2010 NAIC Financial Summit

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Table of Contents

Federal Legislative Activity—
Fallout from the Financial Crisis Click here to read this article.

Solvency Modernization Initiative—
Filling in the Framework Document but Group Solvency Oversight Needs Work Click here to read this article.

US Financial Sector Assessment Program Review—
US Scores Well but Limited Independence of Commissioners Criticized Click here to read this article.

Structured Securities—
Increasing Role for the SVO Click here to read this article.

International Accounting—
Update on the IASB/FASB Projects on Insurance Contracts, Financial Instruments & Financial Statement Presentation Click here to read this article.

Derivatives/Schedule DB—
Improved Reporting on the Way for 2010 Click here to read this article.

Principles - Based Reserving—
Timetable for Implementation Delayed by Call for an Impact Study Click here to read this article.

The NAIC held its 2010 Financial Summit, which provides regulators with an opportunity to keep up on the latest insurance accounting issues and earn continuing education credits, was held June 2 – 4 in Jacksonville, Florida. This issue of the Barnert Reports summarizes the sessions that may be of interest to our clients.

Florida Commissioner Kevin McCarty opened the Summit by suggesting that the financial crisis has engendered significant criticism of state-based insurance regulation, however unfairly. One of the most recent complaints has come from a member of the EU Parliament in the form of a letter sent to the US Congress. In spite of these criticisms, the IMF/World Bank survey team gave high marks to the US insurance regulatory regime, the only significant area of exception being group solvency, an area not yet well implemented anywhere in the world. The Solvency Modernization Initiative Task Force (SMITF) is working on the issue in conjunction with international regulators. The FSAP (Financial Sector Assessment Program) results and the work of the SMITF have led to the consideration of many ideas from other regulators and comparisons are being made to the Canadian, Swiss, and Australian regimes. Though Solvency II is utterly untested, ideas from it, such as the ORSA (Own Risk and Solvency Assessment), are worth consideration as well.

The EU equivalence process is raising significant concern, particularly with regard to process. It seems the EU Parliament is only occasionally listening to CIEOPS (Committee of European Insurance & Occupational Pension Supervisors). The consequences of equivalence have the potential to cause serious market disruption to both US subsidiaries of EU companies and US companies doing business in Europe. McCarty said he hoped that Solvency II would eventually become a system as effective as that in the US but that he found it ridiculous to suggest that the US replace its proven and effective regime with one that is completely untested.

He said that the IASB/FASB projects were being followed closely, and that the resulting changes to US GAAP would be analyzed as to whether they are appropriate for regulation, and whether the reliance on statutory accounting should be revised. He said that one likely good result of international dialogue would be a reworking of RBC to place the entire system on a consistent confidence level. McCarty added that an examination of macro-prudential tools was being undertaken and that global standards on corporate governance were being reviewed for application to the US regime.

Given that it was the first day of a hurricane season predicted to be severe, and the recent increase in seismic activity, the Commissioner also mentioned efforts to better understand and protect for catastrophe risks. Lastly McCarty encouraged participants to spend all important tourist dollars in the sunshine state.

Federal Legislative Activity: The manager of the NAIC Government Affairs department, Moira Campion, gave an update on federal activity. She started by discussing the current feelings on the hill about the bailout. The votes to implement the bailout were based on Treasury going to the hill and telling Congress that the sky was falling – that the US economy might collapse in a matter of days if action was not taken. Although the bailout appears to have been effective, it has significantly changed the relationship between the government and the private sector. There were and still are members who oppose it on the principle that the government should never have interfered with the market.

That said, Campion asserted that it should be made clear that the insurance sector was strong. Some 200 banks accepted TARP funds compared to three insurers. NAIC members have been in Washington saying that the AIG financial products operation was a banking and securities regulation failure. She said that the issues around securities lending were identified, and that AIG was in the middle of unwinding the problem when the crisis hit.

Campion described the administration’s intent with financial services reform as an attempt to address too big too fail firms and improve consumer protection, and opined that the current bill accomplishes much of that. The NAIC is concerned about a paragraph in the provisions on systemic risk that appears to put the camel’s nose of federal regulation under the state regulation tent. It suggests that a firm found to pose a systemic hazard could be subject to federal action.

