Life insurance investments are regulated in all 50 states, as are most aspects of insurance law and supervision. Until a few years ago, New York state law dominated investment regulation because of New York City�s central role in financial markets and because for many years companies doing business in New York state accounted for about three-quarters of all United States insurance sales. In the early 1990s, however, a model insurance investment law was prepared under the aegis of the National Association of Insurance Commissioners (NAIC) with the goal of having it adopted by all 50 states.

Actual regulation has gone through three phases: reliance on traditional measures and methods prior to the 1980s (albeit with gradual refinements), substantial liberalization during most of the 1980s, and a search for modern and possibly tightened standards in recent years. These phases reflect the place of insurance in finance and its standing as a long-regulated industry. The market disruption by inflation and interest rate volatility beginning in the 1970s played a key role in confronting the industry and its regulators with serious new problems. Other important factors unhinging traditional regulatory measures were the cross-invasion of each other�s territory by previously distinct types of financial institutions and the closely interrelated technological advances in back-office productivity through computerized data collection, record keeping, and client service.

A further and truly decisive factor contributing to the liberalization phase of the 1980s, however, was the nation�s general turn toward deregulation. The movement was fostered initially in the 1970s by the hope that less regulation would mean more competition and therefore help to keep prices down in industries that had been closely regulated (trucking, air travel, commissions in securities transactions, and so on). By the early 1980s, the movement had gained impetus, and liberalization crept closer to the insurance industry via federal laws giving depository institutions interest-rate freedom and easing asset restrictions. This liberalization greatly influenced insurance regulators, although state-by-state regulation necessarily meant a much slower transition than in federally regulated industries.

By the late 1980s, the pendulum was beginning to swing back, and this trend accelerated in the early 1990s. Investment factors were a key to the latest change. Insolvencies, which had been few prior to 1987, accelerated. An ACLI study in 1990 found that 31 of 68 insolvency cases of 1985 to 1990 were related in part to investment problems, although other factors�fraud, underpricing�were even more frequent causes. (These various factors are of course not mutually exclusive.) By the early 1990s, however, investment problems had quite possibly become the leading cause of insolvencies. In addition, as will be noted later, insurance rating agencies� closer attention to insurance portfolios and their frequent downgradings based on investment problems implied that regulators might drop "behind the curve" and not be near the optimal mix of yield and risk unless they redoubled their investment analysis. Thus a push toward conservatism through regulation and supervision gained momentum in the early 1990s. Risk-based capital standards, another recently adopted regulatory item, were closely related to investment supervision since portfolio problems had given rise to capital deficiencies in the major insolvency cases of 1991. The risk-based capital model ties the minimum capital requirements to the risk characteristics of the investment portfolio. Many insurers have reacted by shifting more of their investments into higher-quality, lower-volatility assets.

Pre-1970s regulation emphasized that policy reserves, conservatively valued, should fully cover insurance liabilities. (Since changes in law and regulation have been gradual�even marginal�many of the traditional requirements still apply.)

In the key New York state law therefore quality and diversification were enforced through investment prescriptions and proscriptions. Major latitude was granted for long-term, private-sector earning assets, such as corporate bonds and commercial and residential mortgages (total mortgages had a very generous quantitative limit of 50 percent of assets), as well as for United States government securities. Other investments, judged more risky and/or less reliable as to earnings, were�and remain�rather strictly limited. Thus common stock can constitute only 10 percent of general account assets, as noted, even after several liberalizations over the decades; investment real estate is at 20 percent; foreign investment is at 3 percent (although a separate 10 percent limit applies to Canadian holdings); and, very significantly, a leeway clause permits a liberalized 10 percent of assets to be held outside the otherwise applicable limits, thereby granting significant discretion to go into novel or generally more risky investments.

Within the quantitative freedom for corporate bonds and mortgages, qualitative standards still apply. Bonds must meet the issuer�s earnings test, and lower-grade holdings are curbed. Commercial mortgages are subject to a
75 percent loan-to-value limit. Both bonds and mortgages are limited as to the percentage of assets for which any one debtor can account. (The leeway clause permits an out in specific cases, provided it is not yet fully used�for example, a mortgage loan can be 90 percent of appraised value if 15 percentage points are charged to the leeway, also known as the "basket clause.")

