SIDLEY GLOBAL INSURANCE REVIEW

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1 SIDLEY GLOBAL INSURANCE REVIEW March 2014

2 SIDLEY GLOBAL INSURANCE REVIEW March 2014 The insurance industry has a global reach. Insurers and reinsurers are critically important to the world economy. They assume and transfer all manner of risk from every corner of the earth and serve as an enormous investor base. Risk is increasingly shared globally among traditional and new market entrants. Risk generated in one part of the world is distributed immediately across multiple continents to other market participants, whether they be other insurers, reinsurers, private equity sponsors, hedge funds, or capital market investors. This constantly evolving industry requires regulatory regimes to adapt on a frequent basis. Regulatory issues arising in one market may influence the way in which similar regulatory concerns are addressed elsewhere. To operate competently within the insurance industry, one must have a solid understanding of global developments. We realize that no one publication could provide adequate coverage to each and every recent global development without becoming cumbersome. Accordingly, this publication attempts to provide an overview of major legal developments in this global industry arising over the past year. We have focused on developments in the United States, United Kingdom, European Union, Asia and other markets with intense insurance activity, such as Bermuda. This review has been produced by the Insurance and Financial Services Group of Sidley Austin LLP. Sidley is one of the world s premier law firms, with approximately 1,800 lawyers and 19 offices in North America, Europe, Asia and Australia. Sidley is one of only a few internationally recognized law firms to have a substantial, multi-disciplinary practice devoted to the insurance industry. We have more than 100 lawyers devoted to providing both transactional and dispute resolution services to the insurance industry, throughout the world. Our Insurance and Financial Services Group has an intimate knowledge of, and appreciation for, the insurance industry and its unique issues and challenges. Regular clients include many of the largest insurance and reinsurance companies, their investors and capital providers, brokers, banks, investment banking firms, and regulatory agencies, for which we provide regulatory, corporate, capital markets, securities, M&A, private equity, insurance-linked securities, derivatives, tax, reinsurance dispute, class action defense, insolvency and other transactional and litigation services. We hope you enjoy the Sidley Global Insurance Review. Attorney Advertising - For purposes of compliance with New York State Bar rules, our headquarters are Sidley Austin LLP, 787 Seventh Avenue, New York, NY 10019, ; One South Dearborn, Chicago, IL 60603, ; and 1501 K Street, N.W., Washington, D.C , Sidley Austin refers to Sidley Austin LLP and affiliated partnerships as explained at Prior results do not guarantee a similar outcome. This Global Insurance Review has been prepared by Sidley Austin LLP for informational purposes only and does not constitute legal advice. This information is not intended to create, and receipt of it does not constitute, an attorney-client relationship. Readers should not act upon this without seeking professional counsel Sidley Austin LLP and Affiliated Partnerships (the firm ). All rights reserved. The firm claims a copyright in all proprietary and copyrightable text in this report. i

3 Table of Contents I. The Global Mergers & Acquisitions Market...1 U.S. Market...1 Life and Annuity...1 Regulators React to Acquisitions by Financial Buyers...1 Outlook for Financial Buyers...2 Disposition of Non-Core Assets by European Insurers...3 Interest in Variable Annuity Business...3 U.S. Insurers Look Overseas...3 No Significant Pension De-Risking Transactions in Property & Casualty...4 Acquisitions of Bermuda Reinsurance Companies...4 Distressed Company Activity...5 Excess and Surplus Lines Activity...5 Canadian Activity...6 Health...7 Continued Consolidation in the Medicaid and Medicare Managed Care Segments...7 Formation of Integrated Healthcare Systems and Other Alternative Partnership Arrangements...7 Blue Cross Blue Shield Conversions...8 C.V. Starr s Acquisition of MultiPlan...8 Insurance Intermediaries...8 Outlook for European and Asian Market...9 Europe...9 Asia Pacific...10 II. The Global Alternative Risk Transfer Market...10 Life Insurance Market...10 NAIC...11 Captive White Paper...11 Rector Reports...11 RBC Activity...12 FAWG...12 Accreditation...12 State Regulatory Developments...13 Federal Regulatory Developments...13 Outlook for ii

4 Property & Casualty Insurance Market...14 Catastrophe Bonds...14 Traditional Reinsurers in the Insurance-Linked Securities ( ILS ) Market...15 Hedge Fund Activity...16 Outlook Ahead...16 III. The Global Longevity Market...16 Transaction Structures...16 Buy-Outs...17 Buy-Ins...17 Longevity Swaps...17 Index-Based Trades...17 Market Overview...18 Increased Regulatory Scrutiny...18 IV. The Global Capital Markets...19 United States Markets...19 United States Legal and Other Developments...20 Impact of European Market Infrastructure Regulation on European Insurance Companies...22 Reporting...22 Record Keeping...22 Clearing...22 Risk Mitigation Techniques...23 V. Global Regulatory and Litigation Developments...25 Introduction...25 United States Federal Regulatory Developments...25 Treasury/FSOC Activities...25 Federal Insurance Office...26 Other Federal Initiatives...28 Volcker Rule...28 TRIA...28 NARAB II...28 Derivative Transactions...29 United States State and NAIC Developments...30 Health Insurance Regulation...30 Principles-Based Reserving...31 PBR Implementation...31 Use of Reinsurance Captives to Finance Reserves Required Under Regulation XXX and Regulation AXXX...33 iii

5 Captives and Captive Reinsurance Transactions...34 Reinsurance...35 Solvency and Corporate Governance Initiatives...35 Corporate Governance Working Group Activities...36 Holding Company Act and Related Changes in Law...36 Enterprise Risk Management...37 Own Risk and Solvency Assessment...37 Capital Adequacy...37 Private Equity Issues...38 Force-Placed Insurance...39 Unclaimed Property...40 State Bills based on NCOIL Unclaimed Life Insurance Benefits Model Act...40 NCOIL Forms Task Force to review Unclaimed Property Matters in Life and Annuity Industries and NAIC (A) Committee Will Study the Issues...40 Litigation...40 Settlements with Insurance Regulators and Unclaimed Property Agencies...41 DMF Restrictions in Federal Budget for Invested Assets...42 Working Capital Finance Programs...42 Capital Efficient Solutions...43 Mortgage Guaranty Insurance...44 Federal Home Loan Bank Loans and Advances to Insurance Companies...45 Contingent Deferred Annuities...46 International (Non-U.S.) Insurance Issues...46 IAIS...46 IAIS Transparency...47 Global Capital Standards...47 ComFrame...47 Solvency II...47 Implementation Set for Non-EU Country Solvency II Equivalence...48 IAIS Global Insurance Capital Standard - Complementary or Conflicting to Solvency II? FSA Reorganization Update...49 Evolution of UK Regulation...49 Finding their Footing...50 Lloyd s Developments...51 iv

