© 2012 The National Association of Insurance Commissioners ASSAL Presentation US Risk-Based Supervision Lou Felice Health and Solvency Policy Advisor NAIC 1

© 2012 The National Association of Insurance Commissioners US Solvency Framework Primary goal is to ensure financial health of insurers for purposes of protecting policyholders Work with companies to remedy areas of concern More severe interventions if company continues to deteriorate e.g. regulators will run off or liquidate the insurer if necessary to ensure protection of existing policyholders A zero insolvencies goal would require a different system Additional goals include availability and affordability of insurance, stable and competitive markets 2

© 2012 The National Association of Insurance Commissioners US Solvency Framework – Key Elements Pillar 1 – Comprehensive body of laws and regulations provide and define the framework boundaries Laws address all of the key elements of solvency regulation and provide conservatism, consistency, and regulatory authority for intervention Pillar 2 – Regulatory oversight provides an assessment within those boundaries Focus on a targeted quantitative and qualitative analysis. Financial analyses tools provide for risk focused surveillance and examination and identification of outliers 3

© 2012 The National Association of Insurance Commissioners US Solvency Framework – Key Elements (cont.) Pillar 3 – Detailed financial reporting Provides transparency Facilitates financial analyses at the both the entity level and across firms Provides basis for early warning and intervention Overarching Accreditation System Solvency Modernization Initiative Wrap-Up 4

© 2012 The National Association of Insurance Commissioners US Solvency Framework Pillar 1 –Laws and Regulations –Risk-Based Capital (RBC) 5

© 2012 The National Association of Insurance Commissioners US Solvency Framework Licensing Each state of operation requires compliance with its laws and regulations (subject to NAIC accreditation requirements); not a passport system Domiciliary state, typically first state of licensure, is lead regulator Adequate business plan required to apply Fixed minimum capital or simple capital calculation must be met, and subject to RBC once up and running Fit and proper management checked for licensure Criminal background check Proper experience, skills Guaranty fund participation Unique State-based policyholder protection system Remaining insurers in the sector are assessed a portion of the shortage of policyholder liabilities less assets 6

© 2012 The National Association of Insurance Commissioners US Solvency Framework Notice of Material Transactions, including intra-group transactions: Acquisition/disposition of assets Revisions to reinsurance agreements Material guarantees/transactions Acquisition/change of control of insurer is approved or rejected by the insurance commissioner Investment limitations Prudent person approach Defined limits approach Derivative use plan requirements Asset adequacy tests and asset/liability matching requirements for life products 7

© 2012 The National Association of Insurance Commissioners US Solvency Framework RBC Overview Developed in early 1990s; F inalized formulas: Life RBC 1993 Property/Casualty RBC 1994 Health RBC 1998 Maintained and evaluated continuously with eye toward predominant risks for each industry segment The formula considers the entity’s size, structure and risk profile Standardized approach, mainly factor based but with some stochastic and full modeling (predominantly Life RBC) upgrades over the years Not all risks are accounted for – only material categories of risks RBC formulas are uniform among the states Largely tied to annual financial reporting for verifiability Annual modifications occur, both maintenance and enhancements 8

© 2012 The National Association of Insurance Commissioners US Solvency Framework Risk-Based Capital (RBC) Results RBC is a baseline tool for providing legal authority for specific regulator action Provides 4 action level triggers based on minimum regulatory capital levels - NOT a target capital level or intended as a financial strength indicator above the action levels RBC is supported by a number of Pillar II and Pillar III tools Used in concert with other analysis and exam findings Augmented by robust annual and quarterly financial reporting and State authority for supplemental reporting or data submission Not totally accurate for all companies but reasonably accurate for most companies Found to be highly effective in HELPING to identify weakly capitalized insurers 9

© 2012 The National Association of Insurance Commissioners US Solvency Framework Pillar 2 –Regulatory Oversight, Assessment and Monitoring 10

© 2012 The National Association of Insurance Commissioners US Solvency Framework Financial analyses (at least quarterly) Automated tools in addition to RBC use audited public data: Ratios Scoring Benchmarking Used to prioritize insurers of concern as well as to compare insurers Prioritization and analysis tools assess: Reserve adequacy Leverage Liquidity Surplus Asset quality Trends, etc. 11