It is clear that an earnings test for bonds or a loan-to-value ratio for mortgages tends to emphasize the past or the present rather than to be an impossible-to-obtain reliable future forecast. The calculus of routine regulation does not encompass adverse general market developments. Thus judgment strongly influences management�s investment decisions. While company capital and its adequacy are the bottom-line test for investment risk, regulators have sought to build intermediate barriers to cushion the effect of adverse portfolio developments.

The first line of these defenses used to be the mandatory security valuation reserve (MSVR), which was a buffer (shock absorber) between the decline in value of market-traded securities and insurer surplus and capital. The MSVR has been supplanted by two reserve accounts (discussed more fully later in this chapter): (1) interest maintenance reserve (IMR) and (2) asset valuation reserve (AVR). Their combined function is essentially the same as the previous MSVR. The IMR and AVR recognize that there are multiple sources of asset value fluctuation risk, and they separate out the interest rate risk of fixed-interest securities. The NAIC, through a Securities Valuation Office, evaluates the quality rating of the bonds in insurance company portfolios.

Common stocks command MSVR holdings in a manner similar to the new AVR requirements. In fact, the stiff provisions of the rules applicable to equities have been a significant factor in curbing common stocks in the general account. The rules, reflecting the perceived wide fluctuations of equity prices, make it difficult to credit the gains from capital values to the policyowner, which make up a large proportion of the total return from equities over the long term. Curiously, however, equity real estate or mortgages have not been subject to the MSVR in traditional insurance regulation, perhaps on the theory that equity real estate was a minor holding and mortgages were not risky if they were restricted by loan-to-value rules. (Impending changes are discussed below.)

A second line of regulatory defense has been required writedowns of company assets as a consequence of adverse developments. Basically, bonds and mortgages are permitted to be held at cost and not at market value, thus stabilizing investment values. But an NAIC decision to recognize major problems and/or outright default of troubled investments points to any inadequacies in the remaining MSVR or company capital.

By the early 1980s, although not abandoned, a great many quantitative rules had been liberalized. As discussed earlier, larger portions of total assets in equities in real estate, in foreign holdings, and in leeway investments had gradually been permitted. Liberalization reached a high point in 1983 when New York insurance law substituted a "prudent-man" rule for many of the inside prescriptions within each category of permitted assets (although the general quantitative limits by asset categories remained in effect). Actual and potential abuses soon forced reconsideration of liberalized regulation.

Below-investment-grade bonds (by the standards of bond rating agencies) had long constituted a substantial part of life insurance portfolios without creating any hazards. These bonds were companies� direct-placement issues that had not yet reached the financial ratios required for investment grade but could pass the earnings test(s) of insurance regulation. The lead insurance companies� close scrutiny of the borrower in such financings, combined with the earnings test(s), virtually assured very few credit problems in such a bond portfolio.

The merger and acquisition and leveraged buyout craze of the 1980s changed this situation materially. Coming at a time when new product needs drove insurance companies into the public market, high-yield, high-risk junk bonds infiltrated insurance portfolios. By 1987, perceiving impending danger, the New York Insurance Department issued an edict limiting such bonds to
20 percent of assets. This regulation was later broadened so that by 1992 the
20 percent limit had additional internal components further restricting holdings (including direct placements) by officially defining riskiness in progressive steps. These rules went beyond preliberalization regulations and, in effect, declared that similarly graded MSVR requirements were not sufficient.

Another important step in modifying liberalization also occurred during the mid-1980s. New York state adopted Regulation 126, a rule requiring justification for the interest rate and cash-flow assumptions underlying the asset/liability match of interest-sensitive products. Aggressive companies had bid up the interest rates they offered on GICs, SPDAs and universal life during the high-rate environment of the early 1980s. Such guarantees on liabilities created surplus strain (weakening of capital ratios) because the earnings assumptions for the corresponding assets were held down by state regulation. High portfolio earnings of the blocks of funds involved were required in order to meet the guarantees and to eliminate the initial capital strain. In addition, the withdrawal privileges often extended for new products, qualified as they might be, generated potential cash-flow problems over questions of asset/liability matching with respect to maturities and values. The New York regulation asked company valuation actuaries to perform adequacy tests under a variety of interest rate scenarios over the life of defined blocks of business. The formulation and enforcement of this rule were key factors in helping regulatory and company actuaries reach an understanding with the investment side of the house about the dynamics of investment-sensitive products.

