Module Overview

Module Introduction

Many government and quasi-government agencies regulate life insurance companies. They exercise authority over both the life insurance industry and the individual companies. Regulation and taxation affect product design—sometimes by incentive and sometimes by required standards. For example, the states in the United States have laws that govern solvency of companies and also often levy state premium taxes.

• Regulation: Laws and rules that govern financial services industries.
• Taxation: System to raise revenue for governments.

This module addresses regulation and taxation separately. Through this module, you will:

• Understand the basis for those laws and how they serve the public’s interest.
• Become familiar with key international regulatory topics.
• Apply the legal and regulatory principles to realistic examples.
• Relate the regulatory environment to product design and management.
• Consider the effect that the conduct of people in various roles has on the solvency of life insurance companies.
• Be introduced to the various government agencies that regulate insurance and annuity products and companies in the United States and Canada and the laws under which they operate.
• Understand the basis for those laws and how they serve the public’s interest.

Module Objectives

By the end of your module study you will be able to:

• Explain the purpose of regulation and taxation.
• Explain the regulation of insurance and annuities in the United States and Canada.
• Describe the taxation of insurance and annuities and how it affects product development, reserving, pricing and business practices.
• Identify areas of general weakness or noncompliance with regulation.

Reasons for Taxation

Taxation has two primary purposes:

• Revenue to operate the government itself, including regulation, education, defense, infrastructure, highways, salaries and so on
• Positive and negative incentives to focus activities of people and businesses. For example, favorable treatment of death benefits encourages private purchase of life insurance. In contrast, “sin taxes” on cigarettes or alcohol discourage behavior that is seen as undesirable

Reasons For Regulation

Insurance is a complex business. An insurance company is a unique combination of finance, accounting, investment, economics, mathematics, contract law, information technology, risk management and other ancillary fields. At a micro level, the company provides its policyholders protection from various financial risks. At a macro level, the insurance industry is an important financial intermediary whose activities can potentially disrupt entire economies.

Insurance is a heavily regulated business, and regulatory actuaries play a critical role in the development and maintenance of insurance regulation. Its goals are to ensure that insurance companies manage their affairs so that policyholders’ needs are met and to maintain a level playing field among the competing businesses. This module will introduce you to some of the most important areas of insurance regulation.

Solvency and Market Conduct Laws

Solvency laws are designed to ensure that insurance companies are able to meet their obligations and pay policy benefits when they come due. Generally, these laws regulate an insurer’s capital and surplus, liquidity, investments, reserves and policy design.

Market conduct laws are designed to ensure that insurance companies conduct their businesses fairly and ethically. These laws regulate a range of company operations, including company management, marketing, underwriting, policyholder service and claims.

Solvency and market conduct laws are integrated concepts. Solvency laws often affect market conduct. For example, insurers must establish premium rates that are adequate for accumulation of all required reserves. Market conduct laws also directly affect solvency. For example, mandated policy benefits affect premium rates and insurer profitability.

You will also become familiar with recent developments in risk management and corporate governance, including own risk and solvency assessment (ORSA), how the Dodd-Frank Act adds some federal oversight to U.S. insurance operations, and the effect of the Sarbanes-Oxley Act (SOX) on insurance financial reporting.

Introduction to Solvency and Market Conduct Laws

Solvency

Monitoring the financial condition of insurance companies to ensure that they follow minimum funding requirements and other rules intended to ensure that they will be able to fulfill their contractual promises to policyholders.

Market conduct

Restricting sales and service practices in various ways, such as requiring that:

• Contracts be understandable and contain certain standard provisions.
• Customers are sold contracts that are suitable to their circumstances.
• Policy illustrations are reasonable.
• Contract values meet or exceed specified minimum values.
• Sales commissions do not exceed certain limits (New York only).
• Servicing and claims adjudication practices are fair.

With respect to insurance, the role of the government is to ensure that insurers are reliable and that they fairly price and maintain their products for the protection of consumers. In serving the public interest, the life insurance industry is highly regulated. An actuary working for an insurance company must ensure that he/she is compliant with solvency and market conduct laws in the jurisdictions in which his/her company’s products are sold.

Regulators and Rules

Regulators

While studying this module, you will gain insights into who regulates the life insurance industry. State insurance departments are the fundamental regulators of life and annuity products issued in the United States. In Canada, generally the Office of the Superintendent of Financial Institutions (OSFI) regulates solvency, and the provinces regulate how the company deals with customers who are residents of that province. The province of Quebec has the most comprehensive insurance legislation and regulates companies licensed in that province, including from a solvency perspective.

Rules

This module covers regulations and rules for both the United States and Canada. No matter where you work, it is important to learn about different countries’ different approaches to similar problems. The United States and Canada have the world’s greatest cross-border trade. Anyone working as an actuary in one country should have some familiarity with the rules in the other country. Actuaries working in neither the United States nor Canada need to be aware of regulations specific to their country. It is still important for you to be familiar with the laws of the United States and Canada, as you may find these useful in the establishment or reform of regulations in your country. Moreover, with increasing globalization, more and more companies are multinational. All countries have the same interest in protecting the public.

Regulations are not static; they are constantly under either development or revision. The development and revision of actuarial regulation is a collaborative process that involves regulatory actuaries, actuaries representing the regulated companies, actuaries and others representing interested parties such as the American Council of Life Insurers (US), and actuaries providing technical advice such as the American Academy of Actuaries (US) and the Canadian Institute of Actuaries (Canada).

Regulation of Reinsurance

Reinsurance is discussed briefly in the module. Governments have an interest in protecting the relatively unsophisticated customer from the sophisticated company. Since reinsurance is between companies, the companies generally need less protection from each other, so reinsurance is relatively less regulated.

However, many laws affecting the direct writer will apply to the reinsurer as well. Insurance regulators are concerned that reinsurance agreements cannot be used to transfer risks to inadequately capitalized companies or inappropriately increase the statutory surplus of the ceding party (the company that sold the policy to a customer). Also, the federal government is concerned that reinsurance and reserves should not be used to avoid income taxes.

Market Conduct Regulation

In any society, our actions are influenced greatly by the actions of government. New laws or regulations may eliminate or modify a problem, or they may create new problems to be solved. The actuary’s work is heavily influenced by and dependent upon regulation and taxation. Governmental actions usually limit the range of available actuarial solutions, with some solutions forbidden and the relative value of others changed.

Read Chapter 3¹ (pages 48–74) of Life and Health Insurance Marketing. This chapter provides a high-level introduction to the regulatory environment in the United States and Canada.

Insurance policies are complex contracts, and regulators need to be sure that customers will be treated fairly and ethically. The insurance industry in both the United States and Canada is heavily regulated to protect the public trust.

Market conduct is largely governed by state regulations in the United States and provincial regulations in Canada. Regulations for products and pricing are in place to ensure that insurance is reliable, fairly priced and of good quality. Regulations for distribution and promotion are designed to ensure that distributors treat consumers fairly and ethically and provide accurate information.

The U.S. Congress can pass legislation if it feels that state regulation is inadequate. The U.S. federal government has regulations on antitrust, privacy, credit reporting, unfair competition, variable insurance products and bank insurance. In Canada, the federal government regulates insurers in incorporation, corporate governance, solvency and unfair competition. Protection of privacy is mostly handled through provinces in Canada.

Solvency Is a Primary Concern

Solvency of insurance companies is a primary concern, because country governments want the promises made to their citizens to be kept. Solvency regulations important to the actuary include:

• Minimum solvency requirements
• Reserve calculations
• Asset requirements
• Risk-based capital requirements
• Investment limitations
• Risk management and corporate governance

Introduction to Who Killed Confederation Life?

Confederation Life Insurance Co. (Confed) was seized by regulators on Aug. 11, 1994, causing shock waves across the financial services industry. As told by Rod McQueen:

When Confederation Life Insurance Co. was seized by regulators on August 11, 1994, it ranked as the fourth-largest insurance company in Canada, was among the top thirty in North America, and had $19 billion [Canadian] in assets. Among the politicians and bureaucrats in Washington and Ottawa, the rallying cry used to be “too big to fail,” a phrase taken to mean that governments would step in to save a sick giant for fear a failure would send other, smaller, firms crashing down like dominos.

In this case, “too big to fail” came to mean that nobody believed bankruptcy was possible until it was suddenly inevitable. Confed went under because there wasn’t a single director, officer, regulator, auditor, politician or industry honcho who completely fulfilled his or her job..

…Confed didn’t need to fail. But fail it did, taking 4,400 jobs with it. Thrown into financial disarray were the 300,000 individual policy and annuity holders in Canada, and another 450,000 worldwide, half in the United States.

The Confed disease quickly infected other firms, because the financial services sector is all about full faith and confidence. Without public trust, the system cannot function…The collapse of Confed has so damaged public confidence that the entire industry will never fully recover.

During the course of your module study, you will learn more about the “whodunit tale of who killed Confederation Life” and its relevance to actuaries working in the individual insurance and annuities area of practice.

As a backdrop to your readings, now read the Introduction² (pages 1-5) of Who Killed Confederation Life? The Inside Story by Rod McQueen.

Regulators and Actuaries

Actuaries meet with regulators on an ongoing basis. Why? When? What are the outcomes? How do the relationships add value to the roles of regulators and actuaries and protect the consumers and financial strength of insurers?

Read Actuaries and Regulators in North America to review a practicing actuary’s response to the questions posed above.

The Cost and Funding of Regulation

Regulation is necessary and provides benefits to consumers, the insurance industry and the general public. However, regulation has costs. Governmental agency costs are generally charged back to the industry either directly or indirectly. Some costs of regulation do not involve paying the government, as in the cost of a company preparing a policy submission or its quarterly reports, and other costs are quite unquantifiable, such as the portion of the chief actuary’s salary attributable to following regulations.

United States

As with so many other aspects of state regulation, the allocation methods and the amounts of regulatory charges to the industry vary from state to state. All states impose premium taxes on life insurance products, and these premium taxes may, in part, be directly allocated to pay the expenses of the state insurance regulatory agencies. Some states charge fixed annual fees (usually associated with the filing of insurance companies’ annual statements), while other states charge fees that vary by the type and amount of policy filings and similar items. For example, state insurance departments may charge ten cents per page for a rate filing or $100 for an application for license renewal. With some exceptions, all states charge insurance companies for the specific costs of financial or market conduct examinations; the cost of an extended examination with numerous out-of-state examiners can be significant. In addition, all departments have the ability to impose administrative fines for failure to comply with statutes and regulations.

The state regulatory agencies in the United States receive their funding in different ways. Many state insurance departments are “self-funded”—in other words, specific fees and some taxes are specifically allocated to pay for the expenses of those insurance departments. In other states, insurance-related fees and taxes are remitted to the general fund of the state treasury, and those states’ insurance departments receive their funding through the regular budget process. Still other insurance departments are a combination of self-funded and state-funded.

Canada

The Office of the Superintendent of Financial Institutions (OSFI) recovers its costs from several revenue sources. OSFI is funded mainly through asset-based, premium-based or membership-based assessments on the financial institutions and private pension plans that it regulates and supervises, and a user-pay program for legislative approvals and other selected services. The amount charged to individual institutions for OSFI’s main activities of risk assessment and intervention (supervision), approvals and precedents, and regulation and guidance is determined in several ways, according to formulas set out in regulations. In general, the system is designed to allocate costs based on the approximate amount of time spent supervising and regulating each industry. Costs are then assessed to individual institutions within an industry based on the applicable formula, with a minimum assessment for smaller institutions.

Section Summary

Most actuaries work directly or consult for private companies. These companies provide products, services and benefits that are intended to enhance the well-being of individual members of society. Government may encourage the availability of insurance or investment products or services while striving to protect citizens from the fraudulent or careless actions of companies and agents offering them.

Securities

Life actuaries should be familiar with laws and regulations affecting several areas of insurance company operations.

Securities laws dictate additional requirements on the design and marketing of equity-based products, including:

• Product disclosures and prospectuses
• Contract administration and reporting
• Licensing, education and training of sales personnel
• Sales compensation

Risk Management

Governments and nongovernmental agencies have taken an increased interest in areas of corporate governance and risk management, including:

• Identification, measurement and management of risks.
• Capital measurement and stress testing.
• Liquidation planning (“too big to fail”).
• Distribution of responsibilities and lines of defense.
• Monitoring processes such as investment trading.

Taxation

Tax laws have a direct effect on the profitability of companies and on the design of insurance products, including aspects such as:

• Criteria for product classification (e.g., life insurance, modified endowment contract, annuity, investment).
• Taxation of policyholders and beneficiaries.
• Insurance company income.
• International companies and accounts.

Market Conduct

Market conduct laws are designed to ensure that insurers act in a fair and ethical manner. Areas of regulation include:

• Licensing of agents, brokers and consultants
• Policy forms
• Sales illustrations and other marketing materials
• Insurance rates (e.g., excessive, inadequate, unfairly discriminatory)
• Nondiscrimination in risk classification (e.g., race, sex, age)
• Antitrust laws
• Suitability laws
• Servicing of policies and claims-payment practices

Solvency

Solvency laws help safeguard the ability of insurers and employers to pay promised benefits. Areas of regulation include:

• Incorporation and licensing of companies.
• Relationships between affiliated companies.
• Establishment/empowerment of regulatory oversight bodies.
• Audits, financial statements and regulatory examinations.
• Required minimum levels of capitalization for insurance companies.
• Assets permitted to be held.
• Establishment of funds, associations or corporations designed to protect against the insolvency of insurance companies.
• Reinsurance, including captive reinsurance.

Solvency Regulation

Section Introduction

In this section, you will learn about the enabling laws, history and actions taken by governments in the United States, Canada and elsewhere that regulate, promote and maintain the solvency of insurance companies and insurance holding companies. (An insurance holding company is a financial institution that is not licensed as an insurer but that controls one or more insurers).This section covers the following:

• What are the goals, standards and methods of solvency regulation?
• Who are the regulators?
• What is regulated?
• Required regulatory statements, reports and actuarial opinions.
• The examination and analysis process.
• Guaranty funds.
• An introduction to international solvency regimes, including European Solvency II.

Learning Objectives

After you complete Section 2, you will be able to:

• Explain why solvency regulation is important
• Describe implications of insolvency
• Explain who the regulators are and what is regulated
• Explain guaranty funds (i.e., what the backstop is to protect the policyholder)
• Describe the required financial reporting requirements
• Explain the regulatory processes used to monitor solvency

After you complete Section 2, you will be able to: Explain why solvency regulation is important. Describe implications of insolvency. Explain who regulates and what is regulated. Explain guaranty funds (i.e., what’s the backstop to protect the policyholder). Describe the required financial reporting requirements. Explain the regulatory processes used to monitor solvency.

Goals, Standards and Methods of Solvency Regulation

Insurance is highly regulated in the United States and Canada, and a primary purpose of that regulation is to protect insurance consumers by promoting and maintaining insurer solvency. Life insurance products are complex and often poorly understood by customers. Life insurance contracts are legally binding contracts that specify the rights and obligations of the policyholder as well as the insurance company. In particular, the policy specifies the conditions under which benefits are payable and could explicitly include circumstances under which they are not.

Life insurance and annuity products are usually long-term financial contracts that provide a benefit for events that may occur many years or even decades after the date the policy is purchased. The contract would become worthless to the policyholder if the insurance company becomes incapable of paying benefits after the policyholder has faithfully fulfilled his or her obligations by paying premiums regularly for decades. The financial soundness of the insurance company is crucial to the fulfillment of its obligations and payment of the benefits when due.

It is because of this that governments are concerned with, and regulate, the solvency of insurers.

In the United States, both the state and (since the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act in 2010) federal government regulate solvency.

In Canada, solvency is principally regulated at the federal level. There are a few provincially licensed companies that are regulated at the provincial level, though the solvency requirements are generally those applied by the Office of the Superintendent of Financial Institutions (OSFI). Most provincial regulators are relinquishing financial regulation to OSFI. The province of Quebec has the most comprehensive regulation for companies licensed in that province, and this regulation is very consistent with federal regulation.

Read Goals, Standards and Methods of Solvency Regulations.

Who Regulators Are 

The list below highlights some of the key insurance regulatory authorities for various countries around the world. Regulation in other countries will be briefly addressed at the end of the section.

United States

• State specific, NAIC, SEC, and FIO* (Federal Insurance Office)

Canada

• Office of the Superintendent of Financial Institutions (OSFI)

China

• China Insurance Regulatory Commission (CIRC)

Hong Kong

• Insurance Authority (IA), head of the Office of the Commissioner of Insurance (OCI) administers the Insurance Companies Ordinance (ICO)

Read Who Are the Regulators? to look at the U.S. and Canadian regulators in more detail.

Insurance Holding Companies (IHC)

An insurance holding company is a financial institution that owns insurance companies and possibly other financial or nonfinancial companies.

The IHC may or may not itself be licensed as an insurer but is typically not.

An IHC is often transnational—for example, a U.S. incorporated holding company may own licensed insurers in other countries. Three large U.S. insurers—AIG, MetLife, and Prudential—are all organized as a noninsurance holding company owning licensed insurers in a number of states and countries.

Regulation of IHCs is inconsistent. Prior to the 2008 crisis, there was no consistent regime for coordinated regulation. Generally, the domestic regulator of each insurer indirectly moderated the IHC through the Insurance Holding Company System Regulatory Act, which allowed oversight of financial transactions between the regulated insurer and the IHC (including payment of stockholder dividends or cost-sharing agreements) and also required regulatory approval of change of ownership. Restrictions on ownership of affiliated assets (those controlled by the holding company) similarly moderated holding company actions.

The regulator of the largest insurance subsidiary might have exercised a form of informal regulation of the totality of the enterprise, but the stringency and effectiveness might have varied.

As AIG during the crisis shows, such a regime effectively protects the separate insurance entities but may be ineffective in preventing the holding company, with the economic power represented by the total value of its insurance subsidiaries, from engaging in economic activities outside of insurance regulation that threaten economic disruption to the economy as a whole, much as the failure of a major noninsurance financial institution might.

Response to the 2008 Crisis

In response to the Financial Crisis of 2008, the United States government passed new laws in 2010 adding a new federal level of oversight. Two committees were formed, the Financial Stability Oversight Council (FSOC) and the Federal Insurance Office (FIO).

Both FSOC and FIO strengthen the regulation of IHCs, especially those that include multiple types of financial institutions.

The International Association of Insurance Supervisors (IAIS) was founded in 1994. It issues global principles of insurance supervision (regulation), called Insurance Core Principles (ICPs), and works closely with other international institutions to promote global financial stability.

An internationally active insurer will be accountable to regulators in each of the countries in which it does business. These regulators come together to form a supervisory college, usually led by the regulator in the country in which the insurer has its headquarters. The primary goal of a supervisory college is for regulators to share information among themselves. In 2009, the IAIS issued a guidance paper in 2009 promoting their usage and it has incorporated them into its ICPs.

What Is Regulated?

Solvency regulation imposes restrictions and mandates on:

• Assets and Investments
• Company Licensing
• Reserve Liabilities
• Surplus

Regulation of Assets and Investments

The invested assets of an insurance company, and earnings and gains thereon, secure the contractual promises to policyholders. Therefore, the type and amount of assets are limited by state regulation.

According to J. Robert Ferrari, writing in Life Insurance concerning the general account:

“State laws generally specify investment limitations that can be viewed as being either qualitative or quantitative. The qualitative limitations are aimed at preserving the safety of the assets underlying the policyholder reserves. The quantitative constraints have the dual objective of imposing portfolio diversification among and within eligible types of investments preventing undue control by the insurer through proportionately large investment in any one firm.” (McGill)

Qualitative limits restrict insurers to investment in bonds, stocks, mortgages and real estate. Additional investments are permitted under so-called “basket clauses,” subject to quantitative limits. Bonds and mortgages must usually meet credit quality tests.

No quantitative limits apply to debt, but there are generally limits on the percentage of assets held in stock or real estate and on the percentage of the stock of any single issuer.

Solvency regulation imposes restrictions and mandates on: Assets and investments. Company licensing. Reserve liabilities. Surplus.

United States

State investment limitations should not force complete safety, as a reasonable investment return contributes to the affordability of or return on the life or annuity coverage provided. Consequently, there is pressure for states to liberalize their investment laws.

Assets needed to “hedge” liabilities (such as equity or interest derivatives in connection with variable annuities with guarantees) do not always fit well within investment (or valuation) restrictions.

Similarly, U.S. tax considerations may affect investment choices (for example, differential taxation of dividends versus interest or capital gains versus income.)

Accounting rules, specifically whether a particular asset is valued at amortized book or market value for purposes of determining a carrier’s financial condition, means that assets are indirectly affected by capital and surplus requirements. Similarly, cash flow testing requirements mean that the cash flow characteristics of an asset under various future scenarios affect the reserves held by a company.

Read about the regulation and valuation of assets in The Purpose of Regulation.

Canada

As in many other countries, Canada has moved away from explicitly regulating the quality of investments, known as “legal-for-life” rules, to a “prudent portfolio” approach, which allows more flexibility in investment. For example, the prudent portfolio approach provides more scope for portfolio diversification strategies and the use of derivative products for hedging purposes. Section 492 of the Insurance Companies Act states:

“The directors of a company shall establish and adhere to investment and lending policies, standards and procedures that a reasonable and prudent person would apply in respect of a portfolio of investments and loans to avoid undue risk of loss and obtain a reasonable return.”

According to section 507 of the Insurance Companies Act, companies must monitor the portfolio exposure of equity investments. To be in compliance, life companies must not exceed the prescribed maximum equity investment limit, which is a function of the shareholder’s equity and the actuarial liabilities of the company:

• Shareholder’s equity: 70 percent
• Non-par liabilities: 15 percent
• Par liabilities: 25 percent
• Specified life, guaranteed and disability annuities: 5 percent

Government’s Role in Regulation

As in the case of Who Killed Confederation Life? if an insurance company’s assets become devalued or worthless, the insurance company cannot make good on its promises made, and all parties to the transaction—and the insurance industry as a whole—suffer the loss.

Read Governmental Influences: Finance/Investment/ERM to learn more about the reasons for regulation in this area.

Regulation of Company Licensing

United States

Restrictions and limitations imposed on the incorporation of a new insurance company—or the licensing of an existing company—are one method regulators use to protect insurance consumers. Insurers that cannot demonstrate that they have the professional competence, knowledge of the laws and rules and the financial means to operate in a sound and fiscally responsible fashion will not receive a license to transact the business of insurance.

Read Incorporation, Licensing and Admission of an Insurer in the United States.

