Don’t Be A (F)SAP!

In April 2015, the International Monetary Fund (IMF) issued Country Report 15/90 (i.e., The Financial Sector Assessment Program report). The report is dated March 2015 and analyzes the United States in terms of adherence to the Insurance Core Principles (ICPs) formulated by the International Association of Insurance Supervisors headquartered in Basel, Switzerland. The United States participated in the formulation of the ICPs but they are not, in total, specifically a part of any state law or regulation regarding the oversight of the insurance industry. The ICPs were issued in 2011 (replacing a previously issued set) and were revised in 2013. The report also considers adherence to the Key Attributes of Effective Regulation as formulated by the Financial Stability Board (FSB).

The report runs some 112 pages and was conducted by Ian Tower, Philipp Keller and Nobuyasu Sugimoto (all smart guys who I know, with a regulatory background but not a US regulatory background) over a three-week period from October 27 to November 17, 2014. A prior FSAP report was issued in 2010 but was conducted by different personnel. Thus, the Report is based on an analysis conducted over a whole three weeks. Moreover, the report notes: “While this assessment does not reflect new and on-going regulatory initiatives, key proposals for reforms are summarized by way of additional comments in this report. The authorities provided a full and well-written self-assessment, supported by anonymized examples of actual supervisory practices and assessments, which enhanced the robustness of the assessment.”

Considering the three-week time frame underlying the Report, it seems like that rather than “enhancing the robustness of the assessment,” the material supplied actually was the assessment! The report concludes that “the US regulatory system has been significantly strengthened in recent years.” One might then infer that such “strengthening” was of a weak regulatory system but no evidence is presented to sustain such an inference. In other words the strengthening, at significant cost, might also be inferred to be on top of an already strong regulatory system. There is strong evidence to support the latter inference inasmuch as not many US insurers, if any, suffered financial collapse or even severe financial stress, as a result of the markets’ downturns during the “financial crisis” of 2007-2009. Nevertheless, supposedly “lessons have been learned from the financial crisis.” Those lessons seem to be how a more complex regulatory scheme can be constructed, at considerable cost, but without a quantifiable benefit being calculated for any defined constituency. It’s regulation for the sake of regulation—full employment for regulators and the IMF and its FSAP preparers!

The report notes that the creation of the Federal Insurance Office (the FIO) results in “a mechanism for identifying national priorities for reform and development.” Since the states regulate the insurance industry in the US, I always thought that it was the state regulators through the NAIC that did that job. Also, notice the use of the word “reform” which indicates that the US regulatory system was somehow deficient prior to 2010 and indeed even now. Was it? And, exactly what is it that needed or still needs to be “reformed”?

