Alerts and Updates

NAIC Moving Forward on Regulation of XXX/AXXX Financing Transactions

August 29, 2014

According to the NAIC, the Framework "furthers an action plan to develop proposed changes to the insurer/captive regulations specific to XXX/AXXX transactions."

For more than two years, the National Association of Insurance Commissioners (the "NAIC") has been addressing the use by life insurers of captive reinsurers to finance reserves for certain term life insurance or universal life insurance policies (the reserves are known as "XXX reserves" for the term life insurance policies, and "AXXX reserves" for the universal life insurance policies). The primary work on this subject has recently been undertaken by the Principle-Based Reserving Implementation (EX) Task Force (the "Task Force"). On August 17, 2014, the Executive Committee of the NAIC took a significant step, by adopting a report of the Task Force that included the "XXX/AXXX Reinsurance Framework" (the "Framework"). According to the NAIC, the Framework "furthers an action plan to develop proposed changes to the insurer/captive regulations specific to XXX/AXXX transactions."

The background of the issues raised by XXX and AXXX reserves generally, and of the Framework in particular, has been discussed in prior Duane Morris Alerts, most recently in "Report to the NAIC on Captives: The Controversy About Principle-Based Reserves and Captives Continues," dated March 27, 2014, which outlined proposals made in the "Report of Rector and Associates, Inc. to the Principle-Based Reserving Implementation Task Force," dated February 17, 2014 (the "February Report"). The February Report was later supplemented by Rector and Associates, Inc. in "Modified Recommendations—June 4, 2014" (the "June Report"). The February Report set out a proposed Framework for addressing XXX/AXXX reserve financing issues; the June Report was prepared in response to those comments. Many of the responses were positive or offered helpful comments, but some were decidedly negative—most notably those from the New York and California regulators and a handful of large life insurers, which are opposed to these captives altogether. The negative reactions were not enough to derail the process, however.

The June Report contains a number of recommendations, with detailed exhibits, that the Report describes as "starting points" for the various NAIC task forces and working groups that are involved in this issue. It also states that their recommendations should be adopted in their entirety; they are not a "menu" of items from which some can be chosen and others discarded. In connection with the adoption of the Framework, other NAIC task forces, working groups and committees also took related actions.

With respect to timing, the February Report suggested an effective date of July 1, 2014 for applying the Framework requirements to newly created financing structures, but the June Report notes that the application of the Framework approach is intended to be "voluntary" on the part of regulators, and does not suggest a specific target date. The February Report also suggested a date of January 1, 2015 for applying the Framework to business being ceded to existing structures. The June Report notes that although that date is still appropriate, a formal recommendation of an effective date would be held off until more of the technical implementation work is completed. Effective dates for adoption of various detailed parts of the Framework are discussed below. The June Report also notes that some of the recommendations will take several years to become effective, inasmuch as some actions, such as amending laws and regulations, will require further action by the Executive Committee and by member states.

The part of the June Report from which all else follows is contained in "Exhibit 1—XXX/AXXX Reinsurance Framework," which states the following:

  1. The Framework applies only to reinsurance involving certain types of XXX and AXXX policies.
  2. The Framework does not materially change the ability of insurers to obtain credit for reinsurance ceded to professional "certified" reinsurers (a reinsurer that meets certain requirements under the Model Credit for Reinsurance Law), or to licensed or accredited reinsurers that follow statutory accounting and risk-based capital ("RBC") rules.
  3. When the reinsurer is not described in 2 above—generally the reinsurer is a captive, a special purpose vehicle, is not eligible to become a certified reinsurer, or deviates from statutory accounting or RBC rules—the following will apply:
    1. The ceding insurer must establish gross reserves under current XXX/AXXX reserving requirements.
    2. The ceding insurer has "Primary Security" as collateral at least equal to an amount determined under the "Actuarial Method" (collectively, the "Primary Security Requirement").
      1. Primary Security is defined as cash and securities listed by the NAIC's Securities Valuation Office ("SVO") that meet certain requirements.
        1. An open question is whether letters of credit ("LOCs") that otherwise meet credit for reinsurance requirements (i.e., they are clean, irrevocable, unconditional and "evergreen") can be allowed as Primary Security.
        2. The original proposal was that such LOCs could be used to a limited extent after the inception of the transaction, but that LOCs could not be more than 10 percent of what was then termed Primary Assets, but is now defined as Primary Security.
        3. Will this provision eliminate the use of LOCs as credit for reinsurance when XXX or AXXX business is ceded to foreign reinsurers, as is currently permitted under the Model Credit for Reinsurance Law?
      2. The Actuarial Method is defined as VM-20 (the valuation manual for principle-based reserves) modified to incorporate changes to modern mortality tables. An open issue is whether VM-20 should eliminate the "net premium reserve" component that is used for principle-based reserves generally.
    3. The portion of the gross reserve that exceeds the Primary Security Requirement (the redundant portion of the reserve determined under the new method) may be collateralized by "Other Security."
      1. Other Security is defined as any other security for which the NAIC has developed an RBC asset charge.
    4. At least one party holds appropriate risk-based capital to back the reserves (the RBC "cushion").
    5. The transaction is approved by the ceding company's regulator.

