The Fall National Meeting of the National Association of Insurance Commissioners (NAIC) was held November 29 through December 2, 2012, at National Harbor, Maryland, a convention site that almost technically qualifies as inside-the-Beltway. As at prior meetings, much of the work was motivated by the NAIC’s continuing quest to heed off criticism for falling short of international regulatory standards. In the case of healthcare, regulators are still dealing with the implementation of various aspects of the Patient Protection and Affordable Care Act (a/k/a “Obamacare”).
The main events capturing outside attention involved life insurance reserves. The cameras-rolling, back-channel efforts of New York and California to derail the decade-long Principles-Based Reserving (PBR) initiative, which will change the basic way that life insurance company reserves are set, were also accompanied by regulator disagreement over whether captive insurance companies are being improperly used as vessels for off-balance-sheet financing of life reserves. The PBR initiative passed by a margin of one vote, and the topic now moves to the state legislatures. The captives discussion looks to be part of the continuing discourse well into the next year.
We have not set out to report on every task force and working group, but instead offer a summary of noteworthy developments.
Issues of General Interest
1. Principles-Based Reserving
Prior to and after the NAIC’s 2012 Summer National Meeting, the Valuation Manual was kept closely on track for final adoption by year end so that state legislatures could begin work on amendments to the Standard Valuation Law in 2013. The Valuation Manual was brought before the joint session of the Executive (EX) Committee and Plenary for final adoption on the final day of the Fall Meeting – at long last, after nearly a decade of work on PBR. After a lively debate among regulators, the Valuation Manual, which required the affirmative vote of 42 of the 50 U.S. states, the District of Columbia and four U.S. possessions and territories, passed by a vote of 43.
In anticipation of the vote, New York Department of Financial Services Superintendent Benjamin Lawsky sent a letter to fellow insurance commissioners setting out a number of problems he perceived in moving from the current rules-based system of reserving and recommending that any improvements to regulatory oversight of reserves should be done within the current framework. At the joint session itself, Robert Easton, New York Executive Deputy Superintendent of the Insurance Division, summarized the New York Department’s technical and structural reasons for opposing the adoption of the Valuation Manual. Noting that New York was not unalterably opposed to PBR, Mr. Easton stated that no clear evidence has been presented of its benefits. California Insurance Commissioner Dave Jones also noted that while he was not opposed to PBR, he had three main objections to moving forward with implementation at this point– specifically, the lack of a fiscal analysis, the complexity of the models and the level of collaboration that will be necessary.
Speaking in support of the Valuation Manual adoption, Rhode Island Superintendent Joseph Torti III described the current formulaic approach to calculating reserves as antiquated and inadequate and asserted that the NAIC would be failing in not acting to adapt to the needs of the insurance marketplace. Superintendent Torti additionally said the current Valuation Manual approach incorporated significant conservatism which will lead to stronger, more appropriate reserves. Commissioner William White of the District of Columbia also voiced his concern that not taking action would send the wrong message concerning NAIC’s intent with regard to regulatory reform and that failure to act could erode credibility in the state-based system. Texas Insurance Commissioner Eleanor Kitzman reminded participants and observers of the requirements for PBR to become effective (including adoption by 42 jurisdictions representing 75% of written life premiums in the United States). She said that all remaining concerns can be addressed prior to full implementation and that, while a momentous step, the adoption of the Valuation Manual did not guarantee the future of PBR.
The adoption of the Valuation Manual will allow the Standard Valuation Law amendments and related state legislation necessary for PBR to be presented as a package in 2013. However, important work remains prior to full PBR implementation. At the Fall Meeting, the Principles-Based Reserving (E) Working Group submitted an Implementation Plan and is requesting comments on the plan no later than January 10, 2013. Among other things, the Implementation Plan recommends a survey of the states “to obtain information on their current level of resources, the anticipated resources necessary to support PBR, and the expected costs of and potential for obtaining the necessary resources.” The Working Group anticipates presenting the results of this survey at the 2013 Spring National Meeting.
