The purchase of a life insurance policy initiates a transaction that may span the better part of a century. This period can be further lengthened by a beneficiary’s election of a settlement option. Thus the insurance-consuming public needs and demands assurance that no matter how long the period before the policy matures and final payments are made, the insurer will survive and be financially able to make the payments required by its contract. This fundamental public need for security translates into regulatory concern for an insurer’s financial soundness (solidity), as manifested in the statutory and regulatory standards, and it mandates surveillance mechanisms focusing on the financial management of the insurance enterprise.

Minimizing the number of insolvencies and the magnitude of insolvencies which do occur requires both early detection and swift correction or removal of financially troubled insurers. To do so requires three fundamental elements: the means to detect financially troubled companies, the authority and ability to correct or remove such insurers on a timely basis, and the regulatory will to do so.

Traditionally, regulators have sought to assure that an insurer maintains assets at least equal to its currently due and prospectively estimated liabilities (including minimum capital and surplus requirements). Thus a substantial body of regulation has evolved covering a life insurer’s (1) assets—the bulk of which consist of investments, (2) liabilities—the bulk of which consist of reserves, (3) capital and surplus, (4) hazardous financial condition in general and (5) the means to monitor insurer financial condition.

A life insurer generates considerable investable funds from both its insurance and its investment operations. The excess of cash received (such as premiums, annuity considerations and other deposits) and the cash flow from existing investments (such as interest, dividends, realized capital gains, maturities, and redemptions) over cash disbursements (benefits and expenses) provides funds for investments. Although an insurer possesses many assets essential to the operation of an insurance enterprise (for example, building, furniture, equipment and computers), the bulk of its assets are held in the form of investments. Thus it is essential for an insurer to have an investment portfolio of good quality to assure that the needed funds are available in the amounts and at the times called upon by its promises. Furthermore, since the liabilities of life insurers tend to be relatively stable and predictable, the primary insolvency risk centers on the potential deterioration in the value of a life insurer’s assets.

In short, the ability of a life insurer to maintain financial soundness and perform on its insurance obligations over the long-term depends upon the success, or lack thereof, in handling its investments. Therefore, not surprisingly, regulatory attention has long focused considerable attention on the conduct of insurer investment operations as part of the overall effort to prevent insolvencies and enhance insurer solidity. All states are concerned with and regulate the nature of the investments permitted to insurers. However, over time as the general investment climate has changed, state limitations on investments have correspondingly evolved.

The first law regulating insurance company investments was adopted by New Jersey in 1852 with several other states following quickly in succession. However, the modern era of life insurance regulation began with the Armstrong Investigation in New York in 1905. Various investment abuses discovered led to that state enacting investment controls. The law specifically set forth the types of investments which were permitted such as U.S. government, state and municipal obligations, real estate acquired by the insurer for its own use or by foreclosure, well-secured mortgage and collateral loans, and equipment trust obligations. Also policy loans and certain foreign investments were authorized. Investments in common stock were prohibited. By 1907, 29 states enacted investment control legislation modeled after the New York law. Over time, New York and other states periodically added new categories of permissible investments including income-producing real estate, common stocks and leeway investments.

While New York has been quite influential in the nature of investment regulation, other states have embarked on different courses. For example, in response to the collapse of a domestic insurer, Illinois enacted very strict legislation in 1933 which continued until a major overhaul in 1983. In contrast, Wisconsin revised its law in the 1960s making it the most liberal in the country. At least until recently, the overall trend has been to increase the range and scope of insurer investment authority to enable insurer response to changed market conditions (for example, the profusion of various types of financial products and increased competition from other financial institutions) and the changing nature of investment markets.

Although different authorities have stated the objectives of insurance investment regulation in different ways, in general, the five following objectives afford a good expression.

First, the primary goal in the regulation of insurance company investments is the prevention of insurance company insolvency. Not only does a failed company impact the company itself, such failure can be financially devastating to its customers that have a significant portion of their assets tied to life insurance policies and/or annuity contracts.

Second, in addition to assuring solvency, it is crucial that an insurer possess sufficient liquidity to pay claims, dividends, excess interest payments and to fund policy loans when called upon to do so.

Third, to the extent consistent with the objectives of solvency and liquidity, regulation of investments is, or should be, interested in high yielding returns on investments to enable lower premiums, increased dividends, higher refunds and enhanced financial strength.

Fourth, of somewhat lesser concern but nevertheless manifested in investment regulation of insurers, the goal is avoidance of improper control over other companies. This is similar to antitrust concerns that insurers not use the vast funds under their control to achieve improper control over other enterprises.

Fifth, several states encourage investments designed to achieve certain social objectives even though such investments may not meet the same standards of safety, liquidity, and return required of other investments. Such social investments might include low-income housing, miscellaneous state agencies, etc.

Traditionally, the responsibility for the regulation of insurer investments is primarily that of the insurer’s state of domicile. In fact, the laws of several states explicitly provide that their investment statutes apply only to domestic companies. However, although primary state concern focuses on domestic insurers, a state also possesses a legitimate interest in the solvency of foreign insurers licensed to do business in the state. A citizen of one state who purchases a policy from an insurer domiciled in another state is vitally concerned with the financial condition of such insurer. Since the interests of their citizen policyholders may be greatly affected by the investment policy of foreign or alien insurers doing business in their states, a majority of states impose some form of limitation on investments by foreign insurers.

Perhaps the most common method of regulating investments of out-of-state insurers is to require that their investments be of similar quality to the investments authorized for domestic insurers (the similar quality test). Some states require that the investment portfolio of a foreign or alien insurer be the same or generally the same as required for domestic insurers (the generally same test). New York imposes the most extraterritoral requirement by requiring foreign insurers to be in "substantial compliance" with New York law.

Investment activities of insurance companies are conducted within the limitations established by state insurance law and regulations. Although there are variances between the states, a significant degree of commonality has been achieved due to the common nature of the problems, the leadership role of the State of New York in establishing the pattern of investment regulation, the common requirement in the laws of several states that a foreign insurer licensed to do business in the state must comply, at least in some general manner with that state’s law, and the role of the NAIC. The states not only require that there be a sufficient volume of assets to offset an insurer’s liabilities, but also specify the form in which the assets must be held. The nature of regulation has evolved through three phases: reliance on traditional measures and methods prior to the 1980s, substantial liberalization in the 1980s and a conservative reaction to the events of the late 1980s and early 1990s.

Nature of Traditional Investment Regulation. In general, as indicated above, state investment controls traditionally have sought to prevent insolvencies through preserving the safety and liquidity of assets standing behind policyholder reserves, sought to prevent undue control of other companies by a life insurer through heavy investments in any one firm, and to a lesser extent sought to enable higher returns and certain social investments. To achieve these objectives, insurer investment regulation specifies the eligible types of investment, imposes quantitative limitations on the amount that can be placed in the eligible investments, and establishes minimum quality criteria for individual investments within the eligible categories. Although the traditional pre-1970s investment regulatory controls have been liberalized over time, nevertheless there have continued to be various investment prescriptions and proscriptions by which state regulation attempts to ensure both diversification and quality in life insurance company investments. While there are variations among the states, the following describes a common pattern.

Type and Quantitative Restrictions on Investments. Most states explicitly prohibit certain types of investments. However, what is prohibited may vary from state to state.

Certain types of investments, deemed to be safe by a state, have been authorized for investment without limitation. Such investments tend to be the traditional heart of insurance company investing. State law authorizes investment in almost all forms of U.S., state and/or local government and some foreign government debt obligations. United States government debt may be treated somewhat differently depending upon its source and whether it is guaranteed, insured, or a direct obligation. All states permit insurers to invest their funds in obligations backed by the full faith and credit of the United States without limitation. Most states permit unlimited investment in obligations guaranteed by the United States. Several states also permit unlimited investment in obligations and stock of United States agencies. Virtually all states authorize investments in the bonds of any state; some states permit investments in the obligations of specific domestic state agencies (often selected for political reasons); and all states have allowed unlimited investments in most obligations of state municipalities. Furthermore, most states authorize investment in Canadian government securities on almost the same basis as American securities. Until recently investment in securities of foreign governments, other than Canada, has been severely restricted other than through the use of the leeway clause.

In addition to government securities, states permit substantial latitude in the amount of investments in long-term private-sector earning assets, such as corporate bonds, since these types of investments were also judged to be relatively safe. Over half the states permit unlimited investment in U.S. corporate debt. Some states, however, impose limitations in terms of percent of assets as to how much corporate debt can be held by an insurer. Most states accord Canadian corporate debt treatment comparable to American corporate debt.