The specific recommendations set out in the June Report (including recommendations to "police and enforce" the new requirements) are:

  • Adopt the Framework approach, in concept, as soon as practicable, without waiting for details to be finalized, as adoption would "operate to promote greater uniformity and consistency by generally describing the ?right way' to engage in reserve financing transactions."
  • Move toward implementation of the Framework, by adopting charges to various NAIC task forces and working groups.
  • Use the Actuarial Opinion and Memorandum Regulation ("AOMR") (Model #822) as the basis for adopting an Actuarial Guideline consistent with provisions adopted pursuant to the Framework. This will be taken up by the NAIC's Life Actuarial Task Force ("LATF").
    • If the recommended Actuarial Guideline is adopted, actuaries would be required to follow methods and procedures adopted pursuant to the Framework, and would be required to give "qualified" opinions if a XXX/AXXX reserve financing transaction did not conform to the provisions adopted pursuant to the Framework.
    • A draft of the Actuarial Guideline is attached to the June Report. The June Report notes that the Actuarial Guideline can be made to be effective on a very timely basis, and can be used to encourage and monitor compliance with the Framework in the near-term and the long-term. The Actuarial Guideline could become part of an amended AOMR.
  • Amend the Credit for Reinsurance Model Law (Model # 875) and adopt a new model regulation specifically for XXX/AXXX reserves (the proposed "XXX/AXXX Reinsurance Model Regulation") in order to require captive reinsurers that are licensed or accredited in the state of the ceding insurer (or meet other requirements) but do not follow full statutory accounting and RBC rules, to meet the Framework's collateral requirements. A draft of the proposed model regulation is attached to the June Report. The Reinsurance Task Force was given this charge.
  • Limit the types of "Other Security" that can be used when XXX/AXXX reserves are ceded to a reinsurer that is subject to the Framework's collateralization requirements. Under current practices, a state regulator can permit a reinsurer to post collateral that is other than cash, SVO-listed securities, or certain letters of credit, and some regulators permit the use of letters of credit that allow for certain conditions, such as depletion of other assets, before the letter can be drawn. The limitation would be contained in the proposed model regulation, discussed above.
  • Require disclosure of key aspects of XXX/AXXX reserve transactions to the public, with a target date for filings as of December 31, 2014. The Blanks Working Group was given this charge.
  • Amend the RBC instructions to require at least one party to the transaction to hold an RBC "cushion," and develop RBC asset charges for assets allowed in the Framework as "Other Security." The goal is for these changes to be effective by the end of 2015. This charge was given to the Capital Adequacy Task Force, which delegated the tasks to the Life RBC Working Group.
  • Evaluate existing reinsurance risk transfer rules to address the use of parental/affiliate guarantees of the obligations of the captive or third-party reinsurer in order to keep the risk inside of the holding company system. This charge was given to the Financial Condition (E) Committee.
  • Update the NAIC Financial Analysis Handbook to address XXX/AXXX reserve financing transactions, with a target date of December 31, 2014. The Financial Analysis Handbook Working Group will address this charge.
  • Require audited financial statements to indicate whether reserve financing transactions meet the requirements of the Framework. This charge was given to the Statutory Account Principles (E) Working Group.

