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Date February 1, 2010
Author Connie Jasper Woodroof
Email connie.woodroof@stoneriver.com

Back to the Future?

As many of you that are involved in the statutory reporting cycle are aware, the NAIC, through the Securities Valuation Office (SVO), has become quite active in reviewing insurers’ investment portfolios. Approximately a year ago (think economic crisis), the NAIC formed the Rating Agency Working Group (RAWG). The group’s charges were to research and assess information on the reliance of insurers on rating agencies, reasons for rating agencies shortcomings, current and future possible impact of ratings on insurance solvency regulation, and the effect of using rating agency ratings on the public confidence of insurance regulation. At the 2009 December National Meeting, the RAWG released its report to its parent committee for a public comment period that ends February 6, 2010. The report can be found at

http://www.naic.org/committees_e_rating_agency.htm under Exposure Drafts.

The RAWG report lists four broad recommendations.

1. Find ways to reduce the regulator’s reliance on ratings of structure securities.

2. Help regulators with assessing investment risk, possibly through expansion of the SVO’s responsibilities.

3. Consider expanding the use of additional and/or alternative risk measurement benchmarks for new, structured, and alternative asset classes.

4. Require rating agencies to make major reforms in their methods or risk not being indicated as an NAIC ARO (acceptable rating organization). (ARO’s must be “approved” for use by the NAIC. NAIC ARO’s are: Standard & Poors, Moody’s, Fitch, Dominion Bond Rating Service (DBRS), and A.M. Best.)

There are several specific actions that are listed in support of the above recommendations. The following are some of those suggested actions (for complete listing, please read the released report).

1. Eliminate or revise the filing exempt (FE) rule. Expand the role of the SVO in evaluating credit risk and other risks of securities.

2. Establish a process to monitor and evaluate AROs.

3. The SVO should evaluate whether the difference between ratings for municipal and other securities is enough to warrant changing how ARO ratings are converted into NAIC designations. Financial solvency monitoring should differ between municipal, corporate and structure securities.

4. Risk-Based Capital (RBC) requirements for structured securities should not rely upon ARO ratings. Tools should be developed to measure market and security for structure securities. Different RBC treatment should be considered for municipal securities, residential mortgage-backed securities (RMBS) and structure securities.

5. The development by the NAIC of independent analytical processes.

6. Require insurers to justify their investment policies to regulators by proving they have a sound and reasonable basis for those polices. Additionally, the filing of more “use” plans with regulators should be considered. (Similar to the derivatives use plan now required.)

7. For LAH companies, changes to Asset Valuation Reserve (AVR) and Interest Maintenance Reserve (IMR).

8. The SVO Initiatives Working Group should consider the possibility of establishing an SVO-like entity as a not-for-profit rating agency (this is already being done).

Many of these recommendations are reminiscent of previous times when the SVO was deeply involved with the assigning of NAIC designations and the valuation to be used for statutory reporting.

Remember those days? When the SVO had virtually unlimited power? When industry finally insisted that a SVO oversight group be formed by the NAIC? Filings with the SVO stacked up and were months behind in being processed. Because there was a back log, companies had to report “Z” securities in their statements—and then the regulators wanted to know why there were “Z” securities reported. Being able to talk to a SVO staff member was virtually impossible, even if you had their direct number. Nowhere in their report does the RAWG indicate how this past history is to be avoided if the SVO’s responsibilities increase.

The Rating Agency Working Group report seems to imply that industry relies almost completely on ARO ratings and does not perform its own due diligence. That just is not true. Companies spend thousands of dollars to either hire their own investment staff or to hire outside investment staff - as expertly capable as the SVO staff. It is not in the best interest of the insurance company to not perform their own due diligence. Additionally, industry is usually much more proactive in the investment arena than is the NAIC. It was industry (not the SVO)that recently suggested that RMBSs needed to be handled differently—and the NAIC then agreed.

As seems to often be the case with NAIC reports, much of this report reflects the mistrust that exists between regulators and insurers. Regulators need to realize that their suspicions are often unfounded,  because there’s no business advantage associated with the behavior they fear. Both groups want the same thing although maybe for different reasons; survival of the company.

Another problem specific to the area of investments is the state regulators’ lack of expertise. This is not meant to be a criticism, but rather just a statement of fact. Most state insurance departments do not have, nor can their budgets support, investment specialists. This lack of expertise becomes very apparent in meetings and conference calls where regulators and industry try to agree on investment issues. Yet, it is the regulators who make the final decision, often without a full understanding of the situation.

The NAIC is often criticized for being reactive instead of proactive. The need for this report was triggered by the NAIC’s concern over the existing economic situation, from which we still have not completely recovered. That concern is understandable. But why did it take an economic crisis to trigger that concern? Or at least to make that concern public?

The circumstances covered in this report existed before the crisis. Different concerns will develop in the future. Perhaps the NAIC should spend its time and resources to better situate the SVO as a proactive organization that anticipates the needs of regulation.

Live long and prosper!

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