Critical insights to prepare for year end: ORSA, insurance accounting, and financial reporting updates webinar

Transcription

1 Critical insights to prepare for year end: ORSA, insurance accounting, and financial reporting updates webinar December 2013 Baker Tilly refers to Baker Tilly Virchow Krause, LLP, an independently owned and managed member of Baker Tilly International.

2 Agenda Introductions Segment 1: Insurance accounting and financial reporting update Break Segment 2: ORSA 4

3 Segment 1 INSURANCE ACCOUNTING AND FINANCIAL REPORTING UPDATE 6

4 Objectives 1) Provide an overview of proposed insurance contracts standard 2) Discuss latest developments related to ACA fees 3) Provide a sneak preview of the NAIC Fall Meeting 4) Tax considerations 7

5 Insurance accounting and financial reporting update Insurance contracts proposal 8

6 FASB s purpose of issuing proposal What is driving FASB to propose a new standard for insurance contracts? > Feedback from August 2007 FASB invitation to Comment on the IASB s Discussion Paper, Preliminary Views on Insurance Contracts > Provide comparability > Develop comprehensive accounting framework > Provide decision useful information 10

7 FASB s purpose of issuing proposal Provide comparability Regardless of the type of the insurer Increase decision usefulness of information Increase information on insurer s liabilities including the: Nature Amount Timing Uncertainty of cash flows and The effect on the statement of comprehensive income Develop comprehensive accounting framework Develop common, high quality guidance Establish principles for recognition, measurement, presentation and disclosure 11

8 What is the definition of insurance? Premium Policyholder Significant insurance risk Company Insured event 12

9 Definition of an insurance contract ( ; through 55-22) > A contract under which one party (the insurer) accepts significant insurance risk from another party (the policyholder) by agreeing to compensate the policyholder or its beneficiary if a specified uncertain future event (the insured event) adversely affects the policyholder > Insurance risk can be either underwriting risk or timing risk > Significant insurance risk cannot exist unless there is at least one commercially substantive scenario in which the present value of net cash outflow can exceed the present value of cash inflows (for example, premiums) 13

10 It s not just for insurance companies All issuers of insurance contracts as defined regardless of the type of company/institution/fund issuing those contracts. 14

11 Examples of scope exclusions ( through 55-42) > Product warranties issued by a manufacturer, dealer or retailer > Fixed-fee contracts that meet specified criteria > Employer-provided benefit plans > Guarantees issued by entities that don t regularly issue such guarantees 15

12 Recognition ( through 25-17) > Recognize an insurance contract when the coverage period begins. > Entities need to determine the beginning and end points of a contract (contract boundaries) > Unbundle non-insurance components 16

13 Building Block Approach (BBA) Who > Most life, annuity, and long-term health contracts Key estimate > Fulfillment cash flows Key changes > Margins > Deferred acquisition costs > Revenue recognition > Expense recognition 17

14 Building Block Approach (BBA) Fulfillment cash flows Present value of unbiased, probability-weighted estimate of future cash outflows less future cash inflows Cash flows include all costs directly attributable to or allocable to fulfillment of contracts including expected value of options and guarantees Discount rate reflects the characteristics of the liability Premium recognized as revenue over the coverage period in proportion to the value of coverage and any other services Exclude from revenue and expense amounts expected to be returned to the policyholder or its beneficiary regardless of an insured event occuring Recognize changes in assumptions in net income, except for changes in the discount rate which are recognized in other comprehensive income Margin Expected cash inflows greater than expected cash outflows Recognize as revenue as the uncertainty (the risk) in cash flows decreases Present acquisition costs incurred as an offset to the margin and recognize as an expense in same pattern as margin 18

15 Building Block Approach (BBA) Liability for future claims > Based on the present value of the fulfillment cash flows The unbiased, probability-weighted estimate of the future cash outflows less the future cash inflows (the expected value) Discount rate in present value calculation > Should reflect the characteristics of the liability > Companies will have to use judgment in determination > Changes in discount rates used should be presented in other comprehensive income 19

16 Building Block Approach (BBA) Margin > Expected profitability of the contracts > Amortized into income over future periods > Expected losses would be recognized immediately Deferred Policy Acquisition costs (DAC) > Under the proposal the DAC would be recorded net of the margin 20

17 Building Block Approach (BBA) Revenue recognition > Allocated to individual periods based on the expected pattern of incurred claims and release from risk. > Deposit elements such as cash surrender values should be excluded from cash inflows. Expense recognition > Claims/benefits should be recorded when incurred 21

18 Premium Allocation Approach (PAA) Who > Most property, liability, and short-term duration health contracts Key changes > Liability for remaining coverage > Liability for incurred claims 22

19 Premium Allocation Approach (PAA) Receivable Expected future premiums within boundary of existing contract Adjust for time value if liability for remaining coverage is adjusted Liability for remaining coverage (UPR) Liability for incurred claims (reserves) Contractual premiums within boundary of existing contract Adjust for time value if contract has significant financing component unless meet practical expedient Reduce for qualifying acquisition costs incurred, if not immediately expensed Adjust liability if portfolio of insurance contracts is onerous Recognize revenue for reduction in the liability for remaining coverage on basis of passage of time or expected timing of incurred claims Exclude from revenue and expense amounts expected to be returned to the policyholder or its beneficiary regardless of an insured event occuring Recognize expense when claim is incurred Present value of unbiased, probability-weighted estimate of future cash outflows for claims that have been incurred Discounting not required if effects are immaterial or when incurred claims are expected to be paid within one year of insured event Recognize changes in discount rates in other comprehensive income 23