Furthermore, in addition to the authorized unlimited or virtually unlimited investments noted above, many types of investments are authorized subject to a certain quantitative percentage of insurer assets limitations. These investments were perceived to be too risky or less reliable as to earnings to qualify for unlimited investment treatment. However, they were added to the authorized list on a limited basis because of the potentially higher investment returns available. Authorization of such investments is conditioned upon more stringent quantitative restrictions. These restrictions have been of two types: per investment type and per individual type limitations.

In addition to the authorization of corporate bonds for investment, in some states, generally without quantitative limitation, most other types of corporate securities are eligible for investment subject to limitation. For example, while state law has tended not to stringently limit the amount of preferred stock in which a life insurer can invest, there are limits as to the amount of a single issuer’s preferred stock which the insurer can hold (for example, not in excess of 20 percent of an issuer’s total issued and outstanding stock and not to exceed 2 percent of the insurer’s admitted assets).

On the other hand, states prohibited life insurer investments in common stock until 1951. Since then, even though permitted, common stock investments have been subject to a variety of restrictions. These include limiting total common stock investment to a small percentage of the insurer’s assets or to a percentage of its capital and/or surplus and limiting ownership of the stock of a particular company to a small portion of that company’s outstanding shares. Even after several liberalizations over the years, typically common stocks may constitute no more than 10 percent of an insurer’s general account assets.

In addition to the substantial latitude accorded to government securities and certain corporate bonds, states also permit substantial latitude in the amount of investments in mortgage loans (both commercial and residential). These types of investments were also judged to be relatively safe. Total mortgage investments have been subject to a large quantitative limit such as 50 percent of the insurer’s assets.

In contrast, for many years, investment in direct ownership of real estate, other than that needed for operational purposes (such as home offices and other building used by the insurer to conduct business), was prohibited for most life insurers. In recent years, state laws have become more liberal to permit the acquisition of certain types of real estate subject to a quantitative restraint, such as a specified maximum percentage of the insurer’s admitted assets (for example, 10 percent to 30 percent range) which can be invested in such real estate.

Furthermore, a common quantitative investment limitation has been a 3 percent of assets limit on foreign investment (although a separate 10 percent limit applies to Canadian holdings).

Not only have states imposed quantitative limitations per type of investment, they also limit the amount per individual investment. That is, investment in one issuer’s securities is restricted to a percentage, typically 5 percent or 10 percent, of an insurer’s assets, thereby imposing by statute a diversification of assets in the insurer’s portoflio. Safe investments, such as securities issued by the United States government, state governments, policy loans and certain other investments, are commonly exempt from this limitation. Furthermore, some states impose more restrictive limits on certain types of individual investments, for example, one percent to 5 percent of an insurer’s assets to be invested in an individual common stock, a single parcel of real estate, a mortgage, corporate debt instrument, etc. However, most states impose individual limits on only a few types of investments and leave others subject to only the general 5 percent or 10 percent limitation.

Many states have added to their investment law a leeway clause providing that a domestic insurer may use its discretion in placing its funds in loans or investments not otherwise qualified under any section of the law up to an amount not exceeding a stipulated percentage (ranging from 2 percent to 10 percent as between different states) of its total admitted assets. This provision, sometimes referred to as the basket clause, affords some investment flexibility to enable more creative albeit risky investments without jeopardizing the overall system of safeguarding the investment of life insurance funds.

Control Limitations. To preclude improper control of a noninsurance business by insurers, several states impose control restrictions. These prohibit insurers from controlling more than a certain percentage of stock (commonly 10 percent) of another corporation. These limitations were prompted by concerns that insurers, possessing substantial resources for investment, might obtain too much economic power through control of or influence over numerous noninsurance companies. Furthermore, some states have enacted specific rules and/or prohibitions as to the acquisition of bank or insurance company stock.

Qualitative Limitations. In addition to type of investment limitations and quantitative limitations as to the amount which can be invested in various types of assets, state insurance investment regulation has also long imposed a variety of qualitative limitations intended to enhance the safety of insurer investments. The following examples illustrate.

A common restriction is the imposition of a loan-to-value ratio limit on secured loans such as mortgages. Within substantial quantitative freedom enjoyed by mortgages, a qualitative restriction on uninsured, nonguaranteed mortgages is that the loan must not exceed a specified percentage, commonly 75 percent to 80 percent, of the value of the improved real estate (loan-to-value ratio). Similarly, collateral loans are permitted in most states if the loan amount does not exceed 75 percent to 100 percent of the value of the collateral.

Even though insurer investments in corporate bonds enjoy substantial quantitative freedom, many states apply the nondefault qualitative test which prohibits the purchase of bonds on which there have been a default in interest payments during the preceding 5 years. Also investments in medium and lower investment grade holdings are restricted. Similarly investments cannot be made in stocks which failed to pay planned dividends within a certain period.

Many states also prohibit investments in bonds and/or stocks which fail to meet certain earnings tests. For example, as to bonds, the borrower’s earnings over a specified period, typically 5 years, must exceed its anticipated financing costs by a certain percentage, such as 125 percent or 150 percent. Investments may be barred in common stocks which cannot meet a variety of statistical requirements relating primarily to the issuer’s earnings and dividend records.

Other qualitative/safety restrictions include barring investments in companies that fail to meet minimum size requirements (for example, mutual funds), investments in mortgage loans secured by a leasehold if the term of the loan exceeds a specified percentage of the lease period, investments in companies which have not met minimum length of existence requirements, investments in corporate debt and/or equities of insolvent companies, and investments not meeting geographical qualifications as to the location of the issuer, the collateral or the investment itself.

Enforcement of Investment Restrictions. To ensure compliance with investment requirements, the states possess a variety of enforcement mechanisms such as the following.

First, the most commonly used enforcement method is to classify the nonqualifying assets as "nonadmitted" assets. That is, regulators refuse to recognize and count the asset for financial evaluation purposes, that is, it is nonadmitted. This reduces the amount of recognized insurer surplus which, among other things, could impose restraints on the amount of business which the insurer can write, could trigger regulatory intervention on the basis of financial impairment and perhaps might even lead to insolvency.

Second, an enforcement method arises in situations where an investment loses its eligibility for investment because of changed circumstances, for example, real estate no longer used as a home office. Most states permit such assets to continue to be admitted for a specified period of time (typically 5 years), by the end of which they must be disposed.

Third, many states authorize the commissioner to suspend or revoke an insurer’s license for the failure to comply with that state’s investment laws.

Pressures Leading to Easing of Investment Limitations. The late 1960s and early 1970s witnessed a host of acquisition, merger and holding company activity. In turn, this gave rise to pressure to ease regulatory requirements impeding an insurer ability to diversify. Furthermore, the sharp acceleration of inflation in the late 1970s and early 1980s, coupled with the near trebling of interest rates between 1975 and 1982, confronted the life insurance industry and the regulators with serious new problems fueled by interest-rate competition during a period of historically high yields which ended by the early 1990s. Other factors unhinging traditional regulatory measures included the invasion of one another’s territory by the different types of financial institutions (for example, life insurers, property and liability insurers, banks, securities firms and mutual funds) and the rapid technological advances in back office productivity through computerized data collections, record keeping and client service. And a decisive factor contributing to the liberalization of restrictions on life insurance company investments in the 1980s was the nation’s general turn towards deregulation in a variety of areas. By that time, deregulation inexorably had moved to the insurance industry after federal law granted depository institutions interest-rate freedom and eased asset restrictions. The new competitive environment compelled responses from insurers which, in turn, necessitated greater investment flexibility in efforts to achieve higher investment returns to support new products competing in the highly interest-sensitive market for financial products.

State regulation acceded to the demands for greater liberalization of their investment laws. By the early 1980s, although not abandoned, many of the quantitative rules had been liberalized. A larger portion of total assets invested in equities, in real estate, in foreign holdings and in leeway investments had been gradually permitted. Liberalization reached a peak in 1983 when New York insurance law was changed to substitute the prudent-man investment rule for many of the inside prescriptions within categories of permitted investments. However, general quantitative limits by asset categories remained in effect.

Reversion to Greater Restrictions: Review of Insurer Investment Regulation. During the 1950s and 1960s, the few life insurance companies that failed were small insurers, usually with principal owners seeking personal gain through misuse of company assets. In the 1970s, the failure of Equity Funding, fueled by the rampant dishonesty at the upper echelons of management, shocked the public because of its size. But Equity Funding was hardly a mainstream life insurance company. Similarly, the failure of Baldwin-United in the late 1970s was considered to be another anomaly. This company was also perceived to be outside the mainstream of traditional insurers with its primary emphasis on driving up the price of the company’s stock rather than concern over meeting obligations to the annuity contract holders. Consequently few, if any, perceived the life insurance industry, in general, to be in any sort of financial difficulty.