The House version of the bill passed in December. The Senate had been attempting to craft a filibuster-proof version since then, which passed two weeks ago. Four Republicans voted for the Senate bill. There were 31 amendments accepted from the floor, which surprisingly strengthened the bill. House Committee Chairman Barney Frank is chairing the conference committee. It is surprising that there will be a conference and remarkable that it will be held in public. Five sessions are scheduled with the House scheduled to pass the conference bill June 29 and the Senate July 2nd, very close to the pre-election summer break.

The following are five concerns the NAIC has with the bills:
• The representative on the Financial Stability Oversight Council (charged with identifying what is too big to fail) – in the Senate version who represents insurance issues is not necessarily someone with a regulator background. (It could be industry. Shocking!) The NAIC prefers the non-voting representation by an actual regulator as is in the House version.
• The federal receivership authority in the House version has better protection for the state process for liquidation. The NAIC does not want to see the primacy of policyholder claims compromised.

• The ONI in the Senate version has less responsibility to consult with the states when preempting in favor of international agreements than the FOI in the House version.
• The “Volker Rule” on derivatives trading is not in the House version. In the Senate version there is no carve out but there was a resolution directing the conference committee to insert a carve out for insurance companies.

• There are carve outs for insurance regulation of consumer protection in both bills, but this is another area to watch.

The non-admitted and reinsurance reform provisions that were passed several times by the house are in both bills and there is no expectation of them changing in conference. The bill assigns premium collection solely to the “home state” of the surplus lines carrier (later to be allocated). It also contains provisions preempting licensing-state regulation of reinsurers when the state of domicile is accredited by the NAIC. The NAIC does not like the latter provisions.

Issues other than the financial reform bill include the SEC ruling on equity-indexed annuities. Several bills have been introduced to reverse this decision on equity-indexed annuities, but none of them were incorporated into the reform bill. Work continues with the SEC.

There has been no will to comprehensively reform federal flood insurance. The patchwork of extensions has allowed it to lapse three times so far. The current extension is tied to extensions of unemployment insurance and COBRA which are political hot potatoes. Currently no new policies can be written, but current policies remain in effect.

There is a bill to extend risk retention groups (RRGs) authority to commercial property covers. The bill also gives Treasury a role in resolving disputes between states around RRGs and the NAIC does not like this latter provision.

There are ongoing efforts to create a federal regulator. Treasury has begun saying that policyholders would have suffered if the federal government had not bailed out AIG. The NAIC disputes this. The issue will not be resolved this Congress. However, Congressman Frank has been indicating that the issue will be resolved in the next Congress. It is likely that with Dodd’s retirement, Tim Johnson (D-ND) will become Banking Chairman in the Senate and he has been a stalwart advocate for OFC. Some action is expected after the midterm elections.

Solvency Modernization Initiative: Director Urias (AZ) introduced the topic. The Solvency Modernization Initiative (SMI) was begun to address the appropriate impact of international concerns and standards. The financial crisis, impending federal systemic regulation and G20 statements concerning the strength of regulation have quickened the pace significantly. The effort is intended to be a reevaluation of the US state-based regulatory regime in eight areas: capital and RBC requirements; financial surveillance; group solvency; governance; risk management; reinsurance; valuation (PBR); and accounting.

Action so far has been the development of the framework document, intended to describe the US system. The idea is to facilitate comparison with other regimes and identification of areas for improvement. Other sources for potential change have been the FSAP recommendations, IAIS standards development, Solvency II (particularly equivalence), and the IASB/FASB accounting projects. The Director said she has been getting meeting requests from parties attempting to explain the realities of Solvency II and suggestions for the direction of SMI.

The development of the framework paper has so far led to the following conclusions: the US has a good system but there are other ideas that should be considered, such as ORSA, quality of capital distinctions, modernization of capital requirements, new governance standards, and group surveillance.

In addition to the framework paper, the Task Force has completed two consultation papers (capital and governance), overseen work on the PBR Valuation Manual, and (at the Group Solvency Working Group) has begun work on revisions to the Holding Company Model Act.

Commissioner Joe Torti (RI) presented the work on Corporate Governance. Unsafe business practices by financial institutions prior to the crisis have led to a review of corporate governance requirements. The goal is to develop corporate governance principles that would apply to insurers and a best practices document for examiners. The Working Group is also providing input to the IAIS as its standards are developed.

