Tag Archives: financial crisis

What Every Director Needs to Know

We often get called into corporate calamities where “heavy water” is starting to overwhelm the bilge pump of the corporate yacht. Especially in situations like today, where the markets are stuck in bear market territory, where the oil markets have collapsed, where the coronavirus rampages through the U.S. and where gross uncertainty exists regarding our transportation system and supply chain. We have lived through the financial crisis, regulatory messes and, most importantly, situations where organizations have simply lost the faith of the customers and investors.

Often, directors and officer who have to figure out what to do to “save the ship” must at the very same time try to figure out if they have enough directors and officers (“D&O”) liability insurance to weather the storm and protect them from plaintiffs’ lawyers circling the sinking ship.

Nautical allusions aside, figuring out if your D&O insurance is good enough when you are about to enter stormy seas is not ideal. First, there may be no time to tinker with the D&O coverage. Second, and more importantly, if there is a problem with your coverage, or there is not enough of it, many carriers are reluctant to modify policy wording (to potentially “enhance” coverage), or they add limits of liability when a company is having financial difficulty because the carrier is worried about its potential exposure to directors and officers claims (whether they might be lawsuits or regulatory investigations). To many less-forward thinking carriers, doubling down (in some respect, even if it serves to protect their insureds) sometimes makes no sense.

Finally, despite years of heavy claim activity and many large frauds, bankruptcies and regulatory investigations, we often still see the same problems with policies and towers of insurance. Why? We honestly cannot say. Sometimes corporations and their boards do not focus enough on D&O insurance issues because they are frankly too busy with other issues. Sometimes D&O insurance decisions are based not on “substance” issues but on cost issues, which is generally not the right answer for many reasons. Much of the literature dealing with D&O insurance tends not to be broadly disseminated to the folks who need the information most, like corporate directors and officers. Instead, decisions are often left to risk managers and brokers who do not have much experience dealing with D&O issues at troubled companies.

Our goal in this piece is to place front and center the most important issues relating to such issues. This will allow directors and officers to understand what they need to know and what to ask when questioning management on D&O coverage. These are not the only issues that should be addressed when considering the scope and breadth of D&O coverage, but certainly are ones that should be at the top of any director’s and officer’s list. Truth be told, this advice should hold true for all companies and boards, not just troubled ones. The best time to fix D&O issues is when the sailing is smooth, not when the corporate yacht is about to sink.

Will Your Carrier Hang Tough With You When Things Go Bad?

D&O insurance is frequently purchased in a “stack” or a “tower” of insurance, led by a primary carrier and multiple excess carriers. The excess policies are usually written in “follow form” nature. This means, in most cases, they follow the terms and conditions of the primary carrier. For larger companies, there is both a traditional Side A, B and C tower (covering the entity and individuals) and a Side A tower, covering the directors and officers for non-indemnifiable loss.

Because neither insurance policy forms nor D&O carriers are fungible commodities, it is very important to understand who is the company’s primary D&O carrier, what coverage the carrier offers and whether the carrier “pays claims.” In many ways, the primary D&O carrier is like a critical vendor or business partner that the company cannot do without. The primary D&O carrier can sometimes be the most important business partner (and friend) a company and a director or officer can have. The hope is that, when the seas are rough, like in an insolvency or restructuring scenario, the primary carrier will be there to respond to claims and ultimately protect the personal assets of the directors and officers involved – even in times where indemnification or advancement is unavailable or refused by the corporation.

 A few points to consider:

1. What is the carrier’s claims handling and claims paying reputation? Is it business-friendly and coverage-friendly, or is the carrier known to try to find “outs” to coverage? Does the carrier have a free-standing claims department, or does it farm out claims to hyper-aggressive coverage counsel? And, if the company has multiple offices overseas, how does the D&O carrier handle cross-border claims or investigations? Through a bit of investigation, one can often learn from others (such as defense counsel or experienced D&O brokers) information that might indicate which way a carrier leans on these important questions. Obviously, the best carrier is one that will hang with the directors and officers even in the worst of times, and will not “run and hide” behind coverage defenses so it does not have to pay.

2. What is the carrier’s underwriting response to questions and potential modifications? What is the carrier’s responsiveness to requests to enhance coverage for the insureds? These questions relate to the prior question. Directors, officers, and companies want a business partner in their primary carrier, not a “silent partner.” Many of the better carriers often will consider (and implement) policy changes even days or weeks before a bankruptcy filing to clarify policy language for the potential benefit of the insureds. Those are the types of carriers that a director or officer wants on his or her side.

3. Do you have enough coverage? This can be the most worrisome aspect to any director or officer caught up in a corporate storm. Unfortunately, this is also an area that is confusing because there are often no clear or “right” answers as to what limits should be purchased.

The most important thing a director or officer can do in this regard is ask many questions of management. For a public company with $2 billion of annual revenue, $30 million of D&O insurance likely does not make sense. Similarly, for companies with substantial debt and perhaps not a lot of cash on hand, a low D&O limit also would not make sense. Very often, an experienced D&O broker can provide benchmarking, showing what D&O insurance is purchased by similarly situated companies. Thus, a company can look to a competitor in its space, or at its size, to determine what type and level of D&O insurance comparable companies have purchased. Finally, many larger companies with public debt or equity exposure can perform “mock” damages analyses to understand what a potential securities claim against them might look like from the perspective of damages and defense costs. The variable here is that the cost of a simultaneous regulatory or criminal investigation, as discussed below, can vastly skew those amounts.

