August 2010

Greetings!

This edition of Insurance Perspectives addresses several topics that have received top billing at recent industry meetings. From Deferred Tax Assets and Medical Loss Ratios to RBC formulas, Accounting for Insurance Contracts and Excess Surplus, Invotex professionals present the latest on key topics that are impacting insurers. In addition, we take an updated look at industry leaders who will present at the upcoming Emerging Risks Forum.

As always, we welcome your feedback and invite you to share Insurance Perspectives with your colleagues and business acquaintances. If you do not currently receive our newsletter via e-mail, please subscribe at the left.

Tom Finnell, Jim Stangroom and Les Schott
Managing Directors, Insurance Services

In this Issue

1. Deferred Tax Assets Debate Resurrected
2. As Medical Loss Ratio Debate Nears an End, Insurers Face Daunting Task with Cost Allocations
3. In the Works: a Facelift for RBC
4. Accounting for Insurance Contracts: The Debate over Margins Continues
5. “Excess Surplus” Redux: Is it Bad to Have Too Much of a Good Thing?
6. IFRS a Major Focus at 4th Annual Emerging Risks Forum
7. Upcoming Speaking Engagements

Deferred Tax Assets Debate Resurrected
by Les Schott

At a July 27, 2010 meeting, the NAIC’s Statutory Accounting Principles Working Group – DTA Subgroup resurrected the debate on the admissibility of statutory deferred tax assets (DTAs). The charge of the Subgroup is to provide a recommendation on the appropriate determination for admitted DTAs for reporting periods after 2010. The current direction of the Subgroup is focused on determining the risks associated with DTAs and how those risks should be captured in the RBC formulas. And like the current guidance applicable to 2010 reporting, it appears that those insurers that may be most in need of surplus enhancement in subsequent periods will be the least likely to benefit from eased restrictions on the admissibility of DTAs.

DTAs represent the difference between an insurer’s statutory and tax accounting values that will reverse and then reduce taxes for statutory reporting in the future. The debate over their admissibility dates back to the Statutory Accounting Principles (SAP) Codification Project in the late 1990s, an initiative to develop a comprehensive guide to SAP for use by insurance departments, insurers, auditors and others. As the project got underway, an initial determination was that SAP should continue to nonadmit DTAs consistent with traditional SAP practices that reflected regulators’ concerns that DTAs were not liquid or otherwise readily available to fulfill policyholder obligations.

One goal of the Codification Project was to ensure that financial reporting changes necessary as a result of the development of new standards or from the modification or expansion of existing guidance would, in the aggregate, be surplus neutral to the industry as a whole. However, and as the project wound to a close, an industry survey showed that adoption of the then-proposed Codification would have resulted in a material diminution to the industry’s surplus. Negotiations ensued between the industry and the NAIC’s Codification Working Group, which culminated in an agreement to admit DTAs, but limited to the amount that would reverse within one year and to 10% of the insurer’s surplus. With that change to accomplish the goal of surplus neutrality, and with the wrap-up of other open items, the Codification was adopted effective in 2001.

In November 2008, the life insurance industry through the American Council of Life Insurers (ACLI) requested that the NAIC approve a number of changes that would have provided capital and surplus relief to the industry. Included in the request was a proposal to increase the level of DTAs that could be admitted. Although the proposal ultimately did not pass, a number of states then allowed certain of their insurers to report additional DTAs as a permitted practice for year-end 2008 reporting, a period for which many insurers were under considerable stress from the ongoing credit crisis and recession. Of note is that this was perhaps the first time since the adoption of Codification that there was a spate of permitted practices throughout the industry – the very outcome that Codification had hoped to reign in.

The NAIC further studied this issue during 2009 and ultimately adopted SSAP No. 10R – Revised Income Taxes—A Temporary Replacement of SSAP No. 10. SSAP No. 10R, which provides for increased admissibility of DTAs if specific criteria are met, is only effective for 2009 annual financial statements and 2010 interim and annual financial statements unless subsequent deferred tax asset guidance is adopted before the end of SSAP No. 10R’s effective period. In other words, absent some further guidance from the NAIC, the expanded admissibility of DTAs authorized per SSAP No. 10R would expire beginning with first quarter 2011 financial filings.

The temporary guidance permits insurance companies that exceed a certain risk based capital (RBC) ratio as calculated without the additional admitted DTA to replace the SSAP No. 10 one year realization and 10% of surplus limitation with a more generous three year /15% rule. In other words, the more an insurer needs the additional surplus benefit, the less likely it will be able to obtain it.