The 1980s witnessed a change in the underlying investment environment. Excess debt among corporations and commercial real estate interests was spurred to dangerous levels by supercharged investor speculation predicated upon the expectation of continued high levels of inflation and interest rates. However, such did not come to pass. The early 1990s also experienced a severe commercial real estate recession with nonperforming real estate loans rising to a post-Great-Depression peak of approximately 7 percent in 1992. Furthermore, the weak economic growth in 1991 and 1992, following a general economic recession in 1990 and 1991, prolonged the unusually large credit problems in the corporate sector as evidenced by a moderate increase in nonperforming bond holdings. These developments threatened the stability of financial institutions, especially savings and loans associations.

The insurance industry was not immune. The commonly cited culprits underlying the worsening financial condition of several life insurers were (1) the collapse of the commercial real estate market commencing in the late 1980s (especially for those insurers having a high percentage of assets in real estate concentrated in a few large, high-risk investments, or sections of the country caught up in the development boom of the 1980s), (2) the collapse of the junk bond market, and (3) the eroding profit margins in various product lines. Driving the quest for high-yield, hence high-risk, real estate and junk bond investments was the move to selling high-yield investment-oriented products, especially guaranteed investment contracts, in highly competitive markets.

Thus, by the early 1990s, the tenor of concern changed and deepened. The danger of financial impairment of even large mainstream life insurers became very real. First there was the collapse of Equity Life, although that company was led by an outsider with a well-known appetite for junk bonds. But shortly thereafter came the shocking demise of Mutual Benefit, an old line life insurer, the 21st-largest life insurance company in the United States, the possessor of a long historical tradition, and the recipient of top financial ratings by respected rating services. With the fall of these two companies, financial ratings became the focus of considerable attention. Rating services tightened their standards and several insurers found their ratings downgraded. Emerging negative ratings and the financial realities underlying those ratings pressured other life insurers to shore up their financial strength. The Equitable converted from a mutual to a stock company. Home Life merged with Phoenix Mutual. Mutual of New York sold its group insurance and pension business. And the Travelers was acquired by Primerica. At the same time, the National Association of Insurance Commissioners embarked upon considerable activity to strengthen the financial regulation of both the life and health and the property and casualty insurance business.

Thus, the life insurance industry proved far from immune to the ensuing financial difficulties resulting not only from the nonperformance of significant portions of their investment holdings but also from the narrowing of spreads on traditional insurance products, the fierce competition in new product yields and the rising cost of outside capital. The failures of Baldwin-United and Charter Securities in the mid-1980s and some major life insurer failures in the 1990s (including Executive Life and Mutual Benefit Life), general weakening of the financial condition of the life insurance industry as whole and widespread writedown of assets led to reemergence of conservatism not only by the regulators but also by the industry.

The period of liberalizing investment constraints was over. Instead, states individually and the NAIC collectively embarked upon several initiatives to enhance the regulation for solvency, including risk-based capital requirements, the installation of the asset valuation and interest maintenance reserves, new rules for cash flow testing, other accounting changes, and, the focus here, a review of insurer investment regulation.

Required Justification of Interest Rate and Cash-Flow Assumptions. A significant step in backing off from the trend of investment liberalization occurred in the mid-1980s when New York adopted Regulation 126 requiring insurer justification for the interest-rate and cash-flow assumptions underlying the asset-liability match of interest-sensitive products. Aggressive life insurers had bid up the interest rates which they offered on guaranteed investment contracts (GICs), single premium annuities (SPAs) and universal life insurance during the intensely competitive high interest-rate environment of the early 1980s. High and often unrealistic portfolio earnings were required to meet such guarantees. The insurer high interest-rate guarantees imposed significant strains on insurer surplus, since the earning assumptions for the assets funding these products were restricted under state requirements. In addition, the withdrawal privileges often contained in these new products generated substantial cash-flow problems as to matching assets to liabilities with respect to values and maturities. To combat these tendencies, the New York regulation called for company actuaries to perform adequacy tests under a variety of interest-rate scenarios over the life of defined blocks of business. Among other things, this created better understanding by regulators, insurance company actuaries and investment personnel as to the dynamics of investment-sensitive products.

Limitations on "Junk" Bonds. A particularly significant problem area for many life insurance companies was below-investment-grade (according to standards of bond rating agencies) high-yield bonds, often referred to as "junk" bonds. For a long time below-grade bonds constituted a significant part of life insurance company investment portfolios without posing a special hazard. These bonds were companies’ direct placement issues which had not yet reached the financial ratios required to achieve the status of investment grade. However, they could pass the earnings test(s) prescribed by state insurance regulation. The lead insurer closely scrutinized the borrower in such financing which, along with the earnings tests, provided ample assurance of few credit problems.

However, the acquisition and merger craze of the 1980s dramatically altered the situation. Coming as it did at a time when new investment-oriented insurance products needs drove the insurers into the public market seeking high returns to fund such products, high-yield/high-risk junk (below-investment-grade) bonds infiltrated insurance company investment portfolios. Perceiving impending danger, in June 1987, the New York Insurance Department promulgated Regulation 130 providing that no domestic life insurer, without approval of the insurance superintendent, could invest over 20 percent of its admitted assets in publicly traded junk bonds issued in connection with leverage buyouts or in jumbo private placements, because of the perceived risk that a high concentration of such investments posed for an insurer. The regulation was later broadened, so that by 1992 the 20 percent limit contained additional inside limits further restricting holdings (including direct placements) by defining riskiness in progressive steps. These rules went beyond preliberalization restrictions.

In 1991, the NAIC adopted the Investments in Medium Grade and Lower Grade Obligations Model Regulation, patterned after Regulation 126, to prevent undue concentration of insurer investments in lower-graded so-called junk bonds. An insurer may not invest in such investments in amounts which exceed a specified percentage of the insurer’s admitted assets. Several states adopted the model regulation or something similar thereto, and several other states adopted different but related requirements.

Review of Insurer Investment Regulation in General: Proposed NAIC Model Investment Law. Although the 1980s witnessed a significant liberalization in investment regulation, in reaction to the number, size and nature of life (as well as property and liability) insurer insolvencies in recent years, insurance regulators began to reconsider some of the liberalizations in the quantitative and qualitative restrictions in the insurance investment laws. Contrary to the liberalization of the immediately preceding years, the trend in the early 1990s has been in the opposite direction, that is, toward more detailed limitations on the composition of the insurer’s investment portfolio. This is particularly manifested in the initial drafts of a proposed NAIC Model Investment Law designed to dramatically reduce investment risk in insurance company investment portfolios. The original objective was to incorporate the Model Investment Law as a part of the NAIC accreditation program for ultimate enactment by all 50 states. However, because of the ensuing controversy over both the Model Investment Law and the accredition program, this objective was put on hold.

The work on a Model Investment Law follows several other recent and significant investment-related initiatives by the NAIC such as (1) the model junk bond regulation which severely limits investments in low- and medium-grade obligations, (2) the implementation of the risk-based capital concept, and (3) the institution of an asset valuation reserve system requiring insurers to set aside reserves based upon the riskiness of their assets and the interest maintenance reserve to deal with interest rate riskiness.

As discussed above, for years state insurance investment laws have spelled out what insurers might invest in, what investments were prohibited and what limits or caps were on certain types of investments. Over time, the investment restraints have been somewhat liberalized to adjust to new economic and technological circumstances. The proposed Model Law would not change all that had gone before. But rather, such activity seeks to respond to the more recent concerns over life insurance insolvencies which were attributable in substantial part to insurer investment practices. Furthermore, through the Model, the regulators seek greater uniformity in investment regulation. However, in doing so, the Model would generally make investment requirements more restrictive.

At the heart of the debate over the basic nature of appropriate investment law restrictions has been the issue of the "prudent-person" versus the "pigeon-hole" approaches. The prudent-person approach would set guidelines for insurer investments based upon what a prudent investor would consider appropriate. The approach would afford insurers considerable discretion in their investments. In contrast, the pigeon-hole approach, favored by regulators and opposed by most insurers, would list different types of investments into which insurers could place their investment funds and place limits on how much each insurer could have in each category. That is, investment regulatory law would establish a strict type of investment as well as quantitative limits on specific investments.