6 Cyber Risk/Data Protection Update...51 EU Data Protection Reform and Cyber Security Developments...52 Insurance is the Answer?...53 Brokers Duties and the Insurance Mediation Directive...53 The FCA s Thematic Review...54 Revision of the Insurance Mediation Directive New Remuneration Disclosure Provisions EU/UK Competition Law Enforcement Activity...55 DG Comp...55 Court of Justice judgment in Allianz Hungaria Case Confounds Experts...56 National Level Enforcement in the UK...56 Car Insurance Market Investigation Progresses and Involves Price-Comparison Websites Workplace Pensions Market Study Closed...56 FCA Review of Annuities and General Insurance Add-On Products...57 Asia Regulatory Developments...57 China: Progress on New Solvency Capital Regime...57 CIRC Continues its Financial Liberalization of the Insurance Sector...57 Relaxation of Rules on Equity Investment into the Chinese Insurance Sector...57 CIRC Raises Limits on Investments by Chinese Insurers into the Equity and Real Estate Markets Following Expansion of Permitted Overseas Investment in Launch of the Shanghai Pilot Free Trade Zone...58 Bancassurance in China: Regulators Tighten Requirements...59 VI. Select Tax Issues Affecting Insurance Companies and Products...59 Prospects for Tax Reform...59 FATCA...60 Cascading Federal Excise Tax...61 Alternative Reinsurance...61 Property and Casualty Tax Controversies Loss Reserves...61 Insurance Tax Controversies Timing of Dividends...62 Limitations on What Constitutes Insurance for Tax Purposes...62 Extension of the UK Investment Manager Exemption...62 Financial Transaction Tax...63 UK Taxation of Corporate Debt...63 VAT and Cross-Border Supplies of Services...63 v

7 I. The Global Mergers & Acquisitions Market A. U.S. Market 1. Life and Annuity Relatively few major life insurance acquisition transactions were announced in 2013, and despite a few notable transactions, none could reasonably be characterized as a blockbuster. Of greatest note were (i) SCOR s acquisition of Generali s U.S. life reinsurance operation (US$910 million), (ii) Resolution Life Holdings acquisition of Lincoln Benefit Life Company from the Allstate Corporation (US$600 million), (iii) Protective Life s acquisition of MONY Life Insurance Company from AXA Financial (US$1.1 billion), and (iv) Global Atlantic s acquisition of Aviva USA s life insurance operations (purchase price not disclosed). Wilton Re also recently entered into agreements to acquire CNA Financial Corp. s life and group insurance business (US$615 million) and Conseco Life Insurance Company, a subsidiary of CNO Financial Group, Inc. As part of the latter agreement, Wilton Re agreed to acquire US$3.4 billion of closed-block interest-sensitive and traditional life and annuity statutory reserves and transfer all operations of the business to its administrative services platform. On the annuity side, buyers backed by private equity and other non-traditional financial buyers ( financial buyers ) largely had the field to themselves, as traditional life insurers continued to evince very limited enthusiasm for the acquisition of variable, fixed and indexed annuity businesses. The most significant annuity transactions announced or completed in 2013 all featured financial buyers with roots in the private equity or investment management world. These transactions included (i) the acquisition by Athene Holdings, Ltd. of Aviva plc s U.S. life and annuity business (and the related resale of Aviva s U.S. life business to Global Atlantic) (US$2.6 billion), (ii) Guggenheim s acquisition of Sun Life Financial Inc. s U.S. annuity business (US$1.1 billion), and (iii) Global Atlantic s acquisition of Forethought Financial Group, Inc. (purchase price not disclosed). In addition, Berkshire Hathaway (in many respects akin to a financial buyer) acquired variable annuities issued by CIGNA through an assumption reinsurance transaction (US$4.0 billion) and Hartford s UK variable annuity business (US$285 million). Notwithstanding the relatively modest numbers posted on M&A league tables in the life and annuity sector for the year, 2013 was notable for a number of significant developments and potential trends that bear watching in a. Regulators React to Acquisitions by Financial Buyers As in 2012, financial buyers continued to drive mergers and acquisitions activity in the life insurance and annuity sector in The inhospitable interest rate environment of recent years has prompted insurers to put underperforming blocks of business such as fixed annuity lines up for sale, and few traditional insurers have aggressively pursued these businesses. Those that have expressed interest have generally been at a competitive disadvantage to financial buyers, which by and large have assigned higher valuations to the target businesses. One factor perceived to attract financial buyers to these transactions is the potential to realize efficiencies and higher investment returns through the application of such buyers sophisticated investment management expertise and hedging capabilities to the substantial investment portfolios backing the annuity reserves of the acquired businesses. The increasing participation of financial buyers in life and annuity acquisitions has not gone unnoticed by insurance regulators, and in that regard, 2013 was in some respects a watershed year. For some time, insurance regulators have voiced concern about the possibility that financial buyers may take a more aggressive approach to the management of insurers investment portfolios and the concomitant risk to policyholders. These concerns were voiced in May 2013, when the New York State Department of Financial Services ( NYSDFS ) announced its issuance of subpoenas to a number of leading private equity and other financial firms soliciting financial and other information relating to their involvement in the New York life insurance industry. These firms included Guggenheim Partners LLC, Apollo Global Management LLC, Athene Holding Ltd., Goldman Sachs Group Inc., Global Atlantic Financial Group and Harbinger Group Inc. The NYSDFS expressed concern that these firms may undertake excessive risk and focus on short-term investment gains at the expense of the long-term interests of policyholders of their affiliated insurance companies. 1

8 Later in the year, the scrutiny of the NYSDFS found more concrete expression in the context of the two most prominent acquisitions involving financial buyers completed in 2013: Guggenheim s acquisition of Sun Life Financial Inc. s U.S. annuity business, closed on August 2, 2013, and the acquisition by Athene Holding Ltd. (an affiliate of Apollo Global Management LLC) of Aviva plc s U.S. life and annuity business, closed on October 2, NYSDFS approval of each transaction was conditioned on the buyers agreement to certain heightened policyholder protections proposed by the NYSDFS. In each transaction, the acquirer agreed to the following conditions: the acquirer would maintain the Risk-Based Capital ( RBC ) levels of the acquired company s New York insurer at an amount not less than 450%; the acquirer would establish a backstop trust account (to be maintained for seven years) containing a specified amount of cash (US$200 million in the case of Guggenheim, and approximately US$35 million in the case of Athene) to replenish the RBC levels of the acquired company s New York insurer should they fall below 450%; any material changes in the acquirer s plan of operations for the acquired company s New York insurer would require the prior approval of the NYSDFS; and the acquired company s New York insurer would file quarterly RBC reports (in addition to the annual reports required under the New York Insurance Law), and would disclose necessary information concerning corporate structure, control persons and other information regarding the operations of the company. Additionally, the Iowa Insurance Division (the IID ) conditioned its approval of the Aviva transaction upon Aviva s not paying dividends or distributions for five years, changing its plan of operations, or making investments, payments or agreements with an affiliate without commissioner approval. Further, the IID required Aviva to reserve for all non-variable deferred annuities containing guaranteed minimum death benefits or withdrawal benefits using the more conservative accounting guidelines (AG 33 rather than AG 43). Athene also voluntarily agreed to increase policy reserves by an additional US$150 million and to enter into a capital management agreement with respect to its RBC requirements in Iowa. (It is notable, however, that none of these regulatory requirements placed any heightened restrictions on the investment management activity of these buyers despite the investment management-related concerns initially voiced by the regulators.) The NYSDFS recently announced that it intends to promulgate regulations to formalize these conditions in the context of life insurer acquisitions by financial buyers. On the national level, a working group of the National Association of Insurance Commissioners (the NAIC ) has also been established to consider these issues, as to which NAIC members have thus far expressed varying views. (Please see Section C.6 of Global Regulatory and Litigation Developments below.) b. Outlook for Financial Buyers If, as many observers expect, the heightened policyholder protections that are ultimately promulgated by the NAIC, the NYSDFS or other states are broadly in line with those imposed in the Aviva and Sun Life transactions, we would not expect them to drive financial buyers from the market or materially diminish such buyers interest in life and annuity M&A. We expect financial buyers to continue to play a significant role in overall transactional activity in the life and annuity sector, especially in view of their evident willingness to tackle the regulatory and capital challenges that such transactions present. It remains to be seen, however, how evolving market conditions (especially with respect to the expected rise in interest rates) will alter the calculus, particularly in the context of fixed annuities. Financial buyers will also be paying close attention to recent regulatory developments that could affect the economics and the structure of acquisitions, including regulatory developments as to the use of reinsurance captives, reinsurance to unauthorized reinsurers and principles-based reserving, all of which are discussed in detail in Section A of The Global Alternative Risk Transfer Market and Sections B.2 and B.3 of Global Regulatory and Litigation Developments. 2

