Public Policy Analysis & Opinion

A million here, a million there…

The NAIC is playing games with securities valuation … or
How to use other people’s money to buy friends and influence an industry

By Kevin P. Hennosy

Building true friendships takes time and effort, so the NAIC seems to be taking a time-honored short cut. The NAIC wants to buy some friends.

The poet Ogden Nash observed, “Certainly there are things in life that money can’t buy, but it’s very funny—did you ever try buying them without money?”

The National Association of Insurance Commissioners (NAIC) needs some friends. In particular, the NAIC needs friends in the insurance industry with the political muscle to fend off moves in Congress to reclaim its constitutional jurisdiction over insurance regulation.

Building true friendships takes time and effort, so the NAIC seems to be taking a time-honored short cut. The NAIC wants to buy some friends.

On February 11, the NAIC announced some lavish spending just in time for St. Valentine’s Day. The NAIC issued a news release that announced a $1.58 million gift to the insurance industry.

The NAIC waived “the second installment of a 2004 fixed fee assessment for the NAIC’s Securities Valuation Office (SVO).” In other words, the NAIC will not ask insurers for as much money as they expected to fund an office charged with providing uniform and independent analysis of insurers’ investments.

If anyone thinks for a minute that this decision was not seen as a big deal in NAIC circles, one need only see the first canned-quote in the news release. The release quoted NAIC Executive Vice President Catherine J. Weatherford, who graciously presented the good news, “We are pleased to withdraw the second half of the 2004 assessment.”

The grandeur and majesty of the moment boggles the mind. One can almost picture this Empress of Regulation wielding an orb and scepter as she makes $1.58 million in “fixed fee assessment” go away.

Well, sort of. The $1.58 million might not actually be what unsophisticated analysts may understand as $1.58 million. As industry advocates point out at the annual “public hearings” on the NAIC budget: In the world of NAIC accounting, things are not always what they seem.

Of course, one may ask, “What IS a ‘fixed fee assessment?’” Well, that is an interesting topic, which concerns the dirty underbelly of insurance regulatory empires. Orbs and scepters do not come cheap, and someone has to pay for them.

Long, long ago, actually in 1907, a plague of financial failure fell upon the American insurance sector. Financiers used the vast wealth generated by life insurance companies to manipulate financial markets.

State regulators required insurers to file annual financial statements that delineated the value of their investments; however, there was no uniform system to govern how insurers created those numbers.

A financial panic triggered by the failure of a trust threw the country into recession. Politicians and journalists rushed to find out what went wrong. Initial responses kept pointing toward the investment practices of insurance companies and, in particular, life insurers.

The financial panic resulted in the formation of a New York State Senate Investigating Committee. Chaired by a state senator from Buffalo named William Armstrong and aided by an aggressive young legal counsel named Charles Evans Hughes, the committee rooted around in the insurance industry’s closets and found some frightfully dirty laundry.

The committee found that the investment values that insurers reported on annual financial statements were somewhat suspect. Insurers manipulated the stated value of their investment holdings to make their books look better.

Often, this manipulation included garnering favorable ratings from private rating organizations. Too often, these organizations were heavily laden with conflicts of interest. The organizations knew that both issuers and purchasers of investment products needed favorable ratings to make money. No one in the ratings organizations wanted to earn a reputation for being “uncooperative.” “Market forces” forced “tough raters” to lower standards or lose business.

In addition, Armstrong Committee investigators found that private rating agencies’ differing procedures made it impossible to arrive at uniform valuations for use in regulatory statements. The investigators charged that the valuation of insurers’ investment portfolios needed strong doses of both independence and consistency.

The Armstrong Committee recommended a crackdown on investment valuations. The NAIC, then known as the National Convention of Insurance Commissioners, established a standing committee for the “Valuation of Securities.”

New York, Massachusetts and a handful of other states instituted their own rules for the valuation of securities. The states also contracted with different private statistical agencies to produce “uniform” valuations that were anything but consistent.