Canada

In Canada, statutes in each province require every insurer to obtain a license from the province before conducting business in the province. In order to obtain a provincial license, an insurer must file specific documents with the provincial insurance regulator, including, but not limited to, its incorporation document, financial statements, policy forms and policy application forms that the insurer plans to use in the province. As a condition of obtaining a license in most provinces, each insurer is also required to provide evidence that it has at least a specified minimum amount of capital. Insurers must renew their provincial licenses on an annual basis by filing a variety of reports and returns each year.

Regulation of Reserve Liabilities

The reserve liabilities are the primary liabilities held by insurance companies and are usually the exclusive responsibility of the company’s actuarial function. The reserves are the actuarial estimate of the difference in value between the contractual promises made to the policyholder and the remaining amounts due to the insurance company in payment of those promises. The calculation of the reserves can be technically complex and requires the selection of interest, mortality and other assumptions and the selection or development of calculation methodologies.

Regulators have a keen interest in assuring that the reserve liabilities are appropriately calculated, using assumptions that are reasonably conservative. All jurisdictions, therefore, impose restrictions and limitations on the assumptions and methods used to develop the reserve liabilities.

United States Requirements

Every United States jurisdiction has adopted the Standard Valuation Law, which governs the valuation of reserves for life insurance and annuities. Under NAIC rules, these Standard Valuation Laws are required to be “substantially similar” (not necessarily identical) to the NAIC’s Model Standard Valuation Law (Model #820). They are therefore “substantially similar” to each other. In 2009, a revised Model #820 was promulgated which included the Valuation Manual by reference, in anticipation of the day that the Valuation Manual would become operative. Over the next few years, each jurisdiction’s legislature amended its Standard Valuation Law to be ”substantially similar” to the 2009 edition. This meant that the Valuation Manual would provide all reserve guidance for life insurance and annuity reserves in every jurisdiction, once it became operative.

The Standard Valuation Law requires all insurers to establish, in their statutory financial filings, reserves for their life insurance and annuity policies based on specified methods and assumptions. These assumptions are conservatively established, and insurance companies may not establish reserves less than the statutorily required amount.

Statutory reserves have traditionally been formulaic. The basic concept underlying formulaic reserves for life insurance is that reserves are equal to the present value of future benefits minus the present value of future valuation premiums. Typically, the only permitted assumptions are mortality and interest, which are prescribed, and are locked-in on a policy’s issue date (the valuation interest rate varies by issue year).

Read NAIC’s Model Standard Valuation Law (Model #820) and use a word-search to help you find the references to the Valuation Manual.

Regulation of Reserves: PBR and PBR Reporting

US Requirements

Principle-based reserves (PBR) were first required by regulation for variable annuities in 2009. This approach requires the use of multi-scenario actuarial projections of both assets and liabilities, and applies the concepts of present value of accumulated deficiencies (PVAD) and conditional tail expectation (CTE) to determine the reserve. The methodology is applicable to any life insurance or annuity product. It allows for the explicit modeling of risks, something that the formulaic approach is unable to capture satisfactorily, and allows the company to reflect various aspects unique to the company, such as its hedging program.

The development of PBR has been led by committees of the American Academy of Actuaries. At the time of writing this, the Academy is developing a PBR framework for nonvariable annuities.

Unlike formulaic reserves, in which assumptions are fully prescribed, PBR permits companies to use their own experience in the development of various assumptions, the most important for life insurance being mortality. So, two companies may value the same block of policies and get different results.

As an important supplement to the calculation of reserves, the appointed actuary is required to submit to the regulator:

• statement of actuarial opinion that the reserves are adequate; and
• an actuarial memorandum containing the results of an asset adequacy analysis.

The Valuation Manual became operative on January 1, 2017. It

• introduced principle-based reserves as a requirement for life insurance;
• has now been adopted in all 50 states and the District of Columbia (New York has modified a few sections); and
• applies to all life insurance and annuity policies issued on or after January 1, 2017.

Changes to the Valuation Manual are made by the NAIC in a rigorous deliberative process in which regulators, life insurance companies and other interested parties participate. There is now greater flexibility to make changes to the valuation regulations and greater uniformity among the jurisdictions. There have been several revisions to the Valuation Manual since its effective date, including a major revision of the guidance for variable annuities.

In addition to the Standard Valuation Law and Valuation Manual, the NAIC’s Accounting Practices and Procedures Manual provides statutory accounting guidance that sometimes has implications for statutory reserves.

Canadian Requirements

Statutory statements are prepared based on Canadian generally accepted accounting principles (GAAP) set by the Canadian Institute of Chartered Accountants (CICA). Reserving standards are set by the Actuarial Standards Board of the Canadian Institute of Actuaries (CIA). The main objectives of the standards of practice set forth by the CIA are:

• To respect the actuary’s professionalism and judgment and recognize the actuary’s professional responsibility in performing the valuation.
• To create a range of accepted actuarial practice sufficiently narrow such that two actuaries in the same situation would produce valuation results not materially different.
• To ensure standards of practice are internally consistent within and across practice areas.
• To foster public confidence in the actuarial profession and in the ability of life insurance companies to meet their financial objectives.

Unlike the U.S. statutory reserves, where reserves are calculated based on certain prescribed assumptions and reserve methodologies, the Canadian statutory reserves are calculated using the Canadian Asset Liability Method (CALM). For CALM, the value of policy liabilities for a particular scenario is equal to the value of the supporting assets at the valuation date, which is forecasted to reduce to zero at the last liability cash flow in that scenario. The actuary should calculate policy liabilities for multiple scenarios and adopt a scenario whose policy liabilities make sufficient but not excessive provision for the insurer’s obligations in respect to the relevant policies. In performing a CALM valuation, the actuary must:

• Project both the asset cash flows and the liability cash flows under a range of scenarios, including the base scenario and each of the eight prescribed CALM scenarios.
• Consider policyholder reasonable expectations when projecting the liability cash flows.
• Project cash flows under multiple deterministic or stochastic scenarios to ensure that policy liabilities will be at least adequate under a range of plausible future situations.

When using deterministic scenarios:

• Perform projections for the base scenario and the eight prescribed CALM scenarios and for additional scenarios that are appropriate to the company or required by OSFI or the CIA.
• Ensure that each scenario includes an investment strategy, a rate of return for each asset, a default rate for each asset and an inflation rate.
• Base the liability value on a scenario at the upper end of the resulting range of liability values.
• Ensure that the liability is at least equal to the maximum liability from the prescribed scenarios. When using stochastic scenarios, ensure that the liability value falls in the range of values defined by conditional tail expectation (CTE) 60 and CTE 80 levels (see definition of CTE that follows).

Remember, a CTE is a conditional expected value based on downside risk and can be defined as the average of outcomes that exceed a specified value such as the Q^th percentile. For example, CTE (Q%) is calculated as the weighted average of the highest (Q100%) of the results from stochastic simulation.

Valuation assumptions should be appropriate to the business nature and circumstances of the company. Assumptions must be consistent with principles set forth by the CIA. Valuation of liabilities makes provision for the expected experience scenario and for adverse deviations. Provisions for adverse deviations (PfAD) are necessary to assure the valuation is sufficient without being excessive to provide for liabilities. The CIA publishes educational notes that provide guidance on setting best-estimate assumptions and margins for adverse deviations. Actuaries should be familiar with relevant educational notes and other designated educational material. Candidates will study some of these educational notes in the FSA exams. Approximations to CALM are acceptable if they reduce the cost or the time required to perform a calculation, without materially affecting the result.

Companies in Canada are assessing the impact and transitional approach to IFRS 17 valuation until the end of 2021. The International Financial Reporting Standard (IFRS) 17 is the newly proposed accounting standard to evaluate insurance contract liabilities by the International Accounting Standard Board (IASB).

IFRS 17 eliminated the possibility for insurance companies to recognize immediate profit upon policy issuance, rather such profit recognition is required to be spread out throughout the entire coverage period.

IFRS 17 allows three different liability evaluation approaches: General Model Method (GMM), Premium Allocation Approach (PAA) and Variable Fees Approach (VFA). Refer to the IFRS 17 Standard page for more details on these approaches.

IFRS 17 covers liability book on both direct insurers and reinsurers and requires separate disclosure on financial statements for both direct insurance issued and reinsurance held.

IFRS 17 is tentatively decided to become effective on January 1st, 2023, with at least one year of parallel reporting required beforehand. Early adoption is permitted. Companies are granted waiver to be compliant with IFRS 9 to avoid undue mismatch in their asset liability management practice.

Visit IFRS.org to find the latest IFRS 17 standards.

Reserve Liabilities Summary

In summary, the United States and Canada currently have significantly different rules regarding the minimum reserve liabilities that must be established by an insurance company. Canada places more reliance on the professional judgments of the insurance company’s Appointed Actuary, and the United States more strictly defines and limits the assumptions and methods that may be used in the development of the reserves.

Read about the regulation of capital and surplus.

Required Regulatory Statements, Reports and Actuarial Opinions

This section has already looked at the reasons for regulation, who the regulators are and what is regulated. However, to effectively monitor companies and identify potential problems, regulators require certain information and data from each insurance company. For solvency regulation, that information is primarily contained in the required financial annual statements (commonly called the Blue Book for life companies in the United States) and in statements of opinion, reports and memoranda required of the company’s actuary. Although the details differ, both the Canadian and the U.S. regulators place a very high level of importance on these documents, especially on the actuarial opinions and reports. It is common for regulators to contact the opining actuary to discuss various aspects of the opinion’s wording or conclusions. It is vitally important that companies’ opining actuaries be able to document and defend their decisions.

United States

In the United States, the two primary requirements for life insurers are the annual statement and the actuarial opinion and memorandum. All insurers must submit a comprehensive financial statement that details the company’s assets, liabilities, cash flows, expenses and other information. The form and structure of the financial statement is determined, and periodically changed, by the NAIC and must be completed using accounting practices and procedures published by the NAIC. The opinion is a highly formal document that requires the actuary to provide a public opinion as to the reasonableness of the insurer’s reserves and the adequacy of the assets supporting those reserves. The opinion must be signed by the insurer’s Appointed Actuary, who must be a fully qualified actuary formally appointed by the insurer’s president or board of directors. The state regulatory authority must be notified of the name and qualifications of the Appointed Actuary and of any change in the Appointed Actuary.

The requirements for the Appointed Actuary, and the content and wording of the opinion, are established by a regulation promulgated by each insurance department. For the most part, the states have adopted the NAIC model regulation concerning actuarial opinions and memorandums. In addition, the Actuarial Standards Board has issued an Actuarial Standard of Practice regarding the opinion.

Read Valuation Manual Section VM-30 Actuarial Opinion and Memorandum Requirements.

Read the ASOP 22 Statements of Opinion Based on Asset Adequacy Analysis by Actuaries for Life or Health Insurers.

Annual Audited Financial Reports and Quarterly Reports

Establishment of minimum standards and imposition of specific prohibitions or restrictions are of little use if the regulator lacks sufficient means to ascertain failure of insurer compliance with such requirements or possesses inadequate means of enforcement in the event of violation. Over the years, in addition to the informal methods of oversight through personal contacts and obtaining “street” knowledge about insurers doing business in their jurisdictions, the regulators have evolved a series of formal monitoring mechanisms to detect problem companies. Traditionally, regulators have possessed three basic mechanisms for the detection of financially troubled insurers:

• • insurer financial statements;
  • formal and informal early warning systems supplementing individual insurance department analysis; and
  • examinations of insurance companies.

Life insurance company financial statements have evolved, just as the business conducted by insurers has evolved, in response to the needs of various audiences including investors, pertinent related governmental agencies, insurance regulators, creditors, securities analysts, rating agencies, policyholders, agents and employees of the company, and company management. Each of these audiences possesses different interests. Thus, the financial statements for each have different, albeit often overlapping, objectives. The focus here is on financial statements for regulatory purposes.

Statutory Accounting Principles

Representing existing and potential policyholders, beneficiaries and third-party claimants, the insurance regulators’ primary concern is whether the insurer can meet its present and future policyholder obligations. Consequently, regulatory focus is on the near- and long-term financial safety and solvency (that is, solidity) of the insurance company. Thus, regulatory accounting principles and practices, having evolved in the context of the overriding concern with solvency, are designed to provide a conservative (liquidating) measure of surplus using statutory accounting practices (SAP) as distinguished from focusing on the insurer as an ongoing concern, which would use generally accepted accounted principles (commonly referred to as GAAP). However, the jurisdiction where the company is incorporated does have a right to take over a company in event of hazardous conditions, including the hazard of writing new business if the surplus is relatively low with respect to the liabilities. Other jurisdictions likewise have the right to revoke or refuse to renew the license.

SAP constitutes a form of liquidation-based accounting. That is, it seeks to reflect the insurer’s financial condition as if the insurer is expected to cease operations in an orderly fashion in the near future. SAP tends to conservatively value both assets and liabilities. However, over time the conservatism in the valuation of liabilities has been eroded to the extent that regulators have required the actuary to analyze the liabilities in light of the assets and opine as to their adequacy. SAP sets forth the rules specifying the statutory assets (termed “admitted assets”) and statutory liabilities that are recognized in the balance sheet and the methods to be used in valuation of the assets and liabilities.

In some jurisdictions, and in separate account business where surrender values are not guaranteed at book values, the valuation of assets and liabilities might be on a market value basis and there may be more freedom as to the types of investment that can be made. However, where values are guaranteed at book values, the types of assets might be restricted and the values of the assets might be based on a combination of book for some and market for others.

Implementation of the Statutory Accounting Principles System

In the United States, if each jurisdiction imposed its own distinct set of financial reporting requirements, insurers would be difficult to compare and financial analysis would be severely complicated. A mechanism to achieve at least a reasonable degree of uniformity in regulatory financial statements was essential. This need for uniform financial statements (with separate forms for general account and separate account business) constituted a major factor leading toward the formation of the National Association of Insurance Commissioners (NAIC) back in the late 1800s. The current NAIC annual statement for general account business evolved from the balance sheet adopted in 1875. In addition to prescribing the annual statement form (blanks) that must be filled out and submitted to each state in which the insurer does business, the NAIC has codified statutory accounting practices into policy manuals and procedures and produces an annual statement guide covering information to be included in every report, schedule and exhibit, which make up the NAIC blanks. The accounting format is subject to annual revision by the NAIC in response to changing business conditions and regulatory demands.

A life insurer must comply with the financial reporting requirements of each state in which it does business. Since the laws of the individual states have embraced the NAIC annual statement as the basis of their requirements, the NAIC has long been a predominant player in the nature of financial reporting of life insurance companies. As a result, filing financial statements on the SAP basis is the rule nationwide. However, this does not preclude an individual state insurance department from requiring additional information deemed important to the regulation in that state and a statement different from that filed with the state of domicile. Today, in practice, a state will receive the statement filed with the state of domicile and then a supplement for the adjustments for the peculiarities for the state, such as special reserve requirements, valuation of certain assets or credit for reinsurance with nonrecognized reinsurers. The NAIC’s establishment of a standardized annual statement, while not insuring 100 percent uniformity, does promote the basic objective of uniformity in financial reporting, an area where comparability of data is of major importance. It also enhances efficiency in regulation. If each state were to prescribe its own reporting format, both insurers and insurance departments would incur substantial additional costs. In short, the foundation of financial regulation is the NAIC annual statement blank filled out and filed by insurers in each state in which they do business and with the NAIC central office.

Use of Financial Statements

The NAIC annual statement blank for the general account has evolved over an extended period of time. It encompasses numerous reports, schedules, exhibits and explanations. The most common and significant reports are the balance sheet, the income statement and the statement of cash flows. It is a document with more than 40,000 individual entries designed to reflect the insurer’s assets, the business written, the reserves maintained and the company’s overall operating experience. Numbers used in these reports are normally backed up by a schedule, exhibit, explanation or another report. The annual statement provides a source of voluminous information of the insurer’s financial condition and operations. As such, it serves as the focal point for financial analysis of the insurer. Because of the regulator’s emphasis on solvency, the balance sheet occupies a central role in regulatory monitoring of insurer performance. Insurance department analysts review the annual statements. Data is extracted from them to be processed by individual states and the NAIC. The ensuing analysis can trigger more-in-depth investigations, including a specifically targeted or a full-fledged examination of an insurer when there are suggestions of serious financial difficulty.

To be an effective regulatory tool, the content of the annual statement must be relevant. Through NAIC rules governing the content of the annual statement and individual state regulatory requirements, the regulators mandate disclosure of information deemed relevant to the determination of insurer financial condition. Illustrative are the requirements as to, for example, valuation of assets, minimum reserves and risk-based capital requirements.

In short, the fundamental purpose of the annual statement is to portray an insurer on a conservative liquidating basis, with the insurer being required to maintain minimum policyholder surplus margins. As a consequence, as perceived by many, greater assurance is provided that the insurer does possess sufficient assets in relation to its liabilities to meet obligations to its policyholders and their beneficiaries.

Accuracy and Audits

Mandating relevant information is of little value if an insurer does not report such information accurately. To assure accuracy, the failure to file an accurate annual statement constitutes a violation of law. For example, the filing with the insurance commissioner of any false material statement of fact regarding the financial condition of the insurer is an illegal practice. Also illegal is a knowingly false entry of a material fact in any book, report or statement of the insurer or omitting a true entry of any material fact. Violations are subject to monetary fines and/or license revocation plus possible criminal sanctions for fraud. Furthermore, the insurer must file the statement signed by a responsible officer. Both individual states and the NAIC review filed annual statements with various cross-checks and tests to detect problems in the accuracy of reporting.

Nonetheless, whether due to inadvertent error, sloppy accounting practices or intentional misrepresentations, the reporting of erroneous information is not uncommon. In response, several individual states have moved in the direction of requiring independent certified public accountant (CPA) audits of annual statements and an actuarial or qualified reserve specialist certification to the adequacy of policyholder reserves as a test of the validity of the reserves. One must consider that, in today’s competitive and fast-changing economy, the reserves cannot be established by fixed standards alone. They also require the exercise of professional actuarial judgment.

The amended NAIC Model Standard Valuation Law authorizes the commissioner to promulgate regulations to effect that act. In 1991, the NAIC adopted the Model Actuarial Opinion and Memorandum Regulation (amended in 1992). The purpose of the model is to prescribe (1) guidelines and standards for annual statements, actuarial opinions and supporting memoranda required by the Standard Valuation Law and (2) rules as to the appointment of a qualified actuary. Most state legislatures have enacted the amendments to the valuation law, and most insurance departments have enacted regulations similar to the model regulation.

Timeliness of Financial Statement

Solvency regulation centers on financial analysis to determine whether a particular insurer is tending toward or has actually reached the condition of insolvency. If the financial statement is to serve as an early detection that will trigger timely regulatory action, the availability and utilization of such a statement must be timely. The earlier financial analysis detects problems, the more likely some form of rescue activity can be arranged (such as a merger, infusion of capital or some other type of remedial measure).

The annual statement is required to be submitted by March 1 after the end of the calendar year it covers, and several months may elapse before the statement is reviewed. Furthermore, if adverse developments occurred early in the calendar year of the statement, perhaps as much as a year or more might go by before the information is reviewed. As insolvencies over the past 10 years have indicated, a lot can happen in a period of several months to a year in a financially troubled situation. Timeliness of reporting has proven to be a significant problem.

To address the problem of timeliness, some states require at least some insurers to file abbreviated quarterly statements. In addition, beginning in the late 1980s, states have required their domiciled insurers to submit their annual statements in a computer format to the NAIC Central Office for processing. Initially, a handful of states required their domiciled insurers to also submit annual statements in computer format to the state insurance department, and there was some duplication of effort. Today, every state relies on the computer filings with the NAIC Central Office.

The Roles of the Appointed Actuary and Qualified Actuary

In general, actuaries sign many statements of actuarial opinion. The American Academy of Actuaries has provided the profession the Qualification Standards For Actuaries Issuing Statements Of Actuarial Opinion. There is a set of standards that is specific to the role of appointed actuary in signing the statement of actuarial opinion for the company’s reserves, and a set of general standards for other signing roles.

In the United States, the appointed actuary must meet the qualification standards that are specific to the role of appointed actuary. These standards require that the appointed actuary have specific and current knowledge and sufficient experience in the area (in this case, life insurance and annuities) in which he/she is signing the statement of actuarial opinion.

The Appointed Actuary is appointed by the company’s board of directors. The company’s regulator must be notified when the company is naming an appointed actuary for the first time and when the company is replacing the appointed actuary for any reason.

The Valuation Manual has introduced the role of Qualified Actuary. Chapter VM-31 lays out the specific format required for the PBR Actuarial Report, a report that is required of a company performing PBR. Currently, it requires sub-reports for life insurance and variable annuities. Each sub-report must be signed by a Qualified Actuary, certifying that the reserves addressed in the sub-report for which he/she is responsible, have been calculated in accordance with the Valuation Manual (Chapter VM-20 for life insurance, Chapter VM-21 for variable annuities).

The Qualified Actuary is designated by the company to perform this role, but there is no requirement to inform the regulator. However, the Qualified Actuary must meet the same qualification standards as the Appointed Actuary.

Canada

Similar to the United States, each company in Canada is required to have an Appointed Actuary (AA), who is appointed by the company’s board of directors and is considered by the superintendent to be suitable to hold the position. The AA is responsible for setting valuation assumptions, preparing the annual Appointed Actuary’s report (AAR) and performing dynamic capital adequacy testing (DCAT) on an annual basis. Primary Canadian regulatory requirements that involve the AA include the following.

Primary Canadian regulatory requirements

The Appointed Actuary’s Report (AAR)

The AAR is a confidential document required by the Office of the Superintendent of Financial Institutions (OSFI) annually. The AAR documents the Appointed Actuary’s (AA’s) work in performing the year-end valuation of the company’s liabilities. Included are justifications of the assumptions chosen and descriptions of tests performed to ensure that policyholder data were complete and accurate. In addition, the AA will attest to the fact that methods used are in conformance with professional standards and describe and justify any approximations used.

The AAR contains a signed opinion that states that:

• • • The liabilities make adequate provisions for policyholder obligations.
    • The methods and procedures used to verify data and calculate the liabilities are sufficient and reliable.
    • The actuarial assumptions are appropriate.
    • Liabilities together with total available capital make good and sufficient provisions for all unmatured obligations.
    • Generally accepted actuarial practices were followed.

OSFI provides guidance to the AA regarding the format of the AAR to ensure consistency in presentation and that sufficient valuation detail is provided for the regulator to have comfort that the AA has performed his or her duties in a satisfactory manner.

The Dynamic Capital Adequacy Testing (DCAT) Report

Each year, the AA is required to present a Dynamic Capital Adequacy Testing (DCAT) report to the board of directors. A copy of the report is then forwarded to OSFI on a confidential basis.

