International Insurance Regulation - United States

Insurance Basics: Insurers assume and manage risk in return for a

premium. The premium for each policy, or contract, is calculated based
in part on historical data aggregated from many similar policies and is
paid in advance of the delivery of the service. The actual cost of each
policy to the insurer is not known until the end of the policy period (or
for some insurance products long after the end of the policy period),
when the cost of claims can be calculated with finality.

The insurance industry is divided into two major segments:

property/casualty, also known as general insurance or non-life,
particularly outside the United States, and life. Property/casualty
insurers sell home, auto and commercial coverages; life insurers sell
life, long-term care and disability insurance and annuities. In the
United States, both types of insurers submit financial statements to
regulators using SAP but there are some significant differences
between the accounting practices of property/ casualty and life
insurers due to the nature of their products.

Insurance is regulated by the states whose main objective is to

monitor and maintain the solvency of the companies they regulate.
States also oversee rates, particularly for property/casualty insurers,
to ensure they are adequate, not excessive and not unfairly
discriminatory. To support these goals, all insurance companies are
required to file annual financial statements with state regulators using
an accounting system established by the National Association of
Insurance Commissioners known as statutory accounting principles, or
SAP. SAP generally recognizes liabilities sooner and at a higher value
than GAAP and assets later and at a lower value.

Differences Between Property/Casualty and Life Insurance

Contracts: Some differences between property/casualty insurance
contracts have accounting implications. These include:
Contract duration: Property/casualty insurance contracts are usually
short-term, six-months to a year. As a result, the final cost of most
property/casualty contracts will be known within a year or so after the
policy term begins, except for some types of liability contracts. By
contrast, life, disability and long-term care insurance and annuity
contracts are typically in force for decades.
Variability of claims outcomes per year: The range of potential
outcomes with property/casualty insurance contracts can vary widely,
depending on whether claims are made under the policy, and if so,
how much the ultimate settlement (claims payments and claims
adjustments expenses) costs.

In some years, natural disasters such as hurricanes and man-made

disasters such as terrorist attacks can produce huge numbers of
claims. By contrast, claims against life insurance and annuity contracts
are typically amounts stated in the contracts and are therefore more
predictable. There are very few instances of catastrophic losses in the
life insurance industry comparable to those in the property/casualty
insurance industry.

Financial Statements: An insurance company's annual financial

statement is a lengthy and detailed document that shows all aspects of
its business. The initial section includes a balance sheet, an income
statement and a section known as the Capital and Surplus Account,
which sets out the major components of policyholders' surplus and
changes in the account during the year. As with GAAP accounting, the
balance sheet presents a picture of a company's financial position at
one moment in time—its assets and its liabilities–-and the income
statement provides a record of the company's operating results from
the previous year.

An insurance company's policyholders' surplus—its assets minus its

liabilities—serves as the company's financial cushion against
catastrophic losses and as its working capital for expansion. Regulators
require insurers to have sufficient surplus to support the policies they
issue. The greater the risks assumed, the higher the amount of
policyholders' surplus required.

Asset Valuation: Property/casualty companies need to be able to pay

predictable claims promptly and also to raise cash quickly to pay for a
large number of claims in the event of a hurricane or other disaster.
Therefore most of their assets are high quality income paying
government and corporate bonds that are generally held to maturity.
Under SAP, they are valued at amortized cost rather than their current
market cost. This produces a relatively stable bond asset value from
year to year (and reflects the expected use of the asset.)
However, when prevailing interest rates are higher than bonds' coupon
rates, amortized cost overstates asset value, producing a higher value
than one based on the market. (Under the amortized cost method, the
difference between the cost of a bond at the date of purchase and its
face value at maturity is accounted for on the balance sheet by
gradually changing the bond's value.

This entails increasing its value from the purchase price when the bond
was bought at a discount and decreasing it when the bond was bought
at a premium.) Under GAAP, bonds may be valued at market price or
recorded at amortized cost, depending on whether the insurer plans to
hold them to maturity (amortized cost) or make them available for
sale or active trading (market value).

The second largest asset category for property/casualty companies,

preferred and common stocks, are valued at market price. Life
insurance companies generally hold a small percentage of their assets
in preferred or common stock.

