Insurance Group Supervision
Under the national system of state-based insurance regulation in the United States, the need for group supervision was recognized early on with the first NAIC model law adopted in 1969. While changes have been made in the model laws since that time, the general principles of group supervision, as reaffirmed in the 1978 NAIC Proceedings, still remain. The U.S. approach to group supervision adopted in the NAIC model law and regulation on holding companies 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 the insurer to pay its claims and “walls” to protect the capital of the insurer by requiring the insurance commissioner’s approval of material related-party transactions.
During the 2007–2008 financial crisis, the U.S. group supervisory framework was tested when American International Group (AIG) faced financial uncertainty. The AIG Financial Products unit based in London, a non-insurance component of the AIG holding company system, took on huge losses from risky investments. Had it not been for the “walls” that were established in the United States, it is likely that the funds protecting policyholders in the AIG insurance companies in the United States could have been raided by the AIG holding company, thereby threatening insurance policyholder protection. The “walls” provided options to the insurance commissioners when they worked with banking regulators to work through the AIG holding company system’s financial issues.
The contagion effects experienced by U.S. insurers in the AIG holding company system’s near collapse caused U.S. insurance regulators to reevaluate their group supervisory framework. Through the NAIC Solvency Modernization Initiative, U.S. insurance regulators are devising plans for revisions to group supervision, maintaining the “walls” but enhancing the “windows” of the system. The approach taken in making policy decisions has been to evaluate what information is already available from legal entity supervision and what new information is needed to effectively protect policyholders of insurers in a holding company system. Insurance regulators are enhancing their supervisory cooperation and coordination around the world so that information about an entire group can be gathered and the potential impact on insurance policyholders evaluated.
As part of the enhancement to international supervisory cooperation and coordination, U.S. insurance regulators are working at the International Association of Insurance Supervisors (IAIS) in a variety of work streams, including one to create a Common Framework for the Supervision of Internationally Active Insurance Groups (ComFrame). While some modifications for effective group supervision in the United States are needed, there are a number of unique issues that need to be addressed in order to make group supervision effective internationally. For example, the U.S. system proved effective because of the “walls,” often called “ring-fencing,” that do not exist everywhere around the world. The United States already has a system of cooperation and coordination amongst its state regulators, including shared data systems, financial analysis and financial examination findings; the scope and depth of supervisory data and analysis varies around the globe and a system of cooperation and coordination needs to be developed internationally. The United States already has common accounting and reporting requirements and a shared English language; the lack of international commonality produces challenges. And, the United States already utilizes a lead supervisor concept where a regulator(s) is named to coordinate; some jurisdictions see a stronger decision-making role for a lead group supervisor, which is why it is important to reach a consensus internationally about the expectations of the group supervisor.
The purpose of this article is to highlight insurance group supervision in the United States and the changes being made in the NAIC Solvency Modernization Initiative and to identify what the future might hold at the international level. The aim is to provide a better understanding of the U.S. system and what U.S. regulators believe should be the main focus for a ComFrame in order for it to be most effective in practice. Given time and resource constraints, U.S. regulators believe it is best to focus on the issues that are preconditions to the effective functioning of a global group supervisory system, such as communication needs, data-sharing needs, fungibility of capital, etc. U.S. regulators are primarily focused on understanding the international regulatory regimes and supervisory cooperation and coordination, rather than trying to revise the technical components (e.g., accounting and group capital requirements). In this way, supervisors around the globe can implement a system that will build on common understanding but continue to evolve and one that does not create financial benefits or harm to those insurance groups that ComFrame is to address relative to impact on other insurers or groups.
• Group Supervision in the United States: History and Overview
In the 1960s, increased inflation quickened interest in equity-based investments; profits in the property/liability insurance business had declined, leaving many property/liability insurers in need of additional capital; and increased attention was given to the idea of “one-stop” financial service. These factors sparked the interest of insurers in diversification. Numerous companies were merging and forming holding companies. As a result, in 1969, U.S. insurance regulators adopted the Holding Company System Regulatory Act (#440) so that holding companies could not circumvent the insurance statutes that regulate the formation, financing, management, investments, operations and reporting required of insurance companies at the legal entity level.
