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Linking ERM and the Insurance Underwriting Process

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Enterprise Risk Management (ERM), in one form or another, has been around for almost two decades. The number of publicly traded companies, especially those in highly regulated industry sectors, have been deploying the ERM process primarily because they were pushed (explicitly or implicitly) to do so by the major credit rating agencies, government mandates such as SEC 33-9089 or Dodd-Frank, their internal/external auditors, or members of the board of directors.  No matter where the spark came from, however, the number of companies utilizing the ERM process continues to grow.

CFOs, CROs, and risk managers that have been practicing ERM for years have been incurring the expenses for doing so. As ERM programs mature it might be time to consider, in monetary terms, the value the company and its insurers places on all the work that has been done over the years. CFOs ask questions about return on investment (ROI) all the time – why not about ERM? Linking enterprise risk management and the insurance underwriting process is one approach to produce a tangible result. Because the vast majority of commercial insurance renewals are Jan. 1, CROs and risk managers should consider initiating a discussion with some of their insurers to determine the potential credits for having a functioning ERM program.

Brokers typically represent the vast majority of larger middle-market and Fortune 1000 publicly traded accounts. Brokers start to work with their larger accounts months before renewal dates and assemble a submission package for insurance underwriters. The inclusion of a timely and relevant ERM report to the underwriting submission that demonstrates the changes to the risk profile of the company should make a stronger case for favorable rate considerations for their clients. The general headings that we recommend for discussion within the underwriting submission include:

• Risk organization and governance

• Risk appetite, tolerance and limits

• Risk metrics and measurement

• Risk management process, procedures and controls

• Risk monitoring, reporting and communication

These are the same general areas that insurers themselves are being asked to discuss with their own regulators as part of the new Own Risk and Solvency Assessment (ORSA) soon to be issued by the National Association of Insurance Commissioners. If the broker or insurer does not think that having a functioning ERM program does not merit a price reduction – especially for directors & officers liability insurance – investigate further and dig deeper. Early in the renewal process is a good time for the risk manager, CRO, or CFO to meet directly with underwriters to discuss their ERM from two different perspectives: the amount of rate reduction, or the steps that could be taken to improve the risk profile enough to warrant a premium reduction.

Executive management of a company that adopted and implemented an ERM program five years ago should be considering the return on the investment that the company has made over the years. It will be up to the CFO and risk manager to demonstrate how the ERM process has been used to either change or improve the company’s risk profile from what it had been. We suggest a close working collaboration between the company and their insurance broker to craft an underwriting submission that details the benefits of the ERM program.

The collaboration would also be enhanced by including a company representative such as the CFO on the team, to represent the company in front of underwriters that may be encountering this negotiating tactic for the first time. Since the majority of corporate insurance renewals take place on Jan. 1, initiating a conversation in the summer with the insurance broker(s) involved would not be a bad idea. One caveat however, ERM in one company is not ERM in another. Completing a risk identification and assessment does not an ERM program make.

Captives under Scrutiny

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A mere decade ago, captive insurers were viewed by most regulators as a small, even exotic part of the insurance industry. Most were assumed to be offshore and aroused little attention. Now, captives have gone mainstream. A sizable, but undetermined, portion of the property casualty coverage is placed through, or issued by, captives. A good guess is 30% to 40%, but no one has been able to establish an accurate number. Thirty-nine states have some form of captive or self-insurance law. Captives are now part of everyday life for regulators and the result is more scrutiny.

The issues now on the agenda for captives are significant:

• XXX and AXXX Reinsurance Captives

According to Superintendent Joseph Torti (Rhode Island), 80% to 85% of life and annuity insurance is ceded to reinsurers. Much of the so-called “excess reserves” required by Rules XXX and AXXX are ceded to captive reinsurers or special purpose vehicles owned by the same licensed life and annuity companies which cede the risk. Because the amount of this risk is so large, any trouble collecting this reinsurance could have a major effect on the industry. Some regulators, even a few who approved these cessions, have criticized these arrangements. In some cases, the collateral for the reserves has been subject to parental guarantees, which tends to undermine the confidence which can be placed in the transaction. The NAIC is continuing its examination and has met some stiff resistance from the industry.

• Multistate Insurers 

The proposal to amend the preamble to the NAIC Accreditation Standards to treat captive reinsurers as “multistate insurers” (with some limited exceptions) was withdrawn at the last NAIC meeting in Louisville. A new proposal should be forthcoming (and may have already been issued by the date of publication of this Newsletter). The premise of this proposed change is that non-domiciliary regulators need to know how insurance issued in another state may affect the citizens of their state. The opposite point of view is that the regulators of the domicile have done their job and should be trusted by their regulator colleagues and that the transaction should not affect third parties, anyway. Some say the risk to the domestic captive industry is existential. If enacted and enforced, the proposed change could, ironically, drive much of the industry offshore and therefore beyond the authority of the regulators promoting it.