In addition, SSAP No. 10R requires that gross DTAs be reduced by a statutory valuation allowance adjustment if, based on the weight of available evidence, it is more likely than not (a likelihood of more than 50 percent) that some portion or all of the gross DTAs will not be realized. The temporary guidance resulted in an increase in admitted DTAs of approximately $14 billion for the life, health and property and casualty industry as of December 31, 2009.

The current direction of the Subgroup is focused on determining the risks associated with DTAs and how those risks should be captured in the RBC formulas. In this regard, the NAIC Capital Adequacy Task Force requested the American Academy of Actuaries to review the risks associated with DTAs in all three of the RBC formulas (Life, Health and P&C). The Academy hopes to have their review completed by mid-September. However, in a preliminary report they noted the following:

• The primary risk to realizing DTAs is the inability to earn sufficient taxable income in the future
• The inability to earn needed taxable income is a function of financial strength of the company
• Little risk exists with regard to the DTA supported by previous taxes paid
• Current SAP recognizes the risks in DTAs to a large extent by capping the amount that can be recognized as an admitted asset
• The SAP limitation operates as an implicit RBC charge

Based on these observations, the Academy has preliminarily suggested that the RBC charge reflect how well capitalized a company is as measured by the RBC ratio exclusive of the impact of DTAs (Ex DTA RBC). The effect of the RBC charge attributable to DTAs would then be included in the formula. Based on recommendations of the Academy, it could range as follows:

• One hundred percent for weakly capitalized insurers, e.g., those with an RBC ratio of 200% or less Ex DTA RBC
• Zero percent (with admissibility limits placed on DTA) to 1% (without admissibility limits) for well capitalized companies, e.g., those with an RBC ratio of 300% or more Ex DTA RBC

In other words, and again, the more an insurer needs the additional surplus benefit, the less likely it will be able to obtain it.

Other issues still to be fleshed out by the Academy include the impact of tax sharing agreements on DTAs, and historical experience regarding DTAs in an acquisition or receivership. The Subgroup will have to grapple with all these issues in coming to a decision as to whether to extend, sunset, or amend the guidance contained in SSAP No. 10R with respect to SAP reporting after 2010.

For more information, contact Les Schott.

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As Medical Loss Ratio Debate Nears an End, Insurers Face Daunting Task with Cost Allocations
by Tim Foley and Barry Lupus

Over the past several months, insurance industry executives, lobbyists and regulators alike have been immersed in the legal, financial and regulatory aspects and implications of a single key metric wrought by health care reform: Medical Loss Ratio, or “MLR.” In the May edition of Insurance Perspectives, we discussed the basic concepts of MLRs and their foundation in the Patient Protection and Affordable Care Act (PPACA), as well as some of the related key issues and implications to the industry.

As the industry and its regulators look ahead to the upcoming NAIC National Meeting in Seattle later this month, it appears that efforts are drawing to a close to develop uniform definitions and standardized methodologies as to what costs would be included or excluded from insurers’ MLR calculations as well as how insurers should report the results in their Annual Statements. But the real dirty work for many insurers still lies ahead: using the new guidance to amend a host of very detailed cost allocations, the basis for which many costs are recorded amongst legal entities and lines of business within an insurer’s holding company structure.

Over a period of years, the manner in which costs have been recorded by health insurers has been influenced by a number of factors. A key factor has been guidance issued by the NAIC pertaining to statutory accounting. For example, cost containment expenses are defined in SSAP 85, Claims Adjustment Expenses, as “expenses that actually serve to reduce the number of health services provided or the cost of such services.” SSAP 85 cites examples of such expenses to include case management activities, utilization review and consumer education solely relating to health improvement and relying on the direct involvement of health personnel, among others.

Another key factor in the recording of costs by health insurers has been the manner in which costs are allocated among legal entities within a holding company structure. The larger health insurers have a number of legal entities within their holding company structure, an outcome of growth by acquisition as well as regulatory requirements in the various states. Moreover, efforts to achieve efficiencies through integration has often resulted in one or more particular cost centers being housed in a single entity within a holding company structure while still benefiting other subsidiaries and affiliates. As the benefits of such integrated service platforms were recognized across legal entities within the holding company structure, the need also arose to fairly distribute the related costs. Cost allocations became necessary.