Can a company increase the limits of its D&O coverage midterm, or even after bad news surfaces? This is a common question. The answer is that it depends on the facts and the circumstances of the particular situation. Sometimes the circumstances a company faces are not so dire, and carriers will cooperate with the company’s desire to protect its directors and officers by agreeing to increase the limits of its tower (for a price, of course). Other times, the situation may be so severe that a request to increase limits will be politely declined. The later polite declination proves our point. Directors and officers should ask questions up front regarding coverage amounts. They should not wait until the corporate ship starts to heel over to request higher amounts. By then it might be too late.

See also: What Effective Leaders Do in Tough Times  

Coverage for Regulatory and Criminal Investigations

Troubled companies often encounter a regulatory or criminal investigation (SEC/DOJ) at the same time they are facing civil litigation. This is the potential “double whammy” of defense costs, which often can run into the millions of dollars. Thus, directors and officers need to know what sort of coverage their D&O insurance provides for such investigations because, to the extent such investigation constitutes covered loss under the D&O policy, every dollar spent on investigations will generally reduce the overall limits available to ultimately settle the underlying litigation.

The rules of the road are well established in this area. Directors and officers are generally covered under the company’s directors and officers insurance for formal regulatory and criminal investigations and inquiries as well as “a formal criminal, administrative, or regulatory investigation against an Insured Person when such Insured Person receives a Wells Notice or target letter in connection with such investigations.” 

Corporations are generally not covered for their involvement in such situations, unless individual directors or officers are also simultaneously named in the investigation (these rules of the road are often different in the private equity space, which is beyond the scope of this article). Specialized policies in the D&O marketplace exist to cover regulatory and criminal investigations in those situations where only the company is named, though those policies are reported to be expensive. All other things being equal, a director or officer should ensure that he or she is covered for regulatory and criminal investigations and inquiries. These can be very expensive to litigate and defend, and the last thing the company and its board needs at the time is a loose cannon on deck.

Why Does the Insured Versus Insured Clause (and Its Carve-outs) Really Matter?

The insured versus insured clause has been included in D&O policies for a long time. It finds its genesis in a carrier’s need to guard against collusive lawsuits brought by one insured (say, for instance, the company) against another insured (like a director or officer), solely designed to get to the proceeds of the company’s D&O policy.

Indeed, carriers may have valid reasons for not wanting to cover these types of lawsuits. But there are other types of potential “insured versus insured” lawsuits that should be covered (and thus “carved out” of the insured versus insured exclusion) because they generally would not be collusive (and normally are just as hotly contested as suits brought by traditional third parties). Here is a list of certain types of lawsuits that we believe should be explicitly covered under the D&O policy (i.e., carved out) to protect the interests of the directors and officers.

1. Shareholder derivative actions

2. Suits that generally arise in bankruptcy when bankruptcy-formed constituencies, such as creditors’ committees, bondholder committees or equity committees, bring an action derivatively on behalf of a bankrupt company for alleged breaches of fiduciary duty by the company’s directors and officers.

3. Similarly, suits by trustees, liquidators and receivers against directors and officers. As we have seen from high-profile suits involving companies like Tribune, Extended Stay and BearingPoint, bankruptcy-formed constituencies and trustees have become much more aggressive and litigious over the years, and the threat of such suits simply cannot be ignored.

4. Whistleblower suits brought under the provisions of either Sarbanes-Oxley or Dodd-Frank.

What is Non-Rescindable Side A Coverage?

There are two general coverage sides to a D&O policy (leaving for another day the concept of outside director coverage). Coverage “Side A” is for non-indemnifiable loss, meaning loss for which a company cannot indemnify or is financially unable to indemnify. Under this side, the directors and officers are the insureds. Coverage “Side B,” on the other hand, is for indemnifiable loss. Under Coverage C, the company is insured for securities claims.

Side A covers a range of different scenarios. For example, under Delaware law (where many corporations are incorporated), a company cannot indemnify its directors and officers for the settlement of a shareholder derivative action. And in bankruptcy, a company often will be unable to advance defense costs and to indemnify its directors and officers for claims. Indemnification claims by directors and officers against the company may be treated as unsecured claims that get pennies on the dollar, or may even be subordinated in certain circumstances.

As several of the noteworthy “financial fraud”-related bankruptcies have taught us, having “non-rescindable” Side A coverage is very important. “Non-rescindable” Side A coverage means what it says. Even in cases where a carrier may challenge as false statements made by a potentially complicit CEO or CFO in the company’s insurance application for D&O coverage (attaching to such application, for example, financial statements that later need to be restated), non-rescindable Side A coverage generally cannot be rescinded for any reason, which should allow the directors and officers to sleep better at night. Directors and officers should know that non-rescindable Side A coverage is generally standard in today’s D&O marketplace, and thus primary policies that do not have such coverage should be immediately updated.

What is Side A Excess Difference in Conditions Coverage (and Why Is It So Important)?

As noted above, having non-rescindable Side A D&O coverage is critically important. Having “Side A Excess Difference in Conditions” D&O coverage can be even more important. Why? This coverage reacts in two different, wonderful ways to protect directors and senior management.

First, it acts as “excess” Side A D&O insurance, meaning, in English, that it sits above the company’s traditional tower of insurance and will pay Side A non-indemnifiable claims when the traditional tower is exhausted by either traditional indemnifiable claims or non-indemnifiable claims. For example, a company may have $50 million in traditional D&O coverage and $25 million of Side A excess difference on conditions coverage, where $45 million of that insurance has already been exhausted by the settlement of a simultaneously commenced securities class action and SEC investigation. In such a case, the directors and officers would still have $30 million of Side A insurance to deal with, for example, the settlement of shareholder derivative action.