The purpose of DCAT is to identify plausible threats to the insurer’s financial condition. It is a process of analyzing and projecting trends of the company’s capital position given its current circumstances, recent past and intended business plan under various future scenarios. The AA is required to develop at least three “adverse but plausible” scenarios and study the company’s financial position through a five-year projection period. Results are presented to the board of directors. This enables actuaries, management and the board of directors to understand the risk profile of the company and solvency threats.

The DCAT report presents the results of five-year projections from the most recent year-end under a variety of adverse scenarios. The AA is responsible for the development of scenarios that may put pressure on the institution’s financial condition. The DCAT report will show the Minimum Continuing Capital and Surplus Requirements (MCCSR) and earnings for each adverse scenario during the projection period and compare these with the AA’s best estimate of future capital and earnings results. The AA is also expected to include discussion of possible management actions that the company may employ to mitigate the adverse effects of an unexpected adverse scenario development. Examples of adverse scenarios that might be tested in the DCAT report include:

• • • A mortality or morbidity claims spike, such as one caused by a pandemic event.
    • Adverse economic conditions, such as poor equity market performance, a prolonged low interest rate environment, adverse currency effects or a combination of these.
    • Higher or lower (whichever affects the company’s financial position negatively) than expected policyholder lapses.
    • Lower than expected sales in key product lines.
    • Integrated scenarios combining a number of adverse factors.

The AA will include an opinion in the DCAT report describing the analysis and giving the AA’s conclusions.

The MCCSR calculation

The MCCSR calculation is described in general terms in the previous section titled “Minimum Surplus Standards.” Insurers are required to submit the MCCSR calculation on the prescribed form OSFI 87.

The AA’s signature is required on the cover page of the OSFI 87 return, attesting that the MCCSR calculation has been performed in accordance with OSFI’s MCCSR guideline.

External Peer Review

OSFI requires independent peer review of the AA’s work on valuation, capital, DCAT and participating insurance. The purpose of the review is to narrow the range of practice, to provide professional education among peers and to ensure compliance with standards. Reviewers must be “external” to both the insurer and the AA. Independent consultants in related fields are appropriate peer reviewers, as they are exposed to a range of practice.

Read Section 3 in OSFI’s memorandum to the Appointed Actuary to learn more.

The Appointed Actuary in Canada

As you have read before, a fundamental feature of the Canadian regulation system of insurance companies is the delegation of certain duties and powers to the Appointed Actuary (AA) and to the actuarial profession. The following reading describes all of the duties of an AA and the qualifications that OSFI expects the AA to have. Read Section A in OSFI’s memorandum to the Appointed Actuary to learn more.

Appointed Actuary’s Report (AAR)

Each year, OSFI issues a memorandum to the Appointed Actuary on the report of the valuation of life insurance policy liabilities. The memorandum contains instructions and OSFI’s expectations with regard to the Appointed Actuary’s valuation of policy liabilities as well as the Appointed Actuary’s performance of other responsibilities assigned to that position by legislation or regulation.

Read Section A only of OSFI’s memorandum to the Appointed Actuary to learn more about the general requirements of the AAR.

Examination of the Insurer

U.S. Requirements

The laws of each jurisdiction provide that the commissioner may examine the affairs and condition of any insurer, foreign or domestic, at any time, for the purpose of ensuring that the insurer is being operated in a safe and sound manner. Here are a few key terms:

Jurisdiction

The NAIC consists of 56 jurisdictions: the 50 states, the District of Columbia, and 5 territories, namely Puerto Rico, US Virgin Islands, American Samoa, Northern Mariana Islands and Guam.

Commissioner

The head of the jurisdiction’s insurance regulatory agency.

Domestic

Every insurer is attached to one jurisdiction which regulates it. In most cases, an insurer will choose the regulator that is in the same geographic jurisdiction as its headquarters, but this is not required. A domestic insurer is one that is domiciled in the given jurisdiction.

Foreign

A foreign insurer is one that is regulated by an NAIC jurisdiction but is not domiciled in the given jurisdiction. So a company domiciled in New York is classified as foreign in Minnesota.

Alien

An alien insurer is one that is outside the jurisdiction of all members of the NAIC.

Since many insurers do business in several jurisdictions, if each jurisdiction were to exercise its power to examine each company, there would be an immense duplication of effort, unnecessary and considerable expense, and conflicting reports of examination.

To avoid these problems, the NAIC established an examination system under which the jurisdiction in which the insurer is domiciled conducts a single examination of the company every three to five years. An examination report is then made available to all the NAIC jurisdictions.

All examinations are performed in accordance with the procedures set out in the NAIC Financial Condition Examiners Handbook. An examination must be completed by June 30 in the year following the year in which the examination is due. It usually takes several months to complete an examination In lieu of performing an examination of a foreign insurer, the commissioner may accept the examination report of the insurer’s jurisdiction of domicile.

During the examination, the findings are generally considered confidential. The work product of the examination is both a public document, which would reflect findings and conclusions of public interest, and a management letter setting out issues found during the examination that the regulator is satisfied can be kept confidential.

The examinations are described as “risk-focused”; that is, they focus on the insurer’s ability to identify and manage its risks, rather than simply testing whether or not procedures are followed precisely. Therefore, an examination requires actuaries and other analysts with specialist expertise.

Canadian Requirements

The Office of the Superintendent of Financial Institutions’ (OSFI’s) activities can be divided into two broad functions: regulation and supervision. Supervision involves assessing the safety and soundness of federally regulated financial institutions and using supervisory powers to intervene in a timely manner to protect the rights and interests of policyholders. OSFI supervises in accordance with its Supervisory Framework. As outlined in the Supervisory Framework, a risk-based approach is used in assessing the safety and soundness of the consolidated operations of regulated financial institutions. OSFI focuses on higher-risk significant activities, assessing the level of risk and factoring in the quality of risk management. Institutions that are well managed relative to their risks will require less supervision.

OSFI carries out routine supervisory and regulatory activities pursuant to its mandates, as well as conducting research and analyzing industry wide issues and trends. Routine supervisory activities include:

• Ongoing monitoring of supervised institutions via information obtained from statutory filings and financial reporting requirements:
  • Consider compliance with statutory and other regulatory requirements.
  • Assess financial situation and operating performance.
  • Assess the quality of risk management functions and of senior management and board oversight.
• Periodic on-site examinations of supervised institutions are performed, which include:
  • Interviews with key management staff to ensure an adequate control environment is maintained as an integral part of the institution’s operations.
• Written reports to senior management and, depending on the scope of the review, to the board of directors including findings and recommendations.
• A request to management to provide copies of OSFI reports to the institution’s external auditors.
• Recommendation or requirement that concerns be addressed by institutions.
• Follow-up to monitor that agreed-upon remedial measures are implemented.

OSFI is granted by statute a wide range of discretionary intervention powers to address its concerns regarding an institution. OSFI has defined a graduated and progressive set of intervention levels it will impose on an institution, depending on the degree of weakness perceived. The objective of the process is to employ an early intervention approach to effectively protect policyholder rights while minimizing business disruption.

Financial Analysis

The financial analysis section of the insurance department provides the review and monitoring of an insurer between examinations. It reviews the company’s annual or quarterly statements, assigns review priorities to the company based on various financial ratios or analysis, and reviews and monitors material changes to the company. It works closely with the financial examination section in setting priorities for examinations and evaluation of the risks of the insurer. In addition, the financial analysis section may review proposed changes in a company’s operations, any material transactions such as large reinsurance treaties and changes in the company’s ownership and control.

The Purpose of Guaranty Funds

Despite a strong regulatory framework, insurers do fail. Failure is not defined as having no assets; it is defined as having insufficient assets to meet promises to policyholders. Thus, even when an insurer fails, it almost always has sufficient funds to pay a large percentage of what is owed to policyholders.

Guaranty funds provide additional protection to policyholders in the event of failure, by paying for benefits (not met by insurer assets) from funds provided by insurers in the state of residence of the policyholder. Routinely, there is a limit on the amount covered by the guaranty fund.

Guaranty funds also provide some protection against an insurer failing. Insurers in a state will encourage a strong level of solvency regulation, as they will have some financial consequences should an insurer in the state fail.

U.S. Requirements

Organization of the Guaranty Funds

Guaranty funds are incorporated by each state, but they all also participate in a voluntary national organization, the National Organization of Life & Health Insurance Guaranty Associations (NOLHGA). NOLHGA was founded in 1983, as the individual funds realized that many of their concerns and responsibilities overlapped and that there was a need to coordinate their efforts, especially as insurer insolvencies affect people in many states. All insurers licensed to sell life or health insurance in a state must be members of that state’s guaranty fund.

Policies Covered by the Guaranty Funds

Direct individual or direct group life and health insurance policies as well as individual annuity contracts are generally covered by the funds. However, the funds do not provide coverage for variable contracts or any contract where the investment risk is assumed by the insured. Guaranteed investment contracts (GICs) and policies issued by HMOs may or may not be covered; it depends on the individual state law.

Coverage Limitations

In addition to limitations by type of contract, the various state laws also set maximum limits for the coverage. Most states provide at least:

• • $300,000 in life insurance death benefits
  • $300,000 overall cap per individual life
  • $100,000 in cash surrender or withdrawal value for life insurance
  • $100,000 in withdrawal and cash values for annuities
  • $100,000 in health insurance policy benefits

Funding the Guarantees

The guaranty funds are generally post-insolvency, meaning that they collect money after the insolvency has occurred. The money used to pay policyholder claims and other services is from assessments made to the remaining licensed insurers. The amount of the assessment is generally based on the amount of premiums collected by the insurer. There are limitations as to how much can be assessed in any one year. Therefore, a large insolvency can result in assessments over many years.

In Case of Impairment, Insolvency or Hazardous Financial Condition

When a commissioner determines that an insurer is in—or is likely to soon be in—financial difficulty, the commissioner will generally contact the guaranty fund for advance notice and for assistance. The first effort is to rehabilitate the insurer, which means that the commissioner and the guaranty fund will try to help the insurer recover and regain its financial stability.

If an insurer cannot be rehabilitated, the commissioner generally must seek approval from a state court to proceed with the liquidation of the insurer. When an insurer is liquidated, the commissioner appoints a receiver, who takes control of the insurer. The receiver then proceeds with identifying all outstanding claims and obligations, valuing (and usually liquidating) all available assets, and settling the company’s obligations in accordance with the priorities established by the state statutes.

Canadian Requirements

In Canada, the role of the guaranty funds is performed by Assuris, a not-for-profit organization that protects Canadian policyholders in the event that their life insurance company should become insolvent. Assuris’s role is to protect policyholders by minimizing the loss of benefits and ensuring a quick transfer of their policies to a solvent company where their benefits will continue to be honored.

Organization

Life insurance companies licensed to write insurance in Canada are required to become members of Assuris by the Office of the Superintendent of Financial Institutions (OSFI) or, in the case of provincially regulated institutions, the provincial insurance regulator. Members cannot terminate their membership so long as they are licensed to write business in Canada or have any in-force business in Canada. Assuris coverage applies separately to each member company, regardless of its affiliation with another member company.

Coverage

The following benefits, up to the following amounts, are fully covered by Assuris:

• • Monthly income $2,000
  • Health expense $60,000
  • Death benefit $200,000
  • Cash value $60,000

If a policyholder’s total benefits exceed these amounts, Assuris covers 85 percent of the promised benefits but not less than these amounts.

Accumulated value benefits are fully covered by Assuris up to $100,000. If a policyholder’s accumulated value benefits are over $100,000, Assuris will ensure that the policyholder receives at least $100,000.

Funding

Assuris pays for the cost of providing coverage for members that fail by maintaining a liquidity fund of $100 million and by levying assessments following the failure on the continuing member companies. All life insurance companies licensed in Canada are required to become members of Assuris and to remain members as long as they have any business in Canada.

There are limits on the amount that may be assessed annually; however, assessments may continue indefinitely. The current annual maximum for all member companies combined is approximately $150 million, in addition to a one-time loan assessment limit of approximately $900 million. The maximum assessment rates have been set with regard to maintaining the solvency of continuing companies and exceed the requirements of the Insurance Companies Act.

Assuris’s assessment system is designed to raise sufficient funds to deal with insolvencies that have company-specific causes. As an industry-funded protection plan, Assuris may not have the capacity to deal with an external event causing an industry wide failure.

The present value of Assuris’s assessment capacity exceeds $3.5 billion, more than 15 times the cost of any insolvency incurred to date.

Insurance Company Financial Difficulty

Similar to the U.S. approach, when an insurer is deemed by OSFI (or its provincial regulator) to be in financial difficulty, efforts are made to reinstate the insurer to financial stability. These efforts will involve the company’s board and senior management, the regulator (OSFI or one of its provincial counterparts), and Assuris.

In the event that a life insurance company is declared insolvent, a liquidator is appointed to manage the insolvency. Assuris and the liquidator work together to protect policyholders’ interests. It is not necessary for policyholders to file a claim with Assuris. Each policyholder will be informed on how their respective benefits are protected by Assuris.

Solvency Examples

Now that you have read about the purpose and organization of a guaranty fund and the procedures taken by regulators to try to identify problems before they become uncorrectable, it is time to consider insolvencies that actually happened—Confederation Life and AIG.

Confederation Life Insurance Co. (Confed Life) was seized by regulators on Aug. 11, 1994. At the time, it was the single-largest life insurance company to fail in North America. At the time of its failure, Confed Life was the fourth-largest insurance company in Canada, with about CAD $19 billion in assets. It can be argued that several factors combined to cause the downfall of Confed Life. The most significant, however, was the company’s faith in real estate as a superior-performing asset class. Real estate investments at Confed Life grew significantly before the early 1990s, when a correction in real estate values put increasing pressure on Confed Life’s solvency.

The story of the demise of Confed Life is told in the book Who Killed Confederation Life? The Inside Story, by Rod McQueen. During your module study, you are to read designated sections of Chapters 1–10, 13 and the epilogue. You may, of course, choose to read the entire book. Because the book is out of print, the full text is provided in PDF format (used copies of the book are available for purchase via the Internet). You should decide when you will complete these readings, but plan on finishing them before reaching the end of the module, at which point you will be asked to analyze the parties that contributed to the failure of Confed Life. Consider discussing Confed Life with other candidates via the Community.

In 2007, American International Group (AIG, an international insurance holding company including property and casualty and life subsidiaries as well as noninsurance subsidiaries), was the third-largest life insurer in the United States, with USD $364 billion of assets. Total assets for the holding company were about $1 trillion.

On Sept. 16, 2008, the U.S. government loaned AIG $85 billion at LIBOR plus 8.5 percent and received 79.9 percent of the firm’s equity. Government assistance (later repaid) ultimately reached $185 billion.
 
To understand AIG’s fall, read the following chapters in All the Devils Are Here:

• Chapter 5: “A Nice Little BISTRO” (pp. 69–81)
• Chapter 13: “The Wrap” (pp 187–203)
• Chapter 21: “Collateral Damage” (pp. 322–341)

Links to the readings for Who Killed Confederation Life.

Solvency II

What is Solvency II?

The European regulatory body EIOPA (European Insurance and Occupational Pensions Authority), has instituted Solvency II, which went into effect Jan. 1, 2016.

Solvency II sets out requirements on capital adequacy and risk management for insurers who write business in all 28 European Union (EU) member states plus three of the European Economic Area (EEA) countries, with the aim of increasing protection for policyholders by reducing the possibility of insolvency of the insurers. Solvency II also tries to make it more cost effective for insurers to do business across the European Union by implementing consistent standards and requirements.

The key principles behind the Solvency II framework are:

• Market consistent balance sheets
• Risk-based capital
• Own risk and solvency assessment (ORSA) senior management accountability
• Supervisory assessment.

Solvency II framework for risk-based capital is comprised of:

• Pillar 1 consists of the quantitative requirements.
• Pillar 2 sets out requirements for the governance and risk management of insurers as well as for the effective supervision of insurers.
• Pillar 3 focuses on disclosure and transparency requirements.

Solvency II in Europe

As the regulatory prescribed method for capital management, Solvency II stipulates the minimum capital requirement under Pillar 1, and it has to be calculated for all entities with a solo perspective as well as for all entities in total for a group perspective.

One of the key principles of Solvency II is the market consistent balance sheet, and it is based on an economic balance sheet, where the economic value of liabilities is comprised of the best estimate of liabilities (BEL) and Risk Margin. The BEL captures the value of deterministic and stochastic cash flows utilizing best-estimate assumptions, and the risk margin represents the cost to transfer non-hedgeable or unavoidable risks due to illiquid markets to a third party. Other liabilities would capture all liabilities that are not included in the policyholder liabilities.

In addition to the economic balance sheet, the Solvency Capital Requirement (SCR) is calculated as the amount of capital the company should maintain in a normal operating environment, where the worst-case scenario is considered the 1-in-200-year event, and the standard formula is based on standardized shocks to the balance sheet.

Within the Pillar 2 framework of Solvency II, which sets out requirements for the governance and risk management of insurers, an ORSA (own risk and solvency assessment) is required.

Own Risk and Solvency Assessment (ORSA)

ORSA Becoming an International Requirement

The own risk and solvency assessment (ORSA) framework was adopted by the International Association of Insurance Supervisors (IAIS) in October 2010 as part of the Insurance Core Principle (ICP16), and it is quickly becoming an international regulatory requirement. 

The ORSA framework is designed to achieve the following:

• • Assess the key risks
  • Assess the amount of capital required in order to protect against those risks
  • Document the assessment of risks and capital requirements

ORSA Requirements Under IAIS

ORSA is an Assessment of overall solvency needs, including the following:

• • A holistic view when identifying all the key risks the company faces, including but not limited to underwriting, credit, market, operational and liquidity risks.
  • A forward-looking assessment, quantitative and qualitative analysis of the company’s ability to meet future regulatory capital requirements.

Similar requirements have been or will be adopted by the NAIC in the United States, OSFI in Canada, and Solvency II in European Union, Australia, Switzerland, Bermuda, and many other countries in Asia Pacific region. Read the research report ORSA: An International Requirement prepared by Milliman (pp. 30–34) for an overview of ORSA requirements in different parts of the world.

International Financial Reporting Standards (IFRS)

International Financial Reporting Standards (IFRS) are developed and maintained by the International Accounting Standards Board (IASB), and they are intended to be a single set of accounting standards that are capable of being applied on a globally consistent basis to allow for comparison of financial statements across companies around the world.

As of the end of 2014, IFRS were adopted in some way in 130 jurisdictions around the world including the European Union (EU), the United States, Canada, China, Japan, India, Hong Kong, most of South America, and many others.  China has substantially converged its national standards to IFRS, and some jurisdictions mandate its use with the focus on publicly traded companies, while others (e.g. United States, Japan, and India) permit IFRS on a limited voluntary basis while utilizing other standards as well (e.g. US GAAP in the United States).

The proposed Insurance Contracts Standard is an ongoing joint project between the IASB and FASB (Financial Accounting Standards Board) to review and develop common, high-quality guidance that will address the standards for the financial reporting of insurance contracts, including reinsurance.  One of the intentions of this project is an attempt to improve the alignment of U.S. GAAP and IFRS in order to move toward a more globally comparable standard.  In addition to impacting financial reporting, the proposal may also have an effect on the capital standards required.

Regulatory Bodies Around the World

As mentioned previously, the European regulatory body, EIOPA has instituted Solvency II, which is the foundation for the regulatory requirements across the EU member states plus three of the EEA countries.

In addition, specifics around the regulatory requirements in the Asia Pacific region.

Australia	Australian Prudential Regulation Authority (APRA) Australian Securities and Investments Commission (ASIC)
India	Insurance Regulatory and Development Authority (IRDA)
Indonesia	Financial Services Authority (locally the Otoritas Jasa Keuangan (OJK))
Japan	Japanese Prime Minister with most powers delegated to Financial Services Agency (FSA) and Local Finance Bureau / Local Finance Branch Bureau of Ministry of Finance (collectively)
Malaysia	Bank Negara Malaysia (BNM)
Philippines	Insurance Commission
Singapore	Monetary Authority of Singapore administers the Insurance Act (Cap 142)
South Korea	Financial Services Commission (FSC) and Financial Supervisory Service (FSS)
Taiwan	Financial Supervisory Commission (FSC)
Thailand	Office of Insurance Commission (OIC) under supervision of Ministry of Finance
European Union(EU)	European Insurance and Occupational Pensions Authority (EIOPA)
UK	Prudential Regulation Authority (PRA) and Financial Conduct Authority (FCA)
Ireland	Central Bank of Ireland (CBI)

Summary

The maintenance and promotion of insurer solvency is a primary focus of regulation. In this section, you have learned about the regulators, identified the areas that are regulated, learned about the types of information that an insurance company must submit to assist the regulators in their review, and identified the methods used by regulators to promote solvency. In addition, you have seen what happens if an insolvency does happen.

Actuaries must stay up to date with many aspects of government regulation:

• Actuaries must be familiar with regulations that restrict the types of and amounts of permitted investments.
• Actuaries should be knowledgeable about current fiscal and monetary policy that creates advantages and/or disadvantages for insurance products and pension plans.
• Actuaries should be thoroughly familiar with governmental regulatory bodies that are responsible for overseeing their company and industry.
• Actuaries must be completely up to date with respect to tax policy.

Market Regulation

Introduction

This section will focus on the enabling laws, history and actions taken by state and provincial governments that regulate and enforce the interaction between the insurer and the insured or prospective insured. In the United States, these aspects of regulation are established by the various states. There is not the same degree of uniformity of regulation as there is for solvency regulation.

Similar to the federal regulatory body in Canada, provincial insurance regulatory bodies have responsibilities with respect to financial soundness, as it relates to smaller insurers operating in a single province. In addition, provincial regulators are responsible for the market conduct of insurers and insurance agents operating within the province.

Learning Objectives

After you complete Section 3, you will be able to:

• Explain the purposes of regulatory consumer laws and regulations.
• Recognize the key points of a sample of regulations or laws relating to market regulation.
• Explain the standard limitations on rates and the issues associated with the use of rating factors.
• Describe why consumer protections are needed.
• Describe how the United States and Canada monitor the market and regulate.
• Explain how a policy will be illustrated.

To help you accomplish these outcomes, this section will address the following issues

• The purpose of consumer protections and market regulation
• Regulation of policy forms, rates and minimum values
• Regulation of the sales and marketing of products
• Risk classification and privacy issues
• Market conduct examinations and market analysis
• Agency and consumer issues

Consumer Protections

Purpose of Consumer Protections and Market Regulation

The goals of market regulation are:

• Clear, fair and understandable policy language and disclosures
• Non-forfeiture values that provide equity to lapsing policyholders (United States only)
• Control of contract provisions to protect the interests of the policyholder

To achieve these goals, regulators:

• place limitations and mandates on policy forms, rates and sales practices;
• enforce the policy provisions through complaint investigations;
• monitor the market and conduct formal examinations of an insurer’s practices; and
• regulate the agent and the agent’s practices.