The June Report recommends that many of its suggestions be reflected in NAIC Accreditation Program. This program was established to develop and maintain standards to promote effective insurance company financial solvency regulation, by requiring state insurance departments to meet baseline standards of solvency regulation, particularly with respect to regulation of multi-state insurers. Including the new or revised regulations and other matters in the accreditation program means that they will be implemented by all of the states.

Definition of "Multi-State Reinsurer"

Another proposal that relates to captives is one made by the NAIC's Financial Regulation Standards and Accreditation (F) Committee (which oversees the Accreditation Program, discussed above) to amend the definition of "multi-state domestic insurer" in the preambles to Part A: Laws and Regulations—Traditional Insurers and Part B: Regulatory Practices and Procedures, which introduce the NAIC Policy Statement on Financial Regulation Standards. The term "multi-state domestic insurer" currently excludes "insurers that are licensed, accredited or operating in only their state of domicile but assuming business from insurers writing that business that is directly written in another state."

Under this proposal the exclusion will be deleted, and a new term, "Multi-State Reinsurer," will be introduced, to cover "an insurer assuming business that is directly written in more than one state and/or any state other than its state of domicile." It specifies that "multi-state reinsurers include, but are not limited to, captive insurers, special purpose vehicles and other entities" that reinsure XXX and AXXX business. The proposal also states that "Captive insurers owned by non-insurance entities for management of their own risk will continue to be exempted from both the Part A and Part B accreditation requirements."

The effect of the revised definitions would be to require states to subject captive insurers reinsuring XXX and AXXX reserves (and other captives that insure or reinsure more than their "own risks") to the same requirements applicable to commercial reinsurers, which entails full compliance with NAIC capital and other standards.

Opponents to the revised definitions point out that captive insurers, whether they are used to address XXX or AXXX reserves or for other purposes, are not commercial insurers, and are subject to a different regulatory regime. They point out that to the extent that captives used in XXX or AXXX reserve transactions are in need of revised regulation, the development of the Framework is intended to address those needs. The effort to bring XXX and AXXX captive insurers under accreditation standard can be seen as, at best, a way to impose a moratorium on XXX and AXXX financing transactions until the work laid out in the Framework has been completed; at worst, the effort is a way to end those transaction altogether. The American Council of Life Insurers (the "ACLI"), a trade association for the life insurance industry that supports life insurers' use of captives and their appropriate regulation, pointed out in a May 16, 2014 submission to the NAIC:

[T]he result would be tantamount to an immediate and permanent moratorium on all new on-shore captive reinsurers after July 1, 2014. Such a result would render meaningless the work of the PBR Implementation (EX) Task Force to address some of the recommendations expressed in ?Captives and Special Purpose Vehicles' NAIC White Paper dated June 6, 2013.

The ACLI further pointed out that "the NAIC staff who drafted the [accreditation] proposal are unclear how this proposal will interact with the work being undertaken by the [Task Force]," and thus "we recommend that action on this proposal be deferred until such time as the [Task Force] completes its work." Of course, a moratorium on XXX/AXXX transactions would be fine with many, including the New York Superintendent of Financial Services, who originally made that suggestion some months ago.

There is also a concern within the captive industry (voiced by trade groups and some regulators) that more than XXX and AXXX captives are at risk. The ACLI noted that "[t]his moratorium would include captives established for purposes other than the financing of Regulation XXX/AXXX reserves, which is well beyond the NAIC's stated scope of the captives project." In the course of the NAIC summer meeting, regulators stated that there is no intent to bring industrial captives and other types of captives outside the XXX and AXXX world into full regulation, but many are concerned by the lack of clear meaning of some terms, such as "own risk." There is a related concern that the normal time-frame for consideration of the effect of changes to accreditation standards is not being allowed, which may lead to unintended results. Many cautioned that the uncertainty could push captives offshore. In light of these concerns, further consideration will be given to the multi-state reinsurer issue at the NAIC fall meeting.

Disclaimer: This Alert has been prepared and published for informational purposes only and is not offered, nor should be construed, as legal advice. For more information, please see the firm's full disclaimer.