiction has sufficiently effective regulation and, in doing so, consider other prudential issues pending in the United States and between the United States and affected foreign jurisdictions” and notes that work continues towards initiating negotiations for covered agreements. This echoes statements in FIO’s 2014 annual report to Congress in which it notes the lack of uniformity in state insurance law collateral requirements for non-U.S. reinsurers despite NAIC efforts and reasserts its prior recommendation that the Treasury Secretary and USTR should negotiate and enter into bilateral “covered agreements” with foreign regulatory authorities regarding prudential measures with respect to the business of insurance or reinsurance.
While great strides towards a covered agreement have been made over the last year, it is important to note that significant obstacles remain. Dodd-Frank requires FIO and the USTR to consult with the House Financial Services Committee, the House Ways and Means Committee, the Senate Finance Committee, and the Senate Banking Committee before initiating (and during) negotiations of any covered agreement, and requires a 90-day waiting period between a final agreement being submitted to these committees and implementation. In addition, many U.S. authorities have expressed concern over a covered agreement with the EU that would include EU countries—Latvia and Malta, for example—that some perceive as having inadequate reinsurance regulation. Further complicating things is a general election in the UK in 2017 that may increase the pressure for a referendum before 2017 on whether the UK should leave the EU.