Acquisition Transaction Reinsurance: Key Concepts SEAN KEYVAN AND JEREMY WATSON, SIDLEY AUSTIN LLP

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1 Acquisition Transaction Reinsurance: Key Concepts SEAN KEYVAN AND JEREMY WATSON, SIDLEY AUSTIN LLP

2 Agenda Introduction to Reinsurance Reinsurance in the context of an Acquisition Transaction Regulatory Considerations in Acquisition Transaction Reinsurance Questions 1

3 Introduction to Reinsurance 2

4 What is Reinsurance? Reinsurance involves the transfer (cession) of insurance risk from one insurer (the ceding company) to another insurer (the reinsurer or assuming company) Retrocession involves the further transfer of insurance risk (reinsurance of reinsurance risk) from one reinsurer (the retrocedent) to another reinsurer (the retrocessionaire) 3

5 Objectives of Reinsurance Spread risk and support the financial stability of the ceding company Expand underwriting capacity of the ceding company Capacity to underwrite more risk or larger risks in a particular class Capacity to underwrite high magnitude risks or novel risks Free up operating capital of the ceding company Allow the ceding company to withdraw from a line or class of business 4

6 Objectives of Reinsurance (Cont.) Add flexibility in the structuring of an acquisition transaction Remove from a target company lines or classes of business that the parties desire to exclude from a transaction Transfer into a target company lines or classes of business that the parties desire to include in a transaction that are not written on the paper of entities being sold Provide transitional financial and operational support for continuing operations 5

7 Types of Reinsurance Indemnity Reinsurance vs. Assumption Reinsurance Indemnity Reinsurance The reinsurer agrees to indemnify the ceding company for certain risks to which the ceding company is subject under insurance policies issued by the ceding company Indemnity reinsurance is a contractual relationship between the ceding company and the reinsurer the ceding company remains directly liable to the policyholders, and the policyholders do not have a direct right against the reinsurer 6

8 Types of Reinsurance Indemnity Reinsurance vs. Assumption Reinsurance (Cont.) Assumption Reinsurance Special type of reinsurance, typically undertaken in the context of an acquisition transaction, whereby insurance policies issued by the ceding company are novated to the reinsurer The ceding company s obligations to the policyholders are extinguished and the reinsurer becomes directly liable to the policyholders Most states have specific regulatory requirements that need to be met to effect an assumption reinsurance transaction; often requires policyholder consent 7

9 Types of Reinsurance Funds Withheld vs. Modified Coinsurance Funds Withheld Transactions The reserves associated with the reinsured business are transferred by the ceding company to the reinsurer, while the assets supporting the reserves remain on the books of the ceding company The ceding company establishes a funds withheld payable on its books in respect of the assets in the funds withheld account, and the reinsurer establishes a corresponding funds withheld receivable on its books The profit and loss with respect to the reinsured business and the assets supporting the reserves flow from the ceding company to the reinsurer through periodic settlements (funds withheld adjustments) The ceding company receives credit on its statutory financial statements for the reinsurance transaction because the assets supporting the reserves ceded to the reinsurer are held by the ceding company 8

10 Types of Reinsurance Funds Withheld vs. Modified Coinsurance (Cont.) Modified Coinsurance Transactions Neither the reserves associated with the reinsured business nor the assets supporting the reserves are transferred by the ceding company to the reinsurer The assets supporting the modified coinsurance reserves remain on the books of the ceding company The profit and loss with respect to the reinsured business and the assets supporting the reserves flow from the ceding company to the reinsurer through periodic settlements (modco adjustments) The ceding company does not receive credit on its statutory financial statements for the reinsurance transaction (and credit for reinsurance is not necessary) because the reserves are not transferred to the reinsurer 9

11 Reinsurance in the Context of an Acquisition Transaction 10

12 Reinsurance in Connection with a Stock Acquisition Reinsuring Excluded Business out of the Target Company Acquiring the stock of an insurance company may result in the buyer acquiring unwanted lines of business and/or policy risks Reinsurance can be used to transfer the unwanted insurance business out of the target company prior to the stock acquisition Reinsuring Included Business into the Target Company In certain transactions, some of the insurance business that the buyer is seeking to acquire may not be written by the target company Reinsurance can be used to transfer the desired insurance business into the target company prior to the stock acquisition 11

13 Reinsurance as a Primary Acquisition Structure Reinsurance can be used in a transaction that does not involve a stock sale or merger as the primary method of transferring a business unit or a book of business to a buyer (similar to an asset sale) Provides flexibility to specifically define the insurance business to be acquired May be in conjunction with the acquisition of operating assets, the assignment of third party contracts and the transfer of employees supporting the reinsured business 12

14 Credit for Reinsurance/Collateral Mechanisms Transactions are structured to ensure that the ceding company receives credit on its statutory financial statements for the reinsurance transaction The ceding company may insist on a collateral mechanism (e.g., a collateral trust) to protect against the credit risk associated with the reinsurer 13