In addition to several substantial company failures directly related to investment problems, as noted before, the 1990s have witnessed a continuing severe commercial real estate recession. Nonperforming real estate loans rose to a post-Great Depression peak of about 7 percent in 1992. Furthermore, the moderate economic growth in the 1990s has prolonged the unusually large credit problems in the corporate sector, despite a solid recovery of general bond values associated with a major decline of interest rates. Thus investment regulation of insurance companies remains a challenge to state insurance departments�a challenge accentuated by the increasing role of rating agencies in evaluating company acceptability in the general insurance market. In particular, the regulators and the regulated alike have become aware that perceptions of a company�s soundness, including its ratings, might be as important in avoiding runs (and ruin) as any objective standards applied by the regulators.

The repercussions from the crises among depository institutions are yet another factor in the insurance regulation of the 1990s, especially the emphasis on risk relative to capital in evaluating the need for and tightness of an institution�s supervision. With the NAIC�s Model Investment Law, anticipating potential company problems by appropriate regulation has therefore become the dominant theme.

The model law carefully defines allowed asset classes and establishes concentration limits within these classes, somewhat similar to previous regulations. Even prior to a final draft of the model law, the MSVR was transformed into an Asset Valuation Reserve, in which all classes of assets, including real estate, are exposed to reserving rules. In addition, the accumulation rules are stiffer.

Simultaneously, companies were subjected to a new reserve requirement, the Interest Maintenance Reserve. The IMR makes it mandatory to amortize security valuation gains from interest rate changes over the remaining life of a security, rather than having the gains contribute to the profits (or surplus) in the year in which they occur. This new provision will slow up the realization of profits originating in the interest rate declines of the early 1990s, but it will presumably also provide a cushion for interest-rate-caused losses in each sustained upturn of rates.

It appears likely that the eventual investment rules will vary with a company�s capitalization, with strongly capitalized companies enjoying greater freedoms than weakly capitalized ones. As one example, weaker companies might be confined to publicly traded corporate bonds and negotiable private-placement bonds, whereas stronger companies could invest in private placements. Furthermore, for purposes of investment latitude, a company�s capitalization might be measured not only by capital and surplus versus total assets but also by the ratio of capital to risk-weighted assets. The risk weighing might in turn be influenced by asset concentration ratios, such as an unusually large proportion of mortgages in one location or a large ratio of below-investment-grade bonds.

Some very sticky issues delayed until 1996 the final draft and adoption of the Investments of Insurers Model Act. One such issue was the required integration of risk-based capital standards with the model law. (The risk-based capital standards, for which state-by-state adoption was being sought by the NAIC in the 1993-94 time frame, cover risks beyond those relating to investments alone. Other risks requiring capital include withdrawal potential on the insurance liability side and possible state guaranty fund calls.)

Another issue is the permissible extent of the use of derivative instruments and the disclosure requirements associated with their use. It seems clear that protection, rather than speculation, will remain the key to permissibility, but the distinction is more easily stated in theory than applied in practice. Advancing financial technology, from which insurance companies cannot be isolated, is in itself a problem since regulation is almost necessarily a step behind bright operators. (Gaps may also develop in understanding the latest techniques between these bright operators on the one hand, and top management and the directors on the other�a difficult internal company problem that occurs frequently.) Still another difficulty is the required length of any phase-in period for regulations more restrictive than the existing ones.

Reversion to strict rules appears desirable for many reasons. Reassuring the public of life insurance�s soundness is the most important one; discovering and pursuing early warning supervision systems is a close corollary. Still, innovation in product design and investment policy should be encouraged, not suppressed. It is impossible to draw a Maginot line around the insurance industry when financial service institutions are characterized by increasing and highly competitive overlaps. The risk of failure�indeed, occasional actual failure�increases with the attraction of talented and spirited young people to the investment function and to the insurance industry in general. The problem is to confine greed, susceptibility to imprudence, and ambition itself to limits compatible with the productive function of investments within the conservative societal role of insurance. It is helpful that the competitors, especially the banking industry, are likewise experiencing more stringent tightening of capital adequacy and lending rules in the wake of the abuses of the 1980s.