September 11, 2012

Insurers ought to prepare today for a wave of new compliance edicts from state regulators, according to our sources on the ground. The investment landscape has changed dramatically in the decade-and-a-half since the laws were originally written, but state regulations have failed to keep up. Now, state insurance commissions are taking notice and stepping up their rule-making, meaning insurers need to prepare today to review and revise their internal compliance rules and adjust their investment portfolio as necessary.

Since the 1990s, the NAIC has used two versions of the Investment Model Law as guidelines for states to model their insurance investment laws. The first guideline, adopted in 1996, was the Defined Limits Version. The alternative, adopted two years later, was the Defined Standards Version. Of course, the NAIC's guidelines are just that -- models for states on which they can base their rules. Individual states will enact and enforce their own regulations and limitations for insurers.

The Defined Limits Version is rules-based, with specific provisions of limits on what insurance companies can invest in based upon various characteristics, categories and groups of investments. The Defined Standards Version is more principles based. While it does contain some specific limitations for securities, it primarily offers standards or principles for state regulators to use in determining the quality of an insurer's investments. Under the defined standards version of the investment law, a regulator would be looking at whether an insurance company's investments support the goals and objectives of that insurance company. The insurance company, for the most part, would set policies, goals and objectives of its investment portfolio, as well as set its own internal limits. Under the Defined Standards Version, risk analysis plays a much bigger role.

The model investment rules have been in place for over 15 years, and the NAIC has encouraged states to adapt these guidelines in their own rulemaking to limit insurance companies from investing in risky investments. Most states developed new rules within a couple of years after the NAIC adopted the investment model laws.

Since the mortgage crisis of 2008, the focus on the quality of investments that insurance companies hold has been under even greater scrutiny. The laws were based upon certain assumptions of the risk characteristics of common securities that insurance companies might hold, especially the defined limits version of the law. As we've seen, these assumptions have been found to be less than accurate.

Three examples come to mind:

  • There has been a fundamental change in the methodology of assigning an NAIC designation to asset-backed and structured securities. Previously, these securities would likely have a designation of NAIC 1, meaning they were of the highest credit quality, similar to an AAA rating. Today, because of deeper financial modeling characteristics of modified filing-exempt securities, many of these issues might be tagged with a designation of NAIC 3 or lower. Without their knowledge, companies in states that use defined limits might suddenly be exceeding their internal and state compliance guidelines for lower-rated securities. Clearly, changes in the industry and in valuation methodologies can have an impact on compliance.
  • Another recent occurrence is that insurance companies are replacing many of their long-term securities that are about to mature with lower interest rate securities. Some investment groups might consider "chasing yield" or seeking higher-yielding, riskier investments -- but going with lower-rated securities might put them out of compliance according to the defined limits version. Again, these companies need to be cognizant of the state regulations regarding their investments, and are in need of tools to help identify their compliance.
  • Finally, many states are beginning to revise their investment laws and regulations for insurance companies. The old standards, particularly those based on defined limits, may be out of date, and based on information prior to the market crash of 2008. Existing standards may not adequately address all the risks of investments that are now coming to light. In fact, the NAIC has recently formed the Investment of Insurers Model Act Revision Working Group to study the need to modify the guidelines.

The fixed-income investment landscape has changed dramatically over the past 15 years, yet the rules of the road for insurers -- the investment guidelines set out by the NAIC -- have remained largely the same. Now it appears that state regulators are starting to catch up with the industry. Insurers who want to stay at the top of the game would do well to revisit their investment policies and compliance procedures.

Dennis Lebar is Senior Regulatory and Accounting Specialist, SunGard's Insurance Business.