NAIC.Solvency

Reading: “The U.S. National State-Based System of Insurance Regulation and the Solvency Modernization Initiative,” 2013. Candidates are not responsible for the following:

• Section 2: paragraphs 15-18, 26-28, 32-34, 41-42, Appendix 1, and Appendix 2;
• Section 3: paragraphs 9, 13-15, 23-32, and 38-39;
• Section 4; and
• Section 5: paragraphs 9, 20-29, 30-45, and 61-86.

Candidates are not responsible for the above sections.

Author: NAIC (White Paper)   Forum

Study Tips

This reading is a white paper on insurer solvency published by the NAIC. (A white paper is an authoritative report on a complex issue.) It explains the U.S. solvency regulatory framework and why it works successfully. My candid opinion is that you can ignore 90% of this reading. It seems there's lots of testable information, but my advice is to base your review on past exam questions. Several of them could have been answered just with general knowledge and educated guesses.

30 mins:

• read the wiki article and scan the quizzes and exam questions to get a sense for what's normally asked (you don't have to start memorizing yet)

30 mins:

• read the first couple of paragraphs from each section in the source reading then just quickly scan the rest (except section 4, which isn't on the syllabus)

2 hours:

• review the wiki article and do the quizzes again but study the exam problems thoroughly (you can start memorizing BattleCard answers here)

Optional: (This is a lot of work for potentially very few extra points on the exam, if any.)

• scan the source reading for other items you think might be important and likely exam questions
• write a phrase beside each paragraph to quickly summarize the main point in the paragraph
• for paragraphs you think are important, make further notes

BattleTable

Based on past exams, the main things you need to know (in rough order of importance) are:

• solvency regulation - current and future, impact of globalization, special reinsurance issues
• rate regulation - current and future

Questions held out from Fall 2019 exam: #3. (Skip these now to have a fresh exam to practice on later. For links to these questions, see Exam Summaries.)

reference	part (a)	part (b)	part (c)	part (d)
E (2017.Spring #3)	RBC: - motivation for 1	RBC: - useful attributes	RBC: - new risk categories	insolvency: - corrective actions
E (2016.Fall #5)	rate/solvency regulation: - propose new system
E (2015.Fall #3)	solvency regulation: - elements of	regulatory modernization: - for reinsurance	NRRA: - provisions out,2
E (2014.Fall #3)	Porter.2-Devlpt	Baribeau.Regs	solvency regulation: - duplication of effort	solvency regulation: - challenge & solution
E (2014.Fall #5)	SCENARIO: - U/W/ guidelines P	SCENARIO: - state regulator concerns	SCENARIO: - state regulator actions	SCENARIO: - NAIC involvement out
E (2014.Spring #3)	rate/solvency regulation: - propose new system	rate/solvency regulation: - impact of globalization	rate/solvency regulation: - for reinsurers
E (2014.Spring #6)	NAIC analyst team: - primary goal out	IRIS ratios: - 4 categories + Exs out, 3	IRIS vs FAST: - compare/contrast out	NAIC analyst team: - limitations out

¹ Parts (a), (b), (c) are really RBC questions from Odomirok.19-RBC but they are a good review of that material.

² NRRA = Nonadmitted and Reinsurance Reform Act of 2010.

³ This is really a question from NAIC.IRIS. (And it's the easiest 2 pts you'll even get on this exam.)

^P Part of the answer is from Porter, Chapter 2.

^out Some (or all) of the question is either from an outdated reading or from paragraphs within NAIC.Solvency that have been removed from the syllabus. Note that some of the examiner's report answers for 2015.Fall #3c are still valid while others are from outdated material. Confusing!

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In Plain English!

This reading is organized into 5 sections, each with numbered paragraphs. The paragraphs covered by the syllabus are listed below. You are responsible for 127 of the 233 paragraphs. (There are also 2 appendices in section 2 but they are also not on the syllabus.)

Section 1 (Introduction)

Paragraphs from section 1 that are covered on the syllabus: all sections, 1-17)

paragraph 1-1: Solvency Modernization Initiative

(Note that paragraph 1-1 refers to section 1, paragraph 1)

In 2008, state insurance regulators started the Solvency Modernization Initiative (SMI). The purpose was to evaluate & improve the regulatory framework for insurer solvency. The key components of SMI are:

• capital requirements
• governance and risk management
• group supervision
• statutory accounting
• financial reporting
• reinsurance

paragraph 1-2: NAIC Mission

Of course, what would a white paper be without the corporate mission statement trope. :-)

Anyway, the NAIC's mission is to protect policyholders. Their overall method is to combine financial & market regulation.