20 Premium Allocation Approach (PAA) Liability for remaining coverage > Called unearned premium today > Measured as the contractual premiums expected within the boundaries of the contract less direct acquisition costs (if not immediately expensed) > May have to discount if the contract has a significant financing component 24

21 Premium Allocation Approach (PAA) Liability for incurred claims > Best estimate vs. unbiased probability weighted estimate > Estimate may need to be discounted > Discounting is not required if the effects of discounting are immaterial or when the incurred claims are expected to be paid within one year of the insured event > Discount rate - same principles as the building block approach > Changes in discount rate are recorded to OCI 25

22 Simple PAA example of the use of OCI Assume > Premium for 1 year s coverage of $12,000 > Liability for remaining coverage and premiums receivable not adjusted to reflect the time value of money > Expected claims are $2,400 per quarter, paid 2 years after incurred > A flat yield curve with discount rates at inception of 4% and after Q1 of 5% For Q1 > Claims expense of $2,219 ($2,400 discounted at 4% for 2 years) > Liability for incurred claims of $2,177 ($2,400 discounted at 5% for 2 years > Difference of $42 ($2,219-$2,177) recorded to OCI 26

23 Balance sheet presentation Assets Liabilities and Shareholders Equity Cash XX Liability for remaining coverage (PAA) XX Investments XX Liability for incurred claims (PAA) XX Premiums receivable (PAA) XX Insurance contract liability (BBA) XX Margin (BBA) XX Insurance contract asset (BBA) XX Total liabilities XX Reinsurance contract asset (PAA) XX Accumulated other comprehensive income XX Reinsurance contract asset (BBA) XX Retained earnings XX Total assets XX Total liabilities and shareholders equity XX 27

24 Income Statement Presentation Statement of Comprehensive Income Insurance contract revenue (BBA) Insurance contract revenue (PAA) Ceded reinsurance consideration (BBA) Ceded reinsurance consideration (PAA) Claims/benefits incurred (BBA) Claims/benefits incurred (PAA) Reinsurance recoverable for claims/benefits incurred (BBA) Reinsurance recoverable for claims/benefits incurred (PAA) Adjustment for changes in estimates of future benefits/claims and reversals of those changes Amortization of qualifying acquisition costs Underwriting margin Other income Other expenses Investment income Interest expense Net income Components of other comprehensive income Total comprehensive income XX XX (XX) (XX) (XX) (XX) XX XX XX (XX) XX XX (XX) (XX) (XX) XX XX XX 28

25 Disclosures Objective is to enable users of the financial statements to understand the amount, timing and uncertainty of future cash flows arising from insurance contracts > Amounts recognized arising from insurance contracts > Significant judgments and changes in judgments > Nature and extent of risks arising from insurance contracts Significant judgment involved in determining the level of detail and aggregation to comply with the guidance > Entities should expect having to provide more detailed disclosures than previous GAAP 29

26 Potential implications > Changes to the earnings pattern of underwriting and net investment margins > Changes in the pattern and amount of revenue > Increased income statement volatility due to the requirement to update assumptions each period > Increased involvement of the finance/accounting team with actuaries 30

27 Transition Apply the proposed update retrospectively (as of the beginning of the earliest period presented the transition date) Use objective information to estimate margin for the remaining prior periods. Examples include > Original pricing information > Reinsurance agreements > Original US GAAP valuation assumptions > Economic conditions present at time of portfolio issuance 31

28 Next steps > Due to the changes being considered, entities should begin assessing the potential impact to their products, systems and investor reporting now > Entities should consider the proper internal controls over the implementation of new systems and processes > Need to educate the users of the financial statements regarding the changes they will see 32

29 Next steps Comment Deadline October 25, 2013 Roundtables Dec 2013 Deliberations and outreach Dec 2013 Mar 2015 FASB issues final ASU June 2015 Effective date Jan

30 Insurance accounting and financial reporting update Affordable Care Act fees 34

31 Background on ACA fees > Annual fee on health insurers for each calendar year beginning on or after January 1, 2014 > Health insurer s portion of annual fee payable no later than September 30 of the applicable year > Fee for the health insurance industry will be allocated to individual insurers based on the ratio of the amount of an entity s net premiums written during the preceding calendar year to the amount of health insurance for any US health risk written during the preceding calendar year > Fee becomes payable to US Treasury once entity provides health insurance 35

32 Current GAAP standard ASU No : Other Expenses (Topic 720) Fees Paid to the Federal Government by Health Insurers > Issued July 2011, effective for calendar years beginning after December 31, 2013 > Fee is not considered an insurance related assessment and does not meet the definition of an acquisition cost > Liability should be estimated and recorded in full once the entity provides health insurance in the applicable calendar year in which the fee is payable > Offset will initially be recorded to deferred cost and amortized using a straight-line method 36