Second, most Side A excess difference in conditions D&O insurance has something called a “drop down” feature, meaning that if, for example, an underlying excess carrier refused to pay its limit of insurance for some coverage-related reason, the Side A excess difference in condition carrier might have the contractual obligation to “drop down” and fill that layer. Thus, it is a critically important feature that potentially will help fill potential gaps in coverage. Also, note that most Side A excess difference in conditions policies have very few exclusions (e.g., most do not have an insured versus insured exclusion), so they can be particularly helpful to directors and officers.

See also: COVID-19: Moral Imperative for the Insurance Industry  

Does My Corporation Have Enough Side A Coverage?

In the olden days of D&O (meaning 10 years ago), it was pretty rare to have a large Side A tower of insurance. Companies may have had a large primary tower of insurance, but Side A towers over $100 million were a rarity.

Since the settlement of several large financial crisis cases, we have seen a steady rise in the settlement values of shareholder derivative actions. However, in the last three years alone, the value of these cases has skyrocketed in nine-figure territory on a regular basis. Why? Reasons vary from severity, to regulatory fines and penalties, to the opioid crisis to enormous cybersecurity breaches. One of the major factors in all tends to be a really bad event that caused both a stock-price plunge, along with a large fine or penalty. The resulting litigation is called event-driven.

Event-driven litigation puts pressure on the primary tower of insurance, which quickly gets exhausted, and puts an equal amount of pressure on the Side A tower, which will need to respond to the shareholder derivative action. We would strongly recommend that companies entering troubled water re-evaluate their Side A coverage before the bad event happens. Afterward, it may be way too late.

What is the Priority of Payments Clause, and Why Is It Important?

A priority of payments clause specifies how a carrier should handle competing claims on a policy’s proceeds. For example, most such clauses (some carriers call them “order of payments” clauses) specify that Side A claims get paid first, and then traditional Side B company reimbursement and indemnity claims get paid. Obviously, this approach is tremendously important to directors and officers who may need to defend themselves in securities class actions or bankruptcy-related or inspired litigation.

Some priority of payments clauses give the right to the company or a company officer (like a CEO or CFO) to “withhold” or “delay” payments made under Side B of a D&O policy until those payments are properly designated by the appropriate party. This type of discretion is potentially not a good thing. Why? Giving such potential discretion to the company or a company officer to withhold or direct payments under Side B of a D&O policy might be creatively viewed by some as giving the debtor in bankruptcy “a say” or “control” over the proceeds of the D&O policy. That situation could be used by a creditor or other bankruptcy constituency to control or delay payments to the directors and officers under Side A of the policy, again potentially leaving them without resources to pay their counsel. Varriers are very able to make policy reimbursement calls in bankruptcy settings, and the order of payments under a D&O policy should be left to them, not others.  

Making a Better D&O “Mousetrap”

Admittedly, some of the above items are a bit difficult to understand conceptually for the non-insurance professional, and, admittedly, directors and officers often have more pressing issues to deal with when trying to help their companies navigate through troubled waters. But, as we have seen time and time again in our practice, very often D&O insurance becomes the lifeline for directors and officers when companies face trouble.

How can a director or officer stay on top of these issues in the most efficient manner possible? Here are a few suggestions:

  1. Ask the right questions to the right people, like the company’s risk manager, CFO or general counsel, as to what is covered and what is not, and ask about the above limits of liability issues to make sure you are comfortable that at least these points are properly covered. Again, common sense often prevails here, and, if a director or officer does not like the answers he or she is getting, then corrective action should be demanded before it is too late to act.
  2. Make D&O insurance issues a board topic at least twice a year so that board members can stay abreast of coverage developments, options and modifications.
  3. Make sure management sends out the company’s D&O program and tower of insurance at least once a year for a “tune-up.” In this area, coverage options often change, and better coverage can often be obtained so long as the right diagnosis is made by qualified persons such as an experienced D&O broker or, sometimes, experienced outside counsel.

4 Disasters That Never Should Have Occurred

It’s not easy trying to predict the unpredictable. Yet that’s what risk managers are responsible for doing every day. Sometimes, the plans to identify or protect against a particular disaster come up short. Read on for four of the biggest risk management disasters in history – and how the risk management industry has learned from them.

It’s become an iconic image in pop culture – Leonardo DiCaprio leans in close behind Kate Winslet as she raises her arms and exclaims “I’m flying!”

But what can Kate and Leo teach us about risk management?

Quite a lot, in fact. Thanks to several movies and countless other retellings, the tragedy of the Titanic is something everyone knows. But with a better understanding of some basic risk management principles, the Titanic never would have sunk at all.

Michael Angelina, executive director of the Academy of Risk Management and Insurance at Saint Joseph’s University, uses the Titanic and other notable risk management disasters to give his students a better idea of what exactly risk management is – and why they should care about it.

It turns out some of the most notable risk management disasters had specific causes that create pretty clear lessons for risk managers in a range of industries to learn. Let’s take a closer look at four of the biggest risk management disasters in history and what ARMs and risk managers took from them, starting with the event everyone’s favorite ’90s epic/romance/disaster movie is based on.

The sinking of the Titanic

The shortage of lifeboats on board the Titanic on April 15, 1912, has become a well-known fact representing the arrogance and naiveté of designers, crew members and passengers who were positive the massive vessel was unsinkable. To be sure, pretty much everyone was overconfident, from not giving lookouts binoculars to ignoring warnings from other ships about icebergs in the area.