2. Captive and SPV Use (E) Subgroup
The Captive and Special Purpose Vehicle (SPV) Use Subgroup of the Financial Condition (E) Committee, consisting of representatives of the Financial Analysis Working Group, the Reinsurance Task Force and the Life Actuarial Task Force, continues its work on a white paper on the use of captives and special purpose insurers. A revised draft of the white paper was released prior to the Summer National Meeting, and comments on the draft were due to the Subgroup by November 16, 2012 in advance of the Fall Meeting. The draft includes conclusions and recommendations, including the observation that “the majority use of captives/SPVs by commercial insurers was related to the financing of XXX and A-XXX reserve redundancies.” The draft acknowledges there are business reasons other than statutory accounting relief for the use of a captive or SPV, but stated a preference to see alternative, more transparent solutions to the issues captives and SPVs were designed to address in this context. Of particular concern is use of letters of credit or parental guarantees to support captives, as well as inconsistency among regulators in what they will approve for the funding of captives and SPVs.
Subgroup Chair Doug Slape of the Texas Department of Insurance opened the Subgroup’s meeting by stating that the white paper would be redrafted to respond to the majority of concerns raised in the comments received on the draft, particularly with regard to the draft’s references to captives as a “shadow banking,” IAIS standards and an increase in the use of captives for XXX and A-XXX transactions. The intent of the meeting, according to Mr. Slape, was to focus on additional concerns raised in the comments including accounting considerations, credit for reinsurance and the use of letters of credit, confidentiality, NAIC databasing, and consistency of captive regulation.
Within minutes of these opening statements, Superintendent Torti noted his general disappointment at the tone of the comments received by the Subgroup. Superintendent Torti, a nonvoting monitoring member of the Subgroup, said that the intent of the draft white paper was not to be a commentary on the captive insurance industry as a whole but rather to address particular regulatory concerns with regard to insurer solvency. Superintendent Torti voiced his specific concern that insurance companies are using captive vehicles to avoid statutory accounting requirements and characterized the issues to be considered as specific to adequate reserving rather than to captive use generally.
Commissioner White observed that alternative risk transfer (ART) techniques permit companies to more efficiently make use of capital and are an important factor in accounting for the growth and sophistication of the financial services industry. Commissioner White later echoed the solvency concerns expressed by Superintendent Torti but noted that in seeking to address such concerns, regulators should focus on consistency of application rather than uniformity.
The meeting provoked an animated exchange between Superintendent Torti and representatives from the Delaware Insurance Department, a fast-growing captive domicile. Responding to comments from Steve Kinion, Director of the Bureau of Captive and Financial Insurance Products, that the white paper could reasonably be perceived as an attack on the captive industry, Superintendent Torti said he resented the implication and added that there is no history of the NAIC doing anything harmful to captive insurers. In discussing the white paper’s statement that “consideration should be given to developing a database that includes NAIC company code, name and domiciliary information with respect to all captives in order to ensure that data on the universe of all such entities is available to allow regulators to quickly respond to questions on the same,” Delaware Insurance Commissioner Karen Weldin Stewart asked why Rhode Island would be interested in the activities of a Delaware captive without Rhode Island policyholders. Superintendent Torti responded that he could envision situations in which Rhode Island residents could be impacted by Delaware captives without Rhode Island policyholders and mentioned workers’ compensation as a possible example.
The consensus among participants and observers of the Subgroup meeting appeared to be that the language of the draft white paper would be tempered to assuage concerns among the captive insurance industry while continuing to raise regulators’ concern with regard to the perceived use of captives by insurance companies to circumvent financial regulation. A revised draft of the white paper will likely be just one step in a process involving more detailed studies and proposals to be discussed by the Subgroup and potentially other existing or yet-to-be-formed NAIC working groups.
