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Financial Reporting                                                                                                   S O ...
The Financial	Reporter ISSUE 81 JUNE 2010 Published	by	The	Financial	Reporting	Section	 of	the	Society	of	Actuaries       ...
A CHALLENGE FOR US ALL …Last year, along with the Product Development andReinsurance Sections, we cosponsored a call for e...
Solvency II – What Does … |                     FROM PAGE 1                                       • Pillar 1 consists of t...
must also develop the internal processes and systems                                                                      ...
Solvency II – What Does … |                FROM PAGE 5                                     Relationship with IFRS         ...
Although no one is predicting major delays to the pro-posed timeline, there have been views supportive of adelay. On May 4...
Solvency II – What Does … |                  FROM PAGE 7                                            basis for decision mak...
competitive advantage in pricing products with         dictions that have achieved equivalence. The hope is   low U.S. cap...
Speaking The New Lingo – A US GAAP                                      Codification Primer                               ...
For insurance actuaries, Topic 944 Financial Services– Insurance, incorporates a long list of old standards,including FAS ...
Managing C3 Phase III – A Case Study                                      by Timothy C. Cardinal                          ...
On the in-force block, in order to impact             ing investment strategies and managing therequired capital levels, m...
Managing C3 Phase III … |               FROM PAGE 13                                      on calculation issues, the above...
Report on the International Actuarial Association:Capetown Meetingby James MilhollandO           nce again the Accounting ...
Report On The International Actuarial Association … |                     FROM PAGE 15                                    ...
this topic and it is also not clear what position the IAA    pensions will become the default approach for insur-will take...
Report On The International Actuarial Association … |                    FROM PAGE 17                                     ...
Financial Reporter 2010 Iss81
Financial Reporter 2010 Iss81
Financial Reporter 2010 Iss81
Financial Reporter 2010 Iss81
Financial Reporter 2010 Iss81
Financial Reporter 2010 Iss81
Financial Reporter 2010 Iss81
Financial Reporter 2010 Iss81
Financial Reporter 2010 Iss81
Financial Reporter 2010 Iss81
Financial Reporter 2010 Iss81
Financial Reporter 2010 Iss81
Financial Reporter 2010 Iss81
Financial Reporter 2010 Iss81
Financial Reporter 2010 Iss81
Financial Reporter 2010 Iss81
Financial Reporter 2010 Iss81
Financial Reporter 2010 Iss81
Financial Reporter 2010 Iss81
Financial Reporter 2010 Iss81
Financial Reporter 2010 Iss81
Financial Reporter 2010 Iss81
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Financial Reporter 2010 Iss81

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  1. 1. Financial Reporting S O C I E T Y O F A C T U AR I ES Section The Financial Reporter ISSUE 81 JUNE 20101 Solvency II – What Does It Mean to U.S. Companies? 19 PBA Corner by Karen Rudolph Solvency II – What Does It by Patricia Matson, William Hines and Rony Sleiman 22 Model Compression and Stochastic Modeling Mean to U.S. Companies? by Craig W. Reynolds by Patricia Matson, William Hines and Rony Sleiman2 Chairperson’s Corner by Steve Malerich 29 AG 43: Which Reserves Will Dominate? Standard I10 Speaking The New Scenario Or Stochastic Lingo – A US GAAP by Yuhong (Jason) Xue n the early 1970s, Solvency I was developed for the European Union Codification Primer (EU) countries to provide a standard for monitoring the required capital by Douglas S. Van Dam 35 Is Accounting Theory an to be held by insurers. Several inadequacies in the Solvency I methodol- Oxymoron? ogy have led to Solvency II, the new solvency regime for all EU insurers12 Managing C3 Phase III – by Henry Siegel A Case Study and reinsurers. Due to come into effect in late 2012, Solvency II aims to by Timothy C. Cardinal implement requirements that better reflect risks which companies face and is intended to create a level playing field for insurers across the United15 Report on the Kingdom and Europe through the introduction of a comparable and trans- International Actuarial Association: Capetown parent regulation. Meeting by Jim Milholland This article provides an overview of Solvency II and identifies potential impacts on U.S.-domiciled companies. OVERVIEW The Solvency II regime is somewhat similar to the banking regulations of Basel II. It is based on three guiding principles (pillars) which cut across market, credit, liquidity, operational and insurance risk. It offers insurance companies incentives, potentially in the form of reduced capital require- ments, to implement appropriate risk management systems, have sound internal controls, and to measure and better manage their risk situation. It is significantly more than a calculation of required capital. It is a change in overall risk management and risk culture, and requires embedding into company culture a strong link between decision making and quantitative risk measurement. As in Basel II for Banking, Solvency II includes both quantitative and qualitative aspects of risk, each pillar focusing on a different regulatory component: CONTINUED ON PAGE 4
  2. 2. The Financial Reporter ISSUE 81 JUNE 2010 Published by The Financial Reporting Section of the Society of Actuaries CHAIRPERSON’S CORNER This newsletter is free to section members. Current-year issues are available from the communications department. Back issues of section newsletters have been placed in the SOA library and on the SOA Web site (www. B soa.org). Photocopies of back issues may be requested for a nominal fee. y the time you read this, we will be about two-thirds of the way through the Society’s year. Two others and I will have but four months left on the council. 2009-2010 Section Leadership Yet, as I write this at the end of March, it seems like we’re just getting started Steve Malerich, Chairperson Craig Buck, Vice-Chairperson on much of our work for the year. John Roeger, Secretary Mike Sparrow, Treasurer In December, when I wrote my previous column, we were getting ready for two new Errol Cramer, Board Partner volunteer roles within the Section—volunteer coordinator and a webcast team. Since Mark Alberts, Council Member Mark Davis, Council Member then, the council has decided to add a research team, as well. All three roles have been Rob Frasca, Council Member filled. Both teams are now headed by members of the Section council. The volunteer Basha Hoffman, Council Member coordinator is a new friend of the council and both teams include Section members Dwayne McGraw, Council Member who are not on the council. By expanding the involvement of non-council members Kerry Krantz, Web Coordinator in these roles, we expect to see greater continuity from year to year, much as we see now with the Financial Reporter. Content Managers Tara Hansen, Newsletter Editor Ernst & Young, LLP The first action by our new webcast team was to take a short survey of the Section New York, NY 10036-6530 membership about interest in continuing professional development and research. The e: tara.hansen@ey.com response to the survey was excellent—more than 500 Section members, nearly 13 percent of our total membership. The results of that survey have helped us to plan for Carol Marler, Associate Editor e: carol.marler@ge.com Section-sponsored sessions at the 2010 annual meeting and for 2010 webcasts. Michael Fruchter, Associate Editor Our new research team is also looking closely at the survey results, along with several e: mfruchter@kpmg.com