Cost allocations are not only made among legal entities within a holding company structure but also among the various lines of business underwritten by an individual insurer. For health insurers, this may entail allocations between large group or administrative services only (ASO) business, small to mid-size underwritten groups, and individual business. It likely may also involve allocations to key federal or state government programs such as Medicare and Medicaid as determined pursuant to detailed rules and subjected to audit and adjustments by government agencies.

Cost allocations for many organizations also involve an additional dimension pertaining to function. Functional cost studies inform the cost allocation process and also provide critical insights to actuaries and others involved with product development and pricing.

As a result of such factors, cost allocations by health insurers have been developed over a long period of time, are subjected to tomes of seemingly arcane accounting and contractual guidance, are critical to the insurer’s ability to understand the profitability of contracts and to make sound pricing decisions, and are, therefore, the subject of much scrutiny on a periodic basis by the insurer, insurance regulators and internal and third-party auditors. Moreover, all of this was in place prior to the existence of the PPACA.

The new health care reform law now threatens to make cost allocations even more complex. Section 2718 of the PPACA provides that medical care expenses include not only clinical services but also activities that improve health care quality, a seemingly understandable concept but one that has nonetheless required a Herculean effort on the part of state insurance regulators and the industry over the past several months to provide detailed guidance. Furthermore, the conceptual definition of medical care expenses in the PPACA differs from SSAP 85. Even if SSAP 85 is amended to be consistent with the PPACA definition, the mechanics embedded within many detailed cost allocations used by the insurer would have to change.

For example, consider an insurance holding company structure where the information technology (IT) function is housed in a downstream non-insurance subsidiary; the related IT costs are then allocated to various legal insurance company entities within that structure pursuant to long-tested allocation methodologies as well as approved intercompany agreements. Some of those costs may pertain to call center support services used by administrative staff to address billing questions with subscribers as well as by medical staff to follow up with subscriber/dependent patients with regard to treatment regimens. The former would be an administrative cost and, therefore, excluded from the new MLR, whereas the latter may comprise a qualifying cost relating to a service designed to increase the likelihood of desired health outcomes and that would then be includable in the insurer’s MLR calculation.

The PPACA has, therefore, introduced the need for insurers to distinguish between certain costs in a manner that heretofore has not been necessary. Although the NAIC working group’s efforts may be nearing completion on its guidance for the industry regarding MLRs, many insurers may be challenged to perform on a timely basis the detailed analyses and make the necessary changes to cost allocation methodologies and calculations. For them, the very tedious but critical detail work still lies ahead.

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In the Works: a Facelift for RBC
by Tom Finnell

For those of us who have been around the industry and its regulatory circles for many years, it is hard to believe that it has been almost 20 years since the need for risk-based capital was debated and the detailed requirements hammered out in crowded hotel meeting rooms across the country. Since then, most have moved on to other topics and battles to fight, comforted in the knowledge that the NAIC and the actuarial profession would somehow keep up with the nitty gritty detail work involved in maintaining the RBC formulas and factors over time. Now, however, it is apparent that RBC is in need of something more than just “ongoing maintenance.” The long-term implications for insurers of the changes that may result from a more substantive RBC facelift could be significant.

In June, Arizona Insurance Director and Chair of the NAIC’s Solvency Modernization Task Force Christina Urias wrote to the Capital Adequacy Task Force (CATF) stating that “it is time for a holistic evaluation of the RBC formulas, factors, and methodology.” While the need for such an evaluation may not be linked directly to any single factor, it is apparent that considerations included advances in the body of knowledge about capital requirements by the International Association of Insurance Supervisors; developments in Europe with respect to Solvency II; as well as lingering concerns in the U.S. that the NAIC’s RBC formula omits coverage for certain significant risks.

Last month, a subgroup of the CATF met at the NAIC’s offices in Washington, DC, to discuss ways to proceed with the review. Also present in the group of 60-70 were members of an American Academy of Actuaries task force and various insurer and trade group representatives, among others. While no decisions were made, the group did endeavor to gather some consensus around major points. In doing so, the discussion shed some light on some of the key issues and potential implications, which included the following:

• Recognition that comprehensive company-specific capital models won’t replace a standardized RBC model for years to come.
• A general desire to continue with separate formulas for life, health and P&C but with similarity among them where appropriate.
• Calibration of RBC to a particular level of safety – e.g., a specific confidence level, value at risk, tail value at risk, etc. – would be considered; nonetheless, the group acknowledged that inherent difficulties exist in trying to calibrate the RBC formula to a high degree of precision.
• Improvement in the covariance calculations to recognize that some risks may be partially dependent/independent.
• A desire to continue to move forward with refinements to the RBC formula that are already in process, including the addition of catastrophe risk coverage for the P&C RBC formula and the impact of health reform in health RBC.
• Add coverage for other risks to the RBC formula, e.g., operational risk.
• The potential for RBC application to specialty lines such as mortgage guaranty and title companies.

