Module Overview

Domestic/Foreign/Alien Insurance Companies

U.S. insurance departments classify insurance companies as “domestic,” “foreign” and “alien.” Insurance companies formed outside the United States may be authorized to do business in the United States. These non-U.S. companies are called “alien”.

The McCarran-Ferguson Act

Regulation of life insurance in the United States has always been primarily a responsibility of the various states, as originally the sale of life insurance contracts was considered to be a local event and not interstate commerce. However, in 1944, a Supreme Court ruling (the South-Eastern Underwriters Association case) stated that insurance was indeed interstate commerce and therefore subject to federal regulation. One result of this decision was that the Sherman Act, the Clayton Act and the Federal Trade Commission Act would all apply to the business of insurance.

Among other things, these acts would have seriously restricted or outlawed the ability of insurance companies to use data from rating bureaus (which combine information from many insurance companies) for ratemaking purposes. This decision caused both insurance regulators and insurance companies to ask the U.S. Congress to pass a law permitting the regulation of insurance to remain at the state level. Congress agreed and passed the McCarran-Ferguson Act in 1945. This law basically declares that, so long as the states are actively regulating insurance, federal laws affecting business in general will not apply to the insurance industry. However, the federal government may still enact and enforce federal laws that are specifically applicable to insurance.

Because of its importance to the philosophy and practice of insurance regulation in the United States, read the McCarran-Ferguson Act.

Solvency Regulation

Response to the 2008 Crisis

The crisis brought about a system of state, U.S. federal, and international regulation of insurance that seems absurdly overdesigned and cumbersome unless viewed as an attempt to strengthen the regulation of IHCs.

One response, which appears to come from the International Association of Insurance Supervisors (IAIS) is the concept of a group wide supervisor and supervisory college by which a lead supervisor (e.g., the commissioner of the domiciliary state of the flagship company) exercises coordination and authority over the holding company and all subsidiaries.

A second response, at the U.S. federal level, was the formation of the FSOC and the ability of the FSOC to designate a large IHC (as well as other financial institutions) as “systemic,” which as of early 2015 had been done for three large IHCs. Designation may add federal supervisors to the group coordinated in groupwide supervision, may allow the Federal Reserve Board (FRB) to set capital standards and may allow the FDIC to resolve the noninsurance operations of a failed IHC.

Beyond the scope, international regulators (the International Monetary Fund (IMF) and the IAIS) may impose an additional regime. IAIS has a process similar to FSOC.

Regulation of Reserve Liabilities

United States Requirements

Currently, the states have adopted a nationally developed standard for the minimum valuation of insurance policies, called the Standard Valuation Law. This law requires all insurers to establish, in their statutory financial filings, reserves for their life, annuity and individual accident and health (A&H) policies based on standard, formulaic methods and statutorily set interest rates and mortality tables. These assumptions are conservatively established, and insurance companies may not establish reserves less than the statutorily required amount.

The basic concept for the statutory reserves is that reserves are equal to the present value of future benefits, minus the present value of future net premiums. The only permitted assumptions are mortality and interest; for annuities, lapsation may also be considered in the reserve. The formula does not permit significant consideration of better-than-expected mortality that should result from significant refinements in underwriting of policies.

The “present value of future net premiums” is based not on the actual gross premiums charged but on the valuation net premiums calculated using the statutory mortality tables and interest rates. In addition, should the actual gross premium be less than the valuation net premium at any future policy duration, deficiency reserves may be required.

Although there have been revisions to the statutory mortality table and to the interest assumption, the basic formula for calculating the statutory reserve has remained substantially unchanged for more than a century.

However, the standard formula could not—and does not—address all situations and does not anticipate the advent of certain new policies, especially permanent policies in which the premium could change significantly after an initial period. In response, regulators have adopted various actuarial guidelines and model regulations. One of the most significant of these is the Valuation of Life Insurance Policies Model Regulation, more commonly referred to as Regulation XXX. This regulation, for the first time, permits valuation actuaries to use their professional judgment in the selection of certain factors in the minimum statutory reserve calculation.

Read about the model regulation³. As you read through, pay special attention to Section 5. Section 5 of this regulation introduced a new 20-year select table to be used with the 1980 CSO table. (Section 5 also allows for the adoption of new mortality tables by the NAIC. The current minimum mortality is the 2001 CSO table and its corresponding select rates.) The regulation also takes a step toward using company experience in the mortality assumption for reserves with the introduction of the X-factor for deficiency reserves.

This regulation also includes a new requirement to calculate reserves two ways, using the unitary and segmented approach. The unitary approach is the approach historically used to calculate reserves. The segmented approach is used when premiums increase significantly without the corresponding increase in valuation mortality.

