An Overview of the Prudential Solvency Regime in the United States

Episode Summary

In the latest episode of Skadden’s yearlong podcast series on global prudential solvency requirements, host Rob Chaplin and colleague Chiara Iorizzo explore regulatory capital in the United States, one of the largest insurance markets in the world. They discuss how the insurance industry is regulated across the country, as well as how the National Association of Insurance Commissioners operates and interacts with state-level regulators. They also review how solvency capital is calculated in the U.S. and how companies licensed in multiple states must adhere to relevant laws in each jurisdiction, among other topics.

Key Points

• State-based Regulation: Insurance in the U.S. is regulated by state-level departments of insurance headed by commissioners who oversee laws for all market participants within their jurisdiction, with the National Association of Insurance Commissioners (NAIC) setting standards across all 50 states and territories through model laws and accreditation requirements. Each insurance company is domiciled in one state, subject to certain exceptions where an insurer can be deemed to be commercially domiciled in a second state. While insurers are primarily regulated by the domiciliary regulator, they’re also subject to the laws of each and every state where they are licensed.
• Capital Requirements: Each state prescribes a minimum amount of capital that an insurer must maintain in order to be issued a license. These requirements vary from state to state and depend on the line of insurance for which the insurer is licensed beyond statutory minimum.
• Self-reporting: The insurance industry fared well in the 2008 financial crisis, which some attributed to its risk-based capital (RBC) framework. Still, in recent years, model laws have been adopted that require insurers to report solvency at the group level through Form F, the Own Risk and Solvency Assessment (ORSA) report and Group Capital Calculations.

Voiceover (00:01):
From Skadden, the Standard Formula is a Solvency II podcast for UK and European insurance professionals. Join us as Skadden partner Robert Chaplin leads conversations with industry practitioners and explores Solvency II developments that matter to you.

Rob Chaplin (00:18):
Welcome back to the Standard Formula podcast. Today, we’ll be discussing regulatory capital in the United States, one of the largest insurance markets in the world. This episode is part of our year-long [00:00:30] podcast series on global prudential solvency requirements, which will form the basis of our forthcoming publication, The Encyclopedia of Prudential Solvency. Joining me today is my colleague, Chiara Iorizzo. Chiara, good to have you here.

Chiara Iorizzo (00:49):
Thanks, Rob. It’s good to be here and give our listeners an overview of the regulatory capital in the United States.

Rob Chaplin (00:53):
Let’s start with how insurance is regulated in the United States.

Chiara Iorizzo (00:58):
In the US, insurance is regulated [00:01:00] by the states, specifically by state departments of insurance, which are headed by a commissioner or its equivalent. This authority stems from a combination of common and federal law, which collectively affirms that the regulation of insurance is a power reserved to the states. There are some rare exceptions, such as in the case of federal preemption. Commissioners, sometimes referred to as directors or superintendents, can be either selected or appointed, and in either case, they are charged with overseeing insurance [00:01:30] laws for all market participants within their jurisdiction. Insurance companies are regulated both independently by their jurisdiction of domicile or as part of a broader system under the Insurance Holding Company System Regulatory Act or Holding Company Act. This is headed by a lead state for their respective insurer.

(01:49):
On the whole, regulatory capital is determined on an individual entity basis. However, over the course of the past 15 years, US insurance laws and regulation have [00:02:00] expanded their purview to encompass a broader view of systemic risk and developed a greater interest in coordinating capital regulation across state and international borders. Rob, why don’t you tell us about how the National Association of Insurance Commissioners, or NAIC, operates, and how it interplays with state regulators?

Rob Chaplin (02:21):
Well, it may surprise you to learn that a predecessor of the NAIC was actually formed more than 150 years ago. However, the [00:02:30] NAIC, as we know it today, has only been operating since the late 1960s. The NAIC is the organization that sets the standards for the state insurance regulators across all 50 states, the District of Columbia and the five United States territories - Puerto Rico, the US Virgin Islands, American Samoa, Northern Mariana Islands, and Guam.

