Time Marches on but Does It Get Anyone Anywhere?

On November 16, 2014 the NAIC/Center for Insurance Policy Research issued a paper entitled, “U.S. Group Capital Methodology Concepts Discussion Paper” (the Paper) through the ComFrame Development and Analysis (G) Working Group (hereinafter, “the Working Group”). This Paper was part of the agenda package for the Working Group’s September 24, 2015 meeting. Following is an analysis of the Paper and the continuing efforts of the U.S. state insurance regulators noting that similar efforts are well underway by the International Association of Insurance Supervisors (the IAIS) and the Federal Reserve Board (the FRB), the latter as a result of provisions in the Dodd-Frank Act.

The Paper describes the goal of a group capital standard as “…to enhance the regulatory toolbox of U.S. state insurance regulators by providing an indicator of the financial strength of the consolidated group and to be a valuable addition to the existing assessment of group risks and capital adequacy.” (italics added) The Paper indicates that meeting this goal would serve as a “complement” to the primary focus of financial regulation which it states is to be related to “the financial strength of the insurance legal entities… .” The Paper indicates achieving the goal “would help shape and provide outcomes consistent with, (sic.) group capital standards being developed internationally.” Presumably the NAIC also believes those latter efforts would also include the efforts of the FRB. The Paper’s third paragraph uses the phrase “Group capital requirements” but it is noted that in discussions post-issuance of this Paper up to and including the discussions at the September 24, 2015 meeting, the NAIC and the Working Group have gone to great pains to indicate that what they are actually considering is a “calculation” rather than a standard or a “requirement.” That probably is because the state regulators have little, if any, actual jurisdiction over the financial condition of non-insurer holding companies that have insurer, and thus state regulated, U.S. subsidiaries. Therefore, it seems curious that the NAIC is considering acquiring a tool for which it has little, if any, defined use, especially considering the cost in terms of money, time and effort. As usual, there has been no cost/benefit analysis to justify the effort, either from the perspectives of policyholders, taxpayers or the regulators themselves.

An interesting inclusion in the Paper is the following sentence: “Some proponents of group capital requirements may argue that ‘excess capital’ residing at the legal entity can be freely moved to the holding company to allow for better capital mobilization.” The Paper continues with a non-sequitur stating “that U.S. state insurance regulators continue to maintain that legal entity supervision takes precedence over any group capital needs.” But, the logical and more prescient point would seem to be that if a legal entity in fact possesses “excess capital,” shouldn’t that capital be allowed to freely move to more productive pursuits? After all, it’s “excess” capital!

As background, the Paper notes that the Working Group was formed “…to provide technical and strategic input on the IAIS’ ComFrame, including any group capital developments.” But, the Working Group apparently was also charged with “exploring group capital concepts that would be appropriate for U.S. based internationally active insurance groups.” (emphasis added) The Paper notes that the Working Group is collaborating with other parties engaging in such activities and includes that amongst these are the Federal Insurance Office (FIO), the Federal Reserve Board and key stakeholders (presumably the industry and consumers), “as appropriate.” The question arises as to who determines the appropriate level of collaboration? Certainly, given the nature of insurance regulators as representatives of the people who are charged with overseeing the insurance industry to protect policyholders and other obligees of insurance policies, one would think that the key collaborator constituency would be such policyholders and other obligees. However, when that combined constituency poses questions as to the quantifiable benefits of this effort, one which is costly and ultimately paid for by policyholders, the response to date has been that quantifiable benefits have not yet been identified and efforts to identify such benefits will not be forthcoming until the effort is completed and implemented. Of course, at that point it will be too late to consider a reversal of course because the costs will have already been totally incurred—and paid for. It is as if one buys a tool, finds out they don’t need it or in fact cannot use it but nevertheless refuses to seek a refund and throws it in the toolbox anyway—where it gathers dust.

Another curious aspect of the effort is that it is aimed at U.S. based insurer groups. While the NAIC is collaborating with other regulators and developers of group capital standards (or however, they are characterized) in the U.S. and other various jurisdictions, that does not mean that whatever results from the various efforts will all be the same. Also, it is not clear exactly what “U.S. based insurer groups” means. Does that mean that the ultimate insurer group’s holding company is a U.S. domiciled corporation? Would a group whose ultimate parent is incorporated outside of the U.S. but whose major source of insurance business derives from the U.S. (through that entity’s U.S. insurer subsidiaries) escape the ultimately developed capital requirement, forgive me, “calculation”? What then would happen if such an entity were subject to another group capital calculation, standard or requirement? If the tool is only used towards U.S.-based insurer groups defined as the ultimate holding company being domiciled (i.e., incorporated) in the U.S., how is a level playing field maintained in the open U.S. marketplace which allows a significant amount of U.S. business to be underwritten by insurers within groups where the ultimate holding company is non-U.S.-based?