Response to the consultation paper has been that proportionality (requirements are a function of size, type, and complexity of risk) needs to be clear. Respondents also questioned the need for additional standards given the current requirements and the unique US environment needs to be considered, and stressed that the new requirements should not conflict with other state law.

Torti thinks the industry is protesting too much. He said in his experience that in nearly every case of troubled insurer its board was either asleep or stacked with insiders. He suggested industry work with the effort instead of resisting it.

He said the ORSA was a useful idea, but that much of it was already found in actuarial reports or could be accomplished during the on-site exam. He said that, as part of the principles, board and management responsibilities should be strengthened, suitability of leadership will be examined, remuneration practices will be discussed, and risk management requirements will be clarified.

Director Mary Jo Hudson (OH) discussed the work on financial surveillance, capital requirements, reinsurance, and accounting. Regarding the first two, work has mostly related to the framework and consultation documents. On reinsurance, there are many who believe our system is working but there are others who recognize the market has changed and that collateral requirements need to be adjusted. For accounting, the SMITF formed a subgroup to review and determine the future of statutory accounting.

Lastly Deputy Commissioner Danny Saenz (TX) discussed group solvency. He said the current system focuses on transactions and dividends, ensuring that assets don’t leave, and not analyzing the potential other impacts of the group on the insurer. He said that the crisis made it clear that the model of minimal intrusion up to the holding company had failed and more oversight was required. The Working Group is currently editing the model laws and regulations for holding companies.

Saenz said the conclusion of the Working Group so far has been that there needs to be access to meaningful information about the group’s potential impact on the insurer. It is willing to consider group financial assessment but the current US solo system has worked pretty well and the Working Group feels there is a need to react to EU demands by simply responding. He said that any effort in this area has to work efficiently with how management has set up and runs the company.

US Financial Sector Assessment Program Review: Ray Spudeck (FL) gave a presentation on the recently completed FSAP on US insurance regulation. He was the project coordinator for the NAIC. The IMF and the World Bank conduct the FSAPs to determine a country’s performance based on standards identified by the Financial Stability Board (FSB). A few years ago the G20 agreed that its members would undertake the FSAP process which had until then been targeted at developing economies.

The standards applicable to insurance regulation are the Insurance Core Principles (ICP) of the IAIS. The FSAP examiners solicited a self-examination (which the NAIC did very well on), conducted various interviews (including a surprising number with Treasury), and conducted field visits to New York, Illinois, West Virginia and Iowa.

The ICP’s identify 25 or so areas individually scored by the FSAP. The US insurance regime scored Observed or Mostly Observed on all but three: supervisory authority; group supervision; and anti-money laundering requirements.

The objection to supervisory authority was that the election or appointment process (and threat of removal) for Commissioners exposed the state insurance departments to too much political influence. The FSAP held that the supervisor should be more independent. Spudeck suggested this was a misunderstanding of political accountability in the US. The FSAP went on to say however that, in spite of this review by licensing states, accreditation and the FAWG process meant that in practice supervision was adequately independent.

Spudeck said no jurisdiction scores well on Group Supervision (except one country with four companies all effectively sovereign-owned). The FSAP recognized the efforts of the SMITF to address this and the US participation in the effort to develop IAIS processes and standards.

The objections to anti-money laundering requirements were telling as to the limited misunderstanding the FSAP examiners had of the US system, and their tendency to be requirements rather than results focused. The objection was that insurance laws do not contain anti-money laundering requirements. This was in spite of the fact that effective requirements are contained in federal law.

Spudeck said the positive results of the FSAP are that it has sparked internal review of the US system, global outreach to explain the effectiveness of the U.S. regime, and awareness of the importance of the IAIS standards and the current effort to revise them, as the US will be the first to participate in a peer review under the new standards in 2012.

He said the main challenges were rationalizing the FSAP’s interpretations of the ICPs to be as results-based as possible, and to correct the basic misunderstandings (mentioned above) of the US regulatory environment. [Which is ironic, because the emerging-market economies have been making the same criticisms of the FSAP for years].

Stuctured Securities: Matti Peltonen, Chief of the NYS Insurance Department Capital Markets Bureau, reviewed what structured securities are; the extent insurers’ exposures and the implications thereof; and the steps regulators have taken and plan to take in the future to improve reporting of these exposures. He stated that the traditional role of the SVO had been to evaluate and assign NAIC designations only to securities that are not rated by one of the six NRSROs (Nationally Recognized Statistical Rating Organizations) and securities with NRSRO ratings were given equivalent NAIC designations (those having more than one NRSRO rating were assigned the equivalent for the second lower NRSRO rating).