In the United States, all state insurance regulatory bodies perform these functions. However, it must be emphasized that there is a much greater degree of variation among states in the regulation of market issues than for solvency. The uniformity found in solvency regulation is lacking in this area of regulation, although the National Association of Insurance Commissioners (NAIC) has taken actions to improve coordination among states in recent years.

Regulation of Policy Forms

United States Requirements

The need for regulation in these areas is primarily due to the significant disparity of knowledge and comprehension between the two parties to the insurance contract (the insurer and the policyholder). This is more true for individual policies and less true for group policies.

For individual policies, the insurer dictates the terms of the contract and defines the nature of the risk transfer. The insured can usually only accept or reject the contract in its entirety, and usually has significantly less understanding of the intricacies and implications of the contract. This disparity between the two parties is the reason why insurance regulators and the courts will generally construe any discrepancies or ambiguities in the policy wording to the benefit of the policyholder.

Group policies, on the other hand, are usually negotiated between two “sophisticated parties”. There are regulatory criteria that need to be satisfied, but consumer protection is less of an issue, except as it may involve the rights of the persons (participants or employees) in the covered group.

In either case, the contract is drawn up by the insurer, and is a “contract of adhesion” from the perspective of the policyholder. Therefore, it is very important that the insurer take great care in crafting policy wording that is clear and non-ambiguous and that contains no internal inconsistencies. The actuary is one of the key participants in this process.

Read about the Regulation of Policy Forms Content and Filing: United States Requirements.

Canadian Requirements

In contrast with the United States, life insurers in Canada generally do not file policy forms with regulators, although there are exceptions to this rule. Policy form provisions in Canada are quite similar to those in the United States.

In Canada, insurers are required to file policy forms with the provincial Superintendent of Insurance in only two situations:

• • As a condition of obtaining a license to conduct insurance business within a province.
  • Before marketing a variable life insurance product in a province. Such products are generally referred to as “segregated fund” products in Canada.

To obtain a license to conduct business in most provinces, an insurer must file all proposed policy forms and policy application forms with the provincial superintendent. If any of these forms do not comply with all applicable statutes, regulations and guidelines, then the insurer may be required to amend the forms so that they do comply. Once an insurer is licensed, updated and new policy forms need not be filed unless the policy is a variable life insurance policy.

An insurer that wishes to offer a variable life insurance product in any province must file the policy form, any associated riders, a copy of the policy application form, summary information folders to be used in marketing and copies of any proposal forms. The summary information folder briefly discloses all of the material facts about the particular variable product and contains financial highlights of each segregated fund. The folder must:

• • Describe both the guaranteed and nonguaranteed benefits.
  • Describe the method of determining benefits related to the market value of the segregated fund and the amount of the surrender value of these benefits.
  • State the frequency at which the segregated fund will be valued.
  • Describe fees, charges or basis for calculating the fees and charges against the segregated fund.

Summary information folders, along with updated financial information concerning segregated funds, must be filed with the provincial superintendent annually. Also, if there are any material changes in the content of the information folders, the insurer must file an updated folder in each province where the insurer markets the product.

Provincial insurance laws directly grant insureds and beneficiaries of life insurance policies certain rights, which are enforceable without regard to the terms of the insurance policy. Insurance policy forms typically include provisions that concern these statutory rights as well as provisions that concern other matters. The major provisions that are typically included in individual life insurance policies are:

• • Documents that constitute the entire contract between the insured and the insurance company.
  • Incontestability of the policy after it has been in force for a specified period of time.
  • Grace period the insurer provides the insured for the payment of premiums.
  • Nonforfeiture benefits, if any, available to the owner of the policy.
  • Insured’s reinstatement rights with respect to a lapsed policy.
  • Adjustment methods used to correct a misstatement of age or sex.
  • Manner in which participating policyowners may use dividends.
  • Settlement options the insurer offers for the payment of policy proceeds.

Life insurance policies also contain provisions that are intended to limit the liability of the insurer under certain circumstances. The most common of these provisions are the suicide exclusion, the war hazard exclusion and the aviation hazard exclusion.

Insurance Policy Language

An actuary is usually a key participant in developing the concept and content of the insurance policy. If the actual wording of the contract does not clearly and completely describe the policy, the insurance company will likely be held responsible for unintended claims resulting from the lack of clarity. Regulators impose restrictions on the policy form language to decrease the likelihood of unclear, confusing or deceptive policies.

Regulation of Rates

No insurance rate may be excessive, inadequate or unfairly discriminatory. Unlike private passenger auto rates or health insurance rates, life insurance and annuity rates are rarely subject to extensive insurance department or OSFI review or prior approval. Life insurance rates are primarily regulated by competition.

However, while there is little direct regulation of life insurance rates, there is indirect regulatory influence on the rates due to the minimum nonforfeiture and reserve standards (United States) and the solvency requirements (United States and Canada) imposed. For example, in the United States, while the insurer may legally charge the policyholder less than the valuation net premium for the coverage provided, or may guarantee an interest rate on a deferred annuity that is greater than the maximum valuation interest rate, the company may be required to fund these guarantees through the establishment of deficiency reserves and excess interest reserves. The cost of allocating additional capital to support the higher reserve levels must be considered by the pricing actuary (in Canada, the Appointed Actuary) in development of the gross rate.

In Canada, reserve standards are governed by the Canadian Institute of Actuaries’ Standards of Practice.  Life insurance company reserves must be certified as compliant with these standards by the company’s Appointed Actuary.

Read about U.S. requirements for the regulation of rates.  Although the reading refers to the United States, note that the regulation of rates also applies to Canada.

United States: Credit Insurance

Credit insurance is an exception to the statement that life rates are afforded little regulatory review. Credit insurance is life, disability, unemployment or property insurance sold in connection with a loan or credit account. Credit insurance rates are subject to very strict regulatory requirements due to the fact that the forces of competition do not serve to force rates to their lowest reasonable level, but instead apply pressure to increase the rates. This is known as reverse competition, and is due to the fact that the insured, who ultimately must pay for the coverage, considers this purchase of insurance as a lesser part of a main loan or credit transaction, and has little incentive or opportunity to compare costs and coverage of the insurance product. The issuer of the loan, however, has a strong financial incentive to offer insurance coverage that is higher-priced, as that will generally increase the amount of commission paid to the issuer of the loan.

Therefore, credit insurance rates are generally set by the state insurance department through regulation. Insurers must either use the preset rates or file for approval of any deviations.

Nonforfeiture Requirements

Canada

There is no minimum nonforfeiture law for life insurance in Canada. Canadian actuaries use a concept of “group equity,” where values from terminating policies may be used to reduce premiums or raise benefits for all continuing policyholders. As Canada does not require nonforfeiture values, please note that all content in this section relates only to the United States.

Read Regulation of Minimum Value (Nonforfeiture Requirements).

Nonforfeiture Requirements Summary

In the United States, the state statutes require that nonforfeiture values for life insurance be calculated according to a defined, set formula. The minimum values for annuities are also established by statute. In Canada, nonforfeiture values are not a required policy feature.

Regulation of the Sales

Even if a policy has been rated correctly and has been designed and written in clear, unambiguous language, the insurance company’s responsibility does not stop there. It is the insurance company’s obligation to make sure that the policy is marketed and sold in such a way that the policyholder truly understands the product that is being purchased.

Insurance regulators exercise a substantial measure of control over the methods by which insurers and their agents obtain business. Such control seeks to enforce a higher standard of competition than that prevailing in other fields of endeavor and to protect the insurance-consuming public against practices detrimental to its interest.

Although the sales and marketing of the insurance contract may seem to be outside the usual scope of an actuary’s duties, regulations regarding the suitability, required disclosures and especially illustrations of a policy’s expected value can require significant actuarial involvement and responsibility.

Read Regulation of Market Conduct: Disclosure, Advertising and Replacement.

Regulation of the Sales and Marketing of Products

U.S. Requirements

In the United States, there are three specific topics in the regulation of the sales and marketing of products that can—or more likely will—affect the practicing actuary. These topics are illustrations, best-interest and obligations.

Illustrations

Most non–term life products are designed to provide an investment value to the owner for many years after purchase. The policy will have a guaranteed minimum value, but the actual value of the policy will vary over time and will usually depend on various nonguaranteed factors that may change from time to time, such as the insurer’s declared interest crediting rate, actual mortality charges and expense charges. These policies are often complex and difficult for the prospective insured to fully understand or visualize. Therefore, insurers will typically provide illustrations to the policyholder to both explain the policy and provide an estimate of what the value of the policy may be for many years into the future. Because of the complexity of the product, and because these illustrations are relied upon by consumers, regulatory agencies have generally established limitations and standards that govern these illustrations. These rules include promulgated regulations that govern both what any sales presentation must include or explain and the type and content of any illustrations provided.

Best-Interest

In December, 2019, the NAIC adopted a revision to the Suitability In Annuity Transactions Model Regulation (Model #275). The effect of this was to upgrade the responsibility of a producer from suitability, in which a given product is suitable for the client, to a best-interest standard, in which the product is not only suitable but meets the client’s best interest. The best-interest standard is lower than a fiduciary standard, in which the producer might bear some financial liability if the recommendation does not meet a fiduciary standard of care.

In general, the model regulation applies to all annuities that are sold by producers. Examples of annuities not covered are group annuities covering employees and annuities sold by direct response. Fixed indexed annuities are of particular concern. They are frequently marketed to clients who are close to retirement, and the fact that these annuities have a floor return of 0% can be an attractive risk-return feature to this segment of the market.

Obligations

A producer has obligations of

• • Care – as examples, knowing the client’s financial situation and understanding the available options;
  • Disclosure – for example, disclosing the source of cash or non-cash compensation that the producer may receive;
  • Documentation – for example, recording in writing the recommendation and the basis for it;
  • Revealing a conflict of interest, if applicable.

An insurer must create a supervision system to ensure that producers are in compliance. Examples of what the system must include are as follows:

• • Procedures to inform producers of the provisions of this model regulation;
  • Establish and maintain standards for producer product training, and deliver such producer product training;
  • Establish and maintain standards for the review of each producer recommendation.

The model regulation has provisions for producer training, including continuing education credit requirements.

An insurer is responsible for compliance with this model regulation. A violation may subject the insurer to a financial penalty by the commissioner.

Canadian Requirements

In Canada, many provinces have legislation that prohibits unfair trade practices in the insurance business. These practices include:

• False or misleading advertising of an insurance policy’s terms, benefits or advantages.
• False or misleading statements of an insurance policy’s terms, benefits or advantages.
• Any conduct that results in unreasonable delay or resistance to a fair settlement of claims.

All information in advertisements must be clearly presented, and the content of the advertisement must be comprehensible and coherent. When an advertisement mentions any advantage, such as the nature of the coverage, the benefits payable or any other advantage attached to the product being advertised, it must also fairly disclose (in close proximity to the advantages and in equally prominent print) any limitation, exceptions or reductions that affect the nature of the coverage. Industry guidelines require that advertisements shall not contain any of the following:

• False or misleading statements, presentations or testimonials
• Disparagement of other insurers or their products
• Technical or industry terminology beyond the level of understanding of the public
• Guarantees of any kind, unless any conditions and limits are fully explained

No advertisement shall use statistics without clearly identifying the source, and testimonials used must be of a general nature, be authentic and express the current opinion of the author of the testimony at that time.

Disclosure Regulation

Consumers can expect to be fully informed when they are making decisions about purchasing insurance. There should be full, true and plain disclosure about products and services, in which contracts are written in clear and direct language. A prospective buyer of life insurance must be given a guide to buying life insurance and a policy summary before the initial premium is paid. The guide to buying insurance describes all of the types of life insurance available and the advantages and disadvantages of each type. The policy summary provides information about the specific policy (terms, limitations, restrictions, etc.) that is being considered for purchase. A policyholder may rescind the contract within 10 days after receiving the insurance policy or within any longer period specified in the policy. This free-look provision does not apply to a segregated fund or an annuity offered by the insurer. A policyholder who rescinds a contract under the free-look provision is entitled to receive from the insurer a full refund of the premium that has been paid.

Regulation of Risk Classification

Although there are fewer restrictions on rating and underwriting in life insurance than there are in personal automobile or health insurance, there is growing concern with the use of certain health (especially genetic) information. An awareness and understanding of this issue is very important to every pricing actuary, as restrictions on the factors permitted for rating can have profound impacts on the rate development. As actuaries practicing in health and property and casualty areas have found, actuaries favor the use of any rating factor that is statistically predictive of the amount or timing of future claims, but if the factor is statutorily prohibited, it may not be used either directly or indirectly.

United States Requirements

States have adopted various restrictions on the characteristics and information used to establish the premium for an individual insurance policy, or used to determine whether or not a policy will be issued at any price. Other rating restrictions may include a prohibition against gender differentiation and the use of certain lifestyle determinations as criteria in life insurance rating or underwriting.

The emergence of Accelerated Underwriting brings with it the utilization of any information available about an individual. This could include social media, credit scores, publicly available financial information, electronic medical records, driving records, criminal history, census data and more. The use of big data, artificial intelligence and machine learning in order to determine the risk of an applicant also brings privacy and discrimination concerns.

Data privacy and unfair treatment of protected classes are currently major regulatory concerns. The NAIC has several committees (Artificial Intelligence, Big Data, Market Regulation, Accelerated Underwriting) examining the issues as they emerge. The New York Department of Financial Services issued a circular letter on January 18, 2019 stating various concerns regarding the use of third-party data sources for underwriting. On January 1, 2020 the California Consumer Privacy Act (CCPA) also became effective. These are an indication that states are taking the issue very seriously.

Canadian Requirements

Canadian legislation prohibits an insurer from unfairly discriminating rates in the premium rates on the basis of factors such as race, sex, religion, national origin or marital status. The insurance laws prohibit insurers from establishing premium rates that unfairly discriminate between individuals who present the same risk.

Market Conduct Examinations

Similar to what you learned in Section 2 on solvency regulation, while regulators do rely on the company officials and actuaries to comply with all requirements, they also conduct hands-on examinations to make sure the companies are complying with all applicable statutes and regulations. In addition, insurance regulators are increasingly studying the market to identify and address problems at the earliest possible stage.

Both Canadian and U.S. regulatory bodies conduct market conduct examinations to determine compliance with market activities such as claims handling, complaint resolution and application of underwriting standards. Not all market conduct examinations are comprehensive, on-site visits by the regulators.

Read about U.S. and Canadian requirements for market conduct examinations and market analysis.

Agency and Consumer Issues

The agent is usually the primary contact with the consumer. Given the fact that consumer protection is the primary focus of regulators, there are, of course, a number of regulations and restrictions on agents and brokers. In addition, all insurance regulatory bodies maintain professional staff members who are available to assist consumers with questions or to receive and investigate complaints. These two areas, the regulation of agents and brokers and complaints and other consumer issues, are discussed next.

Regulation of Agents and Brokers

In most cases, the insurer has a responsibility to monitor and control its agents and is generally responsible for their actions. For example, in the 1980s, insurers sold “vanishing premium” life insurance policies, in which, after a certain period of time, the required annual premium would not be required to be paid if the interest credited to the policy met a certain limit. If the insurer did not continue the declaration of an interest rate sufficient to keep the policy in force without additional premium, the policy would become premium-paying once again. In the sales of these policies, however, it was averred by a large number of policyholders that the agent had never advised them that the need to make additional premium payments could “reappear” after it had “vanished.” The insurers were forced to compensate the policyholders for the failure of the agent to clearly explain the policy completely.

The regulation of the agent and agent practices, including agency compensation rules, is intended to minimize the motivation for agents to work against the policyholder’s best interests. Regulators also establish minimum standards for receipt of a license, such as initial testing and continuing education requirements, to ensure that the agents have the minimum knowledge required to explain and sell a policy and that they understand their responsibilities.

United States

In the United States, no one may sell insurance products without first obtaining a license. In addition, once licensed, an agent must generally meet certain continuing education requirements in order to continue that license. While it is true that, in general, actuaries are not involved in the selling process, it is also true that a well-informed, knowledgeable agent can make the actuary’s job easier by reducing consumer misinformation and questions as to product intent or design.

Learn more about what qualifications agents and agencies must have to become licensed.

Canada

Licensing requirements of agents and brokers in Canada are quite similar to those in the United States.

Read about the Canadian requirements for agents and brokers.

Complaints and Other Consumer Issues

State insurance departments maintain staff whose primary duty is to assist consumers. They receive and investigate complaints against insurance companies and agents and serve as a resource to consumers to explain and, if necessary, enforce policy provisions.

State insurance departments also produce various consumer information brochures and interactive websites that provide consumer information and rate comparisons.

Case Scenario: Regulatory Considerations Report

Case Study: Regulatory Considerations Report

You work as an actuary with the Stars and Stripes Life Insurance Company, a niche company specializing in unique product offerings that target highly select market segments. Miranda, Stars and Stripes’ marketing vice-president, just stopped by your office with a new product idea that she is most anxious to have researched. She would like to meet with you to discuss how the product might be designed and launched on July 4 of this year, which is only six months away. Miranda quickly outlines the main product characteristics, which are the following:

• Name: Uncle Sam Life Insurance Policy
• Product type: A whole life insurance product with face amounts in increments of $100,000
• Target customers: Sold to males and females whose birthdays are on July 4
• Issue ages: 20-70
• Death benefit: Doubles in case of accidental death or if death occurs on insured’s birthday(i.e., quadruples if death is accidental and on July 4)

To prepare for your meeting with Miranda, you decide to spend some time outlining a report that would describe all the regulatory considerations that need to be satisfactorily addressed in the research, development, pricing and launch of this product. You plan to use this outline to describe for Miranda how Stars and Stripes will ultimately decide to accept, modify or decline the proposal for the new product.

What goes into the regulatory considerations report for the new product Miranda outlined? Surely, it would cover things such as policyowner and insurer obligations, product legality and classifications issues. But to be comprehensive enough to allow Miranda and Stars and Stripes to make a fully informed decision about the product, what else should the report cover?

What regulatory considerations did you identify for the Uncle Sam Life Insurance Policy to help Miranda, the marketing vice president, understand how Stars and Stripes will ultimately decide to accept, modify or decline the proposal? Read the regulatory considerations report and compare your thoughts with the results outlined.

Case Study: You Are the Regulator

Congratulations! You have just been hired as an actuarial associate by the insurance department of the state of Imagination, which is in the United States. The state of Imagination has just received a policy form from the XYZ Insurance Company for a whole life insurance policy. You have been assigned to review the policy wording for completeness and correctness.

Your supervisor gives you two documents:

• Background information about the state’s requirements for policy forms, including examples of allowed and prohibited wordings.
• The policy form submitted by XYZ.

For this case study, it is recommended that you print out the submitted policy form and mark it up with your suggested revisions. Once completed, you’ll be able to download the fixed policy form and compare your work against it.

Review the Case Study Background information and The submitted policy form from

Your Task:

Go through the policy, provision by provision, to determine whether the wording is acceptable. Also, be sure to look for any missing provisions. As you want to keep your new job with the State of Imagination Insurance Department, you determine to be very careful in your review of this policy form.

Case Study Solution

Compare your results to the possible solutions.

Section Summary

The actuary working for an insurance company is often involved with, or impacted by, the sales and marketing aspects of the business, and may be directly involved with the regulator in market conduct examinations. In addition, the regulatory rules and restrictions on what factors may be used to rate a policy and how that policy’s prospective value may be illustrated will have a very significant impact on an actuary’s day-to-day activities.

The actuary working for a regulatory agency will be heavily involved in the regulated insurance companies’ finances, but is also called upon to support the legal affairs, examination, financial analysis, product filing and market conduct departments. It is therefore important for the regulatory actuary to understand all aspects of the insurance company.

Other Regulations

Introduction and Objectives

In the previous two sections, you learned about solvency regulation and market regulation. In this section, you’ll learn about other regulations that affect product design.

After you complete Section 4, you will be able to:

• Explain how contracts are taxed to the owner of the contract.
• Describe constraints on policy design created by tax laws.
• Describe other constraints (SEC, antitrust) and highlight different approaches (e.g., direct in the United States versus indirect in Canada).

The previous sections of this module have given relatively equal weight to U.S. and Canadian regulations because the countries have relatively equal functions. In this section, however, we’re giving greater weight to the United States because Canada does not always have similar regulatory functions.

Tax and Regulatory Considerations

Affecting Product Design in the United States

As you learned in Section 2, insurance companies operating in the United States are primarily regulated by the states, which focus mainly on solvency concerns. The National Association of Insurance Commissioners (NAIC) creates model laws to promote uniformity. However, some state legislatures meet only every other year, and not all new legislation passes promptly—or even passes at all.  Moreover, some states will modify the NAIC recommended language to reflect state-specific issues and concerns.

The federal government has a significant influence on the product design of individual life insurance and annuity contracts. All life insurance products must pass certain tests in the Internal Revenue Code (IRC) if they are to receive favorable tax treatment and variable products and the companies that sell them are subject to regulation by the Securities and Exchange Commission (SEC). Annuities must also include certain characteristics and contract language, and variable products are subject to additional tests to remain eligible for favorable tax treatment.

Read to learn more about federal regulation in the United States.

Securities and Exchange Commission (SEC)

Additional Requirements Imposed

While variable life insurance products have to meet the same definitions from the tax law described in the previous reading, they are also subject to additional requirements from the Securities and Exchange Commission (SEC).

Since variable life insurance and variable annuity products allow for premiums and annuity considerations to be invested in equities, they are registered as securities under both the Securities Act of 1933 and the Investment Company Act of 1940.  As such, these products must be registered with the SEC, which imposes a number of basic requirements with respect to the sale of registered (as opposed to private placement) variable products.

Some of the basic requirements imposed by the SEC include the following:

Sales of and Prospectus for Variable Products

Sales of variable life insurance and variable annuities must be “suitable,” in accordance with Financial Industry Regulatory Authority (FINRA, formerly NASD) requirements. Although completing a suitability review is an obligation of the broker-dealer, frequently the suitability review is performed by the insurance company on behalf of the broker-dealer, especially if the insurance company has a captive agency force.

Actuarial Opinions and Consents

Actuarial Opinions and Consents are filed with the SEC each time an illustration is filed for a registered variable life product, which is normally done each year as part of the prospectus review. As part of this exercise each year, the actuary represents that the charges of the variable life product meet the reasonableness standard contained in the National Securities Markets Improvement Act of 1996 with respect to the services and benefits provided, the expenses incurred, and the risks assumed.

