October 13, 2016
Federal Insurance Office Report
The Federal Insurance Office Releases 2016 Annual Report on the Insurance Industry
On September 30, 2016, the Federal Insurance Office ("FIO") released its 2016 Annual Report on the Insurance Industry ("Report"), as mandated by the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Dodd-Frank Act"). The Report provides an overview of the financial performance and condition of the U.S. insurance industry and reviews a range of industry and regulatory developments from the past year at the state, federal and international levels that have implications for the U.S. insurance industry.
OVERVIEW OF U.S. INSURANCE INDUSTRY
The Report found that U.S. insurers continue to experience solid financial performance, with record yearend surplus levels in 2015 for the life and health ("L/H") sector, and year-end surplus levels in 2015 for the property and casualty ("P/C") sector that were only slightly less than the record high achieved in 2014. The Report summarizes various financial measures applicable to the L/H and P/C sectors as measured in 2015 and as compared to recent prior years, including premiums written, benefit and surrender payments, market performance, reserves, leverage, and surplus, among others. The Report also reviews capital markets and mergers and acquisitions ("M&A") activities of insurers during 2015, noting that M&A activity was especially significant in 2015 (the aggregate value of announced deals in the 15 months beginning January 1, 2015 represented more than ten times the aggregate value of all insurance M&A transactions in 2014).
FIO notes the impact of the continued low interest rate environment on the insurance industry, with its negative impacts more visible in 2015. According to the Report, investment income has stagnated for both L/H and P/C insurers, and net yields on invested assets have continued to decline, reaching their
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lowest levels in the past ten years. In particular, insurance firms' reinvestment risk or the inability to reinvest funds from maturing investments at rates of return equal to what existed when the maturing investments were originally purchased has made it difficult for life insurers to match asset and liability cash flows. FIO warns that, although insurers have taken measured steps to address the effect of low interest rates, those steps may not be sufficient if interest rates continue to remain historically low, and that life insurers may be challenged to build investment portfolios to support guaranteed benefits on various insurance and retirement products.1 FIO also discusses heightened interest in infrastructure investments as a potential mitigant for life insurer's interest rate and reinvestment risks, and whether capital requirements for insurers participating in this asset class should be calculated differently than for other asset classes.
The Report also reviews the impact on the global reinsurance industry of innovation and development in the "alternative risk transfer" market segment, which includes instruments such as insurance-linked securities, industry loss warranties, collateralized reinsurance and reinsurance sidecars. Capital in the alternative risk transfer market segment reached $72 billion in 2015 and now amounts to 12% of global reinsurance capital. FIO states that the alternative risk transfer market segment has increased the supply of global reinsurance, putting downward pressure on reinsurance premiums at the same time as premiums are facing pressure from higher retentions by primary insurers and the industry is experiencing an extended period of below-average catastrophe losses. FIO notes that "as a source of risk transfer capacity and as a potential challenge to traditional markets, the alternative risk transfer market segment continues to garner attention."