© 2012 The National Association of Insurance Commissioners Overall Analysis of the Insurer and its Operations Detail Analysis of Areas of Concern Management Considerations Statement of Actuarial Opinion Management Discussion and Analysis Holding Company Analysis Audited Financial Report Level 1 Level 2 Supplemental US Solvency Framework - ANALYSIS 12

© 2012 The National Association of Insurance Commissioners US Solvency Framework Risk-focused, on-site examinations Full scope at least once every 3-5 years Risk-focused: Interview senior management Identify key activities and inherent risks Assess/test controls Establish residual risks and plan exam Conduct exam Test and validate residual risks; Modify plan as needed based on findings Target exams as needed based upon concern with company/findings from oversight Some compliance testing for state laws 13

© 2012 The National Association of Insurance Commissioners US Solvency Framework - EXAMS Phase 1 Phase 2 Phase 3 Phase 4 Phase 5 Phase 6 Understand the Company and Identify Key Functional Activities to be Reviewed Identify and Assess Inherent Risks in Activities Identify and Evaluate Risk Mitigation Strategies/Controls Determine Residual Risk Establish/Conduct Exam Procedures Update Prioritization and Supervisory Plan Draft Exam Report and Management Letter Based on Findings Phase 7 PlanningPlanning 14

© 2012 The National Association of Insurance Commissioners US Solvency Framework Continuous monitoring/qualitative assessments using regulator only data – assess: Changes in business plan Material transactions, including group transactions Implications for reputation/contagion risks Impacts of major economic and insurance events, and Stress testing In depth assessments of (potentially) troubled insurers More frequent/extensive: Insurer reporting Regulator analyses/exams Authorities for regulatory actions include Conservation/rehabilitation/liquidation in the domiciliary state Suspending or revoking license to write in the state 15

© 2012 The National Association of Insurance Commissioners US Solvency Framework Pillar 3 –Public and Regulatory Reporting Requirements for Insurers 16

© 2012 The National Association of Insurance Commissioners US Solvency Framework Transparency, uniformity and verification Detailed public disclosure (annual and quarterly) Uniform reporting format Electronic data capture allows creation of prioritization/analytical tools and ad hoc queries, sensitivity analysis Conservative statutory accounting Uniform definitions Nonadmitted assets (not counted toward statutory capital/surplus) Annual independent CPA audit, public Annual actuarial opinion, public Annual detailed actuarial memorandum, regulator only Annual risk-based capital (RBC) calculation, results only public 17

© 2012 The National Association of Insurance Commissioners STATUTORY ACCOUNTING 18

© 2012 The National Association of Insurance Commissioners Statutory Accounting A separate codification of accounting requirements for US insurance regulatory purposes Based on US GAAP –Accept GAAP –Accept GAAP with modifications –Reject GAAP –Separate Statutory Accounting Guidance 19

© 2012 The National Association of Insurance Commissioners GAAP and SAP Differences GAAP Designed to meet the varying needs of different users Stresses measurement of profitability/income Emphasis on earnings Going concern concept SAP Designed to address concerns of regulators Stresses ability to satisfy policyholder obligations Balance sheet emphasis Focuses on liquidity 20

© 2012 The National Association of Insurance Commissioners Foundation Concepts GAAP Relevance Reliability Neutrality Comparability Materiality SAP Additional Emphasis: Conservatism Consistency Recognition 21

© 2012 The National Association of Insurance Commissioners Nonadmitted Assets GAAP does not recognize the concept of “nonadmitted assets”. SAP does not allow certain assets to be “admitted” in the balance sheet. A nonadmitted asset is one which is accorded limited or no value in statutory reporting. Assets NotNet Admitted Assets AdmittedAssets Statutory Balance Sheet $2,794,000 $ 260,000 $ 2,534,000 GAAP Balance Sheet $3,111,000Total Assets 22

© 2012 The National Association of Insurance Commissioners Investments GAAP Classifies investments as follows in FAS 115: –Securities held to maturity are reported at amortized cost; –Securities available for sale are reported at fair value; –Trading securities are reported at fair value. GAAP does not recognize the concept of nonadmitted assets or investment limitations. SAP Bonds are reported at amortized cost except those that are low quality – lower of amortized cost or market (SSAP No. 26). Common Stocks are generally reported at SVO fair value (SSAP No. 30). Nonadmitted assets due to state investment limitations 23

