The financial crisis spurred a wave of new regulatory proposals at the state, federal and international levels. Many of the new ideas in insurance supervision offer extremely promising ways to foster greater cooperation among global supervisors, heightened understanding of the true risk profile of a global insurer and, ultimately, better supervisory outcomes.

The concept of group supervision, for example, ensures that supervisors of global firms do not view risks in different jurisdictions in isolation but instead analyze risk concentrations across the group and between affiliates. Other promising new tools are the Own Risk and Solvency Assessment (ORSA) and the supervisory college.

The time is right for a collective effort by industry and regulators to refine and advance these tools.

Unfortunately, that is not happening. Rather than advancing promising supervisory tools, the International Association of Insurance Supervisors (IAIS) has spent the last three years pursuing the idea that a global group capital standard is the solution to avoid the next financial crisis. Around the world, supervisors have been intensely focused on developing a groupwide, consolidated, risk-based insurance capital standard for so-called global systemically important insurers (G-SIIs) and internationally active insurance groups (IAIGs).

The international capital standard (ICS) that has been proposed is misguided and impractical for many reasons. Fundamentally, though, it’s misguided because it is based on the view that insurance companies fail because they are undercapitalized. In fact, the stresses on insurance companies during the financial crisis arose from gaps in understanding risk exposures, not holes in capital.

The ICS is impractical because the approach is incompatible with the regulatory framework in many jurisdictions outside of the European Union.

This isn’t just an issue for big global insurance groups. U.S. carriers of all sizes need to understand the implications of ceding the U.S. regulatory framework for one developed in Europe.

Those of us in the industry know the pressure regulators are under to create uniform capital standards. We also know that the voices of global insurers—ours included—that want to go in a different direction are sometimes viewed as misinformed, in denial or concerned that our own companies will need to increase capital to meet the new standard.

To be clear, those are not our concerns. We have no doubt that our company, ACE Group, has the capital sufficiency and resources to undertake the internal work to meet the requirements of reporting under an ICS. But just because we are able to live with an ICS does not mean it is a good idea.

Our concern is that so much time and so many resources are being expended on an ICS that there’s a risk of a false sense of security for supervisors who may think they got it right. We think global efforts should be focused instead on qualitative improvements to insurance supervision.

The Financial Crisis Was Not About Capital

Capital is just one component of effective risk management. In our view, if the goal is avoiding insurer company failures, capital is not the most important goal. Insurance companies rarely fail because they are undercapitalized. Rather, they fail when they don’t understand their exposures, have inadequate reserves or underprice their products.

As a group, core operating insurance companies endured the stresses of the financial crisis with few exceptions. It is clear that higher capital standards would not have made a difference for those few insurers that got into trouble during the crisis; however, a strong case can be made that a better understanding of their risk exposures would have.

A capital standard is not a substitute for thinking about risk. No capital standard will properly identify potential issues in risk concentration, risk governance or intragroup contagion. Imposing a formulaic, one-size-fits-all capital requirement is a flawed foundation for regulation that will create a distorted view of financial stability.

Insurance companies have long-term liabilities that are matched against assets. Because the use of mark-to-market valuation is procyclical in nature, insurers would take an artificial hit to their balance sheets during a stress event when this is precisely the moment the industry should be acting as a circuit breaker. In effect, this flawed approach would work against society by exacerbating the problem.

The current ICS proposal is impractical, and pursuing it misses an important opportunity to improve the regulatory framework.

ICS as a Tool, Not a Requirement

A better and deeper understanding of an insurance group and its risk management is a more likely path to avoid the next financial crisis than imposing a formulaic, one-size-fits-all capital requirement. There clearly is value in assessing group-level capital. At ACE, we have our own internal group capital model. In addition, we routinely assess and stress-test our group capital under different models, including those used by rating agencies and various regulatory regimes.