By the early 2000s, changes were made to incorporate acquisition and merger law, to no longer reference the aim of protecting interests of security holders, to modify time frames for approvals and to add confidentiality provisions. However, the general principles that drove creation of NAIC Model #440, reaffirmed in the 1978 Proceedings, remained as follows: 1) the financial condition of the holding company system’s insurers must be protected by an effective and comprehensive regulatory program; 2) the most effective regulatory system is one premised on disclosure and regulation of significant intrasystem transactions involving the insurer, and verification by examination when necessary; and 3) the particular focus of regulation should be on the insurer’s financial status, and in order to prevent the draining of insurance company capital, emphasis should be placed on disclosure of dividends and other transfers, service fees and distributions.
Group supervision continued to be performed under authority of NAIC Model #440 and the NAIC Insurance Holding Company System Model Regulation with Reporting Forms and Instructions (#450) in the early 2000s. These models apply to groups of two or more affiliated persons/organizations, at least one of which is an insurer. Holding company requirements include the following:
- Requirements to acquire an insurer.
- Commissioner approval of certain material transactions (e.g., investment purchases, reinsurance agreements, management agreements, cost sharing, tax-allocation agreements, certain guarantees, intercompany investments and requests for extraordinary dividends).
- Examination authority (of the insurer and affiliates, generally).
- Receivership authority.
These requirements are generally described as the creation of “walls” between the holding company and the insurance entity. Effectively, state insurance commissioner approval is needed for material monetary transactions, thus making sure that an insurance company’s financial assets cannot be raided by the holding company. Money can still flow between the insurer and the holding company, but regulators are charged to assess the risk of large monetary transactions that take funds out of the insurance company’s capital cushion. Regulators assess whether a transaction is fair and reasonable and does not jeopardize the protection of policyholders before approving such transactions.
This approach to group supervision affords U.S. regulators with the following: access to information via the parent (or other regulated group entities) about activities or transactions within the group involving other regulated or non-regulated entities; financial information of the ultimate controlling person; fit and proper requirements; and rights of inspection (examination). These requirements are generally described as the “windows” from the insurance entity to the holding company and the other entities within the holding company.
Regulators perform group supervision utilizing documents required to be filed with the NAIC and/or state and publicly available information. The NAIC Schedule Y includes a holding company organizational chart and a listing of affiliated transactions of a non-routine nature. NAIC risk-based capital (RBC) information and total available capital is available for each insurance legal entity and can be supplemented with company values of public, non-insurance companies for a view of the financial assistance that could be available within the group. The U.S. Securities and Exchange Commission (SEC) requires every publicly traded company to file a 10K form, which contains a comprehensive overview of the company’s business and financial condition, and include audited consolidated financial statements. NAIC Model #450 requires numerous forms, including the Annual Registration Statement (Form B) which contains significant group information, such as the capital structure, financial condition, ownership and management of the insurer and any person controlling the insurer, among others. All of this gathered information is assessed along with information learned in discussions with key leaders, employees of the group, and other financial regulators, as well as other gathered information.
• Group Supervision in the United States: Current Status and Looking Forward
Beginning in 2008 in the NAIC Solvency Modernization Initiative, U.S. insurance regulators reviewed lessons learned from the financial crisis, and, specifically, studied AIG and the potential impact of non-insurance operations on insurance companies in the same group.
AIG is a financial holding company, albeit better known as “the world’s largest insurer.” In 2008, the holding company was comprised of 71 U.S.-based insurance entities and 176 other financial services companies throughout the world. The problems that resulted in the U.S. government’s bailout of AIG arose from the non-insurance AIG Financial Products unit based in London, which Federal Reserve Chairman Ben Bernanke described as making “huge numbers of irresponsible bets” with risky investments and taking on “huge losses.” While this entity lacked direct regulation, group regulation fell to the U.S. Office of Thrift Supervision (OTS) (which has since been eliminated and the duties redistributed to the Office of the Comptroller of the Currency and the Federal Reserve) and not U.S. insurance regulators under the state-based insurance regulatory framework. However, the state insurance regulators were heavily involved in the AIG discussions because of the potential need for funds from the AIG insurance subsidiaries to rectify the liquidity problem faced by the holding company and the regulatory “walls” built between the insurers and the holding company.