33 Current GAAP standard Example: Year of 2013 Insurance activity determines allocation of fee Jan. 1, 2014 Upon providing insurance, fee becomes payable Debit: Deferred cost Credit: Liability for ACA fee January 31, 2014 Amortize 1/12 of liability to expense Debit: ACA fee expense (operating expense) Credit: Deferred cost September 30, 2014 Deadline for ACA payment Debit: Liability for ACA fee Credit: Cash 37

34 SAPWG discussion > To accrue, or not to accrue? > When to accrue? > Does segregated surplus have the desired statutory implications? > Potential for permitted practices? 38

35 Current statutory exposure draft SSAP No. 35(R): Guaranty Fund and Other Assessments > Exposed for comment by SAPWG August 24, 2013 > Liability should be estimated and recorded in full once the entity provides health insurance in the applicable calendar year in which the fee is payable > Offset will initially be recorded to deferred cost and amortized using a straight-line method, although deferred cost will be nonadmitted > Fee does not meet the definition of an acquisition cost 39

36 Current statutory exposure draft SSAP No. 35(R): Guaranty Fund and Other Assessments > Liability recognition is not required in the data year > In data year, reporting entity should accrue (monthly) in special surplus an amount equal to the estimated subsequent fee year assessment > On January 1 of fee year, special surplus accrual reversed and full liability is recorded > Expenses shall be recognized as a component of Taxes, Licenses and Fees > Type II subsequent event disclosure requirement at December 31,

37 Latest SAPWG discussion November 14, 2013 hearing > One state against exposure draft; two states offering compromises; support from AHIP/BCBSA and other interested parties > Suggestion to redraft exposure with following edits Incorporate AHIP/BCBSA changes Remove deferred cost concept Finalize analysis to Statement of Concepts and Issue Paper > Departing remark reminded SAPWG that if compromise can t be reached, GAAP will rule 41

38 Insurance accounting and financial reporting update NAIC meeting preview 42

39 NAIC Fall 2013 National Meeting December 15-18, 2013 in Washington, DC Special meetings/events > IIPRC annual meeting > CIPR event: The Future of Automobile Insurance: Telematics in the US (advanced registration required) Regularly scheduled meetings > Potential adoption of one-year exposure period for ORSA > Emerging Accounting Issues and SAPWG Risk sharing receivables under ACA Working capital finance investments Derivatives Tax contingencies 43

40 Insurance accounting and financial reporting update Tax considerations 44

41 Insurance accounting and financial reporting update Repair and maintenance regulations 45

42 What are deductible repair and maintenance ( R&M ) costs? > Expenditures that keep property in an ordinarily efficient operating condition. > Do not include replacement of major components or substantial structural parts of a unit of property, or amounts that result in a betterment, restoration, or change in use of a unit of property. > Examples may include: Interior and exterior painting Replacing and repairing windows, floors, and ceiling tiles Replacing and repairing heating and air conditioning components Replacing and repairing plumbing and restroom fixtures Replacing and repairing roofs Resurfacing parking lots Other costs incurred to keep facilities looking fresh and cosmetically attractive for customers and employees 46

43 What is the tax opportunity? > The tax treatment of these costs has historically followed the treatment used for book purposes for many companies although the fixed asset capitalization rules are different for tax and book purposes. Therefore, the potential to deduct these costs for tax purposes exists. > To change from capitalizing R&M costs to deducting R&M costs, a company must file a change in accounting method. > On September 13, 2013, the Treasury Department issued final R&M regulations outlining the standards to determine whether and when costs incurred in acquiring, maintaining, or improving tangible property must be capitalized. These new rules provide a framework for analyzing whether an expense is currently deductible or must be treated as a capital improvement and depreciated over a longer recovery period. 47

44 Overview of the final regulations > The final regulations refine and simplify some of the rules in the 2011 temporary regulations and create a number of new safe harbors. Adopt a revised and simplified de minimis safe harbor Extend the safe harbor for routine maintenance to buildings Add a safe harbor for small taxpayers Refine several of the criteria for defining betterments and restorations to tangible property Propose new partial disposition rules > The final regulations are generally effective for tax years beginning on or after Jan. 1,

45 R&M overview for the insurance industry > The final regulations refine and simplify some of the rules in the 2011 temporary regulations and create a number of new safe harbors. Refine the criteria for defining restorations to tangible property Extend the safe harbor for routine maintenance to buildings Add an election to capitalize repair costs Adopt a revised and simplified de minimis safe harbor Add a safe harbor for small taxpayers Propose new partial disposition rules 49

46 De minimis safe harbor overview > NEW: May rely on the safe harbor to expense tangible property under a certain dollar threshold. > Must have a written accounting procedure in place at the beginning of the taxable year with a specified dollar amount and does not exceed a per invoice or per item cost. For taxpayers with an applicable financial statement, the dollar amount is not to exceed $5,000 per item. For taxpayers without an applicable financial statement, the dollar amount is not to exceed $500 per item. > Elected annually by including a statement on a timely filed original federal return (including extensions) for the year elected. 50

