Overall, the Rector Report seems to be an attempt to steer a course between regulators who are opposed to the use of captives to fund XXX and AXXX reserves altogether, and those in the regulatory and insurance communities who see a continuing need for those types of financing transactions.

The use by life insurance companies of captive reinsurance companies to finance XXX and AXXX reserves has been a significant and contentious issue in recent years.[1] Some members of the National Association of Insurance Commissioners (the "NAIC") are deeply opposed to captive-based financing transactions, whereas other regulators and many members of the life insurance industry support their use. Duane Morris has published a series of Alerts on this issue as it has developed:

• Controversy over Principles-Based Reserves & SPVs - Report from the NAIC Fall Meeting
• Principle-Based Reserves & SPVs: Regulatory Developments
• Insurance Regulatory Update - Holding Company Supervision, Designation of Prudential Financial as Being "Too Big to Fail," Principle-Based Reserving and Captives

The most recent developments are the release of a report for the NAIC entitled "Report of Rector and Associates, Inc. to the Principle-Based Reserving Implementation (EX) Task Force," dated February 17, 2014 (the "Rector Report" or "Report"),[2] and related comment letters on the Report by insurance regulators and others, including letters dated March 21, 2014, from Superintendent Lawsky of the New York Department of Financial Services and Commissioner Jones of the California Insurance Department, both of which are critical of the Report.

The Report follows an initial report in September 2013, which sets out (i) a "Threshold Decision" for the Task Force to make with respect to the general permissibility of reserve financing transactions and (ii) a "Framework" setting forth certain requirements for these transactions in the event that the Task Force decides to allow their continued use.

The considerations underlying the Threshold Decision are described in the Report as follows:

[T]he use of financing transactions arises from the belief of some insurers that current reserving and statutory accounting requirements force them to carry traditional insurance admitted assets in larger amounts than is necessary, thereby increasing costs to insurers and policyholders. Those insurers want to fund reserve liabilities using assets, including traditionally non-admitted assets, that in their view better correlate to the probability the assets will be needed to pay claims. However, statutory accounting rules require insurers to support 100% of statutory reserves with admitted assets, even if the probability that the last dollar of the reserve will be needed is much lower than the probability that the first dollar will be needed. In response, some insurers have entered into reinsurance transactions to "finance" different portions of the statutory reserve differently—i.e., to fund different portions of the reserve using different kinds of assets—based on what the insurers believe is a better correlation between the kind of asset used and the probability that it will be needed.

The Rector Report describes the Threshold Decision as "whether to accept the general logic of those insurers—i.e., the logic that atypical, non-admitted assets should be allowed to support the portions of the reserve that have a low probability of being needed to pay claims—or whether, instead, to seek to prohibit transactions that result in an economic effect different than the current statutory accounting requirement that admitted assets be used to support 100% of statutory reserves."[3] The direction Rector received from the Task Force in response to the Threshold Decision was, in general terms, that reserve financing transactions should be allowed to continue only until the Principle-Based Reserving (PBR) rules are effective, but not thereafter, and only if such transactions meet the requirements of the Framework. The Report provides more detailed suggestions for the Framework.

The Rector Report first described what it does not attempt to accomplish:

• It is not recommending any change in the level of reserves now required to be held by life insurers. The recommendations address only the types of assets that can be held to back those reserves—whether only "traditional" assets may be used, or whether it is appropriate to allow the use of other "non-traditional" assets to back the portion of the gross statutory reserve that has a low probability of being needed to pay claims.
• It is not attempting to regulate captives—the focus is on the ceding insurer, and the quality and quantity of assets needed to ensure that the ceding insurer will be able to pay claims as they come due.
• Finally, its recommendations are not dependent on the adoption of PBR, although its core proposals are based on PBR methodology. The Report states that "our recommendations are appropriate even if PBR does not ultimately become effective or even if it is adopted after being altered significantly."