An early draft of the proposed Model Investment Law adopted the pigeon- hole approach on the basis that regulators need concrete guidelines to better be able to determine whether insurer investments are appropriate and reasonable. Furthermore, as the regulators move more towards uniformity in regulation, at least some regulators perceive that insurer and commissioner discretion needs to be somewhat circumscribed. The proposal has been described as telling insurers exactly in what they can and cannot invest and as dictating specific percentage caps and subcaps by every type of issuer for each type of insurer investment asset. In effect, it is said, the Model would compel insurers to invest almost their entire investment portfolios in extremely high-grade, low-yield investments.

The insurance industry’s response has been highly critical. The bill was said to attempt to micromanage an insurer’s investments in a manner seeking to reduce investment risk to an absolute minimum, thereby severely limiting insurer ability to manage investment portfolios in the policyholders’ interests. In effect, by imposing a regulatory bias against investment risk (even well-managed investment risk) the effect of the proposal would be, so it is argued, to dramatically reduce insurer investment income, resulting in higher premiums for consumers and reduced competitiveness in the marketplace with other financial products. It has been urged that justifications for the subcaps have not been demonstrated, that the proposed law fails to address how investment risk should be matched up with insurance risk, that severely restricting flexibility discourages economic development by precluding insurers from investing in stocks and smaller businesses, that appropriate investments in emerging markets (even those possessing an AAA rating) would be curtailed to the point of being meaningless, and that the Model’s requirements would adversely impact, if not prevent, some insurer’s current and/or future use of the insurance holding company structure as already authorized under the widely adopted NAIC Model Holding Company Law.

Particularly harsh criticism has been directed towards the 60 percent loan-to-value requirement for commercial mortgages which could drive insurers from much of the commercial mortgage markets, despite the fact that such investments have been a major source of insurer investment earnings. Furthermore, insurers strongly oppose the ban on investments of types not specifically authorized by the law, since this would place new and potentially valuable investments beyond an insurer’s reach. Also much concern was expressed over the proposed Model Act’s treatment of derivative investment instruments used in hedging transactions to reduce, for example, the risk of falling interest rates. And the draft would limit insurers to only 10 percent of their investments in foreign obligations, 25 percent of their assets in securities of U.S.-based subsidiaries and 5 percent in securities of non-U.S.-based subsidiaries. In turn, this would limit essential portfolio diversification.

Another significant issue is the latitude which the law should grant to the commissioner to permit an insurer to deviate from the investment limitations. Insurers view such discretion as necessary to inject some degree of flexibility into the law. In contrast, the regulator working group drafting the Model Law resisted incorporating any kind of discretion in the commissioner to vary from the Model Law, because such discretion could frustrate efforts at uniformity and because of the added responsibility for making exceptions.

In short, the concept of using over 100 pigeon holes to limit exposure to investment risk is criticized as being archaic in a modern investment environment, evinces a lack of understanding as to how the investment business functions today in a complex modern economy and works contrary to modern professional investment portfolio management.

In response to such widespread concerns and criticism, in 1994, the NAIC working group on the proposed Model Investment Law decided to go back to the drawing board. It was anticipated that a revised draft would move considerably toward addressing several of the insurance industry concerns in such areas as loan-to-value ratios applicable to mortgages, greater flexibility in the use of derivative securities used for hedging (but not speculative) purposes, improved clarity and simplification, etc. However, many of the earlier proposed restrictions are likely to continue (at least in some form). Commissioners will likely be afforded greater discretion to challenge the prudence of insurer investments. And insurers’ board of directors may be required to monitor compliance with board-approved investment plans. Nevertheless, when a revised draft was exposed in late summer of 1994, it gave rise to renewed and substantial industry opposition. Although subsequently the drafters made some changes, by late 1994 very substantial disagreements continued to slow down the efforts to reach a generally acceptable conclusion leaving the ultimate fate of the proposed Model Law very much in question.

Other Topics Related to Investment Regulation. In addition to direct regulation of investments, there exists considerable other regulatory activity which impacts an insurer’s investment activity. For example, deposit laws of some states impact an insurer’s investments by requiring that a certain type of security be deposited in such states in an amount equal to some amount such as that state’s minimum capital and surplus requirements. An insurer’s investments may be impacted by the authorizations and strictures contained in state insurance holding company laws. Investment activity may be restrained by various accounting rules. In addition, most states’ investment laws contain separate provisions in their investment company laws regulating separate account investments.

And finally, most states have adopted various requirements to protect against fraud and self-dealing by insurer management. All states require that most investments (policy loans being the major exception) be authorized by the insurer’s board of directors or committee thereof and that minutes be kept with respect to such decisions to induce deliberate and responsible decision making and to avoid unwise investments by unaccountable employees. Also most states prohibit investments in the stock of the insurer itself or in companies having close ties to the insurer’s directors or employees. And, most states permit investments only at a price equal to fair market value to prevent sellers, who may be related parties to insurer directors or employees, from profiting at the expense of the company. Finally, most states bar insurers from underwriting securities.

Essential to the regulation for insurer solidity is the reporting of financial information using an accounting system geared to that objective and reporting such information on an accurate basis. A review of an insurer’s balance sheet provides an idea of the capital and/or surplus margins available for contingencies if the assets have been properly valued and the liabilities correctly stated. Thus considerable regulatory attention has focused upon the manner of reporting the value of insurer assets.

The valuation of assets held by an insurer for inclusion in the insurer’s annual statement submitted to the insurance regulators is a complex and detailed undertaking. The bulk of a life insurer’s assets consists of securities. Most state laws authorize the insurance commissioner to set forth the rules determining the value of the securities, subject in some states to the limitation that such rules shall not be inconsistent with those established by the NAIC. As a practical matter, if each state imposed its own determinations without coordination with other states, there would not only be duplication of expense incurred by the states and individual insurers, but, more importantly, there would be conflicting valuations. An insurer doing business in several states would report different values for the same securities in different states. Not only would this impose a huge burden on the filing insurers, but submission of differing asset valuations in the different states would result in virtually incomparable financial statements. In turn, this would adversely impact financial analysis and greatly complicate coordinated regulatory actions by the states.

The avoidance of such problems constituted a major reason for the formation of the NAIC in 1871. The NAIC has created an Annual Statement Blank with detailed accompanying instructions which insurers file. It is accepted by all states. The accounting and other rules governing the annual statement are continually under review and subject to change by the NAIC.

In addition, the NAIC created the Securities Valuation Office, which values on a uniform basis the securities held in the portfolios of virtually every insurer in the United States. Consequently every insurer holding the same security reports the same value for that security in its annual statement submitted to all states.

Some assets are valued on an amortized basis (bonds), some on cost basis (preferred stocks), and some on a market value basis (common stock). The adopted approaches were intended to foster objective reporting of financial information to enable the regulator to foster financial solidity of the insurance enterprise.

Traditional MSVR. Since life insurers must value common stocks at market value for annual statement purposes, in the absence of some cushioning mechanism, reported surplus could swing widely due to unrealized capital gains and losses, thereby giving an undue impression of instability in the insurer’s operations. Consequently the regulators introduced the Mandatory Security Valuation Reserve (MSVR) in 1951. The MSVR sought to prevent undue surplus changes, as reported on life insurer financial statements, arising from fluctuations in the market value of securities owned. In addition, the MSVR absorbed, within limits, fluctuations in surplus caused by increases and decreases stemming from realized capital gains and losses.

On the insurer’s balance sheet, the MSVR was shown as a liability even though its nature is essentially that of a contingency fund or earmarked surplus. The MSVR served to accumulate a reserve over a period of years to protect against adverse fluctuations in the value of securities (stocks and bonds) and against losses on their sale. The reserve was built by annual increments until it reached a maximum level as determined by the rules governing MSVR. The amount of annual increments depended upon the values of the bonds and stocks held and upon the net capital gains on bonds and stocks during the year.

A maximum amount was established for the MSVR according to a formula. Until the maximum was reached, capital gains and losses were absorbed by reserve rather than impacting the level of surplus. If the MSVR balance became zero, capital losses would directly decrease surplus. The MSVR applied to general account assets of life insurers. Separate account assets are usually carried at market values.

Although not strictly legal limitations on investments, the statutes and regulations of the various states and the rules of the NAIC relating to the valuation of an insurer’s assets serve to discourage life insurer purchases, at least on an extensive basis, of securities of less than generally acceptable investment quality.

Until 1991 the NAIC required insurers to accumulate a Mandatory Security Valuation Reserve (MSVR) to cover potential investment losses on bonds, preferred stocks and common stocks. The MSVR did not protect against declines in the values of other types of investments. However, by the end of 1991, in recognition of the falling real estate values and the increasing default rates on commercial mortgage loans, which were purchased to match guaranteed investment contract liabilities, the NAIC transformed the old MSVR to include investment reserves for mortgage loans, real estate and equity interests. The reserve was retitled as the Asset Valuation Reserve (AVR) and became effective for 1992. At the same time, the NAIC also imposed a new reserve requirement, the Interest Maintenance Reserve (IMR). Now, the AVR and the IMR have supplanted the traditional MSVR.