Suitability Review

As is the case with other securities, variable life insurance and variable annuities can be sold only through broker-dealers by registered representatives who must have Series 6 licenses. No later than the time of the sale, a prospectus must be provided to the customer, and it must be updated at least annually. The prospectus is an offering document containing information on product features, fees, and charges. An actuary is usually one of the reviewers who must approve prospectuses before they are submitted to the government.

Other Tax and Regulatory Considerations

Historically, life insurance policies in the United States have received preferential federal “life insurance” taxation.

This changed in 1982, and was modified in 1984, when the U.S. Congress codified section 7702 of the Internal Revenue Code to limit the investment orientation of life insurance contracts. Two tests were introduced to determine whether new contracts were eligible for special federal “life insurance” taxation. The two tests were the cash value accumulation test (CVAT) and the guideline level premium (GLP) test.

Congress further modified the law in 1988 when it passed section 7702A, creating the new life insurance class called modified endowment contract (MEC) and the 7-pay test specified for MEC determination.

Variable life insurance products have to meet the same definitions described above from the tax law. In addition, variable life insurance and variable annuities are registered as securities under both the Securities Act of 1933 and the Investment Company Act of 1940, which have additional requirements. This includes the filing of a prospectus that has been reviewed and approved by an actuary.

Estate Taxation in the United States

The federal government taxes certain large estates at death. This tax is imposed on estates, not on inheritances. In other words, it comes out of the assets of the decedent but is not a direct tax on the people who receive bequests.

While most people do not have sufficient assets to trigger any federal estate tax (and assets left to a spouse are exempt), quite a lot of life insurance is sold to people who expect to have the proceeds to pay estate taxes. These are generally contracts with very substantial death benefits, for obvious reasons. In many cases, the insured has significant assets that would be difficult to sell or that are desired to remain in the family. Sometimes a family-owned business is involved. Selling part of such a business can be difficult, especially if the family would prefer to retain control, and selling the whole business could cause surviving family members to lose their jobs.

Note that death benefits under life insurance contracts are generally not subject to income tax, as described above, but are generally subject to estate tax. In other words, if the decedent owned the life insurance contract at the time of death, then the death benefit is part of the decedent’s estate and subject to estate tax. Therefore, if a person wishes to purchase life insurance on his or her life to pay estate taxes and is the owner of the policy, then enough insurance must be purchased to pay the taxes not only on the assets already in the estate but also on the death benefit from the life insurance policy.

Let L = life insurance proceeds necessary to pay estate tax. Then:

L = (estate tax rate) x (estate + L)

Regulation of Agents and Brokers

Although insurance is primarily regulated by the states, the federal government does have a significant impact on life insurance operations and product design, especially related to the tax treatment of products.

Specifically:

• Life insurance products must pass various tests to receive favorable tax treatment. These tests are technically complex and generally require the involvement of actuaries with specialized knowledge of the tax code. These tests generally assess the investment nature (as opposed to the insurance protection aspect) of the contract.
• Variable products and the companies that sell them are directly regulated by the SEC as well as by the states. The regulation focuses on the reasonability of the information provided to the consumer before (or concurrent with) the sale of the product and the suitability of the sale of the product to the particular consumer.
• Insurance companies are required to withhold income tax from distributions to policyholders under certain circumstances.
• Proceeds of an insurance contract are subject to estate tax, even when they are not subject to income tax.

Regulatory Influence

Canada

Regulation affecting product design in Canada is characterized as principle-based, as opposed to prescriptive. In general, products can be designed and priced without regulatory restriction. Regulation acts in an indirect fashion, requiring that adequate reserve and capital requirements are met for all policy obligations in the insurer’s portfolio. Economic drivers play a major part in the pricing of new products and in the re-pricing of existing products. An inadequately priced product will generate significant amounts of strain, particularly if the product proves popular and large volumes are sold within a short time frame. This consequence acts as an encouragement to insurers to maintain disciplined actuarial pricing processes.

In developing responses to these considerations, the pricing actuary is put in a position of having to make assumptions. These assumptions cover the range of future contingent events that can affect the performance of the policy. The pricing actuary must also be aware that the valuation actuary will be making choices of assumptions regarding the same set of contingencies. Divergence between pricing and valuation assumptions can put severe stress on financial results and, in some circumstances, can put the insurer in a position of failing to meet capital requirements.

This creates an incentive for the pricing actuary to liaise with the valuation actuary during the development of the premium scale. Indeed, it is common practice for insurers to have the valuation actuary sign off on the pricing basis, including the choice of pricing assumptions, of a product. While not a regulatory requirement, regulators generally look positively on an insurer that enforces a policy that requires the valuation actuary’s sign-off of pricing bases.

Hence, the regulatory influence on product design and pricing is indirect and is accomplished through strict enforcement of reserve and capital adequacy requirements. The economic consequences of inadequate pricing or ambiguous product design drive insurers in Canada to maintain a prudent approach to these important functions.

Canadian Life Insurance Exempt Test Legislation

On Dec. 14, 2014, Bill C-43—the Economic Action Plan 2014 Act, No. 2—received Royal Assent. The Act includes updates to the life insurance exempt test and related provisions in the Income Tax Act.

The effective date of the revised exempt test is Jan. 1, 2017, with grandfathering provisions in place for existing policies.

One of the most significant changes in the legislation involves modifying the benchmark policy and related regulations used to determine maximum funding room available within the tax-exempt environment of life insurance policies. This will typically result in a decrease to the total amount of funding room available over the lifetime of a policy. While changes will be needed to accommodate the new rules, all life insurance product lines, including universal life, will continue to provide clients with tax-preferred protection solutions. The changes will require re-pricing of all life insurance products in Canada.

Policyholder Rights and Product

Canada

Regulation in Canada is focused on the protection of the rights of policyholders and their beneficiaries. Policies designed with ambiguity in their terms and conditions may be subject to legal challenges, which are often ruled in favor of the policyholder. The insurer has a responsibility to develop contract wording that is clear and is consequently perceived as being the party at fault when disputes over the meaning of a policy’s terms and conditions arise. Disciplined pricing and reserving should take into account the possibility of unintended insurer liability being created through alternate interpretation of contract wording from what the insurer intended.

Product design should, therefore, be clear in addressing each of the following key considerations:

• Who is the policy intended to cover (the insured life or lives should be well-defined)?
• What event will trigger a benefit being paid from the insurer to the insured or the beneficiary (death benefits, surrender benefits, maturity benefits, etc.)?
• What is the amount of benefit for each trigger event (amount may be stated or the method of determining the amount may be defined)?
• What is the policyholder’s obligation to keep the insurance coverage in force (payment of a well-defined premium at a well-defined frequency)?

In developing responses to these considerations, the pricing actuary is put in a position of having to make assumptions. These assumptions cover the range of future contingent events that can affect the performance of the policy. The pricing actuary must also be aware that the valuation actuary will be making choices of assumptions regarding the same set of contingencies. Divergence between pricing and valuation assumptions can put severe stress on financial results and, in some circumstances, can put the insurer in a position of failing to meet capital requirements.

This creates an incentive for the pricing actuary to liaise with the valuation actuary during the development of the premium scale. Indeed, it is common practice for insurers to have the valuation actuary sign off on the pricing basis, including the choice of pricing assumptions, of a product. While not a regulatory requirement, regulators generally look positively on an insurer that enforces a policy that requires the valuation actuary’s sign-off of pricing bases.

Hence, the regulatory influence on product design and pricing is indirect and is accomplished through strict enforcement of reserve and capital adequacy requirements. The economic consequences of inadequate pricing or ambiguous product design drive insurers in Canada to maintain a prudent approach to these important functions.

Taxation of Individual Life Insurance

Canada

With the exception of premium taxes, which are levied by the provinces, the rules governing the taxation of individual life insurance and annuity contracts in Canada are set by the federal government. The federal statutes, which prescribe the rules that govern the taxation of these contracts, are the Income Tax Act and the Income Tax Regulations (collectively, the “Act”).

Read Overview of the Taxation of Individual Life Insurance and Annuity Contracts in Canada

Quizzes

• The reason that many insurers do not allow the face amount of policies subject to Canadian income taxation to increase by more than 8 percent annually is to avoid the administrative complication of having to perform the exempt test with other than a single exemption test policy.
• For exempt policies in Canada, the amount subject to income tax on a policy disposition other than as a consequence of the death or disability of the life insured is the excess of the amount of the disposition over the policy’s adjusted cost basis.
• The taxable amount of a prescribed annuity payment in Canada is the interest element of the payment, determined as the excess of the payment over the result of the purchase price divided by the number of payments expected to be received.

Section Summary

This section introduced various government regulations that an insurance company must comply with when developing its products, with a particular focus on how U.S. federal and state governments regulate life insurance companies. In the United States, actuaries are involved in many aspects of tax compliance.

To comply with tax compliance when considering product design, actuaries:

• Decide which of the two tests defining “life insurance” for federal tax purposes would be most appropriate for a block of business.
• Develop testing procedures to ensure that the tests are applied correctly and that failed contracts are identified.
• Develop procedures to apply the 7-pay testing used to identify MECs.
• Most important design contracts that can pass the various tests in the U.S. tax law.

Policyowners usually care very much about passing the tests discussed, and, as such, companies need to design their contracts correctly to meet policyowners’ needs.

In addition to the taxation approach for particular product features, other tax and regulatory considerations include how estate taxation impacts life insurance and the SEC’s regulations around variable products.

In Canada, actuaries are given more leeway and responsibility to develop products and pricing that will meet both market and valuation requirements.

Similar to the United States, Canadian tax laws place certain limits for insurance policies to qualify for tax exemptions, so policies are generally designed in order for policyholders to qualify for these advantages.

The next section of this module looks at taxation and revenue collection.

Taxation – Revenue Collection

Introduction

The prior section included a discussion of policyholder taxation. These were items that affected how the policyholder is taxed on distributions or deemed distributions from the insurance policy. This section will cover company taxation for both the United States and Canada. It will address ways in which an insurance company is taxed, who is doing the taxing and the major components of the taxes.

The U.S. section will discuss both state and federal taxation of insurance companies. Federal taxation is based upon income tax. This section will include details on the pieces that have the largest impact on an insurance company’s taxable income. The Canadian section will cover both provincial and federal taxation. This includes income tax, capital tax, premium tax, investment income tax, withholding tax, branch tax, sales tax and excise tax.

The U.S. taxation system has general taxes (e.g., income tax and premium tax) that have a few main drivers. The Canadian taxation system has more special purpose taxes (e.g., capital tax and the goods and services tax, or GST) in addition to the more general taxes such as income and premium tax. Adding to the complexity of the Canadian system, there are many different tax rates depending upon the type of business and where it is located.

This section will not cover taxation regarding all income and asset items for the United States and Canada. Only the items that are more specific to insurance companies will be covered.

It is very important for you, as a candidate, to thoroughly understand the key concepts presented in this section, as tax is one of the major cost items for an insurance company. Optimizing the taxable position of the company is generally one of the key goals to accomplish in a competitive environment.

Learning Objectives

How are insurance companies taxed at the federal and the state and provincial levels?  What are the major determinants of the amount of taxes paid?  How do taxes affect pricing and statutory surplus?

After you complete Section 5, you will be able to:

• Describe the forms of state and provincial taxation, specifically premium tax.
• Describe the differences between pre-tax statutory and taxable earnings.
• Describe the following adjustments for U.S. federal income tax: tax reserves, DAC tax, and dividends received deduction.
• Distinguish among the different forms of taxes paid by Canadian companies.

Reminder: Continue reading Who Killed Confederation Life? The Inside Story as you work through Section 5.

Taxation in the United States

Under federal legislation dating back to the 1940s, insurance companies operating in the United States are primarily regulated by the states. The main focus of the state regulators is with the solvency of the insurance company, as discussed earlier in this module. Both the state and federal governments levy a tax on insurance companies. State taxation is primarily based on life insurance companies’ collection of premiums—a gross receipts tax called premium tax. Life insurance companies are also subject to federal income taxation. Excise taxes are also imposed in limited circumstances. Many items affect an insurance company’s taxable earnings. There are a few main drivers that will be covered in this section.

Taxation by States

State taxation is an important financial component to consider in pricing life insurance products and in analyzing the financials of a life insurance company. In the United States, life insurance companies are subject to taxation at the state level on the gross premium income they receive from business sold in that particular state. Each state (and some localities) levies taxes at its own tax rate.

A few states impose an income tax on life insurance companies.

A pricing actuary should provide for the amount and timing of taxes. A valuation actuary should know the impact of the reserve basis on taxes, and the impact of taxes on surplus. (Also, an actuary should have specific responsibility for tax planning and calculation.)

Premium and Retaliatory Taxes

Premium tax is imposed on the gross receipts (premiums) of an insurer.  A typical percentage is 2 percent of premium. It resembles a sales tax. But sales tax is an obligation of the purchaser, collected by the seller. Premium tax is a tax on the insurer, not the insured.

There are some complications. Is a deposit on a deferred annuity a taxable premium? Where should premium tax on a group contract with coverage in many states be paid? Answers vary by state but are beyond the scope of this module.

Retaliatory tax arises when the tax rate payable in a state is lower than the tax rate in the insurer’s state of domicile. Most states “retaliate” by charging the higher rate. For example:

A policy issued by ABC Insurance Company domiciled in state X, where the premium tax rate is 2 percent. A policy is issued by ABC to a policyholder residing in state Y, where the premium tax rate is 1.5 percent  and where the state has a retaliatory tax. The premium collected is $5,000. ABC Insurance Company owes state Y a premium tax of $75 ($5,000 * 1.5%); it also owes state Y retaliatory taxes of $25 ($5,000 * 2% − 1.5%).

Read pages 1 and 2 (the section “Premium Tax”) of The Taxation of Life Insurance Companies

Next, read Retaliatory Taxes for a further explanation.

State Premium Tax Rates

Premium tax rates vary across states and by type of insurance. The premium tax on life insurance ranges from no premium tax charges to a rate of 6 percent, with most of them being in the 2 to 3 percent range. The rates are generally the same between life insurance and health insurance with only a few states charging premium taxes on annuities. Some states also collect an income tax or other form of tax from an insurance company, which may or may not be credited against the premium tax payable.

Each year, the American Council of Life Insurers (ACLI) publishes a list of the premium tax rates by state, as well as other state tax information. This chart is available to all ACLI member companies.

Quizzes

• The purpose of retaliatory taxes is to deter unfair or excessive taxation. It is to deter states from imposing discriminatory or excessive taxes on out-of-state or foreign insurance companies. Retaliation is an attempt to burden an out-of-state insurer in exactly the same way that the out-of-state insurer’s state of domicile would burden a foreign insurer.
• The primary state tax advantage for a nationwide insurance company domiciled in a state with a low premium tax rate is that the company will owe less in retaliatory taxes to other states than if it were domiciled in a high-rate state. When it collects premium from another state, the company must pay that other state a tax that is calculated based on the greater of its home state’s premiums tax rate or that other state’s premium tax rate, due to the retaliatory tax.

Premium and Retaliatory Taxes Summary

The key points on premium and retaliatory taxes include the following:

• It is important to understand the financial impact of state taxes on insurance companies.
• The financial impact of state taxes needs to be taken into account when pricing a life insurance product.
• U.S. states levy taxes on premiums collected in their state.
• Premium tax rates vary by state.
• Most states also levy retaliatory taxes.
• Retaliatory tax is paid by out-of-state or foreign insurance companies that have collected premiums from “in-state” policyholders—i.e., policyholders who live in the taxing state.
• A retaliatory tax is levied on a foreign insurance company so that the total premium tax paid is equivalent to the amount that would have been charged by the foreign insurance company’s domiciliary state.

Federal Income Taxation: United States

Like other corporations, stock and mutual life insurers are subject to federal income taxation. The federal tax rate is generally 21 percent, effective for tax years beginning with 2018. Some insurers, such as fraternal benefit associations or societies, are not required to pay federal income tax.

Both corporate and individual income taxes are defined in the Internal Revenue Code (IRC) and related guidance.

Read In the Beginning: What Are the Sources of the Federal Tax Law? to learn more about the sources of tax law and the different types of guidance that exist.

Federal Income Taxation: LICTI

As defined in the IRC, life insurance company taxable income (LICTI) is the basis for federal income tax (FIT). The main components of LICTI are the following:

• Premiums
• + Net investment income on taxable investments
• + Net realized capital gains (losses)
• + Net capitalization/amortization of tax basis deferred acquisition costs (section 848)
• + Any other items of gross taxable income
• − Net increase (decrease) in tax reserves
• − Deductible expenses, benefit payments and policyholder dividends
• − Dividends Received Deduction.

Some of these components correspond almost exactly to the items reported to regulators in the financial statements of the company (statutory accounting). Others have no equivalent counterpart in statutory accounting.

Key exceptions are the DAC tax, the Dividends Received Deduction (DRD), and different rules for calculating reserves. There are also differences in the timing of recognition of premiums and policyholder dividends. We will explore these and other differences in the rest of the U.S.-focused portion of Section 5.

Federal Income Taxation: Statutory Accounting and LICTI

Both statutory accounting and LICTI are based on accrual, rather than cash, accounting. Treasury Regulation §1.446-1(c)(1)(ii) describes accrual accounting in terms of the “all events” concept:

Income

“Generally, under an accrual method, income is to be included for the taxable year when all the events have occurred that fix the right to receive the income and the amount of the income can be determined with reasonable accuracy.”

Expenses

“Under such a method, a liability is incurred, and generally is taken into account for Federal income tax purposes, in the taxable year in which all the events have occurred that establish the fact of the liability, the amount of the liability can be determined with reasonable accuracy, and economic performance has occurred with respect to the liability.”

So, for example, if a reimbursement is contractually due from a reinsurer but the insurance company has not received the cash at the end of the tax year, this would typically still be considered taxable income in the year it came due. If a death claim is in the course of settlement but the check has not been issued, this would typically still be considered a deductible expense in the current year.

Federal Income Taxation: Insurance Reserves

Insurance reserves are a significant exception to the “all events” test. A typical corporate taxpayer would not be allowed to deduct amounts today that are intended to be used to pay expenses (claims) in future years; rather, it could not deduct it until the expense is actually determinable and enforceable. Due to the nature of the insurance business and the societal good that insurance provides, it is politically and economically inappropriate to tax all premium income upfront but only allow deductions when claims are actually incurred years or decades later. As a result, tax law generally follows the statutory accounting concept of establishing reserves for life insurance and annuities, and permitting deductions not only for the actual claims paid in cash or accrued during a year, but also for the increase in reserves.

In order to be taxed on LICTI, more than one-half of the insurer’s total reserves must be “life insurance reserves,” as defined in section 816 of the IRC. (A life insurer that has the majority of its reserves backing cancellable health contracts or certain types of pension/retirement contracts, for example, might not qualify.) Non-life insurance companies are subject to a different set of tax rules; this module will focus on the rules applicable to companies qualifying as life insurers.

Calculating LICTI

Next, you will learn about the calculation of LICTI. A simple example will walk you through the process. In addition to understanding the items that are added to or subtracted from LICTI, you will learn the following:

• Why isn’t FIT calculated by applying the tax rate to statutory (“blue book”) net income?
• What adjustments are made to statutory net income to arrive at LICTI?
• What timing differences between statutory net income and LICTI result from these adjustments? How are they reflected in the statutory financial statements?
• What permanent differences between statutory net income and LICTI result from these adjustments?

Read Introduction to Tax Accounting to see an example of the main concepts of LICTI.

Quiz

• Life insurance companies in the United States have significant differences between their pretax earnings and their taxable earnings. Most of these differences are due to timing of recognition of income/expenses. What is one of the main components of taxable earnings that produce the largest differences relative to pretax earnings?
  • Tax reserves are the single largest item that affects a life insurance company’s federal income tax.
• Many permanent differences between pre-tax earnings and taxable earnings are due to nontaxable investment income or nondeductible expenses. Which is an example of permanent differences?
  • The company share of dividends received is a permanent difference.
• What are some differences between statutory income and LICTI? Why are there differences?
  • There are many differences, but we focus on three big ones:
    • Tax reserves are generally lower than statutory reserves.
    • Tax accounting capitalizes a portion of premiums as a proxy for capitalizing acquisition expenses.
    • A portion of corporate dividends received is generally not included in taxable income.
  • The goal of statutory accounting is financial adequacy. So the accounting rules are generally conservative – they give a low value for surplus (and, indirectly, income).
  • The goals of tax accounting are:
    • The clear reflection of income.
    • Consistent measurement of tax liability, both within an industry and across industries.
    • Providing revenue collection for the government to operate.

Federal Income Taxation

Key points from the reading on federal income taxation of life insurance companies include the following:

• Life insurance companies pay federal income taxes on their taxable earnings.
• The financial impact of federal taxes needs to be taken into account when pricing a life insurance product.
• It is not sufficient to simply calculate federal income taxes by applying a tax rate to statutory annual statement earnings.
• The taxable earnings for a given year may differ widely from the statutory annual statement earnings.
• These earnings differences are either permanent or due to timing.
• Timing differences are differences between taxable earnings and pre-tax earnings (reported on the company’s annual statement) that reverse over time.
• Permanent differences are differences between taxable earnings and pre-tax earnings that will not reverse over time.

Tax Reserves Component

The single largest item that impacts insurance company federal income taxation is the tax reserves that are held. Unlike statutory reserves that (viewed simplistically) draw a line between liabilities and surplus, changes in tax reserves impact the timing and amount of tax that is paid by the company.

When preparing financial information according to the Internal Revenue Code (IRC), an actuary needs to be aware of the differences between IRC reserve calculations and the reserve calculations done for other financial audiences. IRC rules rely generally on statutory rules but are modified to determine an appropriate amount of taxable earnings. Lower increases in tax reserves result in higher taxable earnings and higher revenues for the federal government.

The rules for calculating insurance reserves are located primarily in IRC section 807. Section 807(c) lists the categories of insurance reserves for which increases and decreases will be included in LICTI (i.e., taxable earnings). By far the most significant item for most life insurance companies is life insurance reserves.

Section 807(c) lists the following items as insurance reserves:

• Life insurance reserves
• Unearned premiums and unpaid losses
• The present value of amounts payable under insurance and annuity contracts that do not include life contingencies
• Dividend accumulations and other amounts held at interest in connection with insurance and annuity contracts
• Premiums received in advance and liabilities for premium deposit funds
• Special contingency reserves under group insurance contracts

Reserves are reported in the tax return in these 807(c)(1) through (c)(6) categories.

Another important concept related to tax reserve reporting is found in IRC section 807(f). This section states the rules for reporting a change in the calculation of tax reserves. In general, when a change is made to the reserve calculation, the impact of the change is taken in the year of the change if it decreases taxable income and is spread over four years if it increases taxable income.

