January 2012

U.S. Insurance Financial Regulatory Oversight and the Role of Capital Requirements

By Kris DeFrain, Director, Research and Actuarial Services

• Introduction

Regulators require insurance companies to maintain specified levels of capital in order to continue to conduct business. Requirements differ by country or regulatory jurisdiction, ranging from specified amounts of capital to risk-based capital, where the capital amount varies based on characteristics of the insurance company and the risks it faces. While international discussions are driving some convergence in regulatory capital requirements around the world, there are still significant differences. Some of the differences include the use of internal models instead of standardized models, the choice of metrics and company-specific inputs to be used, and the means of calibration (e.g., statistical or other measure). Not all jurisdictions agree on approach; perhaps because there is not agreement on the purpose for regulatory capital requirements. In the United States, the regulatory capital requirements form a back-stop to an extensive financial and risk analysis, so the U.S. would not rely on the capital requirements to the extent a country would where capital requirements are used as the means of risk analysis.

To aid international discussions so that supervisors from different jurisdictions might better understand differences of opinion, the following describes the role of capital requirements in the U.S. solvency system and how the entirety of the U.S. financial regulatory framework works together for effective financial regulation. The purpose of this article is to provide the reader with a better understanding of the U.S. approach and why capital requirements are not the sole focus of U.S. regulators.

• U.S. Financial Regulation Overview

The U.S. insurance financial regulatory system can be described in the following three stages: (1) state lawmakers and regulators eliminate or limit some risks through restriction on activities, prior approval mechanisms and regulatory focus; (2) regulators perform financial oversight, the step in the process where most of the regulatory activity exists, looking for companies in hazardous financial condition and evaluating the potential for insolvency; and (3) lawmakers and regulators establish regulatory backstops or safeguards, most notably the guaranty funds and risk-based capital (RBC) requirements, to make up the final stage of the regulatory process.

Limitation of Risk through Design of the System

Some risks are deemed material and potentially contrary to the best interests of policyholders, so lawmakers and regulators restrict or discourage those activities or require preapproval. Regulators discourage activities in numerous ways, including requiring conservative valuation in the financial statement, limiting investment options, and focusing time and attention on certain risky endeavors.

Regulators utilize a codified statutory accounting system, where general purpose financial reporting is either adopted as-is, modified or rejected. Statutory accounting is, generally, more conservative than general purpose accounting. Insurers may choose to invest less in those assets valued more conservatively. Valuation of liabilities can also be conservative in some cases. Credit for reinsurance transactions is only allowed when the reinsurance is from an authorized reinsurer or when security (i.e., collateral) is posted to cover obligations.

Premium and claim reserve valuation for life insurance can be considered conservative when some required parameters and assumptions are selected to be less-than-optimistic and for property/casualty insurance when the reserves are not allowed to be discounted. Even the RBC capital requirements have the potential to influence business decisions. For example, capital charges are greater where the risk is deemed to be higher. Insurers may make different investment decisions depending on the extent of the differences in the capital charges for assets.

Because investment is a large part of the insurance business, regulators pay close attention to investment risk, encouraging less risky investment when appropriate. In the 1990s, insolvencies caused by high-risk investment strategies led U.S. regulators to consider their oversight and possible restriction of insurer investments by imposing either a defined limits or a defined standards approach. Using a defined limits approach, regulators place certain limits on amounts or relative proportions of different assets that insurers can hold to ensure adequate diversification and limit risk. Using a defined standards approach, regulators restrict investments based on a “prudent person” approach, allowing for discretion in investment allocation if the insurer can demonstrate their adherence to a sound investment plan. Also, the NAIC Capital Markets & Investment Analysis Office reviews insurers’ assets for credit risk, potentially driving insurers toward less-risky investment.

For certain material transactions—such as large investment or reinsurance transactions, extraordinary dividends, change in control and the amount of dividends paid—commissioner preapproval is required in an insurance holding company system. This is to help ensure that the assets of an insurer adequately protect the policyholders and are not unfairly distributed to others.

Finally, the transparency of the regulatory process in the United States often sends signals to insurers about where regulators see significant risks in the current financial environment and offer signs where different business decisions could be made to limit those risks and, therefore, limit regulatory attention. Regulators are transparent about their focus on particular issues, especially when an issue arises from specific “risky” activities. The NAIC process highlights areas of concern and aids insurers to appropriately address issues.

