INTRODUCTION

On December 12, 2013, the Federal Insurance Office (FIO) of the U.S. Department of the Treasury released its much anticipated study, How to Modernize and Improve the System of Insurance Regulation in the United States (Report).  The Report, long overdue, was required by Title V of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) and represents the most recent comprehensive statement by a federal authority on the state of insurance regulation in the United States. While the Report reflects extensive study and analysis of the broader issue of the appropriate regulatory framework for insurance, it also reviews some narrower regulatory issues that are current topics of discussion.  FIO’s own in-depth research was augmented by comments received from nearly 150 public and private entities that responded to a request for comment in 2011, and it shows a strong grasp of initiatives taken by the National Association of Insurance Commissioners (NAIC) to improve the state-based system.

The Report does not recommend direct federal regulation of insurance, but does recommend significantly greater federal involvement in a number of areas.  Rather than framing the issues as whether federal or state regulation of insurance is “better,” the Report frames the issues as “whether there are areas in which federal involvement in regulation under the state-based system is warranted.”  

The Report operates from a baseline premise that the state-based system of regulation results in a lack of uniformity that creates inefficiencies and burdens for consumers and insurers alike, and places the U.S. at a disadvantage internationally.  “The need for uniformity …  compel[s] the conclusion that federal involvement of some kind in insurance regulation is necessary.  Regulation at the federal level would improve uniformity, efficiency, and consistency, and it would address concerns with uniform supervision of insurance firms with national and global activities.”

Thoughtful reactions to the Report are still being formulated.  It remains to be seen what effect the Report will have on insurance regulatory policy in the years ahead.  The Dodd-Frank Act mandated only this report, but FIO has an ongoing charge to “monitor all aspects of the insurance industry, including identifying issues or gaps in the regulation of insurers that could contribute to a systemic crisis in the insurance industry or the United States financial system,” and the Report itself hints that there may be successive reports that call for additional measures – perhaps more stridently – if the shortcomings identified in the Report persist.  Indeed, this point is reinforced in the Report’s concluding remarks when it says, “FIO will monitor state regulatory developments, including those called for in this Report, and will present options for federal involvement as such options become necessary.”  (emphasis added)   At a minimum, this puts pressure on states to discuss the Report’s recommendations at the NAIC – at least in those areas within the NAIC’s ability to influence or control.  While creating such pressure is clearly the intention, the Report nonetheless expresses some skepticism that the states can accomplish meaningful change on their own: 

[M]any of the areas for which FIO recommends that there be reform of the state regulatory system relate to subject matter areas in which the states already have been working to make changes.  For a variety of reasons, however, progress has been uneven despite the absence of any dispute about the need for change. As a result, should the states fail to accomplish necessary modernization reforms in the near term, Congress should strongly consider direct federal involvement. 

Some members of Congress may interpret this statement as an invitation to consider the Report’s recommendations without waiting for the states to act.   

OVERVIEW OF THE REPORT

This Legal Alert provides a general overview of the Report.  The Report’s recommendations are divided into two sections: one addressing prudential oversight; and one addressing marketplace oversight and consumer protection.¹ 

STRUCTURE OF THE REPORT

The Report sets out its recommendations in two different categories: (i) areas of near-term reform for the states; and (ii) areas for direct federal involvement in insurance regulation.  The Report identifies 18 distinct recommendations for near-term reform for the states that could become priorities at the NAIC, and individual states, for 2014 and beyond. 

The proposed areas for direct federal involvement in insurance regulation include, but are not limited to:

(1) a covered agreement for reinsurance collateral based on the NAIC models;
(2) FIO involvement in supervisory colleges to monitor financial stability and identify issues or gaps in the regulation of insurers;
(3) adoption by Congress of the National Association of Registered Agents and Brokers Reform Act of 2013 (NARAB II) and monitoring of its implementation by FIO;
(4) FIO reporting on the use of personal information for insurance pricing and coverage; and
(5) FIO monitoring of state progress on the Dodd-Frank Act nonadmitted/surplus lines provisions.  

RECOMMENDATIONS ON PRUDENTIAL OVERSIGHT

OVERVIEW OF THE SOLVENCY FRAMEWORK 

Introducing the analysis underlying its recommendations regarding prudential oversight issues, the Report summarizes the framework by which insurers are evaluated and regulated for solvency, with a focus on how FIO has participated in developments on an international level, particularly with regard to the International Association of Insurance Supervisors (IAIS) and the European Union (EU).  The Report states that “[c]urrently, domestic and international regulatory discussions around solvency regulation are primarily focused on prudential standards, enterprise risk management, and group (i.e., consolidated) supervision.”  The Report goes on to describe the activities of the IAIS, including its work on the Common Framework for the Supervision of Internationally Active Insurance Groups (ComFrame); the instructions to the IAIS from the Financial Stability Board (FSB) relating to enhanced prudential measures for Global Systemically Important Insurers (G-SIIs); and the final adoption by the EU of a new solvency framework known as Solvency II.  The Report also acknowledges the efforts of U.S. state regulators under the NAIC’s Solvency Modernization Initiative (SMI), which the NAIC describes as a critical self-examination designed to update the states’ approach to solvency oversight.  These efforts include adoption of the Risk Management and Own Risk and Solvency Assessment (ORSA) Model Act and amendments to the NAIC Insurance Holding Company System Regulatory Model Act.

