2016 Year End Regulatory Update

AAM continues to monitor important regulatory changes affecting the insurance industry. Below we summarize recent developments on policies currently facing significant changes:

NAIC RBC Changes

The NAIC had their latest meeting in December and discussed the status of their plan to increase the number of ratings categories for bonds for RBC calculation purposes. Here are some highlights:

  • After many months of discussion, there does now appear to be a consensus that the granularity of Life bond RBC factors will increase, in the form of an electronic-only column added to Schedule D
  • The specific factors to be used are still subject to revision, but are likely to be broadly in line with those proposed by the American Academy of Actuaries
  • It is likely (though still not finalized) that the increased granularity will also be applied to P&C and Health insurers, though they may have somewhat different factors
  • Beyond the change in factors, the second step in determining bond RBC involves an adjustment based on the number of bonds/issuers in the portfolio. The details of this second step are also being reviewed, and are likely to be changed from the current form to more accurately reflect the impact of diversification on risk of credit losses
  • The NAIC is still targeting year-end 2017 to implement the changes, though some in the industry view this as ambitious
  • The ACLI proposed a materially different (mostly lower) set of expanded factors based on a study they did of historical default and recovery rates, including a recommendation to provide different factors for different bond types (e.g. corporate, muni, etc). This will be reviewed and discussed in future meetings

AM Best BCAR

In November AM Best released their intended adjustments to the BCAR formula for P&C companies. These were largely in line with those described for Life companies earlier in the year (using factors based on DFA modeling, reporting 5 BCAR scores based on confidence intervals instead of a single one, removing the suggested guidance for BCAR vs rating, etc). They intend to collect comments on this release over the winter, make any additional needed adjustments over the summer, and start implementing the new system in late 2017. The bottom line continues to be that in general they do not expect this new process to change existing ratings, though rare exceptions may exist. One notable investment-related feature of the new system is that bond ratings will now be based on a mix of rating and maturity bucket instead of rating alone, though we continue to believe that the most important BCAR contribution of an investment portfolio is through losses of surplus (if any), not the direct impact of the factors themselves.

Tax Reform

It is fairly likely that a federal tax reform bill will be passed in 2017. The single likeliest feature of such a bill is a reduction in corporate rates, and elimination of the AMT is also a possibility. This has already caused some volatility in the muni market, and will likely cause more in the future. We do not recommend accelerating realization of gains/losses as mechanisms exist to carry gains back to previous years anyway, even if 2017’s tax rates decline. We expect to learn more about the shape of this proposal shortly and will provide commentary at that time.

Schedule D Treatment of ETFs

In past NAIC meetings there was debate about the possibility of breaking ETF holdings out into a separate schedule in financial statements, with a field designating the underlying security type. This was resisted as insurers prefer to be able to keep reporting approved bond ETF’s in Schedule D. As a compromise, the current proposal is to show bond ETF’s as a separate bond subgroup on Schedule D. Relatedly, there has been debate about what book value should be for such ETF’s. Both historical cost and market value are viewed as inappropriate. The prevailing proposal is to use a measure called “systematic value”, which may entail somewhat complex calculations. Blackrock has released a paper offering a suggested form of this calculation, but it is possible that the standard could ultimately vary somewhat from state to state. This project is ongoing but could ultimately see adoption in 2017 or 2018.

Somewhat relatedly, a proposal has been made to institute an abbreviated and electronic-only collection of holdings data at mid-year (currently holdings data is only collected at year-end, with trades reported quarterly). This also appears to be acceptable to the industry and likely to be implemented within a year or two. In AAM’s view this will be very helpful for providing up-to-date industry and peer analytics.

Principles-Based Reserving

Although AAM is primarily focused on regulations with direct investment implications, this one is worth noting here given how significant and long-awaited it’s been. Briefly, this is a regulatory change going into effect in 2017 that will allow life insurers broader discretion in how they calculate reserves for life lines (over time the new rules will be extended to cover other lines), in contrast to the current formulaic approach. Among the various goals of the change is to remove the incentives for complex life reinsurance (“XXX/AXXX”) transactions, which were undertaken due to previous formulaic reserving requirements being viewed as punitive by insurers, but also tended to make the industry more opaque and challenging to regulate. Additionally, the greater flexibility of the new rules should make it easier to accommodate new product designs without needing to constantly alter state laws. This change is probably most material for very large life insurers, but over time will likely impact virtually the entire industry.

Solvency II

This is the recently-implemented European insurer risk-based capital regulation, somewhat comparable to NAIC RBC in the US. While we mainly focus on domestic regulation, we mention this here because the Federal Insurance Office announced in September that the US does not intend to modify our own regulation to be able to apply for Solvency II “equivalence” (which, for example, Bermuda has done), putting speculation to rest on this issue. While US and EU insurance regulation may still converge over time, this will only be to the extent that regulators in each country view it as best for their own domestic jurisdiction. That said, in January the US and EU reached an accord on several key areas of insurance regulation, including ending “local presence” requirements for insurers operating outside their home country, and a reduction in collateral requirements for reinsurers conducting cross-border transactions.

 

Written by:
PeterAWirtala
Peter Wirtala, CFA
Insurance Strategist

 

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