paragraph 1-3: Three-Stage Financial Regulatory Process

The 3 stages of the U.S. financial regulatory process are:

• mitigate
• correct
• provide a backstop

So, the NAIC takes steps to mitigate foreseeable risks, takes corrective action if hazardous financial conditions are detected, and ultimately provides a backstop of financial protection if an insolvency does eventually occur (Ex: state guaranty associations).

paragraph 1-15: Judging Regulatory Effectiveness

The topic of regulatory effectiveness is also covered in Vaughan.Crisis Effectiveness of Regulation but in a slightly different way. Click the link to go to the relevant section of the Vaughan article. Anyway, the factors to consider when judging regulatory effectiveness, according to this white paper are: [Hint: RIICH  ←shout-out to dovidb!]

• were Rehabilitation actions effective
• did regulations help Identify & correct problems before policyholders were harmed
• how frequent were Insolvencies and how effective were the guaranty funds in reimbursing policyholders
• is there a positive Cost-benefit analysis of the regulations
• is the insurance marketplace Healthy

Note that this question was exactly what was asked in part (a) of the exam problem below. (shout-out to bg!)  Parts (b) & (c) are from Vaughan.Crisis.

As a bonus, the mnemonic above pairs nicely with the mnemonic further down for 7 core principles POORER-C.  ←thx again dovidb!

E (2019.Fall #3)

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Section 2 (Solvency Framework and Core Principles)

Paragraphs from section 2 that are covered on the syllabus: 1-14, 19-25, 29-31, 35-40, 43-48 (36 total)

paragraph 2-1: Financial Solvency System

This section of the reading explains the U.S. Insurance Financial Solvency System.

paragraph 2-14: Core Principles

Question: identify & briefly describe the 7 core principles of U.S. insurance financial solvency [Hint: POORER-C]

Note: the letters in the HINT are out of order - I just wanted to spell poorer which is not what insurers want to happen to their financial position!

1. Reporting (includes disclosure & transparency)

   - public financial statements

   - details in paragraphs 19-24

2. Off-site exams

   - regulators maintain an insurer profile using NAIC tools such as FAST (Financial Analysis Solvency Tools.)

   - details in paragraphs 25 (sections 26-28 not on syllabus)

3. On-site exams

   - risk-focused exams covering governance, management, financial strength

   - details in paragraphs 29-31 (sections 32-34 not on syllabus)

4. Capital adequacy

   - RBC and other tools

   - details in paragraphs 35-40

5. Regulatory control of risky transactions

   - require regulatory approval for transactions that could affect insurer's ability to fulfill policyholder obligations

   - details in paragraphs 41-42 ← not on syllabus

6. Prevention & correction

   - timely action to address potential risks (may include regulatory enforcement powers)

   - details in paragraphs 43-46

7. Exiting market

   - framework for orderly exit (includes receivership scheme for policyholder obligations)

   - details in paragraphs 47-48

Section 3 (Regulatory Oversight)

Paragraphs from section 3 that are covered on the syllabus: 1-8, 10-12, 16-22, 33-37 (23 total)

paragraph 3-1: Three-Stage Process

Recall the Three-Stage regulatory process that was briefly introduced in section 1 (paragraph 1-3). Section 3 provides further details on these states. (Note however that several paragraphs in this section are excluded from this syllabus.)

Section 4 (not on syllabus)

Paragraphs from section 4 that are covered on the syllabus: none

Section 5 (Solvency Modernization Initiative)

Paragraphs from section 5 that are covered on the syllabus: 1-8, 10-19, 46-60, 87-104 (51 total)

paragraph 5-4: SMI Priorities

Priorities in the Solvency Modernization Initiative include:

• create a document explaining the U.S. insurance regulatory system
• examine international developments
• comply with ICPs (Insurance Core Principles) promulgated by the IAIS (International Association of Insurance Supervisors)
• learn from the global financial crisis

paragraph 5-55: RRMF (reasons for RRMF)

RRMF is the Reinsurance Regulatory Modernization Framework, came up in part (b) of the problem below. To answer the question, you had to memorize the last few lines of paragraph 5-55.