9 While financial buyers have come under unprecedented regulatory scrutiny in recent years, they have in fact proven thus far to be a source of stable and committed capital. Indeed, as the participation of financial or non-traditional buyers in the life and annuity sector has expanded in recent years, some of the distinctions between such buyers and more traditional strategic players have become harder to divine, and it is clear that the more seasoned financial buyers possess substantial industry expertise and a long term perspective that belies some of the stereotypes about private equity. If that distinction continues to blur and financial buyers continue to demonstrate that they are longterm, committed fixtures in the life and annuity community, the concerns that have heretofore driven regulators to single out financial buyers for enhanced scrutiny could begin to subside. c. Disposition of Non-Core Assets by European Insurers Two significant transactions continued a recent trend of European insurers exiting from, or reducing their exposure to, the U.S. market. In October 2013, as we have noted, Aviva plc completed the sale of its U.S. life and annuity business to Athene, and Generali completed the sale of Generali U.S. Holdings, Inc., the holding company of Generali s U.S. life reinsurance operations, to SCOR. It will be interesting to see whether the factors that have lately driven European insurers to shed U.S. businesses remain relevant in d. Interest in Variable Annuity Business Two notable transactions announced by Berkshire Hathaway in 2013 signaled a potential increase in activity involving variable annuities. In a US$2.2 billion reinsurance transaction, Berkshire Hathaway agreed to assume up to US$4.0 billion of future claims with respect to guaranteed minimum death benefit and guaranteed minimum income benefit exposures under annuities issued by CIGNA. In a separate transaction, Berkshire acquired Hartford s UK variable annuity business for approximately US$285 million. The acquired subsidiary reportedly had approximately US$1.7 billion of assets under management at the time of the transaction. Perceived volatility has traditionally deterred potential buyers of variable annuity businesses. However, among buyers such as Berkshire Hathaway with substantial balance sheets that are better able to handle financial statement volatility, there is the potential for future mergers and acquisitions activity in this space. Recent transactions involving buyers with more modest balance sheets (including Kansas City Life Insurance Company s assumption of American Family Insurance Company s variable life insurance policies and variable annuities) suggest that activity in this space may not be confined to the financial buyers and Berkshire Hathaways of the marketplace. As interest rates trend upwards and the securities markets improve, it will be interesting to see if the mergers and acquisitions market for issuers of variable annuities develops and if strategic buyers return to the fray. Going forward, with improved investment portfolio performance as well as the expectation of rising interest rates, issuers of annuities may opt to hold blocks of business that were previously considered for the auction block. In addition, many insurers have reformed product features, such as guaranteed benefits and surrender charges, which contributed to the development of distressed books in previous years, and may accordingly be emboldened to write additional business rather than explore exit strategies from the annuity space. These developments could limit the movement of large blocks of annuity business that bolstered activity in recent years. e. U.S. Insurers Look Overseas Subject to a few exceptions, the slow pace of consolidation of U.S. life insurance assets has continued in To the extent that U.S. strategic buyers looked for growth through acquisitions, their focus continued to be on emerging markets. For example, Prudential recently completed its acquisition (announced in 2013) of the Malaysian life insurer Uni.Asia Life Assurance Berhad s through a 70/30 joint venture with Bank Simpanan Nasional, a Malaysian bank that will distribute Uni. Asia s products through its bank branches. In a similar vein, in December 2013, MetLife reached an agreement with Malaysia-based AMMB Holdings to acquire fifty-one percent of its stake in AmLife Insurance Berhad and forty-nine percent of AmFamily Takaful Berhad. AMMB would continue to hold forty-nine percent and fifty-one percent of the companies, respectively, in a continuing strategic 3

10 partnership. As a part of the partnership, AmLife and AmTakaful will also enter into exclusive 20- year bancassurance and bancatakaful agreements for the distribution of life insurance and family takaful products through the distribution network of certain of AMMB s banking subsidiaries. These transactions demonstrate the continuing attractiveness of the Southeast Asian market and the importance of bank channels for product distribution in such markets. In Latin America, emerging markets expansion by one life insurer took different form, as MetLife, which already boasts a substantial presence in the region, completed its acquisition of Chilean pension manager AFP Provida SA for approximately US$2 billion. We anticipate that well-capitalized U.S. life carriers will continue to focus more on emerging markets and less on domestic consolidation in order to stimulate top-line growth in Asia and Latin America are expected to remain the most popular targets, as buyers seek to expand their distribution channels through acquisitions as well as strategic partnerships. f. No Significant Pension De-Risking Transactions in 2013 In 2012, Verizon and General Motors each transferred significant pension liabilities to Prudential Financial following an M&A-style auction process. At the time of these transactions, the view was expressed from some quarters that these transactions heralded a wave of similar activity in the U.S. However, since then, in contrast to the activity in the UK market, no similar deals of comparable scale have been announced in the U.S. It remains to be seen whether economic conditions in 2014 will be conducive to an expansion of the U.S. market for such transactions. See The Global Longevity Market in Section III of this Report for a detailed discussion of developments in the pension de-risking and longevity risk transfer market. 2. Property & Casualty As was the case in 2012, activity in the property and casualty sector was sluggish in Although there were few blockbuster transactions in 2013, several areas of the property and casualty market saw steady activity throughout For example, several transactions involving Bermuda-based reinsurance companies, excess and surplus lines providers and Canadian businesses were announced in In addition, reserve deficiency issues and ratings-agency pressures gave rise to acquisition opportunities for certain property and casualty insurers. Finally, transaction flow involving the acquisition of insurance intermediaries continued to be strong in a. Acquisitions of Bermuda Reinsurance Companies With the exception of a few noteworthy acquisitions, despite improved price-to-book ratios for many Bermuda-based reinsurers, overall activity in the historically competitive Bermuda marketplace was relatively quiet in Amidst the generally low level of deal-making activity involving Bermuda property and casualty companies, one high point was the announced acquisition of SAC Re Ltd. by a group led by hedge fund Two Sigma Investments, LLC. Additionally, in a continuation of the 2012 trend of transactions involving buyers specializing in the management of run-off blocks of business, runoff consolidators Enstar Group Limited and Catalina Holdings (Bermuda) Ltd each closed multiple acquisitions involving Bermuda targets in In December 2013, SAC Capital Advisors announced that it had agreed to sell SAC Re for US$625 million to Hamilton Insurance Group, Ltd., a Bermuda holding company founded in 2013 by Two Sigma and other investors with private equity and hedge fund ties. The sale of SAC Re was required as part of a plea agreement relating to insider trading allegations in which SAC Capital Advisors agreed to stop managing outside capital. Following the close of the acquisition in December 2013, Two Sigma became sole investment manager of the investible assets of Hamilton Re, Hamilton Insurance Group s operating subsidiary. Two Sigma s expansion into the property and casualty insurance sector through the acquisition of SAC Re appears to have been motivated in part by its desire to increase its assets under management at lower costs relative to traditional fundraising efforts by hedge funds. One of the more active players in the property and casualty sector in recent years, runoff specialist Enstar completed a pair of acquisitions in 2013 involving active underwriting companies with ties to Bermuda and the Lloyd s of London market. In 4