Some assets are "nonadmitted" under SAP and therefore assigned a

zero value but are included under GAAP. Examples are premiums
overdue by 90 days and office furniture. Nonadmitted assets and limits
on categories of investments may be reconsidered at some point in
time in light of the European Union's drive toward a single market for
insurance which includes a new regulatory framework for insurance
company solvency known as Solvency II.

While the frameworks for solvency regulation and accounting are not
the same, the two are intertwined. Regulators look at balance sheets
in evaluating solvency and balance sheets are the product of
accounting. Solvency II envisions the removal of rules on nonadmitted
assets. In their place will be a set of guiding principles based on the
concept of a "prudent person."

Real estate and mortgages make up a small fraction of

property/casualty company's assets because they are relatively illiquid.
Life insurance companies whose liabilities are longer term
commitments have a greater portion of their investments in
commercial mortgages.

The last major asset category is reinsurance recoverables. These are

amounts due from the company's reinsurers on claims that have been
paid. (Reinsurers are insurance companies that insure other insurance
companies, thus sharing the risk of loss.) Amounts due from
reinsurance companies are categorized according to whether they are
overdue and, if so, by how many days. Those recoverables deemed
uncollectible are reported as a surplus penalty on the liability side of
the balance sheet, thus reducing surplus.

Liabilities and Reserves: Liabilities, or claims against assets, are

divided into three components: reserves for obligations to
policyholders, claims by other creditors and policyholders' surplus.
Reserves for an insurer's obligations to its policyholders are by far the
largest liability. Property/casualty have three types of reserve funds:
unearned premium reserves, or pre-claims liability, loss and loss
adjustment reserves, or post claims liability, and other.

Unearned premiums are the portion of the premium that corresponds

to the unexpired part of the policy period. Premiums have not been
fully "earned" by the insurance company until the policy expires. In
theory, the unearned premium reserve represents the amount that the
company would owe all its policyholders for coverage not yet provided
if one day the company suddenly went out of business. If a policy is
canceled before it expires, part of the original premium payment must
be returned to the policyholder.

Loss reserves are obligations that an insurance company has incurred

due to claims filed under the policies it has issued. Loss adjustment
reserves are funds set aside to pay for claims adjusters, legal
assistance, investigators and other expenses associated with settling
claims. Property/casualty insurers only set up reserves for accidents
and other events that have happened.

Some claims, like fire losses, are easily estimated and quickly settled.
But others, such as product liability and some workers compensation
claims, may be settled long after the policy has expired. The most
difficult to assess are loss reserves for events that have already
happened but have not been reported to the insurance company,
known as incurred but not reported (IBNR). Examples of IBNR losses
are cases where workers inhaled asbestos fibers but did not file a
claim until their illness was diagnosed 20 or 30 years later.

Actuarial estimates of the amounts that will be paid on outstanding

claims must be made so that profit on the business can be calculated.
Insurers estimate claims costs, including IBNR claims, based on their
experience. Reserves are adjusted, with a corresponding impact on
earnings, in subsequent years as each case develops and more details
become known.
Revenues, Expenses and Profits: Profits arise from insurance
company operations (underwriting results) and investment results but
the latter are generally a small part of property/casualty insurance
company profits.

Policyholder premiums are an insurer's main revenue source. Under

SAP, when a policy is issued, the pre-claim liability or unearned
premium is equal to the written premium. (Written premiums are the
premiums charged for coverage under policies written regardless of
whether they have been collected or "earned.")

Premiums are treated as deferred revenues and increase the unearned

premium reserve. Premiums are earned on a pro-rata basis as
coverage is provided over the policy period.

Under GAAP, policy acquisition expenses, such as agent commissions,

are deferred on a pro-rata basis in line with GAAP's matching principle.
This principle states that in determining income for a given period,
expenses must be matched to revenues. As a result, under GAAP (and
assuming losses and other expenses are contemplated as experienced
in the rate applied to calculate the premium) profit is generated
steadily throughout the duration of the contract. In contrast, under
SAP, expenses and revenues are deliberately mismatched. Expenses
associated with the acquisition of the policy are charged in full as soon
as the policy is issued. Consequently, the policy produces a smaller
profit initially but one that grows throughout the policy period.