In addition, since 2001, in an attempt to make the above authoritative guidance more homogeneous among the states, the NAIC has been annually publishing the Accounting Practices and Procedures Manual, which is a compilation of existing authoritative statutory guidance, plus certain additional requirements.

Regulation of Reserves: Principle-Based Reserving

US Requirements

The NAIC is moving toward a principle-based reserving (PBR) method. The PBR valuation system will permit use of factors such as discount rates related to a company’s investment portfolio, lapsation and favorable mortality assumptions, as well as the use of aggregate modeling techniques in the development of statutory reserves. These have not been permitted under the formulaic approach. In September 2009, the NAIC adopted a revised Standard Valuation Law, which allows the implementation of principle-based reserving for life and health insurance.

Here is a quote from the American Academy of Actuaries’ website, regarding principles-based reserves:

The NAIC is moving toward a principle-based reserving (PBR) method. The PBR valuation system will permit use of factors such as discount rates related to a company’s investment portfolio, lapsation and favorable mortality assumptions, as well as the use of aggregate modeling techniques in the development of statutory reserves. These have not been permitted under the formulaic approach. In September 2009, the NAIC adopted a revised Standard Valuation Law which allows the implementation of principle-based reserving for life and health insurance. Here is a quote from the American Academy of Actuaries’ website, regarding principles-based reserves: “The Academy has taken the lead in an ambitious effort to establish a new framework for determining life insurers’ required capital and reserves in the United States. The principles-based framework is being designed to capture the underlying risks of life insurance and annuities more accurately than the current rule-based approach. In the new approach, principles of risk management, asset adequacy analysis, and stochastic modeling are used to set reserves and determine capital adequacy. An actuary’s professional judgment also plays a larger role in a principles-based framework.” It should be stressed that the new PBR valuation system will grant much more flexibility in statutory statement valuations, but it will also place an increased amount of responsibility on the insurance company’s Appointed Actuary to assure continued solvency of the insurer. PBR allows for considerable actuarial judgment in setting assumptions. But the actual calculation method also changes. The PBR reserve for modern products will be a “stochastic reserve” intended to be adequate in 70% of a range of economic scenarios. However, there are also minimum reserves set by more traditional present of value methods, but allowing for lapses and expenses. Read about the regulation of reserves in the United States.

“The Academy has taken the lead in an ambitious effort to establish a new framework for determining life insurers’ required capital and reserves in the United States. The principles-based framework is being designed to capture the underlying risks of life insurance and annuities more accurately than the current rule-based approach. In the new approach, principles of risk management, asset adequacy analysis, and stochastic modeling are used to set reserves and determine capital adequacy. An actuary’s professional judgment also plays a larger role in a principles-based framework.”

It should be stressed that the new PBR valuation system will grant much more flexibility in statutory statement valuations, but it will also place an increased amount of responsibility on the insurance company’s Appointed Actuary to assure continued solvency of the insurer.

PBR allows for considerable actuarial judgment in setting assumptions. But the actual calculation method also changes. The PBR reserve for modern products will be a “stochastic reserve” intended to be adequate in 70 percent of a range of economic scenarios. However, there are also minimum reserves set by more traditional present value methods but allowing for lapses and expenses.

Read about the regulation of reserves in the United States.

Canadian Requirements

A PBR method is already in place in Canada. Read to learn more about the reserving system in Canada.

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. However, the United States, with the implementation of a principle-based reserving method, will be moving closer to the Canadian reserving philosophy.

Required Regulatory Statements, Reports and Actuarial Opinions

United States

Read Actuarial Opinion and Memorandum Regulation.

Read Actuarial Standard of Practice No. 22, Statements of Opinion Based on Asset Adequacy Analysis.

Finally, read Annual Audited Financial Reports and Quarterly Reports.

Canada

To learn about the AA, read Primary Canadian Regulatory Requirements.

Appointed Actuary’s Report (AAR)

Case Scenario 1

You are a Fellow of the Canadian Institute of Actuaries who has the appropriate practical experience to qualify you to perform the duties of an Appointed Actuary (AA). The president of a small Canadian life insurance company has expressed interest in hiring you as the company’s AA, as their current AA is planning for early retirement in a month. The current AA will be out of the country for an extended period of time immediately following retirement. You had indicated to the president that, in your opinion, you are qualified to serve as the AA and would be interested in becoming the AA for the company.

You have just received a letter from the company that the president (and CEO) of the company is appointing you as the new AA, subject to your written acceptance of the offer. Should you accept the offer, you have been asked to return a signed copy of the letter to the company quickly, as the current AA will be retiring soon and the company urgently requires your service.