The Report reviews various regulatory developments in 2015 at the state, federal and international levels, the most significant of which are summarized below. Consistent with FIO's past annual reports and the report FIO issued in 2013 on how to modernize and improve the system of insurance regulation in the United States (the "Modernization Report"), FIO continues in the Report to highlight perceived shortcomings in the state-based insurance regulatory system, advocate for improved uniformity across a number of insurance regulatory issues, and recommend increased federal involvement in certain areas of insurance regulation. According to the Modernization Report, the "necessity for federal involvement should depend on [...] whether states can take measures to regulate effectively and with uniformity, the degree of the national or federal interest, and the nexus of the issues and the firms with the global marketplace."2
U.S. Regulatory Developments
Federal Developments: The Report provides updates on developments in 2015 relating to the Financial Stability Oversight Council's ("FSOC") designation of insurance-based nonbank financial companies as systemically important and the supervision of such companies by the Board of Governors of the Federal Reserve System ("FRB") pursuant to the Dodd-Frank Act.3
Federal Insurance Office Report October 13, 2016
The Report also notes that the FRB in June 2016 published an advance notice of proposed rulemaking describing two potential regulatory capital frameworks that would apply to FRBsupervised institutions significantly engaged in insurance activities, and a notice of proposed rulemaking that would apply certain enhanced prudential standards to insurance-based nonbank financial companies designated as systemically important.4
Reserving Requirements: The Report reviews efforts by state insurance regulators to develop a different reserving method, known as principles-based reserving ("PBR"), to address issues
regarding the standardized formula that has historically been prescribed by state insurance laws to calculate life insurers' reserves for products. A three-year implementation period for PBR will
begin on January 1, 2017 and, for life insurance reserves, PBR will apply only to reserves in
respect of policies issued after January 1, 2017. While the adoption of PBR presents several potential advantages, it also raises concerns; FIO notes that PBR relies heavily on each insurer's
application of internal models to complex data sets unique to each insurer, and expresses
concerns about the ability of states to implement PBR in an effective manner given the limited
number of sufficiently trained expert actuaries and staff examiners at most state insurance
departments. Some state insurance regulators have proposed delegating central regulatory responsibilities to the National Association of Insurance Commissioners ("NAIC"), but FIO warns that this approach "may inappropriately delegate regulatory functions to a private association with limited oversight by state legislatures and governors." The Report also cautions that PBR
implementation alone may not fully eliminate recourse by insurers to captive reinsurance
Captive Life Reinsurance: In 2014 and 2015, state insurance regulators developed, adopted,
and began to implement a new framework to enhance regulations and disclosure requirements
governing the cession of risk for certain life insurance products to reinsurance captives. State
insurance regulators and the NAIC continue to develop new model regulations addressing
reinsurance captives. FIO acknowledges that the new framework demonstrates progress in
efforts to address concerns about the use of reinsurance captives, but repeats its recommendation, first made in the Modernization Report, that state insurance regulators "should
continue to develop a nationally consistent and appropriately tailored capital, solvency, and disclosure framework for reinsurance captives." According to the Report, reinsurance captives
would continue to operate under less stringent requirements than life insurers even under the
new framework, and remain largely exempt from disclosure without sufficient transparency. The Report reiterates FIO's view that "[w]hile the states have improved the oversight of ceding life
insurers, reinsurance captives are U.S.-domiciled insurance entities that warrant appropriate, rigorous, and nationally uniform regulation."
Group Capital: The Report examines the NAIC's ongoing work on the development of a "group capital calculation." FIO states that the RBC aggregation approach proposed by the NAIC and state regulators is conceptually similar to the "building block" capital approach proposed by the
FRB in its advance notice of proposed rulemaking for application to insurance-based savings and
loan holding companies.
Group Supervision: The Report examines amendments made in 2010 to the NAIC's Model
Insurance Holding Company System Regulatory Act. FIO concludes that the amendments do not
provide state regulators with direct authority and oversight over non-insurance affiliates of
insurance companies, including parent holding companies. The Report then reviews 2014 amendments to the Model Insurance Holding Company System Regulatory Act (the "2014 Amendments"). The 2014 Amendments provide for the supervision of Internationally Active Insurance Groups ("IAIGs") by a single group-wide supervisor, and authorize the group-wide
supervisor, in coordination with other insurance regulatory officials of the jurisdictions where
subsidiaries of the IAIG are domiciled, to compel development and implementation of reasonable
measures to mitigate enterprise risk to subsidiaries of the IAIG that are engaged in the business of insurance. FIO notes that the 2014 Amendments raise important questions, including how a state insurance regulator that declares itself a group-wide supervisor will resolve jurisdictional disputes with other insurance regulators (including those in states that have not enacted the 2014 Amendments) or international regulators.
Federal Insurance Office Report October 13, 2016
Cybersecurity: The Report assesses the increased risk insurers face in maintaining cybersecurity. To improve cybersecurity and defend against cyber threats, the Report recommends that insurers participate in information sharing programs to expose cyber threats, adopt best practices and baselines to enhance their cybersecurity, and prepare response and recovery plans that can be deployed if a cybersecurity incident occurs. The Report states that the Treasury Department ("Treasury") strongly encourages insurers and other financial institutions to join the Financial Services Information Sharing and Analysis Center, which provides a platform for the global financial services sector to exchange information about cyber threats.5 FIO also recommends that state insurance regulators develop, adopt and uniformly implement cybersecurity examination standards for insurers that are consistent across all states and that comply with best practices for the oversight of financial institutions. The Report summarizes various efforts made by state insurance regulators and the NAIC to improve cybersecurity and combat cyber threats.