specific research ideas that were brought to the council before the survey. As I write SOA Staff this, it is too soon to report on the direction of our new research this year. However, Sam Phillips, Staff Editor you can expect that research will continue to be a major focus of the council and use e: sphillips@soa.org of Section funds. James Miles, Staff Partner e: jmiles@soa.org Another area of focus for the council is in serving our membership outside of the United States. Twenty percent of us live outside of the United States—10 percent in Christy Cook, Project Support Specialist Canada and 10 percent elsewhere. Among all people currently taking Society exams, e: ccook@soa.org 40 percent live outside of the United States. How we can and should serve these Julissa Sweeney, Graphic Designer members is still being considered. I don’t know what decisions the council will reach e: jsweeney@soa.org in this respect, but we do have two seemingly obvious places to start. Facts and opinions contained herein are the sole responsibility of the persons First, we need to involve more of these members in the work of our Section. Just as expressing them and shall not be attributed we draw on expertise from actuaries working in the United States to serve the mem- to the Society of Actuaries, its commit- bers working in the United States or subject to U.S. reporting requirements, we need tees, The Financial Reporting Section or the to draw on the expertise of those working outside the United States to serve others employers of the authors. We will promptly correct errors brought to our attention. working outside the United States or subject to other requirements. Copyright © 2010 Society of Actuaries. Second, we know there is much activity at the International Accounting Standards All rights reserved. Board (IASB). Especially important to us is the development of new standards for Printed in the United States of America reporting of insurance contracts and the reexamination of standards for financial instruments. Many of our international members will be subject to these changes. Further, we know that, in the United States, the Financial Accounting Standards Board is working together with IASB on these new standards and the Securities Exchange Commission is planning for adoption of International Financial Reporting Standards (IFRS). Altogether, these tell us that we need to pay attention to the coming changes to both IFRS and US GAAP.2| JUNE 2010 | The Financial Reporter
  3. 3. A CHALLENGE FOR US ALL …Last year, along with the Product Development andReinsurance Sections, we cosponsored a call for essays,“Visions for the Future of the Life Insurance Sector.”In that call, we asked you to envision success in ourbusiness 10 years from now. Since then, several ofthose essays have been published. Steve Malerich, FSA, In line with that project, I challenge you to look beyond MAAA, is assistant the basic requirements of current financial reporting vice president and actuary at AEGON standards, to envision a future different from your USA, Inc. in Cedar best estimate and then consider how that future would Rapids, Iowa. He affect your business. That can be hard to do when we’re can be reached at continually pressed to satisfy the recurring and new smalerich@ demands on our time. Yet, pause for a moment and aegonusa.com.think about the things that are driving those increaseddemands.I’ll dare to suggest that the reasons for many newdemands can be summarized simply as—what we’vebeen doing has been found inadequate in some respect.Yet, rather than turning to others to fill the need, thosewho find our work inadequate continue to come to us.Surely, that’s a mixed blessing. It means that our workremains in demand, but it also means that new demandsadd to an already heavy work load.Instead of waiting for the next new demand, examineyour own work and consider where it might still beinadequate. Ask yourself—what are some of the thingsthat could easily happen in the coming years, but provedisruptive in some way? Next, determine how yourbusiness would perform if that were to happen. Then,share your findings with company management. Helpthem to see those possible futures. If you can do thiseffectively, perhaps your company will be the onethat’s well prepared for the next crisis.Collectively, if we can do more of this, then perhapswe can avoid the next large-scale mandate, or at leastensure that we have a significant voice in the develop-ment of its form. The Financial Reporter | JUNE 2010 | 3
  4. 4. Solvency II – What Does … | FROM PAGE 1 • Pillar 1 consists of the quantitative requirements (for the specific risks the organization faces. If the latter example, a calculation of the minimum amount of approach is adopted, the insurer needs to gain approval capital an insurer should hold). from the supervisor to which Solvency II results are • Pillar 2 sets out requirements for the governance and reported. It appears that most large insurers plan to use risk management of insurers, for embedding of quan- an internal model to depart from the embedded conser- titative risk measurement into decision making, and vativeness of the standard formula. for the effective supervision of insurers. • Pillar 3 focuses on disclosure and transparency Pillar 2 deals with the qualitative aspects of a com- requirements. In addition to requiring firms to dis- pany’s internal controls, risk management process and close their capital and risk frameworks, they must the approach to supervisory review. Pillar II includes also demonstrate how and where those frameworks the Own Risk and Solvency Assessment (ORSA) and are embedded in their wider business activities. the Supervisory Review Process (SRP). Irrespective of whether a firm adopts the standard formula or internal Solvency II model under Pillar 1, it has to produce an ORSA. If supervisors are dissatisfied with a company’s assess- Pillar 1 Pillar 2 Pillar 3 ment of the risk-based capital or the quality of the risk Quantitative Qualitative SupervisoryMARKET RISK Requirements Requirements & Reporting and Public Disclosure management arrangements under the SRP they will Rules on Supervision have the power to impose higher capital requirements.CREDIT RISK Regulations on minimum Regulations on financial capital requirements services supervision Transparency The regulator could also impose capital add-ons for Solvency Capital Own Risk and Solvency other reasons as well, and therefore the more robust andLIQUIDITY RISK Disclosure requirements Requirements Assessment (ORSA) embedded a company’s analysis is, the less likely theyOPERATIONAL RISK Technical provisions Capabilities and powers of regulators, areas of Competition related are to face capital add ons. The Pillar 2 requirements activity elements are likely the most challenging in terms of implemen- Investment RulesINSURANCE RISK tation, as they require a change in risk culture within the organization, all the way up to the Board level. Quantification Governance Disclosure Executive compensation is expected to be based on results of an internal model, all senior level individu- More on each of the pillars als involved in the SII analysis and risk management Pillar 1 considers the quantitative requirements of the functions must meet defined “fit and proper” require- system, including the calculation of technical provisions ments to serve in their positions, and the Board retains (reserves), the calculation of the capital requirements ultimate accountability for the internal model results. and investment management requirements. Pillar 1 sets out a valuation standard for liabilities to policyholders Pillar 3 involves enhanced disclosure requirements and the capital requirements insurers will be required to in order to increase market transparency. There are meet, and uses a market-consistent framework for those two required reports: the Report to Supervisor (RTS), requirements. There are two Solvency requirements— which contains narrative and quantitative information the Minimum Capital Requirements (MCR), and the that is provided to the supervisory authority and kept Solvency Capital Requirement (SCR). If available confidential, and the Solvency and Financial Condition capital (which is also defined by the Solvency II regu- Report (SFCR) which is publicly available. Companies lations) lies between the SCR and MCR, it is an early must interpret the disclosure requirements, develop a indicator to the supervisor and the insurance company strategy for disclosure and educate key stakeholders on that action needs to be taken. An insurance company the results of the analysis. The onus is placed on firms can choose whether to calculate the capital require- to design the information which, through public dis- ments using the standard formula set by the regulator closure, will be available to regulators, analysts, rating or whether to develop its own internal model to reflect agencies and shareholders. In addition, organizations4| JUNE 2010 | The Financial Reporter