U.S. Tax Reserves

The next reading addresses how life insurance reserves are defined for tax reporting purposes. While reading the material listed below, focus on the following questions:

• What is an NAIC prescribed method?
• How are tax reserves calculated for non-variable products?
• How are tax reserves calculated for variable life and variable annuity products?
• What is the statutory cap?

Read Effect of 2017 TCJA on Life Insurers.

Quiz

• Life insurance reserves under the IRC cover life insurance, annuities and some health policies. CRVM is one of the acceptable methods under IRC. For example, annuities are calculated pursuant to the Commissioners Annuity Reserve Valuation Method (CARVM).

U.S. Tax Reserves: Effect of 2017 TCJA on Life Insurers

Under the Tax Cuts and Jobs Act (TCJA) of 2017, for tax years beginning in 2018, the tax reserve calculation is simplified compared to the prior tax law. The law generally applies 92.81% to the statutory reserve to arrive at the tax reserve, although the calculation varies somewhat depending on whether a contract is variable or non-variable. As under prior law, the tax reserve is floored at the net surrender value and capped at the statutory reserve. Deficiency reserves and asset adequacy reserves are excluded from the calculation.

Not all reserves on the books of a life insurance company are classified as life insurance reserves for tax purposes, that is, as section 807(c)(1) reserves. Statutory reserves that are not classified as life insurance reserves include liability for premiums received in advance, the liability for dividends left on deposit and claim reserves on cancelable health insurance.

Tax reserves are the single largest item that affects a life insurance company’s federal income tax. The next topic will cover another item that affects taxable income.

Deferred Acquisition Cost

The prior topic covered tax reserves, which have the single largest impact on a life insurance company’s federal income tax. Another item that affects federal income tax is the deferred acquisition cost (DAC) tax. The DAC tax is an example of tax rules that were created for revenue generation.

Tax legislation in 1990 created a tax deferral of acquisition expenses (commonly referred to as the DAC tax) in IRC section 848. In other words, a portion of acquisition costs is not immediately deductible for tax purposes but must be capitalized and amortized. The DAC deferral amount is based on the company’s net premiums (as defined in the IRC) for the year and the type of business that is sold.

The capitalized amount does not depend on a company’s actual costs; instead, it represents a portion of a company’s deemed acquisition costs. The law prescribes the rates that are to be capitalized, which vary by type of insurance contract:

• For annuity contracts 2.09%;
• For group life insurance contracts 2.45%;
• For all other contracts (which include non-group life insurance, noncancellable and guaranteed renewable A&H), 9.2%.

Likewise, the amortization of the capitalized amount does not vary by company. The amount is generally amortized over a 15 year period (5 years for small companies), with the assumption of mid-year issues. The amount is amortized over the 15 year period, regardless of the original duration or persistence of the policy that gave rise to the amount (e.g., policy surrender).

This capitalization and amortization prevents all acquisition expenses from being deductible in the year incurred. Some acquisition expenses are, thus, deductible only as amortized. The DAC tax is a timing difference between statutory earnings and taxable earnings.

Dividends Received Deduction

One of the significant components of a life insurance company’s taxable earnings is its dividends received deduction (DRD). The financial impact of the DRD may be taken into account in the pricing of a life insurance product.

Most corporations are allowed to deduct a significant percentage of investment stock dividends that they receive from other corporations and to exclude tax-exempt interest that they receive from their taxable income. Note the technical difference between the tax treatment of these two items. Investment stock dividends are included in taxable income and then a percentage is allowed to be deducted. Tax-exempt interest is not included in taxable income.

Life insurance companies, however, are subject to special rules, called “proration” described in IRC section 812, that limit the amount of DRD that is available. Nonlife insurance companies are subject to different proration rules. These rules prorate investment income between the so-called company share and the policyholder share. The life insurance company can deduct the company share of dividends received and tax-exempt income but cannot deduct the policyholder share of these amounts. TCJA defines company share to be 70% and policyholder share to be 30%.

Focus on the following questions as you read the material listed below:

• What is proration?
• Why is a life insurance company only allowed the DRD to the extent of its company share?
• What is a company share? A policyholder share? How do they relate to each other?

Read pages 153–154 of U.S. Tax Reserves for Life Insurers

Quiz

• Why is the amount of DRD that is available to life insurance companies limited, while most corporations are allowed to deduct a large percentage of their stockholder dividend income?
  • The rationale for limiting the DRD that is available to life insurance companies is based on a view that tax reserve increases are funded in part by stockholder dividends, and that it is inappropriate for a life insurance company to exclude most of that stockholder dividend from taxable earnings (via a “full” DRD) and deduct the increase in its tax reserves. Hence, the IRC limits the amount of the stockholder dividend that can be excluded from taxable earnings.

U.S. Federal Deferred Tax Asset

LICTI is statutory net income with tax-specific adjustments. Often, these adjustments (such as tax reserves and DAC) accelerate taxable income compared to statutory income. The tax paid early is really a pre-paid expense—it is (or creates) a pre-paid or deferred tax asset (DTA).

A DTA is based on the difference between actual FIT and tax at the federal rate on statutory income.

In theory, an insurer would establish a deferred tax liability (DTL) if its statutory earnings exceeded LICTI. However, this is unlikely under typical operations.

The following readings will answer these questions:

• Why do financial statements include DTAs or DTLs?
• What gives rise to a DTA/DTL?
• Do statutory statements allow the full reflection of DTAs?

Read pages 199–200 (ending with the first full paragraph of page 200) of U.S. Tax Reserves for Life Insurers

• DTA = (Taxable Earnings x Tax Rate) – (Statutory Income x Tax Rate)
• Taxes have been paid in advance of when the statutory financials would say they were due. This gives rise to a DTA.

Quiz

• Why would statutory accounting limit the amount of DTA that is recognizable on the statutory financial statement?
  • The amount of DTA that is recognizable on the statutory financial statement is limited, due to the concern for solvency.
  • A DTA is the recognition of a timing difference between tax reporting and statutory statements. Due to the long life of some insurance products, the timing difference could last for many years. The longer the timing difference lasts, the less valuable the DTA becomes and there is less certainty that it will be realized.

Case Study

Review

You are a pricing actuary assigned to research the impact of taxes from policy premium payments. You want to know how much of the premium payment “leaks” out of the company due to taxes and cannot be used to support the product.

You decide to track the marginal taxable income related to a $1,000 renewal life insurance premium for your company (the ABC Insurance Company). The premium will flow through the company’s income statement with a payment of expenses and reserve increases due to the payment.

You contact a coworker who provides you with the following information on a sample policy:

• A $1,000 renewal premium is received by ABC Insurance Company (ABC).
• The policy pays a 5 percent renewal commission to the agent.
• ABC is domiciled in State Purple, with a premium tax rate of 1.5 percent.
• The policy was issued in State Orange, with a premium tax rate of 1 percent. State Orange has a retaliatory premium tax law.
• The tax reserve for this policy is the cash surrender value at the beginning and the end of the year. The payment of the premium increases the cash surrender value by $920.
• The deferred acquisition cost (DAC) tax rate for individual life insurance policies is 9.20 percent, which will be amortized over 15 years.

You need to determine how the $1,000 premium flows through the company’s tax bill. You decide to assemble the pieces.

• The $1,000 premium will come in as income, with a corresponding expense of $50 for commission.

Case Study Part 1

A premium being received into a company sets off a chain reaction. Part I of this case study will track the marginal tax resulting from a $1,000 renewal life insurance premium. Taxes for a company are not tracked by each premium payment, but this case study will provide insight into the impact taxes have for an insurance company.

The case study will incorporate what has been covered in this section regarding the taxation of life insurance companies in the United States, including premium tax, income tax, changes in tax reserves and DAC tax. The case study is a simplified example and does not bring in taxes that were not covered in this section. For example, it does not reflect the investment of the premium and the resulting taxes. Part 2 of this case study will be with the reinsurance discussion in Section 6 of this module.

Once you have read the case study, answer a few questions on the next few slides.

Quiz

• • Based on the U.S. taxation case study, what is the DAC tax amortization for year 1?
    • The DAC tax is amortized over 15 years, with half in the 1st year and half in the 16th year. The DAC tax rate for individual life insurance policies is 9.20% of premium. The amortization for the first year is $3.07 = ($1,000 * 0.092 * 1/15) * 0.5.
  • Based on the U.S. taxation case study, what is the base premium tax due to State Orange?
    • A base premium tax of $10 ($1,000 * .01) is due to State Orange.
  • Based on the U.S. taxation case study, what is the increase in the tax reserve as a result of the $1,000 premium payment?
    • It was stated that the tax reserves equaled the cash surrender value at the beginning and the end of the year. The payment of the premium increases the cash surrender value by $920. Therefore, the tax reserves would increase by the $920.

Case Study Activity

Prepare a simplified taxable income statement for ABC Insurance Company, based on a $1,000 premium payment. Use the Taxable Income Calculation spreadsheet template to perform your work.

Taxable Income Calculation Spreadsheet Template

Taxable Income Calculation Solution

Quiz

• • Based on the U.S. taxation case study, what is the DAC tax amortization for year 6?
    • It is $1,000 * .092 * (1 / 15) = $5.13
  • If the tax reserves were equal to the cash surrender value at the beginning of the year and greater than the cash surrender value at the end of the year, what impact would that have on the taxable amount for this premium payment compared to the case study you just reviewed?
    • A higher tax reserve at the end of the year would mean a larger tax deduction for the year. A larger tax deduction translates into a lower taxable amount.
  • Assuming a 21 percent federal tax bracket, what is the total amount of tax due (income and premium) for this case study’s premium payment?
    • It is $103.93 * 21% (federal tax rate) + $10 state premium tax + $5 state retaliatory premium tax. If you will notice on the income statement from the case study, the state premium (and retaliatory) tax that is paid is deductible (i.e., it is a reduction to the taxable income). The total amount of “leakage” for the first year of the $1,000 premium payment is $36.83.

Base Erosion and Anti-Abuse Tax

On December 22, 2017, President Trump signed the Tax Reform into law. It introduces the Base Erosion and Anti-Abuse Tax (BEAT). It is applicable for transactions to foreign affiliated companies and discourages deductible payments. It imposes a minimum tax on these payments and is applicable to large taxpayers.

On December 2, 2019, US Treasury released regulations on the BEAT. They clarify that BEAT excludes claim payments made to a related party to be made to an unrelated party. The regulations also confirm that “netting” is not allowed. For example, Modco Adjustment doesn’t offset Premium when calculating the amount of BEAT.

Read slides from the SOA Webcast Base Erosion and Anti-Abuse Tax (BEAT) Regulations for more information about BEAT.

Life Insurance Company Summary

In this section we have reviewed ways in which insurance companies are taxed, who is doing the taxing and the major components of the taxes. A few key points from this section include the following:

• States levy a tax based upon the collection of premiums.
• Since state premium tax rates vary, many states levy a retaliatory tax to level the playing field.
• The federal government taxes the insurance company based upon its taxable earnings, or LICTI.
• Taxable earnings generally follow annual statement (blue book) earnings, with some primary differences that are either timing differences or permanent differences.
• Tax reserves for non-variable products generally follow the NAIC reserve methodology (CRVM or CARVM) but are subject to a haircut of 92.81%
• Tax reserves for variable products equal the sum of (A) plus (B), where
  • (A) is the greater of the total contract net surrender value and the contract reserve separately accounted for under IRC § 817, and
  • (B) is 92.81% times the excess, if any, of the total contract reserve calculated using an NAIC prescribed method applicable to the contract on the valuation date over the value in (A).
• The reported tax reserve has a cap of the statutory reserve and a floor of the cash value.
• Statutory income is further adjusted by capitalization and amortization of deemed acquisition costs.
• A life insurance company’s stockholder dividend income is prorated between the company share and the policyholder share with the policyholder share fully subject to tax and the company share only partially subject to tax.

Taxation in Canada

Generally, in pricing and designing an insurance product, policyholder and insurance company taxation must be considered. The emphasis in this section is on insurance company taxation for both life and non-life insurance companies operating in Canada. It is very important for you, as a student, to thoroughly understand the key concepts presented in this section as tax is one of the major cost items for an insurance company. Optimizing the taxable position of the company is generally one of the key goals to accomplish in a competitive environment.

Read Overview of Taxation in Canada

Taxation of Multinational

As stated in the overview, the tax rules vary by the type of business that an insurance company is engaged in. Therefore, it is very important for a multinational company to understand the major differences in tax treatment for the different types of companies as described in the reading.

Read Taxation of Multinational Insurance Companies That Carry on an Insurance Business in Canada

Tax Rules for Key Revenue

Below table outlines tax rules on some of the key revenue items. An understanding of the tax treatment on these items is important as they have a major impact on the calculation of taxable income. Taxable income is the basis for calculating income tax and also has an implicit impact on the calculation of capital tax.

Premiums

Premiums for both life and nonlife business include all direct written premiums and premiums assumed under reinsurance arrangements less premiums ceded under reinsurance agreements.

Investment Income and Investment Gains and Losses

Investment income includes interest, dividends, rent and royalty income. It also includes accrual of discount net of amortization of premium on fixed income investments and the mark-to-market gains or losses for specific types of assets. In addition, it can include income from interests in partnerships and trusts, where generally the underlying nature of the income earned in a partnership or trust is preserved for tax purposes.

Generally speaking, gains and losses on investments that are considered held on capital account have more favorable tax treatment than those that are considered as held on income account. Currently, only 50 percent of the net capital gains realized in a year is included in income (i.e., taxable capital gains), and only 50 percent of any net capital loss (i.e., allowable capital loss) is deductible. However, allowable capital losses on capital property can be applied only to offset taxable capital gains but can be carried back to the three prior years and carried forward indefinitely.

Under Canadian tax law, the treatment of a particular type of investment is often prescribed. Otherwise, for a corporation, it is a question of fact as to whether or not a property is considered held on capital account. Historically, most debt obligations held by insurers for their life insurance business have been mandated as on income account. However, insurers with nonlife business often claimed to be holding debt obligations for their nonlife business on capital account. Similar claims for capital treatment of share investments were made by insurers. Since Feb. 22, 1994, most securities held by financial institutions (including insurance companies, banks, trust companies, credit unions and investment dealers) were deemed to be held on income account. Other than depreciable property, the shares of subsidiaries and real estate held for long-term investment are the two main categories of capital assets.

Most securities can be classified into two broad categories: specified debt obligations (SDOs) and mark-to-market (MTM) properties. SDOs include loans and debt obligations held by an insurer that are not reported at market value in the financial statements. For SDOs, interest income is included in income as accrued, and credit losses are deductible. As with Canadian generally accepted accounting principles (GAAP) reporting, purchase premium and discount are amortized into income for tax purposes over the remaining payment period of the loan or bond. Currency fluctuations are included in taxable income in the year the currency rates change. Also, realized gains and losses other than credit losses are amortized for tax purposes over the remaining payment period.

The MTM properties for insurers include publicly traded shares with less than 10 percent ownership and any loans and debt obligations that are accounted for on a fair value basis. For these properties, the realized and unrealized gains and losses, as well as dividends and interest, are included in income for tax purposes. However, taxable dividends from taxable Canadian corporations that are included in income are deductible in the calculation of taxable income.

For assets that are neither SDOs nor MTM properties—for example, real estate—the regular tax law principles continue to apply, so that gains or losses arise only on realization. In the case of depreciable capital property, such as real estate, previously deducted capital cost allowance (the tax equivalent of depreciation) is required to be included in income before any capital gain is computed and any loss is on income account.

A life insurer that owns vacant real estate property under development must include imputed interest in income and add the same amount to the cost of property. This increase in the cost base of property will increase future deductions for tax depreciation to the extent attributed to depreciable property and otherwise reduce the gain or increase the loss when the property is sold. This rule is intended to parallel the tax treatment of other investors who would be required to capitalize interest expense on vacant land and property under development. The imputed interest recognizes that insurers in effect finance at least a proportionate amount of such property with policy reserves, an interest-bearing liability.

Other Fee Income

It is common for large employers to purchase the administrative and claims expertise of a life insurer for its group benefit program for employees without purchasing insurance. Fee income from administrative-only type contracts is included as income from carrying on an insurance business, since the activity is ancillary to the insurance business. Contracts whose benefits depend on the performance of assets held in a segregated fund receive special tax treatment. For each segregated fund, the segregated assets are deemed to be held in a trust for tax purposes, even though they are legally held in the name of the insurer. From the insurer’s perspective, transfers of premiums to the segregated fund are deductible, whereas transfers from the segregated fund to pay benefits are included in income. The net result is that the fees charged to the segregated fund are income to the insurer. Any guaranteed benefits are reserved for in the general accounts of the company.

Negative Reserves

The policy reserves in respect to many items may be a negative amount for tax purposes, especially in the early policy years. Should the sum of all the policy reserve calculations be negative, rather than directly allow a negative policy reserve, the policy reserve is set to zero and the absolute value of the negative amount determined is added to income. Any corresponding amount added in the previous year is deducted from income.

Tax Deductions

The following reading highlights the tax rules on some of the allowable deduction items. Understanding these tax deductions is important, as they reduce income tax payable.

Read Tax Deductions.

Quiz

• For Canadian resident multinational life insurance companies and non-resident insurance companies, interest on borrowed money used to earn foreign insurance income is not deductible for tax purposes against income, since the foreign insurance income is not included as income for these companies. Also, thin capitalization rules further restrict the amount of interest deductible for tax purposes.
• Losses arising after 2005 can be carried forward 20 years, and by underclaiming maximum tax actuarial reserves (MTARs) to increase income, creation of a noncapital loss can be avoided or income in a future year can be created to enable a noncapital loss to be absorbed.

Federal and Provincial Income

Next, you will study the different forms of tax payable in Canada. Understanding how these taxes are computed is important for you to assess the tax exposures of a company. It will also enhance your understanding of the tax impact of complex business structures and transactions.

Read Income Tax in Canada.

Segregated Funds

For most income tax purposes, a segregated fund is deemed to be a trust and so the general rules that apply to trusts, apply to segregated funds. Property and income of the trust are deemed to belong to the trust and not to the insurer. The income of the trust is deemed to be payable to the policyholder. Consequently, the income of a segregated fund is taxable in the hands of the policyholders, not the fund. In addition, any capital gains or losses of the segregated fund are deemed to have been realized by the policyholder, not by the fund.

From an insurer’s perspective, a transfer of funds from the general fund into a segregated fund is treated as an expense, and a transfer of funds from a segregated fund into the general fund is treated as income. Consequently, expense loads charged against premiums before deposited, fees charged against the assets or income of the funds and amounts otherwise transferred to the insurer offset the insurer’s expenses and benefit payments.

In most respects, the income tax consequences for an investor in a segregated fund are the same as for a unit holder in a mutual fund. One major difference is that capital losses of a segregated fund are deemed to be realized by the policyholder and so may be used by the policyholder to offset current capital gains from other sources.

An insurer may have seed money in a segregated fund, in which case the insurer would own an interest in the segregated trust fund and share in the income. Investment income from a segregated fund tends to retain its tax character rather than being subject to the rules applicable to financial institutions, such as mark-to-market accounting for publicly traded equities. However, if the portion of a segregated fund that is not policyholder funds is too high, the segregated fund will be treated like a “financial institution” with respect to the recognition of investment income.

Accounting for Income Taxes

The future tax allocation method of income tax accounting requires that a company record its current income taxes and a charge or credit for future taxes. This charge or credit is determined using a liability approach that focuses on the temporary differences between the accounting values and tax values of assets and liabilities. The charge or credit is based on the change in the value of the future tax asset or liability over the accounting period. A prospective approach is used to determine the value of a future tax asset or liability. It considers the likelihood of the occurrence of a future taxable event and applies the tax rate applicable to that future period to the taxable income from taxable temporary differences expected to reverse in that future period.

In this process, all possible future sources of taxable income with more than 50 percent probability of realization must be taken into consideration. Either an affirmative judgment approach or an impairment approach can be used to recognize the future income taxes. In Canada, the Canadian Institute of Chartered Accountants (CICA) has adopted the affirmative judgment approach for recognizing the future income taxes, but this may be changing. Under the affirmative judgment approach, the net amount of a future tax asset or liability “more likely than not” (with greater than 50 percent probability) to be realized is recognized. On the other hand, an impairment approach will explicitly reflect the portion of tax benefit that “more likely than not” will not be realized. This approach allows the tax benefit of each deductible temporary difference and loss carryforward to be recognized with an offsetting valuation allowance.

The possible future sources of taxable income include the following:•Future reversals of existing taxable temporary differences.

• Future taxable income.
• Carrybacks and carryforwards, including unused tax losses and income tax reductions other than investment tax credits.
• Tax-planning strategies that would likely be implemented.
• Changes in future tax rates or tax law.
• Future business mergers or acquisitions.

There are four items that are excluded specifically from the future tax calculation:

• Nondeductible goodwill.
• Foreign exchange gains and losses on nonmonetary items, such as inventory and capital assets of foreign subsidiaries or joint-venture operations.
• Transfers between entities within a consolidated group.
• Undistributed income of subsidiaries and joint ventures that will not be distributed in the foreseeable future.

Future tax assets and liabilities can be netted only if they relate to the same taxable entity and the same taxation authority. They are classified as current or noncurrent, based on when the temporary differences are expected the tax asset or liability will be considered as current. No offset is allowed between a current and a noncurrent item.

Discounting is not considered in calculating the accounting of future tax assets and liabilities but is recognized partially through the valuation of actuarial liabilities, as described in Section 2 for the Canadian Asset Liability Method (CALM).