11 June 2013, Enstar signed an agreement with Arden Holdings Limited to acquire its subsidiaries Atrium Underwriting Group Limited and Arden Reinsurance Company Limited for a reported US$262.6 million. Approximately US$183 million of the purchase price was paid for Atrium, a Lloyd s managing agency and syndicate specializing in a wide range of property and casualty lines. The remaining US$79.6 million was paid for Arden Reinsurance, a Bermuda-based company that provides reinsurance to Atrium and certain other runoff blocks of business. A month later, Enstar, in a 60/40 partnership with private equity firm Stone Point Capital LLC, reached an agreement to acquire specialty insurer Torus Holdings Limited for approximately US$646 million. In connection with the transaction, Enstar and Stone Point acquired Torus Holdings six operating subsidiaries, which include Bermuda, U.S. and UK insurers and a Lloyd s managing agency and syndicate. In announcing the acquisition, Enstar revealed Stone Point had also committed to provide financing for the Atrium/Arden acquisition, leaving Enstar with a 60% stake in those companies and Stone Point with a 40% stake. Public reports regarding Enstar s acquisition of live underwriting platforms indicate that such acquisitions will bolster its ability to offer competitive bids for future runoff acquisitions, which appear to remain the core focus of Enstar s business. The Torus acquisition also appears to have been motivated in part by a desire to gain entrance to the Lloyd s market without undertaking the formation of a start-up syndicate. Another runoff specialist, Catalina Holdings was also active in the Bermuda property and casualty sector in In August 2013, Catalina Holdings announced an agreement to acquire Bermudabased American Safety Reinsurance, Ltd. for an undisclosed amount from Fairfax Financial Holdings Limited, in connection with Fairfax s acquisition of parent company American Safety Holdings Ltd. For additional information regarding the acquisition of American Safety Holdings Ltd. by Fairfax, see the Excess and Surplus Lines Activity discussion in Section A.2.c below. Then, in September 2013, Catalina Holdings announced it had agreed to acquire runoff reinsurer Alea Group Holdings (Bermuda) Ltd. from buyout firm Fortress Investment Group LLC. Catalina Holdings had previously acquired Alea s UK business from Fortress in b. Distressed Company Activity In 2013, reserve deficiencies at several property and casualty insurance companies resulted in ratings downgrades and downward pressure on the share prices of the affected companies, creating deal-making opportunities that were typified in the January 2014 announcement of the indirect acquisition of Tower Group by AmTrust Financial Services Inc. While ratings downgrades and the threat of downgrades can make it difficult for distressed companies to compete for business, declining share prices may create attractive valuations for potential buyers. Following a series of announcements in the fall and winter of 2013, Tower disclosed reserve shortfalls totaling nearly US$500 million as a result of loss development primarily associated with its workers compensation line. In January 2014, AmTrust Financial Services announced that it had reached an agreement to indirectly acquire Tower in a transaction also involving its affiliates ACP Re Ltd. and National General Holdings Corp. ACP Re, which is owned by a trust established by the founder of AmTrust Financial and National General, paid approximately US$172.1 million for Tower. Concurrently, in a series of reinsurance transactions, AmTrust Financial reached an agreement to acquire the renewal rights and assets of Tower s commercial lines for an additional US$125 million, while National General acquired the renewal rights and assets of Tower s personal lines for an undisclosed amount. In addition to Tower, property and casualty insurance companies confronting serious reserving issues in 2013 included Australian-based QBE Insurance Group Ltd. Beginning with a February profit warning, over the course of 2013, QBE announced an aggregate of more than US$1 billion in reserve deficiencies tied to its North American operations, which ultimately led to the resignation of the company s chair. c. Excess and Surplus Lines Activity Another bright spot of property and casualty mergers and acquisitions activity in 2013 was the excess and surplus lines market. Non-admitted 5

12 specialty lines, such as excess and surplus insurance products, have emerged as an attractive segment, due in part to the fact that they are less encumbered by government regulation and have more flexibility to effectively address the growing demand for coverage of unique business risks. The flexible regulatory environment and profit potential in the excess and surplus lines segment has attracted new players to the sector and has prompted existing players to expand their presence. In June 2013, Berkshire Hathaway Inc. announced that its newly formed subsidiary Berkshire Hathaway Specialty Insurance had commenced operations and would focus on providing tailored excess and surplus lines products to commercial customers. Several months later, in January 2014, Berkshire Specialty announced it had reached an agreement to acquire MyAssist Inc., a live-agent concierge and telematics service provider to a variety of travel and insurance companies, and Insure America LLC, a provider of niche insurance products to the travel industry, from privately-held Noel Group, which enhanced Berkshire Specialty s operations and distribution platforms. In addition to its planned organic expansion in the excess and surplus lines market, given the opportunities presented by market fragmentation, Berkshire Hathaway may look to continue to acquisitively build out its specialty business unit in the years ahead. As noted in the discussion of Catalina Holdings purchase of American Safety Reinsurance, in June 2013, Fairfax announced an agreement to acquire American Safety Insurance Holdings in a merger valued at approximately US$306 million (the transaction was approved by the target s shareholders in August 2013). Previously, in June 2013, American Safety had announced an agreement to sell its Bermuda-based reinsurance subsidiary to Tower for approximately US$59 million. However, shortly after that announcement, American Safety terminated the proposed transaction with Tower in favor of an acquisition by Fairfax. In addition to paying the contractually required break-up fee to Tower, Fairfax also agreed, immediately upon the close of the acquisition, to sell American Safety Reinsurance to Catalina Holdings. For Fairfax, the acquisition of niche insurer American Safety Insurance Holdings signals its interest in expanding its existing specialty insurance platform. Also indicative of an interest in acquisitive excess and surplus lines growth was Enstar s aforementioned acquisition of Torus Insurance Holdings, which included subsidiary Torus Specialty Insurance, a company that devotes a substantial portion of its business to excess and surplus lines products. Given that excess and surplus lines have historically outperformed other lines in harder markets, in 2014, similar mergers and acquisitions activity may take place as economic conditions improve and pricing in the property and casualty sector continues to harden, particularly if other niche players decide the benefits of merging with conglomerates like Berkshire Hathaway outweigh the risks of being crowded out of the marketplace. d. Canadian Activity As was the case in 2012, consolidation in the Canadian property and casualty market continued in 2013 and early 2014 with the announcement of large acquisitions by the Travelers Companies, Inc. and Desjardins Group. In November 2013, Travelers announced the completion of its approximately US$1.1 billion acquisition of the Dominion of Canada General from E-L Financial Corporation Limited (the transaction was announced in June 2013). The transaction signaled Travelers commitment to acquisitive growth of its international commercial lines operations with the purchase of a personal and commercial lines carrier that will be rebranded as Toronto-based Travelers Canada. In another deal indicative of ongoing consolidation in Canada s property and casualty market, in January 2014, State Farm announced the US$1.46 billion sale of its Canadian assets to leading Canadian financial services provider Desjardins Group. Desjardins will operate the business under the State Farm banner for an unspecified period of time. The transferred assets include State Farm s Canadian property and casualty and life insurance businesses as well as its Canadian mutual fund, loan and living benefits companies. Upon the completion 6