And while the lack of lifeboats is held up as the primary example of that hubris, the 20 lifeboats actually complied with safety regulations at the time. In fact, only 16 rescue ships were required. Lifeboat capacity was determined by the weight of the ship, not the number of passengers on board. This rule was developed for much smaller ships and hadn’t been updated to adjust for the enormous ships that were built in the early years of the 20th century. What’s more, there hadn’t been a significant loss of life at sea for 40 years, and large ships usually stayed afloat long enough for individual lifeboats to make multiple trips to and from a rescue vessel. For all of those reasons, everyone tragically assumed there were an adequate number of lifeboats for passengers.

The risk management lesson learned: Complying with regulations and established best practices is no guarantee that a specific risk has been effectively mitigated. Risk managers need to consider these safeguards the same way they would any other risk prevention effort and take additional action when they don’t sufficiently guard against risk.

See also: A Revolution in Risk Management  

Deepwater Horizon explosion

When the Deepwater Horizon oil rig exploded on April 20, 2010, several executives from BP and Transocean were actually on the structure to celebrate seven years without a lost-time safety incident on the project. Company leaders were so focused on preventing – and measuring – lesser risks like slips, trips and falls that they failed to identify the more complicated process management risks that ultimately led to the explosion.

Risk management lesson learned: All risk analysis is essentially weighing how likely an event is to occur against what impact that event would have, then identifying effective ways to address those risks. Thanks to complacency, cutting corners, arrogance or some combination of those factors and others, BP and Transocean targeted risks with high probabilities and low impact. In the process, they neglected risks in the opposite quadrant of that matrix that were unlikely to occur but could have catastrophic results.

Sept. 11 attacks

Since the tragic events of Sept. 11, 2001, individuals, businesses and the U.S. government have put vast effort and resources into preparing for and defending our nation against further attacks. Professors of risk management at the University of Pennsylvania call 9/11 a “black swan” event – one that is very rare and difficult to prepare for.

Risk managers are extremely good at preventing what’s happened before from happening again. But unlikely events are extremely difficult to predict. Before Sept. 11, 2001, terrorism was listed as an unnamed peril in a majority of commercial insurance deals, according to Penn researchers. After the attacks, insurers paid $23 billion, and many states passed laws permitting insurers to exclude terrorism from corporate policies. Today, the semi-public Terrorism Risk Insurance Act covers as much as $100 billion in insured losses from terrorist attack.

Risk management lesson learned: These black swan events are difficult to predict and even more difficult to prepare for. A portion of the risk management field will always be reacting to the specifics of previous significant events and incorporating them into their models forecasting future risk.

Financial Crisis of 2007-2008

Plenty of people were quick to blame risk managers for failing to protect the world’s largest financial institutions against the biggest economic disaster since the Great Depression. The Harvard Business Review identified six ways companies fail to manage risk, while the Risk and Insurance Management Society (RIMS) argues the financial crisis was not caused by the failure of risk management, but rather organizations’ failure to embrace appropriate enterprise risk management behaviors. Companies provided short-term incentives and did not communicate enterprise risk management principles to all levels of the organization.

Risk management lesson learned: Risk management cannot exist in a vacuum. Creating a robust enterprise risk management program also requires communicating it to all levels of the organization and creating a culture and incentive system that matches the level of risk.

See also: Can Risk Management Even Be Effective?  

Interested in learning more about risk management? Check out the Associate in Risk Management designation from The Institutes.

A Commissioner’s View of Innovation

There’s a thundering herd running through Iowa this year — and not just the herd of presidential candidates. There also is a herd of technological innovators driving considerable change in insurance.

Many people find it intriguing that technology innovators are coming through Iowa, but Iowa is an insurance state and home to some of the largest insurance companies in the U.S. Iowa also is home to niche companies that price out very specific risks to targeted markets.

In my role as Iowa’s insurance commissioner, I’ve met with many entrepreneurs whose ideas will improve, enhance and create value for insurance companies and consumers. In these meetings, I hear a fairly consistent and constant theme: State insurance regulators are a major burden for entrepreneurs and, in turn, for their ideas for innovation.

However, when I walk them through what regulators do and provide them a copy of the Iowa insurance statutes and regulations that empower my office, I’ve found that most haven’t read even one word of insurance law before working on an idea or creating a product or service.

To be clear, I don’t believe I stand in the way of innovation. On the contrary, I am very supportive of innovation.

But my fellow regulators and I do have an important job — consumer protection. Insurance is one of the most regulated industries in the nation because, for the insurance system to work, when things go wrong and a consumer needs to make an insurance claim the funds to pay the claim must be available.

The days on which people file insurance claims may be the worst days in their lives, and they may be very vulnerable. Perhaps a loved one passed away; a home is destroyed; an emergency room visit or major surgery is needed; someone may be entering a long-term care facility; a car is totaled; or injuries are preventing a return to work. Insurance is a product we buy but really hope we never use. However, when we need to use it, we want the company to have the financial resources to pay the claim. It’s our job as regulators to make sure the companies in our states are financially strong enough to pay claims in a timely fashion.

Insurance is regulated at the state and territorial level by 56 commissioners, superintendents or directors. The state-based regulatory system has served consumers well for more than 150 years and demonstrated extreme resilience in the last financial crisis. My fellow commissioners and I are public officials either elected or appointed to our respective posts. We are responsible and accessible to the citizens of our states or territories.

However, I do understand that complying with the laws of all the states, District of Columbia and territories poses challenges to entrepreneurs. In recognition of this, state regulators have worked together to help minimize differences between states through the National Association of Insurance Commissioners, thereby creating a more nationally uniform framework of insurance regulation while recognizing local markets and maintaining power in the hands of the states.

