US and European Insurance/Reinsurance Issues Arising Out of the Credit Market Turmoil

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1 Insurance/Reinsurance October 14, 2008 US and European Insurance/Reinsurance Issues Arising Out of the Credit Market Turmoil On October 10, 2008, the turmoil in the financial markets claimed its second insurance casualty when the Japanese insurer, Yamato Life Insurance Co., filed for bankruptcy. This followed steep declines in its asset values, resulting in its insolvency. 1 On the same day, stock markets around the globe suffered some of their worst losses, with the FTSE 100 falling more than 10% in early trade, the Nikkei 225 Average falling 9.62%, and the Dow Jones Industrial Average losing 600 points at one time. The turmoil in the credit markets, originally confined to the sub-prime segment but now spreading to other areas, shows no clear sign of recovery. This is despite unprecedented action by authorities around the world. The purpose of this briefing is to highlight some of the key global issues in the context of insurance and reinsurance, and the insurance and reinsurance industries, that have arisen from what has been described as the worst financial crisis since the Great Depression. 1 United States The impact of credit turmoil on the insurance industry, including the near-collapse of one of the largest insurance companies in the world, American International Group, Inc. ( AIG ), has led to renewed proposals for significant change in the way insurance is regulated in the United States; a revamping of the regulation of monoline insurers; and 1 Komaki Ito, Tomoko Yamazaki, Yamato Life Files for Bankruptcy, Citing Investments, BLOOMBERG, Oct. 10, 2008, a controversial attempt by the state insurance regulator to classify certain credit default swaps ( CDSs ) as insurance. 2 Renewed proposals to federalize insurance regulation The ongoing credit crisis has revived a long standing discussion in the United States about who should regulate insurance companies. Under the McCarran-Ferguson Act of 1945, Congress left the regulation of insurance to the individual states. In March 2008, the US Department of Treasury, in its Blueprint for a Modernized Financial Regulatory Structure (the Blueprint ), suggested the creation of an optional federal charter for insurance companies and the creation of a Commissioner of National Insurance. The proposal has been opposed by the National Association of Insurance Commissioners ( NAIC ) but supported by other industry groups. 2 A CDS is a privately negotiated contract in which one party (the protection buyer ), pays a fee to the other party (the protection seller ), in return for the right to receive a payment from the protection seller (or deliver a qualifying obligation to the protection seller in exchange for its par value) if certain credit events, such as a default, occur in respect to the obligations (the reference obligations ) of a third party (the reference entity ). NYDOCS02/

2 2 The debate was recently amplified by the near-collapse and federal take-over of AIG in September 2008, with leading senators and representatives from both parties jointly calling for the establishment of a federal insurance regulator. 3 The NAIC responded by pointing out that AIG s 71 state-regulated insurance companies are financially sound and that its problematic financial products division, originator of the CDSs that led to AIG s difficulties, was under the oversight of a federal regulator. 4 Eric Dinallo, the state insurance commissioner, testified before Congress that AIG s problems came from its parent company and from its non-insurance operations, which are not regulated by or any other state. The outcome of the Blueprint proposal remains to be seen. There are at least two bills in Congress that address some aspect of federal insurance regulation, including H.R. 5840, introduced April 7, 2008, which establishes an Office of Insurance Information capable of advising on and establishing federal policy on state and international insurance regulation; and H.R. 3200, introduced July 26, 2007, which establishes an Office of National Insurance in order to supervise national insurers and agencies, with the aim of streamlining insurance products for consumers. However, all bills are expected to be on hold until after the November elections, in which all representatives and over one third of senators are up for reelection. Tightened regulation of monoline insurers The inability of financial guaranty (or monoline ) insurers to meet obligations relating to non-performance of securities backed by mortgages and other assets has been one of the known precipitators of the credit crisis. Such entities are known as monoline insurers because, under state insurance law, they may only 3 John Sununu, Tim Johnson, Melissa Bean and Ed Royce, Insurance Companies Need A Federal Regulator, Wall St. J., Sept. 23, Sandy Praeger, AIG s Problem is Not Insurance Regulation by States, Wall St. J., Sept. 26, insure repayment of third-party debt and may not insure any other obligations. In the fall of 2007, the State Department of Insurance (the Department ) developed a three-part plan to address the serious challenges recently faced by the bond insurance industry. The Department states that it has: encouraged the entry of additional, well-capitalized insurers into the monoline market and facilitated capital raising by existing insurers; protected policyholders and the public by helping financially distressed monolines to develop workable solutions to stave off adverse financial impact and further ratings deterioration; and worked to develop new standards to which the financial guaranty business should adhere. As part of this process, the Department embarked on a rescue effort of most of the monoline insurers to permit their obligations relating to municipal bonds to remain viable. For example, in August 2008, financial guaranty insurer MBIA Inc. reinsured a $184 billion portfolio of municipal bonds insured by rival Financial Guaranty Insurance Co. under a cut through transaction brokered by the Department. Most recently, as part of Circular Letter No. 19 (2008) issued September 22, 2008, the Department set forth best practices which the superintendent expects monoline insurers to adhere to. According to those best practices, monolines should significantly restrict the issuance of policies that back collateralized debt obligations ( CDOs ) of asset backed securities ( ABSs ). In particular, monoline insurers generally may not: insure ABSs that are collateralized by successive pools of ABSs, so as to create several layers of securitization between the debt security insured by the monoline insurer and the mortgage or other obligation ultimately backing the security; 5 or 5 An exception exists if the monoline insurer, known as an FGI, meets any of the following four criteria:

3 3 issue policies on CDOs, except in very limited transactions, for example where the insurer is not required to post collateral and where the credit event being insured is limited to a default under the reference obligations instead of mere changes in credit rating and the like. The Department also strongly criticized the practice of monoline insurers using minimally capitalized special purpose vehicles ( SPVs ) to write the CDSs and guarantee the obligations of the SPVs. The Department intends to promulgate regulations or seek legislation, as necessary, to formalize these guidelines. In light of current market conditions, issuance by monolines of new polices on ABSs or CDOs is expected to be substantially reduced. Therefore, it is important to examine the proposed best practices in light of the Department s recent decision to treat sellers of certain CDSs as monoline insurers for regulatory purposes. Treatment of CDSs On September 22, 2008 the Department announced that, as of January 1, 2009, it would begin treating certain CDSs as insurance contracts. The Department s communication announcing the change, Circular Letter No. 19 (2008), appears to group sellers of certain CDSs in the same category as monolines, referred to by the Department as financial guaranty insurers ( FGIs ), which are currently regulated, as described above. CDSs were previously not considered to be insurance contracts for the purpose of the Insurance Law, on the grounds that the payment by the protection seller is not conditioned on the incurrence of an actual pecuniary loss by the protection buyer. Based on public statements and the Circular, the Department is expected to issue new guidance that, when the buyer of the CDS holds or reasonably expects to hold a material interest in the underlying security on which he is buying protection (that is, in covered CDS contracts), then the swap is an insurance contract under the existing statutory definition. 6 Accordingly, such swaps could be subject to state insurance regulation and therefore could only be issued in state by sellers licensed to conduct insurance business. Based on its public statements, the Department would not purport to regulate so called naked CDSs, where the buyer of the CDS does not own the underlying security on which it is buying protection. 7 Under the new approach, sellers of these kinds of covered CDSs would likely be financial guarantee insurers and would accordingly be required to maintain sufficient capital (as determined by Department regulation) to minimize the risk of default on the obligations under the CDS, and to subject themselves to substantial regulation. There is some ambiguity as to whether the Department s new approach applies before January 1, Although a press release from s governor refers to an effective date of January 1, 2009, the Circular Letter itself states with today s Circular Letter the protection seller should consider seeking an opinion from the Department s Office of General Counsel to assess whether the protection seller should be licensed as an insurer the insurance policy provides that the FGI holds an unsubordinated, senior position, provided such position has an investment rating of single-a or above; the pool consists solely of asset-backed securities that are issued or guaranteed by a government-sponsored enterprise, Federal National Mortgage Association, Federal Home Loan Mortgage Corporation, the Federal Agricultural Mortgage Corporation, or the Farm Credit Insurance Fund; the pool consists entirely of the portion of other pools of asset-backed securities that are already insured by the FGI, so that no additional obligations are incurred by that FGI; or the Superintendent has determined that the insurance is without undue risk to the FGI, its policyholders, and the people of the State of. 6 An insurance contract is defined by Section 1101 of the Insurance Law as any agreement or other transaction whereby one party, the insurer, is obligated to confer benefit of pecuniary value upon another party, the insured or beneficiary, dependent upon the happening of a fortuitous event in which the insured or beneficiary has, or is expected to have at the time of such happening, a material interest which will be adversely affected by the happening of such event. 7 The Department has urged that naked CDS be regulated at the federal level.

