Why the life insurance industry needs a watchdog.

In recent years, state regulators for the life insurance industry have come under considerable fire from Congress and consumer groups for their seeming inability to effectively regulate and for their slow responses to public concerns about their practices. It's only logical to wonder where state insurance regulation has gone wrong in establishing sound financial oversight and whether the federal government should step in.

The life insurance industry changed significantly in the early 1980s with the advent of universal life insurance, single-premium deferred annuities and guaranteed investment contracts. These new products attracted investors instead of traditional insurance buyers, a development that altered the thrust of the industry's activities. The National Association of Insurance Commissioners, the umbrella regulatory body for the state insurance departments, has tried to respond to these changes, but it's a cumbersome framework of 50 state regulatory authorities, each of which can enact its own rules. Plus, life insurance companies have two different ownership forms, mutual and stock, which further complicates the regulatory process. Finally, the industry has far too much influence on the NAIC. As a result, regulators have failed to provide insurance investors with uniform and comprehensive financial information.

Life insurance is unique among American industries in that eight of the 12 largest companies are mutual companies, which means they aren't owned by public stockholders. These eight, along with other mutual life insurers, control about 43 percent of all life insurance industry assets, according to Townsend and Schupp Co., an insurance research firm.

This is not to say that mutual companies are in private hands. In fact, their ownership may be among the most public in the nation, because their policyholders own them directly. While policyholders at mutual life insurers can't buy and sell their ownership positions the way public stockholders do, they make stockholder-like decisions in deciding whether to purchase new policies, surrender the ones they have or, in some cases, add to their policies' investment funds.

The insurance regulatory body of each state prescribes life insurance accounting for the insurers licensed to do business there. Generally, the regulations of the company's home state take precedence. Statutory accounting practices, or SAP, aren't formally codified, but the NAIC guides the industry on statutory accounting, to which all insurers must conform.

In addition, stock life insurers must conform with generally accepted accounting principles and with federal securities laws. GAAP for stock life insurers differs materially from SAP. Mutual life insurers that operate investment funds must maintain them in separate accounts for their policyholders, so they must also conform with certain federal securities laws. For example, they must file financial statements with the Securities and Exchange Commission.

But for the most part, SAP and GAAP are equivalent for mutual life insurers, at least until the Financial Accounting Standards Board adopts its proposed interpretation on the "Applicability of GAAP to Mutual Life Insurance Enterprises," which isn't likely before the end of this year. In the meantime, mutual life insurers aren't required to comply with FAS 12, 60 and 97, which include deferral of policy acquisition costs, alternative policy reserving methodologies, declines in market values of investments that aren't temporary and profit recoverability issues. Mutual life insurers' financial statements often note their compliance with GAAP and the accounting practices permitted by regulatory authorities.

A SHAKY FOUNDATION

Statement of Auditing Standards No. 62 refers to SAP as a "comprehensive basis of accounting other than GAAP." In practice, nothing could be further from the truth. Because SAP isn't codified, the result is often inconsistent state positions on important industry matters, such as sale and leaseback accounting, accounting for financial reinsurance and accounting for pledged assets.

The carrying value for bond investments is one good example. Under NAIC's SAP guidelines, insurers generally carry bonds in good standing at amortized cost in their financial statements. In one state, however, the insurance commissioner selectively established a "trading portfolio" for certain bonds that had depreciated and were held for sale by an insurer in his jurisdiction. He required these bonds to be carried at market value, while other bonds in the same portfolio were carried at amortized cost. The bonds carried at market value had appreciated by more than the amount of depreciation of the trading portfolio.

By adopting this accounting treatment, the jurisdiction created an insolvency of more than $80 million. Had the commissioner used the NAIC rules, the insurer would have been solvent by more than $60 million -- a swing of more than $140 million -- and the carrying value of the bonds would still have been less than their then-current market value.

No precedent existed under SAP for this trading portfolio concept. In fact, the jurisdiction's position was not even in accordance with the GAAP rules at the time, which would have required carrying all the bonds the insurer didn't intend to hold at fair value. The state's position was so unusual that the insurer's accountants restricted access to their audit report to regulatory bodies only.

Under SAP, all life insurers, both stock and mutual, must prepare an annual statement, which contains basic statutory financial statements, along with pages of exhibits, schedules, notes and interrogatories. But the annual statement doesn't address several important areas. Investment-oriented insurers operate very much like other financial institutions in their revenue cycles. They attract deposits in the form of annuity and investment funds and invest the proceeds at a spread, but the annual statement doesn't address the adequacy of investment spreads, asset/liability matching or trends in investment defaults.

Other financial institutions, including publicly owned stock-like insurers, include such disclosures in their SEC filings. Traditional insurance and some investment-oriented insurance products have either life or health benefits, but the annual statement mentions neither mortality nor morbidity trends. The long-term profitability of insurance policies depends on insurer assumptions, including the estimated persistency of the business; yet the annual statement doesn't disclose how actual policy persistency compares with a company's estimates.