47 De minimis safe harbor considerations > Is there a written financial accounting policy in place prior to Jan. 1, 2014? > Do you have an AFS? A financial statement required to be filed with the SEC; A certified audited financial statement that is accompanied by the report of an independent certified public accountant (or, in the case of a foreign entity, by the report of a similarly qualified independent professional) that is used for:» Credit purposes;» Reporting to shareholders, partners, or similar persons; or» Any other substantial non-tax purpose; or A financial statement (other than a tax return) required to be provided to the federal or a state government or any federal or state agency (other than the SEC or the IRS). > Does the current financial accounting policy exceed the safe harbor amount? If so, does it clearly reflect income? 51

48 Timing > Effective date Generally effective for tax years beginning on or after Jan. 1, May choose to apply the final regulations to taxable years beginning on or after Jan. 1, May elect to apply the temporary regulations to tax years beginning on or after Jan. 1, 2012, and before Jan. 1, > Transition relief for 2012 and 2013 tax returns available for certain provisions. > Revenue procedures with accounting method procedures expected by the end of the year. 52

49 Insurance accounting and financial reporting update SSAP 101: Valuation allowance considerations 53

50 Valuation allowance versus nonadmitted does it matter? Valuation allowance (VA) considerations > More likely than not (MLTN) that some portion or all will not be realized MLTN is a likelihood of more than 50 percent > Based on weight of all available evidence Nonadmitted deferred tax asset (DTA) determination > Admissibility test - Mechanical with subjective components > Performed after valuation allowance 54

51 Valuation allowance versus nonadmitted does it matter? Many filers consider VAs and nonadmitted DTAs as one in the same > Both reduce the gross DTAs and have the same impact on surplus > Both must be considered in determining admitted DTAs > Careful consideration should be given to both > VA: Likelihood of realizing gross DTA is 50% or less > Nonadmitted DTA: Likelihood of realizing gross DTA is 50% or more, but will not be realized within the time period prescribed by SSAP 101 and cannot be offset by gross deferred tax liabilities (DTLs) 55

52 Insurance accounting and financial reporting update SSAP 101: DTA admissibility Part 1 (Paragraph 11.a.) 56

53 Observations related to 11.a. Important to distinguish between life and non-life companies > Different carryback periods Life companies 3 year ordinary carryback Non-life companies 2 year ordinary carryback 3 year capital carryback 3 year capital carryback > How is life versus non-life determined? Annual statement versus tax return 57

54 Observations related to 11.a. 58

55 Observations related to 11.a. Taxes paid is maximum amount that can be admitted under 11.a. (Footnote 2, SSAP 101) Intricate spreadsheet calculations Scheduling of temporary reversals > Supporting documents > Consistency and trends between years 59

56 Observations related to 11.a. Alternative minimum tax (AMT) considerations > Taxes recoverable in carryback years can be limited if loss carrybacks trigger AMT Taxes paid on audit for years prior to carryback periods cannot be included in taxes recoverable Tax loss contingency considerations > Impact of releases of tax loss contingencies > RAR adjustments 60

57 Observations related to 11.a. Consolidated return issues > Impact of tax-sharing agreements (See Footnote 2, SSAP 101) > Hypothetical NOL calculations Merger and acquisition considerations > Pre- versus post-acquisition tax provision matters > Recovery of prior taxes paid in accordance with IRS rules and regulations 61

58 SSAP 101 overview DTA admissibility Part 2 (Paragraph 11.b.) 62

59 Observations related to 11.b. Three-part comparison Lesser of: > Remaining gross DTA > Amount expected to be realized > Stated percentage of adjusted capital and surplus First step: Know which Realization Threshold Limitation applies > 0yrs / 0% or 1yr / 10% or 3yrs / 15% > Adjusted capital and surplus determined as of current period > Know exdta ACL RBC percentage 63

60 Observations related to 11.b. Expected to be realized (with and without calculations) > Inherently subjective > Consolidated groups that don t forecast on a separate entity basis > Reversal patterns consistent with 11.a. NOLs arising from reversing DTAs > DTAs from projected losses can be included in expected to be realized if they can offset taxes recoverable in applicable carryback or carryforward years (Q&A 6.14) > See example 64

61 Observations related to 11.b. Current year capital and surplus difficulties Draft capital and surplus calculation Changes between threshold limitations Audit adjustments not accounted for in annual statements 65

62 SSAP 101 overview DTA admissibility Part 3 (Paragraph 11.c.) 66

63 Observations related to 11.c. Practical considerations related to scheduling Relationship between valuation allowance and 11.c. Character considerations Consistency from year to year 67

64 Insurance accounting and financial reporting update Acuity Insurance Company case 68

65 Background - IRS Coordinated Issue Paper > Annual Statement a general guide > Statutory accounting favors conservatism ; tax rules do not > Fair and Reasonable > Paper s Conclusion: Not all "reserves" shown on the Annual Statement or allowed by state insurance regulators are allowable as deductions for federal income tax purposes The Service is not bound by the numbers shown on the Annual Statement The Service is not bound by the Statement of Actuarial Opinion included in the Annual Statement, and the actuary's opinion is not entitled to any presumption or deference For federal income tax purposes, the deduction for unpaid losses must be based on actual loss events 69