Setting forth its own priorities, the Report notes that FIO is currently focusing on:  (1) developing and field testing ComFrame so that it serves supervisors’ interests and reflects the realities of insurance industry practices; (2) refining a methodology and process to identify G-SIIs; (3) establishing enhanced supervisory measures to be applied to a G-SII, including cross-border resolution practices; and (4) enhancing insurance group supervision in light of recent FSB recommendations. With regard to the FSB mandates to the IAIS regarding global uniform capital requirements for insurers, the Report states that “[d]evelopment of international insurance capital standards remains a daunting and unprecedented challenge.  Nevertheless, driven by the fast-paced internationalization of insurance markets, IAIS members appear committed to achieving the stated objectives.”

Europe’s Insurance Regulatory Regime – Solvency II

The Report also includes a specific overview of Solvency II, which is now scheduled to be implemented in the EU in 2016.  According to the Report, Solvency II establishes a risk-based approach to insurer capital requirements that relies on three pillars, modeled after the three-pillared Basel II framework for banks.  These pillars include:  (1) substantive and quantitative risk-based capital requirements; (2) a system of governance; and (3) market discipline through disclosures to supervisors and the public.  Solvency II would also establish a single group supervisor and consolidated capital requirements for insurance groups, and would require adherence to risk-based capital requirements at both the individual regulated entity and group levels. 

The Report notes that Solvency II as originally formulated would have provided for unilateral assessments of insurance regulation in other jurisdictions for so-called “equivalence,” and insurers in non-equivalent jurisdictions would have been required to “ring-fence” European assets from non-European assets.  Under the EU-U.S. Insurance Project, however, the EU and the United States committed to a collaborative work plan aimed at increasing the convergence and compatibility of the two insurance regulatory regimes.  The Solvency II overview presented by the Report culminates in a warning that “[g]iven the national importance of the agreed-upon objectives of this project, failure of the U.S. state regulatory system to pursue adoption of these objectives could warrant greater federal involvement.”

CAPITAL STANDARDS

Solvency Oversight:  FIO Calls for State Regulation But with Enhanced Uniformity and Rigor

As noted above, the primary thrust of the FIO Report is to recommend ways to achieve uniform regulatory requirements throughout the United States by utilizing state regulatory mechanisms where they can be coordinated effectively, and recommending federal action where the desired result cannot readily be achieved through coordinated state action.  This approach is reflected in FIO’s discussion of capital standards and “solvency oversight” in the insurance industry.  The Report notes that the NAIC’s Financial Regulation Standards Accreditation Program has been useful in enhancing “generally consistent solvency oversight approaches” across jurisdictions, but concludes that there are still too many areas of non-uniformity.

The first area of concern is that even though all states have adopted Risk-Based Capital (RBC) standards, these standards are not applied to all insurers (e.g., fraternals, monolines) and, when applied, are not applied uniformly because of discretionary decisions and approaches applied ad hoc by individual states, including permitted deviations from standard accounting practices and the ways in which reinsurance captives may be used.  Thus, the Report concludes that “the regulatory system has not resulted in consistent implementation of solvency oversight, notwithstanding coordination efforts through the NAIC, because regulators have interpreted and enforced even similar standards differently.” 

The Report makes two remedial recommendations.  First, if the principal state regulator of a company is inclined to allow a deviation involving an important insolvency oversight matter, it should be required to obtain the consent of regulators from other states in which the insurer operates.  This would assure the concurrence of multiple state regulators as to any significant permitted deviation.  Second, the effectiveness of the NAIC’s Financial Regulation Standards Accreditation Program should be bolstered by a layer of independent third-party review.  According to the Report, “an additional independent review and audit layer would provide a helpful perspective on the uniform adoption and implementation of capital rules and. . . help maintain the incentive for accreditation reviews to be conducted with appropriate and objective rigor.”  The Report gives no recommendation concerning how this independent layer of review would be structured.

