1/27/09 Public Hearing of the NAIC Capital and Surplus Relief (EX) Working Group

STROOCK SPECIAL BULLETIN

NAIC Executive Committee Votes Against Adoption of ACLI Proposals

January 30, 2009

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Executive Committee Rejects CS Working Group’s Final Recommendations

On January 29, 2009, the National Association of Insurance Commissioners (the “NAIC”) held a meeting of the Executive Committee to consider the final recommendations (the “Final Recommendations”) of the Capital and Surplus Relief (EX) Working Group (the “CS Working Group”) regarding the American Council of Life Insurers’ (“ACLI”) nine-part proposal (the “ACLI Proposal”) requesting that the NAIC make adjustments to existing solvency framework components that impact statutory capital and surplus requirements on an accelerated basis. Rather than considering each of the nine proposals individually, the Executive Committee voted to deliberate on the entire ACLI Proposal as one package, and voted 16-1 against supporting the Final Recommendations.[1] The Executive Committee noted during the call that: (i) requests set forth in the ACLI Proposal will be referred to the appropriate NAIC technical groups and committees for further consideration and (ii) should an insurer require emergency relief, state regulation permits regulators to grant it on a case-by-case basis.

Several commissioners, including Director Scott Richardson, South Carolina, Commissioner Dilweg, Wisconsin, and Commissioner Michie, Utah, stated that although they saw merit in many of these proposals going forward individually, they saw no evidence that an emergency exists that would require immediate implementation of these emergency measures. "Simply put, the industry has not made a credible case for why we need to make changes on an emergency basis, and why those changes should be limited to the specific proposals made by the industry," stated NAIC President and Commissioner Roger Sevigny, New Hampshire, in a press release issued after the vote.

January 27th CS Working Group Hearing on the ACLI Proposal

The Executive Committee vote was held just two days after the CS Working Group’s January 27th public hearing and working group meeting in Washington D.C., at which the CS Working Group continued its review of the ACLI Proposal and voted to recommend adoption of variations of six parts of the ACLI Proposal. The CS Working Group, chaired by Commissioner Thomas Hampton, District of Columbia, was specifically formed by the Executive Committee to consider the ACLI Proposal and charged with quickly (1) considering the need for and appropriateness of changes to existing NAIC solvency framework components that have an impact on statutory capital and surplus requirements and (2) making recommendations, including as to whether any such changes should be temporary or permanent, to the Executive Committee.

In a four hour hearing attended by reportedly over 150 people, various interested parties testified regarding the ACLI Proposal. Immediately following the hearing, the CS Working Group conducted a public meeting at which it voted on the final recommendations to be made to the Executive Committee concerning specific requests set forth in the ACLI Proposal.

The ACLI Proposal, submitted to the NAIC on November 11, 2008, was grounded on the premise that

[our] nation’s economic turmoil has forced life insurers to find new ways to conserve and attract capital [and] in some situations, our current… risk-based capital (“RBC”) systems are simply too conservative which has the effect of reducing stated capital positions…[and] with the current market dispositions…capital markets solutions have virtually disappeared or become unavailable to many companies… [thus] having an impact on some balance sheets.

The ACLI noted that the NAIC’s principal-based reserving initiative is intended to address many of these concerns, but as execution of principal-based reserving is several years away, the ACLI Proposal recommends that the NAIC employ specific measures with respect to reserves and RBC to be implemented in the interim in the following four categories: (1) life insurance reserves; (2) annuity reserves and RBC; (3) RBC for investments; and (4) accounting for deferred tax assets.

At the 2008 NAIC Winter Meeting, the CS Working Group met primarily behind closed doors and announced that input on the ACLI Proposal had been requested and technical reports submitted from various other working groups, specifically (1) the Life and Health Actuarial Task Force (“LHATF”); (2) the Life Risk-Based Capital (E) Working Group (“LRCWG”); (3) the Statutory Accounting Principles (E) Working Group (“SAPWG”); and (4) the Reinsurance (E) Task Force. Subsequently, on January 2, 2009, the Executive Committee and the Plenary held an informational conference call to discuss the findings of the CS Working Group. In addition, the CS Working Group issued a report summarizing each request in the ACLI Proposal and setting forth the CS Working Group’s conclusions with respect to each of those proposals.