66 IRS Coordinated Issue Paper (cont.) > Conclusion (cont.) For federal income tax purposes, the deduction for unpaid losses must represent a fair and reasonable estimate of the amount the company expects to pay. No administrative "margin" or "tolerance" is required or allowable For federal income tax purposes, the determination of a fair and reasonable estimate of unpaid losses is a factual determination to be made based on the standards set forth in Treas. Reg (a)(14) and (b), and not on the standards of the Annual Statement. The taxpayer must establish that the deduction for unpaid losses is comprised of only actual unpaid losses, and the taxpayer may be required to submit detailed information with respect to its actual experience as is deemed necessary to establish the reasonableness of the deduction 70

67 Acuity Insurance Company Court Case > Filed April 2011 > Single issue: loss reserves $96 million proposed adjustment 15% of total reserve > Tax court ruled September 4, 2013 in favor of Acuity > Key elements of the decision NAIC/ASOP loss reserve standards apply Subsequent favorable development does not demonstrate that a loss reserve estimate was unreasonable. Inherent uncertainty of the insurance business makes sound, well-informed actuarial judgment crucial Use of actuarial ranges of loss reserve estimates Margins 71

68 Segment ORSA UPDATE 72

69 Why did the NAIC propose an ORSA? Improve solvency regulation in the US > Well-executed risk management improves a company s changes of continuing to operate in a strong and healthy manner > Quantitative analysis should improve the assessment of (hazardous) financial condition Assist the regulator with risk-focused analysis and examinations Aid the ability to evaluate the industry s ability to withstand stresses 74

70 What is ORSA? The Own Risk and Solvency Assessment (ORSA) is becoming a key part of the regulatory framework for US insurers. The ORSA Guidance Manual states that ORSA is: > A component of the insurer s Enterprise Risk Management (ERM) framework > A confidential internal assessment appropriate to the nature, scale, and complexity of an insurer conducted by that insurer of the material and relevant risks identified by the insurer associated with an insurer s current business plan and the sufficiency of capital resources to support those risks 75

71 NAIC Own Risk and Solvency Assessment Guidance Manual Overall, the ORSA is essentially an internal assessment of the risks associated with an insurer s current business plan, and the sufficiency of capital resources to support those risks. 76

72 NAIC Own Risk and Solvency Assessment Guidance Manual ORSA s two primary goals > To foster an effective level of enterprise risk management at all insurers, through which each insurer identifies and quantifies its material and relevant risks, using techniques that are appropriate to the nature, scale, and complexity of the insurer s risks, in a manner that is adequate to support risk and capital decisions > To provide a group-level perspective on risk and capital, as a supplement to the existing legal entity view 77

73 NAIC Own Risk and Solvency Assessment Guidance Manual Exemption from ORSA > The individual insurer s annual direct written and unaffiliated assumed premium, including international direct and assumed premium but excluding premiums reinsured with the Federal Crop Insurance Corporation and Federal Flood Program, is less than $500,000,000 and > The insurance group s (all insurance legal entities within the group) annual direct written and unaffiliated assumed premium including international direct and assumed premium, but excluding premiums reinsured with the Federal Crop Insurance Corporation and Federal Flood Program is less than $1,000,000,000 78

74 NAIC Own Risk and Solvency Assessment Guidance Manual Exemption from ORSA An insurer that is otherwise exempt may be required to meet the ORSA requirement based on unique circumstances at the discretion of the commissioner including, but not limited to, the type of business written, federal agency requests, and international supervisor requests, etc. A commissioner also has authority to require an ORSA if the insurer is in a RBC action level event, meets one or more of the standards of an insurer deemed to be in hazardous financial condition, or otherwise exhibits qualities of a troubled insurer. 79

75 NAIC Own Risk and Solvency Assessment Guidance Manual General guidance The ORSA process is one element of an insurer s broader Enterprise Risk Management (ERM) framework. It links the insurer s risk identification, measurement and prioritization processes with capital management and strategic planning. Effective date: January 1, 2015 with the first Summary Report filing sometime in 2015, a date yet to be determined. High-level ORSA Summary Report annually to the domiciliary regulator, if requested. 80

76 NAIC Own Risk and Solvency Assessment Guidance Manual General guidance > Each ORSA process will be unique > The ORSA Summary Report will be used to gain a high-level understanding of the process > The report will be supported by the insurer s internal risk management materials > Minimum the ORSA Summary Report should discuss: Section 1: Description of the insurer s risk management framework Section 2: Insurer s assessment of risk exposure Section 3: Group risk capital and prospective solvency assessment 81

77 NAIC Own Risk and Solvency Assessment Guidance Manual March 25, 2013: Revised ORSA Guidance Manual adopted > Changes to be made to substitute the notion of group assessment of risk capital for that of group risk capital > Section 2 should be a high level summary > Included changes to synchronize guidance in the Manual with the requirements in the adopted Risk Management and Own Risk and Solvency Assessment Model Act (Model #505) > Added language that the insurer should identify the basis of accounting for the ORSA Summary Report (e.g., GAAP, SAP or IFRS) > Added language that the insurer should include a summary of material changes to the ORSA from the prior year 82

78 NAIC Own Risk and Solvency Assessment Guidance Manual March 25, 2013: Revised ORSA Guidance Manual adopted > Added language that the insurer should explain the scope of the ORSA such that the ORSA Summary Report identifies which entities within the group are included in the ORSA Summary Report, possibly accompanied by an organizational chart > Added language that the insurer should provide a comparative view of group capital from the prior year > Included edits that are considered general clean-up of the technical language throughout the Manual, as well as minor modifications to clarify the intent > Added a glossary of terms in the Appendix 83