The report then declares that “(t)he extension of the Federal Reserve Board’s responsibilities to cover consolidated supervision of insurance groups (now covering around 30% of total premium income in the United States) has strengthened supervision of the affected groups and promises to empower U.S. regulators in the negotiation and implementation of new international standards of regulation.” Well, what is the quantification of this “strengthening”? Is there any evidence to support that there already has been such strengthening? The report certainly doesn’t set forth any measurement so how can one tell if the assertion of strengthening is factually true? By the way, is there any mention of the cost of this new paradigm? It would be nice to actually compare the benefits of this alleged strengthening to the costs. Perhaps such a comparison would indicate that it’s not such a good deal for policyholders, shareholders, taxpayers or even regulators! The report itself belies the assertion. The very next paragraph states: “The FRB’s supervisory approach to insurance groups has benefited from its experience with banking supervision, but still needs to strike out in its own direction; and the development of FRB regulation is proceeding slowly.” So the FRB is proceeding slowly but it has also already strengthened regulation. Just exactly how much strengthening has occurred and how much has it cost—so far? Again, for the answers, the Report leaves readers in the dark. The Report concludes that “(o)verall the assessment finds a reasonable level of observance of the Insurance Core Principles.” However, “reasonable” is not a reasonable enough standard for the IMF. The first area for criticism is the valuation standards for assets and liabilities within the US statutory framework. However, it is not clear whether that criticism extends to the GAAP accounting framework, the latter being the framework utilized by nonmutual insurer-headed groups that contain insurer components. The Report states: “The standard for valuation of assets and liabilities has developed over many years. For life insurers, it is prescriptive and in many cases formula-based. As products have become more complex, the prescribed algorithms and formulae used to determine reserves have grown in complexity. The standard has varying levels of conservatism, which leads to a lack of transparency. It does not give an incentive for appropriate dynamic hedging. Its shortcomings are circumvented and mitigated by complex structures that life insurers put in place, including transactions with affiliated captive reinsurers. The standard should be changed to reflect the economics of the products better. Principles- Based Reserving, part of the solvency modernization initiative, would mitigate some of the issues, but its implementation date is uncertain. In relation to capital, there are no group-level capital standards in place for groups, whether supervised by states or the FRB. States should have the ability to set group-wide valuation and capital requirements, while the FRB should develop a valuation and capital standard speedily. RBC should be extended to financial guaranty companies, responding to the experience with this sector in the financial crisis.” The criticisms of this paragraph abound. First off, does this pertain to US GAAP or US SAP? Second, the accounting standards for life insurers, both GAAP and SAP, have proven quite successful measured by activity in the capital markets. Not many companies have failed and even the few that have failed constituted only a minute fraction of the marketplace. Third, the paragraph doesn’t seem to specifically relate to the property/casualty and health sectors of the US industry, about two-thirds of the US insurance industry. Fourth, as opposed to there being a lack of transparency of the statutory accounting system, every standard and change thereto is thoroughly developed and discussed in open forum. The issues that arise, e.g., the use of captive reinsurers by life insurers, are relatively minor as compared to overall capitalization of the US life insurance sector and have been duly dealt with by the NAIC (as indicated by the actions taken at the NAIC’s Spring 2015 meeting). As to PBR, the reason for the uncertainty of the implementation date is that we have a system of government that relies on open debate and involves local jurisdictions, in this case the states, to deal with issues rather than merely accepting the dictates of some central authority. The state system is not a hindrance to good regulation, but makes regulation better because it allows for many more perspectives to be put forth. Fifth, the idea that state insurance regulators, and/or federal regulators with scant non-banking related experience and expertise, should set group capital standards that would apply to groups containing insurance components as well as significant non-insurance and non-financial service components is absurd on its face. This point is especially prescient inasmuch as without such group capital standards the industry, including such groups, has thrived without any defined problems. And sixth, the financial guaranty segment of the industry constitutes a miniscule amount of the insurance industry’s premium volume. The Report then contains the following: “There are also gaps in governance and risk management requirements and in market conduct and intermediary supervision. Neither state nor FRB supervisors have set insurance-specific governance requirements that would hold boards responsible for a governance and controls framework that recognizes and protects the interests of policyholders. There are no requirements for risk management and compliance functions, although state insurance regulators will require larger companies to have internal audit functions from next year. An increasing focus on governance and controls in supervision by both states and FRB mitigates the effect of the gap in regulation. However, state examinations normally take place only every five years (FRB examinations are more frequent, if not continuous). More frequent state examinations of larger companies and reduced reliance on outsourcing of the work in some states should be considered. Market conduct supervision, which is carried out only by the states, should be strengthened through a risk-focused supervisory framework, enhanced analysis of risk (including those due to complex products and commissionbased sales) and supervision of the more significant intermediaries.” One wonders how the industry has survived since its US onset in the 18th century considering the so-called “gaps” in governance requirements (two current companies having been formed in the 1700s). It is noted that in the current U.S. life insurance market many of the major players have existed for well more than a century. How could that have occurred if such companies were without the corporate governance requirements so necessary to protect the interests of policyholders? The Report presents no evidentiary material to indicate that boards are not currently responsible for protecting the interests of policyholders or that any furtherance of corporate governance requirements is necessary. Especially ignored is the price for these contemplated requirements, the