The job of an insurance regulator sounds easy. We exist to enforce the state’s laws, to make sure that companies and agents follow that law and to ensure that companies domiciled in our state are in financial position to pay claims when required. As with many things, the duties of regulators are more difficult than they appear. Regulators need to have great knowledge of multiple lines of insurance, technological advances, financial matters and marketing practices. In reality, the execution of our job duties in enforcing our state’s laws may at times cause friction with some innovative ideas.

As I stated, I don’t believe that I or my fellow regulators stand in the way of innovation. I believe that a robust and competitive market that delivers value to the consumer is one of the best forms of consumer protection. However, our insurance laws are also designed to make sure that insurance companies stay in the market and keep the promises that they have made to their customers when the products were originally sold.

In executing my duties as commissioner, I pay a great deal of attention to innovation and developments. I personally spend time with entrepreneurs, investors and others to learn about new trends and ideas. My commitment to enforcing state laws, combined with the laser focus on protecting consumers, requires keeping abreast of innovation.

My office addresses more than 6,000 consumers’ inquiries and complaints every year. People on my staff address issues quickly and care deeply about their roles in helping Iowans. I’ve learned in my nearly three years as commissioner that many consumers don’t understand the insurance they own. They may have relied on an agent, or purchased insurance coverage on their own, hoping it will suit their needs. However, when life happens and an insurance claim needs to be made, consumers may discover the coverage they purchased did not suit their needs. For instance, some people may discover their health plan network doesn’t have healthcare providers near their home. Others may discover too late that certain items lost in a fire were not covered under their homeowners’ policy. Some consumers may discover that the very complex product that they bought simply did not measure up to their expectations.

Having consumers be comfortable with making a purchase and not understanding what they purchased is a culture we need to change. Some consumers desire to simply establish a relationship with an insurance agent or securities agent they feel they can trust, schedule automatic withdrawals from their bank account to be invested or submit their premiums for their insurance products as required so they can ultimately focus their attention on all the other activities that occupy our busy lives. In essence, they forget that they purchased the coverage, and, while it may have been the right purchase at that time, it may not fully suit their needs now or when they need to file a claim.

Insurance regulators and the insurance industry need to encourage consumers to learn more about their coverage needs and the insurance they actually purchase. Innovation that leads to personalizing insurance and better consumer understanding is a good thing. Innovation that increases speed-to-market, enables better policyholder relations through in-force management and provides more value to the consumer is a good thing. However, all that innovation must comply with our state’s laws.

To that end, I’ve met with several entrepreneurs to highlight issues that would arise with certain proposed business models. I enjoy discussing ideas about our industry and sharing Iowa’s perspective. Innovation can help consumers, and it’s my hope that entrepreneurs continue to work with regulators to develop new products and services. This collaboration helps both the regulators and the entrepreneurs and has led to some very positive and healthy dialogue in Iowa.

10 Questions on Capital Standards

PwC U.S. risk and capital management leader Henry Essert and PwC global insurance regulatory director Ed Barron recently sat down to discuss the proposed International Capital Standards (ICS) for insurers. They addressed at length what the ICS is and what it could mean to insurers. Here are their thoughts on the standard, as well as some background information on capital management and related issues in the insurance industry.

1. Why have an ICS?

The ICS is about creating a consistent capital measure across globally active insurers and is being promoted as a solution for group-wide supervisors to better manage capital allocation around an international business.

Insurers generally have developed their own capital standards, and what they have developed applies globally across groups. However, regulators need a capital measure to oversee insurers, and most of the regulatory measures are at the legal-entity level. During the last financial crisis, problems arose when parts of a troubled financial institution fell through a regulatory crack.

Even before that, many insurance regulators were concerned that they did not have a good picture of companies as a whole because capital is measured differently in different jurisdictions. This makes it hard for a supervisory college to identify where there may be shortfalls in capital.

2. Who wants it?

Primarily regulators and, by extension, policymakers and politicians/elected representatives. At the end of the 2008 crisis, many of them were concerned about avoiding or better handling any subsequent crises. This prompted politicians (via the Financial Stability Board) to direct regulators to improve the regulatory system for all of financial services, particularly as it relates to capital standards. And, while the banking industry has received the most attention, the insurance industry is part of a wider move for change in financial services; in fact, the FSB is now firmly focusing on the sector.

However, many elected officials in the U.S. are now concerned about adopting a “foreign” calculation that differs from what regulators in their jurisdiction have used. To run their business and generate a good return on capital, multinational and other groups need to have some way to measure how much capital they need in total on a consistent basis. They have devised their own ways of doing this calculation using a combination of current regulatory calculations and their own capital models (which are sometimes called economic capital models). They tend to do these calculations on their own without outside prompting and have concerns that the ICS calculation could conflict with what they are already doing. There has been extensive regulatory change in recent years, and the ICS is yet another initiative that insurers have to address – and in a very aggressive timeframe.

3. Does it reflect current practices or does it break from them?

Practices differ by country, so there is no single current practice standard to compare with, and the ICS is intended to be a truly global group measure. The current ICS proposal is not the same as any practice in any jurisdiction currently, but most people would say it is closer to European Solvency II approach than to the current U.S. practice. Accordingly, ICS (as it currently stands) would be a considerable change to the U.S. market. This is why the Federal Insurance Office (FIO) is leading a workstream on setting up a GAAP+ concept that will be more closely aligned to U.S. practice.

4. Who’s going to enforce compliance?

The International Association of Insurance Supervisors (IAIS) does not have any executive powers; its role is strictly to develop regulatory guidelines and best practices for national supervisors to adopt, either in whole or part. Application of the ICS is up to individual supervisors, and the question remains if they will act in many major jurisdictions. In theory, the ICS will apply (via ComFrame) to only internationally active insurance groups (IAIGs), of which there are roughly 50 worldwide. However, many observers expect that when the ICS becomes an industry standard, other companies also will use it to calculate and report their capital adequacy.

