By Terri M. Vaughan, Ph.D., ASA, ACAS, MAAA, CPCU

CEO, National Association of Insurance Commissioners

Adapted from a presentation to The Insurance Institute of London, February 17, 2011 

The supervision of internationally active insurance groups, or IAIGs, is a subject of considerable discussion in international supervisory circles.  In particular, the International Association of Insurance Supervisors (IAIS) has a major project underway – known as ComFrame – that aims to define a Common Framework for the Supervision of IAIGs.   Creating a system for supervising internationally active groups requires careful attention to multijurisdictional issues – the requirements placed on firms by different supervisors, the relationships among those supervisors, and the level of coordination and collaboration in supervision.  

The U.S. has a multijurisdictional system of regulation and supervision, with regulatory authority resting with the states, that offers useful experience for consideration by the IAIS in its ComFrame project. Although regulatory authority rests in the individual states, the U.S. system has, over the years, become increasingly uniform and coordinated, with a variety of checks and balances that act to constrain the discretion of a single state.  In the early 1990s, the National Association of Insurance Commissioners (NAIC) Solvency Policing Agenda accelerated that process, creating a national system of state-based regulation.

The NAIC – A Model for Multinational Supervision

The NAIC is a voluntary association of state insurance supervisors formed in the middle of the nineteenth century to share ideas and coordinate state regulatory activity.  The NAIC was instrumental in the formation of the IAIS in the mid-1990s, and the IAIS performs a similar function for global regulators.  The role of the NAIC in the U.S. regulatory system has evolved over the years, as the U.S. states, through the NAIC, have built a number of centralized processes and uniform requirements.  For example, we have a standard regulatory accounting system, known as statutory accounting, and a uniform financial reporting system with centralized data collection.  We do multistate examinations of companies, and we have intensive multistate interaction when problems are identified.

Our accreditation program plays an important role in our national system.  We have a set of model laws and regulations, including a uniform risk-based capital system, that states must adopt to be accredited by the NAIC, and all states are currently accredited.  The accreditation program covers not just the laws and regulations, but regulatory processes also, including requirements related to financial analysis and examinations and to communication with other states. Under the accreditation program, the NAIC conducts on-site reviews every five years and off-site reviews every year to ensure that a state has the necessary regulatory authority, but, equally importantly, to ensure that its practices related to examinations, analysis, qualifications of staff, and communication with other states are effective.

Beyond that, we have built extensive centralized processes to enable states other than the home jurisdiction to monitor the financial condition of insurers (host companies) operating in their states. Our central database of comprehensive financial information, along with a variety of analysis tools, is made available to all states. While not all states look at host companies in detail, some do, and when they identify issues, they are not hesitant to raise them with the home state. We also have central tools to allow states to track regulatory actions that are being taken, and we maintain the expectation that home states keep the host states informed about developments.

Backing up this multistate oversight, we have central staff and processes at the NAIC, known as the Financial Analysis Division, that work on behalf of all states, constantly scanning the market and nationally active insurers in an effort to identify trends, outliers, and emerging issues. We collect extensive financial data and process those regulatory filings centrally through a battery of quantitative tests, including benchmarking various metrics against other insurers. We watch credit spreads and short sales of the companies’ stock, follow public filings and analyst reports, integrate our data with other publicly and privately available data in further efforts to identify anomalies, all in an attempt to find outliers or firms that need additional attention. This robust data-driven analysis of individual company and market-wide data is regarded by the IMF as world-leading (according to our recent Financial Sector Assessment Program (FSAP) report, issued by the IMF and World Bank).

When a potential problem is identified, our peer review processes are engaged.  The potential problem is referred to the Financial Analysis Working Group (FAWG), a group that is comprised of the top financial regulators from around the country. These individuals, who have lived through many prior troubled company situations, serve as an advisory panel and form of peer review for the home state’s actions. The FAWG meets constantly, interacts with home state supervisors, and offers guidance and support.

All of this multistate oversight and interaction rests within a structure of accountability that is key to its success. Host states tend to defer to the home state to supervise its companies, but there is always a hook. The host states reserve their right to take action independently, e.g., to revoke or restrict a license, if the home state fails to take appropriate action. This provides a powerful incentive for the home state to cooperate and collaborate with the host states.