Financial Oversight and Intervention Powers

An insurance company must hold capital greater than the minimum regulatory capital levels to continue in business; but financial regulation extends beyond just capital requirements. U.S. commissioners can order conservation, rehabilitation or liquidation on numerous statutory grounds ranging from financial insolvency to unsuitable management and operations. The Insurer Receivership Model Act (NAIC model law #555) includes the following grounds for regulatory action (among others):

Impairment, insolvency or hazardous financial condition.
Improperly disposed property or concealed, altered or destroyed financial books.
Best interest of policyholders, creditors or the public.
Dishonest, improperly experienced or incapable person in control.

The most typical financial intervention occurs when a company is in hazardous financial condition; this usually occurs prior to an insurer triggering an RBC level. A regulator may deem a company in hazardous financial condition based upon adverse findings in a financial analysis or examination, a market conduct examination, audits, actuarial opinions or analyses, cash flow and liquidity analyses; insolvencies with a company’s reinsurer(s) or within the insurer’s insurance holding company system; finding of incompetent or unfit management/director; a failure to furnish information or provide accurate information; and, any other finding determined by the commissioner to be hazardous to the insurer’s policyholders, creditors, or general public.

Financial oversight and determination of hazardous financial condition is the most valuable and extensive part of U.S. insurance financial regulation. Oversight focuses on appropriate asset and liability valuation, the risks accepted by the insurer, the mitigation of those risks and the amount of capital held in light of the residual risks.

This valuable oversight is possible because of the extensive financial reporting databases at the fingertips of each insurance regulator, allowing the financial analysis to occur without additional significant and time-consuming company input. Insurers are required to file standardized annual and quarterly financial reports that the regulators use to assess the insurer’s risk and financial condition. These reports contain both qualitative and quantitative information and are updated as necessary to incorporate significant common insurer risks. Reporting requirements run the gamut from typical accounting requirements (e.g., balance sheet and income statement) to detailed data reporting on specified schedules (e.g., Schedule D – investment schedules, Schedule F – reinsurance issues and Schedule P – loss triangles). An actuarial opinion on major components of an insurer’s financial statement (asset adequacy and claim/loss/premium reserves) is required to ensure the adequacy and/or reasonableness of reserves. The independent financial audit helps to provide assurances that all material aspects of the insurer’s financial reporting are accurate.

Generally, regulators judge financial condition based on the company’s financial reporting, accompanying audits and actuarial opinions, supplemented with additional information about the company. In addition, there are numerous financial analysis tools and resources that highlight “red flags.” These tools are possible because of the detailed, validated and uniform financial reporting, which allows for the identification of risk concentrations and anomalies.

Regulatory Backstops

As a final backstop in the U.S. financial oversight process, state insurance regulators have the RBC calculation and analysis. Regulators developed RBC to supplement the fixed minimum capital and surplus requirements, which vary by line of business and do not sufficiently account for differences in size, risks or financial conditions among insurers. Although the RBC formula is the same for companies in a particular line of business, the specific calculation for each company reflects the particular risks unique to that specific company.

RBC strengthens the regulatory safety net in the U.S. system by recognizing a company’s different size, financial condition and types of risks assumed. More important, regulators created RBC as a legal authority to provide for timely regulatory action, consistent across jurisdictional borders, with minimum court involvement when a company triggers an RBC intervention level.

The intervention levels consist of four trigger points: company action, regulatory action, authorized control and mandatory control. These intervention levels are established to require regulatory action, but the regulator may otherwise consider a company to be in hazardous financial condition, despite a specific RBC level finding.

Rounding out the policyholder protections, if a financially impaired insurance company is unable to pay its insurance claims, a state guaranty fund will pay them, subject to certain limits.

• Financial Oversight Tools and Resources

In assessing the financial condition of an insurer, the overall goal is to identify potential adverse financial indicators as quickly as possible, evaluate and understand such problems more effectively, and develop appropriate corrective action plans sooner, thus potentially decreasing the frequency and severity of insolvencies. The U.S. solvency oversight framework is not designed to eliminate all insolvencies, but rather to minimize the number of insolvencies and their corresponding impact on policyholders and claimants. Regulators conduct a risk-focused surveillance of insurers’ financial reports that includes financial analysis, financial examination and supervisory plan development.