price being primarily paid for by—policyholders! My gosh, how did companies grow and thrive as well as provide the economy with appropriate and innovative products for more than a century without ERM and Chief Risk Officers, without supervisory colleges and ORSAs, without ICPs for that matter? How could that have happened? It’s incredulous! By the way, even as incredulous is the suggestion that banking model for examinations is the way to go. Examine continuously! Yes that worked very well when in place prior to 2008! Even subsequent to the “crisis” such a system really detected the London Whale, didn’t it? This next one is a beaut! The Report states: “There is a need to review governance and funding arrangements for state insurance regulators. The arrangements for appointment and dismissal of commissioners in many states expose supervision to potential political influence. The high dependence on state legislatures in respect of legislation and resources exposes supervisors both to political influence and to budgetary pressures.” Aren’t you “shocked” there’s political influence regarding regulation? Where isn’t there political influence? And imagine “budgetary pressures” too? Moreover, how should commissioners be selected if not either directly elected or through appointment and confirmation by elected officials? The Report states: “The objectives of state regulators and scope for conflict between FRB objectives and policyholder protection should be reviewed. State regulators’ objectives are not clearly and consistently defined in law. The FRB’s objectives in relation to insurance consolidated supervision do not include insurance policyholder protection and there is potential for conflict, in times of stress, between the expressed objectives of the regulation of savings and loan holding companies and non-bank financial companies, and the interests of insurance policyholders.” I agree that state insurance laws do not clearly and consistently define the purpose of regulation. Is it to ensure 100% against failure within the insurance industry? Why should that be the case when it isn’t within most other industries, many of equal import to their respective customers. Maybe the conclusion should be that Dodd-Frank needs to be amended to delete the FRB from a regulatory role over the insurance industry in any capacity. Of note too is that one way to reduce insurance costs is to apply a deductible. Perhaps that concept should be embedded into the regulatory paradigm in that a regulatory deductible is set at an amount that reflects what the person or entity at risk (in this case, regulators) can afford and relates well to the reduction of insurance (and in this case regulatory) costs. The Report then states: “While recent reforms are bringing benefits, the regulatory system for insurance remains complex and fragmented and reform should be considered to address the resulting risks. There are differences between state insurance regulators and between state and federal regulators, in both regulation and supervision. The regulatory system is complex and there are risks from a lack of consistency, including the creation of opportunities for unhealthy arbitrage (which accounts in part for the growing use of affiliated captive reinsurers, for example); and risks of failure to act on gaps or weaknesses in regulation with sector or systemwide implications. The current regulatory architecture lacks capacity to fully address these issues. The authorities should review the options for change, which include strengthening the capacity of the FIO to bring about convergence on uniform high standards of regulation and supervision as well as comprehensive market oversight.” “Reform” of the US regulatory system has been considered numerous times over the preceding decades and rejected each and every time. The basic reason for the rejection is that the current system (and the system existing at the respective time of consideration) has not been found overly wanting of reform. Thirty years ago or so, US Congressman Dingell issued his report, “Failed Promises.” That report, generated by a rash of relatively small insolvencies, criticized the insurance regulatory system then existing rather harshly. A vast overhaul or federalization of the insurance regulatory system was deemed unnecessary by the Federal legislature which had the power to vote for such a vast change. The Report fails to set forth real reasons why the authors are suggesting such a change as a “reform.” Has the current system failed in some material way? Insurance is complex even if only for the reason that the products offered are quite diverse. It follows then that regulation would be somewhat complex. However, in truth, the actual existing regulatory system is not that complex nor that much fragmented. In the body of the Report (in the instant case, Box 1) it states: “This assessment has identified differences and inconsistencies between state insurance regulators and between state and federal regulators, in both regulation and supervision. The regulatory system is complex and there is scope for conflict between the mandates of the different agencies. There are risks from a lack of consistency, including the creation of opportunities for unhealthy arbitrage (which accounts in part for the growing use of affiliate captives and which appears to influence companies’ choice of states in which to incorporate); and risks of failure to act on gaps or weaknesses in regulation with sector or system-wide implications.” However, the Report fails to cite a single example of the so-called risk exposure of “lack of consistency” having occurred. Has there been any “unhealthy arbitrage”? Has there been any “failure to act on gaps or weaknesses in regulation with sector or system-wide implications”? Frequently the matter of AIG (full disclosure, my former employer) has been raised. Did regulators fail to act? It appears that insurance regulators acted appropriately? Did a single AIG policyholder fail to receive what they were supposed to receive pursuant to their AIG policies? And are we supposed to believe that banks don’t behave in the same way as insurers relative to their choosing the sites of their operations? In the US, there is a duality of bank regulation as between federal regulation and state regulation and many banks, including large ones, have switched back and forth as between federal and state charters. The Report then goes on to state: “The current regulatory architecture lacks capacity to fully address these issues. The NAIC continues to promote uniform standards of state regulation, through model laws and the states’ accreditation program that includes most solvency laws. However, the NAIC cannot enforce convergence. One of FIO’s objectives is to monitor all aspects of the insurance sector, including identifying issues or gaps in the regulation of insurers. However, FIO can only highlight issues and it too lacks powers to bring about convergence. The extension of the FRB’s powers to insurance supervision of NBFCs and some other groups, while valuable in strengthening insurance consolidated supervision, has added to the challenges of achieving regulatory consistency (for example in holding company regulation and approaches to capital adequacy).