E (2015.Fall #3b)

They ask for reasons for the development of RRMF:

• promote competition in reinsurance market
• reflect globalization of insurance (by recognizing foreign insurers & streamlining regulation)
• reduce penalties for unauthorized reinsurers that are strongly capitalized

paragraph 5-56: RRMF (reasons for proposed regulation to be federal)

RRMF was never passed into law, but this paragraph provides 3 reasons for NAIC's proposed RRMF to be implemented federally rather than on a state basis:

• preserve and improve state-based reinsurance regulation
• uniform implementation in all states
• comprehensive alternative to related federal legislation (that may be more focused on other issues)

paragraph 5-57: NRRA

NRRA is the Nonadmitted & Reinsurance Reform Act of 2010 and came up in part (c) of the problem below. It is part of Dodd-Frank and applies to nonadmitted insurance, which includes surplus/excess lines insurance and reinsurance. In very general terms, NRRA gives the customer's home state exclusive authority to regulate the placement of nonadmitted insurance. It was discussed more fully in another reading no longer on the syllabus so several of the sample answers in the examiner's report aren't relevant anymore. The answers I've listed below however are from the current reading. (Note that Emmanuel.ExcessLines further discusses NRRA and covers some of the previously outdated sample answers in the examiner's report.)

E (2015.Fall #3c)

You basically had to memorize the provisions of NRRA that were listed within this paragraph: (you only had to list 2 items)

• a state cannot deny credit for reinsurance if certain conditions are met:

   - if domiciliary state has already granted credit

   - if domiciliary state is an NAIC-accredited state

• a state may proceed with reinsurance collateral reforms on an individual basis (if the state is NAIC-accredited)
• a state is given sole responsibility to regulate solvency for a reinsurer

paragraph 5-87 to 5-104: RBC

• good overview of RBC (bedtime reading)
• closely related to Odomirok.19-RBC

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Two Important Exam Problems

There are 2 problems that deserve further attention: Be sure to study the examiner's reports in addition to my answers below.

E (2016.Fall #5)

E (2014.Spring #3)

Both ask you to propose a new system of rate and/or solvency regulation. In the latter, you're also asked to comment on the impact of your system on the globalization of the insurance industry and whether reinsurance has unique characteristics that must be dealt with separately. That's a mofo of an undertaking! That's what the whole Solvency Modernization Initiative is about and they give you 10 minutes to propose and justify a solution during the exam. WTF?

Actually these questions are easier than they seem, and the examiner's report accepted many different answers. You just had to write something half-way intelligent to get the points.

For the 2016 problem, the question tells you specifically what you have to address, so the first thing I would do is make the appropriate subheadings on my paper and then fill in the actual information. The layout would probably look something like this: (with 4 or 5 lines between each)

• proposed rate regulation
  • advantages
  • disadvantages

• proposed solvency regulation
  • advantages
  • disadvantages

Your choices for the proposed regulations are federal, state, or some sort of combination. The simplest is to choose state regulation for rates (specify prior approval, file and use, use and file, open competition) and federal regulation for solvency. Then you have to list 2 advantages and 2 disadvantages for each.

• 2 advantages for state regulation of rates (use & file)

   - insurer can respond quickly to changing conditions

   - regulator still reviews rates and can modify as necessary

• 2 disadvantages for state regulation of rates

   - increased costs since regulations may be different across states

   - regulator has belated control so unfair rates may enter the market before regulator can take action

• 2 advantages for federal regulation of solvency (using IRIS, RBC, ORSA)

   - lower costs for insurer because rules are uniform across states

   - easier for insurers to enter foreign markets if foreign regulators are familiar with a uniform system of evaluating financial health

• 2 disadvantages for federal regulation of solvency

   - no duplication of review so likelihood of error is greater

   - no diversity of opinion so flaws in the regulatory system may persist

For the 2014(a) problem you would again start by writing the appropriate subheadings and then fill in the necessary answers:

• regulatory jurisdiction

framework: state regulation

justification: states retain authority based on unique characteristics of states (population, economy,...)

• duties of regulators

framework: off-site exams, on-site exams, monitoring of capital adequacy (I just chose a few for the Core Principles)

justification: promotes the NAIC mission of protecting policyholders by ensuring that policyholder obligations can be met

• rate regulation

framework: use and file

justification: insurer can respond quickly to changing conditions but regulator still maintains a degree of control

• solvency jurisdiction

framework: federal regulation with internal models for large companies, standard IRIS & RBC ratios for smaller companies

justification: large companies have greater resources and understand their own risks, smaller companies may not have the resources for an internal model so regulators can rely on standardized ratios

For 2014(b), I might have said a state regulatory system wouldn't be cost effective with respect to globalization because of the lack of uniformity across states. Foreign insurers would be less likely to enter the U.S. market because of the cost of complying with each state system separately.

For 2014(c), I would have said the reinsurers may require variations in their regulatory treatment because many insurers are foreign, which would require a separate framework from domestic reinsurers. Also, capital requirements for reinsurers may be higher because of their increased exposures to catastrophes.

These and the remaining exam questions from the BattleTable are included in the quiz below.

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