Financial Analysis

NAIC financial analysis tools and resources (e.g., Financial Analysis Solvency Tools (FAST) scores and handbooks) supplement individual state regulatory efforts. FAST is a collection of analytical solvency tools and databases designed to provide state insurance regulators with an integrated approach to reviewing the financial condition of insurers operating in their respective jurisdictions. FAST is intended to assist regulators in prioritizing resources to those insurers in greatest need of regulatory attention. The creation and development of sophisticated and comprehensive financial tools and benchmarks (through data management evolved from personal knowledge of troubled companies) encapsulate various categories, including leverage, asset quality, liquidity and insurer operations.

Three key tools within the FAST System include:

Insurance Regulatory Information System (IRIS): IRIS has served as a baseline solvency screening system for the NAIC and state insurance regulators since the mid-1970s. Its first (or statistical) phase involves calculating a series of confidential financial ratios for each insurer based on statutory financial annual statement data. Because the ratios by themselves are not indicative of adverse financial condition, an experienced team of state insurance examiners and analysts then reviews the IRIS ratio results and other financial information through the second (or analytical) phase.

In this second phase, the Analyst Team reviews a computer-selected priority listing of insurers that might be experiencing weak or declining financial results and meets to identify insurers that appear to require immediate regulatory attention. The team then validates the listing based on further analysis of those companies, and provides a brief synopsis of its findings in a document that only state insurance regulators and authorized NAIC staff can access.
Scoring System: The NAIC Scoring System is based on several financial ratios and is similar in concept to IRIS ratios, but provides results on an annual and a quarterly basis. The Scoring System also includes a broader range of financial ratios and assigns a score to each ratio based on the level of solvency concern each result generates. As with the IRIS results, the Scoring System results and scores are available only to state insurance regulators and authorized NAIC staff.
Insurer Profiles System: Finally, the Insurer Profiles System produces quarterly and annual profiles on property/casualty, life, health and fraternal insurers that include either a quarterly or an annual five-year summary of a company’s financial position. The Insurer Profile reports provide not only a snapshot of the company’s statutory financial statement, but also include analytical tools, such as financial ratios and industry aggregate information, for analytical review. Insurer Profile reports also assist state insurance department analysts in identifying unusual fluctuations, trends or changes in the mix of an insurer’s assets, liabilities, capital and surplus, and operations.^[1]

State regulators developed an NAIC Financial Analysis Handbook to advise use of a “stair-step” approach that directs analysts to perform more in-depth analysis commensurate with the financial strength, prospective risks and complexity of each insurer. The Financial Analysis Handbook requires regulators to use many analytical tools, databases and processes in completing their quarterly analysis of insurers (such as ratio analysis and review of the actuarial opinion, audited statutory financial statements, holding company filings, and the management discussions and analysis filings). The Financial Analysis Handbook provides a means for insurance departments to more accurately identify companies experiencing financial problems or posing the greatest potential for developing such problems. Furthermore, the Financial Analysis Handbook provides guidance for insurance departments to define and evaluate particular areas of concern in troubled companies.

NAIC Financial Analysis Working Group (FAWG)

FAWG's activities, oversight and insurer review includes, but is not limited to:

Identifying companies that are outliers when compared with industry benchmarks and reviewing companies individually submitted to FAWG by state regulators.
Developing communication for the financial staff and commissioner for the state of domicile for the insurer/group under review; including a description of the issue, questions and suggestions on regulatory options.
Reviewing domestic or lead state regulator responses on identified issues and questions.
Considering whether responses identify a need for further regulatory action or FAWG intervention, including requesting that the domiciliary regulator answer questions and make a presentation to FAWG and other regulators.
Considering whether to request the formation of a FAWG subgroup for certain insurers or groups to facilitate regular communication and collaboration with applicable regulators (when the state regulators have not proactively communicated with appropriate regulators on their own, as is the typical case).

Ensuring a nationwide system of checks and balances, the NAIC and, specifically, the NAIC Financial Analysis Working Group (FAWG), offer a layer of peer review for each regulator’s solvency monitoring efforts, thus ensuring that experienced state regulator colleagues improve and enhance state regulator judgments regarding a company’s financial condition.

FAWG’s mission is to: identify nationally significant insurers/groups that exhibit characteristics of trending towards financial trouble; interact with domiciliary regulators and lead states in order to assist and advise on appropriate regulatory strategies, methods, and actions; and encourage, promote and support coordinated, multi-state efforts in addressing solvency issues.