Another key difference between the GAAP filings of the mutual companies and those of stock insurers is management's discussion and analysis (the MD&A). Public stock companies must complete an MD&A, under SEC Regulation S-K. Mutual life insurers aren't required to disclose this information. It's the MD&A that includes most of the disclosures about an insurer's important investments, insurance operations, liquidity and capital adequacy issues. Although the proposed FASB interpretation would extend FASB pronouncements to mutual companies, it doesn't require an MD&A.

The Top Players in the Game of Life

A handful of insurance companies dominates the life insurance industry. With
their combined assets of $703 billion, these 12 giants have about 43 percent
of the industry's assets in their corner.

                                 % of Industry      Assets
Largest Mutual Life Insurers        Assets       ($ billions)

Prudential Insurance Co.             9.6              155
Metropolitan Life                    7.3              118
Teachers Insurance and Annuity       3.8               62
New York Life                        2.9               47
Northwestern Mutual Life             2.4               40
John Hancock Mutual Life             2.4               39
Principal Mutual Life                2.2               35
Massachusetts Mutual Life            1.9               31

Total                              32.5%             $527

Largest Stock Life Insurers

Aetna Life                           3.1               51
Equitable Life                       2.9               47
Connecticut General                  2.7               44
Travelers Insurance Co.              2.1               34

Total                               10.8%            $176

Total Industry Assets: $1.62 trillion

Source: Townsend & Schupp Co., 1992

The NAIC is sensitive to many of these important issues. For instance, when it was criticized by consumer groups and the General Accounting Office for its ties to industry interests last year, it voted to disband its industry advisory panels and abandon its practice of accepting industry sponsorship of its quarterly conventions. And after Congress pressed it to standardize insurance regulation, the NAIC developed an accreditation program for the states. It also examines insurers and requires an actuarial certification along with the annual statement. But these measures haven't been very effective. Only 32 states have been accredited, and New York, a leader in state insurance regulation, has already lost its previously granted accreditation. And it's still much more difficult than it should be for investors to get descriptive information on insurance companies.

On some matters, the NAIC promulgates model regulations, most recently on reinsurance, investment and risk-based capital issues. Usually it starts by forming a committee from its membership. Until last year, it then appointed an industry advisory panel to study the issue and make recommendations to the committee. Although the NAIC has now abolished the panels, they've been replaced by "technical resource groups," which remain industry-dominated. Once a model regulation is promulgated, it's up to each of the 50 state legislatures to determine whether it will become law. Often the states modify the model regulations, and just as often the state legislatures don't even pass them.

Mortgage loans and real estate reserving, which comprise about one-fourth of total industry assets, are good examples of NAIC largess to industry interests. In 1990, under pressure from Congress and after a large, permanent decline in the value of First Executive Corp.'s high-yield bonds, the NAIC changed its entire bond classification system to step up scrutiny on the few insurers whose principal risk investments were public high-yield bonds. Such bonds were then less than 4 percent of industry assets. At the same time, despite national problems recognized by bank and thrift regulators, the NAIC deferred the issue of real estate and mortgage loan reserving for another two years, on the recommendation of an industry panel. This allowed many insurers with investments in these areas to continue carrying zero reserves.

TOO LITTLE, TOO LATE

When the NAIC finally promulgated mortgage loan and real estate reserves and risk-based capital rules at the end of 1992, the reserve and RBC factors for current, commercial mortgage loans were 3 and 3.5 percent, respectively, for insurers with average delinquencies. The industry's commercial mortgage loan default rate now exceeds 23 percent and is still rising (from American Council of Life Insurance data, including delinquent, restructured and foreclosed loans). Plus, the definition of "current loans" includes many that have been the subject of troubled debt restructuring.

Despite all of this, I believe better insurance regulation can be accomplished without expanding the state or federal bureaucracy. First, the FASB should adopt its proposed interpretation extending GAAP to mutual life insurance enterprises. Also, the SEC's MD&A rules should apply to all insurers required to file financial statements with the commission. Since nearly all large mutual insurers operate separate accounts, this rule would cover the overwhelming majority of industry assets.

The exemption that mutual life insurers get for filing GAAP financial statements with the SEC should be eliminated. For insurers not subject to SEC proxy rules, the NAIC should dictate the form and content of the annual reports, and it should require them to be filed with policyowners, especially audited GAAP financial statements and the SEC's MD&As. The annual statement should include relevant information on asset/liability matching, persistency, morbidity and mortality trends.

Another good control is a federal uniform net capital rule, similar to that used by the securities brokerage industry, that meshes with insurer risk-based capital rules. Last year, the American Institute of Certified Public Accountants exposed a draft statement of position on insurance entities' disclosures. This proposal would require footnote disclosure in GAAP statements on risks and uncertainties in operations, regulation and asset-liability matching -- a "mini-MD&A" that could be a big step forward.

Large life insurers, regardless of their state of domicile or form of ownership, are national institutions. Most industry assets are controlled by entities which, either through security ownership or policy ownership, the public owns. That's why it makes good sense to place financial oversight of the life insurance industry in federal hands.