However, the financial crisis highlighted the significant shortcomings of this practice and in February 2009 the NAIC decided to develop its own rating system for those types of asset-backed securities for which insurers had major exposures. The 2009 book-adjusted carrying value of loan-backed and structured securities (which are loan-backed securities that have been divided into two or more classes for which the payment of interest and/or principal of any class of securities has been allocated in a manner which is not proportional to interest and/or principal received by the issuer from the mortgage pool or other underlying securities) was over $483 billion with the two largest types being RMBSs (Residential Mortgage-Backed Securities) at $160 billion and CMBSs (Commercial Mortgage-Backed Securities) at $207 billion.

The annual statement currently reports these securities in one of five categories but for 2010 a blank’s proposal calls for condensing them into three buckets – RMBS, CMBS, and all other asset-backed securities. Peltonen stated that in 2008 over $200 billion in asset-backed securities, mostly structured securities, were misfiled (as corporate securities) but that reporting had improved in 2009. Because of this extensive misfiling, the actual total exposure to structured securities is unknown.

Peltonen listed some of the shortcomings of the ratings provided by the NRSROs, including that they have been inaccurate and that they are often quite stale, with many ratings unrevised for several years. (As of February 2010, 36% of Moody’s and 49% of S&P ratings were over two years old.) The actual age of a rating is not readily available so the regulators are trying to get the agencies to provide the date of each rating.

Peltonen noted that the NRSROs resisted re-rating RMBSs when the residential housing market first started to deteriorate and later they made downgradings that went beyond what was justified. In addition, the NRSROs have found it so difficult to rate a new type of structured security, the CPDO (Constant Proportion Debt Obligation), that they have stopped trying.

The NAIC considered moving to an investor pay model but this solution would not address existing securities. The working group formed to devise a solution finally settled on a modeling approach which would utilize consistent and controlled assumptions, consistent timing of the data, and a consistent and controlled model. It also decided to assign NAIC designations based upon the insurer’s carrying value of the security. Peltonen noted that the rating agencies assume all investors buy at par but an insurer’s exposure differs based on when the security was purchased and the price paid. A contract to develop the model to be used for RMBSs reported at yearend 2009 was awarded PIMCO and the project was completed in three months. Time constraints prevented development of a model for CMBSs but one will be developed for 2010 reporting.

Peltonen reviewed the actual model under which each RMBS was analyzed under five economic scenarios. He stated that the approach did a better job of identifying risks in the mezzanine and junior tranches and that the results correlated better to market values and, happily for the insurers, the use of carrying values for these tranches has resulted in lower RBC charges. (The use of carrying value is significant because an insurer who purchases a security at 50 can loose no more than 50, whereas an insurer that purchases the same security at 100 can loose 100 and both will get the same cash flows. Said another way, the lower the purchase price, the higher the yield, an insurer holding a security with an expected loss of 20% if purchased at 100 can expect to loose 20% but if purchased at 65 can expect to gain 15%.)

Peltonen noted that the accounting rule to go along with this new rating system, SSAP 43R, had to be revised in record time in order to allow it to be implemented for 2009.

International Accounting: Rob Esson (NAIC) and Henry Siegel (NY Life and the American Academy of Actuaries) made a joint presentation on the status of three joint IASB/FASB projects that impact the insurance industry and insurance regulation. Both stressed that their remarks should not be attributed to their respective organizations.

Insurance Contracts Project: This project was started by the IASB in 1993; an Issues Paper issued in 1997 was received badly by industry, users, and regulators. Esson noted that the 13 years this standard has been under development is testament to the complexity of the issue, both practical and theoretical. There are differences of opinions between jurisdictions as well as within the industry between life and non-life insurers. The current status of this project calls for issuance of an Exposure Draft next month and issuance of a final IFRS in June 2011. Esson noted that nothing is set in stone; that there had been many deadlines set and missed in the past, and that just this week the Boards had stated that some convergence projects (although not specifically the Insurance Contracts Project) would be delayed.