The Paper lays out two basic approaches for developing the calculation tool (“RBC Plus” and “Cash Flow”) and sets forth three parameters, or elemental questions, to be answered by the NAIC. The first is consideration of “whether the output would provide a meaningful group perspective on capital adequacy that would complement the legal entity view.” The second relates to “the practical aspects of developing and implementing a consolidated approach using such a design.” The third is “the relative recognition and compatibility considerations of other U.S. financial regulators and the international supervisory community, as well as views of other interested parties.” More than a year after the Paper’s issuance, it doesn’t seem that there has been an adequate response to any of these parameters.

Relative to the U.S.-based insurer groups that contain operations that are apart from the insurance realm, some of those operations fall within industries that do not require any capital level maintenance. Ergo, it is hard to see how a group capital level could be meaningful. Plus in any case, rating agencies provide a view of such organizations’ capital levels that appears to satisfy the needs of capital markets participants. And it is the capital markets participants that are most important to subsidiary insurer regulators inasmuch as if needs arise for additional liquidity and capitalization, it is those participants that will have to answer the call and they are not obligated to do so.

This observer believes that without a cost-benefit analysis the practical aspects of developing and implementing a consolidated group capital approach (no matter how characterized) cannot even be considered because the main “practical aspect” is, for all intents and purposes, the cost! And surely the cost must be weighed against the benefit, the latter currently not even estimated much less calculated with any degree of precision. Lastly, the idea of comparability is lost if not all U.S. insurers within a group are measured in the same way and such insurers within a non-U.S.- based group are not definitively covered by the “calculation” and thus not subject to the same use of the tool.

As noted above, the Paper sets forth the two possible approaches, i.e., the “RBC Plus” route and the “Cash Flow” model and also denotes the pluses and minuses thereof. In actuality, the former represents a NAIC RBC-like approach but is not an aggregated RBC. First it would work off of group GAAP numbers as opposed to regular RBC calculated on a legal entity basis using the U.S. statutory accounting basis (i.e., SAP). It also contemplates that the same factors used in statutory legal entity RBC calculations would be re-evaluated for use as against GAAP amounts. The key difference in valuing assets of insurers as between GAAP and SAP relates to bonds where many insurer-held portfolios are valued at market for GAAP purposes while valued at amortized cost for SAP purposes. However, analysis of capital adequacy on a group basis has to take into consideration the valuation of non-financial assets that surely inure to groups with non-financial operations. How to judge the risks attendant to those assets and integrate that risk analysis with that of the insurance operations is surely a difficult question probably beyond the capabilities of insurance/financial regulators? Moreover, there is the question as to how to deal with depreciation of non-financial fixed assets and inventory valuation, key factors of the asset side of a balance sheet of a group with non-insurance and nonfinancial operations. On the liability side, liabilities attendant to non-financial operations are probably easier to assess inasmuch as they frequently represent fixed amounts rather than estimates which are attendant to insurance liabilities.

One overall problem with any type of analysis of a fixed capital amount is that it is calculated as of a fixed point in time and generally applied as a single fixed amount rather than a range of amounts. In order to make the calculation as of a fixed point in time (e.g., year-end) it means that the actual determination will not be known until a time post-determination date. That makes such a calculation less than useful since conditions may change, and perhaps materially so, during the interval between the group capital determination date and the actual calculation determination date. If that’s the case (and it was significantly so as between December 31, 2008 and March 2009), then regulators may be led into taking corrective action where none is warranted or vice versa.

It is noted that since the issuance of the Paper, the NAIC has been leaning towards the “RBC Plus” approach notwithstanding that an analysis of the pluses and minuses set forth in the Paper about each approach would seem to lean towards the Cash Flow approach, at least insofar as the insurance component of a group’s operations. Further, the Paper suggests that a “hybrid” approach (i.e., some amalgam of the RBC Plus and the Cash Flow models) might be feasible; however, to date, the NAIC has not seemed ready to pursue such a model which indeed might be overly complicated to construct.

It is also noteworthy that the other ongoing efforts regarding group capital assessment have not brought forth a clear and convincing argument for the need for the effort or that a quantification of derived benefits exceeds its costs. This likely would not make consumers of insurance products happy since they are paying the freight and it increasingly seems like they are paying for nothing more than a fulfillment of directions by the G-20 and the Financial Stability Board so they can finally say that after seven years they did something, anything, to relieve themselves of the blame for the so-called 2007-2008 “financial crisis.” Since the Christmas season approaches, I’ll quote Scrooge, “Bah Humbug!”