(02:55):
Its primary role is to set standards and provide model laws and regulations. [00:03:00] Adoption of certain model laws and regulations is a necessary condition for a state to remain accredited, but it’s not sufficient alone. Accreditation is a rigorous process that each state must undergo every five years. It allows each state to afford other states a degree of deference and give assurance that they are operating under a common regulatory framework. It also focuses on standardizing financial reporting and [00:03:30] solvency ratio requirements. Statutory Accounting Financial Standards, or SAFS, the Holding Company Act, Risk-based Capital, or RBC, own risk solvency and group capital are all examples of accreditation standards.

(03:48):
Chiara, most of our US clients are active in multiple US jurisdictions. Would you please clarify how a company or a legal practitioner determines which laws [00:04:00] apply?

Chiara Iorizzo (04:01):
Certainly. Each insurance company is domiciled in one state, subject to certain exceptions where an insurer can be deemed to be commercially domiciled in a second state. While insurers are primarily regulated by the domiciliary regulator, they’re also subject to the laws of each and every state where they are licensed. RBC requirements are regulated by the domiciliary state. RBC rules are an accreditation standard, so variations from state to state derive primarily from the state’s application [00:04:30] of the Statutory Accounting Principles or SAP.

(04:34):
Although SAP is an accreditation standard, states have some flexibility in its adoption, including through the issuance of permitted and prescribed practices. Certain states also maintain desk drawer rules, which can lead to a higher reserving and, accordingly, higher RBC requirements for the domestics, for example, as is the case in the context of reinsurance. For now, Rob, can you run us through how solvency capital is calculated [00:05:00] in the United States?

Rob Chaplin (05:02):
With pleasure. For an insurer to be licensed, all states prescribe, by statute, a minimum amount of capital that must be maintained in order to be issued a license. These requirements vary from state to state and depend on the line of insurance for which the insurer is licensed. Beyond statutory minimum capital, insurers must also hold RBC, which we’ll discuss in a moment.

(05:28):
To assess whether an insurer’s [00:05:30] RBC is adequate, insurance regulators look to the RBC ratio. There are two relevant ratios, authorized control level RBC, or ACL, and company action level RBC, or CAL. As an aside, most property and casualty or P&C companies will think of RBC in terms of ACL, whereas life and annuity insurers will generally refer to their ratio [00:06:00] in terms of CAL. While the formula for RBC depends on the type of underlying business, the RBC ratio is calculated for all insurers by taking the eligible total adjusted capital, or TAC, of the insurer and dividing it by either the insurer’s RBC, such as is the case for ACL RBC, or two times the insurer’s RBC in the case of CAL RBC.

(06:30):
[00:06:30] The RBC formula works on a square-root basis, which means some diversification benefit is reflected. This is analogous to both Solvency II in Europe and the Bermuda Solvency Capital Requirement, or BSCR, which we discussed in one of the earlier episodes of this podcast series.

(06:49):
Chiara, could you tell us more about how the RBC varies based on the type of insurer?

Chiara Iorizzo (06:56):
Of course. As previously noted, the formula for RBC [00:07:00] depends on whether the insurer is engaged in writing P&C, life and annuity, or health business. RBC for insurers is comprised of several categories, which are commonly referred to as C factors and are identified by number. C-0 refers to risks relating to affiliate transactions. C-1 refers to asset risk. While all insurers are exposed to asset risk, the components of the C-1 calculation differ significantly by type of insurance. Not surprisingly, [00:07:30] the C-1 for life and annuity includes more detailed requirements given the specific asset classes and the charges applicable thereto. This has led to a significant focus on part of many insurers, asset managers and certain service providers to originate assets that are optimal for the balance sheet of life and annuity insurance from an RBC perspective. By comparison, while P&C insurers are also subject to asset risk with certain exceptions, the risk is typically shorter [00:08:00] tail and therefore supported by assets with shorter duration and less complexity.

