Overview Of The NAIC'S Solvency Modernization Initiative

Wednesday, June 2, 2010 - 01:00

General Background Of The Solvency Modernization Initiative

The Solvency Modernization Initiative ("SMI") of the National Association of Insurance Commissioners ("NAIC")1began in June 2008 and represents a significant regulatory undertaking. Through SMI the NAIC is conducting a self-critical examination of U.S. insurance solvency regulation, a review of international insurance regulatory developments and accounting standards and an assessment of the potential use of such international standards in the U.S. Potential weaknesses in the current regulatory structure exposed by the recent financial crisis and continuing global developments play a role in shaping the SMI agenda, which focuses on capital requirements, international accounting, insurance valuation, reinsurance, group solvency and corporate governance.

The NAIC has established a number of objectives for SMI in the form of a work plan (the "Work Plan"). The Work Plan is periodically updated in response to developments in solvency regulation in the U.S. and internationally.2It identifies key SMI tasks, including articulation of the U.S. solvency framework, study of solvency and accounting initiatives worldwide, creation of a new reinsurance regulatory framework, movement to principles-based reserving for life insurance and annuity products ("PBR"), enhancement of group supervision and incorporation of new ideas in the U.S. solvency system. The NAIC is addressing each of these tasks, and some, such as the U.S. solvency framework and PBR,3have been adopted by the NAIC. A brief discussion of certain elements of SMI and recent developments is provided below.

U.S. Solvency Framework

The NAIC's first step in implementing the Work Plan was to articulate the U.S. solvency framework and core insurance regulatory principles in one document. This document, entitled "The United States Insurance Financial Solvency Framework" (the "Framework"), was adopted by the NAIC on February 19, 2010.4It describes the mission of U.S. insurance regulation as protecting policyholders and claimants while facilitating an effective insurance marketplace. The core principles of the U.S. solvency regulatory regime are also described in the Framework, including a system of regulatory peer review, standardized financial reporting, risk-focused financial examination and surveillance, capital adequacy measured through the risk-based capital ("RBC") system, regulatory approval of significant, risk-related transactions and preventive and corrective measures to be taken by U.S. insurance regulators. The NAIC intends to use these core principles to compare the U.S. insurance solvency regime with other international solvency systems and provide a foundation for long-term solvency modernization goals.

Group Solvency Issues

The group solvency component of SMI addresses the regulatory oversight of U.S. insurers operating within corporate groups as well as of the groups themselves. The NAIC is studying the current state of such group supervision. A Draft Memorandum on Group-wide Supervision (the "Draft Memorandum") notes that the U.S. insurance regulatory system is generally characterized as having a "solo entity" approach to regulation, with attention focused on the insurer.5This contrasts with other jurisdictions that apply a consolidated approach to insurance regulation by focusing on the entire holding company system. The Draft Memorandum suggests that, in fact, the U.S. system is a "solo plus" system in light of U.S. regulators' authority to monitor groups through licensing, holding company regulation and financial analysis. Nevertheless, the Draft Memorandum recommends enhancing U.S. group supervision in certain areas, suggesting a "windows and walls" approach to regulation that would "provid[e] a window into group operations, while building upon, rather than rejecting, the existing walls which provide solvency protection" to U.S. insurers. Specifically, the Draft Memorandum suggests the addition of the following general "regulatory windows": the coordination of state participation on a national level for sharing information with international regulators; supervisory colleges for internationally active groups; access to information about unregulated entities within the holding company system; and group capital requirements to avoid potential financial and reputational contagion among group entities.