Asset Valuation Reserve. The AVR imposes reserve requirements on real estate and commercial mortgages as well as on stocks and bonds. Investment reserve factors are set by the NAIC for the different subcategories of investments. Multiplying these investment factors by the insurer’s assets in each class and adding the totals generates the company’s maximum AVR liability.

By expanding the MSVR to include real estate and commercial mortgages in particular, life insurers with troubled real estate portfolios are compelled to come up with additional reserves to meet NAIC requirements. After a period of transition, commencing in 1994, for any asset of the AVR which is not held at its maximum reserve, the insurer must add 20 percent of the deficit plus capital gains arising by credit enhancement. Funding 20 percent of a shortfall can cause large transfers of surplus to the AVR for some companies. Furthermore, since the maximum AVR liabilities are higher than the previously imposed MSVR requirements, this will cause movement of funds from surplus to the AVR in future years.

Interest Maintenance Reserve. In December 1991, effective for 1992, the NAIC adopted not only the AVR but also the interest maintenance reserve (IMR). The AVR/IMR approach seeks to improve the old system by focusing upon all invested assets rather than just stocks and bonds.

In short, the IMR requires insurers to put interest-related bond gains and losses into the IMR and amortize them to income over the remaining life of the sold security rather than such gains contributing to the profits (or surplus) in the year in which they occur. Thus IMR slows the realization of profits originating in the interest-rate declines of the early 1990s, but it should also provide a cushion for interest-rate-caused losses in sustained upturns of rates.

The preponderance of the liabilities of a life insurance company (perhaps in the neighborhood of 80 percent) consists of policy reserves. Policy reserves are the amounts of funds (based upon assumed mortality tables and interest rates) which are needed, in combination with estimated future net premiums to be received, to provide the benefits promised in the insurer’s life insurance policies and annuity contracts. Life insurers are required to reflect policy reserves as a liability in their financial statements.

If an insurer fails to maintain the proper amount of assets to match its liabilities, including policy reserves, the insurer may become insolvent and unable to pay claims. Thus establishing adequate reserves and accurate reporting thereof is essential to assuring insurer solidity. With solvency as the focus, to assure that reserve liabilities are properly reflected, state law has long imposed minimum reserve requirements by prescribing the method by which minimum policy reserves shall be calculated.

Prior to 1948, the legal basis for calculating minimum net level premium reserves for ordinary insurance was the American Experience Table, and a 3.5 percent interest assumption applied under the prospective method of valuation. However, most states accepted some modification of the net level premium reserve. Under the Standard Valuation Law (initially adopted by the NAIC in the early 1940s), which became effective in all states in 1948, the minimum reserve basis for ordinary policies became the 1941 CSO Table and 3.5 percent interest applied under the prospective formula. (However, modified reserves in lieu of net level premium reserves are sanctioned on a prescribed basis to deal with the problem of high first-year expense drain on an insurer’s surplus.) The NAIC and the states have periodically brought the valuation requirements up to date by amendments.

Pursuant to the law, the commissioner shall annually value or cause to be valued the reserve liabilities (hereinafter called reserves) for all outstanding life insurance policies, annuity contracts and pure endowment contracts of every life insurer doing business in the state. The statutory method is set forth in terms of the mortality tables to be used, the maximum interest rates to be assumed and the valuation methods to be applied. The requirements vary as between life insurance and annuities and between individual, group and industrial insurance. Special requirements pertain to proceeds left with an insurer under supplementary agreements. Over time and as circumstances change, the NAIC has and will adjust the mandated assumptions such as the mortality table used and the interest rates assumed. For those coverages not subject to prescribed minimum standards, insurers must satisfy the insurance commissioner that the reserve basis used is adequate.

The states prescribe only the basis upon which minimum reserves are to be computed. Insurers are permitted to use any other basis which results in reserves that are equal to or greater than those generated by the statutory method. (Life insurers commonly compute their reserves on a more conservative basis than required by law.) However, an insurer must disclose the details of the basis for its policy reserves as part of the NAIC annual statement which it files. The various methods of computing policy reserves are discussed elsewhere and need not be dealt with here.

Furthermore, under the NAIC Model Actuarial Opinion and Memorandum Model Regulation every life insurer shall annually submit the opinion of a qualified actuary (that is, a member in good standing of the American Academy of Actuaries) as to whether the reserves are computed appropriately, are consistent with prior reported amounts and are in compliance with the laws of the state. By regulation, the commissioner may define the specifics of the actuarial opinion including the addition of items deemed necessary. The actuarial opinion shall also include whether the reserves, when considered in light of the assets held by the company with respect to the reserves, make adequate provision to meet the company’s obligations. A memorandum supporting the opinion must also be provided at the request of the commissioner. The actuarial opinion shall be submitted with the annual statement and shall be based upon standards adopted by the Actuarial Standards Board of the American Academy of Actuaries. To be qualified, the actuary must be a member in good standing of the American Academy of Actuaries.

On an insurer’s balance sheet, the excess of assets over liabilities constitutes the insurer’s capital and surplus for a stock company and surplus for a mutual company. Although the capital of a stock company reflects an interest of the stockholders, nevertheless, such capital is available for the protection of policyholders in the event of financial difficulties.

Traditionally, all states have established minimum capital and surplus requirements which an insurer must meet in order to obtain a license to do business. Commonly such minimum amounts are to be maintained by the insurer as an ongoing operation, although some states permit a lesser amount. If the excess of assets over liabilities drops below the minimum requirements, the insurer may be referred to as financially impaired. If the assets drop below the amount of liabilities, the insurer is insolvent. Avoiding insurer financial impairment and/or insolvency constitutes the essence of the goal of solidity of the insurance enterprise.

A prime requisite for organizing and operating an insurer is money. Although the details and the amounts vary significantly by state, traditionally, a state insurance code sets forth minimum capital and surplus fixed-dollar amounts which differ depending upon the line or combination of lines of business to be written and which vary depending upon the type of insurer. To illustrate, a stock insurer might be required to put up $500,000 of capital and $500,000 of surplus for writing a specific line of business such as life insurance or $1.0 million capital and $1.0 million surplus for authority to write several lines, such as a multiple line property and liability insurer. In contrast, a mutual insurer might be required to put up $500,000 surplus.

In the early 1960s, capital and surplus requirements ranged from a few hundred thousand dollars up to $1.2 million. Even then, such amounts were perceived as inadequate for sound and steady growth. Since then the minimum levels have been increased. By the early 1990s minimum fixed capital and surplus requirements ranged from less than $500,000 to $6.0 million depending upon the state of domicile, with most states specifying amounts in the $1 million to $2 million range.

Solvency regulation starts with the threshold question: What is the appropriate minimum level of capital and surplus? Over the years the required levels have been periodically criticized as being inadequate. However, in determining whether the traditional system has fallen short, it is appropriate to ask what purpose or purposes are such requirements intended to serve.

Screening Function. One function of minimum capital and surplus requirements is to screen certain insurers out of the marketplace. The higher the minimum levels, the greater the discouragement of entry into the business by small undercapitalized insurers possessing an immediate high potential for failure. In addition, high entry requirements tend to discourage or prevent those operators seeking to utilize an insurance company as a source of unethical or fraudulent aggrandizement of personal wealth. Low minimum levels in many states have been said to compel only small personal investments in an insurance company as the purchase price of a license to steal. If the basic purpose of imposing capital and surplus requirements is limited to the screening function, simply increasing fixed levels of the minimum requirements would probably suffice.

Buffering Function. Few are likely to urge that the objectives of capital and surplus requirements should be restricted to only a screening function. Capital and/or surplus funds serve many purposes including protection against inadequate reserves, inadequate premiums, decreases in the value of assets, uncollectible reinsurance, catastrophic events and shortfalls in investment income. That is, the higher the capital and surplus requirements (assuming the absence of a corresponding decrease in the level of established reserves), the greater the buffer to absorb at least some adverse operational experience and/or other financial setbacks. Given the broader "buffer" purposes, recent consideration has been given to imposing varying capital and surplus requirements based upon the nature and volatility of the business.