4 4 Numerous concerns arise in relation to state insurance regulation of the CDS market, including that the approach: gives rise to the administrative difficulty of implementation and differentiation between insurance and non-insurance CDSs in large organizations; causes issues with the statutory and common law meaning of insurance, which across the common law world has been taken not to apply to CDSs since the holder of a CDS is entitled to claim whether or not he has an insurable interest or suffers a loss; may undercut or complicate proposals to create a central clearing house for the over-the-counter CDS market, since the clearing house may be required to assume insurer status to deal in insurance CDSs; may be inconsistent with existing risk reduction mechanisms, including netting and the posting of collateral; separates insurance and non-insurance CDSs in a way that does not track how the market currently works; has the potential to drive the private, over-thecounter derivatives market offshore to or other financial centers; and will potentially lead to attempts at regulation by other state insurance regulators and a further balkanization of regulation that would complicate a national and global business. If the CDS market is to be regulated, it would better be handled uniformly at the federal level. More generally, CDSs also fall outside the definition of a security for the purposes of US securities laws (though they may be subject to anti-fraud and related provisions applicable to securities). The Securities and Exchange Commission ( SEC ) on September 23, 2008 exhorted Congress to confer authority upon the SEC to regulate CDSs within the definition of securities. Other regulators, including the Federal Reserve and the Commodity Futures Trading Commission, have also taken an interest in the credit derivative markets. The question of appropriate oversight may end up being determined as part of regulatory reform proposals more generally. Europe For the vast majority of insurers in Europe (with the exception of monoline insurers), exposure to structured credit products has been quite limited. Accordingly, there are no urgent concerns about any deterioration of their portfolios as has been the case with institutions that bought mortgage-backed securities or CDO-type products. 8 Monolines European affiliates of US-based mortgage insurers and monolines potentially bear considerable exposure to the credit turmoil. 9 Several major affiliates (located primarily in the UK) have seen their ratings downgraded during Q2 and Q in line with their US parents. The downgrades in themselves generally do not trigger either a contractual default on the part of the monoline or an obligation to post collateral. However, the wider market turmoil does raise a number of immediate and longerterm issues for monolines. Immediate concerns include that: on October 10, 2008, CDSs guaranteeing debt issued by Lehman Brothers were given a date of October 21, 2008 by which to make payouts on Lehman CDS, at a price of cents on the dollar Report on issues regarding the valuation of structured credit products, COMMITTEE OF EUROPEAN INSURANCE AND OCCUPATIONAL PENSIONS SUPERVISORS ( CEIOPS ), Aug. 2008, %20CEIOPS%20Report%20on%20Valuation%20Issues%20_ pdf. 9 Spring 2008 Report on financial conditions and financial stability in the European Insurance and Occupational pension fund sectors , CEIOPS, May 2008, FS pdf. 10 Serena Ng, Emily Barrett, Jacob Bunge, Lehman Swap Payments Look Bigger Than Expected, Wall St. J., Oct. 11, 2008.

5 5 there is uncertainty over the extent to which further claims will arise under monoline guarantees; and an increase in bank or corporate failures whose debt was guaranteed by monolines may result in payout obligations that monolines are unable to honor. In the longer term, there are concerns that the downgrading of monolines will drive down the value of the underlying bonds and dampen demand for bond insurance in Europe. More positively, it is worth noting that under the EU s proposed Solvency II capital adequacy regime for the European insurance industry (see below), insurers and reinsurers would be able to use insurance securitization, in the same way as reinsurance, to meet capital requirements. These rules should have a positive effect on supply and facilitate the development of the insurance securitization market and possibly the credit protection often bundled with such securities. The monoline industry is not as developed in Europe as in the US, with the EU regulators describing the number of monoline undertakings in Europe as small. It should also be noted that (in England at least and other non-us common law jurisdictions) CDS business is not currently regulated as insurance business, because CDSs are not generally regarded as being contracts of insurance (assuming they are structured to pay out whether or not the protection buyer suffers a loss). A statutory definition of insurance is currently under review by the UK law commissions, but this is a general project and not a specific response to the role of CDSs in the credit crunch. General insurance: increase in claims It has been reported that, from January 2007 to March 2008, 448 sub-prime related lawsuits had been brought in the US, with a substantial surge in filings in Q It would be surprising if a significant proportion of these did not bring into play errors and omissions, or directors 11 Insurance & Reinsurance Law Briefing, Issue 141/142, Aug at 1. and officers, liability insurance. There would be an impact on European insurers with US exposures. General insurance: deteriorating portfolios The treasury portfolios of many insurers include holdings of credit instruments and related structured finance products, which form an asset class that has recently been subject to significant writedowns. However, there are a number of reasons to feel cautiously optimistic about the potential impact of these writedowns: it has been estimated that only 2%-10% of firms risks are in such products (some of which includes risks that are borne by policyholders); 12 in May 2008, Standard & Poor s stated that the insurance operations of European financial institutions had to date revealed sub-prime markto-market losses of $7 billion, and expressed confidence that this had had a relatively minor impact on individual insurance companies; 13 and the committee of European insurance regulators reacted to the failure of Yamato Life Insurance Co. on October 10, 2008 by stating in a press release later that day that no similar failure was foreseen in Europe. 14 Nonetheless, asset price deflation and the economic downturn are likely to have some effect on European insurers. For example: 12 Spring 2008 Report on financial conditions and financial stability in the European Insurance and Occupational pension fund sectors , CEIOPS, May 2008, FS pdf. 13 Further, a survey of insurers treasuries conducted by EU insurance regulators in March 2008 suggested that total net exposure to structured credit products represented 2.8% of the total assets held by the firms that it surveyed. 14 CEIOPS comments on turmoil and current equity developments, CEIOPS, Oct. 10, 2008, 10%20Press%20Release,%20CEIOPS%20comments%20on%20Market%20 Crisis.pdf.