SAP mismatches the timing of revenues and acquisition expenses to

enhance the likelihood of the insurer's solvency. By recognizing
acquisition expenses before the income generated by them is earned,
SAP forces an insurance company to finance those expenses from its
policyholder surplus. This appears to reduce the surplus available to
pay unexpected claims. In effect, this accounting treatment requires
an insurer to have a larger safety margin to be able to fulfill its
obligation to policyholders.

The IASB Proposal for International Insurance Accounting

Standards: IASB's aim in creating new accounting standards for the
insurance industry is to facilitate the understanding of insurers'
financial statements. Until recently, insurance contracts had been
excluded from the scope of international financial reporting standards,
in part because accounting practices for insurance often differ
substantially from those in other sectors, both banking and other
financial services and nonfinancial businesses, and from country to
country.
The IASB plan divided the insurance project into two phases so that
some basic improvements in insurance contracts could be
implemented quickly. The first phase to enhance transparency and
comparability was completed in 2004 with the publication of
International Financial Reporting Standards 4, Insurance Contracts.
Although these standards were adopted by the European Union in
2005, they have yet to be agreed to by FASB. The second phase is
now underway with opportunities for comments as the work
progresses.
Insurers' Concerns: These concerns center on the IASB "exit value"
approach to valuing liabilities. IASB defines exit value as "the amount
the insurer would expect to pay at the reporting date to transfer its
remaining contractual rights and obligations immediately to another
entity," and suggests that insurers measure their current liabilities
using three "building blocks," which together constitute the exit value
approach. The three building blocks represent current estimates of
liabilities, including loss reserves and unearned premiums reserves; a
discount for the time value of money, meaning that the company can
earn investment income on the reserves until they have to be paid out
at some time in the future; and a "risk margin," which takes into
account the uncertainty of the future outcome of the business and the
possibility that the seller may need to provide assistance to the buyer.

Exit value does not reflect reality: The exit value concept is highly
theoretical. It is based on the notion that there is a secondary market
and a reliable price for insurance policies, as there are for securities of
various kinds, and that, therefore, a profit or loss can be calculated
immediately after the policy has been issued. However, in reality, such
a transfer of liabilities would virtually never occur, particularly in the
case of property/casualty insurance contracts.

Without a robust secondary market, the only way to value liabilities is

to create a model to represent such a market. This would entail
modeling cash flow patterns for all potential scenarios, establishing
discount factors to calculate present value and setting risk margins to
compensate for the uncertainty of results as envisaged by the IASB
model. With inputs and assumptions that are not independently
verifiable, the IASB model is likely to produce outcomes that are
different from the reality of the insurance transaction.

This is particularly true for insurers that cover rare (low frequency) but
potentially devastating (high severity) risks, where the range of
potential outcomes is enormous and difficult to predict and where the
timing of cash flows depends on many variables including legal
proceedings which can be dragged out for years. The subjectivity of
the estimates calculated in this manner and the possibility of errors is
more likely to impair rather than enhance the understandability and
comparability of financial statements. As recent experience mortgage-
backed securities including subprime loans shows, models can be
wrong.

The volatility and complexity of the exit value approach could

lessen investors' interest in some insurance companies:
Property/casualty insurers' financial results naturally vary substantially
from one year to the next, depending on the number and severity of
natural and man-made disasters and the level and outcome of
litigation, among other things. Many different factors could add extra
volatility, including changes in the interest rates selected for
discounting and risk margins. Artificial volatility could also come from
all the various assumptions insurers are forced to make about how
their business will develop over time. Some insurers will be forced to
add voluminous notes to their financial statements to explain their
assumptions and inputs to their model, dampening the enthusiasm of
some potential investors who will be put off by the difficulty of
weighing the import of each note. As a result, some companies fear it
will be harder to raise money. If they have to pay more to entice
investors, their cost of capital will increase which in turn will lead to
higher insurance prices.

The exit value approach and the need to satisfy many

constituencies may force companies to reveal too many details
of the their business: Companies with a complex business model
that requires them to reveal and explain proprietary information may
find that competitors benefit from this information or that is
misunderstood by readers of their financial statements.

