ASSAL Presentation

1. ASSAL Presentation US Risk-Based Supervision Lou Felice Health and Solvency Policy Advisor NAIC

2. 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

3. 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

4. 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

5. US Solvency Framework • Pillar 1 • Laws and Regulations • Risk-Based Capital (RBC)

6. US Solvency Framework • Licensing • Each state of operation requires compliance with its lawsand 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

7. 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

8. US Solvency Framework • RBC Overview • Developed in early 1990s; Finalized 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

9. 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

10. US Solvency Framework • Pillar 2 • Regulatory Oversight, Assessment and Monitoring

11. 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.

12. US Solvency Framework - ANALYSIS Level 1 OverallAnalysis of the Insurer and its Operations Level 2 Detail Analysis of Areas of Concern Supplemental Management Considerations Statement of Actuarial Opinion Management Discussion and Analysis Holding Company Analysis Audited Financial Report

13. 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

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

15. 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

16. US Solvency Framework • Pillar 3 • Public and Regulatory Reporting Requirements for Insurers

17. 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

18. Statutory accounting

19. 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

20. 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 GAAP and SAP Differences

21. GAAP Relevance Reliability Neutrality Comparability Materiality SAP Additional Emphasis: Conservatism Consistency Recognition Foundation Concepts

22. 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. Nonadmitted Assets GAAP Balance Sheet Statutory Balance Sheet Assets Not Net Admitted Assets Admitted Assets Total Assets $3,111,000 $2,794,000 $ 260,000 $ 2,534,000

23. 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 Investments

24. 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. Goodwill GAAP Balance Sheet Statutory Balance Sheet Assets Not Net Admitted Assets Admitted Assets Investment in Firemen's Insurance Company 50,000 33,000 17,000 Goodwill 20,000

25. 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. Agents Balances

26. 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. Reinsurance Recoverable

27. 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

28. 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. DAC

29. 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. Furniture, Fixtures & Equip.

30. 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 P & C Reserves

31. 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 A & H Reserves

32. 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. Unearned Premiums

33. 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. Debt

34. 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. Surplus GAAP Balance Sheet Statutory Balance Sheet Common stock 12,000 Common stock 12,000 Additional paid in capital 100,000 Additional paid in capital 100,000 Retained earnings 675,000 Unassigned funds (surplus) 216,000 Accumulated other comprehensive income 208,000 Surplus notes 50,000

35. SAP - Final Thoughts • GAAP and SAP have fundamentally different approaches. • Although SAP reviews and uses some of the GAAP pronouncements, the objectives are different.

36. Accreditation Program

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

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

39. 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: • Adequate solvency laws and regulations to protect consumers and guarantee funds. • Effective and efficient financial analysis and examination processes • Appropriate organizational and personnel practices • To allow states to rely on the work performed by other states.

40. 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

41. 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)

42. Part B: Regulatory Practices & Procedures • Financial Analysis • 8 standards • Financial Examinations • 10 standards • Information Sharing and Procedures for Troubled Companies • 2 standards • Scored by the accreditation team members

43. Part C: Organizational & Personnel Practices • 3 Standards • Professional Development • Minimum Educational and Experience Requirements • Retention of Personnel • Not scored by the accreditation team members

44. Part D: Organization, Licensing & Change of Control • 6 Standards • New company applications • Applications for mergers/acquisitions • Not scored by the accreditation team members

45. Types of Accreditation Reviews Pre-Accreditation Review Accreditation Review Sub-Part Re-Review Interim Annual Review Periodic Reporting 45

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

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

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

49. Communication Tools • NAIC Administrative Policies Manual of the Financial Regulation Standards and Accreditation Program • Published each year as of January 1st • Hard copies of manual sent to state insurance departments • Updates to manual included on the website • Accreditation Website http://www.naic.org/committees_f.htm

50. Solvency Modernization Initiative (SMI)