Converging efforts: a risk-based regulatory model may be around the corner as insurers' compliance efforts come together with NAIC initiatives.

Achieving a regulatory model that is more effective in monitoring risk has long been a goal of the insurance industry and its regulators. Now, as a result of converging efforts to improve internal controls and risk assessment, there are real signs of progress toward that goal. Insurers' increased risk-management capabilities, and their desire to get some return from their investment in Sarbanes-Oxley compliance, are coming together with efforts by the National Association of Insurance Commissioners to improve oversight while reducing the regulatory burden for insurers that proactively manage risk. Key changes being considered include:

* Better coordination of financial examinations among state insurance departments. The Holding Company Working Group of NAIC has been working to encourage coordinated group exams of all insurer members within a corporate group. In the past, group exams have usually been performed only when insurers operated trader a joint pooling arrangement. Other efforts now under way will cause state insurance departments to better coordinate their market conduct exams, which delve into areas such as insurers' underwriting, claims, and sales and marketing practices.

* A risk-based approach to financial oversight that better integrates field exams and departmental analysis. The Risk Assessment Working Group has drafted a paper that delineates an approach to using risk assessments in the regulatory process. Key elements of this proposed framework include risk-focused exams and financial analysis, and creation of an insurer risk profile that would be used to identify companies that merit attention.

* Greater reliance on the Sarbanes-Oxley work done by insurers and their auditors. As publicly traded insurers continue their efforts to comply with Section 404, examiners are closely watching the quantity and quality of information relating to the effectiveness of internal controls. The expectation is that the information will be more complete, more accurate, more readily available and more relevant than the information available to examiners in the past, and that it will improve the examination process.

More complicated is the current NAIC proposal that internal controls provisions similar to Section 404 be added to state insurance regulations and applied to all insurers, public or not. Given the controversy surrounding this proposal, there are signs that the NAIC will consider exempting smaller insurers from the internal controls requirement and also may back down from the idea of applying it at the individual legal-entity level rather than on an enterprisewide basis.

When all issues related to the proposed changes have been resolved, they could result in placing an insurer's management, its auditors, and state insurance regulators on the same page in how they view the insurer's risks and controls. This would be an enormous step forward. In the past, insurers relied on internal processes and controls when preparing their financial reports. Meanwhile, their independent auditor might have chosen to use other tests that it regarded as more substantive. And examiners, for their part, might have separately performed additional procedures outlined in the Examiners Handbook, which would not necessarily be correlated with the company's risks and controls, or with the auditor's tests.

Now, when the requirements mandated by Sarbanes-Oxley and the Public Company Accounting Oversight Board are considered together with the NAIC proposals, we can foresee:

* A risk assessment process that will give auditors and examiners a common platform for evaluating the company;

* Improved effectiveness of controls--the outgrowth of efforts to improve documentation and testing of controls and correct identified deficiencies;

* Examination procedures that are correlated with both the risk assessment and the internal control testing performed by the independent auditor; and

* More examinations performed on a group basis and better coordinated by a lead state.

Much work remains to be done to achieve these goals. Ultimately, improved regulatory effectiveness will depend on proper execution to become a reality. The NAIC and the states will have to allocate resources to train examiners and analysts. And the changes will have to be rolled out in a way that assures effective execution, which will be no small feat. In fact, many would argue that poor execution is the reason the current NAIC examination approach has failed to achieve similar goals. But now, some states are showing a willingness to innovate on a company-by-company basis. This is an encouraging sign that state insurance regulation is on the right track.

Robert W. Stein, a Best's Review columnist, is chairman of Global Financial Services for Ernst & Young. He may be reached at [e-mail].