Testimony of Interested Parties

The following parties submitted testimony in front of the CS Working Group: Bob Hunter, Director of Insurance, Consumer Federation of America (“CFA”) and on behalf of Center for Economic Justice (“CEJ”); Peter Gallanis, President, National Association of Life and Health Guaranty Associations (“NOLHGA”); Pat Baird, Chairman of the Board of Directors, ACLI; Paul Graham, Chief Actuary, ACLI; Bradley M. Smith, Chairman, Milliman, Inc. (“Milliman”); Caitlin Prendiville, Research Analyst, UNITE HERE (“UH”); Scott Harrison, Affordable Life Insurance Alliance (“ALIA”); National Council of Life Insurers (“NCOIL”) and the Virginia Bureau of Insurance (“VA Bureau”).

The ACLI and other advocates argued that the ACLI Proposal would bring overly conservative restrictions on the use of a life insurers' surplus and capital up to date and allow insurers to make more efficient use of cash at a time when liquidity is essential due to the current economic climate. Mr. Baird, President of Aegon USA, testified that:

the problem that must be addressed is that ultra-conservative capital and reserve standards paint an inaccurate picture of the financial health of the industry at the very time consumers are making these important decisions. Unless these inaccuracies are addressed, consumers could well make poor financial choices.

Mr. Baird went on to ask the group to review the ACLI Proposal and have the courage to take action during this economic crisis, even if there may be a risk in doing so.

Mr. Smith, the Chairman of Milliman, a leading provider of actuarial consulting services to the life insurance industry, also expressed Milliman’s support of the ACLI Proposal. When questioned about the motivation for Milliman’s support, Mr. Smith responded:

Milliman's endorsement of the proposed changes is not a reaction to the financial stress caused by today's volatile and depressed capital markets. Rather, Milliman believes that current statutory standards concerning reserves and the amount of capital and surplus necessary to support insurers is, and has been, overly conservative. Today's economic environment merely illuminates the negative consequences of this excessive historic conservatism. Consequently, we do not endorse these proposed changes as something to be adopted on an 'interim' basis until the economic environment returns to a state of 'normalcy.' Rather, we support these changes because we believe that doing so helps to establish reserves and capital and surplus at levels that best protect and reflect the interests of policyholders, now and in the future.

Mr. Harrison, on behalf of the ALIA, stated that the ALIA believes the ACLI Proposal “provides essential yet modest relief to insurers that will strengthen companies by allowing them to efficiently allocate capital to address changes in market conditions.” In addition, he stressed the importance of uniformity within the states and that the ACLI Proposal was carefully designed to provide a national solution to a vast spectrum of companies with different products lines that would treat companies fairly. Mr. Gallanis of NOLHGA stated that the ACLI Proposal would not be troubling to the solvency of insurance companies.

The CS Working Group asked certain advocates of the ACLI Proposal whether implementation of the ACLI Proposal would change the way rating agencies view the financial strength of life insurance companies and whether there are any companies that are in danger of failing. These advocates responded that rating agencies have informed them that these proposals would not affect the ratings, as the rating agencies utilize their own methodologies.

Various participants voiced strong objections to the ACLI Proposal. Mr. Hunter, testifying on behalf of CFA and CEJ, reminded the CS Working Group that the “foundation of statutory accounting is to value assets and liabilities conservatively to ensure insurers have cash to meet their claim… [and we] urge extreme caution as you consider reducing the available surplus and reserves that currently protect policyholders.” Mr. Hunter then questioned the emergency and rushed treatment of the ACLI Proposal given the fact that the NAIC and state regulators have claimed that state-based regulation has protected insurers where federal regulators have failed to do so. He went on to accuse the NAIC of putting on this public hearing as a sham to give the appearance of public input based on the lack of transparency of NAIC’s actions to date.