• Nonadmitted Risk and Reinsurance Act

Captives have been inadvertently drawn into the regulatory structure imposed by this federal legislation intended to streamline the reporting and payment of surplus lines taxes. It has shined a spotlight on the payment (or non-payment) of state self-procurement taxes, but, ironically, does not in any way alter either the application of them or their payment. While risk retention groups (RRGs) were able to get an exemption from the law during its formative phase, captives, because they are (generally) single state entities and therefore not doing business as a “non-admitted” insurer, did not even attempt to get an exemption. Now there is a group, the Coalition for Captive Insurance Clarity, which is seeking a legislative exemption on Capitol Hill.

• Insurance Company Income Taxation

The Internal Revenue Service is investigating several insurance pooling mechanisms and, in some cases, the captives that have utilized them to establish third party risk—which is essential for an insurer to get the benefit of insurance tax treatment. This investigation is presumably a response to the rapid growth of “micro-captives” as mechanisms to assist with avoidance of taxation in estate planning and wealth transfer. This process is in its early stages, but is likely to produce some dramatic results.

• Federal Home Loan Bank (FHLB)

Who would have thought that the FHLB would have anything to do with captives?  It appears that some captives, and at least one risk retention group, are members of the FHLB, which allows them to obtain federal funds at advantageous rates. The Federal Housing Finance Agency (FHFA), which regulates the twelve FHLBs, has proposed a rule that would exclude all captives from membership by defining “insurance company” to mean an entity which “has as its primary business the underwriting of risk for nonaffiliated persons.”

Why is this happening now? While there are numerous reasons for these kinds of actions, there are two primary motivators. First, regulation is always subject to the problem of “what’s worth doing is worth overdoing.” Reasonable minds can differ on the interpretation of statutes and regulations. Each of the above includes an element of “pushing the envelope,” which can be significant or insignificant issues depending on your point of view. Second, captives have been caught in the vortex of regulatory competition. As we have discussed before in this column, the National Association of Insurance Commissioners (NAIC), the Federal Insurance Office (FIO), and the International Association of Insurance Supervisors (IAIS) are jockeying for position and power. Add to the mix the position of the Organization for Economic Cooperation and Development (OECD) that captives may be used as a device to avoid taxation (“base erosion” in OECD parlance), and you have a tumult of regulatory action which at the same time can be challenging and conflicting in its goals and implementation.

What does this bode for the future of captives? Once you have been seen on the radar, it is hard to drop off. Captives can expect more of the same for the foreseeable future.

This blog was previously published on the Morris, Manning & Martin, LLP website.

Outrage Against AIG on Capitol Hill

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Chairman Paul Kanjorski presided over the congressional hearing involving state representatives, the NAIC, the Treasury Department, the Office of Thrift Supervision and Standard & Poor’s.

“We meet today to scrutinize American International Group,” Kanjorski began. He continued, explaining that the reason for the current and future meetings was to discern several things – namely how AIG got to where it is now, how they are using (or misusing) taxpayer bailout funds and how and when the company will pay back its bailout money, plus interest.

Time was then given to the always-outspoken Representative Barney Frank from Massachusetts, who undoubtedly received nods of satisfaction from the viewing audience.

“Something is seriously out of whack and AIG needs to fix it now,” Frank stated. “Many Americans have made personal sacrifices to make it in this difficult time – AIG should do the same.”

Frank then read from the AIG contracts in question, stating the specifics of the bonuses, which said if the company has a net loss for the year, the employees still receive their bonuses.

“This is a problem with compensation structure,” Frank lambasted. “They give themselves contracts that effectively insulate them from losses. We should exercise our rights as owners of this company and bring about lawsuits.” Referring to the breaking of the contracts in question, he made vocal what most Americans are thinking right now: “the magnitude of the losses is so great that we are justified in rescinding the bonuses.”

Representative Spencer Bachus from Alabama blamed Washington, the regulators, and Congress for failing to do their jobs.

“However, the blame game needs to be secondary,” he stated. “Recouping the taxpayer’s money is first and foremost. But will AIG ever return to profitability and will they ever be able to return the money.”

A valid question indeed.

Chairman Kanjorski then turned the questioning to the panel of three individuals representing the NAIC, Standard and Poor’s, the OTS and the Treasury Department. From the insurance regulator perspective- the head of the NAIC claimed that AIG has become the poster child for systemic risk. He then revealed the obvious – that there are “threats on horizon in terms of reputational risk in regards to the insurance division of AIG.”

After two hours of questions and statements, the meeting broke with heckling from some in attendance who held signs reading “honest taxpayer fund.”

You can watch the full video of the hearing here. Another hearing is set for March 24, when Congress will hear from Treasury Secretary Tim Geithner, among others.