© 2012 The National Association of Insurance Commissioners Goodwill GAAP goodwill = purchase price less market value GAAP does not limit goodwill. SSAP No. 68 goodwill = purchase price less book value Goodwill in excess of 10% of adj. capital & surplus is nonadmitted. Assets Not Net Admitted AssetsAdmittedAssets Investment in Firemen's Insurance Company Goodwill 50,00033,00017,000 20,000 GAAP Balance SheetStatutory Balance Sheet 24

© 2012 The National Association of Insurance Commissioners Agents Balances GAAP requires receivables for premiums and agents’ balances to be reported net of a valuation allowance for doubtful accounts. Companies are simply required to nonadmit any premium receivable balances greater than 90 days past due. (Exception for government insured plans is within SSAP No. 84.) Uncollectible amounts are written off. 25

© 2012 The National Association of Insurance Commissioners Reinsurance Recoverable GAAP requires all amounts due from reinsurers to be recorded as assets. SSAP No. 61 and SSAP No. 62 requires reinsurance recoverables on unpaid claims and IBNR to be recorded as a contra-liability and netted against gross losses and loss adjustment expenses or in cases where the right of offset exists, reinsurance payables. 26

© 2012 The National Association of Insurance Commissioners Deferred Acquisition Costs DAC calculation includes: – Commissions; – State premium taxes; – Underwriting expenses; and – Issuance costs. DAC is usually the largest difference between GAAP and SAP 27

© 2012 The National Association of Insurance Commissioners DAC FAS 60 allows acquisition costs and commissions to be capitalized and amortized to expense over the life of the policy. SSAP No. 71 requires acquisition costs and commissions to be expensed as incurred. Premiums are recognized as income on a pro rata basis. 28

© 2012 The National Association of Insurance Commissioners Furniture, Fixtures & Equip. FF&E is capitalized and depreciated over its useful life. FAS 13 requires reporting entities to classify leases as capital or operating leases. SSAP No. 19 nonadmits all such equipment. SSAP No. 22 requires all leases to be considered operating leases. 29

© 2012 The National Association of Insurance Commissioners P & C Reserves Management’s best estimate of the liability Generally allows discounting of this liability Requires recording of the minimum point in a range as its liability when all points are equally probable Management’s best estimate of the liability Generally does not allow discounting of this liability Requires recording of the mid-point in a range as its liability when all points are equally probable 30

© 2012 The National Association of Insurance Commissioners A & H Reserves Management’s best estimate of the liability Generally allows discounting of this liability Requires recording of the minimum point in a range as its liability when all points are equally probable Management’s best estimate of the liability Generally does not allow discounting of this liability Requires recording of the mid- point in a range as its liability when all points are equally probable 31

© 2012 The National Association of Insurance Commissioners Unearned Premiums FAS 60 only allows premiums to be recognized on a pro- rata basis (daily pro-rata or monthly pro-rata). This results in the recording of an unearned premium liability for the portion of premium received but not yet earned. SSAP No. 53 also only allows premiums to be recognized on a pro-rata basis (daily pro-rata or monthly pro-rata). SSAP No. 54 requires premiums to be recognized when due. 32

© 2012 The National Association of Insurance Commissioners Debt GAAP requires L/T debt to be recorded as a separate liability on the balance sheet. GAAP generally does not allow debt to be used as an offset against the related asset acquired with the debt. SAP allows certain debt to be used as an offset to the related asset for which the debt was obtained. SAP No. 41 allows reporting entities to issue instruments with characteristics of both debt and equity, referred to as surplus notes. These are reported in surplus. 33

© 2012 The National Association of Insurance Commissioners Surplus GAAP recognizes stock- holders’ equity adjusted for net income within R/E. GAAP requires recognition of “Other Comprehensive Income” (OCI). GAAP requires surplus notes issued by the company (which is similar to debt) to be reported as long-term debt. Unassigned funds include the cumulative effect of net income, unrealized gains and losses, exchange rate fluctuations, nonadmitted assets, provision for reinsurance, asset valuation reserve, and changes in DTAs and DTLs. No OCI SSAP No. 41 allows surplus notes to be reflected in surplus. Common stock12,000 Additional paid in capital100,000 Retained earnings675,000 Accumulated other comprehensive income208,000 GAAP Balance Sheet Common stock12,000 Additional paid in capital100,000 Unassigned funds (surplus)216,000 Surplus notes50,000 Statutory Balance Sheet 34