Several jurisdictions do not have an IAIG. Therefore, we assume they would not be pressured into introducing an ICS concept. However, because most jurisdictions readily adopt many IAIS principles, we would not be surprised to see some of the principles within ComFrame and the ICS “trickle down” to smaller markets, especially where there is not necessarily global activity but a high concentration of regional activity (e.g., Asia).

The reason countries tend to adopt IAIS guidelines is because, when the IMF/World Bank conducts its Financial Sector Assessment Program (FSAP) reviews, it uses IAIS principles as the benchmark for assessing the insurance sector. Therefore, it is in many people’s interest to adopt IAIS standards to achieve strong FSAP results (which feed into sovereign rating, etc.).

5. Who at insurers will be most affected?

If the calculation is similar to others already in use, then primarily risk, actuarial, financial and compliance will be affected. If, on the other hand, the calculation is very different, then just about all functional areas could be affected because of a knock-on effect on product portfolio, pricing, investment strategy and so on. In either case, boards will need to demonstrate they understand the numbers and what they mean, particularly as they relate to
strategic decisions.

Taking a look at the bigger picture, the ICS is only part of a larger regulatory package for IAIGs called Comframe. Other aspects of Comframe, like governance, risk management policies and Own Risk and Solvency Assessment (ORSA) also will have an effect on many areas, regardless of where the ICS ends up.

6. How much investment/effort would implementation and compliance require?

This depends on the nature of both the calculation that is adopted and its enforcement. It is almost certain that the calculation will be complex. But, if the calculation is similar to what groups are already using, either because it is similar to the main regulatory calculation groups use or is similar to their own internal, economic capital calculation, then the investment/effort will be less significant.

More importantly, if it winds up being similar to current calculations, then the new ICS would not have a major impact on how the company’s business profitability is measured. However, if the calculation is different, implementation/compliance and business impact will be significant.

Investment and effort may not necessarily be limited to basic compliance. Insurers can look to their experience with Solvency II, which entailed more than just change to capital standards, and required significant investment in new technology, as well as potential changes to organizational structures.

7. Will product offerings change? Are there certain products that may disappear?

If calculations are different than those now in use, then, yes, there would likely be impacts on premiums for some products, and some may even become nonviable. Many life companies are concerned that if certain types of calculations (notably, market-consistent calculations) are used, then long-term savings products may be too costly to remain viable. At the least, if certain products do not disappear, then their design may need to change (which would change the balance of insurers’ product portfolios).

8. What’s been the reaction of ratings agencies and analysts?

Ratings agencies typically have their own capital calculation formula and, for the most part, at the group level. It is not clear if they will replace their own with ICS but could do so if they think the latter is a comparable or better formula.

Equity analysts typically are concerned with the ability to pay dividends or buy back stock, which happens at the parent company level. Accordingly, they typically do their analysis at the group level. They have not been a vocal part of this discussion but probably would find an ICS helpful.

In fact, most stakeholders are likely to support the concept of a global capital standard for the insurance industry, but there almost certainly will be differences of opinion about what one should look like as details are hashed out about how the standard will actually work.

9. With all this in mind, is a true ICS likely?

It’s too early to say for certain one way or the other, but even the regulators who question the necessity of an ICS seem reconciled to the notion that one should be developed. The debate now is what the one true ICS should look like, and how the calculation should be done is the main area of disagreement between and among geographies. For other aspects of the Comframe regulatory package, like governance, risk management policies and ORSA, there is significantly less disagreement.

10. What should insurers be doing now?

Building the ICS calculation formula and finalizing the rest of Comframe probably will take several years. The following are likely to be key steps in the journey:

  • In the early stages, companies will want to understand how the different, proposed ICS options may affect them, to determine which option they favor.
  • As regulators further develop the different options’ details, they will want to study how different factors in the proposed formulas will affect companies. They will ask insurers to conduct studies of these different factors for their business (i.e., field testing).
  • Once the nature of the ICS becomes clear, companies will need to implement the formula (and eventually, the rest of Comframe).
  • All stakeholders should remain aware of ICS developments to assess where there is consensus and disagreement. If there continues to be significant divergence in how required capital is calculated across regimes, and if ICS adds complexity rather than reducing it, then most insurers will need to factor these developments into how they are modernizing or plan to modernize their risk, actuarial, financial and technology platforms to operate effectively and efficiently in the new environment.
  • Insurers may need to redesign and reprice their products, as well as potentially rethink their business strategies. It is possible that they will need to divest certain businesses and add others.

What are current capitalization requirements?

Current capital requirements in the U.S. are set at a legal-entity level. There are no global requirements for a company that operates in more than one country, and calculation formulas for capital requirements typically vary in each jurisdiction. Solvency II gets close to mandating a group standard. However, it uses the concept of “equivalence” to deal with differing capital regimes between the EU and the rest of the world, rather than enforcing Solvency II capital standards on a third country. In other words, if a country outside of the EU is deemed equivalent, then the group headquartered in the EU can use the capital standard of the operation outside the EU within its group calculation on the grounds that EU regulators are comfortable with the system in that
third country.

Are those requirements adequate if there’s another market shock like 2008 or a series of catastrophic events?

During the 2008 shock, some significant companies did not have enough capital, and governments intervened. In many cases, the formulas that set the capital requirements that proved insufficient are still in use.

However, that doesn’t necessarily mean current requirements would be inadequate for future shocks. There’d need to be a model to test if current requirements are adequate for a defined market shock like 2008, but we would need to define exactly what “a series of catastrophic events” means before modeling its impact.