If you intend to accept the offer, do you sign the letter and return it to the company, thus becoming the new AA?

There are a few things that need to be done before you can sign the letter and be appointed as the new AA. You need to acquire a written statement of the circumstances and reasons of revocation of the previous AA (early retirement in this case). Appointment of an AA should be from a resolution of the board (not from the president or CEO of the company). You should also contact the previous AA and discuss various issues regarding the appointment and the position of the AA within the company. The company must also notify OSFI, in writing, of the new appointment to ensure there are no objections from the superintendent.

Case Scenario 2

You are the Appointed Actuary (AA) for XYZ Company. As you are performing the year-end valuation for the company, the company’s auditors have assured you that there will be extensive verification of data when they perform annual audits right after year-end. Your staff has informed you that there have not been major data issues in the past few, years and the auditors can confirm that. Are you satisfied with the accuracy and completeness of the data in your valuation, knowing that the auditors will perform checks in a short period of time?

According to the AA memo, the AA must ensure that data verification has been performed. This cannot be deferred to work not yet completed by the auditor. Even if the AA could rely on work done by the auditor, the AA still needs to take reasonable care to ensure data is complete and accurate. Ultimately, the responsibility of data verification lies with the AA, who must establish check procedures to ensure the completeness and accuracy of the data used in valuation.

Case Scenario 3

You are a consulting actuary with experience in performing external peer reviews. In April of this year, ABC Company decided to engage your service to complete an external peer review for their year-end work to satisfy the requirements of OSFI Guideline E-15. In May, the AA of ABC Company resigned for personal reasons. To resolve the absence of an AA, the company decided to hire John, a colleague of yours, to perform the duties of an AA for this year-end. In your consulting firm, actuaries work independently on various projects. John will have no involvement in your external peer review, and you won’t be involved in his work as the AA. Can you still be the external peer reviewer for this company?

According to OSFI Guideline E-15, the external peer reviewer should have no relationship with the insurer or with the AA that would in any way impair objectivity. It states that, if the AA is a consultant, another actuary in the same consulting firm may not be a reviewer of that actuary’s work. Therefore, the situation described in this case scenario creates an unacceptable situation. Since you started working on the external peer review in April, John cannot join the firm as a temporary AA in May.

The Examination and Analysis Process

While it is true that regulators rely on insurance companies to accurately report their financial affairs in the annual financial statement and other reports, the regulators also must periodically inspect the books and records of the insurance company to verify the accuracy and completeness of that information. In addition, the purpose of the annual statement is not simply to collect data but to use that data to identify weaknesses within the company that could lead to a hazardous financial situation or to identify areas of noncompliance.

U.S. Requirements

The two primary sections of the insurance departments that are responsible for financial solvency monitoring are the financial examination section and the financial analysis section.

This module will discuss each of these sections in more detail following, but first read more about the examination process.

In the past, insurance departments would perform a substantive financial examination of every domestic insurer on a fixed schedule, usually every three to five years. These examinations were comprehensive, extensive, detailed, focused on the balance sheet and frequently took many months to perform. However, in the early 2000s, the NAIC and the various states adopted a risk-based approach to examinations. Examinations were scheduled based on the perceived risk of the insurer, and examinations could be limited to certain targeted areas. This risk-based approach was expanded in 2004, to include evaluation of risks not previously considered.

Here is a quotation from the NAIC’s June 14, 2004 “Risk-Focused Surveillance Framework”:

“A risk-focused approach is already utilized in the examination process set forth in the NAIC Financial Condition Examiners Handbook (the “Examiners Handbook”). The risk assessment in this Framework offers three significant advantages to the current approach:

1. it provides a clearer methodology for assessing residual risk in each activity under review and explaining how that assessment translates into establishing examination procedures;
2. it allows the assessment of risk management processes other than those that result in financial statement line item verifications including, for example, the board of director’s effectiveness and corporate governance activities, thus providing a prospective look at the operations and quality of the risk management process of an insurer, a benefit not recognized under the current examination process; and
3. it allows utilizing the examination findings to establish, verify or revise the uniform company priority rating system (i.e., CARRMEL) being developed as a part of this Framework. The incorporation of these advantages should enhance the risk-based approach as set forth in the NAIC Examiners Handbook, which states “… a risk-based approach whereby resulting examination fieldwork will emphasize the analysis of an insurer’s current or prospective solvency risk areas and the fair presentation of surplus.”

Canadian Requirements

Similar to the United States, Canada employs a risk-based approach in financial examinations, in which inherent risks and risk management quality are evaluated.