Form B - Insurance Holding Company System Annual Registration Statement
The following information is reported on Form B:
- The capital structure, general financial condition, ownership and management of the insurer and any person controlling the insurer.
- The identity and relationship of every member of the insurance holding company system.
- Agreements and transactions related to loans, asset purchases/sales, guarantees, management agreements, reinsurance agreements, dividends and other distributions to shareholders, consolidated tax allocation agreements, etc.
- Any pledge of the insurer’s stock, including stock of any subsidiary or controlling affiliate, for a loan made to any member of the insurance holding company system.
- Financial statements of or within an insurance holding company system, including all affiliates.
- Other matters concerning transactions between registered insurers and any affiliates as may be included from time to time in any registration forms adopted or approved by the commissioner.
- Statements regarding the role of the insurer’s board of directors in corporate governance and internal controls.
- Any other information required by the commissioner by rule or regulation.
The federal bailout was initially perceived by some policymakers and others as a failure of insurance regulation. However, it became apparent that U.S. insurance regulation effectively protected insurance policyholders, despite the federal bailout of AIG.
While the national system of state-based insurance regulation in the United States protected policyholders during the AIG crisis via the “walls” established between insurers and holding companies, major issues came to light. Insurance regulators recognized the following: 1) the potential for significant, disastrous impact from non-regulated or non-insurance financial entities on insurance companies in the group, even in the United States, where there are “walls” between the insurers and holding companies; and 2) the need to establish better international relationships, coordination and communication in order to address financial issues before they arise in an insurance group or impact insurers in a group. U.S. insurance regulators also validated the use of “walls” and saw that, in countries where no such measures were in place, supervisors faced much greater financial uncertainty for their insurance companies.
One of the lessons learned from the financial crisis was the need for regulators to be able to assess the enterprise risk within a holding company system and its impact or contagion upon the insurers within that group. Therefore, U.S. insurance regulators want to enhance certain prudential features of group supervision within the models and monitoring practices, providing clearer “windows” into group operations, while building upon the existing “walls” that provide solvency protection for insurers. The concepts addressed in the enhanced “windows and walls” approach include communication between regulators and supervisory colleges, access to and collection of information from groups, enforcement measures and group capital assessment.
In 2011, changes were adopted to NAIC Model #440, NAIC Model #450 and to regulatory practices to do the following:
- Expand the ability to evaluate any entity within an insurance holding company system that may or may not directly affect the holding company system, but could pose reputational risk or financial risk to the insurer.
- Enhance the regulators’ rights to access information, especially regarding the examinations of affiliates and access to books and records to better ascertain the financial condition of the insurer, as well as language to require notification of divestiture of controlling interest.
- Introduce participation in and funding of supervisory colleges.
- Enhance corporate governance (i.e., board of directors and senior management responsibilities) in line with the NAIC Annual Financial Reporting Model Regulation (#205), state laws and legal practices.
- Provide guidance on the disclaimer of affiliation filings that includes disallowance of a disclaimer of affiliation language and an opportunity for an administrative hearing on those matters.
- Introduce additional standards to review affiliated agreements to enhance minimum requirements.
Form F – Enterprise Risk
Information regarding the following areas that could produce enterprise risk are to be reported on Form F:
- Any material developments regarding strategy, internal audit findings, compliance or risk management affecting the insurance holding company system.
- Acquisition or disposal of insurance entities and reallocating of existing financial or insurance entities within the insurance holding company system.
- Any changes of shareholders of the insurance holding company system exceeding ten percent (10%) or more of voting securities.