In requiring an ICS, however, IAIS is aiming for an international requirement to produce the identical—and presumably “correct”—level of capital in every jurisdiction. We question whether the kind of comparability the IAIS seeks is achievable, let alone desirable.

Insurance companies with international operations are extremely diverse in their geographic scope, product lines, distribution channels and the customer segments they serve. Each company has a unique risk appetite. As a result, the exposures of global insurance companies are not easily comparable. An ICS that tries to fit round pegs into square holes is bound to fail.

This position should not be mistaken for opposition to the U.S. or any other jurisdiction developing a group capital standard. However, an ICS should be a capital assessment tool, not a requirement.

This view should also not be misread to suggest that capital requirements in local jurisdictions should avoid review and scrutiny. If there are perceived shortcomings in a jurisdiction’s approach to capital, bankruptcy law or policyholder guarantee system, these should be addressed through local regulation. Superimposing a global standard is not the answer.

Protecting Policyholders

The prescriptive approach taken by IAIS raises other concerns. In our view, the universally accepted purpose of insurance capital is to ensure that companies have sufficient capital to meet their fiduciary obligations to pay policyholder claims. Regulators in the U.S. and many other jurisdictions long ago established capital standards to ensure that insurers fulfill their responsibility to protect policyholders. This focus has served consumers and the U.S. industry well, creating a diverse and stable market to serve policyholders.

The proposed ICS, however, goes well beyond the objective of protecting policyholders. Instead, IAIS envisions a capital standard that protects not just policyholders but shareholders, bondholders and other risk-takers who historically have not been a concern of insurance regulation. By embracing a so-called going-concern principle, this regulatory framework would protect sophisticated creditors at the expense of policyholders who would ultimately need to pay higher premiums to cover the added protection.

Insurance companies are in the risk-taking business. They should be allowed to stumble or fail so long as there are regulations in place to protect policyholders. Financial risk for creditors should not be borne by policyholders.

Flawed Valuation Methodology Distorts View of Financial Stability

IAIS has considered three valuation methodologies and, regrettably, is emphasizing an approach that, even if it were to overcome practical obstacles to implementation, would likely produce a distorted and misleading picture of an insurer’s financial position.

The market-adjusted valuation methodology starts with the value of assets and liabilities of each legal entity based on accounting standards in its own jurisdiction. Then, at the group level, it applies an IAIS-determined interest rate to discount those liabilities. The stated goal is comparability, even though the interest rate applied to discount the liabilities may be different from the interest actually earned on invested assets. This has the potential to produce spurious volatility that is not representative of actual gaps in policyholder protection, particularly during times of stress.

The market-adjusted valuation approach also creates particular challenges for U.S. companies. Currently, market-adjusted valuation standards do not exist under U.S. generally accepted accounting principles (GAAP). While it’s true that the International Accounting Standards Board (IASB) is in the process of attempting to implement standards, the Financial Accounting Standards Board (FASB) has announced it will not adopt a market-adjusted approach for insurance contracts. Thus, it remains unclear if a market-adjusted valuation will ever become the standard basis for accounting around the world.

Even if an IASB standard is adopted in parts of the world, it will be years before that model becomes one that is as trusted and proven as U.S. GAAP. Given this reality, we do not agree with the headlong rush to move to an unproven basis of accounting over U.S. GAAP, which is well known and understood.

A Better Basis for Determining Qualifying Capital

The second major part of the proposed ICS is qualifying capital resources. Here again, the proposed approach departs from the prevailing standard in the U.S. and many other jurisdictions.

Specifically, the current language in the IAIS consultation document does not recognize senior debt as capital. In the U.S., senior debt consistently is the preferred option for raising capital. Critically, debt obligations of the holding company are structurally subordinate to the policyholder obligations of the insurance subsidiary.

This structure has long been accepted in the U.S. regulatory system, which includes extensive financial controls to protect the interests of policyholders, including significant restrictions on a holding company’s ability to access capital from its insurance subsidiaries. As a result, U.S. senior debt typically is treated as capital by both U.S. regulators and rating agencies.