What results in undercapitalization?

The more risky the business, the theory is that insurers will need to hold more regulatory capital against the risk. To be undercapitalized is normally a reflection of poor reserving or liquidity management.

More specifically, companies hold assets to defease their liabilities, which are calculated based on a more or less average level of claims. Additional assets are set aside (not available to pay shareholder or policyholder dividends) to pay for claims should they be higher than the average. This amount of additional assets is the regulatory required capital. If these assets set aside prove insufficient during a crisis, then undercapitalization results.

What is an adequate level of capital reserves (and, if the level varies by sector, what is the appropriate level for each)?

Figuring out the answer to this question is what the whole ICS global and country level debate is all about.

Which sector (reinsurance, P&C, life) has the biggest challenges remaining adequately capitalized?

There is no perception that this is a bigger issue for one sector compared with another. Problems have occurred in all sectors. Some future crisis events will affect all sectors, like credit risk events; others are more harmful for PC (wind storms) or life (pandemics).

Do different sectors have different standards? In other words, does life have a lower standard than P&C?

No, the same formula is used across the sectors. The formula will cover risks that are common across sectors with the same calculation. Different types of risk are covered by having different factors assigned to different exposures. Some of these will apply only to business/exposures written by life companies or PC companies.

Which are better capitalized, groups or subsidiaries (or does it vary)?

Each subsidiary typically has an amount of actual and required capital it holds on its own balance sheet. The group actual and required capital is the sum of these. Many companies hold actual capital in the subsidiaries just sufficient to cover the regulatory requirement in that subsidiary. They would hold any significant excess at the parent company. So for these types of companies, that would mean the group is better capitalized than the subsidiaries. But that is not always the case.

A group parent company typically can send capital to subsidiaries, subject to meeting its own capital requirements if it is an insurance company. However, the normal capital flow is from subsidiaries to the parent, but the flow is constrained by the subsidiaries’ own capital requirements. (Laws differ from country to country about how readily a company can move capital from one entity to another when it has a group capital position.)

Are there certain insurance lines that are difficult to adequately capitalize?

There are certain coverages for which the level of required capital is too high to make premiums affordable. Where this occurs, some form of government intervention typically occurs (e.g., flood insurance in certain areas). This is unlikely to change with or without an ICS.

However, when the objective is policyholder protection, capital is not the only tool. Better risk management is also key, with tools such as the ORSA and governance protocols being paramount. If it is hard to quantify a certain risk type, then strong risk management principles should augment the degree of policyholder protection.

Reinventing Life Insurance

Many life insurance executives with whom we have spoken say that their business needs to fundamentally change to be relevant in today’s market. Life insurance does face formidable challenges.

First, let’s take a hard look at some statistics. In 1950, there were approximately 23 million life policies in the U.S., covering a population of 156 million. In 2010, there were approximately 29 million policies covering a population of 311 million. The percentage of families owning life insurance assets has decreased from more than a third in 1992 to less than a quarter in 2007. By contrast, while less than  a third of the population owned mutual funds in 1990, more than two-fifths (or 51 million households and 88 million investors) did by 2009.

A number of socio-demographic, behavioral economic, competitive and technological changes explain the trends — and the need for reinventing life insurance:

  • Changing demography: Around 12% of men and an equal number of women were between the ages of 25 and 40 in 1950. However, only 10% of males and 9.9% of females were in that age cohort in 2010, and the percentage is set to drop to 9.6% and 9.1%, respectively, by 2050. This hurts life insurance in two main ways. First, the segment of the overall population that is in the typical age bracket for purchasing life insurance decreases. Second, as people see their parents and grandparents live longer, they tend to de-value the death benefits associated with life insurance.
  • Increasingly complex products: The life insurance industry initially offered simple products with easily understood death benefits. Over the past 30 years, the advent of universal and variable universal life, the proliferation of various riders to existing products and new types of annuities that highlight living benefits significantly increased product diversity but often have been difficult for customers to understand. Moreover, in the wake of the financial crisis, some complex products had both surprising and unwelcome effects on insurers themselves.
  • Individual decision-making takes the place of institutional decision-making: From the 1930s to the 1980s, the government and employers were providing many people life insurance, disability coverage and pensions. However, since then, individuals increasingly have had to make protection/investment decisions on their own. Unfortunately for insurers, many people have eschewed life insurance and spent their money elsewhere. If they have elected to invest, they often have chosen mutual funds, which often featured high returns from the mid-1980s to early 2000s.
  • Growth of intermediated distribution: The above factors and the need to explain complex new products led to the growth of intermediated distribution. Many insurers now distribute their products through independent brokers, captive agents, broker-dealers, bank channels and aggregators and also directly. It is expensive and difficult to effectively recruit, train and retain such a diffuse workforce, which has led to problems catering to existing customers.
  • Increasingly unfavorable distribution economics: Insurance agents are paid front-loaded commissions, some of which can be as high as the entire first-year premiums, with a small recurring percentage of the premium thereafter. Moreover, each layer adds a percentage commission to the premiums. All of this increases costs for both insurers and consumers. In contrast, mutual fund management fees are only 0.25% for passive funds and 1% to 2% for actively managed funds. In addition, while it is difficult to compare insurance agency fees, it is relatively easy to do so with mutual fund management fees.
  • New and changing customer preferences and expectations: Unlike their more patient forebears, Gens X and Y – who have increasing economic clout – demand simple products, transparent pricing and relationships, quick delivery and the convenience of dealing with insurers when and where they want. Insurers have been slower than other financial service providers in recognizing and reacting to this need.

