Temperature's Rising

Mills, currently chief advisor to Deloitte's insurance practice, believes some statutory changes will be needed to allow regulators to get into the areas that weren't being regulated prior to the economic collapse. "A lot of the complex instruments, such as credit default swaps, fell into a gray area," he says. "They weren't in the Office of Thrift Supervision portfolio; they weren't in the SEC; and they certainly weren't with state-based regulation. Both state and federal regulators are going to have to close those loopholes."

Mills is certain there will be significant re-regulation of all financial services, but what those changes will be, at this point in time, is still speculative. "The issue Congress has to look at in the context of this current financial crisis is the real problem happened in the broad area of systemic risk," he says. "There were a number of things that originated with the mortgage industry that spilled over into other products and sectors and have become a contagion that has hit the global economy."

State regulators may be quick to credit themselves for keeping a close eye on insurers in the midst of the credit and investment crisis, but Celent's senior analyst Donald Light points out the industry has not come through this mess unscathed. "The failure of AIG–rightly or wrongly–may be attributed in part to insurance regulation," he says. "Secondarily, the well-publicized difficulties of a number of life insurance companies–specifically around the valuation of their annuity contracts–also are going to bear a lot of scrutiny."

The states need to communicate the success they have had, Light asserts. "I think so far the life insurance companies that have been taking losses actually are well capitalized," he says. "It's an open book as to what will happen over the next three, six, or twelve months, but the industry itself is still pretty strong." Regulators will need to deal with the holding company issue to prevent another AIG, points out Light, as well as work closely with the life industry to deal with the exposures and the impacts of guarantees with the variable products.

Accenture sees three categories of companies in the market today, according to Costonis. The first category includes companies that are severely distressed and are looking at radical change of their business, either through divestiture or transformation as a way to get out of their current situation. "That list grows daily," he says.

The second category in the market is a select group of companies–many of which are mutuals–that are looking to take advantage of the market. "Through their underwriting discipline, their investment discipline, or even their structure, they are able to wait out this market, pick their spots, and pick up some market share with specific products or sit on the right side of an acquisition," says Costonis.

The third group–about 80 percent of the industry, relates Costonis–fit in the middle. "They have gone into a fairly modest wait-and-see mode with some cost reduction," he says.

The ability of any of these companies, no matter which category, to make major changes in their operations will be restrained by the need to address the coming regulatory demands, contends Costonis. "If I'm a company looking to stop the bleeding, I have the added burden to come up to snuff on the regulatory side," he says. "If I'm looking to acquire another company, I need to know [my company] is ready to meet the regulatory challenge. If I thought I could sit on the sidelines and not do anything, I won't have a choice because the government is going to make that choice for me. It's just an added dimension of activity we are going to see in the market."

Insurance IT departments need to be ready to expend IT time to meet new government requirements. "It's tough to plan for [more regulation] because planning cycles include project approval at the executive management and board levels," says Mike Sciol?, CIO of the IFG Companies. "Then you assign those projects to staff. Those projects don't leave time for additional work. Whatever those [new regulatory] guidelines are going to be, we're going to have to shift some resources to do the work."

With any regulatory changes, carriers have to gauge the amount of change and then identify what will be needed to meet the requirements. "Is it something you can do manually, or is it something that will require a third-party product?" Sciol? asks.

The decision for IT will be based on how long it will take internally to write custom code that would address reporting or control-based requirements vs. the price of products on the market that would address those needs. "If [new controls] are something that require immediate attention, the only way to address it would be to develop software in-house because I doubt any of the software companies would have time to develop and integrate software into their packages," says Sciol?. "You have to assess internal expense, internal development time, what vendors are in the marketplace or have a presence, and whether [the vendors] are going to be quicker."

Insurance IT leaders need to focus on the use of enterprise risk management this year, advises Light. "ERM depends on IT capabilities, the right kinds of programs, the right kinds of systems, and the right kinds of people using those systems to do the modeling and constructing the scenarios that are at issue," he says. ERM is not a new area for insurance, but Light indicates its prominence in IT discussions has never been greater.

The big compliance issues–keeping in sync with the laws and regulations in all 50 states–have not disappeared, continues Light, but a new wrinkle involves the recent spate of insurance companies acquiring banks in order to participate in the government's troubled asset relief program (TARP). An insurer has to have the right kind of IT infrastructure to support a bank, including the regulatory issues the banking industry faces. "Most of these banks are quite small, but they are still banks and you have to comply with a new and different sort of regulation," he says.

Enterprise risk management, better catastrophe modeling, and underwriting insight are the capabilities that will help carriers get out of this market cycle, Costonis remarks. "We see a shift away from things that are growth oriented to more risk-sensitive areas that are designed around looking at exposure and protecting underwriting profitability," he says, adding ERM has garnered more attention recently among insurers than at any time in the last three to five years. "[ERM] doesn't quite knock out items designed to drive out infrastructure costs and change the underlying operating model, but it has moved up significantly in regard to priority," says Costonis.

Some comparisons are valid between the U.S. market and what European insurers have gone through with Solvency II, according to Ed Grau, lead for risk and regulatory management in Accenture's financial services practice. "[Companies] are taking a look at the asset side of the business–revisiting how they manage their assets, how they are valuing them, [taking] better credit risks, [gathering] information around some of their exposures, [achieving] better indications and pricing on the volatility of their instruments, and being able to get a better handle on the liquidity of their various securities or timing with asset and liability requirements," he says.