Ms. Prendiville, the UH representative, stated that “we are tired of industry-backed deregulation followed by taxpayer bailout [and urged the body] to move in the other direction entirely – toward tighter, not looser capital requirements; more, not less transparency; more, not less aggressive consumer protections…” She went on to state that UH questions the “future of state regulation of insurance that the NAIC would even consider this proposal at a time when the public, and hopefully the incoming administration here in Washington, is looking for comprehensive solutions that will strengthen enforcement and consumer protections and prevent weaknesses in one part of the financial system from infecting the entire system.”

NCOIL submitted a letter that opposed adoption of the ACLI Proposal and argued that the recommendations appear to be relaxing standards when the rest of the world is calling for increased regulation. NCOIL’s letter also stated that it is concerned with the process instituted by the NAIC, which the letter stated has been characterized as a “secretive effort” when a deliberative process is necessary to implement measures of this magnitude. Finally, the VA Bureau also testified voicing its to the SAPWG’s current recommendations with respect to the treatment of deferred tax assets (“ DTAs”).

ACLI Proposal and CS Working Group Recommendations to Executive Committee

At the public meeting that followed the hearing, the CS Working Group voted on the nine specific proposals set forth in the ACLI Proposal. The following summarizes the suggestions set forth in the ACLI Proposal and the Final Recommendation to the Executive Committee with respect to each proposal. As stated above, the Executive Committee voted yesterday to reject the ACLI Proposal in its entirety but stated during the meeting that each of these issues will be taken up separately during the upcoming year.

Life Insurance

Make “Interim Solution” Retroactive

L1a.

Proposal: Allow the 2001 CSO Preferred Mortality Tables (“PMT”) to be used with contracts based on the 2001 CSO and issued prior to January 1, 2007 with domestic Commissioner’s consent.

Summary: The proposal would allow the expanded use of the 2001 CSO PMT, which are currently only available for policies issued in 2007 or later even though many states approved use of the 2001 CSO PMT prior to 2007.

FinalRecommendation: The CS Working Group voted to recommend this proposal by modifying NAIC Model Regulation 815, provided the following two conditions are complied with: (i) insurers will provide statistical experience data in a form acceptable to the Commissioner as set forth in Regulation 815 5C and (ii) reinsurance accounting restrictions are imposed by the Commissioners to demonstrate that insurers have not used questionable reinsurance accounting practices in the past as set forth in Regulation 815 5D. The CS Working Group explained that reserves for certain policies may be overly conservative and reserves calculated under the 2001 CSO PMT are adequate.

L1b.

Proposal: Allow Section 8C of Actuarial Guideline 38 (“AG 38”) to be effective for policies and certificates issued July 1, 2005 to December 31, 2006, currently covered under Section 8B, retroactive to July 1, 2005 with domestic Commissioner’s consent.

Summary: AG 38 Section 8B, which requires more conservative reserves than those required under AG 38 Section 8C, applies to policies issued on or after July 1, 2005, and before January 1, 2007 and to policies issued on or after January 1, 2011; while AG Section 8C applies to the policies issued on or after January 1, 2007 and before January 1, 2011.

Final Recommendation: The CS Working Group voted to reject this proposal based on the reasoning that there is no convincing evidence that reserves in the aggregate for these types of policies are redundant and technical regulators are not convinced that Section 8C will produce adequate reserves.

L1c.

Proposal: Clarify by means of an Actuarial Guideline that when using the 2001 CSO Preferred Structure Tables (“PST”) for basic reserves, the original smoker or non-smoker tables respectively may be used for determining segments when complying with the Valuation of Life Insurance Policies Model Regulation.

Summary: Clarification of the Regulation XXX calculations to prevent technical requirements of the calculation from taking away relief envisioned in 1a.

Final Recommendation: The CS Working Group voted to recommend this proposal because Item L1a was adopted and the clarification prevents the technical requirements of the calculation from taking away reserve relief envisioned by Item 1a.

Deficiency Reserves

L2.

Proposal: Remove the artificial X factor restrictions from deficiency reserve calculation required by Regulation XXX.