3. Call for More Capital for Operational Risk
The Solvency Modernization Initiative’s Risk-Based Capital (E) Subgroup received a report that concluded with an observation that operational risk is a significant risk for financial institutions, and it is not fully reflected in capital standards. In response, the Subgroup Chair, Alan Seeley of New Mexico, said he would like RBC risk factors to give due regard to operational risk and noted these efforts are underway to develop an RBC risk factor for operational risk.
A presentation was provided by Mr. John Simone on behalf of the Operational Risk Consortium, a voluntary association of insurers started under the sponsorship of the Association of British Insurers that describes its activities as collecting, standardizing and reporting operational risk loss data for the insurance and asset management industry. The presenter described operational risk, as defined by Basel II, as the risk of loss resulting from inadequate or failed internal processes, people and systems or from external risks. Operational risk does not include underwriting, strategic or reputational risks, but does include legal risks. The presenter noted, for example, that mis-selling is an operational risk. He observed that loss data reveals that operational risk is “perhaps the most significant risk faced by the financial services industry,” and that the “tail risk associated with operational risk is significant as 1% of the number of losses account for 60% of the dollar amount of losses.” He cited as significant events Lehman Brothers, Société Générale, Knight Capital and UBS. He concluded that operational risk is considered relatively insignificant in comparison to credit and market risk, although a single credit default will probably not have a near or actual catastrophic impact on a firm, and that credit and market risks are “permissioned” while operational risk is not. He also recommended considering an expense ratio as a better metric than revenue for calculating operational risk capital requirements.
Insurers will want to watch the development of this risk factor closely. Insurers that have made considerable investments in good compliance and risk control processes could find themselves facing increased capital requirements because of an operational risk factor that does not give appropriate credit for their investments.
4. Reinsurance Collateral Reform
Update on State Implementation.
The Reinsurance Task Force received reports on the implementation of recent amendments to the NAIC Model Credit for Reinsurance Law and Regulation that allow ceding insurers to take full credit for reinsurance ceded to “certified reinsurers” incorporated in “qualified jurisdictions” without having to secure the full amount of the ceded liabilities with acceptable collateral. NAIC staff reported that 11 states have now adopted collateral reduction measures: California, Connecticut, Delaware, Florida, Georgia, Indiana, Louisiana, New Jersey, New York, Pennsylvania and Virginia. The Chair reported these states collectively represent approximately 40% of the directly written premiums in the U.S. NAIC staff reported that an additional 11 states have indicated they intend to adopt revisions and that 26 states report they are still undecided. New York and Florida are the only two states that have actually approved any reinsurers for reduced collateral.
The most significant development on this topic at the Fall Meeting was approval of the Model Law and Regulation as optional standards under the NAIC’s accreditation program.
Some context: Currently, states are required to adopt the Model Law and Regulation to meet NAIC standards for accreditation. Accreditation is important because it allows non-domestic regulators to rely on the oversight by an accredited domestic regulator for a host of regulatory requirements. The recent amendments to the Model Law and Regulation deviate from current standards. By accepting the amendments as an optional standard, states that allow for collateral reduction along the lines of the amendments will continue to be accredited, but because the amendments are an optional standard, states can continue to require 100% collateral and remain accredited.
There are a few hitches. Reinsurance collateral reduction legislation enacted by individual states is required to have a few elements of the Model Law that are considered essential. First, reduced collateral can only be applicable to new reinsurance after the effective date of the amendments. Second, a state’s collateral reduction rules must allow for revocation of certification after a rating downgrade or other disqualifying circumstance with full collateralization afterwards. Third, ceding insurers must be required to notify their domestic regulator if they exceed certain reinsurance concentration thresholds similar to Section 2J of the Model. (Notification to the commissioner is required if reinsurance recoverables from any single reinsurer or group of affiliated reinsurers exceeds 50% of policyholder surplus or if it cedes more than 20% of its gross written premiums from the prior calendar year, or if it is determined that recoverables/written premiums are likely to exceed those limits. The notice must demonstrate that the exposure is safely managed by the domestic ceding insurer.)