Finally, the Report discusses potential deficiencies in RBC methodology as it has evolved to date and notes that state regulators are taking steps to address these weaknesses.  The Report also notes the nascent development of annual risk self-assessment procedures (ORSA) whereby insurers conduct stress testing and reviews of their risk management systems and report the results to state regulators.  As currently contemplated, such self-assessments would cover both each insurance entity and any consolidated group involved in the business of insurance.  While seemingly supportive of ORSA, the Report questions “whether state regulators possess sufficient resources with the prerequisite technical skills and experience to review the complex insurer self-assessments of risk and capital adequacy.”  If regulators cannot amass adequate resources in-house and thus move to the use of third-party contractors, the Report states that there should be uniform national qualification standards for these contractors and clear principles assuring that state regulators “adequately understand, and are accountable for, the work and findings of such contracted specialists.”

Mortgage Insurance:  A Special Case for Federal Regulation

With respect to mortgage insurance, the Report finds an exceptional degree of inconsistency in state rules and oversight.  The Report concludes that mortgage insurance is of such national systemic importance that it should be committed to federal regulation.  “The private mortgage insurance sector is interconnected with other aspects of the federal housing finance system and, therefore, is an issue of significant national interest.  . . .  Robust national solvency and business practice standards, with uniform implementation, for mortgage insurers would help foster greater confidence in the solvency and performance of housing finance.  To achieve this objective, it is necessary to establish federal oversight of federally developed standards applicable to mortgage insurance.”

Life Reinsurance Captives:  FIO Calls for Uniformity and Transparency

The Report draws FIO into the current controversy surrounding the increasing use of life reinsurance captives as vehicles for insurers to transfer risk to an affiliated entity thereby reducing reserve obligations and freeing up capital.  The Report notes that insurers receive credit for reinsurance ceded to insurance captives even though the regulation of such captives is not consistent across states, is subject to lower levels of disclosure, and involves reinsurance capital requirements far less strict, in both quantum and quality, than would be required of reinsurers with commercial insurance licenses.

The Report calls for uniformity and transparency.  “[S]tates should develop and adopt a uniform and robust standard for transparency, not only of the liabilities transferred to a reinsurance captive, but also of the nature of the assets that support a reinsurance captive’s financial status.”  The Report also recommends a uniform capital requirement for reinsurance captives.  Further the Report recommends adoption of nationwide standards as a part of the Financial Regulation Standards Accreditation Program.

RESERVING

The Report gives only a lukewarm assessment of the decade-long effort to replace formula-based reserving (based on the NAIC Model Standard Valuation Law (SVL)) in the life insurance industry with principles-based reserving (PBR).  The Report notes that the process to date has been very difficult, and that there has been much controversy over whether major problems will, or can be, solved in the near term.  The Report notes that convening an NAIC working group to tackle these issues amid continuing concerns about the efficiency of the working group process itself and some outright opposition to PBR could result in “an initiative that could lead to further weakening of the state solvency oversight regime.”  Given the complications, the Report’s recommendation is cautionary:

States should move forward with substantial caution to implement PBR.  State regulators require significant additional technical expertise or resources to properly evaluate the rigor and quality of idiosyncratic reserve models that vary among firms within a heterogeneous insurance industry.  Therefore, states should also adopt standards for the oversight of the vendors who will provide related consulting services to the states.

CREDIT FOR REINSURANCE:  TREASURY AND USTR TO PURSUE “COVERED AGREEMENTS”

Based upon its assessment of the current state regulatory regime affecting reinsurance and the appropriate credit therefor, FIO recommends that the Treasury (acting through FIO) and the United States Trade Representative (USTR), pursuant to the authority granted under the Dodd-Frank Act, negotiate and enter into appropriate “covered agreements” to provide greater uniformity in the treatment of reinsurers.  Under the Dodd-Frank Act, “covered agreements” are bilateral or multilateral agreements regarding prudential measures with respect to the business of insurance between the U.S. and one or more foreign governments/authorities/regulators that achieve a level of protection for insurance or reinsurance consumers that is substantially equivalent to the level of protection achieved under state insurance or reinsurance regulation.²

The Report summarizes the current status of state regulation of reinsurance, noting that state regulators do not have direct oversight over non-U.S. reinsurers, but instead regulate reinsurance indirectly through regulation of the domestic ceding companies.  In particular, non-U.S. insurers typically must post qualifying collateral to back the reinsured obligation “regardless of the financial strength of the foreign reinsurer or the strength of the supervisory regime in the reinsurer’s home jurisdiction.”  Given that foreign reinsurers account for at least 58% of reinsurance premium volume ceded by U.S.-based insurers, FIO believes that the need to address this issue is significant.