The Report also describes FIO's involvement in international efforts addressing cybersecurity in the insurance sector. For example, FIO chairs the International Association of Insurance Supervisors ("IAIS") Financial Crime Task Force, which is considering the development of internationally applicable guidance on cybersecurity for insurance supervisors.
Insurance Producers: The Report notes that in 2015 the President signed into law the National Association of Registered Agents and Brokers Reform Act of 2015, which will provide a national, standardized licensing process for insurance producers by the later of January 2017 or two years after the National Association of Registered Agents and Brokers' date of incorporation.
Availability and Affordability of Personal Automobile Insurance: The Report notes that FIO is currently preparing a report on the affordability of personal auto insurance in the United States and has published a methodology for measuring the affordability of personal automobile insurance for traditionally underserved communities, minorities and low- and moderate-income consumers.
Terrorism Risk Insurance Program: The Report reviews legislative and regulatory developments with respect to the Terrorism Risk Insurance Program ("TRIP"). TRIP is administered by Treasury with the assistance of FIO, and was reauthorized in 2015. On April 1, 2016, Treasury issued a notice of proposed rulemaking to implement changes to TRIP required by the TRIP Reauthorization Act of 2015, and FIO continues to consider comments received in developing a final rule. Treasury also submitted in 2016 a required report on the effectiveness of TRIP, which concluded that it remains an important mechanism in ensuring that terrorism risk insurance remains available and generally affordable in the United States.
The Report also summarizes several recommendations respecting insurance supervisory matters made by FSOC in its 2015 Annual Report. FSOC recommended that FIO and state insurance regulators continue to closely monitor and assess the growing risks that insurers have been taking by extending the duration of their investment portfolios and investing in lower quality or less liquid assets in order to increase returns in the current low interest rate environment. Additionally, FSOC recommended that state insurance regulators continue to improve the public availability of data, including financial statements of captive reinsurers, and that FIO continue to monitor and publicly report on the regulatory treatment of issues relating to captive reinsurance.
International Regulatory Developments
Covered Agreement: The Report reviews the status of negotiations between representatives of the United States including officials from Treasury and the United States Trade Representative ("USTR") and officials of the European Union ("EU") to enter into a covered agreement with the
Federal Insurance Office Report October 13, 2016
EU, as authorized by Title V of the Dodd-Frank Act. A covered agreement is a written bilateral or multilateral agreement between the United States and one or more foreign governments or insurance authorities regarding prudential measures with respect to the business of insurance or reinsurance. The Report notes that EU and U.S. representatives have advised that they have "made progress on key issues, and identified next steps toward a possible completion of negotiations in the near future." The key subjects for negotiation are group supervision, exchange of confidential information across national borders and reinsurance supervision, including collateral. According to the Report, four negotiating sessions have been held thus far, in February, May, July, and September 2016. FIO notes that state insurance regulators are closely consulted throughout these negotiations, including in the development of U.S. proposals.
IAIS Developments: The Report summarizes FIO's involvement in the IAIS, and its coordination and collaboration with state insurance regulators, the FRB and the NAIC in respect of IAIS initiatives. The Report also notes FIO's efforts to provide U.S. stakeholders with opportunities to engage with U.S.-based members of the IAIS. The Report reviews efforts made by the IAIS to develop, as part of its common framework for the supervision of IAIGs, a risk-sensitive international capital standard ("ICS") that will apply to IAIGs and global systemically important insurers ("G-SIIs"). In connection with the development of the ICS, the IAIS in July 2016 issued a public consultation document seeking public comment on the proposed ICS.6 The Report also reviews revisions to the assessment methodology used by the IAIS to determine whether an insurance-dominated financial conglomerate is considered a G-SII, and a related IAIS consultation paper on systemic risk from insurance products.7 FIO also summarizes developments in 2015, as well as developments expected to occur in the future, by the IAIS with respect to stakeholder engagement and transparency at the IAIS, cross-border resolution planning and combating financial crime in insurance, as well as FIO's involvement in other international efforts involving the OECD and the Financial Stability Board.