The foregoing is a brief snapshot of just some of the issues that the CATF’s subgroup will apparently address as it begins to develop its plans and timetable. The review may also be impacted by the outcome of other issues, for example, the possible impact on statutory accounting that might result from adoption in the U.S. of International Financial Reporting Standards. Moreover, it is clear that from the standpoint of industry representatives present at the meeting in Washington, DC, that the more substantive or even radical the proposed changes become that past experience and current evidence support the need for those changes.

Based on the experience gained in the development of the initial RBC formula nearly 20 years ago and the fact that many aspects of the industry have only become more complex since then, our view is that the review and adoption of substantive changes to the RBC formulas will take years to complete and will be the subject of much debate along the way.

For more information, contact Tom Finnell.

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Accounting for Insurance Contracts: The Debate over Margins Continues
by Jim Stangroom and Tim Foley

The IASB’s July 30, 2010 release of the long-awaited exposure draft of the IFRS on Insurance Contracts essentially confirms that significant accounting changes are on the horizon for the insurance industry. At the same time, the FASB remains at odds with the IASB on at least one core component of the proposed standard — the idea of separately calculating and reporting risk adjustment and residual margins. The FASB’s response is anticipated later this year and will be critical in determining the cost-benefit of quantifying and separately reporting the amount of risk remaining within a block of insurance contracts and, to a significant degree, the future of insurance accounting.

The IASB’s “building block” approach to the valuation of insurance contracts was first outlined by the IASB in a 2007 discussion paper. The building block approach is based on a discounted cash flow valuation methodology that incorporates separately calculated margins for risk (risk adjustment margin) and profit (residual margin).

The FASB has been working with the IASB on insurance contracts since 2008 as part of its convergence efforts. And while the FASB supports the use of a discounted cash flow model that incorporates a risk and profit margin, it does not agree with the notion that those would be calculated separately; rather, the FASB supports the concept of a single “composite margin.”

The debate over the merits of the FASB’s single composite margin approach relative to the IASB’s two-margin approach will continue as the FASB proceeds with its own project of developing standards of accounting for insurance contracts. The theoretical precision garnered by the two-margin approach will likely be countered with arguments surrounding practical implementation considerations, including cost.

On the surface, it sounds as if the FASB and the IASB are in relative agreement with only minor conflict over presentation and semantics. However, a deeper look into the reasoning behind the development of these alternative approaches reveals a more fundamental conflict over the level of detail required by investors and regulators and over how profit should emerge over the life of an insurance contract.

In simplest terms, a risk adjustment margin is an amount representing an adjustment to the estimated discounted cash flows of an insurance contract for the effects of uncertainty about the amount and timing of those cash flows. The residual margin is an amount representing the estimated future profitability of an insurance contract. While these concepts may be easily understood, the calculations involve complex actuarial and statistical techniques such as confidence levels, conditional tail factor expectations, cost of capital techniques, and emergence of earnings.

At the inception of a contract, both the FASB and IASB models would usually produce the same result. However, at subsequent reporting periods, the pattern of earnings would begin to diverge. While the FASB composite margin would amortize to earnings over the coverage and claims handling period, only the IASB residual margin would amortize in a similar fashion. The IASB risk adjustment margin would be revalued at each reporting date, adjusted upward or downward based on the most current information available.

The measurement of separate risk and residual margins is much more likely to result in the recognition of a loss at the inception of a contract relative to the composite margin approach. Using an example outlined in the IASB’s basis for conclusions publication, consider a policy with probability-weighted discounted cash inflows of $1,000 and cash outflows of $900. Under the FASB model, the composite margin would be set at $100, with no gain or loss recognized at inception. However, under the IASB model, there is the possibility that the calculated risk adjustment margin could exceed the amount of the net probability-weighted present value of the cash inflows and outflows, calculated for example as $130. In that scenario, the IASB would require the recognition of a loss of $30 at inception, with the $130 risk adjustment recalculated at each reporting period and released “systematically” over time.