These checks and balances – multiple eyes and voluntary deference – help to counter the potential for regulatory failure in the home state, whether due to poor judgment or to incentive problems. It results in a system in which home state supervisors have a certain amount of discretion, but it is constrained by the willingness of other states to accept the actions taken by the home state, i.e., a system of constrained discretion.

Most of this activity – the multistate coordination, cooperation, and peer review – is invisible to the regulated entity.  It doesn’t always work perfectly, but it generally works pretty well, and it is constantly improving.  It works because of the checks and balances.   There is robust information sharing, and the deference given by host jurisdictions is voluntary and constantly subject to the threat of revocation.

Those are key elements to what we envision as a structure for supervising internationally active insurance groups.   

Lessons from the Financial Crisis for Group Supervision

One of the main lessons for us from the financial crisis – AIG in particular – has been the need to do a better job in the area of group supervision. In the U.S., as in many countries, we have traditionally taken a single entity approach to supervising insurance companies. While we did look at holding companies, that work tended to be primarily focused on interactions between the insurer and holding company. That is, we focused on maintaining the walls around the insurance company, and on monitoring and restricting transactions between the insurer and its affiliates. AIG taught us that we needed to pay more attention to the risks that are created by activities going on outside those entities – the reputational and contagion issues that could exist.

Enhancing our systems for group supervision is a very high priority for us. In December, the NAIC adopted changes to the Holding Company System Act and Regulation to strengthen and clarify our authority to gather information from the holding company, and to require new disclosures. We are creating a new reporting Form F in which firms will identify and report their enterprise risks. In addition, we are looking at how to implement group capital assessment through an Own Risk and Solvency Assessment (ORSA) requirement.

There are two fundamental beliefs that underpin the NAIC’s work on group supervision.

The first is that group supervision complements, but does not replace solo entity supervision. Another thing the crisis taught us is that corporate structures matter. When the music stops, it matters where the money resides. To use the NAIC’s terminology, it’s about walls and windows: maintaining the walls of the legal entity approach, but opening up the windows into the group.

Second, our approach to group supervision is informed by our understanding of the importance of incenting supervisors. So, rather than empowering a single group supervisor, we favor our system of checks and balances – multiple eyes, strong information sharing, and voluntary deference to a lead supervisor, with the threat of revocation. A key element is that the lead supervisor is accountable to the other supervisors, not the other way around.

The Challenges of Supervising IAIGs

When thinking about the supervision of internationally active groups , I think it is important to first agree on the problems we are trying to solve.  The first problem – one that tends to be raised by supervisors –revolves around issues of regulatory competition and geographic arbitrage. This is the fear that other jurisdictions will compete to attract insurers, encouraging regulatory arbitrage and creating what some call “regulatory black holes, ” where insurance sector capital and risk become concentrated in particular, less well-supervised jurisdictions. Basically, these are global standards to guard against a race to the bottom.

The second problem – one that tends to be raised by internationally active firms – is the inefficiency of having to comply with multiple sets of regulations and a fragmented regulatory system. Unfortunately, as insurance supervisors around the world are implementing group supervision, we are not doing this in a well-coordinated way. Companies are being asked to provide various reports to supervisors in a variety of countries. Our information requests, formats, and focus are different; some rules may conflict.  From what I can tell from some companies, this lack of supervisory coordination is creating frustration and unnecessary administrative costs. As we all try to figure out how to supervise insurance groups, we need to figure out how to do this together. In the worst case, we will all create different sets of requirements, and make it impossible for internationally active groups to function.

Third, there is “the AIG problem” – the problem of risk concentrations that are created in unregulated entities.

I do not, however, agree that the problem we are trying to solve is that other sectors think we need a new framework.  In the discussion over financial stability and systemic risk, we are working hard to get policymakers in other sectors to understand the differences between banking and insurance. Our first job is to make sure we understand what makes sense for our sector, given, of course, that insurance is part of the broader financial services marketplace and has certain interlinkages with banks and other financial firms. But then it is our job to sell that, and not to have those who have a more limited understanding of the insurance sector drive the answers.

Building a Solution

So let’s assume we are trying to solve the first three problems: the potential for regulatory arbitrage because of jurisdictional competition, inefficiencies for companies from fragmented and diverse regulatory requirements, and the AIG problem of unregulated affiliates.