79 Best practices from the pilot project In 2012, the NAIC conducted a pilot program review of 14 voluntarily submitted ORSA Summary Reports. Resulting best practices > Defining the legal entities that are covered by the ORSA > Explaining the basis of accounting > Having prior year comparative analysis > Describing the ERM process 84

80 Understanding the examination process In order to be able to increase examination efficiency and to get examiners to fully leverage work being done by the company, it is important to understand the risk examination process and requirements. 85

81 ORSA vs. international standards Comply with Financial Sector Assessment Program (FSAP) Each country pledges to review and report on its regulatory system... (A)ll G-20 members commit to undertake a Financial Sector Assessment Program (FSAP) report. > Next FSAP review: November 2008 G20 Financial Summit declaration International Association of Insurance Supervisors (IAIS) Insurance Core Principle (ICP) 16 Enterprise Risk Management, in 2014 ICP self-assessments of ICP 16 earlier > IAIS develops the insurance supervisory standards through ICPs that are used by the International Monetary Fund (IMF) to perform the FSAP Specifically, ORSA relates to ICP 16-Enterprise Risk Management. 86

82 A practical approach for insurers The ERM continuum Key implementation factors > Build the ERM engine creating the process > Risk identification, assessment, and analysis > Validate risk assessment and responses > Risk monitoring and reporting 87

83 Building the engine for the ERM process Determine that management is continuing to: > Build consensus around the ERM process > Gather relevant information and existing data > Conduct interviews, surveys and facilitation work sessions > Identify key risks and develop a risk profile > Initiate risk mitigation, optimization activities, and ownership to emerging risks Create ERM process Risk identification, analysis, and prioritization Validate risk assessment and responses Risk monitoring and reporting 88

84 Building the engine for the ERM process Create ERM process > Executive endorsement is always needed Tone at the Top > Direct reporting is critical roles and responsibilities > Leverage existing risk functions, processes and controls > Establish framework, definitions, common language 89

85 Building the engine for the ERM process Confirm that management has > Compiled a list of risks that impact the business sorted by category > Performed risk assessment facilitated workshops and surveys to identify, analyze, and prioritize key risks and strategies 90

86 Building the engine for the ERM process Risk identification, analysis, and prioritization > Results of the risk identification process are compiled > Risk are evaluated and assessed (high, medium, low) from two perspectives, impact and likelihood > Options used: - Accept = monitor - Avoid = eliminate (get out of situation) - Reduce = institute controls - Share = partner with someone (e.g. re-insurance) > Risk assessment is linked to strategic objectives > Results are compiled and risk maps developed to summarize and prioritize key risks (top 10 to 15 risks) 91

87 Building the engine for the ERM process ERM results: High risk areas Owner Summary risk Risk tolerance Key risk/performance indicators Chief Strategy Officer Ineffective strategic partnering for go to market efforts (Excludes vendor relationships) Low tolerance for failure to maintain appropriate strategic partnerships Loss of business opportunities Loss of critical core competencies needed for next customer CTO Technology not aligned or scaled to meet business needs Low tolerance for any technology that puts us at risk of losing our preferred provider classification, that does not have a reasonable mitigation solution Track all Priority 1 Outages Annual Strategy Update EVP-HR No corporate philosophy and approach to attract, develop, retain, and succeed skilled, professional, and executive staff No tolerance for more than 5% turnover rate for high performers (those receiving the Exceptional rating on the performance review) Fewer applicants Fewer internal referrals 92

88 Building the engine for the ERM process Validate risk assessment and responses > Review management s feedback on risk assessment; identify and evaluate possible responses to risks (Accept, Avoid, Reduce and Share) > Evaluate options in relation to entity s risk appetite, cost vs. benefit of potential risk responses, and degree to which a response will reduce impact and/or likelihood > Select and execute response based on evaluation of the portfolio of risks and responses > Facilitate meetings or work sessions with key members of management to address developed responses 93

89 Building the engine for the ERM process Risk monitoring and reporting > Ensure accountability for risks > Summarize a risk assessment report > Create risk dashboards for high-level board reporting Leverage technology tools > Develop a continuous monitoring program Ensure updates are reflected (i.e., changes in systems or processes) Risks are being properly addressed Controls are working to mitigate risks 94

90 ORSA Summary Report The ORSA Summary Report should discuss three major areas > Section 1: Description of the insurer s risk management framework > Section 2: Insurer s assessment of risk exposure > Section 3: Group assessment of risk capital and prospective solvency assessment 95

91 2013 ORSA guidance revisions > The insurer should identify the basis(es) of accounting for the ORSA Summary Report (e.g., GAAP, SAP, or IFRS) > The insurer should explain the scope of the ORSA such that the ORSA Summary Report identifies which entities within the group are included in the ORSA Summary Report, possibly accompanied by an organizational chart > The insurer should include a summary of material changes to the ORSA from the prior year > The insurer should provide a comparative view of risk capital from the prior year > Included changes to synchronize guidance in the Manual with the requirements in the adopted Risk Management and Own Risk and Solvency Assessment Model Act (#505) 96