(08:05):
C-2 refers to insurance risk. With life insurance, there is less risk. The C-2 factor for life and annuity insurance focuses on mortality and longevity. For certain types of products, morbidity is also a significant factor. By comparison, for P&C insurers, insurance risk focuses on both premium risk and reserve risk.

(08:26):
C-3 refers to interest rate risk. This is only [00:08:30] utilized for life and annuity given the potential for significant interest rate fluctuations over a longer duration of liabilities. We’ve previously discussed this in one of our webinars in our presentation on the convergence of insurance and asset management. There, we addressed how a 15-year sustained low interest rate environment led insurers to look for yield beyond traditional fixed income portfolios. It was followed by a spike in rates which drove record-breaking annuity sales [00:09:00] and forged expanded partnerships between insurers and asset managers in order to meet the demands of unprecedented annuity volumes with the yield from alternative investments. These commercial changes have led to a heightened regulatory emphasis on asset and interest rate risk for life and annuity insurers.

(09:19):
C-4 refers to operational risk. While this applies to all insurers, it is more relevant for life and annuity. In sum, while the RBC ratio formula is the same [00:09:30] across the lines of business, the components of RBC and its underlying C factors do not apply equally across all lines of insurance and the formula for calculating RBC varies as well. This is why comparing the RBC of a life and annuity company to a P&C company, though both stated as ratios, is truly comparing apples and oranges.

(09:51):
Rob, with the emphasis on individual entity solvency, how do insurance regulators address systemic risk that makes them beyond an individual entity?

Rob Chaplin (10:00):
[00:10:00] That’s an excellent question, Chiara. There are some within the NAIC who are skeptical of systemic risk. This is because the insurance industry actually fared quite well in the 2008 financial crisis, particularly as compared to other regulated industries. Many believe this was in large part due to the RBC framework. That said, in recent years, new model laws have been adopted, which require reporting of solvency at the [00:10:30] group level, specifically through Form F, the Own Risk Solvency Assessment, or ORSA report, and group capital. Form F is a holding company system’s enterprise risk report. It’s submitted annually by all insurers that are part of a holding company system, and it’s designed to identify risks that could adversely affect the holding company system as a whole. This self-reporting mechanism is used as a tool by [00:11:00] regulators to help identify systemic risk and to enhance their understanding of the interdependencies of members of holding company systems.

(11:10):
Form F is an accreditation standard and was codified into law as a revision of the Model Holding Company Act. It’s mandatory across all states and it’s submitted to the lead state regulator with a copy sent to all other domiciliary states. Form F is treated as highly confidential under most [00:11:30] state laws since regulators view it as their prerogative and not that of the individual consumers in order to regulate solvency and systemic risk.

(11:43):
Form F covers everything such as corporate governance and structure, affiliated transactions, and other areas of risk exposure. This includes off balance sheet liabilities and support, operational and reputational risks, and [00:12:00] risks of third parties, for example, from cyber criminals. Like group capital, which we’ll discuss in a moment, Form F also considers the impact of non-insurers on the holding company. Most states have a submission deadline of end of April or mid-May for the submission of the form F.

(12:19):
In addition to Form F, the ORSA Model Act, which is also an accreditation standard, requires an insurer to provide a self-assessment that looks at its risk management [00:12:30] framework, its assessment of risk exposure, and its group-level capital adequacy. For international groups that are primarily in Solvency II jurisdictions, the ORSA report can look to adequacy as determined under Solvency II.

(12:47):
ORSA is primarily a tool for enterprise risk management, but is also another effective mechanism for regulators to gain further insights into how insurers manage their capital [00:13:00] relative to their exposure and risk. Beyond Form F and ORSA, insurance holding company systems are also required to produce a Group Capital Calculation. As previously noted, over the past decade, there has been an increasing push within the NAIC to more broadly review the overall solvency of an insurer’s holding company system rather than the solvency of the individual insurers in isolation.