  5. 5. must also develop the internal processes and systems What is it? What does it Who develops? Who decides?to produce these reports. include? Level 1 Solvency II Overall European EuropeanThe development and evaluation process of Solvency Directive framework Commission ParliamentII requirements has been divided into four levels as principles +Council Ministersoutlined in the following chart. Level 2 Implementing Detailed European European measures implementation Commission Commission, measures but with consentThe European Commission serves as a govern- of EIOPC andmental-type regulatory body across all of Europe. EuropeanCEIOPS is the Committee of European Insurance and ParliamentOccupational Pension Supervisors, and is a technical Level 3 Supervisory Guidelines to CEIOPS CEIOPS Standards apply in day-to-committee providing guidance for regulatory bodies day supervision(similar to the NAIC). Level 4 Evaluation Monitoring European European compliance and Commission CommissionAfter many years of deliberation, the work on the enforcementlevel 1 framework was completed in April, 2009,with the publication of the Solvency Directive. TheDirective is intentionally a principle-based document, Impact of Solvency II on European Life Insurersin order to minimize the need to involve parliaments in The most recent quantitative impact study was QIS 4changes to the guidance. Therefore, further guidance completed in the summer of 2008. The industry usesis provided from levels 2 through 4. Development draft implementation guidance to perform the calcula-of level 2 implementing measures has been ongo- tions and share feedback and results. Approximatelying for several years and included four quantitative 1,100 companies participated representing more thanimpact studies (QIS) so far. The most recent set of one-third of the entire European insurance market.consultation papers on level 2 measures were released Three hundred fifty-one life insurers and 227 compos-throughout 2009 with a fifth quantitative impact study ite insurers participated. The majority of the life firms(QIS 5) slated for mid-2010. A possible QIS 6 could reported a lower solvency ratio compared with thehappen in late 2011. Level 3 guidance will be released current country-specific Solvency I requirements. Theduring 2010 and 2011, leading up to implementation average ratio of available capital to SCR was 287.5in October 2012. percent, with significant variability between countries, market segments (reinsurance, health, life and P&C)There are “equivalence” rules under Solvency II and company sizes.which lay out required characteristics of local non-EUregulatory regimes in order for the capital standards The total balance-sheet composition did not changeof those regimes to be considered “equivalent” to substantially. Insurance liabilities typically decreasedSolvency II. The Solvency II implementation time- because of, for example, the removal of implicit mar-table provides for consulation by the Committee gins, but this was counteracted by an increase in capitalof European Insurance and Occupational Pension requirements.Supervisors (CEIOPS) on the criteria to assess third-country equivalence. This will be followed by discus- The economic crisis of late 2008 and 2009 has prompt-sions with the third-countries concerned, leading to a ed CEIOPS to increase capital requirements containedfinal descision on the issue by the Commision itself in the level 2 guidance papers released in 2009. It is notin June 2012. There are concerns that this may leave yet clear what level of required capital will ultimatelylittle time for international insurers to prepare for be required, but it could very likely be higher than thatSolvency II by October 2012. indicated by QIS 4. CONTINUED ON PAGE 6 The Financial Reporter | JUNE 2010 | 5
  6. 6. Solvency II – What Does … | FROM PAGE 5 Relationship with IFRS The key recent and upcoming dates regarding Solvency Solvency II regulations were initially developed with II implementation are as follows: the intention of being compatible with International Financial Reporting Standards (IFRS), the basis of pub- • CEIOPS published its last wave of technical advice on lic accounting requirements used in Europe that were associated implementation measures (level 2) which developed by the International Accounting Standards is expected to be formally approved in the second half Board (IASB). As the IASB is still working on a final of 2010 by the European Commission, and adopted accounting standard for insurance contracts, divergence by October 2011, one year in advance of the Solvency is occurring between the IFRS 4 insurance contract II implementation date of October 2012. liability measurement requirements and the Solvency • CEIOPS has published a consultation paper on level 3 II technical provisions, which will create additional guidance and is expected to finalize level 3 guidance challenges for insurers as they adopt the measures. by the end of 2010. The level 3 guidance is based Liabilities are expected to be largely based on the same on the level 2 advice on the internal model approval concepts, but potentially material differences could process. exist in certain items such as discount rates and treat- • July 2010: CEIOPS is expected to provide a complete ment of future premiums. There are also likely to be draft of the QIS 5 technical specification along with a differences in the definition, calibration and amortiza- comprehensive calibration paper by the end of March tion of the margins used. to enable the European Commission to publish final technical specifications by the end of July. TIMELINE • June through November 2010: First wave of organi- The deadline for Solvency II compliance is Oct. 31, zations to initiate a “dry-run” (initial production of 2012. The implementation of Solvency II may seem results) of their internal models. a long way off but in order for organizations to meet • During 2011: Many regulatory bodies requiring orga- this deadline they should look to initiate implementa- nizations to submit initial results of analysis. tion preparations now, in light of the complexity of • October 2012: Organizations to be compliant with SII the analysis and, for those companies planning to use requirements. an internal model, the significant requirements that Solvency II be embedded throughout the organization for use in decision making. Draft Framework Framework Level 2 Directive implementation Solvency II Directive in force - published - approved - approved - July 2007 H2 2010 Oct 2012 Apr/May 2009 CEIOPS reports on Groups and CEIOPS provides Proportionality advice on CEIOPS finalises - May 2008 implementation Level 3 guidance - Oct 2009 H2 2010 QIS 3 - QIS 4 - report - report - Nov 2007 Nov 2008 MILESTONES 2007 2008 2009 2010 2011 2012 FSA TIMELINES QIS 4 - QIS 5 Apr to Jul 2008 FSA notified Dry runs of of Sol II project Formal Model models for submission to lead - Mar 2009 approval- approval FSA for effective Jun to Nov 2010 approval- Firms to notify Oct 2011 of intention to seek int model approval Jun 20096| JUNE 2010 | The Financial Reporter