The NAIC’s Valuation of Securities Committee (VOS) hammered out an agreement between multiple jurisdictions that allowed the committee to contract with a single statistical agency to produce a uniform report on valuations for reporting purposes. The NAIC contracted with Moody’s, Poor’s Publishing and others.

Over the years, the NAIC found that using an outside agency was expensive. It would not be surprising if these agencies charged the NAIC higher rates to perform an independent review. Independence would require that they turn away business that might bring a conflict of interest.

By 1938 the NAIC decided that it could hire staff to conduct the valuation work at lower cost and higher independence than an outside firm. The Securities Valuation Office (SVO) became the first NAIC staff function.

The SVO gained a great deal of expertise in insurers’ investment patterns and portfolios. The SVO counseled the VOS Committee (and later task force) in times of crisis, like after the 1929 stock market crash or the collapse of the junk bond market in the late 1980s.

This is not to say that the SVO was without its troubles. The NAIC often had trouble holding on to SVO staff, who could receive much higher compensation from Wall Street firms. There were never enough staff resources to conduct effective reviews of the many varied investment instruments in insurance companies’ portfolios.

In addition, the SVO was not bereft of scandal. In the early 1990s, Senator Howard Metzenbaum sent investigators into the SVO. The investigators found a relatively loose corporate culture that allowed staffers to accept overseas travel from firms with business before the office. At that time, the NAIC top management acted quickly to reinstate ethical standards and independence.

The SVO ran afoul of insurance industry advocates in the mid-1990s. Regulators noticed that after the implementation of Risk Based Capital (RBC) standards, insurers were “gaming” the system of SVO ratings. They would submit invest-ment instruments for particular SVO review only to escape RBC reserve requirements.

Rather than changing the RBC or annual statement rules in response, NAIC simply raised the fees for valuation. By raising the fee, they reduced the profit in the transaction. In the short term, the use of the fee structure was an effective way of forcing compliance with RBC requirements, but it made enemies in the insurance industry.

The SVO was now a target for lobbying pressure. Industry advocates made repeated proposals for “outsourcing” the valuation function—or doing away with it all together. The fee system became a matter of controversy at several NAIC budget hearings.

In 2002, the National Association of Mutual Insurance Companies (NAMIC) proposed that regulators exempt Nationally Recognized Statistical Rating Organization (NRSRO)-equivalent securities from SVO oversight. This exemption would allow insurers to save the money that they usually paid to the SVO in filing fees. In the spring of 2003, New York Superintendent of Insurance Gregory V. Serio made the same proposal to regulators. (Serio recently joined Park Strategies, former Senator Alfonse D’Amato’s stable of lobbyists.)

The proposal met with initial resistance from the regulators. The record shows that two camps of opposition formed in response to the proposal.

Some regulators cautioned that this integral factor in financial regulation should remain the domain of a relatively independent SVO. At the time, newspapers still featured many stories documenting how private rating agencies missed massive problems in Enron. Companies like Weiss Research were calling for reforms of the NRSRO sector. Weiss released a policy statement that pointed to conflicts of interest and a lack of competition in the NRSRO sector.

Ultimately, most of the opposition centered on concerns over the NAIC budget. The filing fees charged by the SVO provided a revenue stream.

At the 2003 NAIC Fall National Meeting, the NAIC staff and elected leadership cut a deal to placate the fears over the proposal’s impact on the association’s budget. According to an NAIC description of the deal:

Under the agreement, the industry would be exempt from filing Nationally Recognized Statistical Rating Organization (NRSRO)-equivalent securities with the SVO effective January 1, 2004. This agreement was implemented on a “revenue-neutral” basis to offset lost SVO revenue from these exempt securities. The agreement called on the industry to pay a fixed assessment of $1.58 million in 2004 based proportionately on each company’s holdings of non-government bonds and preferred stocks limited to companies with a minimum of $1 billion of these holdings.

