November 2009

Greetings!

In this edition of Insurance Perspectives, change and reform continue to be the mantra for industry and regulators alike. Our insurance professionals discuss regulatory reforms on Capitol Hill, changes impacting the role of credit rating agencies in the valuation of securities owned by insurers and recent accounting standards developments. We also provide a peek at our report on the surplus of CareFirst BlueCross BlueShield that will be the center of an upcoming Maryland Insurance Administration public hearing.

As always, we welcome your feedback and invite you to share Insurance Perspectives with your colleagues and business acquaintances. If you do not currently receive our newsletter via e-mail, please subscribe at the left.

Tom Finnell
Managing Director

Jim Stangroom
Managing Director

In this Issue

1. Reinsurance Regulatory Modernization: Change-in-Waiting
2. Credit Rating Agency Reform – A Blessing for Insurers?
3. Convergence or Divergence? Fundamental Differences Remain Between the IASB and FASB Proposals on Accounting for Financial Instruments
4. Maryland Public Hearing on Surplus of CareFirst BlueCross BlueShield to Feature Invotex Report

Reinsurance Regulatory Modernization: Change-in-Waiting
by Tom Finnell

With Congress preoccupied in debates on reforms at the national level regarding health care, systemic risk regulation, repeal of health insurers’ anti-trust exemption and more, a proposed federal bill offered up by the NAIC awaits a date to the prom. In September, the NAIC’s Reinsurance Task Force adopted the Reinsurance Regulatory Modernization Act of 2009, but it remains in search of a congressional sponsor.

Changes made to the proposed bill prior to its approval by the task force revised the role of the NAIC from one of direct authority over a governing body that would be known as the Reinsurance Supervision Review Board, to that of making recommendations to the Board as a new federal agency. Among the recommendations the NAIC could provide are various operating standards for the Board’s consideration and the submission of nominees to the President for his consideration for ten out of fifteen Board directors from the ranks of state insurance regulatory authorities. Despite passage, insurers remain concerned that the bill would reduce collateral requirements for non-U.S. reinsurers.

The bill is a stark example of how the NAIC is re-thinking its relationship with the federal government. In the past, the NAIC’s modus operandi has largely been to focus on development of model laws that would require enactment in 50 states, an approach that takes considerable time and often results in variations from state to state. With reinsurance modernization, the approach taken was to put forward a bill for congress that, with the stroke of a pen by the President, would result in uniform national application.

The bill provides that “National Insurers,” i.e., those domiciled in a qualifying “Home State” and approved by that state to transact assumed reinsurance business nation-wide, can do so while submitting solely to the regulatory authority of the Home State for purposes of its reinsurance business. Non-U.S. assuming reinsurers, referred to as “Port of Entry Reinsurers,” could enter the U.S. market through a qualifying “Port of Entry State” but would still need authority to transact insurance business in any other state.

The bill includes a scale to determine the amount of collateral that reinsurers would be required to post based on a financial rating assigned by the Port of Entry or Home State supervisor, as appropriate. For Port of Entry Reinsurers, no collateral would be required with a “Secure-1” rating. Collateral requirements would then kick in at lower ratings and increase on a graduated scale until 100% collateralization is required at a “Vulnerable-5” level. On the other hand, National Insurers would not be required to post collateral for the first few levels, but after that they would be subjected to the same requirements as Port of Entry reinsurers, including 100% collateralization at the “Vulnerable-5” rating level.

For more information, contact Tom Finnell.

Back to top.

Credit Rating Agency Reform – A Blessing for Insurers?
by Elise Brenneman

Last week, the NAIC approved a proposal that will revamp the manner in which residential mortgage-backed securities (RMBS) are rated with implications on insurers’ risk-based capital. Rather than relying on rating agencies for a credit quality designation, the NAIC will contract with an outside vendor to model approximately 18,000 RMBS, which will include an evaluation of the severity of loss that may exist with each. The changes will become effective for year-end 2009 reporting.

Since the collapse of the residential real estate market, the major credit rating agencies have borne much of the blame. After all, they had assigned their very highest ratings to residential mortgage-backed securities (RMBS) based on their assessments of low likelihood of default, which we now know proved overly optimistic. The three major credit rating agencies – Standard & Poor’s, Moody’s and Fitch – are now paying dearly for these flawed judgment calls. Calls for reforms of credit rating agencies have accelerated with the NAIC Rating Agency Working Group efforts including its public hearing in September. More recently, the House Financial Services Committee passed H.R. 3890, the Accountability and Transparency in Rating Agencies Act. In response to such criticisms, S&P announced that it will launch a service that will assess potential RMBS loss amounts in addition to loss probability, a needed and possibly critical move to restore the credibility of the ratings firm.

The House bill calls for a new SEC office to oversee the agencies and their ratings, open up the agencies to investor lawsuits and remove some federal law mandates that require agencies’ credit ratings. The NAIC has gone further, deciding in September it can no longer rely on the agencies’ ratings of RMBS, and is bidding out the ratings work to risk advisory firms. The NAIC plans to adopt these enhanced ratings methodologies in the 2009 statutory RBC calculation for life insurers. Further, rather than the issuer paying for the rating, the current business practice for the agencies, the insurance companies will pay the fee for the rating.