The Reinsurance Task Force also received reports from the Reinsurance Financial Analysis Working Group (R-FAWG). The stated purpose of the R-FAWG is to provide assistance to states with respect to certified reinsurers eligible for reduced collateral. However, the name suggests more than that – it takes its name from the Financial Analysis Working Group that serves as a peer oversight and regulatory coordination mechanism for troubled companies or companies presenting a heightened risk profile. The R-FAWG is developing a procedures manual. As with the FAWG, these procedures will not be published. The R-FAWG will meet behind closed doors.
The Chair emphasized that the R-FAWG would operate only as an advisory body, and that authority to issue individual ratings of certified reinsurers is reserved to the individual state insurance departments under their respective statutes and regulations. It is not clear to what extent the R-FAWG will influence individual state decisions on individual company applications. Doubtless it will attempt to do so.
“Qualified Jurisdiction” Approvals.
The Qualified Jurisdiction Drafting Group is working on processes for the review of non-U.S. jurisdictions. Under the Model Law, the NAIC is charged with recommending jurisdictions for recognition by the individual states as qualified jurisdictions. A state that deviates from the NAIC’s list must document the reasons why.
The Working Group released a paper outlining its proposed processes and standards just prior to the Fall Meeting. The paper describes the evaluation as “intended as an outcomes-based comparison to financial solvency regulation under the NAIC Accreditation Program, adherence to international supervisory standards and relevant international guidance for recognition of reinsurance supervision. The standard for qualification of a jurisdiction is that the NAIC must reasonably conclude that the jurisdiction’s reinsurance supervisory system achieves a level of effectiveness in financial solvency regulation that is deemed acceptable for purposes of reinsurance collateral reduction.”
The procedures call for regulators in a foreign jurisdiction that is being considered to conduct a written self-evaluation. Foreign regulators will be allowed to respond to a preliminary report to be prepared by NAIC staff, but there is no mechanism for public participation or comment before the report is finalized.
The paper notes that the NAIC will evaluate and expedite the review of Bermuda, Germany, Switzerland and the UK. Commentators at the Fall Meeting asked for immediate review of priority jurisdictions, rather than awaiting finalization of procedures for review and prioritizing jurisdictions. The paper has been exposed for a 45-day comment period.
5. Corporate Governance
The SMI Task Force’s Corporate Governance (E) Working Group continues to work on a reporting requirement for governance and compensation. During the Fall Meeting, it extended the comment period on two disclosure proposals – one calling for periodic disclosure of an insurer’s corporate governance framework, the other calling for disclosure of executive and director compensation. The Working Group Chair, Commissioner Susan Donegan of Vermont, said that she felt confidentiality issues have not been sufficiently vetted and proposed an additional 45-day comment period.
The context is the Working Group’s continuing work on a response to the comparative analysis of U.S. and international standards for insurance regulation. The product of this work was a “Proposed Response to a Comparative Analysis of Existing U.S. Corporate Governance Requirements” that was exposed earlier this year. The response covered increased reporting as part of the annual statement (including interrogatories on compensation practices), development of standardized review techniques, development of a common methodology for assessing corporate governance, and a requirement that life company actuaries report to the board on an annual basis. During conference calls leading up to the Fall Meeting, Superintendent Torti said that the group originally set out to develop corporate governance requirements for insurers. However, the direction moved to gathering information about insurer governance practices and using that information to adjust solvency monitoring activities. A consensus appears to have developed that regulators need some experience in collecting and analyzing this information before setting standards. Various insurance industry representatives have resisted the Working Group’s proposals on grounds that governance requirements vary depending on state law, the information being requested is duplicative of information already being reported or available from other sources, or that it requires disclosure of confidential information. During the interim calls, regulators reemphasized their view that inadequate governance was a leading contributor to insurance insolvencies and that regulators are set on elevating the review of corporate governance to a higher priority by requiring insurers to gather information on company practices into a centralized document that can be updated and reviewed on an annual basis. The governance disclosures are viewed as complementing the information provided in the ORSA report and ERM reports, not duplicating it.