"Field Test" needed: Insurers note that the IASB itself was split in
its approval of the exit value concept, voting 7-6 to accept it with one
abstention. Some insurers suggest that the approach be given a dry
run to test its acceptability before it is formally adopted. A field test,
where companies actually filed financial statements using the exit
value approach, would determine whether the new approach creates
unintended or unrepresentative results, whether they can be reliably
audited, whether the approach is expensive or unreasonably difficult to
implement and whether there are ambiguities that might produce
inconsistent interpretations of desired practices from one company to
another.
INTERNATIONAL TERRORISM INSURANCE POLICY

Terrorism insurance is insurance purchased by property owners to

cover their potential losses and liabilities that might occur due to
terrorist activities.

It is considered to be a difficult product for insurance companies, as

the odds of terrorist attacks are very difficult to predict and the
potential liability enormous. For example the September 11, 2001
attacks resulted in an estimated $31.7 billion loss. This combination of
uncertainty and potentially huge losses makes the setting of premiums
a difficult matter. Most insurance companies therefore exclude
terrorism from coverage in Casualty and Property insurance, or else
require endorsements to provide coverage.

On December 26, 2007, the President of the United States signed into
law the Terrorism Risk Insurance Program Reauthorization Act of 2007
which extends the Terrorism Risk Insurance Act (TRIA) through
December 31, 2014. The law extends the temporary federal Program
that provides for a transparent system of shared public and private
compensation for insured losses resulting from acts of terrorism.

The United States insurance market offers coverage to the majority of

large companies which ask for it in their polices. The price of the policy
depends on where the clients are residing and how much limit they
buy.

Industry Needs

Concentration of risk is another factor in determining availability for

terrorism insurance. Due to the concentrated losses of the World Trade
Center, carriers were hit with large losses in one centralized location.
Insurers seek to spread the coverage over a wider geographic area
than as with other aggregate perils, such as flood.

Modeling the Risks

Insurance companies are using an approach that is similar to that used

with natural catastrophe risks. A Swiss report suggested that in this
case where demand is greater than the supply for terrorism coverage
that a short-term solution is possible: a mix of government and private
resource to make easy the transition. In this situation, the government
would serve two functions: to establish rules to overcome the capacity
shortage and to be the insurer of last resort.

Crisis Management

Crisis management planning can save large amounts money in the

long run. According to experts, for every dollar spent on developing
crisis management plan ahead of time, $7 is saved in losses when a
disaster comes.

Netherlands

Insurance payments related to terrorism are restricted to a billion euro

per year for all insurance companies together. This regards property
insurance, but also life insurance, medical insurance, etc.

Iraq

The New York Times reports that in Baghdad personal terrorism

insurance is available. One company offers such insurance for $90,
and if the customer is a victim of terrorism in the next year, it pays
the heirs $3,500.

UK

In the UK, following the Baltic Exchange bomb in 1992, all UK insurers
stopped including terrorism cover on their commercial insurance
policies with effect from 1st January 1993 (home insurance policies
were unaffected). As a consequence, the government and insurance
industry established Pool Re. Primarily funded by premiums paid by
policyholders, the government guarantees the fund although any such
support must be repaid from future premiums. To date no government
support has been necessary.

Countries With Long-Term Terrorism Insurance Programmes

According to the policy agenda of The Real Estate Roundtable, the

following countries are the only ones in the world with long-term
terrorism insurance.

Australia
Austria
Finland
France
Germany
Israel
Namibia
Netherlands
Russia
South Africa
Spain
Switzerland
Turkey
United Kingdom

Insurance Credit Score:

An insurance credit score is a number that is determined by looking at
certain aspects of an individual's credit history. This number is
provided to insurance companies by a credit evaluation service.
Insurance companies then use this number as one of many factors
that determine the rates a policyholder is charged. Statistics have
shown that insurance scores are an accurate tool to help predict the
amount of claims that a policyholder will file.

RESIDUAL MARKET: The residual market consists of facilities to

provide coverage for consumers or businesses that cannot purchase
insurance in the regular market. Some examples of residual market
facilities are Assigned Risk Plans, Joint Underwriting Agreements, and
FAIR plans.