U.S. Insurance Financial Regulatory Oversight and the Role of Capital Requirements
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.
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
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
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
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.
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.
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.
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.
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
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
insolvency or hazardous financial condition.
disposed property or concealed, altered or destroyed financial books.
- Best interest
of policyholders, creditors or the public.
improperly experienced or incapable person in control.
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.
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.
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
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
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.
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.
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.
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
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
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.
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.
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).
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.
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.
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.
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.
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.
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.
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.
between full scope examinations, additional examinations might be needed that
are limited in scope to review specific insurer operations.
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.
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.
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.
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.
 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.