No doubt competition for rating firm business and advisory services will emerge in the credit ratings realm as these and future initiatives are enacted. Certainly new approaches to the rating of debt and structured securities will be considered and implemented, new rating scales and methodologies may be introduced, and the “issuer as payer” business practice could fall by the wayside. Each of these developments can have far-reaching impacts for insurers. So too, regulators will have new rules, ratings criteria, rating methods, as well as risks to consider in this new environment. And while new credit rating content is largely a welcome development, insurance companies and regulators will have to navigate through these changes and address their applicability, usefulness and cost.

For more information, contact Elise Brenneman.

Back to top.

Convergence or Divergence? Fundamental Differences Remain Between the IASB and FASB Proposals on Accounting for Financial Instruments
by Jim Stangroom

The International Accounting Standards Board (IASB) and the U.S. Financial Accounting Standards Board (FASB) are jointly undertaking a project to revamp the accounting for financial instruments. This is a high priority project for each Board, and they are targeting to issue new accounting standards in 2010. These new standards will dramatically affect investment income recognition, measurement, classification, impairment and hedge accounting. At a joint meeting in October 2009, the Boards agreed upon a set of core principles to achieve convergence. Both Boards will continue to deliberate the issues with the ultimate goal of convergence; however, substantial differences remain between the two Boards, including differences in such fundamental aspects as the applicability of fair value accounting and impairment loss recognition.

The IASB has tackled the project in three phases. The Board issued an exposure draft on classification and measurement of financial instruments in July 2009 (phase 1); issued an exposure draft on impairments November 5, 2009 (phase 2); and is currently deliberating hedge accounting issues (phase 3) with an exposure draft expected by the end of 2009. The FASB has reached tentative decisions on accounting for financial instruments, and its plan is to release a comprehensive exposure draft in the first quarter of 2010. The FASB exposure draft will include not only classification and measurement like the IASB’s phase 1 effort but also impairment and hedge accounting.

One area where both Boards generally agree is that there would be three categories of financial instruments:

1. Fair value through earnings
2. Fair value through other comprehensive income
3. Amortized cost
   

The categories of available-for-sale and held-to-maturity would be eliminated. Under current accounting standards, the vast majority of an insurance company’s investments are typically classified as available-for-sale and such investments are carried at fair value with changes in fair value recognized through other comprehensive income (OCI). The tentative positions of both FASB and IASB call into question whether this would continue to be the case. Under the FASB-proposed approach the default classification for nearly all financial instruments would be fair value through earnings. However, the FASB-proposed approach provides for an option to classify financial instruments as fair value through OCI, comparable to the current available-for-sale approach, if the following criterion is met:

If an entity’s business strategy is to hold debt instruments with principal amounts for collection or payment(s) of contractual cash flows rather than to sell or settle the financial instruments with a third party, certain changes in fair value for those instruments may be recognized in other comprehensive income. (Accounting for Financial Instruments Summary of Decisions Reached to Date As of October 26, 2009, FASB, p. 4.)

The FASB criterion is consistent with the IASB’s, but it is not clear whether there is a holding period requirement to qualify for the fair value through OCI option. For example, if an insurer holds investments for a long term horizon to match its liabilities, but not necessarily to maturity, it is not clear that it would qualify for the OCI option.

Some of the more significant differences between the tentative positions of the two Boards are summarized in the table that follows:

Topic

IASB Tentative Position

FASB Tentative Position

Scope

Applies to financial assets but not to financial liabilities

Applies to both financial assets and financial liabilities with certain exceptions

Classification

Reclassification

Required if the asset no longer meets the conditions for its original classification

Prohibited

Impairment

Expected loss approach that takes into consideration estimates of future credit losses in recognizing investment income

Estimates of future cash flows used for impairment analysis takes into consideration past events and existing conditions (but not expectations about future credit loss scenarios)

Hedge Accounting

Fair value hedge accounting would be similar to cash flow hedge accounting with gains and losses recognized through OCI

No decisions yet but it is possible that fair value hedge accounting could be eliminated if it is deemed unnecessary upon adoption of the fair value through earnings approach

Insurance company accounting professionals, regulators and financial analysts will need to closely monitor the deliberations of the Boards on their financial instruments projects. Changes are likely to have a dramatic effect on insurance company investment accounting. Developments expected from both the IASB and the FASB in the upcoming months will be reported in future newsletters.

For more information, contact Jim Stangroom.

Back to top.

Maryland Public Hearing on Surplus of CareFirst BlueCross BlueShield to Feature Invotex Report
by Tom Finnell

Maryland Insurance Commissioner Ralph S. Tyler announced that he will hold a public hearing regarding the financial surplus of CareFirst BlueCross BlueShield’s (CareFirst) nonprofit health service plans beginning Thursday, November 19, 2009. A press release states that the agency’s expert consultant, Invotex Group, will present a report of their review, and CareFirst and the public will be able to respond.

“As a standard part of our regulatory function of protecting consumers, we want to ensure that CareFirst is financially viable today and into the future for its policyholders,” said Tyler. “This review of CareFirst surplus will offer a valuable framework for looking at the financial status and operational conditions of the company and better guidance on future decisions regarding oversight of this unique company.”

The Maryland Insurance Administration (MIA) has made the expert report public on its web site in advance of the hearing. The review of the surplus of CareFirst of Maryland, Inc. (CFMI) and Group Hospitalization and Medical Services, Inc. (GHMSI) was commissioned to, among other things:

1. evaluate whether the current statutory requirements are adequate to protect CFMI and GHMSI members, and
2. recommend a regulatory framework for reviewing and determining when the surplus for both companies on an individual or consolidated basis has become excessive.

For more information see the MIA’s web site or contact Tom Finnell.

Back to top.