A vicious cycle has begun (see graphic below). Insurers claim that, in large part because of product complexity, life insurance is “sold and not bought,” which justifies expensive, intermediated distribution. For many customers, product complexity, the need to deal with an agent, the lack of perceived need for death benefits and cost-of-living benefits make life products unappealing. In contrast, the mutual fund industry has grown tremendously by exploiting a more virtuous cycle: It offers many fairly simple products that often are available for direct purchase at a nominal fee.

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Reasons for optimism

Despite the bleak picture we have painted so far, we believe that reinventing life insurance and redesigning its business model are possible. This will require fundamental rethinking of value propositions, product design, distribution and delivery mechanisms and economics. Some of the most prescient insurers are already doing this and focusing on the following to become more attractive to consumers:

  • From living benefits to well-being benefits: There is no incentive built into life policy calculations for better living habits because there traditionally has been very little data for determining the correlation between these behaviors and life expectancy. However, the advent of wearable devices, real-time monitoring of exercise and activity levels and advances in medical sciences have resulted in a large body of behavioral data and some preliminary results. There are now websites that can help people determine their medical age based on their physical, psychological and physiological behaviors and conditions. We refer to all these factors collectively as “well-being behaviors.” Using the notion of a medical age or similar test as part of the life underwriting process, insurers can create an explicit link between “well-being behaviors” and expected mortality. This link can fundamentally alter the relevance and utility of life insurance by helping policyholders live longer and more healthily and by helping insurers understand and price risk better.
  • From death benefits to quality of life: Well-being benefits promise to create a more meaningful connection between insurers and policyholders. Rather than just offering benefits when a policyholder dies, insurers can play a more active role in changing policyholder behaviors to delay or help prevent the onset of certain health conditions, promote a better quality of life and even extend insureds’ life spans. This would give insurers the opportunity to engage with policyholders on a daily (or even more frequent) basis to collect behavioral data on their behalf and educate them on more healthy behaviors and lifestyle changes. To encourage sharing of such personal information, insurers could provide policyholders financial (e.g., lower premiums) and non-financial (e.g., health) benefits.
  • From limited to broad appeal: Life insurance purchases are increasingly limited to the risk-averse, young couples and families with children. Well-being benefits are likely to appeal to additional, typically affluent segments that tend to focus on staying fit and healthy, including both younger and active older customers. For a sector that has had significant challenges attracting young, single, healthy individuals, this represents a great opportunity to expand the life market, as well as attract older customers who may think it is too late to purchase life products.
  • From long-term to short-term renewable contracts: Typical life insurance contracts are for the long term. However, this is a deterrent to most customers today. Moreover, behavioral economics shows us that individuals are not particularly good at making long-term saving decisions, especially when there may be a high cost (i.e., surrender charges) to recover from a mistake. Therefore, individuals tend to delay purchasing or rationalize not having life insurance at all. With well-being benefits, contract durations can be much shorter — even only one year.
  • Toward a disintermediated direct model: Prevailing industry sentiment is that “life insurance is sold, not bought,” and by advisers who can educate and advise customers on complex products. However, well-being benefits offer a value proposition that customers can easily understand (e.g., consuming X calories per day and exercising Y hours a day can lead to a decrease in medical age by Z months), as well as much shorter contract durations. Because of their transparency, these products can be sold to the consumer without intermediaries. More health-conscious segments (e.g., the young, professional and wealthy) also are likely to be more technologically savvy and hence prefer direct online/call center distribution. Over time, this model could bring down distribution costs because there will be fewer commissions for intermediaries and fixed costs that can be amortized over a large group of early adopters.

We realize that life insurers tend to be very conservative and skeptical about wholesale re-engineering. They often demand proof that new value propositions can be successful over the long term. However, there are markets in which life insurers have successfully deployed the well-being value proposition and have consistently demonstrated superior performance over the past decade. Moreover, there are clear similarities to what has happened in the U.S. auto insurance market over the last 20 years. Auto insurance has progressively moved from a face-to-face, agency-driven sale to a real-time, telematics-supported, transparent and direct or multi-channel distribution model. As a result, price transparency has increased, products are more standardized, customer switching has increased and real-time information is increasingly informing product pricing and servicing.

Implications

Significantly changing products and redesigning a long-established business model is no easy task. The company will have to redefine its value proposition, target individuals through different messages and channels, simplify product design, re-engineer distribution and product economics, change the underwriting process to take into account real-time sensor information and make the intake and policy administration process more straight-through and real-time.

So, where should life insurers start? We propose a four step “LITE” (Learn-Insight-Test-Enhance) approach:

  • Learn your target segments’ needs. Life insurers should partner with health insurers, wellness companies and manufacturers of wearable sensors to collect data and understand the exercise and dietary behaviors of different customer segments. Some leading health and life insurers have started doing this with group plans, where employers have an incentive to encourage healthy lifestyles among their employees and therefore reduce claims and premiums.
  • Build the models that can provide insight. Building simulation models of exercise and dietary behavior and their impact on medical age is critical. Collecting data from sensors to calibrate these models and ascertain the efficacy of these models will help insurers determine appropriate underwriting factors.
  • Test initial hypotheses with behavioral pilots. Building and calibrating simulation models will provide insights into the behavioral interventions that need field testing. Running pilots with target individuals or specific employer groups in a group plan will help test concepts and refine the value proposition.
  • Enhance and roll out the new value proposition. Based on the results of pilot programs, insurers can refine and enhance the value proposition for specific segments. Then, redesign of the marketing, distribution, product design, new business, operations and servicing can occur with these changes in mind.