On average, 16 percent of total capital for U.S.-based P/C companies is senior debt. Given the clear priority of policyholder obligations, there is no need for U.S. IAIGs to change the manner in which they raise capital. Doing so would only increase an insurer’s capital costs, which would result in higher premiums without any additional level of protection for policyholders.

The ICS Capital Requirement Also Misses the Mark

The third leg of the ICS stool covers capital requirements by identifying critical risks facing insurers (for example, catastrophic risk or reserve risk) and determining the capital to support such risks. This will require a substantial effort to gather and calibrate data—a task made more onerous by the diversity of products offered by global insurers. This process will not identify the true exposures and risk drivers faced by companies and the industry as a whole.

Barriers to Implementation

Aside from, or in addition to, the substantive concerns, it is unlikely the ICS as currently proposed will be implemented widely in the U.S. due to practical issues. To understand the challenges of implementation, it is useful to review how the U.S. system of insurance regulation works.

The Federal Insurance Office does not have authority to regulate insurers or to set capital standards that are binding on state regulators. The U.S. Federal Reserve has authority to regulate companies designated in the U.S. as systemically important and to oversee insurance groups that also own depository institutions. However, for all other insurers, regulation—specifically capital and solvency requirements—are set by the states.

An ICS adopted by the IAIS may be considered by the National Association of Insurance Commissioners (NAIC), its U.S. counterpart. U.S. industry, however, will have ample opportunity to provide advice and comment on various provisions. Even if a model act adopting the ICS is approved by the NAIC, it will not be binding until individually adopted in each of the 50 states. This process involves state legislatures and, almost certainly, many additional years of debate and consideration.

Experience suggests that state legislatures are unlikely to adopt a capital requirement that adds significant costs and burdens to U.S. consumers and companies in the absence of compelling benefits.

It is also unclear how the proposed approach to consolidated group capital could be practically enforced. Take, for example, a U.S.-based IAIG with insurance subsidiaries in many locations, each meeting local capital requirements. If the ICS does not credit senior debt as capital, that IAIG could have a deficiency in its consolidated capital assessment. In this scenario, where should that IAIG hold the additional capital so that its consolidated assessment meets the ICS standard?

Adding capital to an already well-capitalized subsidiary is inefficient. More importantly, who determines that the consolidated capital is deficient and in which entity capital should be added to become compliant?

Let’s assume the group supervisor has this responsibility. This raises another question: What legal authority does a group supervisor based in one jurisdiction have to order and enforce a decision to add capital to an entity in another jurisdiction?

Each jurisdiction has its own approach to solvency, policyholder protection and resolution of firms which, in the absence of a binding world law, cannot be overridden. These questions regarding the practical enforcement of an ICS are critical and need to be answered before the ICS is further developed.

Setting Minimum Standards

Given these fundamental and practical concerns, what is the optimal way to build a regulatory framework that protects policyholders and minimizes potential contagion that could threaten financial stability?

Our pragmatic view is that the foremost goal should be to develop an effective ICS that stands the best chance of being widely adopted. By definition, this means that the ICS cannot be primarily derived from only one jurisdiction’s approach to solvency. In such circumstance, other jurisdictions will not readily accept drastic changes to their approach.

Instead, the ICS should provide a minimum international standard for group capital targeted at policyholder protection and against which a jurisdiction’s approach can be assessed. This standard should be compatible with local accounting approaches, allowing for minimum adjustments to provide a comparable review of the group’s solvency.

We would redirect the energy and resources of the industry and regulators to focus on advancing sound principles of risk governance and assessment, including promising group supervision tools such as ORSA and supervisory colleges. This approach can enable supervisors to better assess an insurance group’s risk management framework, review whether the group is well managed, evaluate governance and—most critically of all—determine if the group has the available capital to meet its policyholder obligations, including under stress scenarios. These are the principles around which both the U.S. industry and regulators should rally.