The Report further summarizes the current NAIC Credit for Reinsurance Model Law and Regulation (Model Collateral Law), noting with favor its provisions that allow state regulators to certify unauthorized (e.g., non-U.S.) reinsurers for reduced collateral regulatory standards.  Despite that advantage of the Model Collateral Law, FIO notes several shortcomings of the current system, including that not all states may adopt it, that differing state versions could result in a lack of practical uniformity, and that a determination by one state does not bind other states.  In addition, FIO criticized the Model Collateral Law’s heavy reliance on credit rating agencies to determine a reinsurer’s creditworthiness, preferring instead “more risk-based empirical factors” and “[s]ound credit risk management practices by ceding insurers.”

Consequently, FIO said that the harmonization of reinsurance credit/collateral requirements is a crucial matter that is best addressed at a national level.  Citing the specific authority provided under the Dodd-Frank Act and noting that FIO “is well-positioned to make determinations regarding whether a foreign jurisdiction has sufficiently effective regulation,” FIO recommends that Treasury and the USTR pursue covered agreements based upon the provisions of the Model Collateral Law in order to “afford nationally uniform treatment of reinsurers.”

CORPORATE GOVERNANCE:  ENHANCED DIRECTOR AND OFFICER SUITABILITY AND FITNESS REQUIREMENTS

The Report suggests that states should develop corporate governance principles that impose character and fitness expectations on directors and officers appropriate to the size and complexity of the insurer.  Particularly, the Report cites to the 2009-2010 Financial Sector Assessment Program (FSAP) of the United States conducted by the International Monetary Fund (IMF) which found that there are “no NAIC model laws or regulations that address corporate governance directly.” 

While that may currently be the case, the NAIC responded to the FSAP assessment by creating a working group tasked with reviewing corporate governance requirements for U.S.-based insurers and making recommendations for enhancing regulation and oversight of governance practices.  Since 2013, the working group has been working, with active industry participation, to develop a model law that would require licensed insurers to file an annual report describing their corporate governance practices, and significant developments are expected in the near term.³  In fact, at the NAIC’s Fall National Meeting in December 2013, the chair of the working group opened the group’s meeting by noting that corporate governance was mentioned a number of times in the Report and that it appears that the working group is on the right track to address FIO’s concerns and that the Report contained a number of good recommendations that the working group will consider.  The working group’s goal is to have the corporate governance model law effective in 2016.  Nevertheless, the Report contemplates that states should develop substantive standards scaled to the size and complexity of the insurance enterprise to ensure that individuals nominated to serve in leadership have sufficient capacity to understand and challenge the insurer’s enterprise risk management, and suggests that developing mere disclosure standards of insurer governance practices, as currently contemplated by the working group’s draft, is insufficient.  This may, therefore, become an area of increasing tension among state and federal regulators and industry participants.

GROUP SUPERVISION:  FIO INDICATES SOME SUPPORT FOR SUPERVISORY COLLEGES

The Report identifies the traditional “solo entity” approach to regulation as a shortcoming of the current state-based system.  The absence of state regulatory authority over holding companies and only indirect authority over non-insurance entities within an insurance group is identified by FIO as potentially undermining the acceptance of U.S. insurance groups in the international arena due to fears that solvency and other issues are not being properly addressed on an enterprise-wide basis and also allowing potentially avoidable failures.  The Report then engages in some “Monday-morning quarterbacking” when it reports instances (without citing to precedent) where a “consolidated group supervisor with knowledge of an insurer’s enterprise risk management and intra-company transactions, together with the appropriate authority, could have been in a position to improve the supervision of the failed firms to help assure the safety and soundness of those firms.”

The Report also notes that “[t]he limits on state regulatory authority hamper effective regulation at a time when insurers are increasingly part of internationally active, diversified financial conglomerates that engage in a variety of non-insurance businesses.”  The Report concludes that “the insurance regulatory system itself should be reformed to provide for group supervision.”  The Report, however, does not go so far as providing details as to how this goal would be effectively accomplished.

The Report is skeptical that the most recent changes of the NAIC Holding Company Model Act will do much to fill the breach.  It notes that other NAIC initiatives are only in the early stages of development.

The Report endorses the states’ good faith efforts to establish and operate “supervisory colleges,” many of which are in the “nascent stages of development,” and recommends that FIO itself be included as an active participant stating, “[i]n the absence of direct federal regulation of insurance groups, supervisory colleges will be an important means of addressing the conduct of group supervision in the intermediate term. . . . A supervisory college should be a forum that includes all of an insurance group’s functional regulators, both domestic and international, to meet and to share information relating to the supervised group, and identify trends or areas of strength or weakness within the group.” 

For multi-national groups, whether U.S. or foreign based, FIO sees itself as a necessary participant in the supervisory colleges, “in light of FIO’s statutory mission to monitor all aspects of the insurance industry, including issues or gaps in regulation, and FIO’s significant role with respect to financial stability.”  But, the Report concludes, supervisory colleges are necessary but not sufficient and do not “substitute for a consolidated regulator.”