- Developments in various investigations, regulatory activities or litigation that may have a significant bearing or impact on the insurance holding company system.
- Business plan of the insurance holding company system and summarized strategies for the next 12 months.
- Identification of material concerns of the insurance holding company system raised by supervisory college, if any, in past year.
- Identification of insurance holding company system capital resources and material distribution patterns.
- Identification of any negative movement, or discussions with rating agencies that might have caused, or might cause, potential negative movement in the credit ratings and individual insurer financial strength ratings assessment of the insurance holding company system (including both the rating score and outlook).
- Information on corporate or parental guarantees throughout the holding company and the expected source of liquidity should such guarantees be called upon.
- Identification of any material activity or development of the insurance holding company system that, in the opinion of senior management, could adversely affect the insurance holding company system.
In NAIC Model #440 and NAIC Model #450, regulators adopted an expansion of the Insurance Holding Company System Annual Registration Statement (Form B), broadening requirements to include financial statements of all affiliates, statements about governance and internal control, and a catch-all for the commissioner to open the “windows” to obtain other information. Regulators also are introducing a new Enterprise Risk Report (Form F) to allow regulators to more clearly identify risks to the U.S. insurers posed by non-insurers within the holding company system. With Form F, holding companies will confidentially report on enterprise risk, including reporting of any material developments in strategy, risk management, litigation, etc., affecting the enterprise.
In addition to changes to NAIC Model #440 and NAIC Model #450, U.S. insurance regulators are currently implementing the international concept of the Own Risk and Solvency Assessment (ORSA). In an ORSA, every U.S. insurer (or their holding company group) will complete a self-assessment of their risk management, stress tests and capital adequacy on a yearly basis. Through the ORSA, U.S. regulators will be able to add to their existing assessment of group capital (i.e., the analysis of the capital requirements of all regulated entities in the groups to identify where surplus exists or the lack thereof) with analysis of the company’s own assessment of group capital needs.
• A View to Global Group Supervision: IAIS Supervisory Forum and ComFrame
Insurance supervisors recognize structural changes to insurers and the interconnectivity and globalization of insurance markets call for regulatory innovations. As a result, supervisors around the world are strengthening their approaches to group supervision. The IAIS has been focused on improving group supervision internationally through three main initiatives: standard setting, the Supervisory Forum and ComFrame; U.S. regulators have been, and will continue to be, actively engaged in all of these initiatives.
Insurance supervisors around the world work together at the IAIS to develop international standards, also known as Insurance Core Principles (ICPs). The IAIS adopted its revised and updated set of the ICPs in October 2011; the ICPs are written to apply at the legal entity and group level, unless specified otherwise. The ICPs are used for the Financial Sector Assessment Program (FSAP) conducted by the International Monetary Fund (IMF) and the World Bank where financial sector regulatory frameworks of a jurisdiction are assessed against the appropriate international standards; for the insurance sector, the ICPs are used. Numerous U.S. regulators and NAIC committees and working groups, including the International Insurance Relations Committee and the Solvency Modernization Initiative Task Force and its working groups, have been engaged in the IAIS standard-setting process.
To move from the overarching theory to the practical, the IAIS has established the Supervisory Forum to provide input to IAIS activities related to standard-setting, standard implementation and financial stability from a real-world, supervisory practice perspective. The aim of the Supervisory Forum is to bring front-line, senior regulators together, engaging financial analysis experts from various jurisdictions on a variety of emerging risk issues and the supervisory responses and techniques that can be used in practice to identify and respond to those issues. The concept of the Supervisory Forum stemmed from a U.S. proposal based on the U.S. multi-jurisdictional approach of dealing with emerging risks, industry trends and troubled companies, similar to the NAIC Financial Analysis Working Group.