Summary: Regulation XXX provides that the use of an experience factor (the “X factor”), used to reflect anticipated mortality experience in developing anticipated valuation premiums is restricted by the requirements that the X factor shall be no less than 20 percent and is none decreasing.

Final Recommendation: The CS Working Group voted to recommend this proposal by modifying NAIC Model Regulation 830 based on the reasoning that X factor restraints on the deficiency reserves are redundant, provided the following two conditions are complied with: (i) a statement in the actuarial opinion discussing the X factor development process and the resulting change is provided; and (ii) the resulting reduction in deficiency reserves is reported as a change in valuation method and reported in Exhibit 5A.

Commissioner Discretionary Authority on Collateral

L3.

Proposal: Facilitate Commissioner’s use of their existing discretionary authority under the Credit for Reinsurance Model Law and Regulation to provide immediate relief to ceding insurers.

Summary: (a) Expand existing collateral accepted for reinsurance reserve credit including (i) lines of credit (“LOCs”) issued by the Federal Reserve or issued by US banks and confirmed by the Federal Reserve; (ii) accept funds provided by the Federal Reserve in US trusts; (iii) accept LOCs issued by non-bank US institutions; and/or (iv) expansion of the interpretation of the phrase “any other form of security acceptable to the commissioner;” and (b) establishing criteria for special purpose vehicles (SPVs) as accredited reinsurers.

Final Recommendation: (a) The CS Working Group voted to recommend expansion of some forms of collateral as fully set forth in a guidance memo prepared for commissioners as well as a model bulletin commissioners can use for public notice purposes and (b) voted to reject expansion of accredited reinsurer status to SPVs.

Variable Annuities

Reserves

VA1.

Proposal: Eliminate standalone asset adequacy analysis requirements in Actuarial Guideline (“AG”) 39 – Reserves for Variable Annuities.

Summary: AG 34 requires a stand-alone asset adequacy analysis reflecting all benefits, expenses and charges associated with the variable annuity contract. This request asks the regulators to remove the requirement of AG 39’s stand-alone asset adequacy analysis.

Final Recommendation: The CS Working Group recommended the alternative suggested by the LHATF which provides that a company may incorporate the asset adequacy analysis in AG 34, provided certain conditions are met with respect to the scope of the analysis and the blocks of business to which it should be applied, investment volatility, policyholder behavior and insurer documentation such as the actuarial memorandum in the annual statement. The CS Working Group noted that Actuarial Guideline VACARVM which incorporates two aspects key to this issue: (i) reserve calculation recognizing all cash flows and (ii) constraints on assumptions and economic scenarios, had been adopted by LHATF in Third Quarter 2008 with an effective date of year-end 2009.

Risk Based Capital

VA2.

Proposal: Modify C-3 Phase II for year-ends 2008 and 2009 to waive the Standard Scenario.

Summary: Requests that the Standard Scenario floor be removed from the total asset requirement (“TAR”) calculation in C-3 Phase II because the Standard Scenario’s use of a single deterministic scenario and a single set of assumptions to quantify risk on products with embedded guarantees results in an inaccurate assessment of the risks compared to the CTE calculation which may result in overstatement of required capital.

Final Recommendation: The CS Working Group rejected this proposal because the Capital Adequacy Task Force is currently reviewing the results and the group is unable to confirm that removing the Standard Scenario floor in C-3 Phase II would not compromise regulatory objectives. In addition, C-3 Phase II instructions allow for a smoothing option with domestic commissioner approval which provides some relief for companies with TAR calculations that increase this year due to the current credit crises.

Investment

Risk Based Capital for Mortgage Experience Adjustment Factor (“MEAF”)

I1.

Proposal: Temporarily modify the calculation of the life RBC MEAF.

Summary: The MEAF, developed to recognize the difference in risk among the mortgage portfolios of different companies, is calculated by dividing a company’s default experience by the default experience of all life insurers. Due to recent low mortgage default rates, the denominator of this calculation is near zero, which causes volatile RBC rates for some companies. The ACLI Proposal suggests that a temporary floor be set for the denominator.