The NAIC has worked over the past year to amend the Insurance Holding Company System Regulatory Act and Regulation (collectively, the "IHCA"). Proposed amendments to the IHCA would strengthen regulators' access to group affiliate information (including information about unregulated entities) and provide for the assessment of group financial strength upon initial application for control of a U.S. insurer and pursuant to annual holding company filings. In this respect, regulators seek to focus on potential financial and reputational contagion within a holding company system. Proposed amendments would also authorize multi-state coordination of regulatory filings and insurance commissioners' participation in supervisory colleges. A public hearing on proposed changes to the IHCA is scheduled for June 4, 2010, at the NAIC's 2010 Financial Summit. 6

Capital Requirements

Currently, RBC standards are used to identify insurers with weak capitalization and provide a benchmark for regulatory intervention. The capital requirements component of SMI will consider many questions affecting the development and measurement of regulatory capital standards. Issues to be addressed by the capital requirements group include the purposes of regulatory capital, the appropriate level of capital required of U.S. insurers (regulatory vs. economic), the use and disclosure of capital measures, the use of internal modeling, the potential effect of changes in accounting standards on regulatory capital requirements and the application of proportionality to capital standards (i.e., appropriate standards measured by the nature, scale and complexity of an insurer's business).

International Accounting and Regulatory Standards

Statutory Accounting Principles ("SAP") are based on U.S. generally accepted accounting principles ("GAAP") as established by the U.S. Financial Accounting Standards Board ("FASB"). Since 2002, FASB has worked with the International Accounting Standards Board ("IASB") to improve and eventually converge the International Financial Reporting Standards ("IFRS") and GAAP.7In order to facilitate convergence of IFRS and GAAP, FASB and IASB entered into a joint project to establish cohesive global accounting standards, including those related to insurance accounting, by 2011.8Since SAP requires U.S. insurance regulators to adopt, amend or reject changes to GAAP affecting insurance accounting, a convergence will affect the maintenance of SAP and the interactions between statutory accounting and Federal taxes, RBC and other regulatory processes. Accordingly, the NAIC will consider policies regarding the future of statutory accounting, evaluate international developments affecting accounting and prepare recommendations concerning the need for public financial reporting by all insurance companies.

SMI is also analyzing the applicability of international standards to the U.S. solvency system and the convergence of international regulatory solvency regimes, including the EU's Solvency II Directive ("Solvency II").9Although achieving a finding of U.S. equivalence under Solvency II is not a specific objective of SMI, regulators have indicated that they are open to converging solvency systems internationally where practicable and consistent with the U.S. focus on policyholder protection. The insurance core principles formulated by the International Association of Insurance Supervisors ("IAIS") are used to assess the effectiveness of U.S. insurance regulation by virtue of U.S. participation in the IMF-World Bank Financial Sector Assessment Program ("FSAP"). The U.S. participated in FSAP for the first time this year and received an overall positive rating for observance of the IAIS insurance core principles.10U.S. involvement with the development of the IAIS core principles and either satisfaction of, or the ability to define differences from, such principles is important for the NAIC and U.S. insurance regulators.

Reinsurance

Another SMI objective is the modernization of the reinsurance regulatory framework in order to facilitate reinsurance transactions between U.S. and international parties, as well as to simplify administrative processes such as licensing and certification for multi-state insurers, increase uniformity of regulation across U.S. states and reduce collateral requirements. The NAIC has worked to implement these goals through adoption of the Reinsurance Regulatory Modernization Framework Proposal and exposure of a draft Federal bill entitled the "Reinsurance Regulatory Modernization Act of 2009." Both efforts are currently on hold as the NAIC monitors Federal regulatory initiatives relating to reinsurance.

Corporate Governance

The NAIC recently formed a subgroup to study corporate governance principles. The NAIC will consider the development of model laws, analyze current state laws and practices and review relevant principles of the IAIS concerning corporate governance. Future discussions are expected to focus on proportionality of corporate governance requirements and whether the U.S. should adopt international corporate governance standards.