Read OSFI’s Supervisory Framework.

The Purpose of Guaranty Funds

Read about U.S. and Canadian requirements for guaranty funds.

No law, actuarial method or regulatory review can prevent every insolvency. The establishment of guaranty funds is intended to minimize the impact of an insurer insolvency on the policyholders. However, even the guaranty funds will not fully eliminate the impact; large policyholders may receive no reimbursement from the fund, and small policyholders may experience delays in the receipt of their benefits, or limits on the amount received.

Consumer Protections

Purpose of Consumer Protections and Market Regulation

The Interstate Insurance Product Regulation Commission (IIPRC or “Interstate Compact”) was developed by the NAIC as an initiative that benefits state insurance regulators, consumers and the industry by establishing one commission that will serve as the regulator for member states.  Each member state (or “compacting state”) adopts the same product standards which serve to create uniformity throughout the states and within the industry.  Standards are developed by the IIPRC, industry participants and state participants. However, while the Interstate Compact appears to be very promising and offers a multitude of benefits ranging from the promise of uniform standards, one product filing and speed-to-market initiatives, member states may choose to “opt-out” of any uniform standard.  Should states begin exercising this right, the uniformity of the IIPRC will be lost, as will the benefits of filing with one regulatory body like the Interstate Compact. Nonetheless, the efforts of the NAIC in developing the IIPRC, and the participation of the member states, has shown a mutual desire between the industry and the states to improve the current regulatory conditions.

Regulation of Policy Forms, Rates and Minimum Values

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). 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.

Therefore, it is very important that the company 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.

As noted before, the policy form is a contract between the insurance company and the policyholder, and the wording of that contract is very important, both as a consumer protection and a protection against unwarranted claims.

Most states will require the insurer to file with the regulator all the policy forms that will be sold by the insurer in that state. The states vary in their review of these forms; some will review forms only upon the receipt of a complaint, while others will perform a rigorous review of the form before granting approval for the use of that form in their state. Whether or not the review is rigorous, permission to use the form in any particular state, even when labeled “approval,” does not relieve the insurer from its obligation to process, issue and administer all forms in compliance with the law. Approval just means it can be used.

The requirements for and limitations on the policy form also vary from state to state. Various states have found it in the public interest to require certain contract language, limit the type and font of the contract and mandate that the policy meet certain readability standards. All require that the form comply with any statutory minimum nonforfeiture standards. Most states require that the policy pay interest on the policy proceeds. For some states, interest is required only if the claim or settlement is not promptly paid. Many have additional requirements for specific types of policies or riders, such as universal life or accelerated benefits. Many states also have imposed additional restrictions or required disclosures based on the nature of the prospective policyholder. For example, many states require additional information to be collected (by the insurer) or disseminated (to the prospective policyholder) if the policy is intended to be sold to a policyholder who is older than age 65.

Read about the U.S. restrictions and requirements on the policy form language and content.

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. Read to learn more about the Canadian requirements for policy forms.

How would you compare and contrast the regulation of policy forms, rates and minimum values, between the United States and Canada?

The United States generally requires policy forms to be filed with the regulatory body, while Canada does not. Neither generally places material restrictions on rates for life and annuity products. However, the United States requires nonforfeiture values, while Canada does not require any nonforfeiture values.

Nonforfeiture Requirements

Marketplace Influences Versus Strict Regulation

Rates may not be excessive, inadequate or unfairly discriminatory. However, a competitive market can be relied upon to ensure that rates are not excessive, without the need for active regulation, with the exception of credit insurance. The life insurance and annuity market clearly meets the definition of a competitive market. Most of the products are similar, and consumers can easily compare rates among insurers before making a decision. There are many different companies offering products, and it is reasonably easy for companies to enter or leave the market.

Regarding inadequate rates, regulators generally rely on the company’s officers and board to keep rates from being inadequate. In addition, the establishment of minimum reserve standards helps ensure that the policies sold will be honored, irrespective of whether or not the rate itself was adequate—remember, it is the protection of the policyholder, not the protection of the company, that is the regulators’ prime concern. Regarding unfair discrimination, historically there have been few complaints or concerns in this area (and, therefore, little regulatory attention), with the notable exception of the race-based rates charged by many companies up until the 1960s. However, it should be noted that there has recently been increasing regulatory scrutiny of company practices that may be considered “unfairly discriminatory,” including the charging of different rates based on foreign travel patterns, or genetic testing.

Regulation of the Sales and Marketing of Products

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.

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

Read about U.S. and Canadian requirements for the regulation of the sales and marketing of products.

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.

Regulation of Risk Classification and Privacy

Read more about risk classification.