© 2012 The National Association of Insurance Commissioners SAP - Final Thoughts GAAP and SAP have fundamentally different approaches. Although SAP reviews and uses some of the GAAP pronouncements, the objectives are different. 35

© 2012 The National Association of Insurance Commissioners ACCREDITATION PROGRAM 36

© 2012 The National Association of Insurance Commissioners US Solvency Framework Accreditation Program o Peer review making States accountable to each other for solvency oversight o Formed in 1989 o Voluntary program for state insurance departments administered by the NAIC o Focus on multi-state life/health and property/casualty insurers o 50 states, District of Columbia and Puerto Rico accredited 37

© 2012 The National Association of Insurance Commissioners 38 Supervision and Administration of the Accreditation Program Financial Regulation Standards and Accreditation (F) Committee o Chair: Eleanor Kitzman (TX) o Vice Chair: Tom Leonardi (CT) Open Session: o Discuss standards/guidelines Regulator-to-Regulator Session: o Discuss state-specific issues/reviews 38

© 2012 The National Association of Insurance Commissioners Mission Statement of the Accreditation Program The objective of the accreditation program is: To provide a process whereby solvency regulation of multi-state insurance companies can be enhanced and adequately monitored with emphasis on the following: o Adequate solvency laws and regulations to protect consumers and guarantee funds. o Effective and efficient financial analysis and examination processes o Appropriate organizational and personnel practices To allow states to rely on the work performed by other states. 39

© 2012 The National Association of Insurance Commissioners Accreditation Standards Part A: Laws and Regulations Part B: Regulatory Practices and Procedures Part C: Organizational and Personnel Practices Part D: Organization, Licensing and Change of Control 40

© 2012 The National Association of Insurance Commissioners Part A: Laws and Regulations States must adopt certain laws and regulations for solvency 19 laws and regulations are currently required The state must have all the laws and regulations in effect to be accredited (i.e. pass or fail) 41

© 2012 The National Association of Insurance Commissioners Part B: Regulatory Practices & Procedures Financial Analysis o 8 standards Financial Examinations o 10 standards Information Sharing and Procedures for Troubled Companies o 2 standards Scored by the accreditation team members 42

© 2012 The National Association of Insurance Commissioners Part C: Organizational & Personnel Practices 3 Standards o Professional Development o Minimum Educational and Experience Requirements o Retention of Personnel Not scored by the accreditation team members 43

© 2012 The National Association of Insurance Commissioners Part D: Organization, Licensing & Change of Control 6 Standards New company applications Applications for mergers/acquisitions Not scored by the accreditation team members 44

© 2012 The National Association of Insurance Commissioners 45 Types of Accreditation Reviews Pre-Accreditation Review Accreditation Review Sub-Part Re-Review Interim Annual Review Periodic Reporting 45

© 2012 The National Association of Insurance Commissioners 46 Pre-Accreditation Review Performed one to two years prior to full review by NAIC Staff Duration is approximately 1.5 days High level review of financial analysis and financial examination functions to identify areas of improvement Voluntary but strongly recommended Confidential pre-accreditation report issued to the Commissioner No Committee responsibility 46

© 2012 The National Association of Insurance Commissioners 47 Accreditation Review Once every 5 years subject to interim annual reviews Duration is approximately 1 week (5 business days) Review Team composition supervised by the NAIC Accreditation Program Manager Full review of Part B & C Standards by Review Team Full review of Part A Standards by NAIC Legal Division Reports distributed to the Financial Regulation Standards and Accreditation (F) Committee (FRSAC) FRSAC members vote 47

© 2012 The National Association of Insurance Commissioners How has accreditation helped the regulatory process? Information provided by companies was not verified o Annual CPA audit and actuarial opinion required No mandatory requirement regarding frequency of examinations o Domestic companies must be examined no less frequently than every five years Lack of interstate coordination and cooperation o Documented policy regarding such is required 48