Many of the issues have been resolved and there is now general agreement, according to Esson, that there will be one model (with some differences) covering both life and non-life and instead of a fair value model it will use contract fulfillment value in place of fair value. Esson stated that the two boards are not sure what contract fulfillment value means precisely but they have identified three (or four) building blocks – best estimate of future cash flows, time value of money, and one or two margins.

According to the speakers, best estimate of future cash flows should include renewal premiums, policyholder dividends, and all expenses including acquisition or transaction expenses. Esson noted problems with each of these elements. For renewal premiums the problem seems to be largely terminology; including “renewals” works for life insurance where a contract remains in force unless allowed to lapse but not for a property/casualty policy where a renewal relates to an affirmative decision by both the insurer and the policyholder to issue a new policy. The IASB recognizes the problem but the FASB is not sure.

Siegel stated that some FASB members feel policyholder dividends should not be included in cash flows because they are not guaranteed. The Boards also do not agree on how acquisition costs should be handled; the IASB, by an eight to seven vote, agreed with industry that they should be included in cash flows as they must be included in the calculation of the price of the contract but the FASB opposes recognition of revenue to offset acquisition costs. FASB would expense all acquisition costs as incurred because it equates this issue with treatment of acquisition expenses in its recent revenue recognition decision. This is, again, a terminology issue since in general what insurance companies call acquisition expenses are actually costs associated with the completion of the contract and are therefore closer to transaction costs in other situations.

Regarding discount rates (for the time value of money), the IASB is expected to require discounting of property/casualty reserves but there is no agreement as to what rate to use. FASB is set to discuss this. [Note: On June 9th, the FASB staff proposed and the Board generally agreed that claim reserves on short-term contracts should be discounted unless the result was immaterial. Discussion continues on the definition of a short-term contract.] One option is to use the risk-free rate (according to Esson, what some financial theorists consider the theoretically correct rate) but this may discourage the sale of long-term products like immediate annuities and LTC insurance. The presenters believe that this approach is not politically viable given that finance ministers worldwide are attempting to encourage the privatization of pensions.

Esson stated that the alternative of a risk-free rate with a liquidity adjustment would be acceptable because Treasuries are quite liquid relative to insurance liabilities but so far no one has figured out how to calculate the liquidity adjustment. Siegel is doubtful the Boards will agree to use an expected portfolio rate but a corporate bond index is a possibility given that it is now used by the IASB for pensions.

Siegel stated the Boards have identified two potential ways to calculate a margin which they believe is necessary in order to ensure that there is no gain or loss at issue. One approach would be to establish a risk margin plus a residual margin to ensure there is no gain or loss at issue; the second would be a single composite margin. US constituents have argued that only one margin is needed but the Europeans want a risk margin plus a residual margin either to make users aware that there is volatility in the reserves or because they have gotten an agreement from their regulators that the residual margin will count as surplus. (Esson noted that a risk margin was necessary because it had been “pre-legislated” by Solvency II.)

Siegel stated that there is no consensus as to how the risk margin should be calculated and he believes the Boards do not understand the actuarial implications of a risk margin. He also noted that this approach might not work for non-life business. The composite margin approach might be viable but the Boards’ staffs believe that it could not be remeasured. The staffs have told the Boards that there was no way to remeasure a composite margin, apparently ignoring a paper Esson had submitted explaining how remeasurement could be done.

Siegel noted that the staffs subsequently came up with their own formula (premium for the period plus the costs for the period divided by the total premium and total costs applied to the margin) which no one understands but which was nevertheless adopted by both Boards. Siegel pointed out that the formula does not say whether it uses paid or incurred claims or what the period referred to is. Several other open issues were touched upon including unbundling, presentation, reinsurance, disclosures (to be greatly increased); own credit risk; contract boundaries; and transition (earlier in the week the IASB decided to use retained earnings to run off the differences for existing contracts).

At the prompting of Ed Stephenson (Barnert Global), Esson added that the IASB had made a concession to the non-life insurance industry and would allow the use of an unearned premium reserve (UPR) for the pre-claim period.

Financial Instruments Project: Under existing standards the Boards permit three alternatives to account for financial instruments use – amortized book value for investments to be held to maturity; fair value through net income for investments to be traded; and fair value through OCI for investments available for sale. The financial crisis has put pressure on the Boards to re-examine how financial instruments are accounted; the current approach with its three alternatives has been demonized as being too complicated and its results have been criticized as being pro-cyclical because it requires low values for certain CMOs and other thinly traded securities so the G20 has demanded that the IASB revise its standard and the FASB has been put under similar pressure.