RESOLUTION OF INSOLVENT INSURERS:  MORE REFORMS RECOMMENDED FOR LARGE INTERNATIONALLY ACTIVE INSURERS

The Report recommends that further reforms should be considered with respect to the resolution of large, internationally active insurers.  Specifically, the Report stresses the need for the resolution planning of complex, global insurance firms to extend beyond the framework of state-based receiverships and guaranty funds.  For example, the Report notes that non-insurance company affiliates and holding companies do not participate in guaranty funds or state-based receiverships, and, further, insurers often sell products either partially or fully excluded from guaranty fund protection.  Consequently, a significant part of the activities of an insurance group may fall outside of a state’s insurer resolution scheme.  The Report, therefore, recommends that separate, holistic orderly resolution plans be developed for globally active insurers.

The Report also explains that the resolution of insurers is a focus of the international regulatory agenda.  The FSB will initiate a thematic peer review on resolution regimes, which will include a review of the adequacy and effectiveness of resolution regimes for non-bank financial institutions, such as insurers.

RECEIVERSHIP

The Report briefly summarizes the insurer receivership process, but notes that “[t]he determination as to whether and, if so, when to place an insurer into conservation, rehabilitation, or liquidation is subject to the discretion of the state regulator.”  According to the Report, state political, consumer, and economic development issues may impact the timing of any such action by a state regulator.   

The Report also addresses state-by-state differences in the insurer receivership process.  According to the Report, only 32 states have enacted legislation, in whole or in part, based on the NAIC’s 1978 model law on insurer resolution, and only two states have enacted the 2005 version, called the Insurer Receivership Model Act.  Specifically, the Report highlights differences in the treatment of derivatives and other qualified financial contracts, and recommends that states adopt a uniform approach to address the closing out and netting of qualified contracts with counterparties.  However, although only two states have adopted the 2005 Model Act in full, approximately 20 states have adopted the Model Act’s provision that provides protections for qualified financial contracts.⁴  FIO strongly recommends that the remaining states should adopt substantially similar protections for qualified financial contracts.

The Report also recommends that states develop uniform requirements for transparent financial reporting about the administration of a receivership estate.  The Report describes the NAIC’s Global Receivership Information Database (GRID) that serves as a repository of information about estates administered by state insurance regulators as receivers, but expresses concern about the wide variances among states as to the extent of the information that has actually been made available through GRID.  According to the Report, data submitted to GRID by many states is less than 25% complete.  Further, the Report explains that the nature, form, extent, and timeliness of financial information about insolvent insurers are inconsistent (and often unavailable). 

GUARANTY FUNDS:  FIO CALLS FOR UNIFORM COVERAGE AMOUNTS

The Report summarizes the protection provided by state guaranty funds.  Maximum payouts provided by state guaranty funds are set by state statutes, and the Report highlights the fact that the maximum per claim payouts fluctuate by state.  The Report recommends that states adopt uniform guaranty fund recovery rules (with respect to dollar limits), so that policyholders get the same maximum guaranty fund benefits regardless of where they live, and if states fail to achieve such uniformity, “then federal involvement may be necessary to ensure fair treatment of all policyholders.”

While the issues raised by guaranty funds are complex, there are groups and commentators that might rebut or re-frame some of the findings and recommendations made in the Report.  For example, the Report does not address the fact that policyholder recoveries are not solely from guaranty funds – instead, policyholders also have claims against the general estate of the insolvent insurer.  Due to regulatory tools, such as risk-based capital, state regulators may be able to intervene before there is a significant shortfall of assets to liabilities in the insolvent insurer’s estate.  Accordingly, a policyholder may still be able to recover a significant percentage of his/her claim from the insurer’s estate.⁵  

 After detailing the historical success of guaranty funds with respect to the insolvencies of both property and casualty insurers and life and health insurers, the Report questions how the system would fare in the event of a failure of a large insurance group in the United States, and recommends that the guaranty fund periodically model the potential adverse impacts of such scenarios on the guaranty fund system. 