FSOC brings together most of the players, but its mandate is focused on system-wide stability and its membership does not provide for sector-wide coverage of insurance on the same basis as other sectors.” Of course, the NAIC cannot enforce convergence. It’s a non-governmental agency. “Convergence” seems to be the paradigm most important to the IMF; however, the evidence (the lack of any single significant market participant having failed in the last decade plus) overwhelmingly suggests that “convergence” is not a material matter. The “unconverged” system seems to work well as measured by — outcomes!

The Report continues by stating: “Many of the approaches to insurance regulatory reform proposed over recent years could help address these issues, although with differing costs and implications. While extensive reform, including an optional federal charter, was canvassed before the financial crisis, the changes made by the Dodd-Frank Act in insurance regulation were relatively limited. Changes that would deliver greater consistency could be undertaken at state or federal level or both, such as:

• The states could strengthen their commitment to convergence on high standards and the mechanisms to deliver them, including relying on the work performed and shared with the states by the FRB.
• Federal regulation of insurance could be broadened to cover direct financial regulation of either all or at least the larger insurance companies; or there could be a “dual mandate” system, as for banks.
• The federal government could coordinate the establishment of national standards for insurance regulation, to be implemented by states and the FRB, or could set such standards directly.
• A new agency, at the national level, with appropriate independence and expertise, could be created with a mandate and powers to deliver consistency and coordination.
• The existing accreditation program could be strengthened and extended, for example with an independent panel appointed under appropriate processes by Commissioners and FRB.

None of these changes would be sure to deliver on the objectives of consistency and high standards (across state and federal regulation and supervision) without risks of introducing inefficiencies or significant transitional costs, including a loss of expert insurance supervisory staff (most of whom are at the state level at present). Implemented with appropriate safeguards, however, they should deliver significant change.”

The IMF seems to fail to understand democracy and how a democratic republic operates (certainly not by fiat). Federal regulation of the insurance industry has been thought of before and has been abjectly rejected by Federal legislators. Federalization of insurance regulation is not a new idea and there is nothing to indicate that it is a better idea now than at any time of past consideration. Additionally, there already is an entity that coordinates the establishment of standards; it’s the states themselves through the NAIC. Paraphrasing Max Bialystock: “Where has that system gone right?”

In summary, the chart on page 16 of the FSAP report seems to say it all. It shows the aggregate RBC levels of the three main segments of the insurance industry (life, p/c and health). All three segments show for 2009 through 2013 relatively flat graphed lines of their RBC ratios—all between 600% and almost 1,000%. Guys, if it “ain’t” broke, don’t fix it!