The Report then makes the following suggestions:[4]

1. The ceding insurer would determine what the reserve for its XXX and AXXX business would be under a modified PBR-type calculation (referred to in the Report as the "Actuarial Method").
2. The ceding insurer would be required to hold traditional assets (referred to in the Report as "Primary Assets") on a funds withheld or trust basis equal to a reserve calculated under the Actuarial Method (the result of this calculation is referred to in the Report as the "Primary Asset Level").
3. The remaining portion of the "gross" XXX or AXXX reserve (that is, the excess of the full reserve determined under present reserve requirements over the Primary Asset Level) could be funded with assets approved by both the ceding company's and the reinsurer's domiciliary regulators (these assets are referred to in the Report as "Other Assets"), and might include letters of credit (LOCs).
4. Risk-based capital (RBC) calculations on the basis of existing NAIC standards would be made by at least one party to the transaction in order to ensure that either the ceding insurer or the captive reinsurer has sufficient capital (i.e., assets in excess of the gross reserves) to support the business.
5. Key information about financing transactions and underlying assets should be disclosed to regulators and the public.
6. The insurers that write the business subject to financing transactions and their auditors should determine compliance annually.

More generally, the Report suggests that when reinsurance is ceded to "traditional" reinsurers—those that follow NAIC accounting and RBC rules—there is generally no need to apply the targeted rules outlined in the Report. The Report also recommends that the NAIC should develop a new "XXX and AXXX Model Reinsurance Regulation" as an Accreditation Standard to codify these recommendations. Finally, the Report suggests the following effective dates for new requirements for financing transactions:

• July 1, 2014, for newly created financing structures.
• December 31, 2014, for new disclosure requirements.
• January 1, 2015, for business ceded to existing financing structures.
• December 31, 2015, for new RBC rules.

Analysis

Actuarial Method

The Rector Report lays out two options:[5] Alternative A uses existing captive reinsurer-based structures as its starting point; Alternative B considers whether XXX and AXXX reserve financing could be structured at the ceding company level. The initial key component of both alternatives is the Actuarial Method. The goal of the Actuarial Method calculation is to identify a reserve level (i.e., the Primary Asset Level) that is sufficiently conservative to provide for the payment of all policyholder claims, but that is less conservative than the currently required gross XXX or AXXX reserving levels. Under the approach outlined in the Report, the Primary Asset Level would be funded by specified types of Primary Assets, but the remaining reserve could be funded with Other Assets.

The Report expresses the hope that the Actuarial Method chosen will achieve "consensus acceptance by all (or at least most) regulators and insurers," but will "effectively eliminate the financial incentive for financing transactions once PBR becomes effective." The Report further notes that "[i]f the Actuarial Method leads to a Primary Asset Level that is significantly less than what the reserve would be once PBR becomes effective, then the financial incentive to engage in financing transactions will continue to exist." It then concludes that the most effective means of meeting the direction given by the Task Force was to base the Actuarial Method on PBR reserving methods, as they exist today, but modified as needed to take into account anticipated changes in those methods.

For this purpose, Rector looked to NAIC Valuation Manual, VM-20, Requirements for Principle-Based Reserves for Life Products, stating that "[b]ecause the PBR reserve will be determined using VM-20, the only way to effectively eliminate the financial incentive for further financing transactions post PBR is to select an Actuarial Method that leads to a Primary Asset Level that is approximately equal to or greater than what VM-20 will be as of the date PBR is effective." In order to allow for anticipated developments, the Report suggests modifying the current VM-20 to take into account changes that will likely be made by the time PBR becomes effective. Thus, the Report suggests using mortality tables that are revised to be closer to what the mortality tables are expected to be under PBR, and revising interest rate and other assumptions currently reflected in VM-20. Overall, the Report suggests that rather than requiring a wholesale re-writing of VM-20 for this purpose, the Task Force should allow insurers to use their actuarial judgment in applying the modifications to VM-20, provided that insurers document those judgments.

Primary Assets and Other Assets

The second key component is the determination of what types of assets will be allowed as Primary Assets or as Other Assets. The Report notes that it rejected simply using "admitted assets" as Primary Assets, because there are too many state variations as to which assets qualify as admitted assets—particularly in light of state law "basket" provisions, which allow insurers to invest in non-traditional assets within certain percentage limitations. Also, as the Other Assets that could be permitted to back the portion of the gross reserve that exceeds the Primary Asset Level may have liquidity or credit risks, the Report suggests that Primary Assets should be limited to assets that are allowed under Section 10 of the NAIC Model Credit for Reinsurance Regulation (Model 786), which consist of cash, and securities listed by the Securities Valuation Office of the NAIC (the "SVO"), including securities exempt from filing with the SVO because they are otherwise rated, and that otherwise qualify as admitted assets.