RECOMMENDATIONS ON MARKETPLACE OVERSIGHT, CONSUMER PROTECTION AND ACCESS TO INSURANCE

PRODUCER LICENSING:  FIO SUPPORTS THE ADOPTION OF NARAB II

The Report recommends that Congress adopt The National Association of Registered Agents and Brokers Reform Act of 2013 (NARAB II).   The Report reviews the history of the first NARAB proposal under the Gramm-Leach-Bliley Act of 1999 that resulted in the required number of states adopting the NAIC’s Producer Licensing Model Act (PLMA) to stave off NARAB’s creation.  The Report points out that three of the states that have not adopted the PLMA are among the largest insurance markets in the U.S. (i.e., California, Florida, and New York).  The Report indicates that despite the efforts related to state law adoption of the PLMA, “the inconsistencies and inefficiencies resulting from the lack of uniformity in state producer licensing regimes persist.”  In that regard, the Report points to, among other things, the different requirements for business entity licensing with respect to appointments, branch offices, individual agent affiliation notices, and required filings of organizational documents.  Moreover, the Report points out that given the mobility of today’s society, insurance purchasers frequently move to a new state and want the option of maintaining a relationship with their insurance producers.   

It is not surprising that the Report would focus on one of the most frequently noted burdens of state regulation imposed on insurers and their intermediaries.  As anyone who has undertaken the task of forming a nationwide insurance agency can attest, while the process is undoubtedly easier today than it was 15 years ago, it can still take significant effort and time to become licensed in all states.  Since this recommendation requires Congressional action to be implemented, it remains to be seen whether Congress will pass NARAB II in 2014.  If NARAB II is passed by Congress, the Report recommends that FIO will monitor the establishment and implementation to ensure that it has been successfully implemented.  

PRODUCT APPROVAL:  FIO CALLS FOR MORE UNIFORMITY AND POSSIBLE FEDERAL INVOLVEMENT

The Report’s recommendations focus on the inefficiencies and burdens in garnering state approvals for new products.  The Report indicates that those factors impact the speed-to-market and innovation of insurance company products.  In addition, the Report notes that the lack of uniformity related to the product approval process impacts the consumer protection afforded to policyholders in different states, thus leading to the possibility of regulatory arbitrage.  The Report summarizes the current state of the Interstate Insurance Product Regulation Commission (IIPRC) and highlights certain of its weaknesses, including:

1. There are at least eight states that are not members of IIPRC, including California, New York and Florida, which comprise a sizeable portion of the insurance marketplace (as noted above, those three states have not adopted the PLMA);
2. The product lines available for IIPRC review are limited, and do not include group annuity, long-term care, and disability products; and
3. Insurers can avoid the consumer protection standards established under the IIPRC review by submitting the product directly to the member state. 

The Report reviews the current framework for IIPRC review and recommends that:

1. Every state should participate in the IIPRC;
2. The standards under the IIPRC should serve as a “baseline,” and higher state standards should be permitted;
3. To eliminate the possibility of regulatory arbitrage, state regulators should restrict insurers from opting into less restrictive standards; and
4. The products available for approval through the IIPRC should be expanded to cover group annuity, group long-term care, and group disability products. 

The Report also touches upon commercial lines issues, and indicates that, despite certain positive developments, commercial lines regulation should “continue to modernize.”  In that regard, the Report recommends that state regulators should pursue the development of nationally standardized forms and terms, or an interstate compact or reciprocity mechanism, to streamline and improve the regulation of commercial lines. 

While the recommendations identified by the Report focus on actions to be taken by state regulators, FIO clearly stakes out the position that if improvements are not made in this area, then federal solutions may be necessary.  In this regard, FIO carves out a role for itself to provide ongoing monitoring of the product approval process.  In addition, the Report warns that “Federal action may become necessary if the current, and long-standing, shortcomings are not improved in the near term.”

The Report purports to establish a basis for some type of uniform national minimum standards for life insurance, annuity, disability income, and long-term care products (and for other products as described herein).  Whether such nationwide minimum standards develop, and whether such development occurs through an expanded IIPRC arrangement or some type of “federal solution,” remains to be seen.
 
PERSONAL AUTO POLICIES FOR SERVICE MEMBERS

The Report focuses on the particular difficulties faced by U.S. military personnel, who often move every two to three years, with respect to their financial needs and services.  In particular, the Report notes that certain financial services can be transitioned simply through a change of address form (e.g., credit cards, checking accounts), but that auto insurance requires the issuance of a new policy.  FIO recommends that it will convene and work with federal agencies, state regulators, and other interested parties to develop auto insurance policies for service members that are enforceable across state lines.  The Reports suggests that one option may be to create and adopt a common form that does not require the issuance of a new policy when the insured is transferred to a new base.
 
ANNUITY SUITABILITY:  FIO CALLS FOR NATIONWIDE ANNUITY SUITABILITY STANDARDS AND MAY CALL FOR FEDERAL ACTION  

The Report refers to the importance of national standards of suitability for annuities and recommends that every state adopt and enforce the NAIC Suitability in Annuities Transactions Model Regulation (Model Suitability Regulation); if this is not done in the near term, then the Report says “federal action may become necessary.”  In this regard, the Report notes that the U.S. is entering an unprecedented demographic era of residents of retirement age, and states that “financial security for the aging population is an essential priority.” 