92 Leveraging ORSA to understand corporate governance A key component of ORSA is executive endorsement tone at the top > Cohesive executive management team > Communication to the entire organization or group 97

93 Leveraging ORSA to understand corporate governance An ORSA program sets up a corporate governance structure. > To obtain information regarding guidance and oversight provided by the board of directors and executive management, the examiner must understand the corporate governance structure and be able to assess the tone at the top. > This information, along with information on how the insurer identifies, controls, monitors, evaluates and responds to risks will enhance the examiner s consideration of current and prospective risk areas and assist with the appropriate determination of detailed examination procedures that should be performed as described in the NAIC s 2012 Financial Examination handbook. 98

94 Focus on other than financial risks Successful ORSA programs identify other than financial risks: > Strategic > Regulatory > Operational > Insurance 99

95 Focus on other than financial risks The Risk Focused Examination emphasizes the expansion of the examiner s consideration from the retrospective verification of financial condition, to include consideration of other than financial risks that could impact the insurer s future solvency. 100

96 Focus on other than financial risks An ORSA program identifies both financial and enterprise risks that currently exists, as well as potential future risks. > To the extent that identified future risks were also present during the period of examination, the procedures performed for the current exam process may also be utilized in considering the future impact and monitoring necessary for such risks 101

97 ORSA Summary Report Three main sections: > Description of risk management framework Enterprise Risk Management (ERM) > Assessment of risk exposure > Group risk capital and prospective solvency assessment Economic Capital Model (ECM) 102

98 ORSA Summary Report Considerations in developing an ECM > Nature and complexity of risks > Financial position > Economic environment ECM should include > Stress testing > Stochastic simulation models 103

99 Two parallel tracks ERM / ECM development Maturity level Qualitative ERM Risk governance Risk identification Risk impact assessment Quantitative ERM Risk appetite and tolerance limits Measuring risk impacts Dashboards Framework audits Foundational ECM Initial models Focus on financial risks assets and underwriting Use of ESG Reflects correlation and diversification Robust ECM Robust enterprise models Quantifying mitigation effects Cost/benefit analysis of risk management action All risks included Fully integrated with planning and management processes 104

100 Two parallel tracks ERM / ECM development Maturity level Qualitative ERM Risk governance Risk identification Risk impact assessment Quantitative ERM Risk appetite and tolerance limits Measuring risk impacts Dashboards Framework audits Foundational ECM Initial models Focus on financial risks assets and underwriting Use of ESG Reflects correlation and diversification Robust ECM Robust enterprise models Quantifying mitigation effects Cost/benefit analysis of risk management action All risks included Fully integrated with planning and management processes 105

101 Assessment of risk exposures All relevant categories of risk must be addressed Normal and stress conditions must be reflected Examples of relevant material risk categories may include, but are not limited to, credit, market, liquidity, underwriting, and operational risks. quantitative and/or qualitative assessments of the risk exposure in both normal and stressed environments for each material risk category 106

102 Assessment of risk exposures Should review impact on financial statements each insurer s quantitative methods for assessing risk may vary; however, insurers generally consider the likelihood and impact that each material and relevant risk identified by the insurer will have on the firm s balance sheet, income statement and future cash flows. Should recognize unique risk profiles and stress conditions Because the risk profile of each insurer is unique, each insurer should utilize assessment techniques (e.g., stress tests, etc.) applicable to its risk profile. U. S. insurance regulators do not believe there is a standard set of stress conditions that each insurer should test. 107

103 Economic Capital Model (ECM) Model architecture Insurance business Economic scenarios Management actions Accounting Solvency assessment Invested assets 108

104 Stress tests or stochastic models? > Best practice: use both stress tests and stochastic models > NAIC ORSA Guidance Manual mentions both approaches without indicating a preference. > Complementary strengths and weaknesses 109

105 Stress test modeling Company A Company B Capital Held Static RBC Capital Requirement Capital Held Static RBC Capital Requirement > Two companies, same balance sheet and mean growth forecast same capital requirement under standard RBC formula, assuming everything plays out as expected 110

106 Stress test modeling Company A Company B Capital Held Static RBC Capital Requirement Capital Held Static RBC Capital Requirement > Two companies, same balance sheet and mean growth forecast same capital requirement under standard RBC formula, assuming everything plays out as expected > Stress test model asks what happens under a single, specific alternative set of conditions (green lines), e.g., an adverse economic environment > Greater impact on Company A greater need for capital to remain above minimum thresholds 111

107 Stochastic risk modeling Company A Company B Capital Held Static RBC Capital Requirement Capital Held Static RBC Capital Requirement > Two companies, same balance sheet and mean growth forecast same capital requirement under standard RBC formula > Stochastic risk model shows range of possible scenarios > Company A has much greater potential for upside and downside variation greater need for capital to remain above minimum thresholds 112

108 Stress scenario from the news Property/casualty insurance group downgraded by both Fitch and A.M. Best in October 2013 Complex stress scenario: > 2011: 6.5 point increase in loss ratio (Hurricane Irene) > 2012: 12.6 point increase in loss ratio $50 million increase in loss reserves $80 million loss from superstorm Sandy > 2013: $365 million increase in loss reserves $215 million write-down of goodwill Credit downgrade complicates efforts to bolster capital 113