U.S. insurance regulators also have been heavily engaged in the development of ComFrame since it officially began in July 2010. While ComFrame is not intended to create prescriptive means of regulation, the exact nature of ComFrame remains under discussion and development. The intent is for supervisors around the globe to work together to supervise internationally active insurance groups (IAIGs). ComFrame has three main objectives: 1) developing methods of operating group-wide supervision of IAIGs in order to make group-wide supervision more effective and more reflective of actual business practices; 2) establishing a comprehensive framework for supervisors to address group-wide activities and risks and set the grounds for better supervisory cooperation; and 3) fostering global convergence of regulatory and supervisory measures and approaches. In light of enhancements being made to the U.S. insurance regulatory system and the overall U.S. approach to group supervision, U.S. insurance regulators have emphasized the following when it comes to ComFrame:
- Group supervision should complement legal-entity supervision, leveraging the work already done at the legal-entity level and only adding regulatory steps to the extent needed to gain information from the group that could impact insurers. While interactions and collaboration at the international level are important, the authority to take action remains at the legal-entity level of individual jurisdictions. Thus, one needs to consider tools at the legal-entity level, such as ring-fencing (which worked in the United States), as part of the underlying preconditions of ComFrame.
- An international group supervisory approach should utilize the effective insurance regulatory systems already in place. Insurance supervisors should monitor groups for incoming issues from non-insurance entities in order to have a view to the potential impact of financial conglomerates on the insurers and insurance groups. Supervisors can achieve this through a variety of approaches (direct, indirect, etc.) to group supervision, but regardless, to effectively do this, we need to understand each other’s systems and not create only one system. And, we should maintain our authority over insurance supervision, using the lead group supervisor to aid communication and coordination, rather than ceding authority to a lead group supervisor.
- Communication, cooperation and coordination should be improved amongst international supervisors, both within the insurance sector and cross-sector. This step should be a priority for quick resolve, otherwise convergence on any other matters would be difficult to achieve. A key element to facilitating communication, cooperation and coordination among supervisors for IAIGs is the use of supervisory colleges, which are addressed in ComFrame. While supervisory colleges have many benefits and should be conducted in person at least annually for IAIGs, in-person meetings come with time and costs; thus, supervisors need to also consider other communication mechanisms that can supplement in-person meetings. Better communication and coordination methods need to be designed across regulatory sectors around the world, as well. Qualitative communication is needed, as well as quantitative. We need to ensure confidential data-sharing and information-sharing mechanisms are in place and function as intended. There are significant barriers to overcome in having different languages, accounting and supervisory reporting and public disclosure requirements; thus, reducing procedural and/or administrative burdens is one step to improving communication, cooperation and coordination among supervisors.
- Capital should be assessed at the group level. We view this in two steps. First, regulators need to know the capital position of each entity within the group system so that when things go wrong, regulators can quickly address potential remedies involving moving capital within the group. One might picture this (simplistically) as a table, listing every regulated entity, its available capital and its capital requirement and identification of financial strength of non-regulated entities. Second, regulators need to assess a group’s financial position, including the level of funding available, for when things go unexpectedly wrong. While options include establishment of uniform regulatory requirements with approvals for internal models, U.S. regulators opt for the less-expensive option to assess the group capital determination already made by the group. This decision recognizes the solvency capital requirements already in place at the legal entity level, but adds the ability to assess the interconnectedness and financial condition of the group.
- Just as communication mechanisms are key, it also matters what will happen in practice, rather than in theory. When things go wrong with insurers and insurance groups, regulators and jurisdictions could potentially have a protective reaction, protecting the insurers in their own borders first and foremost, and exacerbating any fungibility issues that exist. We need to ensure all of our plans are established to avoid such action, but plans written on paper will have little use unless they are based on mutual understanding, communication and trust.
The solvency framework of the U.S. system of state-based insurance regulation has included a review of the holding company system for decades, with an emphasis placed on each insurance legal entity. In light of the financial crisis and the globalization of the insurance business model, U.S. insurance regulators have begun to modify their group supervisory framework and have been increasingly involved in developing an international group supervisory framework.
As the IAIS continues to address group supervision, especially with ComFrame, it is important to recognize and understand that jurisdictions might have different approaches to group supervision, but effective group supervisory outcomes can still be achieved.