13 of the transaction, expected in January 2015, Desjardins will become Canada s second largest property and casualty underwriter and its fourth largest life and health insurer. In the near term, Canadian consolidation activity is likely to continue, as Intact Financial Corporation, the country s largest property and casualty underwriter, has announced that it intends to continue seeking large-scale acquisition opportunities (Intact s last acquisition occurred in 2011 with the purchase of AXA SA s Canadian division). In addition, if, as expected, the Canadian government publishes regulations establishing a framework for the demutualization of Canadian property and casualty insurers, transactions involving Canada-based mutual companies may be an additional driver of Canadian consolidation activity. 3. Health Coming off a strong 2012, mergers and acquisitions activity in the health insurance sector was slow in comparison in 2013, in large measure because of the uncertainty surrounding the rollout of healthcare reform under the Patient Protection and Affordable Care Act and its companion, the Health Care and Education Reconciliation Act of 2010 (together, the ACA ) and the implementation of state insurance exchanges. Such uncertainty was likely a contributing factor for a number of insurers deciding to exit the individual health insurance market. Opportunities for large-scale consolidation were also limited following the consolidation and related integration that resulted from a number of large health insurer acquisitions completed in Rather than searching out potential blockbuster deals, large managed care companies focused their efforts on integrating recently acquired businesses or effecting small-scale state-specific transactions. Isolated bright spots of activity in the health insurance sector involved the continued consolidation of Medicaid and Medicare managed care providers, the pursuit of integrated healthcare systems providers and a pair of Blue Cross Blue Shield conversions. However, despite a slow 2013, the February 2014 announcement of C.V. Starr & Co. Inc. s US$4.4 billion acquisition of MultiPlan Inc., the country s largest healthcare cost management solutions provider, may signal the start of another upsurge in activity relating to the health insurance industry in a. Continued Consolidation in the Medicaid and Medicare Managed Care Segments In February 2013, Florida-based managed care provider WellCare Health Plans, Inc. completed its acquisition of UnitedHealthcare s South Carolina Medicaid business, a transaction that was announced in October Then, in April 2013, WellCare consummated its acquisition of Aetna Inc s Missouri Medicaid management business, Missouri Care Inc. Finally, in January 2014, WellCare completed its acquisition of Windsor Health Group Inc. from Munich Re. After a very acquisitive 2013, WellCare has announced that it intends to continue to pursue aggressive growth in 2014, despite the twin headwinds of ACA implementation and lower Medicare Advantage reimbursement rates. b. Formation of Integrated Healthcare Systems and Other Alternative Partnership Arrangements To combat increased costs associated with the ACA and distinguish their products in a highly competitive marketplace, some health insurers are seeking to form integrated healthcare systems or other alternative partnership arrangements with community healthcare providers. For example, in April 2013, Highmark Inc. completed its US$1.1 billion acquisition of West Penn Allegheny Health System, a transaction first announced in June 2011 and subsequently renegotiated in January 2013 following regulatory approval delays and the settlement of antitrust claims brought by both sides. The transaction resulted in the creation of the Allegheny Health Network, an integrated healthcare delivery network serving Western Pennsylvania. Pennsylvania regulators approved the transaction subject to a series of safeguards aimed at fostering regional competition, transparency and the protection of Highmark policyholders. Highmark s regional consolidation push continued with its February 2014 announcement of an agreement to merge with Blue Cross of Northeastern Pennsylvania, pending public hearings on, and regulatory approval of, the proposed merger. For further discussion of recent Blue Cross Blue Shield activity, see Blue Cross Blue Shield Conversions in Section A.3.c below. Similar regional consolidation 7

14 activity is likely to occur in 2014 and beyond as managed care insurers and healthcare providers continue to seek opportunities to manage the rising costs associated with the U.S. healthcare system. c. Blue Cross Blue Shield Conversions In March 2013, Michigan legislation was signed into law transforming Blue Cross Blue Shield of Michigan from a tax-exempt nonprofit to a taxable nonprofit mutual insurance company. In response to concerns that the implementation of the ACA would undermine Blue Cross Blue Shield of Michigan s financial stability, as it would no longer be the state s health insurer of last resort, the statutory conversion resulted in the relaxation of certain regulatory constraints applicable to the insurer and will allow for substantial product expansion. In August 2013, Health Care Service Corp. completed its merger with Blue Cross Blue Shield of Montana. Health Care Service Corp., which also owns Blues insurers in Illinois, New Mexico, Oklahoma and Texas, paid US$40 million for the acquisition, which will serve as an endowment for a new state-owned public interest foundation. The conversion of Blue Cross Blue Shield of Montana to a for-profit entity received regulatory approval subject to certain conditions, which included a freeze on administrative fees on policies for three years and public disclosure of salaries for certain Montanabased executives. Also in August 2013, the proposed statutory conversion of Blue Cross Blue Shield of Florida was approved by state regulators. As part of the conversion, which was approved by policyholders in September 2013, the Florida Blue was transformed into a stock insurance company with a newlycreated nonprofit mutual holding company as its parent. While the policyholders of Blue Cross Blue Shield of Florida will continue to own 100% of the statutorily-created mutual holding company, the transformation s regulatory impact on the insurer will allow for increased flexibility in terms of the range of healthcare services and solutions that it may offer to customers. d. C.V. Starr s Acquisition of MultiPlan After a slow 2013, February 2014 saw the announcement of C.V. Starr s agreement to acquire healthcare cost management solutions provider MultiPlan from private equity firms Silver Lake Partners and BC Partners for a reported US$4.4 billion. Heading an investor group that included Swiss investment firm Partners Group, the transaction is reportedly part of C.V. Starr s effort to expand its presence in private equity investment. The blockbuster deal represents the largest acquisition to date for the insurance and investment conglomerate, which is led by Hank Greenberg, former chair and CEO of American International Group Inc. 4. Insurance Intermediaries Mergers and acquisitions activity involving insurance brokers and insurance services providers remained strong in In addition to numerous small to mid-size strategic transactions that were announced and/or consummated, private equitybacked acquirers continued to demonstrate substantial interest in the brokerage and insurance services sector in The continued influx of private equity investment in the insurance brokerage sector has been driven by the opportunity for high internal rates of return associated with such investments in the current low cost of capital environment. In July 2013, Chicago-based private equity firm Madison Dearborn Partners, LLC completed its purchase of National Financial Partners, a benefits, wealth management and insurance services provider, in a transaction valued at a reported US$1.3 billion. In August 2013, investment adviser Hellman and Friedman announced it had agreed to acquire Hub International Limited, a global insurance broker, for US$4.4 billion from Apax Partners and a private equity affiliate of Morgan Stanley. The deal, which ranks as the largest takeover of a U.S. insurance broker on record, represents a substantial return for Apax and Morgan Stanley, which took Hub private in a 2007 transaction valued at approximately US$1.8 billion. Finally, in January 2014, privatelyheld USI Insurance Services, which was acquired by private equity firm Onex Corporation in 2012, announced it had agreed to purchase 42 regional insurance brokerage and consulting firms from Wells Fargo Insurance for an undisclosed sum. There were also several large strategic transactions in the brokerage and insurance services sector in Brown and Brown, Inc. was involved in two such acquisitions in the latter half of