© 2012 The National Association of Insurance Commissioners Communication Tools NAIC Administrative Policies Manual of the Financial Regulation Standards and Accreditation Program o Published each year as of January 1 st o Hard copies of manual sent to state insurance departments o Updates to manual included on the website Accreditation Website 49

© 2012 The National Association of Insurance Commissioners SOLVENCY MODERNIZATION INITIATIVE (SMI) 50

© 2012 The National Association of Insurance Commissioners 0 Solvency Modernization Initiative (SMI) o Group Solvency Lessons Learned Own Risk and Solvency Assessment (ORSA) o A Review and Evaluation of RBC for Possible Enhancements 51

© 2012 The National Association of Insurance Commissioners US Solvency Framework Lessons learned from financial crisis: o Holding company enterprise risk o Re-assessing Impact of Rating Agencies on solvency tools o “Windows and Walls” Responses to lessons learned: o Revisions to Holding Company Model Act and Regulation Enhance coordination with banking and other regulators as well as insurance regulators from non-US jurisdictions o Adjustments to valuation / quality designations / RBC requirements for mortgage backed securities o Own Risk and Solvency Assessment (ORSA) 52

© 2012 The National Association of Insurance Commissioners US Solvency Framework US Own Risk & Solvency Assessment (ORSA) o ORSA Manual developed with industry comments o Two primary goals: Foster effective level of ERM, thru which each insurer identifies and quantifies material and relevant risks using techniques appropriate to the nature, scale and complexity of the insurer’s risks, in a manner adequate to support risk and capital decisions Provide a group-level perspective on risk and capital as a supplement to the existing legal entity view ORSA Exemption o Individual insurer’s annual direct written and unaffiliated assumed premium, including international direct and assumed premium but excluding premiums reinsured with the Federal Crop Insurance Corporation and Federal Flood Program, is less than $500,000,000; and o Insurance group’s (all insurance legal entities within the group) same annual premium is less than $1,000,000,000 o Insurer specific waiver granted by Commissioner based upon unique circumstances including, but not limited to, type and/or volume of business written 53

© 2012 The National Association of Insurance Commissioners US Solvency Framework ORSA process is one element of insurer’s broader ERM framework o Links the insurer’s risk identification, measurement and prioritization processes with capital management and strategic planning o Each insurer’s ORSA process will be unique, reflecting its business, strategy and approach to ERM Regulators will use the ORSA Summary Report to gain a high-level understanding of the process o Summary Report may be provided in any combination as long as all insurance legal entities within the group are represented o Summary Report will be supplemented by the insurer’s internal risk management materials o Summary Report, at a minimum, should discuss: Section 1 – Description of Insurer’s Risk Management Framework Section 2 – Insurer’s Assessment of Risk Exposure Section 3 – Group Risk Capital and Prospective Solvency Assessment 54

© 2012 The National Association of Insurance Commissioners US Solvency Framework SMI review of RBC: o Purpose of RBC in U.S. Regulatory Framework US regulators’ response: Maintain RBC as one of many analytical tools, not a target capital level Rely upon RBC for explicit actions authorized by statute o RBC Enhancements Assess missing risks - considering a catastrophe component for property/casualty RBC o Partial Internal Models for RBC Life RBC currently uses modeling for variable annuities with certain guarantees and similar products Considering expansion to other life products Principle-Based Reserve project will increase RBC models 55

© 2012 The National Association of Insurance Commissioners US Solvency Framework – Wrap UP Focus on a targeted, robust quantitative and qualitative analysis rather than establishing target capital levels o Consistent, comparative public data reviewed by 3 rd parties (e.g. CPA) o RBC – legal authority for regulatory intervention when minimum capital is breached, and used in concert with other analysis and exam findings Regulatory review/approval of significant transactions Multiple eyes on same insurer/issue; coordinated review o Domiciliary state leads solvency oversight, but other licensed states also perform analysis and can participate in exams; FAWG peer review o Accreditation Program establishes appropriate, common framework ORSA provides insurer’s own assessment of capital adequacy Collaborative, group-wide stress testing 56

© 2012 The National Association of Insurance Commissioners QUESTIONS? 57