To address the demand for simplification both Boards could have gone with fair value for all financial instruments; the FASB will soon issue an Exposure Draft that is expected to use fair value for all securities, [Note: It was exposed on June 8] through either Profit and Loss or Other Comprehensive Income (OCI) (Esson indicated some uncertainty as to whether this would be required for liabilities given the illogical results – if the insurer’s rating was to decrease the value of its surplus would go up). The IASB elected to divide the project into three parts – classification and measurement (it issued IFRS 9 covering classification and measurement of financial assets in November of 2009 with early adoption permitted but with an effective date of January 2013 and released an Exposure Draft on financial liabilities in May 2010), impairment (comments on its Exposure Draft are due this month), and hedge accounting (work on this part has just begun).

IFRS 9 did away with the Available For Sale (AFS) category meaning fair value of fixed income securites through OCI is eliminated, it provides for most bonds to be carried at amortized cost (provided they are held for the collection of principal and interest as opposed to held for trading) but there is a fair value option if needed to eliminate a mismatch. (The IASB has made it clear that the insurance contracts project would include a fair value option to address mismatches and there would be an opportunity to reclassify assets when the insurance contracts project is effective.)

Siegel noted that this standard will be a real problem for insurers which is why the availability of a fair value option in the Insurance Contracts standard is so important. The IASB took this approach after stiff lobbying by the banking industry whose liabilities consist mostly of demand deposits and therefore need to be able to carry their assets at amortized costs in order to avoid mismatches. Esson suggested it was ironic that the entities that caused the financial crisis and hold most assets for the short term, were being accommodated at the expense of insurers who remained stable throughout the crisis.

Regarding impairments, Esson stated that the current incurred loss model requires a triggering event and the G20 believes this causes recognition of an impairment to occur too late. It therefore proposed moving to an expected loss model and because the G20 has decreed it to be so the revised model will be called an expected loss model although it is not clear how this would work. The IASB has released an Exposure Draft of an expected loss impairment model (which Esson implied may in fact be an incurred loss model) and has created an expert advisory panel charged with making the model operational. Esson believes this will be very difficult to accomplish and as he the only “pure” insurance representative on the panel, he requested input from anyone with ideas on how this could be accomplished.

Financial Statement Presentation: Siegel stated that the balance sheet as it is currently known will be replaced with a Statement of Financial Position which will report assets and liabilities in three separate sections – operations, investing, and financing and will not provide a total for assets or liabilities. A similar change will be made to the income statement. Esson is on the advisory group for this project and has argued, so far to no effect, that this approach does not work for the financial services entities.

During Q&A Siegel mentioned that the SEC will take another look at the convergence project in 2011 and that sometime before 2014 it will probably permit US entities to use IFRS but it may not make this a requirement. He hopes the Boards will eventually converge but Esson suggested this will be difficult given that there is not only division between the Boards but also within each Board.

It was also noted that a Commissioner level group has been established to consider the future of SAP in the event US GAAP is eliminated.

Derivatives / Schedule DB: Joseph Prakash, who heads the SVO group responsible for portfolio analysis, and Dan Daveline (NAIC) made a joint presentation to help the examiners understand what derivatives are, how and why they are used by insurers, and how they should be reported in Schedule DB of the annual statement. Most of the participants in this session had little familiarly with Schedule DB but Prakash told them not to worry as there will be extensive changes to Schedule DB for 2010.

Prakash told the examiners that they should not be dazzled by people who claim to have superior understanding of these products because understanding them requires only common sense and some experience. Later he said that no one understands them in their entirety. He explained that there are only four basic building blocks for derivatives but cautioned that the actual products will have nuances and may be a combination of more than one type of derivative; for example, a product could be a combination of a swap and an option (a “swaption”).

He stated that derivatives are instruments whose value is derived from or based on the value of an underlying variable which are typically such things as interest rates, equity prices, or commodity prices.