15 In July 2013, Brown and Brown completed its US$360 million acquisition of rival Bleecher Carlson Holdings, Inc. from an investor group led by Texas-based private equity firm Austin Ventures, in a transaction that enhanced the large accounts platform of Brown and Brown, which has historically been associated with the retail market. This acquisition was followed by the January 2014 announcement that Brown & Brown had reached an agreement to acquire Wright Insurance Group for a reported US$640 million from an investor group led by Aquiline Capital Partners LLC. In addition, in its largest acquisition to date, Arthur J. Gallagher & Co. announced an agreement in August 2013 to acquire New Jersey-based Bollinger Inc. for US$276.5 million in net consideration. Structured as a taxfree reorganization, the transaction will expand Arthur Gallagher s Northeastern operating platform through the absorption of Bollinger s retail property and casualty placement, wholesale brokerage, employee benefits brokerage, program management and consultancy businesses. 5. Outlook for 2014 We expect financial buyers to continue to play a leading role in the annuity M&A market, and that new financial buyers will emerge to follow the path mapped out by Athene, Guggenheim and other major players. One unknown is how economic conditions will affect this marketplace, including the availability of targets. In the context of stabilized equity markets and a rising interest rate environment, insurers may feel less immediate pressure to sell, or at any rate to sell at the valuations seen in recent years, and aside from changing transaction economics, this could limit the supply of blocks of business coming to market. Another perspective is that higher valuations, far from limiting supply, may in fact prompt insurers to pursue sales of blocks they had been unwilling to sell at depressed valuations. It will also be interesting to see whether improved market conditions inspire traditional insurers to become more active bidders for annuity blocks than they have been in recent years. On the life insurance front, we expect U.S. insurers to continue to focus more on emerging markets than on domestic consolidation opportunities. Non-U.S. insurers, particularly Asian insurers, may prove to have a greater appetite than their U.S. counterparts for U.S. life insurance acquisitions in Mirroring developments in the life insurance and annuity sectors, we expect that involvement of financial buyers in the property and casualty M&A market will continue to increase in 2014 as financial buyers seek growth opportunities in the property and casualty reinsurance business. In addition to demand driven by financial buyers, 2014 may also see an increase in strategic acquisitions, which are the traditional drivers of deal volume. Many potential strategic buyers have accumulated significant amounts of cash during the past few years. Given that share buybacks, the primary alternative to putting cash to work in the mergers and acquisitions market, have become less effective as stock valuations continue to rise, such stockpiles could fuel an uptick in strategic acquisition activity, especially if the trend of reserve strengthening announcements based on loss development in prior accident years continues to create downward pressure on the share prices of certain property and casualty insurers in In the health sector, although activity in 2013 was muted, deal volume in 2014 could trend upwards once the impact of the ACA becomes clear and is absorbed by market participants. Activity involving insurers, hospital networks and other healthcare providers may increase as other insurers seek to achieve the operational efficiencies that an integrated health system provides, which include streamlining the delivery of wellness and individual healthcare services and combining information technology systems. B. European and Asian Market 1. Europe Multiple factors combine to suggest increasing activity, as compared with 2013, in the insurance M&A sector in the European region and, specifically, the UK. In particular, London will continue to attract attention, where Lloyd s vehicles remain sought after, due to the diversification of risk they provide, being generally uncorrelated with other risks. The attractiveness of a Lloyd s platform is further enhanced by the fact that, in 2013, all but two of the Lloyds syndicates generated a profit for their capital providers. The returns generated, 9

16 often double-digits, suggest that the Lloyd s vehicles remain highly sought after, and, when available, tend to be transferred at a premium, driven in many circumstances by an auction process. Recent years have seen a large-scale investment, in particular, in Lloyd s Syndicates by private equity, and that trend is expected to continue given the attractive returns generated by the Lloyd s syndicates in A continuing soft market on the P&C side of the industry also promotes consolidation, which is more likely to occur when compared to 2013, because of the growing certainty around the new regulatory regimes, including Solvency II. Given increased familiarity by the market with the proposed regulations, and indications from those leading the reforms that the current proposals will be adopted and implemented in substantially the forms currently circulating, there is a corresponding growth in confidence among market participants regarding capital requirements. Knowledge of capital requirements in turn allows for decisions to be made about how much capital can be deployed in the acquisition context. Because of the soft market and the pressure on companies to grow the bottom line, consolidation leading to cost efficiencies is an attractive solution. The soft market delivers consolidation in another way, too: with premium rates stagnant or declining and competition for business increasing, there can be a slackening of discipline, resulting in depressed returns. To the extent this occurs, companies looking to bolster their results may consider doing so through the tack-on of additional business, acquired either as a discreet book or through the acquisition of an entity. Additionally, with global interest rates remaining low for an almost unprecedented five years, the pressure on investment portfolios remains acute. Taken with a general industry-wide improvement in stock valuations, there is currently a coming together of sellers and buyers; with the spread narrowing between what sellers expect to receive and buyers are willing to pay; sellers eager to dispose of assets are finding a way to dispose of such assets to buyers seeking economies of scale, or greater diversification. Globalization of the insurance industry is another continuing trend further driving M&A activity across Europe and, in particular, in the UK. For all but the most regional industry participants, remaining competitive in 2014 (and beyond) requires a presence in all markets, including emerging markets in Africa and South America. The recovering European economy has allowed insurance companies as well as investors to consider acquisitions that will, in the case of companies, expand their global reach and, in the case of investors, allow for increased geographic diversification. Both objectives are continuing to drive M&A activity in the sector. 2. Asia Pacific The trend of increased M&A activity in China and the pan-asia market should also continue throughout With a burgeoning middle class, the Asian market China alone representing 600 million consumers is booming in terms of potential policyholders, and traditional European insurers and reinsurers, joined by Bermudian companies, seek a greater footprint in the region. Acquisitions of regional Asian firms present a means of recognizing growth materially more quickly than organic growth allows. Given the attractiveness of the market, Asia is likely to continue to be a focal point for acquisitive European and Bermudian entities. Unevenness country-to-country within the Asian market, in terms of regulatory structures and the health of local economies, will make certain jurisdictions more attractive than others. Political stability is another factor distinguishing one jurisdiction from another, with M&A activity within countries with a sustained history of political calm predictably leading the jurisdictions targeted for M&A transactions. The presence of a Lloyd s platform in China further promotes M&A activity in the region, providing as it does a benchmark for the growth of business generally in Asia. II. The Global Alternative Risk Transfer Market A. Life Insurance Market In 2013, the pace of reserve financing transactions continued, despite a flurry of regulatory developments. The bulk of these transactions involved the financing of life insurance companies perceived excess reserves associated with blocks of level premium term insurance subject to Regulation XXX ( Regulation XXX ) or universal life products with secondary guarantees subject to Actuarial Guideline XXXVIII (AXXX) ( Regulation AXXX 10