6 6 firms may have to scale back on business, raise premiums and/or raise capital from investors to repair their balance sheets; firms ability to raise premiums may well be constrained if the economy goes into recession; and capital raising by way of rights issues will also be increasingly difficult if insurers stock prices continue falling. Solvency II Solvency II is a fundamental review of the EU capital adequacy regime for the insurance industry to replace the existing Solvency I regime. So wide-ranging are the proposed reforms that Standard & Poor s has remarked that Solvency II will have a greater effect on the European insurance sector than the US sub-prime crisis, with perhaps over 25% of Europe s insurers required to reevaluate their businesses. Solvency II consists of three pillars setting out: (1) valuation standards for liabilities to policyholders and capital requirements; (2) the supervisory review process, as part of which supervisors may decide a firm should hold additional capital over and above the normal requirements; and (3) disclosure obligations regarding certain details of risks, capital and risk management. greater public disclosure of information; and strengthened role for group supervisors, enabling insurance groups to be managed as a single economic entity. The European Commission adopted the proposal for Solvency II in July 2007, before most of the key events of the current financial turmoil. Whilst there is currently speculation in the financial press that regulators may have to postpone implementation due to market conditions, 15 the European authorities have not announced any intention to postpone; indeed, the European Economic and Monetary Affairs Committee agreed a text for a framework directive for Solvency II on October 7, The response from the industry has been mixed: CEA, the European insurance and reinsurance federation, welcomed the move, arguing that delays to implementation would send the wrong message to consumers at a time of market turmoil; 16 but other industry leaders have questioned the wisdom of implementing it at a time of market crisis. 17 We must wait for the debate to unfold and to review the final form in which the directive is adopted. The key changes from Solvency I are: more risk-sensitive and sophisticated economic risk-based solvency requirements; total balance sheet approach to solvency requirements that takes account of asset-side risks as well as insurance risks, with capital to be held against market risk, credit risk and operational risk; requirement on insurance firms to focus on and devote significant resources to the identification, measurement and proactive management of risks; introduction of the Own Risk and Solvency Assessment and Supervisory Review Process, to enable insurers and supervisors to identify risks better and earlier; 15 Nikkit Tait, Insurers fight for supervision scheme, Financial Times, Oct. 7, CEA welcomes European Parliament committee vote on Solvency II, EUROPEAN INSURANCE COMMITTEE, Oct. 7, 2008, 17 Doubts over Solvency II in financial crisis, INSURANCE TIMES, Oct ,

7 7 This memorandum is intended only as a general discussion of these issues. It should not be regarded as legal advice. We would be pleased to provide additional details or advice about specific situations if desired. If you wish to receive more information on the topics covered in this memorandum, you may contact your regular Shearman & Sterling contact person or any of the following: David J. Beveridge Christopher J. Cummings Toronto Adam M. Givertz Toronto Geoffrey B. Goldman Jonathan L. Greenblatt Washington, DC Stephan Hutter Frankfurt Roger Kiem Frankfurt Jason Lehner Toronto Thomas S. Martin Washington, DC Douglas R. McFadyen Robert H. Mundheim Barnabas W B Reynolds Josanne Rickard Joanna Shally Tommaso Tosi Rome Henry Weisburg Aatif Ahmad James Brilliant Carl B. McCarthy LEXINGTON AVENUE NEW YORK NY Shearman & Sterling LLP. As used herein, Shearman & Sterling refers to Shearman & Sterling LLP, a limited liability partnership organized under the laws of the State of Delaware.

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