109 Deterministic vs. stochastic models Deterministic Stress Test (single what-if scenarios) Stochastic Model (potentially thousands of scenarios processed simultaneously) Advantages Easy to implement Can re-create actual historical events Simple cause & effect structure Easy to understand risk drivers, interpret results, explain More complete picture Range of results & probability reflected in distributions More useful information about the potential outcomes of strategic decisions Disadvantages Incomplete picture Limited by modeler s imagination Prone to behavioral biases Single scenarios are insufficient basis for strategic decision-making Can be difficult to parameterize need to calibrate both body and tail of distribution Complexity of output May be more difficult to interpret & explain Best practice is to employ both approaches and use a long historical data set, which includes historical stress events. 114

110 ECM as a Stochastic P&L system > Moving parts of ECM Lines of a P&L > Expected values tie directly to the financial planning process > Variability is based on (1) analysis of data, (2) substantial input from business leaders and (3) economic factors > Result is a stochastic P&L estimating the probability distribution of potential outcomes Financial Plan Best Estimate P&L ECM Stochastic P&L s Ranges of possible results Policies xxx,xxx xxx,xxx xxx,xxx Avg. Prem. x,xxx x,xxx x,xxx Prem. Written xxx,xxx xxx,xxx xxx,xxx Prem. Earned xxx,xxx xxx,xxx xxx,xxx Losses xxx,xxx xxx,xxx xxx,xxx Expenses xx,xxx xx,xxx xx,xxx Net UW Gain xx,xxx xx,xxx xx,xxx Variable economic drivers Analysis of volatility and dependencies of insurance business Policies xxx,xxx 2012 xxx,xxx 2013 xxx,xxx 2014 Avg. Policies Prem. xxx,xxx x,xxx2012 xxx,xxx x,xxx2013 xxx,xxx x,xxx2014 Prem. Avg. Policies Written Prem. xxx,xxx xxx,xxx x,xxx2012 xxx,xxx xxx,xxx x,xxx2013 xxx,xxx xxx,xxx x,xxx2014 Prem. Prem. Avg. Policies Earned Written Prem. xxx,xxx xxx,xxx x,xxx xxx,xxx xxx,xxx x,xxx xxx,xxx xxx,xxx x,xxx Losses Prem. Prem. Avg. Earned Written Prem. xxx,xxx x,xxx xxx,xxx x,xxx xxx,xxx x,xxx Expenses Losses Prem. Earned Written xx,xxx xxx,xxx xx,xxx xxx,xxx xx,xxx xxx,xxx Net Expenses Losses UW Prem. GainEarned xx,xxx xxx,xxx xx,xxx xxx,xxx xx,xxx xxx,xxx Net Expenses Losses UW Gain xx,xxx xx,xxx xxx,xxx xx,xxx xx,xxx xxx,xxx xx,xxx xx,xxx xxx,xxx Net Expenses UW Gain xx,xxx xx,xxx xx,xxx Net UW Gain xx,xxx xx,xxx xx,xxx 0 UW Gain Potential for UW Loss Translates to Capital Need Management input from business units 115

111 Millions Analysis of adverse scenarios 5,000 Scenarios That Fail To Maintain Benchmark Capital 4,500 Scenario 470 4,000 3,500 3,000 2,500 Scenario 2459 Scenario 3106 Scenario 4606 Scenario 4992 Scenario ,000 Scenario ,500 Avg. Proj. Capital 1, Min. Benchmark Capital Company Action Level Q4 2012Q1 2012Q2 2012Q3 2012Q4 2013Q1 2013Q2 2013Q3 2013Q4 2014Q1 2014Q2 2013Q1 116

112 Analysis of adverse scenarios Well-constructed ECM should enable drill-down into the details of specific adverse scenarios > Model validation > Identification of key drivers of tail risk > Formulation of management response to risk exposure > Connect ECM output to ERM process Appropriate aggregation and risk correlation is critical Scenario number and description of capital impairing events 470 Reputation damage and subsequent loss of market share 2,459 Reputation damage, loss of market share, adverse claim trend preventing recovery 3,106 Unexpected investment losses, loss of key account, inability to fully achieve price increases 4,606 Sustained adverse claim trend, inability to fully recover with price increases, loss of membership 4,992 Unexpected losses due to poor underwriting, adverse results of market conduct 10,873 Adverse regulatory action in key markets 10,946 Sustained adverse claim trend, inability to fully recover with price increases, loss of membership 117

113 Disclosure Pursuant to the rules of professional conduct set forth in Circular 230, as promulgated by the United States Department of the Treasury, nothing contained in this communication was intended or written to be used by any taxpayer for the purpose of avoiding penalties that may be imposed on the taxpayer by the Internal Revenue Service, and it cannot be used by any taxpayer for such purpose. No one, without our express prior written permission, may use or refer to any tax advice in this communication in promoting, marketing, or recommending a partnership or other entity, investment plan, or arrangement to any other party. Baker Tilly refers to Baker Tilly Virchow Krause, LLP, an independently owned and managed member of Baker Tilly International. The information provided here is of a general nature and is not intended to address specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought Baker Tilly Virchow Krause, LLP 121