Industry advocates argued that the SVO system resulted in a redundant cost for insurers. Yet, industry advocates negotiated a deal that is “revenue neutral” for the NAIC. What happened to the cost concern? It now appears that the real aim of the proposal was to remove a second round of review from the securities valuation process.

Under the agreement, the NAIC adjusted the 2004 assessment to variances between actual 2004 non-NRSRO rated filing volumes and the volumes projected as part of the NAIC’s 2004 budget. The non-NRSRO filing fee revenue anticipated and budgeted for 2004 totaled $4.5 million.

According to the NAIC, the SVO fell short of its revenue projections by $387,850 (9.4%). Nevertheless, the SVO made more money than expected analyzing credit and pricing in two areas: 1) insurance companies’ 2003 non-NRSRO-rated securities filed very late in 2003 and completed in 2004; and 2) insurance companies that continued to submit 4,097 of the exempt NRSRO-rated securities in 2004.

Toward the end of the NAIC news release, the association provides the following explanation: “The additional revenues arising from these unantici-pated components reduced the shortfall to approximately $61,000, and while the agreement allows for the recouping money, the NAIC has decided to waive the assessment.”

So which is it? Did the NAIC waive $1.58 million or $61,000? I suppose one should not let vague statements about a million dollars stand between two friends. It is the perception that counts.

The NAIC got its headlines in February of this year and moved on, hoping that no one would care by April. Those headlines build warm and fuzzy feelings among insurance company executives who might complain to their trade associations about NAIC management.

Amid these self-protective maneuvers on the part of NAIC senior staff, an important public policy concern is lost. Is the valuation of securities that insurers hold conducted in an independent and competent manner? Do regulators and other analysts have the information necessary to judge the financial strength of a vital center for capital formation?

This is certainly not a new concern. It is the public policy concern expressed by the Armstrong Committee a century ago. Nor is the concern antiquated because commenta-tors raised those same concerns again following the implosion of Enron and other companies.

Prior to January 1, 2004, SVO analysts reviewed NRSRO-rated securities. Under the old rules the SVO could not raise a rating higher than one given by the NRSRO. The SVO did sometimes lower ratings.

If the SVO was simply conducting redundant or ineffectual reviews of securities, then that was a problem that the NAIC should have addressed. But it seems that the NAIC could have addressed the long-term interest of both the industry and the public by making the SVO more independent and effective.

Instead, under the pressure of industry lobbying, the NAIC simply ceded responsibility for rating large numbers of securities to private agencies. This raises questions of compliance with the McCarran-Ferguson Act.

Under uniformly adopted state laws, the insurers must report the value of securities holdings using SVO ratings. Now the NAIC has transferred responsibility for creating those ratings on some of the most common securities issues to a number of private firms. Since many argue that financial solvency regulation is the only reason for state insurance regulation, one could view this action as the transfer of regulatory responsibility to these private firms.

In the case of FTC v. Travelers Health, the Supreme Court opined that the borrowed authority rested upon the states by McCarran-Ferguson, could not be transferred again. In particular, the Court ruled that the states could not pass this authority to private entities. Justice Potter Stewart drew from a public statement made by the two men who brokered the act to illustrate the Court’s ruling. Senators Patrick McCarran and Joseph O’Mahoney said in a conference committee report:

“The NAIC, which became a private entity itself under the leadership of Mrs. Weatherford, continues to play fast and loose with the McCarran-Ferguson framework. The NAIC uses the McCarran-Ferguson framework like the proverbial drunk uses a lamppost—as a source of support and not illumination.” n

The author
Kevin P. Hennosy is an insurance writer who specializes in the history and politics of insurance regulation. He began his insurance career in the regulatory compliance office of Nationwide Insurance Cos. and then served as public affairs manager for the National Association of Insurance Commissioners (NAIC). Since leaving the NAIC staff, he has written extensively on insurance regulation and testified before the NAIC as a consumer advocate. Hennosy publishes a quarterly briefing paper on the activities of the NAIC, which is available at www.spreadtherisk.org.