  7. 7. Although no one is predicting major delays to the pro-posed timeline, there have been views supportive of adelay. On May 4, 2010, Michel Barnier, in his openingspeech at the European Commission’s Public Hearingon the Solvency II Directive, specifically proposeddeferring the implementation date to Dec. 31, 2012.Implications for U.S.-based InsurersActivity with respect to Solvency II is increasing inthe United States. The implications vary dependingon how directly impacted a given U.S. company is bySolvency II:1. U.S. subsidiaries of parent companies in a loca- tion planning for Solvency II adoption In the United States, the companies most inter- ested in the development of Solvency II are U.S.- relates to the “equivalence” rules under Solvency domiciled subsidiaries with parent companies II. These rules lay out required characteristics of located in the EU. In order for the parent company local regulatory regimes in order for the capital to meet the requirements, its subsidiaries must pro- standards of those regimes to be considered “equiv- vide the required MCR and SCR calculations, alent” to Solvency II. The National Association of must meet the Pillar II requirements regarding risk Insurance Commissioners (NAIC) has embarked management practices and structure (including the on a Solvency Modernization Initiative (SMI) to Own Risk and Solvency Assessment, an insurer’s examine current solvency requirements, review internal view of the required capital based on their international developments, move toward a princi- view of risk), governance, documentation and con- ple-based approach to solvency regulation, and ulti- trols, and must provide information to their parent mately improve the U.S. solvency system. The SMI in order to meet the reporting requirements under Task Force issued two papers in December 2009 Pillar II. In addition, if the parent plans to use a full requesting feedback from the industry regarding internal model, the subsidiary must then demon- potential changes to the U.S. regulatory framework, strate that the results of their own internal model is including potential quantitative capital require- used as the basis to make broad business decisions, ments (akin to pillar 1) changes and governance including pricing, underwriting, performance mea- and risk management (akin to pillar 2) changes. The surement, and executive compensation. As a result papers lay out potential revisions to U.S. require- of these requirements, a number of U.S. subsidiar- ments, including consideration of requirements ies of multinational insurers are undertaking signifi- similar to those of Solvency II. Comments on the cant projects, many of those costing tens of millions paper were due March 1, 2010. Depending on the of dollars, to prepare for Solvency II requirements, extent of and timing of changes to the U.S. system, with several participating in the quantitative impact as well as the political environment, equivalence studies. Therefore, forward planning for capital may or may not be reached in time. adequacy, risk management and disclosures will become a part of strategic decisions. Responding If equivalence is met in the United States, the U.S. adequately to these new requirements will mean a subsidiaries with EU parent companies could base major shift in thinking for many organizations, and their Own Risk and Solvency Assessment on U.S. a rigorous and planned approach to bridge the gap statutory capital requirements, and use that as a between standards now and those required for 2012. One unknown with respect to U.S. subsidiaries CONTINUED ON PAGE 8 The Financial Reporter | JUNE 2010 | 7
  8. 8. Solvency II – What Does … | FROM PAGE 7 basis for decision making within an internal model public disclosures from a competitive perspective framework. The U.S. subsidiary would still need and ongoing communication with stakeholders to produce the SCR and MCR calculations, as well will be needed. as meet certain other requirements with respect to risk management and reporting; however, the level 2. U.S. companies with subsidiaries in a location of effort for implementation would be significantly planning for Solvency II adoption lower. To the extent equivalence is not achieved, Certain U.S. companies that have subsidiaries competitive issues are likely to result between in locations that are adopting Solvency II-like- U.S.-domiciled companies and U.S. subsidiaries regulations will need to meet the requirements as of EU parents, as the former will price products outlined above with respect to those subsidiaries. with a view toward statutory capital requirements, At a minimum, those subsidiaries will need to whereas the latter will be required to consider produce the required MCR and SCR calculations, market-consistent, Solvency II capital requirements comply with governance requirements, and pro- in their pricing. vide the required reporting and disclosure. There will be implications for the parent company due to the change in the capital requirements themselves, Solvency II is a reality and will impact not as well as implications on business decisions relat- ed to the subsidiary to the extent an internal model only those companies with operations in is being used, similar to the implications described above for U.S. subsidiaries of EU companies. the European Union (EU). … Jurisdictions that have announced intentions to move to solvency regimes patterned on or equiva- lent to Solvency II include Canada and reinsurance The emphasis on a market-consistent approach centers such as Bermuda, and Guernsey. Other to Solvency II and risk management will likely jurisdictions such as Japan and Chile are modern- require accessing data that have not been avail- izing their solvency regimes using concepts under- able or used in the past. For example, there are lying Solvency II; a company-based, risk-driven regulations to produce capital requirements for 16 scheme emphasizing corporate governance, risk specific categories of business, and some compa- management and transparency between companies nies may not have data at this level of granularity and the regulator. currently. In addition, all material risks must be considered in a company’s ORSA, which may 3. Broader implications for the U.S. marketplace require increased capture of information regard- Solvency II is a reality and will impact not only ing operational risk, CAT risk, spread risk and/ those companies with operations in the European or market risk. It will potentially require building Union (EU), but also the broader U.S. industry. new data warehouse functionality with enhanced Solvency II is likely to raise the bar for risk man- reporting and disclosure tools in order to have agement practices for all insurers, and potentially results available in a timely manner for decision disclosures as well. This will be fueled by regula- making. It may also require business process rede- tors and rating agencies as they review the detailed signs in order to fully integrate risk management analysis and disclosures for those companies that and capital analysis, and be capable of continuous do implement Solvency II. recalibration and assessment of emerging risks. Additional disclosures will be necessary for both In addition, there will be product and pricing a public report as well as a regulatory report. implications caused by differences, in some cases Careful consideration of the interplay between the significant differences, in capital requirements by regulatory report requirements and the enhanced product. U.S. domiciled companies may have a8| JUNE 2010 | The Financial Reporter