Many insurers suggested including LOCs as Primary Assets, as LOCs have long been used to provide full credit for reinsurance under the Credit for Reinsurance Model Regulation, but many regulators opposed allowing LOCs as Primary Assets. In fact, the Report notes that some regulators are of the view that allowing LOCs to provide credit for reinsurance without restriction was a mistake in the first place, and their use should not be extended in this instance. The Report suggests, however, that LOCs could be used as Primary Assets in very limited circumstances that could arise after the inception of the transaction: If and when changes in the market value of assets and payment of claims produce shortfalls between the Primary Asset Level and the market value of Primary Assets, LOCs could be used to make up the shortfall in years after the year of inception of the transaction and only for so long as such LOCs in the aggregate comprise no more than 10 percent of the Primary Asset Level.

The Report then suggests that the judgment as to the types of LOCs or Other Assets that can be used should be left to the regulators of the ceding insurer and the reinsurer, both of which are required to approve any reserve financing transaction, with additional oversight by the NAIC’s Financial Analysis (E) Working Group (FAWG). The Report also suggests developing a list of assets that regulators, insurers and financing entities (such as banks) believe will be commonly used as Other Assets, so that appropriate RBC charges can be determined.

Alternative B

The Report also presents Alternative B, which is intended to "achiev[e] substantially the same economic effect as Alternative A, but without using reinsurance."[6] In essence, the same concepts used in Alternative A would be used, but on the books of the ceding company. The Report notes, however, that most insurers have continued to look to reinsurance-based solutions to their XXX and AXXX issues: Captive-based transactions have been used for more than 10 years, and insurers, financing entities and regulators are familiar with how they are structured, and with the legal issues that arise. The Report also states that although financing reserves at the ceding company level is theoretically possible, a methodology for financing of reserves without the use of a reinsurance structure will require more development.

The most significant issue in connection with Alternative B is whether it is possible to sufficiently separate the assets backing the reserves that are being financed from the rest of the insurer's liabilities, so that third parties will be comfortable to provide financing. In a reinsurance-based structure, financing parties derive comfort from "ring-fencing" of assets and "bankruptcy-remoteness" of the reinsurance entity. Achieving the same protection inside the ceding company can present numerous issues. For example, if LOCs are used as Other Assets to fund a portion of the reserves and the insurer enters insolvency proceedings, what would prevent a receiver from drawing on the LOCs and using the proceeds for unrelated purposes? Regulators have also questioned whether Alternative B would require changes to statutory accounting principles and existing insurance insolvency laws. As a result of these concerns, the Report suggests that the Task Force seek out insurers that are interested in developing the Alternative B concept. One suggestion in the Report is to consider the possibility of using protected cell or separate account concepts to separate the LOC or similar Other Assets from the general account of the insurer.

Appropriate Amount of Capital/Surplus

The Report then discusses the proper level of capital needed to support XXX and AXXX business. It states that "[t]he traditional way insurance regulators measure the adequacy of available capital/surplus is RBC. In other words, an insurer is required not only to hold appropriate level of 'reserves,' but also to hold capital/surplus in amounts sufficient to allow the insurer to sustain an appropriate RBC ratio." The Report notes that in reserve financing transactions, the ceding company's RBC does not fully consider the business ceded, and the assuming reinsurers are not required to calculate RBC ratios, or if so, in a modified fashion, so that "full RBC consideration using traditional NAIC methodology is often not given to the business subject to financing transactions." As a solution, the Report suggests that when an assuming reinsurer performs RBC calculations in full compliance with standard NAIC accounting requirements, nothing more is needed, but if the business is ceded to a captive reinsurer that does not perform RBC calculations, or does so on a modified basis, or does not use statutory accounting methodology in general, the RBC calculation must be done at the ceding company level as if the reinsurance was not in place. In addition, under either Alternative A or B, appropriate RBC treatment for Other Assets would have to be determined.

Non-Affiliate Transactions

The Report states that its "guiding principle has been that the new requirements should apply to related party transactions that are entered into for the primary purpose of using non-traditional (non-admitted) assets to support part of the statutory reserve or reserve credit taken. In general, we believe that the new requirements should not apply to 'traditional' reinsurance arrangements with well capitalized unaffiliated third party reinsurers." The Report suggests that transactions with specified types of assuming reinsurers, such as transactions with "certified reinsurers" (those that qualify under Section 8 of the Credit for Reinsurance Model Regulation) and licensed or accredited reinsurers that use NAIC statutory accounting practices (without any permitted practices) and RBC rules, would be exempt from the new requirements.