Options: An option is a contract which gives the investor the right to buy (a call) or sell (a put) a fixed amount of the underlying variable at a specified price within a limited time period. A call option has intrinsic value when the price of the underlying (e.g., stock) is greater than the strike price of the option; a put option has intrinsic value when the opposite is true. There are five factors that determine the market value of the option, which Prakash stated changes by the minute:

• Difference between market price and strike price
• Volatility of the underlying
• Time to expiration
• Interest rate levels (A higher interest rate increases the value of a call and decreases the value of a put.)
• Dividends (The existence of dividends depresses a call price and increases a put price.)

Prakash note that options traded on European exchanges have a date certain to exercise whereas US options may be exercised at any time before they expire.

Forwards and Futures: Prakash stated that forwards and futures serve the same purpose. They are both contracts to either buy or to sell an item in the future at a price that is fixed upfront; however, futures are exchange-traded and marked-to-market; the contract language is fixed with respect to amount, tenor and settlement; their counterparty risk is absorbed by the exchange; and they are mostly liquid. In contrast, forwards are traded over-the-counter; they are not marked-to-market; the holder bears the counterparty risk; the contracts are customized, and they are mostly illiquid.

Hedging: Hedging is a risk management and control tool. Examples of derivative instruments used for hedging purposes include interest rate swaps to hedge interest rates; credit default swaps to hedge credit risk; and currency forwards, futures, swaps, and options to hedge currency risk. Derivatives are also used for asset/liability matching, price discovery (using futures contracts), and speculation.

Financial Crisis: Prakash explained how speculation (when investors buy protection covering an underlying they do not own – betting the price will go up or down) led to ever increasing exposures that eventually led to the run on AIG which began in August 2007 when Goldman Sacks asked AIG to post $1.5 billion in collateral to cover some credit default swaps. AIG was able to negotiate this collateral call down to $450 million but Goldman made a second call in October, this time for $3 billion which was satisfied by AIG with $1.5 billion. In November two other banks got into the act, followed in December by three others. By August 2008 AIG had posted $16.5 billion in collateral, which led to cuts in its credit rating and the government coming to its rescue in September.

Daveline went through the changes to Schedule DB which he stated are intended to simplify the schedule, provide better information to the regulators and other users, and to make the schedule consistent with other schedules such as Schedule D and the acquired schedule has been eliminated.

In addition a new line has been added to the asset and liability pages of the balance sheet for derivative reporting. The 2010 asset page will include an invested assets write-in line for reporting of derivative asset amounts shown as debit balances on Schedule DB, Parts A, B, C and D, if any. On the liability page, derivative instruments liability amounts, if any, will be reported on the other liabilities write-in line.

Principles - Based Reserving: Dave Sandberg (Alliance Life) made this presentation on behalf of the American Academy of Actuaries. The slides he used had been put together by Pete Weber, an actuary with the state of Ohio and Sandberg stated he would try to give the presentation from the regulatory perspective whose primary concern is solvency (ensuring that the insurer will be able to fulfill its obligations to its policyholders) and to promote a healthy competitive insurance market.

The formula-based reserving method for life insurers was developed about 150 years ago and for many years it worked very well. It used net level premiums, conservative mortality and discount rates, and assumed no lapses or expenses. Regulators “loved” formula-based reserving because they are conservative, easy to calculate and audit, involved no judgment, and actuaries are believed to “do mortality” really well. However, the development of new and innovative life and annuity products in response to consumer demands has made it increasingly difficult to apply the formulas and regulators have now come to “hate” them.

Over the past twenty years or so regulars have attempted to make adjustments but they are loosing the formulas effectiveness because they can only address the risks contemplated by the formulas and the new products bring with them new types of risk. Additionally the formulas conservative assumptions can disguise risks, they do not capture how insurers operate, and the resulting reserves are too high for some products and too low for others.

Regulators are concerned that insurers have attempted to compensate for reserve redundancies by investing in more complex and risky strategies, such as hedging, off-shore reinsurance, and securitizations. Regulators therefore have committed to the development of a principles-based approach which they have come to believe will better recognize the risks imbedded in an insurer’s products; will allow the regulator to get a better picture of the insurer’s investment, underwriting and operating processes and strategies and the risks involved; and will enable evaluation of the adequacy and effectiveness of the insurer’s asset/liability matching strategies.