The IAIS’s ComFrame – the Common Framework for the Supervision of Internationally Active Insurance Groups  – is still in its embryonic stage, and there is much work to be done to define just what it is, but it is likely to play an important role in the future evolution of how we supervise IAIGs.  With that in mind, allow me to offer some observations. 

Observation #1: Incremental change is better than revolutionary change.   The system generally is not broken as much as it is experiencing some growing pains.  Regulation inevitably has unintended consequences.  It is easier to manage those if you take them in bite size bits. Also, wholesale revolutionary change is very hard to achieve. Incremental change is possible, and incremental change over time can have real lasting effects. Having some incremental successes can promote trust among supervisors around the world, which can serve as the basis for continued improvements in the future.  We shouldn’t try to create some grand new system of group supervision, trying to reinvent the various aspects of solo entity supervision at a group level. Let’s identify some key things that we need to do better when it comes to groups. We need to better understand the interactions among the group, the gaps and interlinkages. We need to understand the risk posed by unregulated entities. We can collaborate to address geographic arbitrage. And we should find a way to do this in a coordinated way, so we minimize the burden on the companies that we supervise.

Observation #2: We need to have the proper balance between regulation and supervision.   We should not put too much faith in global capital requirements.  More important than finely-tuned capital requirements is a system of robust supervision, one that looks for emerging risk concentrations in a variety of ways.  Unfortunately, defining a capital regime is, in some respects, easier to do. Supervision is amorphous. It can’t be defined. It’s a process. It’s much harder to assess the quality of supervision. But that doesn’t mean it shouldn’t be or can’t be done. Supervisory colleges are a start to greater collaboration in supervision, but they still have a long way to go. We need to do a better job of sharing processes globally, and at a practical level, coordinating our information requests and oversight. Recognizing the importance of increased collaboration in supervising internationally active groups, the NAIC has proposed the creation of a Supervisory Forum at the IAIS. This is a body that would be comprised of actual on-the-ground supervisors, sharing information on what they are doing and seeing, sharing best practices, and trying to foster more consistency and coordination in how we approach internationally active groups. In some respects, it is modeled after our coordination efforts in the United States, but on an international scale.

Observation #3: We need to have the right relationship between the group or lead supervisor and the other supervisors. This is critical to getting the incentives right and to giving host supervisors faith in the process.

When talking about group supervision and the role of a group supervisor, I have heard it said, “Someone has to be in charge.”  I don’t agree – a group can be in charge, as in a board of directors, for example. But the more important question is who is accountable to whom. The incentives of the home and host jurisdictions are not necessarily aligned, and in many cases, it is the host jurisdictions that have more to lose. It is essential that a global system of regulation empower host jurisdictions to halt behaviors that are potentially harmful to their markets. And that means the group supervisor has to be accountable to the other supervisors, not the other way around. That is the only way to create a structure that is efficient, seamless, and has the right incentives -- through the kind of voluntary deference that we have in the United States.

Finally, observation #4:  We cannot achieve that level of coordination internationally without a consistent benchmark for measuring.  Presently, approaches to valuing assets and liabilities, including technical provisions, are so dissimilar, that the barriers to effective communication across jurisdictions about financial condition and performance are immense. We don’t need to agree on a single accounting system.  Any accounting system has its strengths and weaknesses. But if we have a common benchmark, we can come to understand the strengths and weaknesses and the ways in which deviations matter. But we need a starting place. In the U.S., that is our statutory accounting system. On occasion, states will deviate from statutory accounting, but those deviations are fully transparent to all of the other states. I don’t know what that benchmark measuring system will be for internationally active groups, but the logical candidate at this point is IFRS, something that has certain growing pains of its own.

ComFrame is an exciting and important project because it is an attempt to make insurance regulation more efficient without making it less effective.  This is good for both supervisors and the regulated industry. ComFrame should be less about regulation, i.e., about developing a single set of rules, than it is about supervision and better supervisory cooperation. Done right, ComFrame has the potential to create a multijurisdictional approach to supervision that is built on collaboration and coordination, emphasizes robust oversight, maintains the proper balance between home and host jurisdictions, and is seamless from the perspective of regulated companies.  It’s a win/win, and that’s why we in the U.S. are so committed to its success.