Overview of Tax Reporting Impact Due to Fair Value Accounting

Canadian generally accepted accounting principles (GAAP) moved to fair value accounting on Jan. 1, 2007, for certain assets and liabilities. Assets are identified as held for trading, as available for sale or as held to maturity. As a result, there are both direct and indirect effects on tax reporting for insurance companies. Furthermore, income is being booked as current period income or booked to other comprehensive income (OCI), with the treatment of unrealized gains depending on the identification of assets as held for trading, held to maturity or available for sale. Under the current tax law, these accounting changes have unintended tax consequences. Consequently, the Department of Finance issued a news release on Dec. 28, 2006, announcing proposed changes to the tax regime (“the December Proposals”). These proposed changes were passed into law and implemented as of Jan. 1, 2007. The effect of the accounting changes are summarized below:

• Publicly traded equities are marked to market for Canadian GAAP rather than the prior approach of amortizing realized and unrealized gains and losses over time. The then-existing temporary difference between GAAP and tax values was eliminated, except for holdings of 10 percent or more.
• The tax treatment of bonds and mortgages follows Canadian GAAP. Publicly traded bonds are now marked to market for Canadian GAAP, unless designated as held to maturity. Consequently, publicly traded bonds acquired after 2006, which were not designated as held to maturity, are also marked to market for tax. Bonds acquired before 2007 are marked to market for tax purposes, according to the same rules. Any changes in tax cost at implementation were amortized evenly over five years for tax purposes.
• Where debt obligations are classified as “loans,” both the tax and Canadian GAAP bases of accounting remain on amortized cost.
• There was no change in respect to real estate.
• Unamortized, unrealized gains and losses for Canadian GAAP purposes on assets changing to mark to market disappeared. Instead, unrealized gains on assets designated as available for sale are booked to OCI. Unamortized realized gains and losses are booked to retained earnings to the extent attributable to assets in the surplus segment of assets and in effect booked to actuarial liabilities to the extent attributable to assets supporting actuarial liabilities.
• Canadian GAAP liabilities changed when the book value of the supporting assets moved to market value. Consequently, the MTARs in respect to policies issued after 1995 were changed and amortized evenly over five years.
• From a tax policy perspective, the changes in accounting have unintended consequences by creating significant timing differences between assets and reserves when measuring taxable income. MTARs for pre-1996 policies are now calculated using the methods for post-1995 policies. The change in MTAR at implementation will be amortized evenly over five years. However, there is no change in the MTAR basis used for the investment income tax (IIT) or for determining whether or not a life insurance policy is a policy exempt from accrual taxation.
• Furthermore, the difference between accounting reserves and MTARs was removed from the tax base for the Part VI Tax on Capital of Financial Institutions.
• Generally, the provinces of Alberta, Québec, and Ontario have followed any changes in the federal law.

Optional Reading

For further reference, please read:

• Pages 16–28 and Chapters 3–11, in Canadian Insurance Taxation (4th ed.) by Jason Swales and Erdem Erinc. 2015. PwC. LexusNexis Canada Inc.
• Income Tax Act Part XIV Sections 1400-140813, regarding policy reserves.

Section Summary

This section covered some of the tax costs of an insurance company. Taxes are an important element of pricing a product. Taxes paid out of the company are a true cost to the company (i.e., cash flowing out the door). Taxes reduce the amount of each premium and any investment returns that are available to support the product.

This section has covered the state premium taxation and federal income taxation in the United States. It has looked at the major parts of the federal income taxation, including tax reserves, DAC tax, DRD and DTA/DTL. Each of these can have a major impact on federal income taxation, and they are areas where actuaries are involved.

This section also has covered provincial and federal taxation in Canada. It has looked at the many forms of taxation in Canada and the importance of understanding each.

Taxes are one of the major cost items for an insurance company. Optimizing the taxable position of the company is generally one of the key goals to accomplish in a competitive environment.

Reinsurance

Introduction and Objectives

In the prior section you learned about the different forms of taxation. Next we will explore reinsurance.

It is the availability and affordability of reinsurance that affects life insurance and annuities. Many insurance products or companies could not exist without reinsurance.

Reinsurance is defined as “insurance of insurance; that is, a type of insurance that one insurance company, known as the ceding company, purchases from another insurance company, known as the reinsurer, to transfer risks that the ceding company insures.”

After you complete Section 6, you will be able to:

• Describe the purpose of reinsurance
• Understand the different types of reinsurance
• Assess the purpose and affects of reinsurance

Reinsurance Examples

Below are a few examples of usages of reinsurance.

Large Face Amount Life Insurance

If a customer wants to buy a large face amount life insurance policy ($10 million, for example), the insurance company is usually interested in writing the business because it hopes the policy will create a profit—on an expected value basis. However, if there is a claim on the large face amount policy, the insurer will, at best, have a large variation in claims experience. In the worst case, the insurer will not even have the money to pay the claim.

To reduce this risk, most life insurance companies limit the amount of retained risk on a life to a set amount, such as $1 million per person insured. This is called the retention limit. The issuing company will then reinsure all amounts in excess of this limit. If there were no reinsurance, the issuing company would be able to sell coverage only up to its retention limit—$1 million. If a customer wanted $10 million in coverage, he or she would have to either find a company with a retention limit that high or apply for policies from several companies.

Small Insurance Companies

Statistically, the law of large numbers allows insurance programs to work. If an insurance company is small or new, there is increased variability in the claims. With a low volume of business and an average or high retention limit, there is usually an unacceptably high probability that a high claim year could put a small company out of business. Therefore, new and small life insurance companies need to have a low retention limit, which can be gradually increased as the company grows.

New or Experimental Policy Features

When there is a new policy feature, insurance companies need to be very careful regarding how their exposure to loss will be affected. An example from the 1980s is the living death benefit rider, in which a terminally ill policyholder could receive the death benefit while still alive if he or she was expected to die within a specified short period of time, such as a year. It is difficult to accurately price benefits like this when there is little or no experience data available. There is also the risk that the benefit will be determined by the courts to be greater than intended, due to factors such as ambiguous policy wording or sales issues.

Reserving conservatively and/or reinsuring the coverage are advisable, at least until the benefit becomes established and predictable.

Reinsurance Companies

Compared to the number of regular insurance companies, there are relatively few reinsurance companies. Reinsurers must use the law of large numbers to have any predictability in their claims experience. Thus, to be successful, a reinsurance company must reinsure the business of many insurance companies.

Reinsurance Concepts

Read pages 383–392, Sections 7.1 through 7.31 , in Chapter 7, of Life Insurance Products and Finance by David B. Atkinson and James W. Dallas to learn more about reinsurance concepts.

Quiz

• Which are reasons for reinsurance to exist?
  • To limit a company’s liability on a life that is insured for a high amount
  • To manage the risk for new or experimental coverages.. undefined
  • To help new and smaller insurance companies manage their risk

Types of Reinsurance

The two common types of reinsurance are:

• Yearly renewable term (YRT)—the most common reinsurance method.
  • Read pages 392–404 , Section 7.4, of Life Insurance Products and Finance to learn more.
• Coinsurance—the simplest form of reinsurance.
  • Read pages 404–410 in Sections 7.5 and 7.6 of Life Insurance Products and Finance to learn more.

Quiz

• A reinsurance treaty:
  • Is a contract or legal agreement between the ceding company and reinsurance company.
  • Sets which policies or categories of business will be reinsured, what benefits must be paid and the premiums that the ceding company will pay to the reinsurer.
  • Explains how potential disputes between the companies will be handled.
• Excess reinsurance is insurance over the retention limit.
  • The ceding company’s retention limit must still be enforced, however. One hundred percent of the policy benefit above the retention limit will be ceded. This is called excess reinsurance.
• The basic elements of YRT reinsurance are:
  • Ceding company pays a reinsurance premium annually.
  • Reinsurer pays the ceding company a death benefit if and when the insured dies.

Effect of Reinsurance

Reinsurance lowers the ceding company’s risk by lowering exposure so required reserves will generally be lower for each policy reinsured. The financial effect of cash flow of premiums between the ceding company and the assuming company also needs to be considered, as they may not be the same. For example, an insured may pay monthly while reinsurance premiums may be payable annually.

To learn more about the effect of reinsurance on reserves, read pages 593–605, Section 12.8 in Chapter 12 of Life Insurance Products and Finance.

Reinsurance of Annuities

Reinsurance on annuities is less common than for life insurance because there is less perceived need for reinsurance. For annuities, a single death can’t produce a large financial loss. However, annuities in the aggregate living longer than expected can produce financial losses.

Read pages 678–680, Section 13.7 in Chapter 13 of Life Insurance Products and Finance to learn more about reinsurance of annuities.

Regulation of Reinsurance

Regulation of reinsurance is primarily concerned with solvency. Market conduct regulation is usually concerned only with the direct writer. The insured’s contract is with the direct writer. The insured has no claim on the reinsurer. Since the parties to reinsurance contracts are recognized as sophisticated in insurance matters and well able to guard their own interests, the reinsurance contract and rates have generally not been subject to approval or filing. The primary regulatory concern is the ability of the direct writer to meet its obligations.

In order for the direct writer to take credit for reinsurance, there must be expectation of being able to obtain the funds from the reinsurer to pay claims. Licensed insurers who also do a reinsurance business have to comply with the reserve requirements of the ceding insurer. A nonlicensed insurer or reinsurer who meets the financial standards of a state in which the ceding insurer is licensed may obtain recognition as an approved or accredited reinsurer. A reinsurer might not be licensed or accredited in every state in which the ceding insurer does business and files an annual statement. In the case of a reinsurer that is neither licensed nor accredited, the ceding insurer may still take credit for the reinsurer but only to the extent that funds are withheld. (In the accounting, the credit for reinsurance is taken regardless of whether the reinsurer is licensed or accredited or neither. However, the ceding insurer must set up a liability for the excess of credit taken over funds withheld, in case the reinsurer is neither licensed nor accredited.)

The reinsurance premiums are not directly subject to premium taxes. The direct premiums are subject to premium taxes, and the reinsurance premiums may reflect a reimbursement to the ceding insurer for the taxes on a portion of the direct premiums.

At one time, the funds withheld were actual assets, whether cash or invested assets. In the case of property-casualty insurers reinsuring with alien reinsurers, a letter of credit was recognized as a fund withheld in the situation where claim payments were due from the reinsurer in the months immediately following the statement date. Once the letter of credit was recognized as funds withheld, it was also used by life insurance companies. From a solvency standpoint, the regulator was not concerned with the financial condition of the reinsurer, as long as there were funds withheld to cover the reinsurance credit taken by the ceding insurer.

Some insurers wish to use reinsurance not to limit their mortality or other insurance risk but as a way to manage their surplus (surplus relief). While there were some insurers wishing to take on reserves, whether for tax purposes or because of limitation of surplus, there were not enough such insurers to provide the capacity for insurers seeking surplus relief. Many life insurers seeking surplus relief sought reinsurance with alien insurers neither licensed nor accredited, with the reinsurance credit covered by a letter of credit. Regulators responded to this by requiring that, for a ceding insurer to receive credit, there must be a transfer of risk. The National Association of Insurance Commissioners (NAIC) adopted a model regulation, and many of the states have enacted the regulation.

With a letter of credit considered as funds withheld, there was concern that the funds would actually be there in case the ceding insurer needed to draw down on the letter of credit. This in turn led to regulation over the size and credit rating of the issuing bank. Since letters of credit were good for only a year, regulation required that, in the event the letter of credit would not be renewed, there be sufficient notice before the termination date so that the ceding insurer could draw the letter of credit down. This so-called evergreen provision enabled the letter of credit to be used for long-term contracts. New York was the only state to require mirror reserving where a letter of credit was used and put the onus on the ceding insurer to get the necessary documentation from the reinsurer. However, this regulation was ineffective, as a ceding insurer could go to a jurisdiction that used generally accepted accounting principles (GAAP) accounting, and although the reserves were set up, a deferred acquisition expense was set up as an asset offsetting the reserve.

Reinsurance for Purposes Other Than to Spread Risk

Reinsurance is significantly less regulated than direct insurance of ceding companies because there is less perceived need for regulation. Most insurance regulation is to protect the “little guy” (the customer) from the “big guy” (the large, sophisticated insurance company). Since reinsurance is between two presumably large and sophisticated companies, less regulation is needed. Consequently, reinsurance regulation is primarily concerned with the solvency of the companies involved. Below are a few examples.

Reducing Income Taxes

Reinsurance has at times been used for purposes other than the spreading of the risk. Some mutual life insurers entered into modified coinsurance agreements where dividend payments became expense payments, without the limitation that dividend payments were subject to federal income tax under a previous tax law, and reduced their income taxes to little or nothing. The stock life insurers had been taking advantage of an approximate adjustment from the CRVM to the NL reserve with a modified premium whole life policy (which was effectively yearly renewable term (YRT) insurance but being treated as permanent insurance for tax purposes) and had reduced their taxes to little or nothing. This was not necessarily the concern of state regulators, except to the extent that the deduction and approximations would not be allowed by the Internal Revenue Service and back taxes and penalties could impair the surplus of the companies. The response from the federal government told the life insurers to develop a new tax law, with proportional tax coming from both the mutual and the stock insurers. This resulted in tax legislation.

Avoiding New York Limitation on Compensation

Regulators have also been concerned that reinsurance has been used to front for an insurer that for one reason or another might not want to be licensed to do a direct business. For example, New York has a law and regulation concerning agent compensation from life insurers, which legislation has considered as applying to all business of all licensed insurers, no matter where the business is issued. Some insurers choose not to be licensed in New York. Some set up a subsidiary insurer, which then becomes licensed to write business in New York. Some have attempted to use a licensed insurer and then assume the business through reinsurance. This has prompted some states to regulate fronting by limiting the amount of life insurance that can be reinsured without approval.

Captive Companies

In the case of credit insurance, some states have attempted to limit the total compensation of the group creditor policyholder. Some creditors have gotten around such regulation by having the credit insurance reinsured with a captive insurer set up and owned by the creditor or by the holding company, which owns the creditor. Most of these captives do not have much capital and surplus, but credit for reinsurance is allowed to the ceding insurer, provided funds are withheld. Many of these captive insurers with very little capital and surplus have been set up in Arizona, where past laws required only minimal capital and surplus for a limited capital company. These captives are not permitted to write insurance directly. In some cases, there may be tax advantages to the holding company in having the profits funneled through the captive reinsurer rather than through the creditor. The regulatory response generally has been to either establish the rate through regulation or require approval of the credit insurance rates based on the reasonableness of benefits in relation to the premiums charged. Reasonableness is often defined as a percentage of earned premiums being paid in incurred claims (loss ratio).

Assumption Reinsurance

Another form of reinsurance that has caused concern for regulators has been assumption reinsurance, where one insurer transfers a block of business to another insurer and then claims it has no more obligation to the insureds. This type of insurance is good where a rehabilitator seeks to continue coverage for the insured of a failed insurer, but it has been misused in other cases. In a few highly publicized cases, the assuming insurer became insolvent and the original insurer claimed it no longer had any responsibility toward the insureds, which it originally wrote, even though the original insurer was solvent. This transfer was done without the consent of the insureds. The regulatory response was to require notification of the transfer to the insureds and to offer the insureds the right to stay with the original carrier or to go with the new carrier. The original carrier could still enter into a reinsurance contract for those remaining, but the original insurer would remain responsible to the remaining insureds.

Case Study: Part 2

Review of Case Study Part 1

In Part 1 of this case study, you had originally calculated the amount of a premium payment that, due to payment of taxes, was unavailable to support the product. ABC Insurance Company is considering reinsuring the policy on a 100 percent coinsurance basis to Company Y. How does the reinsurance change the amount of the premium payment that is available to support the product?

Recapping the facts from Part 1 (Section 5 of this module):

• A $1,000 renewal premium is received by ABC Insurance Company (ABC).
• The policy pays a 5 percent renewal commission to the agent.
• ABC is domiciled in State Purple, with a premium tax rate of 1.5 percent.
• The policy was issued in State Orange, with a premium tax rate of 1 percent. State Orange has a retaliatory premium tax law.
• The tax reserve for this policy is the cash surrender value at the beginning and the end of the year. The payment of the premium increases the cash surrender value by $930.
• The deferred acquisition cost (DAC) tax rate for individual life insurance policies is 9.20 percent, which will be amortized over 15 years.

Additional information:•The $1,000 premium paid to the reinsurer is a deduction to ABC, and the reimbursements from the reinsurer for commission expense and premium taxes come in as income.

• The DAC tax for the reinsurance is computed on a “net consideration” basis. Net consideration includes all items that flow to and from the reinsurer. For Company Y, the net consideration is −$935. The amortization for the current year is − -$2.87 (-$935 * 0.092 * (1 / 15) * 0.5).
• The reinsurer shares in the fortunes of the ceding party with respect to premium tax and retaliatory tax.

Case Study: Part 2

In the next part of the case study you will gather information about how the introduction of reinsurance will affect the scenario as detailed in Part 1 of the case study.

Once you have read the case study, answer a few questions on the next few slides.

Quiz

• What is the reinsurance tax reserve credit taken by ABC as a result of reinsuring the $1,000 premium payment?
  • It was stated that the tax reserves equaled the cash surrender value at the beginning and the end of the year. The payment of the premium increases the cash surrender value by $920. The tax reserves would increase by $920 on the direct side. The reinsurance reserve credit is a reduction for the same amount.
• Which items are included in the “net consideration” basis used to determine the DAC tax for the reinsurer?
  • $1,000 premium; $50 commission expense; $10 premium tax; $5 retaliatory premium tax
  • The DAC tax basis for the reinsurer will be the “net consideration” (i.e., what the reinsurer paid the direct company). The reinsurer would receive the $1,000 premium from the direct writer and would reimburse the direct writer for the commission expense, premium tax and retaliatory premium tax. The “net consideration” would be ($1,000) + $50 + $10 + $5 = ($935).
• What is the DAC tax amortization for the reinsurer?
  • The “net consideration” used by the reinsurer is ($935). The DAC amortization is over a 10-year period, with half a year’s worth in years 1 and 11. The DAC amortization is −$2.87 = (−$935 * 0.092 * (1 / 15) * 0.5). The reinsurer would receive the $1,000 premium from the direct writer and would reimburse the direct writer for the commission expense, premium tax and retaliatory premium tax. The “net consideration” would be ($1,000) + $50 + $10 + $5 = ($935).

Case Study Activity

What would the new income statement of ABC look like now net of reinsurance? Use the Taxable Income Calculation with Reinsurance spreadsheet to do your work.

• Taxable Income Calculation Spreadsheet Template
• Taxable Income Calculation Solution

Section Summary

You have now learned about the different aspects of reinsurance. Next, we will explore other external forces and how they apply affect actuaries’ work.

Other External Forces

Introduction and Objectives

You have now completed the major topics of this module: regulations on solvency, consumer protection and other insurance-related topics and taxation. In addition, an actuary needs to be cognizant of a myriad of external forces. Many factors were covered in Module 2 of the Fundamentals of Actuarial Practice (FAP) course.

This section includes five shorter topics affecting actuaries’ work. They are vitally important—such that, if ignored, they could ruin an insurance company.

After you complete Section 7, you will be able to:•Describe the purpose of reinsurance.

• Describe the effects of rating agencies.
• Explain quasi-regulation.
• Be aware of additional insurance oversight.
• Be familiar with changes made to corporate governance.
• Understand and apply these concepts to model exercises as well as to your work as an actuary.

Effect of Rating Agencies

Rating agencies serve consumers and investors. Although an insurance company’s financial statements are available for public review at the state insurance department, most consumers and investors have neither the time nor the training to interpret the documents. Rating agencies investigate, analyze and evaluate all available information and issue a succinct review and grade that can be readily understood by the consumer.

Reread pages 139 (last paragraph) through 1408b in Who Killed Confederation Life? The Inside Story for a general description of rating agencies and how they work. Also read page 258 (all full paragraphs).

Effect of Rating Agencies

A.M. Best is the most well-known rating agency for life insurers. Standard & Poor’s, Moody’s Investors Service, and Fitch Ratings (formerly known as Duff & Phelps) also rate insurance companies. Ratings that are low or are falling can have a negative impact on the company, in addition to the reason(s) that the company was so rated. Sometimes this negative impact is catastrophic for the company.

A Self-Description of A.M. Best, a Rating Agency

To perform a constructive and objective role in serving the insurance marketplace as a source of reliable information and ratings dedicated to encouraging a financially sound industry through the prevention and detection of insurer insolvency.

A.M. Best Company is:

• A worldwide insurance-rating and information agency with more than 100 years of history. The company was founded in 1899 by Alfred M. Best. Offices are located in the United States, the United Kingdom and Hong Kong.
• The largest and longest-established company devoted to issuing in-depth reports and financial-strength ratings about insurance organizations. Its flagship publication and database, Best’s Insurance Reports, offers the largest coverage of insurers and reinsurers in the United States, Canada, the United Kingdom and worldwide of any interactive rating organization.
• An issuer of fixed-instrument debt ratings that cover bonds, notes, securitization products and other financial instruments issued by insurers and reinsurers. Its debt and commercial paper ratings are used by capital-market issuers and professionals worldwide.
• A publisher of books, directions, CD-ROM products and Internet-based services pertaining to the insurance industry. Products focus on insurance company financial information, underwriting information, providers of legal representation and claims-adjusting services to the insurance industry and company-specific or industrywide analytical information in the United States, Canada, Europe, Middle East and Asia insurance markets.
• The longest-running, largest and most-recognized source for insurance news. Articles generated by A.M. Best’s news staff are published in Best’s Review magazine and BestWeek and through its real-time news channels and are distributed via more than a dozen international information distributors.
• The premier source for regulatory statement financial information. Best’s Statement File products and reports are the industry standard for reliable, accurate and comprehensive statement-source information about insurance organizations operating in the United States and Canada.

Best Financial Strength Ratings

A Best’s Financial Strength Rating (FSR) is an opinion of an insurer’s ability to meet its obligations to policyholders. Rating modifiers and affiliation codes may also be associated with these ratings. The following table outlines Best’s rating scale and associated descriptions.

Secure

• A++, A+: (Superior)
• A, A−: (Excellent)
• B++, B+: (Good)

Vulnerable

• B, B−: (Fair)
• C++, C+: (Marginal)
• C, C−: (Weak)
• D: (Poor)
• E: (Under Regulatory Supervision)
• F: (In Liquidation)
• S: (Rating Suspended)

Not Rated

Not Rated (NR) categories are assigned to companies reported on by A.M. Best but not assigned a Best’s FSR. The five categories and descriptions are as follows:

• NR-1: Insufficient Data
• NR-2: Insufficient Size and/or Operating Experience
• NR-3: Rating Procedure Inapplicable
• NR-4: Company Report
• NR-5: Not Formally Followed

Rating Modifiers and Affiliation Codes

A rating modifier can be assigned to indicate that a Best’s FSR may be subject to near-term change (under review), that a company did not subscribe to Best’s interactive rating process (public data), and that the rating is assigned to a syndicate operating at Lloyd’s. Affiliation codes (g, p and r) are added to Best’s FSRs to identify companies whose assigned ratings are based on, respectively, group, pooling or reinsurance affiliation with other insurers.

Rating Modifiers

• u: Under Review
• s: Syndicate
• sf: Structured Finance
• i: Indicative

Affiliation Codes

• g: Group
• p: Pooled
• r: Reinsured

Rating Outlook

Best’s interactive ratings (A++ to D) are assigned a rating outlook that indicates the potential direction of a company’s rating for an intermediate period, generally defined as the next 12 to 36 months. Outlooks, which appear in the rating rationale section of a company’s Best Company Report, include Positive, Negative and Stable. View the online guide “Understanding Best’s Credit Ratings” for complete definitions on outlooks.

Best’s Explanation: Why is a Best’s Rating Important?