Discussion has focused on the best mechanism to capture this information through the examination laws, annual holding company act disclosures, the annual statement process or RBC reports.
It is not clear where this group is heading. Its work could result in a relatively benign statement of principles that every insurer meeting basic requests of corporate law already follows, or it could culminate in disclosure obligations that have the effect of compelling insurers to change their governance structures and practices to meet regulators’ expectations, similar to what U.K. insurers have had to do in past years.
Other Issues of Particular Interest to Life Insurers
1. The (A) Committee – Continuing Down a Well-Traveled Road
The Life Insurance and Annuities (A) Committee moves into 2013 focused generally on the same issues as in 2012. The primary change is the formation of the ERISA Retirement Income (A) Working Group, which convened for the first time at the Fall Meeting (see discussion below).
In receiving the reports from the applicable working groups and task forces, outgoing Iowa Insurance Commissioner Susan Voss reported briefly on the developments from the activities of the Principles-Based Reserving (E) Working Group. Commissioner Voss thanked a number of contributors involved in the adoption of the Valuation Manual. As described above, she indicated that the group exposed an Implementation Plan and is requesting comments on the plan no later than January 10, 2013.
The (A) Committee also heard its report on federal legislative impacts including the fiscal cliff and possible tax reform. The report indicated that the (A) Committee would be monitoring those developments and their possible impact on the life insurance industry.
2. Contingent Deferred Annuities – A Long, Winding Road Ahead?
The Contingent Deferred Annuity (CDA) (A) Working Group met and received significant comments on its definition of “Contingent Deferred Annuity” and heard two recommendations on contingent deferred annuities for the (A) Committee.1
The Working Group heard a presentation from the life insurance industry relating to the investments made related to CDAs. In addition, Amy Sochard, FINRA’s Director of Advertising, provided input to the Working Group on FINRA’s experience with respect to CDA advertising. Ms. Sochard indicated that, while the volume of advertising reviewed by FINRA to date with respect to CDAs had been somewhat sparse, she and her staff had done some significant work in reviewing the advertising for the unique products. She highlighted the following general comments that FINRA had about such advertising:
- Some of the advertisements had unclear descriptions of the “triggering” event;
- FINRA had some concerns about the clarity of disclosure with respect to the potential layering of fees with CDAs;
- Some hypothetical illustrations related to CDAs had been incomplete; and
- Some advertisements exaggerated the benefits of the product.
The Working Group also heard a presentation from the National Organization of Life and Health Guaranty Associations (NOLHGA) and its counsel related to the potential guaranty fund coverage of CDAs under the model NAIC Life and Health Insurance Guaranty Association Model Act. In summary, the presentation indicated that (1) a CDA issued by a member insurer likely constitutes a covered product, and (2) none of the exclusions to coverage appear applicable to CDAs. The Working Group will continue its work in 2013 with a focus towards finalizing the recommendations to the (A) Committee related to CDAs.
3. The Annuity Buyer’s Guide – Close to the End of the Road?
The Annuity Disclosure (A) Working Group met to discuss the November 28, 2012 Draft of the Buyer’s Guide for Deferred Annuities. Given the brief period of time between the exposure of the most recent draft of the Guide and the meeting, there were not significant comments made during the meeting. Comments on the draft will be due by January 2, 2013. In working toward finalizing the Buyer’s Guide, Jim Mumford (IA), the Chair of the Working Group, reported to the (A) Committee that he anticipated moving the Guide forward through a review of the Guide and conference calls early in 2013. The current draft of the Guide contemplates a single guide for both variable and fixed annuity products.
4. The ERISA Retirement Income Working Group – Entering the On-Ramp
The ERISA Retirement Income (A) Working Group met for the first time at the Fall Meeting. The NAIC formed the Working Group after a request from the DOL to receive input from the NAIC particularly on the safe harbor for ERISA fiduciaries in selecting annuity providers as distribution options for a pension plan.2 In addition, the Working Group is likely to focus its review on the possible removal of the Seller’s Exemption from the DOL’s pending reproposal of an expanded fiduciary definition for ERISA plans and IRAs.