The periodic debate on the adequacy of state solvency regulation, which has gone on since the inception of insurance regulation, received new impetus with the failure of a sizeable number of property and liability insurers and reinsurers in the early and middle 1980s. The number, size and nature of the insolvencies led to congressional investigations and renewed self-examination by state insurance regulators, both individually and collectively, through the NAIC. With the savings and loan bailout, the property and liability insurer debacle, failures of banks and other financial institutions, the financial impairments of some high-profile life insurers in the early 1990s and intense federal scrutiny, momentum built for strengthening the existing system of insurance regulation for financial solidity of the insurance enterprise. A prime target of inquiry was the traditional fixed-dollar minimum capital and surplus requirements which were perceived as being too low and ineffectively related to the riskiness of an insurer’s current operations.

In December 1992 the NAIC adopted risk-based capital requirements (to be implemented in 1993 for life insurance companies) to better enable regulators to ensure that insurers maintain an adequate financial cushion to protect against a wide range of risks to insurers’ financial condition. This was to be achieved by designing standards and procedures to enable a regulator to better identify inadequately capitalized life and health insurers and to enhance the regulator’s ability to take corrective action to avoid or minimize the size of an insolvency.

Prior to risk-based capital requirements, insurers were subject to the same minimum capital requirements regardless of the insurers’ size or the nature and amount of risks undertaken. Risk-based capital standards were designed to replace this arbitrary fixed amount system with a system which required insurers to maintain minimum capital levels based upon the various risks which an insurer assumes. At the heart of the risk-based capital requirements is an NAIC adopted formula to calculate the amount of capital/surplus an insurer should possess as a minimum in view of that individual insurer’s exposure to a variety of risks. This required minimum level is compared to the insurer’s actual capital level.

The amount of minimum capital needed is termed risk-based capital since it is computed with a view towards the four types of risks confronting insurers: (1) asset default risk which concerns the risk that long-term assets (such as mortgages, bonds, and stocks) may go into default, (2) insurance risk which relates to the risk that claims may be larger or more frequent than anticipated or that products may be severely underpriced, (3) interest-rate risk which is the risk that securities may not perform as expected to support the rates the insurer guarantees to its policyholders, and (4) general business risk which involves the ordinary risks of doing business such as the quality of management, fraud, market competition and guaranty fund assessments due to the insolvency of other insurers.

An insurer’s assets are evaluated and given a factor based upon how they are affected by these risks. Factors assigned are higher for those items subject to greater risk and lower for those subject to less risk. Then, the insurer’s actual capital is divided by the results of the formula to yield a ratio. A ratio of 1.00 or 100 percent is the minimum amount of capital which an individual insurer needs to maintain. The riskier the individual insurer’s operations, the greater the risk-based capital required to avoid regulatory action. The regulator can compare the insurer’s actual capital/surplus with its risk-based capital to assess whether there is need for regulatory action.

The risk-based capital formula approach and the results derived thereunder are incorporated into the NAIC Annual Statement Blank submitted by each life insurer commencing with the annual statement submitted for calendar year 1993. That is, each life insurer is required to compute its risk-based capital and report the results in its annual statement. In addition, there is a risk-based capital report which is a detailed presentation of the insurer’s calculation of its risk-based capital which is subject to review by the insurance department.

The NAIC risk-based capital system goes beyond calculating and reporting risk-based capital for each insurer. An integral part of the risk-based capital system is the NAIC Risk-Based Capital for Life and/or Health Insurers Model Act which, when enacted by the separate states, requires every life and health insurer licensed to do business in the state to calculate its total adjusted capital/surplus and its risk-based capital requirement. The Model Act also requires every domestic insurer to annually file, by March 1, a report of its risk- based capital levels as of the end of the previous calendar year with the domestic commissioner, the NAIC and, upon request, each state in which it is licensed to do business. If the commissioner deems the report inaccurate, he or she shall adjust the risk-based capital report accordingly.

The Act sets forth several regulatory action levels with each succeeding level triggered by a worsening relationship between the insurer’s actual capital and its adjusted risk-based capital and/or some other specified event. The lower the insurer’s actual capital level in relation to the amount of risk-based capital called for, the greater the regulatory intervention by the commissioner which is allowed or mandated. An insurer whose actual capital and surplus exceeds the computed risk-based capital standard requires no regulatory action. At the "company action" level (that is, the actual capital and surplus falls between 75 percent and 100 percent of the computed risk-based capital standard for the company), the insurer must prepare and submit to the commissioner a comprehensive financial plan to identify the problems(s) and propose corrective actions. The commissioner shall review and approve or disapprove the plan for implementation. At the "regulatory action" level (50 percent to 75 percent), the commissioner shall require a risk-based capital plan, perform an appropriate examination of the insurer and order corrective actions. The primary new element, as compared to the company action level, is regulatory authority involvement in developing the recovery plan, using outside resources as necessary. Insurer management has lost a substantial degree of freedom in dealing with its problems. If the "authorized control" level is reached (35 percent to 50 percent), the commissioner is authorized to take such actions necessary to cause the insurer to be placed under rehabilitation or liquidation. If the "mandatory control" level (below 35 percent) is triggered, the commissioner shall (as distinguished from "may") place the insurer into either rehabilitation or liquidation. Consequently the Act is designed to enhance the regulator’s authority to intervene if an insurer experiences financial difficulty.

In short, the risk-based capital model establishes minimum capital/surplus requirements for each insurer which vary according to that insurer’s particular risk characteristics as to default proneness of assets, insurance risk, risk due to changes in interest rates and other business risks. Those insurers undertaking riskier activities must maintain greater capital and/or surplus to provide an adequate buffer in the event of adversity. Thus by adopting standards based upon risk rather than the prior system of static minimum capital and surplus requirements, state insurance regulators seek to compel insurers to achieve and maintain levels of capital and surplus which more adequately support their individual operating and investment strategies and activities. If an insurer’s capital and surplus, after certain adjustments, exceed the required minimum amount as determined by the risk-based capital formula, the insurer meets what the regulators consider to be the necessary safety margins. However, those insurers falling below these capital and surplus standards are subject to varying degrees of regulatory intervention.

With the implementation of the risk-based capital system, public confidence in the regulation of the life insurance business should be enhanced, regulators should intervene sooner into the activities of financially troubled insurers resulting in either a revitalization of the company or reduced insolvency costs due to timely regulatory action. Then industry should become better capitalized as implementation of risk-based capital creates greater awareness among many insurers of the risks they are running.

The events adversely impacting the financial condition of the insurance industry in the 1980s and early 1990s led to dramatic responses by the insurance regulators. The severe tightening of investment limitations, as evidenced especially by the evolving NAIC Model Investment Law, the implementation of the asset valuation reserve and the interest maintenance reserve concepts, and the development and adoption of risk-based capital, reflect individual partial reactions to the shaky conditions experienced by the industry during these years. Although these responses give rise to overlaps and contradictions, they also reflect complementary efforts in dealing with fundamental concerns. Although risk-based capital may currently be at the cutting edge of constraints on insurer investments, the Model Investment Law potential may be more restrictive. Although insurance companies both fear and contest potential regulation overkill, most do not deny that the regulators have vigorously responded to real and fundamental concerns.

In 1985, the NAIC adopted the Model Regulation to Define Standards and Commissioner’s Authority for Companies Deemed to Be in Hazardous Financial Condition. This Model Regulation, or something similar thereto, has been adopted in approximately one-half of the states with a few other states adopting related legislation or regulations.

The purpose of this Model Regulation is to establish standards which the commissioner may use in finding that an insurer is in such condition so as to render its continued operation hazardous to the public or to the policyholders. It enumerates a litany of tests, inquiries and events which might indicate that the insurer has serious problems. If the commissioner determines that the transaction of such business is hazardous in light of these factors, he or she may order the insurer, subject to an appropriate hearing and judicial review, to take specific corrective actions (for example, reduce the risk retained, obtain additional reinsurance, limit the amount of new or renewal business written, reduce commission and/or general expenses, increase capital and surplus, suspend declaration of shareholder and/or policyholder dividends, submit reports, etc.). The hazardous standard is embodied in numerous statutes covering both financial condition and market conduct. By defining the factors relevant to applying the standard with greater specificity, better guidelines are provided for the regulators and the regulated, but also serve to bolster the commissioner’s position should his or her actions be subject to judicial challenge.

Establishment of minimum standards and imposition of specific prohibitions or restrictions are of little use if the regulator lacks sufficient means to ascertain failure of insurer compliance with such requirements and/or possesses inadequate means of enforcement in the event of violation. Over the years, in addition to the informal methods of oversight through personal contacts and obtaining "street" knowledge about insurers doing business in their states, the regulators have evolved a series of formal monitoring mechanisms to detect problem companies. Those used on a widespread basis have developed in the context of state collective efforts through the NAIC. Traditionally, state insurance departments have possessed three basic mechanisms for the detection of financially troubled insurers: (1) insurer financial statements, (2) formal and informal early warning systems supplementing individual insurance department analysis and (3) examinations of insurance companies. In addition, the NAIC has implemented the risk-based capital approach discussed immediately above.