  9. 9. competitive advantage in pricing products with dictions that have achieved equivalence. The hope is low U.S. capital requirements as compared to the that it gives regulators, rating agencies, analysts, and Solvency II required capital. However those com- investors a higher level of confidence in the insurance panies using Solvency II approaches may have a industry’s business model and management. However deeper understanding of the underlying risks in the it may also result in lack of consistency and introduc- products, which may provide longer term advan- tion of competitive advantages and disadvantages tages as financial results are realized. between U.S. domiciled companies and subsidiaries of multinational companies for jurisdictions where Patricia Matson FSA, equivalence is not achieved. In light of all these factors, MAAA, is a princi-CONCLUSION U.S. companies will be well served to understand the pal with Deloitte Solvency II requirements, their implications on the risk Consulting LLP. She Clearly the implementation of Solvency II will require management framework and culture, particular chal- can be contacted at a significant amount of effort, and a change in culture pmatson@deloitte.and management’s approach to making decisions. lenges related to U.S. products, and the plans of U.S. com.Solvency II may help promote the application of a prin- regulatory bodies with respect to gaining equivalenceciple-based approach for determining capital require- and/or adopting Solvency II-like standards.ments, better alignment of risk management, andcapital analysis using complex modeling techniques. Itmay encourage management to use more comprehen- The authors would like to thank Aniko Smith ofsive and integrated risk management, provide increased Deloitte & Touche and David Schraub of Aviva forconsistency and comparability in measurement in juris- their contributions to this article. William Hines, FSA, MAAA, is a consult- ing actuary with Milliman, Inc. He can be contacted at 781.213.6228 or william.hines@ milliman.com. Rony Sleiman, FSA, MAAA is a senior manager with Deloitte Consulting LLP. He can be contacted at rsleiman@deloitte. com. The Financial Reporter | JUNE 2010 | 9
  10. 10. Speaking The New Lingo – A US GAAP Codification Primer by Douglas S. Van Dam T here is a new acronym you need to know. ASC sub-topics will vary by the topic, but three-digit sub- stands for Accounting Standards Codification. topics will correspond to the topic with the same num- My goal in this article is to give a little back- ber. For example: ground on ASC and a very basic tutorial for speaking the new lingo. 225 [Income Statement] 944-225 [Financial Services Insurance-Income In 2004 the FASB undertook a project to replace the Statement] Douglas S. Van US GAAP hierarchy, which included accounting guid- 944-20-20 [Financial Services Insurance-Insurance Dam, FSA, MAAA, is ance from FASB, AICPA, EITF, and others, with a sin- Activities-Glossary] manager, Actuarial gle authoritative codification. Codification, which was Services for effective Sept. 15, 2009, replaces the hierarchy, where Sections where the number is preceded by an “S” refer- Polysystems, Inc. He certain sources were considered more authoritative than ence SEC material. can be contacted at others, with a single level. If it is in the codification, it 312.578.3090. is authoritative, and if it is not in the codification, it is As changes are made in the standards, there will be not authoritative. An exception to this is pronounce- Accounting Standard Updates issued. The number- ments from the SEC. SEC rules may be considered ing system for the updates will be the year followed authoritative and codification may reference SEC rules, by sequential number of the update for that year. The but they are typically not reproduced in ASC and they updates will be a transient document that includes may be updated outside of the process the FASB has background, the update to codification, and the basis put into place for updating the ASC. for conclusions. The updates are not in themselves authoritative. As codification is updated, both the cur- A goal of codification was to simplify access to all US rent paragraph and the updated paragraph will be in the GAAP by codifying it in one spot and replicate the codification during the transition period. Once the new guidance that existed as of July 1, 2009. In that respect paragraph is fully effective the outdated guidance will it isn’t new–it is just a reorganization of current mate- be removed. rials. This was a large project that combined the 168 FASB statements with thousands of other authoritative Due to the volume of materials in ASC, it is anticipated statements and produced one large guide with roughly that the primary method for accessing the information 90 Topics. in ASC will be electronic. It is available at asc.fasb.org. Most of you will work for companies with a subscrip- Topics represent a collection of related guidance. There tion to the professional view. There is a basic view, are five main groupings for topics: which is available for free, but it is fairly inefficient to use. A single user license for a year of professional 1. General Principles (Topic Code 105) view is $850. There are also multi-user licenses avail- 2. Presentation (Topic Codes 205-280) able. 3. Financial Statement Accounts (Topic Codes 305- 740) Even using the basic view at asc.fasb.org you can get 4. Broad Transactions (Topic Codes 805-860) a good feel for how codification is organized. In my 5. Industry Specific (Topic Codes 905-995) opinion FASB did succeed in making things easier to find. You can review the topic names or, if you know Within topics are sub-topics and within sub-topics are the old standard and you want to know the new topic, sections. The sections follow a consistent numbering you can use the cross reference tool. Due to the reor- system (XXX-YY-ZZ where XXX = topic, YY = sub- ganization of the material, there is not necessarily a topic, ZZ = section). For example, section 20 is always one-to-one or many-to-one mapping from old to new. the Glossary. Those that work with the ASC regularly Below are some rough descriptions of where to find will also notice a pattern in the sub-topics. Two-digit things.10 | JUNE 2010 | The Financial Reporter
  11. 11. For insurance actuaries, Topic 944 Financial Services– Insurance, incorporates a long list of old standards,including FAS 60, 97, 113, 120, 163, SOP 92-5, 93-6,94-5, 95-1, 00-3, 03-1, 05-1, FSP FAS 97-1, DIG B7,B8, G04, Practice Bulletins 8, 15, EITF 92-9, D-34,D-35, D-54 the AICPA’s Accounting and AuditingGuides.For pension actuaries, it appears that much of their mate-rial has been combined into Topic 715 Compensation-Retirement Benefits. This topic includes in the crossreference FAS 87, 88, 106, 132(R), 158 various EITFsand FSPs. There is also Topic 712 Compensation-Nonretirement Post Employment Benefits with cross-references to prior standards FAS 88 and 112.Other topics that you might previously have referred toby the FAS number include:Topic Prior FAS Incorporated Into Topic310 Receivables FAS 91320 Investments-Debt and Equity Securities FAS115, EITF D-41350 Intangibles-Goodwill and Other FAS 142450 Contingencies FAS 5805 Business Combinations FAS 141(R)815 Derivatives and Hedging FAS 133, 138, 149, and 155820 Fair Value Measurements and Disclosure FAS 157825 Financial Instruments FAS 159 The Financial Reporter | JUNE 2010 | 11