Copyright Sullivan & Cromwell LLP 2016
Federal Insurance Office Report October 13, 2016
1 FIO reports that the United Kingdom's recent vote to leave the EU ("Brexit") has elevated global concerns in the insurance industry about the risks of low interest rates, and that heightened volatility and uncertainty in financial markets caused by Brexit may exacerbate the current interest rate environment.
2 How to Modernize and Improve the System of Insurance Regulation in the United States, Report of the Federal Insurance Office, U.S. Department of the Treasury, Completed pursuant to Title V of the Dodd-Frank Wall Street Reform and Consumer Protection Act (December 2013), available at https://www.treasury.gov/initiatives/fio/reports-and-notices. See S&C publication, "Federal Insurance Office Report: The Federal Insurance Office Releases Report on How to Modernize and Improve Insurance Regulation in the United States" (December 16, 2013), available at https://sullcrom.com/Federal_Insurance_Office_Report.
3 The FSOC designated Prudential Financial, Inc. ("Prudential") and American International Group, Inc. ("AIG") as systemically important nonbank financial companies in 2013. The Report notes that the FSOC completed its second annual reevaluations of Prudential and AIG in 2015 and did not rescind either determination. The FSOC designated a third insurer, MetLife, Inc. ("MetLife"), in December 2014; however, as permitted by Dodd-Frank, MetLife challenged its designation in federal district court and, on March 30, 2016, the district court rescinded the designation. The FSOC has appealed that decision and the appeal is pending. For additional information on this decision, see our memorandum to clients entitled "D.C. District Court Rescinds FSOC's Designation of MetLife as Systemically Important" (Apr. 7, 2016), available at https://www.sullcrom.com/dc-district-court-rescinds-fsocs-designation-of-metlife-as-systemicallyimportant.
4 Federal Reserve System, Advance Notice of Proposed Rulemaking, Capital Requirements for Supervised Institutions Significantly Engaged in Insurance Activities (June 14, 2016), available at https://www.federalregister.gov/documents/2016/06/14/2016-14004/capital-requirements-forsupervised-institutions-significantly-engaged-in-insurance-activities; and Federal Reserve System, Notice of Proposed Rulemaking, Enhanced Prudential Standards for Systemically Important Insurance Companies (June 14, 2016), available at https://www.federalregister.gov/ documents/2016/06/14/2016-14005/enhanced-prudential-standards-for-systemically-importantinsurance-companies. See S&C publication, "Federal Reserve Proposes Regulatory Capital Frameworks for Supervised Insurers and Enhanced Prudential Standards for Insurers Designated as Systemically Important" (June 7, 2016), available at https://sullcrom.com/federal-reserveproposes-regulatory-capital-frameworks-06-07-2016.
5 Financial Services Information Sharing and Analysis Center, "About FS-ISAC," available at https://www.fsisac.com/about.
6 IAIS, Risk-based Global Insurance Capital Standard Version 1.0 Public Consultation Document (July 19, 2016), available at http://www.iaisweb.org/page/consultations/current-consultations/riskbased-global-insurance-capital-standard--second-consultation//file/61557/2016-risk-based-globalinsurance-capital-standard-ics-consultation-document. See S&C publication, "IAIS: Global Insurance Capital Standard" (August 5, 2016), available at https://sullcrom.com/iais-globalinsurance-capital-standard-iais-issues-second-consultation-document-for-risk-based-globalinsurance-capital-standard.
7 IAIS, Global Systemically Important Insurers: Updated Assessment Methodology (June 16, 2016), available at http://www.iaisweb.org/page/supervisory-material/financial-stability-andmacroprudential-policy-and-surveillance/file/61179/updated-g-sii-assessment-methodology-16june-2016. See S&C publication, "IAIS Issues Updated G-SII Assessment Methodology" (June 28, 2016), available at https://sullcrom.com/iais-issues-updated-g-sii-assessment-methodologyiais-updates-assessment-methodology.
Federal Insurance Office Report October 13, 2016
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