The NAIC Solvency Modernization Initiative
By Kris DeFrain
U.S. insurance regulators continue to improve upon the financial regulatory system. In the 1990s the U.S. created property and casualty risk-based regulatory capital (RBC) requirements. The RBC requirements established minimum capital requirements directly related to the risks undertaken by an insurance company, as opposed to only minimum dollar amounts of capital for any company, regardless of risk. This same risk-based philosophy is also at the core of a recent change adopted by the NAIC to evaluate prospective risks in a financial examination using an enhanced risk-focused surveillance process.
There are other U.S. financial regulatory changes on the horizon. In June 2008 the NAIC announced the Solvency Modernization Initiative. The initiative encompasses projects already underway at the NAIC and includes study of international solvency regulatory efforts such as Basel II for banking regulation and the European Union’s proposed Solvency II for insurance regulation.
The initiative places emphasis on five key focus areas: capital requirements, international accounting, insurance valuation, reinsurance, and group solvency.
Capital Requirements—Regulators are considering whether the action and control levels in the RBC are established at appropriate levels, whether the RBC should be expanded beyond its current determination of a minimum capital requirement, and whether to require regulatory reporting of a company’s economic capital level and information about the development of the company’s target capital. In doing so, regulators could learn more about the risks faced by a company and how those risks interact and change.
Regulators are also discussing whether additional tools could be useful, such as the use of internal models within or as a replacement to RBC and the requirement of enterprise risk management (ERM) reporting. Partial internal modeling already exists for certain products in the life RBC formula and the use of internal modeling could be expanded to develop an explicit property/casualty catastrophe risk charge. In addition, there is consideration of the use of full internal modeling by a company, with some restrictions and deterministic elements, to replace the RBC calculation. For ERM, regulators might consider requiring insurers to perform their own risk and solvency assessment, including assessment of their risk management and evaluation of the potential impact of risks on their solvency position.
Reinsurance—In 2008, the NAIC adopted a Reinsurance Regulatory Modernization Framework Proposal that includes a design to create a modernized system for the regulation of reinsurance in the U.S. The NAIC has now begun its work to implement the framework. The first step is to draft proposed federal legislation to implement the legal framework. Next will be structural development of a Reinsurance Supervision Review Department that will assess non-U.S. regulatory regimes as well as facilitate the evaluation of states wishing to become home state or port of entry supervisors.
Group Solvency Issues—The Holding Company Model Act includes standards governing material transactions between an insurer and its affiliates and relating to changes in control of an insurer.
The NAIC is creating a Group Solvency Issues Working Group to study potential revisions to the Holding Company Model Act, the use and potential improvement of Supervisory Colleges with regulators from around the world, and group-wide supervision requirements, which may include group-wide capital requirements.
International Accounting—For insurance contract accounting, the U.S. Financial Accounting Standards Board (FASB) entered into a joint project with the International Accounting Standards Board (IASB). The two groups will work to establish International Financial Reporting Standards (IFRS), which then will become U.S. generally accepted accounting principles (GAAP). The insurance regulators’ accounting system, statutory accounting, requires regulators to review any changes to GAAP accounting and determine what changes should be made to statutory accounting. U.S. regulators are already reviewing and commenting to the IASB on international accounting proposals.
Insurance Valuation—The valuation aspect of this initiative is mainly focused on life insurance reserves, given that property/casualty reserves are already principles-based. However, the life insurance principles-based reserving project could influence property/casualty regulation, especially relating to governance and actuarial requirements.
If international accounting is implemented, numerous valuation issues would arise for property/casualty insurance, as well. While the U.S. reports the expected ultimate value of its loss reserves (somewhat equivalent to discounted reserves with implicit risk margins equal to the discount), international accounting utilizes discounted reserves and explicit risk margins.
Now appears to be the time for change, especially as regulators in the U.S. and around the world learn lessons from the current financial crisis. Amidst other countries who are improving their systems of insurance regulation, the U.S. will study and implement change within the U.S. Solvency Modernization Initiative.
The initiative is being led by Commissioner Alfred Gross, Virginia Bureau of Insurance, as chair of the NAIC’s Solvency Modernization Initiative Task Force. Additional information can be found on the NAIC Web Site.
Kris DeFrain, FCAS, MAAA, CPCU, is the Director of Actuarial and Statistical Services for the National Association of Insurance Commissioners. Her article reflects her own personal opinions and do not necessarily reflect the views of the National Association of Insurance Commissioners or its members.