17 or AG 38 ) through the use of captive reinsurers (each, a Captive ). These transactions typically involve a third party stand-by capital provider who funds reinsurance payments after exhaustion of all other available funds. Stand-by capital may take the form of bank letters of credit, surplus notes or other capital funding solutions. Recently, most new money transactions have been structured as surplus note issuances. There have also been letter of credit transactions completed. A number of regulatory developments at the state and federal level have affected the way in which market participants view reserve financing transactions. These developments have been met with varying levels of support and dissent throughout the regulatory community, and universal acceptance of any one proposal seems improbable. The following summarizes these regulatory developments and the potential impact they might have on the alternative risk transfer market for life and annuity companies. 1. NAIC a. Captive White Paper In 2011, the NAIC established a working group to study the use of Captives by affiliated insurance companies. The working group, known as the Captives and SPV Use (E) Subgroup of the Financial Condition (E) Committee (the (E) Committee ), focused on the reserve financing of level premium term and universal life products with secondary guarantees. The (E) Committee prepared and exposed for public comment in March 2013 a white paper (the White Paper ) discussing issues associated with the use of these types of Captives. On June 6, 2013, the (E) Committee voted unanimously to adopt the White Paper (which was subsequently adopted by the (E) Committee on July 17, 2013 and the Executive & Plenary Committee of the NAIC on July 26, 2013). The White Paper included recommendations regarding (1) accounting considerations, (2) confidentiality, (3) access to alternative markets, (4) the International Association of Insurance Supervisors, (5) credit for reinsurance model enhancements, (6) disclosure transparency and (7) financial analysis handbook guidance. For a more detailed discussion of the recommendations proposed in the White Paper, please see the Sidley Global Insurance Review (March 2013). The first, second, sixth, and seventh White Paper recommendations were assigned to the Principle- Based Reserving (PBR) Implementation (EX) Task Force the (the PBR Task Force ) for analysis within the context of the proposed adoption of principal-based reserving ( PBR ). The third, fourth, and fifth White Paper recommendations were referred to the Reinsurance Task Force for review. The PBR Task Force charged Rector & Associates, Inc. ( Rector ) with the responsibility of reporting on the use of financing techniques relating to Regulation XXX and Regulation AXXX, and in response, Rector has issued two reports discussed below. b. Rector Reports The first report, issued on September 13, 2013 (the 2013 Rector Report ), addressed the ability of an insurer to use reinsurance as well as self-funded solutions to finance Regulation XXX and Regulation AXXX reserves (collectively Regulation A/XXX Reserves ). Regardless of the technique, the 2013 Rector Report focused on the type of assets used to back the Regulation A/XXX Reserves. Under the proposal, the insurance company could use a previously approved actuarial method to determine the level of assets expected to be needed to support reserves. These assets, known as Primary Assets, would consist of certain types of admitted assets. To support reserves in excess of the level of required Primary Assets (the Primary Asset Level ), the insurer would be able to use assets that were admitted assets, as well as assets that would not qualify as admitted assets (known as Other Assets ). On February 17, 2014, Rector issued a second report (the 2014 Rector Report, and together with the 2013 Rector Report, the Rector Reports ). This 2014 Rector Report concluded that the Primary Asset Level should be set at the level dictated by PBR (which is reflected in NAIC Valuation Manual 20, Requirements for Principle-Based Reserves for Life Products). The 2014 Rector Report suggested that reserve financing transactions should not be necessary following the adoption of PBR. This assertion will likely be challenged by the 11

18 industry and some regulators given that many industry participants believe significant reserve redundancies would still exist despite the adoption of PBR. Other interesting suggestions found in the 2014 Rector Report include limiting the type of Primary Assets to cash, securities that are listed (and filing-exempt) by the Securities Valuation Office (the SVO ) and, after the first year of a financing, letters of credit (so long as such letters of credit in the aggregate comprise no more than 10% of the insurer s total Primary Asset Level). In other words, admitted assets outside of cash and SVO-listed securities would be ineligible to back Regulation A/XXX Reserves. The 2014 Rector Report also recommends that RBC should be calculated by the cedent or the reinsurer and disclosed in an enhanced Schedule S filing. Finally, the 2014 Rector Report introduced a draft Regulation XXX/AXXX Reinsurance Model Regulation which encompasses all of these proposals. Under the proposed regulation, the NAIC Financial Analysis Working Group (the FAWG ) would be required to review any non-compliant transaction which, given its non-compliant nature, would be deemed to be financially hazardous. The 2014 Rector Report recommends that the requirements contained therein be used (i) in concept, with as much detail as possible based on available requirements and regulator judgment, with respect to any new financing structures that are created on or after July 1, 2014, and (ii) in greater detail, with respect to any Regulation A/XXX business written on or after January 1, 2015, regardless of when the financing structure or vehicle was created. The 2014 Rector Report will be addressed at the NAIC Spring meeting. We anticipate significant debate and measured deliberation before any of these proposals are codified. c. RBC Activity In addition to the Rector Reports, there has been additional NAIC activity relating to RBC and unauthorized reinsurers. On its January 31, 2014 conference call, the Life RBC Working Group discussed a NYSDFS proposal to require life companies to collateralize the amount of RBC that would be released when ceded to unauthorized reinsurers. This proposal would reduce RBC released for business ceded to any unauthorized reinsurer. The Working Group decided to refer the issue to its parent Capital Adequacy Task Force ( CATF ), so that the CATF can consider how to coordinate with other NAIC Task Forces and whether such requirement should be considered also for health and P&C insurers. d. FAWG In addition to various NAIC proposals, the FAWG has been activated. The FAWG is an established, ongoing committee charged with analyzing and monitoring nationally significant insurers and groups that exhibit characteristics of trending toward or being financially troubled. Arising out of the White Paper adoption, the FAWG received a new charge. The FAWG was required to (i) review Regulation A/XXX transactions occurring on or after July 26, 2013, by nationally significant U.S. life insurers to preserve the effectiveness and uniformity of the solvency regulatory system, and (ii) for transactions entered into and approved prior to July 26, 2013, and still in place, collect specified data in order to analyze the prevalence and significance of those transactions throughout the industry. At the recommendation of the (E) Committee, State regulators are encouraged to present Captive transactions to the FAWG for its review and comment on a confidential basis. It remains unclear how this confidentiality will be maintained. At the time of publication, we are not aware of any specific transaction that has been reviewed by the FAWG. e. Accreditation Rhode Island Superintendent Torti stated in December 2013 that Captives used in Regulation A/ XXX transactions should be designated as multistate insurers for purposes of accreditation; specifically, whether life insurer-owned Captives should be considered multi-state insurers and therefore subject to Regulations XXX and AXXX, as compared to traditional Captive insurers owned by non-insurance entities for purposes of managing their own risk. On December 15, 2013, the Financial Regulation Standards and Accreditation (F) Committee (the (F) Committee ) discussed the definition of multi-state insurer and the potential impact on the States financial regulation of Captives and Captives themselves if such a designation were given. The (F) Committee noted some inconsistencies in existing guidance and asked 12