Another key difference is the accretion of interest on the margins. The FASB model would not accrete interest on the composite margin, in part to reduce complexity. The FASB also views the margin as a deferred credit, rather than a liability that would typically be subject to accrued interest. The IASB model would require the accretion of interest for consistency with the discounted cash flow portion of the liability measurement.

In our view, the debate over the merits of the composite margin relative to the two-margin approach will continue as the FASB develops its response to the IASB exposure draft. The FASB project plan calls for it to issue a discussion paper during the third quarter of 2010. It is anticipated that the FASB’s discussion paper will compare the IASB’s proposed model, the FASB’s tentative decisions reached to date and current U.S. GAAP.

For more information, contact Tim Foley or Jim Stangroom.

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“Excess Surplus” Redux: Is it Bad to Have Too Much of a Good Thing?
by Tom Finnell and Les Schott

If you happen to be a non-profit BlueCross BlueShield plan, some would say, “Yes.” That is the conclusion of ConsumersUnion, which recently issued its report studying the surplus levels of 10 such plans. The report observed that those 10 plans held surplus levels at year-end 2009, on average, of eight and a half times the regulatory minimum requirements. This news emerges against a backdrop of continuing press coverage about health insurers’ rate levels and about the implementation of health care reforms. One of those reforms involves the application of mandated minimum loss ratios (MLR), a tactical measure that may wreak havoc on the surplus contingency plans of some health insurers.

An insurer’s surplus stands as a line of defense against unanticipated or prospective risks as well as to absorb adverse fluctuations from reserving and other estimates in the financial reporting process. If a health insurer were to experience suppressed surplus levels as a result of such occurrences, it would presumably strive to rebuild its surplus to targeted levels over a reasonable period of time. For nonprofit health insurers that lack access to the capital markets, rate increases may provide the only practical solution to rebuilding surplus.

Section 2718 of the Public Health Service Act provides, effective in 2011, that health insurers rebate funds to subscribers to the extent that their Minimum Loss Ratio (MLR) for a plan year is below 85% for large group business or 80% for individual and small group business. Thus, rate increases going forward may be tempered as compared to the insurer’s perceived financial needs.

The irony is that while public policy has come down on the side of controls over rate levels through the application of MLRs and other requirements, it is those very restrictions that cast more uncertainty on the ability of insurers to replenish surplus, should the need arise, over a reasonable time frame. In effect, they introduce a new dimension to the insurer’s pricing risk which would then be considered with other risks in the determination of an insurer’s target surplus levels.

For more information about the excess surplus issue see our article that incorporates insight from the surplus analysis by Invotex on behalf of the Maryland Insurance Administration with respect to the two non-profit health service plans of the CareFirst BlueCross BlueShield group.

For more information, contact Tom Finnell or Les Schott.

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IFRS a Major Focus at 4th Annual Emerging Risks Forum

Issues surrounding IFRS will play a major role at the 4th Annual Emerging Risks and Insurance Management Forum to be held September 22-23, 2010 at the Kimmel Center in downtown Philadelphia. Featured speakers include:

• Julie Erhardt, Deputy Chief Accountant for the SEC
• Jay Muska, Second Vice President, Accounting Policy and Finance of the Travelers Companies
• George Brady, International Counsel for the NAIC
• Pat Coyne, Second Vice President, MassMutual Financial Group
• Jim Stangroom, Managing Director, Invotex Group

Collectively, they will address the issues behind the efforts to converge U.S. accounting standards with IFRS; the fundamental changes facing the industry; their experiences to date in grappling with these reforms and their perspectives on longer term business implications and practices; and emerging practices and ways forward for companies to consider in preparing for and implementing necessary changes.

This year’s Forum will focus on the very significant and profound changes facing insurers as they emerge from the crisis. These include the need to implement healthcare and financial regulatory reforms, the pressures to conform to international regulatory and solvency standards, and the challenges posed by preparing for an entirely new accounting model – International Financial Reporting Standards.

The Forum is designed for insurance company executives and staff in the areas of finance and accounting, risk management and internal audit, as well as insurance regulators and their staffs. It is also relevant for insurance company directors who may benefit from perspectives on emerging risks facing the industry. The Forum is again being sponsored by Invotex Group and Interactive Solutions LLC.

Please mark your calendars for September 22-23, 2010. For more information and to register, visit the conference website at http://www.rmconference.com.

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Upcoming Speaking Engagements

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