Corrective Action

The Report also suggests that when a ceding insurer reinsures its XXX and AXXX business in a manner that does not comply with the new requirements, it will be presumed to be in a financially hazardous condition within the meaning of NAIC's Model Regulation to Define Standards and Commissioner's Authority for Companies Deemed to Be in Hazardous Financial Condition (Model 385). This will provide regulators with the authority to take corrective actions.

Disclosure Requirements

One of the key concerns raised by the Task Force is that of disclosure. As reported on in prior Duane Morris Alerts, some members of the NAIC have expressed a concern that reinsurance-based XXX and AXXX financing transactions have not been subject to proper scrutiny. The Report suggests that appropriate disclosure should be required, and that the requirements should be aimed primarily at the ceding company, not the reinsurer. The Report also suggests that information should be made available to both regulators and the public at about the same level of detail as contained in existing public documents, such as statutory financial statements.

"Permitted Practice" Approach

Finally, the Report raises the possibility of allowing states to grant "narrowly defined" permitted practices allowing insurers to begin using PBR early, before the new standard becomes effective nationally. The Report notes, however, that some states continue to question whether PBR is sufficiently conservative as a reserving standard, and whether the regulatory community has adequate resources to devote to PBR. Rector states that it is not recommending the permitted practice approach; rather, it is raising the concept for further consideration.[7]

Observations

According to the Report, "the overwhelming consensus—among regulators and insurers alike—is that establishing the direct insurer's reserves at the 'right' level to begin with" is the best way to address the issues discussed in the Report, so as to eliminate the "expense and complication of using reinsurance finance transactions."

Overall, the Rector Report seems to be an attempt to steer a course between regulators who are opposed to the use of captives to fund XXX and AXXX reserves altogether, and those in the regulatory and insurance communities who see a continuing need for those types of financing transactions. As noted above, one of the goals of Rector's work was to select a method that "achieves consensus acceptance by all (or at least most) regulators and insurers." The recommendations in the Rector Report are built around one key assumption: The eventual adoption of PBR will result in the "right" level of reserves for the types of business now subject to XXX and AXXX reserving requirements.

The Report acknowledges, however, that its proposal may not meet the goal of achieving consensus "because a number of insurers believe [PBR methodology] is too conservative," even though it might be acceptable to most regulators and some insurers. If industry members are correct in their analysis of PBR reserving methodology, under PBR there will likely continue to be some level of reserves that are deemed to be excessive. Under the methodology suggested in the Report, an insurer will not be permitted to use anything other than Primary Assets to fund the portion of the XXX or AXXX reserve equal to the amount determined under the Actuarial Method, i.e., the Primary Asset Level. Moreover, once PBR is fully adopted, the Report anticipates that the Primary Asset Level will roughly equal the PBR reserve. Thus, in the view of many in the industry, adopting the suggestions set out in the Rector Report may somewhat alleviate, but will not solve, the issues faced by the life insurance industry—some portion of required reserves will continue to exceed the economic reserves, and that excess continues to be a capital issue for insurers. On the other hand, some regulators believe that the current level of reserving is appropriate, and that PBR methodology is not sufficiently conservative.

Although the proposals in the Rector Report are well-thought-out and plainly presented, they appear to raise a number of issues.

• First, it seems likely that there will be pushback from the life insurance industry. To the extent the industry believes that reserve redundancies will continue to exist both under the recommendations in the Report, as well as under the final PBR regime, it is likely that the industry will continue their efforts at the NAIC to allow for greater relief than is offered by the procedures outlined in the Report. Failing that, there may be continued use of permitted practices on a state-by-state level—which could lead to competitive imbalances among life insurers.
• The Report acknowledges that VM-20 will need further development before there is methodology in place for even this limited purpose. In view of the history of PBR, is it reasonable to assume that a modified VM-20 can be developed expeditiously?
• If this is the case, will life insurers and regulators be in a position to apply the new methodology to specific transactions?