Sandberg stated that six or seven years ago the Academy developed a set of principles the principles-based approach (PBA) should follow which include:

• Capturing the benefits and guarantees in the products including “tail risk” (events that are unlikely but could occur);

• A learning process so that knowledge on how to measure and manage risk can expand, modify, and improve the methodology;

• Actuarial statutory reporting that mirrors the information management is actually using to run the company (Sandberg noted that this typically already happens in property/casualty and health companies whose quarterly reports include all the key risk drivers and performance, including expenses, loss ratios, and investment results.);
• Utilizes the company’s experience, based on the availability of relevant and credible and benchmarks it against aggregate industry data;
• Incorporates assumptions that reflect an appropriate level of conservatism and recognizes the solvency objective of statutory reporting; and
• Reflects changes in products and the company’s risk management processes.

Sandberg reviewed the regulatory concerns that led them to consider this new approach. He stated that Guideline 38 was developed about 15 years ago to deal with some of the complicated products that life insurers were introducing into the marketplace that were incompatible with the extremely conservative mortality mandates in the formulas.

Regulators were concerned that insurers were not following the spirit of the law and were developing ways to get around the formulas and lower their reserves. This led them to recognize that a new approach was needed but they are concerned that insurers may take advantage of the greater discretion inherent in PBA to inappropriately lower reserves on very aggressive, judgment-based assumptions. In defense of the insurers Sandberg suggested that regulators should not be surprised that they would try to find a way to hold the minimum reserves and noted that reserve adequacy testing ensures that aggregate reserves are sufficient to meet their obligations.

Another concern of the regulators is that PBA might produce different reserves for two companies operating in a similar way. Concerns shared by regulators and companies is whether the internal models developed by the companies under PBA will reflect the company’s liabilities, assets, and philosophy; how will the models be benchmarked; whether they will do a good job of projecting reality; and whether there will be adequate controls in place around the models. Sandberg noted that the International Association of Actuaries has just completed a paper on internal models that will be the guidebook on practices for developing internal model and will serve as the textbook for how the information would be verified and validated.

Sandberg stated that actuaries will have more accountability and responsibility under PBA for setting the appropriate level of reserves and there will be more transparency in that the models will be submitted to the board of directors, to the rating agencies, and of course to the regulators. He said that the increased transparency under PBA will enable regulators to identify and target company’s that are less well managed and therefore at greater risk. He noted that his company’s parent has hired independent actuaries to verify its internal models.

Sandberg stated that the Academy has completed its work on the new Valuation Manual and that it has been the hands of the LHATF since the fall of 2007 where is has been hotly debated by the regulators, industry, and other interested parties. In the slides Weber likened the debate to an “intense discussion on trees amid a forest”. Outstanding issues include what discount rate should be used (the intent is to limit overly optimistic returns); stochastic scenarios; and what assumptions should be used when a company has no data.

The regulators are considering establishment of a centralized actuarial review office to ensure consistent reviews of PBA reserves and capital; creation of a data warehouse of model output (Sandberg noted that the financial regulatory reform bills now before Congress include creation of a data warehouse.); the need for a feedback loop as an education tool; and peer review.

Regarding the timeline for implementation, Sandberg stated that up until May 4th the plan had been for LHATF to adopt the Valuation Manual at the end of June or early July, to be followed in July with adoption by “A” Committee so that Plenary could adopt during the national meeting in August and legislators could begin considering the amendments to the Standard Valuation Law and Valuation Manual during legislative sessions beginning in 2011. However, on a May 4th conference call the NAIC decided to do an impact study, which Sandberg noted could not be completed in time for adoption in July and no new timeline has been announced.

He listed some outstanding implementation issues, the primary one being the need for uniform adoption of the amendments to the SVL by the states. (It has been decided that PBA would go into effect after 42 states have enacted the amendments.) Others are whether it should be phased in product by product or all at once; the role of corporate governance; the purpose of reserves, risk-based capital, and ERM (Enterprise Risk Management) in a principle-based framework; how examinations and analysis of life companies should change; training; data collection oversight; federal taxes; and small company issues.

There are also outstanding structural issues, including how to construct a state/NAIC/company regulatory feedback loop; who “owns” principles for reserves vs. solvency oversight; whether there should be more or less minimum capital required for experience-based reporting (is it more o less credible?); whether it is true that P&C has greater underwriting risk, but little investment risk, and life has had little underwriting risk, but more investment risk; and whether calibration should include offsets in supervisory or disclosure provisions.

Sandberg emphasized that this project will never be finished and that the Valuation Manual will constantly be updated to take into account emerging experience, practice, and technology.

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