(13:28):
As a result, [00:13:30] the NAIC developed group capital calculations, which were adopted as a model law in December 2020 with an emphasis on oversight of insurance holding company systems as a whole. Group capital is a tool, similar to RBC and other capital measures for individual insurers, that regulators use to assess solvency and systemic risk. Group capital remains an evolving regulatory topic. Notably, it does not confer [00:14:00] any additional authority on state regulators to compel capital contributions. Starting on January 1st, 2026, under the NAIC Model Law, Group Capital requirements are expected to become an NAIC accreditation standard.

(14:17):
Chiara, why don’t you tell us more about Group Capital Calculation?

Chiara Iorizzo (14:22):
Certainly. The Group Capital Calculation, or GCC, was developed to provide US state insurance regulators [00:14:30] with a more consistent and holistic analytical tool to assess the capital adequacy of insurance groups. Many state departments of insurance think regulation at the individual entity level is sufficient and effective for protecting solvency. However, this GCC initiative stemmed from the 2008 financial crisis, which arguably exposed a lack of visibility into the financial interconnections between insurance entities and their non-insurance affiliates, amongst other considerations.

(15:00):
[00:15:00] The GCC’s key goals include improving transparency and group level risk assessment, identifying capital adequacy issues that may not be visible at the individual legal entity level, and supplementing existing group analysis processes with standardized financial metric. Subject to certain exemptions and limited filings, which are possible under specific circumstances, the GCC covers the following entities in the scope of its application: all insurance entities directly or indirectly controlled [00:15:30] by the ultimate controlling person or UCP, all financial entities such as banks and asset managers within the broader group, regardless of where they’re located in the organizational hierarchy, and non-insurance and non-financial entities that pose material risk to the insurance group.

(15:48):
The assessment of such entities begins with review of a properly completed Schedule Y, which forms part of the overall risk assessment. Entities not meeting the above criteria can be excluded from the [00:16:00] calculation, and this can be agreed with the lead state following a materiality review. The GCC uses an RBC aggregation approach which does the following: it leverages existing legal entity capital requirements, for example, RBC for insurers; it incorporates adjustments for inter-group transactions and ownership structures; it applies scalers and proxy measures for non-regulated or foreign entities; and it aggregates available capital and required capital [00:16:30] across the group to compute a group-level capital ratio.

(16:34):
This calculation is organized via a standardized template that includes entity inventory and classification, adjusted carrying values, capital instruments such as debt and surplus notes, sensitivity and scenario analysis and summary analytics.

(16:52):
The GCC is intended to enhance but not replace the existing supervisory authority. State insurance regulators, particularly lead states, [00:17:00] use the GCC results to evaluate group-wide financial risks and capital adequacy, identify potential capital strains or contagion risks from non-insurance entities, inform supervisory strategies, including enhanced monitoring, further requests or coordinated action, and complement other regulatory tools like ORSA or Form F filings.

(17:22):
Beyond this, for more than a decade, the NAIC has been participating in supervisory colleges of the International [00:17:30] Association of Insurance Supervisors, or IAIS. And the NAIC regulators deeply value the insights gained from foreign regulators even if the US model of capital regulation remains, by large distinction, individual-, state- and entity-centric.

Rob Chaplin (17:49):
That’s a great note to end on. We hope you enjoyed this episode, and please look out for our upcoming chapter on the US prudential regime, which will cover what we discussed today and [00:18:00] more. Thank you ever so much for listening. And if you have any questions, comments, and suggestions, please reach out as we’d love to hear from you. Stay tuned for more episodes in this Standard Formula podcast series.

Voiceover (18:14):
Thank you for joining us on the Standard Formula. If you enjoyed this conversation, be sure to subscribe in your favorite podcast app so you don’t miss any future episodes. Additional information about Skadden can be found at skadden.com.

(18:27):
The Standard Formula is a podcast by Skadden, Arps, Slate, Meagher &, Flom, [00:18:30] LLP, and affiliates. Skadden is recognized for its deep experience in representing insurance and reinsurance companies and their advisors on a wide variety of transactional and regulatory matters. This podcast is provided for educational and informational purposes only and is not intended and should not be construed as legal advice. This podcast is considered advertising under applicable state laws.