  12. 12. Managing C3 Phase III – A Case Study by Timothy C. Cardinal T o date, numerous articles have covered the Dec. 31, 2011. (A proposed change may limit the scope details of C3 Phase III in terms of various to UL policies with secondary guarantees greater than exposure drafts and associated terminology, five years.) Senior management is concerned about the calculations, and requirements. Others have made potential magnitude of the increased required capital on comparisons between the proposed and current capital the block of UL with secondary guarantees both at C3 levels in a simplified setting. This article will do nei- Phase III adoption and in the future. Are there actions ther. Instead, the following discussion will center on management can take to manage its required capital? Timothy C. Cardinal, the implications for the Chief Actuary in communicat- FSA, MAAA is a Vice ing the impact of C3 Phase III to management, once it President, PolySystems, becomes effective. UL C3 Phase III Required Capital – Inc. He can be Preliminary Report contacted at tcardinal@ The stage after implementation will involve under- polysystems.com To: CEO, CFO, CRO standing the implications of C3 Phase III from a From: Chief Actuary business sense and how it will impact management decisions. Almost immediately, this stage will evolve Background into a process of trying to find answers to critical busi- Our UL block can be divided into two sub- ness issues and implementing viable solutions. See the blocks. Block A consists of policies issued sidebar on page 14 for a few questions management prior to 2003 with five-year secondary guar- might ask. antees and Block B is made up of policies issued in 2003 and later with guarantees Once actuaries have dealt with the mechanics, have to maturity. Up until now, all UL poli- wrestled with interpretations and have struggled with cies belonged to one asset segment. For the implementation issues (or perhaps even before all that purposes of performing the C3 Phase III occurs), management will want to anticipate what will calculation we recently formed a new asset happen to their capital and their business strategies. sub-segment for Block B by taking a pro rata Management will entrust the challenging details to the share of the total UL segmented assets based actuaries, but they will want answers and they will want on account value. their questions answered not with details, but with a business view from 30,000 feet. Findings Block B has $115 million in statutory reserves In the shaded box on the right is an Executive with $100 million in account value. The cur- Summary case study. The analysis provided is a sample rent C3 required capital is $0.6 million. The high-level summary of the business issues of C3 new C3 Phase III required capital is $9.5 mil- Phase III, without going into the minutiae that would lion (8.3 percent of the reserve). Maintaining necessarily be included in the actuarial supporting our target 300 percent RBC ratio (which is documentation. The block of business analyzed is well above the minimum required capital) based on a block of competitively designed UL poli- will require $26.7 million in additional capital cies with secondary guarantees to maturity. The assets (24.8 percent of the reserve). were modified and the results scaled for illustration purposes and anonymity. The large impact on capital is due to the short duration of the assets. Block B has much Business issue: The new C3 Phase III capital require- longer liability durations than the pro rata ment for all life insurance policies becomes effective assets chosen to back Block B. Also, a recent Dec. 31, 20XX and will apply to both in-force and new buildup of cash and short-term bonds has business. At the March 24–27 NAIC Meeting, Life shortened average asset durations relative to RBC Working Group Chairman Barlow announced the liabilities. that C3 Phase III can be implemented no earlier than12 | JUNE 2010 | The Financial Reporter
  13. 13. On the in-force block, in order to impact ing investment strategies and managing therequired capital levels, management can con- trade-offs between cost of capital, yield, andtrol credited rates, investments and modify/ credit and liquidity risks. C3 Phase III consid-enter into reinsurance or hedging arrange- erations will also need to be incorporated intoments. We found that changing the target product design and underwriting.spread is ineffective with respect to reducingrequired capital levels. Changing the target The brevity of this report is not indicativespread 50 bps reduces required capital by $1.0 of the work effort required to implement amillion. The efficacy of increasing spreads basic C3 Phase III framework. Work includedis limited since many of the “bad” scenarios performing experience studies and settingoccur in low interest rate environments where assumptions and margins, vetting interpreta-much of the block is at minimum guaran- tions, and developing position papers. Inteed credited interest rates. However, we addition, we evaluated alternative modelingfound that re-assigning assets to the Block decisions and determined model granular-B sub-segment to more closely match the ity, built new tools for analysis and con-liability duration was completely effective. trols, validated output, documented work pro-The new C3 Phase III required capital under cesses and outcomes, and performed audits.this asset re-allocation would be $0, thus not Considerable time and effort will be neededonly preventing an additional $26.7 million to perform sensitivity analysis, to explorein capital but also freeing up $1.8 million in “what-ifs,” and to answer additional seniorcapital or 1.6 percent of reserves (and main- management questions. We have concernstaining a 300 percent RBC ratio). Note that regarding run-time and the impact on busi-statutory reserves are calculated according ness close deadlines, business forecasts andto current deterministic methodology and in strategic planning.this instance are greater than the C3 Phase IIIcalculated capital requirements. Method Based on the Dec. 31, 2009 inventory weWe did not consider product feature modifi- worked with our software vendor to build acations nor did we explore YRT reinsurance. C3 Phase III model based on our reportingWe did not believe either to be a driver in the production environment. We streamlined set-large capital requirements. Coinsuring the ting the C3 Phase III assumptions by makingsecondary guarantees, if available and fea- simplistic adjustments to our GAAP best esti-sible, would reduce the capital requirements. mate assumptions. Note we could have made adjustments to our cash flow testing assump-Recommendations tions instead of to GAAP. Assumptions doWe recommend creating asset sub-segments reflect our significant underwriting experi-where warranted. Active asset management ence, whether guarantees are in-the-money,will be needed going forward. Asset-liability and the degree to which the guarantee is fullyduration mismatch risk is clearly a key driver funded. Using our model, we projected theof required capital levels. Further analysis required liability and asset cash flows overwill be needed to find the appropriate (best) 1,000 scenarios and performed the requisitebalance between earnings and risk and to calculations.evaluate the cost of the additional requiredresources. C3 Phase III capital needs to be The case study above demonstrates the potential foranother factor to be considered when evaluat- business issues that might arise from the implementa- tion of C3 Phase III. While the focus to date has been CONTINUED ON PAGE 14 The Financial Reporter | JUNE 2010 | 13