SMI is a wide-ranging initiative that, by its nature, will evolve to respond to national and international insurance regulatory and solvency developments. Current SMI goals and the principles developed through SMI's exploration of capital requirements, group solvency, reinsurance and international accounting will likely result in significant changes to the landscape of U.S. insurance regulation and solvency standards. 1 The NAIC is a voluntary organization of insurance regulators from the 50 states, the District of Columbia and the five U.S. territories.Its main objective is to assist state insurance regulators in protecting consumers of insurance and maintaining financial stability in the insurance industry, which it does through the promulgation of model laws and regulations and the work of organized committees, task forces and working groups.SMI is a broad-reaching initiative that requires input from many of the NAIC's subgroups and committees.Additional information on the NAIC is available athttp://naic.org/ index_about.htm.

2 The current SMI Work Plan, updated as of September 20, 2009, is available at http://www.naic. org/documents/committees_ex_isftf_iswg_smi_roadmap.pdf.

3 PBR is a reserve calculation methodology for life and annuity products based on the magnitude of risk as contrasted with the current formula-based reserve approach.Several steps have been taken to initiate this valuation methodology, including the NAIC's adoption of certain amendments to the Standard Valuation Law relating to PBR in 2009 and drafting of the Valuation Manual, which sets forth minimum reserve and related requirements under the Standard Valuation Law .See http://www.naic. org/Releases/2009_docs/svl_adopted.htm. Application of the PBR standards will depend on states' enactment of the amended Standard Valuation Law.

4 The Framework is available at http://www.naic. org/documents/committees_e_us_solvency_framework.pdf.

5 The Draft Memorandum is available at http://www.naic.org/documents/committees_ex_isftf_group_solvency_exposure_100129_draft_memo.doc.

6 Additional information regarding the 2010 Financial Summit is available at http://www.naic. org/frs_financial_summit.htm.

7 See The Memorandum of Understanding-FASB and IASB, September 18, 2002, available at http://www.iasb.org/NR/rdonlyres/6F81606F-6182-4D27-A2C9-6A6DD5D10BA4/0/Norwalk_agreement.pdf.

8 See FASB and IASB Reaffirm Commitment to Memorandum of Understanding, November 5, 2009, available at http://www.iasb.org/NR/rdonlyres/0AE63429-BCF3-461A-8B5D-3948732C DDC2/0/JointCommunique_October2009FINAL4.pdf; see also IASB, Convergence Between IFRSs and US GAAP , available at http://www.iasb.org/ Use+around+the+world/Global+convergence/Convergence+with+US+GAAP/Convergence+with+US+GAAP.htm.However, continuing divergence over fundamental components of the standards among participating countries makes agreement on a final set of standards in 2011 uncertain.

9 Solvency II is a framework developed to create a single market insurance solvency regime throughout Europe.The Level I Solvency II Framework Directive was formally adopted by the European Parliament and the European Union's Economic and Financial Affairs Council in 2009.Additional information regarding Solvency II is available at http://ec.europa.eu/internal_market/insurance/solvency/index_en.htm.

10 FSAP conducts an annual in-depth analysis of the financial sector of each of the countries participating in the program. According to the Detailed Assessment of Observance of IAIS Insurance Core Principles for the United States published on May 14, 2010 (the "Assessment"), the U.S. received ratings of "observed" or "largely observed" on 25 out of 28 core principles.See IMF, Detailed Assessment of Observance of IAIS Insurance Core Principles for the United States 18-20, available athttp://www.imf.org/external/pubs/ft/scr/2010/cr10126.pdf.The Assessment found that the U.S. insurance regulatory system is thorough and effective, acknowledging that the strength of the U.S. system was a factor in the stability of the insurance industry during the recent financial crisis.Id. at 14.However, the Assessment also outlined certain areas, including group supervision, where U.S. regulation would benefit from further development.Id. at 15.

Leah Campbell is a Partner in the Corporate and Financial Services Department of the New York office of Willkie Farr & Gallagher LLP; she specializes in insurance regulation, insurance coverage and reinsurance. Tonisha Calbert is an Associate in the Corporate and Financial Services Department.

Please email the authors at lcampbell@willkie.com or tcalbert@willkie.com with questions about this article.