The importance of such preparedness is underlined in the global environment where a Solvency II mentality is necessary if carriers want to be on par with global reinsurance companies, adds Grau. "If you can demonstrate your ability to be funded on the same level as European firms that have put in full Solvency II measures to show they have a better handle on how their assets are timed, the volatility of the assets, various components of what they hold, and compare that to the liabilities and exposures, those companies become better bets," he says. "Uncertainty could cause you a risk premium if you were not able to demonstrate the same type of transparency of how solvent you are as an insurance company."

Insurers also have to deal with what Costonis calls the "hidden costs of compliance." He points out in the IT environment of an insurance company, there are layers of complex and unknown business rules that ripple through the legacy systems. "What we typically see is when you go to make any type of change in that environment, it becomes readily apparent making changes to [legacy systems] is incredibly hard," he says. "The idea that a new regulation regime is coming down in which the changes need to be substantiated into the system is a whole other level of complexity."

The cost of change is difficult to ascertain until a company sees how the inner workings of the system are architected and how it can respond to changes. "When this new regime does come down and we do open the [systems], it will expose some of that complexity," says Costonis.

In any environment, Grau maintains if a carrier is going to revisit technology spending and its internal infrastructure–whether it is to adapt to compliance or some other project–Accenture advises clients to take a look not only at the hidden costs of compliance but at the overall architecture and ways to simplify it to cut costs and to make things easier.

Grau has visited firms where there are multiple compliance platforms in addition to operations platforms and learned the compliance platforms were built at a time when they were hard wired. "Being hard wired makes them inflexible and requires them to run in isolation of each other, which multiplies your costs," he says. "It always behooves you to simplify the factory. Keep those underlying data elements in their pure sense, and do more of a flexible reporting off the back end from an architectural point of view. So, as regulations change, you are not trying to modify 15 hard-wired compliance platforms. Your internal architecture will be flexible enough to adjust based on the information and data points you collected upfront. That reduces your overall compliance costs going forward."

Pamela Olson, vice president corporate underwriting, Tokio Marine Management, already has seen the pressure build on insurers after the financial problems of several carriers came to light. Tokio Marine has earned and continues to earn a high rating, but the bad scent of a few is tainting the industry.

"There are outside pressures coming to bear with the financial problems in the country as well as in the world," she says. "[Tokio Marine] does not have the problems other carriers do, but all carriers are experiencing an influx of endorsements the brokers and agents want to put on the policies about cancellation and financial strength."

Olson says her company, which is in the process of implementing Insurity's Policy Decisions administration system, doesn't honor such requests. "From our standpoint, we don't like attaching those endorsements and we don't do it because we have the A++ 15 [rating] to wave in people's faces," she explains. "We can say, 'Why should we put this on our policy? Go find somebody else to bother.'"

Olson does see the collateral damage turning into a significant problem in 2009 as more insurance companies experience financial problems. "I expect there will be more [problem companies]," she says. "There also will be a stepped-up approach on financial governance."

The states won't cede control of the American insurance industry without a fight, in Olson's opinion. But she also concedes if companies continue to go belly-up or come close to it, there is a high probability the federal government will move toward federal regulation. "The administration coming in is much more driven toward that than the one going out," she says.

Olson herself has mixed views on the state vs. federal debate. "I would love just for five minutes not to deal with 50 different entities," she says. "It is very difficult, very confusing, and very hard to manage that kind of scenario."

Japanese companies such as Tokio Marine are attuned to regulation, notes Olson. Japanese regulation is done on a national level, and the charter can look at how a carrier operates in other countries, such as the United States. "In other words, if we aren't playing nice, the FSA [Japan's regulatory agency] can impede us from doing business," she says. We are in a unique situation. We not only have to satisfy the [American] regulators, we have to satisfy the regulators in Japan, also."

Olson could see some benefits if a federal charter replaced the state charter, particularly for carriers such as Tokio Marine, which operates in all 50 states. "However, if you are going to add federal on top of state–which is what I assume is going to happen–that's a whole new potential nightmare."

Mills agrees with Olson on that point. "The paradigm always has been the optional federal charter, which implied there would be a federal regulator and companies could choose to go with the federal or stay with the states," he says. "The debate might go forward but with the word optional dropped out."

Mills contends the states hold too much power to allow state-based regulation to go away, but he believes there will be an added layer. "I think we are headed toward a system of dual regulation," he says. "There will be a federal charter–that [question] is no longer on the table–but it's a distinct possibility you'll have a state regulator and a federal regulator."

One of the top concerns in the industry today is history will repeat itself, and history shows when bad things happen, regulators and legislators tend to over-react, warns Mills. "The worry is the regulatory system will become more difficult and there will be much more scrutiny," he says. "You certainly can make the case for more scrutiny after what has happened, but will it go so far it will hurt the ability of business to do well? Will it stifle innovation? Will it curb people from a willingness to take on risk and, in effect, hamper the economic recovery?

Individual insurance companies must participate in the regulatory debate this year, states Mills. "[Insurers] have a lot at stake," he says. "They need to recognize they are going into a period of much greater regulatory scrutiny, so they need to be prepared for that. There are some that [delay] the compliance function to save money. They need to be careful there, since this is not a good time to get into a regulatory discussion."

Because of the attention the American economy has received and the more serious problems facing the banking and investment communities, Olson believes the worried observers looking at the insurance industry might remain on the sidelines for a bit. But if the problems in the industry continue, Olson expects quick action by Congress. "The reality is if some of these other insurance companies go the same way [as those currently in financial trouble], people are going to scream to nationalize [insurance]," she says.

In contrast, Sciol? doubts this will be the case in the current financial crisis. "I think we are going to have to act quickly and shift priorities to do exactly what we need to do," he says. "I expect a significant amount of scrutiny. It's not going away in the spring, and it's not going away by summer."