15 Renewal Rights The ceding company grants to the reinsurer an exclusive right to renew any policies comprising the acquired business upon their expiration Transfer books and records relating to the acquired business and ceding company s rights to data relating to policyholders Renewal rights transaction may be structured without a reinsurance arrangement 14

16 Fronting Arrangements The ceding company grants the reinsurer the authority to quote, underwrite and issue policies on the paper of the ceding company If buyer is not able to directly write the type of business being acquired If the seller is not able to directly write the type of business comprising the excluded business The fronted business is reinsured 100% to the reinsurer and administered by the reinsurer The fronting company (ceding company) retains full liability to the policyholders if the reinsurer becomes insolvent 15

17 Administration Appointment of the reinsurer as agent to administer and service the acquired business The reinsurer will typically desire to assume responsibility for administering all aspects of the acquired business Administrator and/or adjustor licensing requirements Control over certain types of litigation and regulatory inquiries 16

18 Inuring Reinsurance Due diligence of existing reinsurance agreements is critical Retention provisions may require third party consents Amendment of existing affiliate reinsurance agreements Collectability of existing reinsurance Typically at the risk of the reinsurer Ceding company may assume the risk of collectability issues arising out of the unenforceability of existing reinsurance contracts or the failure to obtain necessary consents 17

19 Extra-Contractual Obligations Extra-contractual obligations (ECOs) generally include obligations that are not covered by the express contractual provisions of an insurance policy ECOs relating to included business Buyer typically accepts responsibility for ECO risk arising out of actions occurring following the closing Responsibility for ECOs arising out of actions occurring prior to the closing is subject to negotiation ECOs relating to excluded business Buyer typically expects the seller to retain responsibility for all ECO risk relating to excluded business 18

20 Non-Solicitation/Non-Competition Non-solicitation of policyholders provision prohibits the seller/ceding company from soliciting policyholders of the acquired business for policies similar to the acquired business Non-competition provision prohibits the seller/ceding company from engaging in a business that competes with the acquired business 19

21 Duty of Utmost Good Faith Duty imposed on the ceding company under common law to exercise the utmost good faith in its dealings with the reinsurer Duty may extend to, among other things, disclosure matters, the negotiation of the reinsurance agreement, reporting obligations and notice of claims and the investigation and administration of claims Disclaiming or limiting the duty of utmost good faith 20

22 Regulatory Considerations in Acquisition Transaction Reinsurance 21

23 Risk Transfer SSAP 62R (property and casualty) Reinsurance agreements must transfer risk from the ceding company to the reinsurer in order to receive reinsurance accounting treatment Generally, reinsurance agreements for property and casualty business must: Contain an acceptable insolvency clause Provide for orderly settlement of recoveries due the ceding company Constitute the entire agreement between the parties and provide no guarantee of profit Require reporting at least quarterly Provide for transfer of insurance risk, including both underwriting risk and timing risk 22

24 Risk Transfer SSAP 62R (property and casualty) (Cont.) Other property-casualty reinsurance issues Special rules are provided for retroactive reinsurance agreements Reinsurance agreements with multiple cedents require written allocation agreements that are fair and equitable Reinsurance agreements that do not provide for transfer of insurance risk are accounted for using special deposit accounting rules 23

25 Credit for Reinsurance Obtaining proper statutory accounting treatment for reinsurance agreements is an important part of a reinsurance transaction Each state has its own credit for reinsurance statute based on the NAIC Model Credit for Reinsurance Act Credit for reinsurance typically requires: Certain mandatory contractual provisions (e.g., a proper insolvency clause) That the assuming reinsurer be licensed or accredited in the state of domicile of the ceding company or post a letter of credit or establish a reinsurance trust Some states allow certified reinsurers to post less than 100% collateral based on their ratings 24

26 Bulk Reinsurance Many states have bulk reinsurance laws that may be triggered by a reinsurance transaction involving a large portion of the insurance business of the ceding company the thresholds for triggering the bulk reinsurance laws vary The entire business (or entire line of business) of a ceding company; All or substantially all of the business (or line of business) of a ceding company; or A specified portion of the business (or line of business) of a ceding company Bulk reinsurance laws typically require prior approval of a bulk reinsurance transaction by the insurance regulator 25

27 Withdrawal Requirements Compliance with applicable laws relating to withdrawal from a line of business Statutory requirements vary, but typically include providing the insurance regulator prior notice of the withdrawal Some states require prior approval of the insurance regulator to effect a withdrawal with respect to certain lines of business and may require a withdrawal plan to take effect over time Other states (including New York) require the posting of collateral in trust for a withdrawal from the state in its entirety 26

28 Questions? BEIJING BOSTON BRUSSELS CHICAGO DALLAS FRANKFURT GENEVA HONG KONG HOUSTON LONDON LOS ANGELES NEW YORK PALO ALTO SAN FRANCISCO SHANGHAI SINGAPORE SYDNEY TOKYO WASHINGTON, D.C. 27

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