  14. 14. Managing C3 Phase III … | FROM PAGE 13 on calculation issues, the above scenario highlights the actuary’s role in the aftermath of the implementation Potential Questions for the Chief of C3 Phase III. Actuary from Management • What are the key elements of the C3 Phase In addition, the above scenario demonstrates the pos- III calculation for our business that will sibilities for management to make decisions to better cause required capital to change from the manage capital and earnings trade-offs. This is actually current required capital calculation? not surprising, but expected. The intent of the new • How is the assumption setting and docu- requirements is that actions taken by management— mentation different from what we do for product design, underwriting, actions influencing poli- GAAP or EV? cyholder behavior, investment and risk mitigation such • Are our current systems, processes, models as reinsurance and hedging—can be used to improve and experience studies capable of support- the financial health and performance of the insurance ing these new requirements? company and increase the understanding of the rela- • How can we implement C3 Phase III cost- tionships between the risk profile of the company and effectively? top/bottom line results. • How will it affect business close deadlines and will quality and controls suffer? Almost hidden in this case study, is that considerable • What are our staffing and outsourcing needs effort and infrastructure will be needed prior to being during implementation and beyond? in a position to answer the questions that will inevitably • How do we do our business forecasts and be asked. And when answered, the solutions will need support other strategic planning activities? to be communicated in terms of top-level business • What does it mean to my capital especially actions management can take. at a time when capital and liquidity are kings? • How does it affect how we manage our present and future top and bottom lines and risk profile? • How do we reflect C3 Phase III in our pric- ing and risk mitigation development cycles?14 | JUNE 2010 | The Financial Reporter
  15. 15. Report on the International Actuarial Association:Capetown Meetingby James MilhollandO nce again the Accounting Committee of problem, generally relating to various rationales for the International Actuarial Association had recognizing revenue or deferring costs. These ideas hoped to use its meeting to write a com- were those that the IASB has already discussed, butment letter on the exposure draft of an International because it has not made a final decision and it contin-Financial Reporting Standard on insurance, but when ues to discuss them there is reason to hope that furtherthe IAA met in Cape Town on March 3-5, the expo- clarification may contribute to finding a resolution.sure draft had not been published. Despite the deferral James Milholland is of the response to an exposure draft, the Accounting The second topic was risk margins, which are now owner of Milholland Committee had a full agenda. It included organizing for more commonly referred to as risk adjustments to Actuarial Consulting the response to the exposure draft, commenting on the distinguish them from the residual margins, which in Roswell, Ga. IASB’s proposed revisions to accounting for liabilities, are now often referred to simply as the margins. He can be reached at approving a request for proposals on a monograph on Notwithstanding the confusion caused by the shifting actuary@milholland.discounting, addressing the development of actuarial terminology, actuaries agree that there should be a risk com.standards, and sharing ideas with pension actuaries on adjustment to insurance liabilities. There was a vocal accounting topics of common interest. minority of one, namely the author of this report, taking the view that there should be no risk adjustment to theTHE INSURANCE STANDARD measurement of insurance liabilities. Actuaries agreedUndeterred by the delays in the exposure draft, the that the IASB should not prescribe an approach to riskCommittee decided to provide unsolicited input to the margins but should instead articulate the purpose of theInternational Accounting Standards Board on certain risk margin and leave the approach to quantification ofcritical topics. The Committee hopes to assist the IASB risk adjustments to preparers of financial statements. Ifby clarifying the issues and will not take positions on the IAA gets its wish, it will undoubtedly be active inissues in this letter. developing educational material and professional guid- ance on determining risk margins.Leading the list of topics was acquisition expenses.Actuaries agreed that, if acquisition costs are expensed Discussion on the third topic, revenue recognition,with no offsetting effects in revenue recognition or focused on treatment of the residual margin. Somein the measurement of liabilities, the results may be committee members expressed concern that the resid-misleading to users of financial statements. Committee ual margin obscures the profitability of new business,members discussed several ideas for resolving the but most committee members acknowledged the dif- CONTINUED ON PAGE 16 The Financial Reporter | JUNE 2010 | 15
  16. 16. Report On The International Actuarial Association … | FROM PAGE 15 ficulty of measuring liabilities reliably enough to allow PREPARING TO COMMENT ON THE for some initial revenue recognition. The consensus EXPOSURE DRAFT view was that there should be a residual margin and the It now appears probable that the IASB will publish the discussions centered on how it should be released. The ED in May or June with a comment period that ends in period of release is the period over which the obliga- September. The IAA does not meet during this period, tions of the contract are fulfilled, but it may be difficult so the comment letter must be prepared without benefit to identify a driver of the performance and hence a of a regular meeting. The committee made plans for basis for the pattern of the release for some contracts, a process that uses smaller groups to address specific such as immediate annuities and long-tailed nonlife topics by using the Internet and by tele-conferencing. There will be a special meeting to pull the letter togeth- er either in July or September, depending on the actual date of publication for the exposure draft. There is also broad agreement among actuaries at the meeting that contracts The planning was accompanied by additional discus- sions of topics not to be included in the unsolicited should not be unbundled. … letter, with some interesting insights and perspectives. There is consensus among actuaries that the IASB should not prescribe approaches to the calculation of the liabilities, but should leave the development of practices to preparers. This means that the standard insurance. There was discussion of the relative merits would not prescribe how insurers should set risk mar- of re-measuring or not re-measuring residual margins gins (as noted previously) or discount rates. The dis- when there are changes in the assumptions underlying cussion of discount rates included some observations the measurement of the liabilities. Re-measurement about adjustments to observed rates for differences has a shock absorber effect and can mask the effects in the liquidity of insurance contracts from that of the of changes in assumptions. On the other hand, not re- observed instrument. The discussions revealed that not measuring seems more consistent with the idea that the all actuaries are confident that the adjustments can be residual margin should be reflected in revenue margins made reliably. One can conclude that the process of at some point in time and that a contract’s revenue developing application guidance to follow on to the should not be affected by changes in the estimated cost standard may be very difficult indeed. to fulfill the obligations. Committee members agreed that the amount of the residual margin and the move- There is also broad agreement among actuaries at the ment in the residual margin should be disclosed. meeting that contracts should not be unbundled, i.e., separated between the deposit and the insurance com- A recurring topic in the discussion was the unit of ponents, unless the components