Responses to Report

In his letter of March 21 to the NAIC, Superintendent Lawsky repeated statements he has made in the past regarding the use of captives to engage in "shadow insurance transactions" to "juice financial results" and make their balance sheets look "artificially rosy." The letter states that the recommendations in the Report would "essentially [try] to solve one serious problem by creating an even larger one." More generally, Superintendent Lawsky stated that he "harbors serious reservations" about PBR, as it allows life insurers to use "internal black box models" to determine the amount of reserves, which, in his view, "ultimately will imperil policyholders by siphoning off the financial cushion that enables insurers to stand strongly behind their products." Instead, he believes that life insurers should be required to use "reserve requirements that are established by formulas and diligently policed by insurance regulators." The Superintendent does state, however, that his Department "is willing to work constructively with other regulators and insurers to make smart, targeted, limited adjustments to the historical reserving formulas."

Commissioner Jones of California also expressed strong reservations about the recommendations in the Report. Commissioner Jones has previously expressed concerns about the ability of regulators and insurers to implement PBR and that he "does not believe that regulators will have resources and expertise required to implement and evaluate the VM20 reserves within the time period proposed in the [R]ector Report." In his view, "[m]any of the problems and issues outlined [regarding the recommendations in the Report] could take a considerable amount of time and regulatory resources to resolve," and that "time and resources may be better spent on addressing the broader PBR proposal and implementation." The Commissioner agrees with an earlier suggestion of Superintendent Lawsky, that there should be a moratorium on captive-based transactions, and that pending implementation of fully-developed PBR reserving rules, the NAIC should "expeditiously move to develop an interim step to update the most egregious aspects of the current reserving requirements to eliminate any truly excessive reserving requirements related to XXX and AXXX reserves."

Not surprisingly, many in the life insurance industry and in the regulatory community do not agree with the views of the New York and California regulators. The issues raised in the Rector Report will be discussed at the Spring Meeting of the NAIC, which begins at the end of March.

For Further Information

If you have any questions about this Alert, please contact Hugh T. McCormick, K. Oliver Rust, Alice T. Kane, any member of the Insurance - Corporate and Regulatory Practice Group or the attorney in the firm with whom you are regularly in contact.

Notes

1. These issues are discussed in the NAIC's White Paper Captives and Special Purpose Vehicles, dated June 6, 2013 (the "Captives White Paper"). Duane Morris provided the NAIC with comments on an early draft of the Captives White Paper. The reserves at issue, which are referred to as "XXX" or "AXXX" reserves, are required to be held by life insurance companies with respect to certain types of term or universal life insurance contracts. The relevant authorities are the NAIC's Valuation of Life Insurance Policies Model Regulation (Model 830) and Actuarial Guideline XXXVIII—the Application of the Valuation of Life Insurance Policies Model Regulation (AG 38), respectively.
2. The Principle-Based Reserving Implementation (EX) Task Force (the "Task Force") was established by the NAIC's Executive Committee to deal with the development of principle-based reserves and other matters, including studying the use of captive reinsurers in XXX and AXXX reserve financing transactions. The Task Force commissioned the Rector Report.
3. Many if not most actuaries believe that XXX and AXXX reserves substantially exceed the "economic" reserves that will actually be needed to fulfill claims. The portion of the XXX or AXXX reserves that have a "low probability of being needed to pay claims" is the amount in excess of the economic reserves, and is sometimes referred to as the "redundant" portion of the reserves.
4. For the reasons discussed below, the Report focuses on the continued use of captive-based transactions.
5. The Report discusses other approaches, including a "total capital" calculation advanced by the American Council of Life Insurers (the "ACLI"). The Report raises a number of issues that would result from the ACLI's proposal, including greater complexity, and the fact that the approach is aimed at the assuming reinsurer, not the ceding company, which could be problematic if the assuming entity is organized outside the United States.
6. In Alternative B, the Report is responding to one of the key suggestions in the Captives White Paper, to develop a means of dealing with "perceived XXX and AXXX reserve redundancies" by dealing with accounting and reserving issues "within the ceding company, thereby eliminating the need for separate transactions outside of the commercial insurer [i.e., the ceding insurer]."
7. The Report observes that under the existing Credit for Reinsurance Model Regulation, Section 10.A.4, an insurance regulator has broad authority to accept, in lieu of specified forms of security, "any other form of security acceptable to the commissioner." This authority has been used in existing XXX and AXXX transactions to accept non-traditional assets. The Report suggests that this same authority can be used by regulators to implement the new requirements set out in the Report for new transactions after July 1, 2014, and for new business in older structures after January 1, 2015.

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.