The Working Group heard presentations from the ACLI and the National Association for Fixed Annuities, among others, discussing the issues raised under DOL’s current safe harbor, and the issues created by the likely reproposal of the DOL rulemaking that could eliminate the Seller’s Exemption. With respect to the safe harbor for the selection of annuity providers, it was suggested that the options for the NAIC would range from simply providing information to the DOL about the financial regulation and guaranty fund coverage of annuity providers, to something as broad as potentially creating some sort of NAIC certification of such providers.
As next steps, the Working Group is determined to engage in the following projects:
- Discuss the possible need for assistance on the issues related to financial conditions with the Financial Condition (E) Committee;
- Begin the process of gathering information, requesting input from interested parties, and spotting issues to address;
- Discuss with the DOL the formation and work undertaken by the Working Group; and
- Convene a conference call in January 2013 to review progress.
The scope of activity of the Working Group remains to be seen. While the primary focus of the Working Group will be the DOL request for information on the safe harbor available to fiduciaries under 29 C.F.R. 2550.404a-4, it seems likely that the Working Group may take on a number of additional topics. For example, the Working Group intends to monitor and provide input on any possible rule reproposal from DOL related to the Seller’s Exemption from fiduciary requirements for sales made to plans or IRA sales. In addition, the Working Group could also conceivably look to review with DOL how annuities are generally used in benefit plans (e.g., those annuities that are not being offered solely as an immediate annuities at the time of distribution).
1. NAIC-NCOIL Market Regulation Subgroup Survey
At the NAIC/State Government Liaison Committee meeting, Kentucky Insurance Commissioner Sharon Clark presented a summary of the NAIC-NCOIL Market Regulation Subgroup survey, which compiled the responses of 47 state insurance departments with regard to market conduct examinations and enforcement. Commissioner Clark stated that data calls and interrogatories have significantly increased in recent years and that despite an increase in insurance department staff expertise, one-third of examiners are outside contractors. Costs of examinations range from $10,000 to $5 million, and these results are being analyzed to ascertain outliers. To supplement regulators’ responses, the NAIC-NCOIL Market Regulation Subgroup is drafting a survey for industry which will be exposed for comment in the near future.
2. Multistate Tax Commission Proposal
Also at the NAIC/State Government Liaison Committee meeting, Rhode Island Representative Brian Kennedy described a Multistate Tax Commission (MTC) proposal on insurance taxation which was due to come before the MTC Executive Committee on December 6, 2012. The proposed model statute would impose income tax on a partnership or limited liability company that is more than 50% owned by a non-corporate income tax entity, which would include insurance companies subject to premium and retaliatory taxes rather than corporate income tax. Representative Kennedy expressed his concerns that the MTC has moved forward with this proposal with little input and no backing from the NAIC, state legislators or insurance regulators, and that the proposal would disrupt the long-standing statutory tradition of taxing insurance companies based on premiums rather than income. NCOIL will be drafting a letter in opposition to the MTC proposal.
3. FEMA Presentation Regarding National Flood Insurance Program
At the Government Relations (EX) Leadership Council meeting, representatives from the Federal Emergency Management Agency (FEMA) gave a presentation regarding, among other things, the rate increases in the agency’s National Flood Insurance Program due to be phased in over the next four years beginning January 1, 2013. The intent of the rate increases is to bring rates more in line with actuarially determined rates for flood insurance. This may present insureds with significant increases in payments for flood insurance. Mississippi Insurance Commissioner Mike Chaney thoroughly questioned the FEMA representatives concerning increased flood insurance rates and referred to the increases in a number of other meetings. David Miller, Associate Administrator, Federal Insurance and Mitigation Administration, also stated that federal officials are being updated daily with regard to the effect of claims related to Superstorm Sandy on the current assets of the program. Notably, Mr. Miller would not comment on whether the administration will seek to increase the borrowing authority of the program.