Life insurance company financial statements have evolved in response to the needs of various audiences including investors, the Securities Exchange Commission, state insurance regulators, creditors, securities analysts, rating agencies, policyholders, agents and employees of the company, and company management. Each of these audiences possesses different interests. Thus the financial statements for each have different albeit often overlapping objectives. The focus here is on financial statements for regulatory purposes.

Statutory Accounting Principles. Representing existing and potential policyholders, beneficiaries and third-party claimants, the state insurance regulators’ primary concern is whether the insurer can meet its present and future claim obligations. Consequently regulatory focus is on the near and long-term financial safety and solvency (that is, solidity) of the insurance company. Thus regulatory accounting principles and practices, having evolved in the context of the overriding concern with solvency, are designed to provide a conservative (liquidating) measure of surplus using statutory accounting practices (SAP) as distinguished from focusing on the insurer as an ongoing concern which would use generally accepted accounting principles (commonly referred to as GAAP).

SAP constitutes a form of liquidation based accounting. That is, it seeks to reflect the insurer’s financial condition as if the insurer is expected to cease operations in an orderly fashion in the near future. SAP tends to conservatively value both assets and liabilities. SAP sets forth the rules specifying the statutory assets (termed "admitted assets") and statutory liabilities which are recognized in the balance sheet and the methods to be used in valuation of these assets and liabilities.

In addition to the mandated filing of SAP-based financial statements, insurers whose securities are traded on public stock and bond exchanges must also prepare GAAP-based financial statements for filing with the Securities and Exchange Commission and for the use of external users such as investors and creditors. GAAP is promulgated by the Financial Standards Accounting Board (FASB)

Not uncommonly, regulated industries have developed alternative accounting principles designed to better meet regulatory oversight needs for which GAAP, given its focus on investor and creditor decision making, is perceived to be deficient. The differences between SAP and GAAP are primarily the consequence of differing informational needs between regulators, investors and creditors. Insurance regulators are primarily interested in ascertaining the ability of insurers to pay claims when due, therefore giving rise to the emphasis on insurer liquidity. The investor orientation of GAAP emphasizes information on earnings as the primary focus of financial reporting. The balance sheet of an insurer prepared pursuant to SAP is thought by many to afford a more conservative presentation of financial condition than does a GAAP balance sheet in that both statutory net worth (surplus) and statutory income typically are smaller than in GAAP statements. However, it should be noted that arguments have been made that the general perception that statutory accounting is substantially more conservative than GAAP accounting is incorrect.

It also should be noted that the statutory accounting based annual statement does not escape criticism. An asserted inherent problem with statutory accounting is that it is not rooted in, hence has not evolved from, a defined set of principles. Instead, it is a system which has developed over time (much like the Internal Revenue Code) in response to various issues, pressures, and developments. Although GAAP accounting is subject to some of the same type of political pressures (for example, from the Securities and Exchange Commission), it is said to be more disciplined and guided by principles.

Uniformity: Implementation of the Statutory Accounting Principles System. If each state imposed its own distinct set of financial reporting requirements, insurers would be subject to onerous conflicting demands, financial information would be difficult to compare, financial analysis would be severely complicated, and general chaos would reign. Early on it became quite clear that a mechanism to achieve at least a reasonable degree of uniformity in regulatory financial statements was essential. This need for uniform financial statements constituted a major factor leading towards the formation of the NAIC back in the late 1800s. The current NAIC annual statement evolved from the balance sheet form adopted in 1875. In addition to prescribing the annual statement forms (blanks) which must be filled out and submitted to each state in which the insurer does business, the NAIC has codified statutory accounting practices into policy manuals and procedures, and produces an annual statement guide covering information to be included in every report, schedule, and exhibit which make up the NAIC blanks. The accounting format is subject to annual revision by the NAIC in response to changing business conditions and regulatory demands.

A life insurer must comply with the financial reporting requirements of each state in which it does business. Since the laws of the individual states have embraced the NAIC annual statement as the basis of their requirements, the NAIC has long been a predominant player in the nature of financial reporting of life insurance companies. As a result, filing financial statements on the SAP basis is the rule nationwide. However, this does not preclude an individual state insurance department from requiring additional information deemed important to the regulation in that state.

The NAIC’s establishment of a standardized annual statement, while not insuring 100 percent uniformity, does promote the basic objective of uniformity in financial reporting, an area where comparability of data is of major importance. It also enhances efficiency in regulation. If each state were to prescribe its own reporting format, both insurers and insurance departments would incur substantial additional costs. In short, the foundation of financial regulation is the NAIC annual statement blank filled out and filed by insurers in each state in which they do business.

Use of Financial Statements. The NAIC annual statement blank has evolved over an extended period of time. It encompasses numerous reports, schedules, exhibits and explanations. The most common and significant reports are the statement of financial position (commonly referred to as the balance sheet), the income statement, and the statement of cash flows. It is a document with over 40,000 individual entries designed to reflect the insurer’s assets, the business written, the reserves maintained, and the company’s overall operating experience. The annual statement provides a source of voluminous information on the insurer’s financial condition and operations. As such, it serves as the focal point for financial analysis of the insurer. Because of the regulator’s emphasis on solvency, the balance sheet occupies a central role in regulatory monitoring of insurer performance.

Insurance department analysts review the annual statements. Data is extracted from them to be processed by individual states, the NAIC, and private analytical computer systems. The ensuing analysis can trigger more in-depth investigations, including a specifically targeted or a full-fledged examination of an insurer when there are suggestions of serious financial difficulty.

To be an effective regulatory tool, the content of the annual statement must be relevant. Through NAIC rules governing the content of the annual statement and individual state regulatory requirements, the regulators mandate disclosure of information deemed relevant to the ascertainment of insurer financial condition. Illustrative are the earlier discussed requirements as to, for example, valuation of assets, minimum reserves, and risk-based capital requirements.

In short, the fundamental purpose of the annual statement is to portray an insurer on a conservative liquidating basis, with the insurer being required to maintain minimum policyholder surplus margins. As a consequence, as perceived by many, greater assurance is provided that the insurer does possess sufficient assets in relation to its liabilities to meet obligations to its policyholders and their beneficiaries.

Accuracy and Audits. Mandating relevant information is of little value if an insurer does not report such information accurately. To assure accuracy, the failure to file an accurate annual statement constitutes a violation of law. For example, the NAIC Model Unfair Trade Practice Act defines as an illegal practice the knowing filing with the insurance commissioner of any false material statement of fact regarding the financial condition of the insurer. Also illegal is a knowing false entry of a material fact in any book, report, or statement of the insurer, or omitting a true entry of any material fact. Violations are subject to monetary fines and/or license revocation plus possible criminal sanctions for fraud. Furthermore, the insurer must file the statement signed by a responsible officer. Both individual states and the NAIC review filed annual statements with various cross checks and tests to detect problems in the accuracy of reporting.

Nevertheless, whether due to inadvertent error, sloppy accounting practices, or intentional misrepresentation, the reporting of erroneous information is not uncommon. In response, several individual states and the NAIC have moved in the direction of requiring independent certified public accountant (CPA) audits of the annual statement and an actuarial or qualified reserve specialist certification as to the adequacy of policyholder reserves as a test of the validity of the information submitted in the annual statement. When opining as to the adequacy of the reserves, one must consider that in today’s competitive and fast-changing economy, the reserves cannot be established by fixed standards alone. They also require the exercise of professional actuarial judgement.

CPA Audits. The NAIC position on increasing reliance upon independent audits performed by certified public accountants (CPAs) as an integral part of monitoring the financial condition of insurance companies has evolved over a period of time since the 1970s. In 1988, a policy statement was adopted to the effect that state statutes or regulations should require annual audits of domestic insurers by CPAs. The NAIC annual statement instructions were modified commencing with the 1991 statement to require a CPA audit as does the NAIC Model Rule (Regulation) Requiring Annual Audited Financial Reports. However, the requirement of CPA audits does not limit the commissioner’s authority (although hopefully the need) to conduct insurance department examinations.

To qualify, the CPA performing such an audit must be in good standing with the American Institute of CPAs, and he or she must conform to the ethical standards of the profession. No person shall be recognized as qualified if he or she has been convicted of dishonest conduct under federal or state law, has been found to have violated the insurance law as to previous reports submitted, or has demonstrated a pattern of failing to detect or disclose material information in previous reports.