19 the NAIC staff to draft proposed clarifying language regarding the definition and treatment of multi-state insurers for the (F) Committee s review at the 2014 Spring National Meeting. 2. State Regulatory Developments At the State level, some State insurance departments have also recently weighed in on the use of Captives in certain reserve financing transactions, with the NYSDFS taking an aggressive stance against the use of Captives. In June 2013, the NYSDFS released a white paper titled Shining a Light on Shadow Insurance, in which it labeled captive reinsurance transactions as shadow insurance transactions. The NYSDFS suggested that no actual risk transfer exists because the insurer is ultimately liable for paying claims. Additionally, the NYSDFS posited that these transactions could put the stability of the broader financial system at risk as they could leave insurance companies on the hook for the Captive s losses. The NYSDFS provided recommendations to address these concerns, including: detailed disclosure of these transactions by New York-insurers and their affiliates; enhanced general disclosure requirements (to be developed by the NAIC); other states and governing bodies to conduct similar investigations; and consideration of an immediate national moratorium on approving these transactions. On June 13, 2013, the NAIC, through then-president Jim Donelan, commented that a moratorium was not necessary and was premature. Presently, no other State has followed New York s recommendation for a moratorium. On the other side of the debate, in January 2014, the Vermont Department of Financial Regulation (the Vermont Department ) released a bulletin titled Captive Insurance Division Bulletin No. C The Vermont Department reaffirmed its belief that such Captives should be regulated more like traditional companies in order to preserve the confidence of policyholders in the traditional insurers and in the state-based regulatory regime. The bulletin listed the types of collateral that would be considered best practice for treatment as permitted assets or as a reduction in liabilities to support underlying reserves (i.e., prioritized letters of credit in favor of the ceding company, securitizations, surplus notes issued in accordance with SSAP 41 and reinsurance agreements with traditional insurance or reinsurance companies with acceptable financial strength ratings). The bulletin increased transparency requirements with respect to company group codes given by the NAIC and periodic financial statements to be filed with the Vermont Department and the NAIC. Although the increased transparency requirements are only effective for Captives licensed after January 1, 2014, the bulletin stated that the Vermont Department will encourage voluntary compliance for Captives licensed prior to that date. 3. Federal Regulatory Developments In addition to State regulatory developments, the use of Captives has also received attention at the Federal level. On December 12, 2013, the Federal Insurance Office (the FIO ) issued a report to Congress on how to modernize and improve the system of insurance regulation in the United States (the Modernization Report ). With respect to Captives, the Modernization Report recommended that States develop a uniform and transparent solvency oversight regime for the transfer of risk to Captives. The Modernization Report did not endorse the moratorium recommendation of the NYSDFS discussed above. The U.S. Securities and Exchange Commission (the SEC ) has asked various life insurers to disclose more detail regarding the use of Captives and any potential solvency concerns that would arise if they were forced to refrain from using Captives. Certain life insurers have responded to the SEC noting potential problems that could arise from a Captive moratorium, and also these insurers have made more detailed disclosures in their management discussion and analysis (MD&A) sections describing the types of financings. 4. Outlook for 2014 During the past few years, the NAIC has studied the use of Captives and A/XXX Reserve transactions may be the year of NAIC action. The 2014 Rector Report is the first concrete proposal to address these types of transactions. Even if the Rector framework is not fully adopted, we anticipate 13

20 that the proposals will influence the approach state regulators take when approving these types of transactions. B. Property & Casualty Insurance Market The importance of alternative risk transfer ( ART ) products in the property and casualty market proved to be on the rise in 2013, taking the trends of 2012 to new heights. In the catastrophe bond market, it was a groundbreaking year for deal activity, market size and innovation. Building on the prior year s themes of broadened investor demand and structural flexibility, 2013 also brought continued growth of third-party capital, sidecar capacity and hedge fund reinsurer activity. According to market sources, increasingly favorable pricing within the ART market was partially responsible for falling rates on line among traditional reinsurers. The following provides an overview of the global property and casualty ART market s highlights and trends of Catastrophe Bonds The issuance of catastrophe bonds soared in 2013, reaching a total of over US$7.5 billion, up more than US$1.25 billion from Market sources reported 34 catastrophe bond transactions having been completed in 2013, with an average issuance size of US$216.1 million per transaction, sponsored by 30 different sponsors, 11 of which were firsttime sponsors. Non-traditional sponsors, including various governmental entities and non-insurance companies, contributed to the exceptional number of issuances, and three long-time sponsors (AIG, Nationwide and USAA) each went to market twice over the course of the year. With a record number of transactions brought to the global market, not only was 2013 a remarkable year in terms of deal activity, 2013 also saw the total catastrophe bond limit reach the highest level in market history with more than US$20.5 billion in catastrophe bonds outstanding at year-end. According to Swiss Re, the catastrophe bond market has now grown by nearly 50% from its post financial crisis low set in In addition, 2013 catastrophe bond returns were notable. The Aon Benfield All Bond ILS index posted returns of 10.87% (compared to 9.75% in 2012), outperforming comparable fixed income indices for The majority of catastrophe bond issuances in 2013 included coverage for U.S. hurricane risk. In addition, indemnity coverage continued to dominate the market. Market sources reported other catastrophe bond features becoming more prominent in 2013, including optional resets, annual aggregate bonds and tranches of longer duration (four-year maturities in particular). Expanding on the non-standard transaction structures and elements emerging over the last several years, 2013 also saw new types of underlying risk brought to market. With the increased demand for catastrophe bonds and ever-increasing sophistication among the investor base, first-of-their-kind transactions once again made headlines in Four of the more distinctive deals of the year are highlighted below. Residential Reinsurance 2013 Limited (Series ). The Residential Reinsurance transaction (sponsored by USAA) offered investors a tranche of U.S. multi-peril notes that was one of the riskiest layers ever offered in the catastrophe bond market, with an expected loss of 13.06%. These notes priced at the lowest end of marketing guidance and resulted in the year s highest yielding transaction, paying a 20% coupon. The transaction was reported to be oversubscribed even after the size of the issuance was increased. The overwhelming demand for these notes pushed the interest spread below the modeled sensitivity case attachment probability, another first for the market. Tradewynd Re Ltd. (Series ). The Tradewynd Re transaction (sponsored by AIG) introduced a novel approach with respect to modeling. In addition to detailed exposure data having been provided to Risk Management Solutions, Inc., the modeler retained to perform the risk analysis provided in the transaction s offering documentation, EQECAT, Inc. and Air Worldwide Corporation 1 See Aon Benfield Securities, Inc. Insurance-Linked Securities, Fourth Quarter 2013 Update. 2 See Swiss Re Insurance-Linked Securities Market Update, January See Aon Benfield Securities, Inc. Insurance-Linked Securities, Fourth Quarter 2013 Update. 14

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