The Report also provides some general background on the regulation of, and different types of, annuities, including specific references to fixed, indexed, and variable annuities.  The Report refers to the role played by the Model Suitability Regulation in the Dodd-Frank Act (1) under the so-called “Harkin Amendment” that provides a safe harbor from registration as securities with the Securities and Exchange Commission (SEC) for certain annuity contracts and life insurance policies (the Report specifically references indexed annuities), and (2) through the financial grants available to states that have adopted the Model Suitability Regulation or otherwise enhanced the protection of seniors in the sales of financial products.  Moreover, the Report specifically refers to all three prongs of the Harkin Amendment, including the third prong’s reliance on the Model Suitability Regulation. 

Given the concerns identified by FIO about the growing population of retirement age residents and the importance of national suitability standards, the Report expresses substantial concern that the Model Suitability Regulation has not been adopted by more, if not all, states.  In addition, FIO’s reference to the financial grants that were made available to states adopting the Model Suitability Regulation appears to suggest the view that, even in the face of federally granted financial incentives to states to adopt such regulation, the levels of adoption have not been acceptable.  In this and other recommendations, FIO seems to indicate little tolerance when critically important insurance regulatory standards have been adopted by only a limited number of states, thus falling well short of becoming nationwide standards.  Finally, it is unclear precisely what “federal action” might be taken to ensure that annuity purchasers are covered by a suitability regulation, and what role, if any, FIO or any other federal agency such as the SEC might play in that process vis a vis the Harkin Amendment or otherwise.  It is clear, however, that the Report lays the foundation for national uniform minimum national suitability standards, either through federal prodding of the states to act (e.g., through Harkin-type safe harbors and federal grants, as noted above) or through some more direct type of “federal action.”

MARKET CONDUCT REGULATION:  FIO CALLS FOR MORE CONSISTENCY AND COORDINATION 

The Report makes a number of recommendations for states to act on with respect to market conduct examinations.  The Report is quite critical of the current market conduct regulatory structure, prefacing its review by stating that “[m]arket conduct regulation has been the focus of significant criticism by industry and third-party commentators.”  The primary criticisms focus on the burdens and inefficiencies of insurers being subject to examinations from many different jurisdictions without coordination on timing or standards applied.  The Report also reviews and relies upon the findings of two Government Accountability Office (GAO) reviews of the market conduct examination process, and a survey by the American Council of Life Insurers (ACLI), to drive certain of its recommendations.  In particular, the Report notes that the 2011 ACLI survey found that 63% of the respondents rated market conduct regulation as “unsatisfactory/needs improvement.”  The Report further indicates that the ACLI survey indicated issues with lack of uniformity, speed/timing, costs, and expertise/capacity.  The Report makes the following familiar recommendations for state market conduct regulation:

1. State regulators should perform market conduct examinations consistent with the NAIC Market Regulation Handbook;
2. States should seek information from other regulators before issuing a document or examination request to insurers;
3. States should develop professional standards and rigorous protocols to govern market conduct contractors; and
4. States should develop a list of approved market conduct contractors based on objective qualifications. 

As with producer licensing, the overlapping regulatory examination structure faced by insurers is “low hanging fruit” in terms of a regulatory critique.  However, the issues of being subject to multiple state examinations are not faced solely by insurers, but are also challenges faced by the securities and banking industries.  FIO refers to initiatives from the NAIC that have attempted to help remedy some of these issues (e.g., the Market Conduct Surveillance Model Law), but importantly notes that these initiatives have not been widely adopted. 

RATE REGULATION

The Report briefly reviews the history of rate regulation, and catalogs the different ways in which states’ regulatory authority is used to oversee rates, including through: open rating structures; use and file rate review; file and use rate review; and prior approval.  The Report indicates that the different approaches provide states with an opportunity to review a variety of different methods to identify best practices.  In this regard, the Report also highlights several studies that have indicated that rate regulation may have a negative impact on the insurance marketplace by resulting in higher prices and market share increases in the residual market.  FIO ultimately recommends that the states should monitor the results of the varying rate regulation regimes to identify those that create the most competitive markets for personal lines.  In addition, FIO indicates that it will work with state regulators to assist with the formation of pilot programs to maximize the number of insurers offering products in the states.