For more than two decades, the NAIC FAWG has ensured that state insurance financial regulators have shared information and ideas to identify, discuss and monitor potentially troubled insurers and nationally significant insurance groups (a classification that considers the size of the company or group’s premium volume combined with the number of states in which it writes business; i.e., insurers that write the majority of insurance in the United States). FAWG has identified market trends and emerging financial issues in the insurance sector and has leveraged the expertise of select chief financial regulators from around the United States to provide an additional layer of solvency assessment to our national system of state-based insurance regulation.

While FAWG does not have specific regulatory authority, no state has ever refused a FAWG recommendation. The U.S. state-based system of supervision fosters healthy peer review that creates peer pressure to be diligent and vigilant domiciliary regulators, knowing that each jurisdiction where a company is licensed has the separate authority to act on a FAWG recommendation if the domiciliary state regulator does not.

Through the FAWG forum, individual states work together to support and guide fellow regulators for the benefit of the whole. FAWG also reviews and considers trends occurring within the industry, often concentrating on particular market segments, product, exposure or other problem that has the potential of impacting the solvency of the overall industry.

Financial Examination

U.S. regulators carry out periodic risk-focused, on-site financial examinations in which they evaluate the insurer’s corporate governance, management oversight and financial strength. Regulators use risk identification and evaluate mitigation systems both on a current and prospective basis, assessing the reported financial results through the financial examination process.

Examinations consist of a process to identify and assess risk and assess the adequacy and effectiveness of strategies/controls used to mitigate risk. The process includes a determination of the quality and reliability of the corporate governance structure, risk management programs and verification of specific portions of the financial statements. Financial examiners evaluate the insurer’s current strengths and weaknesses (e.g., board of directors, risk-management processes, audit function, information technology function, compliance with applicable laws/regulations, etc.) and prospective risk indications (e.g., business growth, earnings, capital, management competency and succession, future challenges, etc.). Then, regulators document the results of the examinations in a public report that assesses the insurer’s financial condition and sets forth findings of fact with regard to any material adverse findings disclosed by the examination. Examination reports may also include required corrective actions, improvements and/or recommendations.

In between full scope examinations, additional examinations might be needed that are limited in scope to review specific insurer operations.

Supervisory Plan

At least once a year, regulators develop a supervisory plan for each domestic insurer using the results of recent examinations and the annual and quarterly analysis process to outline the type of surveillance planned, the resources dedicated to the oversight and the coordination with other states. At the end of a financial examination, the financial examiner will document appropriate future supervisory plans for each insurer (e.g., earlier statutory exams, limited-scope exams, key areas for financial analysis monitoring, etc.). This supervisory plan provides an oversight link between financial examination and financial analysis processes.

• Conclusion

The focus of the U.S. insurance financial regulatory system is the financial surveillance for financial oversight. Financial surveillance is predominately built around an extensive and uniform financial reporting system that allows for detailed analysis of asset holdings, reinsurance, loss/claim reserves, etc. Through the use of an extensive centralized database, regulators can perform stress tests on companies, determine the impact of other company insolvencies on the market, find anomalies from one company to another through benchmarking and other processes, and look for new risk concentrations and/or optimistically valued risks. Because this data and disclosure is vital to the regulatory system, regulators spend considerable effort to validate appropriate financial reporting to allow for extensive analysis without significant extra attention from the company, thereby keeping regulatory disruptions to a minimum.

As a national system of state-based regulation, insurance regulators are keenly aware of the unique structure and have developed tools and financial regulatory processes, adopted by all jurisdictions—such as peer review and FAWG oversight—to ensure that regulators are effectively and efficiently maximizing resources to protect consumers, while maintaining the solvency of regulated entities. U.S. regulators utilize a number of coordinated resources to assess the financial strength and condition of insurers—from small single-state insurers to large multi-state groups—to verify the consistency, integrity and success of the supervisory approach.

Capital requirements can encourage less risky behavior, but, for all intents and purposes, the RBC exists to be the back-stop in the financial regulatory process. Because of this, U.S. regulators look to create capital requirements that are lower in cost, fair, sufficiently accurate and verifiable.

[1] Testimony of the NAIC before the Subcommittee on Capital Markets, Insurance, and Government-Sponsored Enterprises, Committee on Financial Services, U.S. House of Representatives: “Supervision of Group Holding Companies,” March 18, 2010.

We welcome your questions and comments. Please contact us at ciprnews@naic.org or shall@naic.org.