For insurance companies, a Best’s Financial Strength Ratings Rating (FSR) is a strategic tool that can enhance consumer confidence in the organization’s stability as well as its attractiveness to investors. A high rating also enhances an insurer’s credibility with reinsurers—a valuable resource, particularly for insurers entering new markets.

Insurance professionals depend on Best’s FSRs to determine the financial strength and operation of specific insurers, to evaluate prospective reinsurance accounts, to compare company performance and financial condition, and more. A Best’s FSR can influence an agent’s selection of plans to market. In recent years, ratings also have become an increasingly important factor in consumers’ decisions to purchase insurance. Today’s insurance consumers are well aware of how regional, political and economic instabilities can affect a marginal company. Best’s FSR provide these consumers with the information necessary for an educated buying decision.

Financial Size Category (FSC)

To enhance the usefulness of its ratings, A.M. Best assigns each letter-rated (A++ through D) insurance company a Financial Size Category (FSC)1. The FSC is designed to provide a convenient indicator of the size of a company in terms of its statutory surplus and related accounts.

Many insurance buyers want to consider buying insurance coverage only from companies that they believe have sufficient financial capacity to provide the necessary policy limits to insure their risks. Although companies utilize reinsurance to reduce their net retention on the policy limits they underwrite, many buyers still feel more comfortable buying from companies perceived to have greater financial capacity.

II	1 to 2
III	2 to 5
IV	5 to 10
V	10 to 25
VI	25 to 50
VII	50 to 100
VIII	100 to 250
IX	250 to 500
X	500 to 750
XI	750 to 1,000
XII	1,000 to 1,250
XIII	1,250 to 1,500
XIV	1,500 to 2,000
XV	2,000 or greater

Effect of Rating Agencies

Large corporate policyholders will review company ratings and will not purchase from a company that they consider unsound—and “unsound” can be anything below “good.”

On the life side, this happens most often with the issuance of guaranteed investment contracts (GICs) or other similar investments. Many of these GICs are purchased by pension trusts. These trusts are big on security, and if a life company’s rating falls, the trust is less likely to purchase a GIC or the insurer will have to increase the crediting rate to sell. Thus a drop in rating can mean big losses to a large life insurer.

Question

Even though rating agencies have a lot of expertise and knowledge about insurance companies’ financial health, they are not all-seeing and all-knowing. They do not have a crystal ball or magic formula that gives them a complete, accurate and current picture of the status of each company. While cooperation with rating agencies is essential, it may also be necessary to educate rating agencies on a larger picture or a changing world.

Response

Rating agencies can have a tremendous impact on the business of a life insurance company. Upgrades or downgrades in ratings can have significant effects on the insurance sales of a company due to buyer perceptions. Rating agencies also can have a significant influence on the amount of capital that a company must hold. Certain levels of capital are generally required for each notch on the rating scale. Although these certain levels of capital do not guarantee a specific rating, the levels are generally viewed as a minimum requirement to attain a rating.

Capital requirements can have a direct impact on the profitability and operations of a life insurance company. If a company has certain capital requirements, it may not have adequate capital for alternative uses such as acquisitions, sale of large amounts of new business and so on.
Over the past several years, the company that I work for has embarked on a broad campaign to influence the rating agencies’ view of the amount of capital that a life insurance company must maintain. The idea is that a single capital requirement formula is not applicable to all life insurance companies. In other words, in our opinion, capital requirements are not “one-size-fits-all” and should be customized for each company. A large well-diversified company should have different capital requirements than a small life insurance company with a limited variety of business.

As a result, my company devoted significant resources to developing models that provided a clear picture of the capital requirements for the company. The models took into account the diversification of the business and of the entire corporation and many other elements that define the company’s “economic capital” requirements.

Recently, the rating agencies have become much more receptive to this concept. One rating agency has developed its own capital modeling structure that focuses on the dynamics of each company. Another rating agency has a formula-based capital model that it uses to begin discussions with companies but then takes into account the company’s internal capital models in evaluating capital adequacy. Other rating agencies are also evaluating companies’ capital adequacy more holistically.

Actuaries understand that the quantification of risk is dependent on a number of factors that may be unique to each insurance company. As with many actuarial issues, it requires an effective communication of these complex issues to nonactuaries at rating agencies to achieve a result that provides an improved situation for all parties.

Effect of Rating Agency

Even if a downgrade is not a trigger to call investment instruments, it will result in a loss of current and future customers’ business and confidence. It can often result in the bankruptcy of the downgraded company. Read what happened to the Quanta Insurance Group when its rating dropped.

The Quanta Insurance Group was a casualty specialty line insurer (such as environmental recovery), and it was selling primarily to large commercial insureds. Lines of business included marine and aviation reinsurance, property and casualty reinsurance, environmental, fidelity and crime, professional liability, technical risk property, trade credit and political risk, structured products and surety.

Large corporations pay very close attention to the rating of their insurer. And rightly so—some guaranty funds will not provide coverage for insureds with a very high net worth. Therefore, when the Best’s Rating dropped, the company lost its customer base.

Here is a quote from Quanta’s web site:

“Quanta’s chairman, James J. Ritchie, commented, “While Quanta had made progress in its transition to a specialty lines focused carrier, the decision of A.M. Best to downgrade Quanta below the A level in March interrupted that effort and significantly impacted our ability to write attractive business. After consideration of alternatives, Quanta’s Board has made a decision that it believes enables the Company to best protect the value of its capital. We also believe this approach offers us the flexibility to support our syndicate in the A rated Lloyd’s market and to protect the value of our ESC consulting operation, which provides us with fee-for-service business.”

The decision they made was to go into voluntary run-off for much of their business. This means that they will not sell new business, but will maintain and service the business already sold:

As announced on May 25, 2006, the company is in the process of running off most of its specialty insurance lines. The company intends to eventually wind up the insurance business that it has placed into run-off after some period of time, which is not currently determinable.

The timing was quick, too: They got the notification from A.M. Best that there would be a downgrade in March 2006, and withdrew from the market in May 2006.

In summary, the downgrade to B by A.M. Best caused the company to choose to go out of business.

Rating agencies must not be ignored while engaging in the business of insurance. It is important to cooperate with the agencies themselves as they collect information. It is also important to try to maintain a good rating, as this will help in attracting new business, as well as in persistency of old business. The rating process and the subsequent publicity and public awareness are additional motivation to keep the company far from trouble, which is generally helpful for the insurance industry.

Quasi-Regulation

The next topic of this section is quasi-regulation.

There are a few areas of regulation that fall outside of what is normally considered as law. These have a significant impact on the insurance business, so it is important to be aware of them.

This section will discuss insurance department regulations, NAIC model regulations and courts of law. In addition, this section will touch on the additional insurance oversight that is being put into place as a result of the financial crisis that hit an all-time low in 2008.

State Insurance Department Regulations

In the United States, you know that insurance is mainly regulated by the states. In many situations, state laws give state insurance departments quasi-legislative power over insurers. This is done by the insurance department issuing a regulation with which insurance companies must comply. Often this is providing more detail or guidance about the scope or application of an insurance law. These may or may not be uniform from state to state, even regarding an identical law.

State insurance law has generally created state insurance departments with broad administrative, quasi-legislative and quasi-judicial powers over the insurance business.

Typically, the insurance department is headed by a commissioner, superintendent or director (hereafter, the common term “commissioner” will be used). A few states vest ultimate responsibility in a commission or board that selects an individual commissioner to carry out policy. Nearly one-fourth of the states elect the commissioner, while the remainder are appointed, usually by the governor. In some states, the insurance department is combined with some other department (such as the department of banking or securities). And in some states, the insurance commissioner also has other duties, such as state auditor, comptroller, and so on.

The nature and scope of the commissioner’s authority is derived from the legislative enactments. To provide greater specificity and procedures than those set forth in general legislative standards, the insurance commissioner will often promulgate regulations. State insurance codes prohibit commissioners from exercising authority in an arbitrary or capricious manner. The validity of regulations is subject to constitutional due process limitations. These limitations require that a regulation be adopted by fair procedures, including advance notice to those who must comply with the regulation, once adopted, and the opportunity to be heard on the proposed regulation through a hearing process. Once a regulation is finalized, it usually has the same legal effect as a statute. In addition, the commissioner may issue bulletins and other communications setting forth his or her expectations or guidelines for compliance with statutory or regulatory requirements. However, while alerting the regulated as to the commissioner’s views, noncompliance of such advisories is not necessarily a violation of the law.

Enforcement of the insurance laws is achieved through a variety of techniques, including the power to grant or revoke licenses to do business, the power to compel disclosure and perform financial and market conduct examinations, the power to conduct investigations and promulgate regulations or rules, the power to approve or disapprove filings of such items as rates and policy forms, the power to remove officers and directors, and so on. These powers and sanctions, coupled with alternative informal powers, afford the insurance commissioner substantial “clout” with which to regulate the insurance business.

In practice, most commissioners serve for a very short term, typically three or four years, although there are a few with very long service. Many find jobs in the insurance industry after their term of office expires, although the right of a former insurance department official to represent an insurance company before the department may be limited by law.

State insurance department regulation is in practice very uneven. Some states have limited funding and scope, while others have greater resources and responsibility. Even though premium taxes were originally meant to fund the state insurance department, now premium taxes generally go into the general revenue of the states. The insurance departments are funded out of general revenues. While the cost of an examination may be assessed back against the company being examined, there are other costs that have to come out of general revenue. In some states, the cost of running the insurance department, other than reimbursement for the cost of an examination, is assessed back against all domestic companies to reimburse the funds from general revenue. Thus some states are able to hire sufficient qualified help to carry out its tasks, while others cannot.

National Association of Insurance Commissioners (NAIC)

The National Association of Insurance Commissioners (NAIC) tries to encourage good insurance laws that are uniform from state to state. NAIC model regulations have received varying welcomes by different states, so there is not uniformity. However, an insurer doing business in multiple states is wise to follow the model regulations. You have seen some NAIC model regulations earlier in this module. Remember that model laws are not actual laws. The actual laws are passed by the states (including any NAIC model regulations that are adopted). This is why the model laws are called quasi-regulation.

Initially, the NAIC central office relied primarily on assessments from the states and on the fees charged to nonregulators for attendance at the NAIC conventions for its funding. This allowed for only a small staff. Over time, with more conventions and higher fees, the staff was able to expand. Then with the computer filings of annual statement data with the central office and with the states requiring that their domestic insurer file with the central office, fees were assessed against the insurers filing to cover the cost of processing. This was beneficial to the companies to avoid multiple filings. Such fees enabled the central office to expand, and today the NAIC has its main offices in Kansas City, Kansas; a security valuation office in New York; and a legal and examination office in Washington. The staff is highly qualified and competent. The NAIC also receives income from the sale of reports. The NAIC central office today is able to fund seminars for commissioners and provide funds for some for necessary travel.

One of the proposals for federal legislation included the designation of the NAIC as the overseer of the states in carrying out insurance regulation. This would have reversed the role of the central office from being the servant of the commissioners to being the supervisor of the commissioners. That legislation did not materialize, and today the legal authority still resides with the individual states, with the NAIC central office furnishing services, such as the compilation of annual statement data and risk-based capital reports, to the commissioners.

The NAIC performs a variety of functions. It provides a mechanism for regulators to exchange information and share expertise. NAIC meetings afford various industry, consumer and other groups, individuals and other government agencies an opportunity to speak out on and participate in solving regulatory issues. The NAIC provides the mechanism for standardized annual statements, a coordinated examination system, a uniform valuation of securities and the development of model laws and regulations.

Furthermore, consistent with the objective to reserve regulation to the states, the NAIC takes serious interest in federal legislative and regulatory activity. It tracks significant federal insurance-related activity, supports commissioners in the conduct of federal liaison activity, prepares statements on federal issues and supports commissioners testifying on behalf of the NAIC before congressional committees and federal agencies.

Canadian Equivalent

The regulatory situation is different in Canada. The legislative body for federally licensed insurers is Parliament, and the regulator is the Office of the Superintendent of Financial Institutions (OSFI). Provincially licensed companies are regulated by the province in which they are licensed, though some of the provinces are turning more authority for financial regulation over to OSFI. In particular, the province of Québec has comprehensive regulation over its provincially licensed companies. In general, federal and provincial regulatory bodies conduct regulatory activities on a similar basis.

The end result is a regulatory environment that is generally consistent for federally and provincially licensed companies alike.

A quasi-regulatory body in Canada is the Canadian Life and Health Insurance Association (CLHIA) which is a non-profit, voluntary organization representing life and health insurance providers within the insurance industry that serves to promote a favorable legislative and regulatory environment for the industry.

Courts of Law

Courts of law sometimes dictate interpretations of insurance contracts or laws that were not anticipated or intended by insurance companies, regulators or even legislatures. These decisions sometimes change business practices and are also a financial risk to insurers. Also, class action suits against insurance companies are becoming more common.

Do you remember the “vanishing premium” example from Section 3 of this module? It was determined by courts of law that the agents had not properly explained to the prospective policyholders that premiums could reappear even after they had vanished, if interest rates fell low enough. The power “forcing” the insurers to compensate the policyholders for the failures of the agents was the courts of law.

The role of the courts in insurance regulation is fourfold. First, courts adjudicate conflicts between parties to disputes, such as an insurer and its policyholder (for example, whether coverage applies or the amount of the claim). Second, courts enforce criminal penalties against those violating the insurance laws. Third, occasionally insurers, agents and/or others seek to overturn statutes, regulations promulgated by the insurance commissioner and/or orders issued by the commissioner as arbitrary and unconstitutional. With the exception of the fourth function, noted next, the judiciary (while very important to the individuals involved) has not emerged as a major player in the scope and nature of state regulation. Fourth, the federal courts in particular have become involved in a plethora of cases seeking to define the parameters between state and federal authority under the McCarran-Ferguson Act.

Quiz

• Which are roles of the courts?
  • Enforcing criminal penalties against companies and their principals who violate insurance laws.
  • Mediating or dictating judgments in conflicts between policyholders and insurance companies.
  • Hearing cases from the insurance industry seeking to overturn statutes or regulations that they believe are arbitrary or unconstitutional.
  • Determining the interpretation of the wording of an insurance policy, statute or regulation.
• Which are considered parts of the role of a state insurance commissioner?
  • Advocates fair treatment by insurance companies of policyholders living in the state.
  • Defines procedures and details to implement insurance laws that are passed in the state.
  • Oversees the state insurance department employees and functions.

Additional Insurance Oversight: United States

In addition to the quasi-regulations already discussed, additional insurance oversight is being put into place as a result of the financial crisis, which in the Dodd-Frank Act becoming a law in the United States in 2010. The implications of this act will be discussed further on the next few slides.

Coming out of the financial crisis, the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”) became law in July 2010. Its intentions are to address the weaknesses in the financial industry evidenced in the crisis, to end “too big to fail,” and to protect consumers from “abusive” practices by the financial services industry.

As such, the Dodd-Frank Act impacts the regulatory environment for insurance in a few ways, which are discussed here and on the following slides.

First, as part of the Dodd-Frank Act, the Financial Stability Oversight Council (FSOC) was established as a new council of regulators, and the Federal Insurance Office (FIO), which is housed within the U.S. Department of the Treasury, was also established.

SIFI Designation

The second way, the Dodd-Frank Act legislation affects regulation of the insurance industry is that, the FSOC has the power to designate financial firms whose failure would jeopardize the financial stability of the United States. These firms receive the designation of “systematically important financial institutions” (SIFIs), and they are subject to increased supervision and regulation by the Federal Reserve Board.

Federal Insurance Office

Established by the Dodd-Frank Act and housed within the U.S. Department of the Treasury, the Federal Insurance Office (FIO) does not have supervisory or regulatory authority over the business of insurance. However, it is charged with the following.

• Monitoring all aspects of the insurance sector (with a few non-life exceptions).
• Representing the United States on prudential aspects of international insurance matters.
• Serving as an advisory member of the Financial Stability Oversight Council (FSOC).

Corporate Governance and Internal Control in the U.S. and Canada

A third way in which the Dodd-Frank Act affects the insurance industry regulatory environment is that, after a series of high-profile corporate and accounting scandals (such as Enron and WorldCom) were discovered in early 2000 as well as a result of the latest financial crisis, many companies are now required to boost their corporate governance standards.

This section will discuss the key changes made in corporate governance by the following external forces:

• The Sarbanes-Oxley Act (SOX), enacted in the U.S. in 2002, introduced major changes to corporate governance and the regulation of financial reporting that affected both publicly traded companies and their auditors.
• Both the U.S. Public Company Accounting Oversight Board (PCAOB) and the Canadian Public Accountability Board (CPAB) have changed their audit standards and requirements in response to the SOX enactment.
• The Committee of Sponsoring Organizations of the Treadway Commission (COSO) also updated its internal control over the financial reporting framework in 2013 for SOX compliance matters.

The main objective of these changes in corporate governance is to increase the accountability and transparency of the company and to avoid or minimize large-scale disasters.

Sarbanes-Oxley Act (SOX)

The Sarbanes-Oxley Act (SOX) Act is a United States federal law that sets corporate governance and internal control standards for all U.S. public companies. It aims to protect stakeholders from accounting errors and fraudulent practices. It was enacted on July 30, 2002, as a reaction to a series of corporate and accounting scandals.

Section 101 establishes the role of the Public Company Accounting Oversight Board (PCAOB). Section 302 requires the CEO and CFO to certify that they are responsible for establishing and maintaining effective Internal Controls over Financial Reporting (ICFR).

Section 404 requires management to:

• Accept responsibility for the effectiveness of the company’s ICFR.
• Evaluate the effectiveness of the company’s ICFR using suitable criteria.
• Support the evaluation with sufficient evidence, including documentation.
• Present a written assessment of the effectiveness of the company’s ICFR as of the end of the company’s most current year. This assessment needs to be attested by an auditor.

Section 404 has adopted (but not required) the COSO ICFR framework since 2002. This essentially puts actuarial processes in scope as part of the SOX 404 compliance.

Read the article Actuarial Aspects of SOX 404 from the Financial Reporter.

Auditing Standard in United States

U.S. Public Company Accounting Oversight Board (PCAOB) Auditing Standard

The PCAOB’s Auditing Standard No. 2 (now superseded by Auditing Standard No. 5—see following) has set guidance on management’s process for assessing the effectiveness of the company’s ICFR:

• Determining which controls to test, including controls over all relevant assertions relating to significant accounts and disclosures in the financial statements.
• Evaluating the likelihood that control failure could result in a financial statement misstatement and the magnitude of such a misstatement.
• Determining the specific business units or locations to include in the evaluation.
• Determining whether any identified deficiencies in ICFR are significant or constitute material weaknesses.
• Communication of its findings.

Auditing Standard No. 5 (adopted in Nov 2007) provides further guidance on ICFR, among other things:

• Reinforcing key concepts such as top-down and risk-based approach, scalable to a company’s size and complexity.
• Focusing on areas with the greatest risk of a material misstatement.
• Emphasizing significance of fraud risk and anti-fraud controls.
• Acknowledging that the auditor is not evaluating management’s evaluation process but is opining directly on ICFR.
• Defining material weakness as a deficiency in ICFR, such that there is a reasonable possibility that a material misstatement of the company’s financial statements will not be prevented or detected on a

Auditing Standard in Canada

Canadian Public Accountability Board (CPAB) Instrument 52-109

The CPAB was established in 2003 shortly after the Sarbanes-Oxley (SOX) Act was enacted in the United States.

Instrument 52-109 contains the equivalent rules to SOX 404:

• Requires the establishment and maintenance of ICFR
• Must use a control framework to design ICFR
• Include a description of the process for evaluating ICFR

Management must certify:

• Responsibility for the design and oversight of ICFR.
• Evaluation of effectiveness of ICFR and any material weaknesses in the management discussion and analysis.

Unlike SOX 404, there is no formal requirement for auditors to attest on management’s evaluation of ICFR. However, review of controls would still be within the scope of an auditor’s work.

COSO Framework

The most common ICFR framework being used in the United States and Canada is the Internal Control–Integrated Framework published by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Sarbanes-Oxley Act recognizes the COSO ICFR as an appropriate framework, but does not make it a requirement.

According to COSO’s standards, an effective system of internal control requires:

• The five components of internal control to be present and functioning.
• Each of the 17 principles to be present and functioning.
• The five components to be operating together in an integrated manner.

Every entity faces a variety of risks from external and internal sources that must be assessed both at the entity and the activity level. Section 404 compliance is concerned with the risks associated with misstating the company’s financial statements.

Control Environment

Sets the tone of an organization influencing the control consciousness of its people.

Risk Assessments

Every entity faces a variety of risks from external and internal sources that must be assessed both at the entity and the activity level. Section 404 compliance is concerned with the risks associated with misstating the company’s financial statements.

Control Activities

Helps ensure management directives are carried out.

Information and Communication

Identifying, capturing and communicating information pertinent to the key financial statement processes and controls in a form and time frame that supports all control components.

Monitoring Activities

Assesses the quality of the system’s performance over time.

Section Summary

In this section, you have learned about a lot of external forces affecting the business of insurance. As an actuary, you must always be aware of these factors and how they affect your work.

Module Wrap-Up

Module Wrap-Up

Before starting this module, you very likely were aware that the taxation and regulation of insurance affected insurance companies at the corporate level, but in this module you have learned how and why taxation and regulation impact the practicing actuary at the very detailed level of product design, product illustrations, rating, reinsurance, investments and reserving. You have learned about the regulators, other governmental agencies and non-governmental organizations (such as rating agencies and the NAIC) that will impact your professional career and determine the rules under which you must perform your professional duties. In addition, you have been exposed to many of the differences—and similarities—between Canada and the United States in these areas.

Congratulations on completing the first six sections of the ILA Regulation and Taxation module. You should now have a good understanding of the framework within which actuaries in the life and annuity practice must work. You must always remember that the trust placed upon you as a professional actuary carries with it responsibility to be aware of and abide by all applicable laws as well as to meet the highest ethical standards.

As you fulfill this responsibility, you will affirm and enhance the excellent reputation of actuaries and our businesses, while contributing to the paramount goal of serving the public.

Confederation Life—An Analysis

Now that you have a basic understanding of the regulation and taxation of life insurance, and before you go on to the End-of-Module Test, it’s time to answer the BIG QUESTION: Who Really Did Kill Confederation Life?

Module Summary

As can be seen from the activity of “Who Really Did Kill Confederation Life?” no single person was entirely at fault. A number of individual and parties contributed to the decline of Confederation Life, and each had an opportunity to save the company.

Are you able to answer the following questions?

• What is the purpose of regulation and taxation?
• Can you explain the regulatory and tax environments for insurance and annuities?
• Can you explain the regulation of insurance and annuities in the United States and Canada?
• Can you describe the taxation of insurance and annuities and how it affects product development, reserving, pricing and business practices?