The CPA audit shall include reporting on the financial position of the insurer, the results of its operations, its cash flows, changes in capital and surplus, and a summary of ownership and relationships between the insurer and its affiliates. If an insurer and the CPA disagree, the commissioner must be notified. Provision is made for submission of the substance of such disagreement to the commissioner and for notice to both the insurer’s board of directors and the commissioner as to the CPA’s finding of insurer material misstatements in its financial condition and/or insurer failure to meet the minimum capital and surplus requirements. In addition, each insurer shall furnish the commissioner a written report prepared by the CPA describing significant deficiencies in the insurer’s control structure.

Most states, as of 1994, have adopted the Model Rule or something similar thereto. Several other states have adopted related legislation or regulations. In addition, some states may have adopted the basic requirements of the Model by requiring the insurer to follow the NAIC annual statement instructions.

Reserve Certification. The amended Standard Valuations Law authorizes the commissioner to promulgate regulations to effectuate that Act. In 1991, the NAIC adopted the Model Actuarial Opinion and Memorandum Regulation (amended in 1992). As of the end of 1994, 17 states adopted the Model or something similar thereto with a few additional states adopting related legislation or regulations. The purpose of the Model is to prescribe (1) guidelines and standards for annual statements, actuarial opinions and supporting memoranda required by the Standard Valuation Law and (2) rules as to the appointment of a qualified actuary.

Timeliness of Financial Statements. Solvency regulation centers on financial analysis to determine whether a particular insurer is tending towards or has actually reached the condition of insolvency. If the financial statement is to serve as an early detection device which will trigger timely regulatory action, the availability and utilization of such statements must be timely. The earlier financial analysis detects serious problems, the more likely some form of rescue activity can be arranged (such as a merger, infusion of capital or some other type of remedial measure).

Since the annual statement is required to be submitted by March 1 after the end of the calendar year which it covers, by the time the statement is reviewed, a few to several months may elapse. Furthermore, if adverse developments occurred early in the calendar year, perhaps as much as a year or more might go by before the information is reviewed. As insolvencies over the past 10 years have indicated, a lot can happen in a period of several months to a year, mostly bad in a financially troubled situation. Timeliness of reporting has proven to be a significant problem.

To address the problem of timeliness, some states and the NAIC require at least some insurers to file abbreviated quarterly statements. In addition, beginning in the late 1980s, several states and the NAIC moved towards requiring insurers to submit their annual statements in a computer format to speed the processing time by the regulators.

In the early 1970s, the NAIC established a computer database consisting of information derived from individual insurance company annual statements. Currently, it is the largest insurance financial database in the world, with more than 5,100 insurers filing their annual statements directly with the NAIC. This database contains financial information for 98 percent of United States domiciled insurers, representing 95 percent of total premium volume.

From the filing of information with the NAIC there evolved the early warning system known as the Insurance Regulatory Information System (IRIS) which is intended to assist state insurance departments in performing their statutory responsibilities in overseeing the financial condition of insurers doing business in their states. IRIS consists of two phases. First, there is the statistical phase during which the NAIC compiles information from insurer financial statements and computes a variety of financial ratios, using the NAIC computer database. The results are made available to the state insurance departments. Second, after the ratios and ranges have been computed, the analytical phase ensues during which a team of examiners and financial analysts representing all zones of the NAIC gather at the NAIC Support and Services Office to review the ratio results. In this phase, focus is on those insurers exhibiting a number of ratios outside specified acceptable ranges. (In establishing the usual ranges, regulators reviewed the ratios for insurers which had become insolvent or had experienced financial difficulties in recent years.) Using the ratio results and other criteria deemed appropriate, insurers are categorized with a view towards prioritizing those insurers requiring immediate regulatory attention. The tests are not intended to be conclusive as to an insurer’s financial condition but rather to provide indications of possible financial problems to the state regulators. Thus IRIS does not replace each state insurance department’s own in-depth financial analysis and on-site examinations. The examiner team prepares synopses or summaries of the financial conditions of most of the insurers reviewed. The examiner team findings are reported to the state insurance departments with a state being immediately informed as to any of its domestic insurers requiring immediate regulatory attention.

When a state is notified that one of its domiciliary insurers has been designated as needing immediate regulatory attention, the domiciliary state notifies the examiner team of any regulatory action initiated. Insurers determined to be immediate attention insurers must file quarterly statements with the NAIC. Furthermore, they are subject to ongoing monitoring by the examiner team throughout the year to measure changes in financial condition.

IRIS and individual state early warning systems, either separately or in conjunction with IRIS, seek to detect those insurers heading for financial trouble far enough in advance so that remedial action can be undertaken on a timely basis or that the insurer can be closed down as soon as possible to avoid prolongation and increased size of insolvencies. As part of ongoing efforts to upgrade its computer facilities, the NAIC instituted a system under which quarterly data is inputed into its database and certain ratios are calculated and sent to the states. Being dependent upon the annual or other required statements as the primary source of information, IRIS is subject to the same problems of accuracy and timeliness as are such statements.

Insurers are subject to both the IRIS

risk-based capital reporting requirements. The purpose of each system is similar in that they both are intended to detect financially troubled companies in order to trigger appropriate and timely regulatory action. Consequently, there is considerable overlap not only in regard to purpose but also with regard to what they measure. The risk-based capital system, being the more recent model, perhaps is the more valuable of the two. Despite any overlap or duplications, however, both systems are currently in place and must be complied with.

States have long possessed the authority to send experts into an insurer and conduct an in-depth examination of its financial condition. However, since many insurers do business in several states if not nationwide, if each state were to exercise its power to examine each company, there would be an immense duplication of effort, unnecessary and considerable expense, and conflicting reports of examination. To avoid these problems, the NAIC established an examination system under which examiners from different states, each examiner representing those states in the geographical zone of which his or her state is a part, conduct a single examination of the company. As a result, a coordinated examination report is then filed with all states in which the insurer does business. In addition, the NAIC develops and updates, on an ongoing basis, the Examiner Handbook so as to maintain and improve the quality and uniformity of examinations conducted under the auspices of the NAIC.

Furthermore, the Society of Financial Examiners, in conjunction with the NAIC, created a three-level system of examiner proficiency. Examiners can achieve different professional designations, depending upon academic achievement and experience, which the NAIC uses in allocating responsibilities in the financial examination system.

Most states require an examination of each insurer every 3 to 5 years. Once an examination is started, it usually takes a considerable length of time to complete, often months or longer. Consequently even though examinations possess the potential of providing the most in-depth information as to the financial condition of the insurer, the availability of such information may be too late to serve as a basis for timely and effective regulatory response.

To alleviate this problem, states have increasingly resorted to more frequent targeted examinations concentrating on certain aspects of an insurer’s operations where there are indications of trouble, rather than undertaking the time-consuming process of examining everything. There has also been movement to not calling an examination merely because of the amount of time elapsed since the insurer was last examined, but rather to base an examination call upon the need to review due to actual or potential problems. As a reflection of state and NAIC efforts to improve the timeliness and relevance of examinations, in 1990, the NAIC adopted the Model Law on Examinations to replace its 1956 version. All states have enacted some type of law and/or regulation governing examinations with nearly half of the states adopting the recent Model Law or something similar thereto.

The Model Examination Law reflects a conceptual change as to the frequency and scope of on-site financial condition examinations of insurers. The Law authorizes the commissioner to conduct examinations whenever deemed necessary and to determine the scope of the examination. The objective is to focus insurance department resources on those companies having or likely to have financial difficulty. The former approach of examining every insurer at approximately the same time intervals resulted in expending too much time and too many resources on financially sound insurers with a corresponding insufficient amount of attention directed towards the more marginal insurers. (However, all insurers are still to be examined at least once every 5 years with the attendant beneficial effects arising from the fact that each insurer knows that sooner or later its time will come.) With the advent of additional regulatory tools in recent years (such as annual independent CPA audits, actuarial opinions on insurance reserves, annual financial statement analyses, etc.), the need for routine comprehensive examinations has been alleviated.

In lieu of an examination of a foreign insurer, the commissioner may accept the examination report of the insurer’s state of domicile. However, commencing in 1994, such reports are acceptable only if that department is accredited under the NAIC’s accreditation program or the examination is performed with the participation of an accredited insurance department and certified as being performed in a manner consistent with the standards and procedures of such department.

The Model Law sets forth the authority and provisions for the conduct of such examinations; authorizes the use of the guidelines set forth in the NAIC Examiners Handbook; establishes procedures governing the preparation, review by the company and the insurance department and adoption of the examination report; and authorizes the commissioner to order corrective actions arising from discovered violations of the law. Nearly 40 states have adopted the Model Law or something similar thereto.