RISK CLASSIFICATION

The Report reviews various aspects of risk classification of insureds using insurance scoring techniques.  FIO indicates that property/casualty insurers use multiple data points including, but not limited to, driving history, age, gender, marital status, zip code, and credit scores to determine rating tiers.  The Report generally walks through the benefits of the use of insurance scores (e.g., it allows for accurate pricing and more equitable cost shifting) as well as the drawbacks (e.g., the arguably inappropriate focus on credit information in assessing auto insurance rates).  The Report warns that the risk classification methods should “not rely on impermissible or discriminatory factors.”  In this regard, FIO suggests that these methods could be an appropriate subject for uniform federal standards.  In addition, the Report recommends that states should oversee the vendors that are providing insurance scoring.  Finally, FIO indicates that in connection with its duty to monitor access to insurance of those in underserved communities, it will study and report on the manner in which personal information is used for pricing and coverage decisions.

Marriage and Insurance

In the wake of the U.S. Supreme Court’s United States v. Windsor⁶ decision, the Report addresses insurers’ use of marital status as an underwriting and rating factor.  FIO recommends that states assess whether, and to what extent, marital status is an appropriate underwriting/rating consideration based on “equality considerations and other factors.”

NONADMITTED AND REINSURANCE REFORM ACT OF 2010:  FIO CALLS FOR MORE UNIFORMITY

The Nonadmitted and Reinsurance Reform Act (NRRA), enacted as part of the Dodd-Frank Act, was intended to reform surplus lines insurance by streamlining the collection of taxes for multi-state surplus lines placements.  Specifically, the NRRA was designed to address the confusion resulting from numerous states taxing surplus lines premium (typically based on the location of the insured risk rather than the location of the insured) at different rates and through different processes.  While the NRRA prohibits any state other than “the home State of an insured” from requiring premium tax payments from nonadmitted insurers, it also permits states to enter into compacts or other procedures to allocate taxes for nonadmitted insurance premiums paid to the home state and expresses the intention of Congress that the states adopt uniform standards with respect to such premium taxes.

As with other topics discussed in the Report, FIO notes with disappointment that state efforts at achieving uniformity regarding surplus lines regulation have met with little success.  The Report notes that only five states and Puerto Rico are participating in the Nonadmitted Insurance Multi-State Agreement (NIMA), which acts as a central clearinghouse for reporting, collecting, and allocating nonadmitted insurance premium taxes.  The Report also mentions that another nine states have entered into another tax payment clearinghouse/allocation compact, the Surplus Lines Insurance Multi-State Compliance Compact (SLIMPACT), but that SLIMPACT has insufficient members to be effective.  Finally, many other states are utilizing other methodologies—hardly the uniform results encouraged by Congress.
As a result, FIO indicates that it will continue to monitor developments relevant to the NRRA but seems pessimistic on future uniformity.  The Report concludes that further federal action “may be warranted in the near term.”

NATURAL CATASTROPHES

The Report identities and reviews the impact that natural catastrophes can have on the insurance marketplace.  In particular, the Report catalogs some of the developments and challenges arising from the so-called “public catastrophe” programs that were established after Hurricane Andrew in Florida in 1992 and the Northridge earthquake in 1994.  FIO indicates that the results of these programs have been “mixed.”  In addition, the Report notes that the secondary impact of natural catastrophes on the private insurance market is that insurers typically raise rates to rebuild capital levels, thus passing some of the costs back onto policy holders.  FIO recommends that states identify, adopt, and implement best practices to mitigate losses from natural catastrophes, and includes an express reference to construction standards.  In addition, the Report indicates that FIO will provide more detail on its views related to natural catastrophes in its report required under the Biggert-Waters National Flood Insurance Reform Act of 2012. 

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We will continue to monitor the practical impact of the FIO Report and other developments related to the possible federal regulation of insurance affecting our insurance company clients.                                           

¹ Each of these sections includes both recommendations for state action and for federal involvement.
² Section 313(r)(2) of the Dodd-Frank Act.
³ Under the proposed draft, each insurer, or the insurance group of which the insurer is a member, would be required to submit an annual filing that contains: (1) a description of the insurer’s corporate governance framework; (2) a description of the insurer’s board of directors and committee policies and practices; (3) a description of management policies and practices; and (4) a description of management and oversight of critical risk areas.  The insurer is specifically permitted to provide information regarding corporate governance at the ultimate controlling parent level, an intermediate holding company level or the individual legal entity level, depending upon how the insurer or insurance group has structured its system of corporate governance.
⁴ See Model Law 555, § 711(A)(3). 
⁵  According to the National Organization of Life and Health Guaranty Associations, in the typical insolvencies of U.S. life insurance companies, “average recoveries have exceeded 96% on life claims and 94% on annuity claims.”See Hearing on Insurance Oversight and Legislative Proposals Before the H. Fin. Servs. Subcomm. On Insurance Housing and Community Opportunity (Nov. 16, 2011) (testimony of Peter Gallanis, President of NOLHGA) at 11.
⁶ 133 S. Ct. 2694 (2013).