are not so interdepen- account, which became the fourth topic for the letter. dent that they cannot be separated reliably. The IASB Currently the IASB sees each insurance contract as a seems to favor unbundling for presentation purposes unit of account with perhaps some consideration of but is having difficulty finding satisfactory criteria portfolios in setting risk margins. In the discussions for requiring unbundling. They are having difficulty of the Accounting Committee, actuaries pointed out a defining “interrelated” and deciding if embedded number of areas where the unit of account needed to be derivatives require separation even if the contract is a portfolio of contracts. Testing for onerous contracts, not unbundled. While it can be said that there is broad and incorporating decrements into revenue recognition opposition to requiring unbundling, some insurers, are examples of areas where the accounting concepts Swedish bancassurers for instance, wish to unbundle are more appropriately applied to portfolios than to and have asked that unbundling be permitted if not individual contracts. required. It is not clear where the IASB will land on16 | JUNE 2010 | The Financial Reporter
  17. 17. this topic and it is also not clear what position the IAA pensions will become the default approach for insur-will take in the end. ance contracts.IAS 37 LIABILITIES The measurement of pension liabilities does not includeThe IAA is submitting a comment letter on the exposure an adjustment for risk. Undoubtedly the IASB will atdraft of proposed revision to IAS 37 Liabilities. This some point discuss the need for measurement of pen-standard applies to liabilities that are not addressed in sion liabilities to be consistent with the measurementother standards, so insurance contracts, pension liabili- of insurance liabilities. Actuaries at the joint meetingties, performance obligations, and financial liabilities agreed that they should add risk margins to their list ofare not in the scope of IAS 37. Because the Board topics of common interest.seeks broad consistency among standards, IAS 37 ispotentially precedent-setting and hence important to the RFP ON DISCOUNT RATESdevelopment of the insurance standard and to the mea- The Subcommittee on Actuarial Standards approvedsurement of pension liabilities as well. The proposed a request for proposals to write a monograph on dis-revisions make clear that the measurement of liabilities counting. The monograph is intended to summarizeinclude an adjustment for risk. The comment letter concepts and practices in actuarial areas where thefrom the IAA is supportive of the proposed revisions. time value of money is significant. It is not intendedAmong the actuaries discussing the IAA’s comment to be an original research project. The request is openletter, there was one dissenting voice on adjustment for to all interested parties and will be circulated widely torisk (once again, yours truly) that echoed the alternative actuaries and others in public practice and in academiaview of some of the IASB members as presented in the who may be interested in proposing.appendix to the exposure draft. The Committee decidedto submit its letter without an alternative view. THE FUTURE OF ACTUARIAL STANDARDSMEETINGS WITH PENSION There are currently 12 International Actuarial StandardsACTUARIES of Practice (IASP). Eleven of them relate to financialThe Accounting Committee met in a joint session with reporting under IFRS. All of the existing standards arethe Pension committee to discuss topics of common Level IV type, which means they do not provide bind-interest. The Pension actuaries are compiling a list of ing guidance but are for educational purposes only.similarities and differences between insurance con- The IAA has recognized that having four classes oftracts and pension plans, which may inform the debate standards (ranging from binding guidance for all actu-on the accounting for both categories of contracts. aries in member organizations to notes for educationalSimilar discussions in past meetings of the IAA have purposes only) is confusing and has decided to movefocused on discount rates. Pension liabilities are dis- to two types of guidance, model standards and practicecounted at high-grade bond yield rates. The IASB has notes. Model standards are binding only to actuaries intentatively decided that the discount rate for insurance member organizations that have adopted the standardcontracts should reflect the characteristics of insur- or if the actuary states that he has followed the stan-ance liabilities and should be based on observed rates dards. Practice notes are for educational purposes.to the extent possible. The IASB does not intend togive further guidance on discount rates for insurance The Standard subcommittee has agreed to convertcontracts. As things stand, guidance on discounting most of the IASPs on financial reporting to Practicefor pensions is fairly prescriptive whereas guidance Notes, an effort that is fairly simple as it requires onlyfor insurance contracts will leave room for interpreta- minor reformatting and editing. The single excep-tion. It remains to be seen if the IASB will see a need tion is IASP 2 Actuarial Practice When Providingto reconcile the standards or make them consistent. Professional Services Concerning Financial ReportingSome actuaries see a possibility that the guidance for under International Financial Reporting Standards. The CONTINUED ON PAGE 18 The Financial Reporter | JUNE 2010 | 17
  18. 18. Report On The International Actuarial Association … | FROM PAGE 17 members of the subcommittee believe that this IASP sions to explore the possibility of global convergence contains valuable general guidance and that it should of national standards, perhaps leading to Globally be converted to a model standard. The subcommittee Accepted Actuarial Standards (GAAS). The initia- voted unanimously to submit to the IAA Council a tive for the discussions comes from the U.K. actuarial Statement of Intent (SOI) to convert IASP 2 to a model standard setters and from the Subcommittee. The dis- standard. cussions are chaired by Hillevi Mannonen, an actuary from Finland, whose country currently has no codified IAA protocol dictates that the approval of the standards and hence can be relatively neutral on the Professionalism Committee is also needed before the topic. The discussions are intended to result in a report SOI is submitted to the Council. The Professionalism or recommendations to be presented to the IAA at its Committee did not approve the SOI because of: next meeting in November in Vienna. It is not known if • concerns that the model standard would supersede the report will recommend that convergence, if it is pur- national standards and become binding, sued, be an objective of the IAA or of some other body. • concern that the SOI did not adequately describe the intended content of the contemplated standard, and NEXT MEETING • a desire that the standard refer to specific IFRSs (e.g., By the time of the next meeting of the IAA in October to insurance and pension standards) rather than to in Vienna, there should be some indication of the IFRSs generally. direction of global actuarial standards-setting. There will also undoubtedly be discussions on the IASB’s While the IAA standards setting process appears Exposure Draft on Insurance and on the comment let- stalled, there is a new initiative to promote convergence ters from the IAA and others. Most importantly, the of national actuarial standards. Concurrent with IAA Accounting Committee will start developing applica- committee meetings and in the same venue, ad hoc tion guidance and education on the new insurance meetings took place in the form of roundtable discus- standard.18 | JUNE 2010 | The Financial Reporter

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