SIDLEY GLOBAL INSURANCE REVIEW

Transcription

1 SIDLEY GLOBAL INSURANCE REVIEW March 2013

2 SIDLEY GLOBAL INSURANCE REVIEW March 2013 The insurance industry is global. Insurance and reinsurance companies are some of the largest financial players on the world stage. They assume and warehouse all manner of risk from every corner of the earth and serve as an enormous investor base in the financial community. Increasingly, risk is shared globally among traditional and new entrants in the market. Risk generated in one part of the world is distributed across multiple time zones to other participants in the market, whether they be other insurers, reinsurers, private equity sponsors or capital market investors. This constantly evolving industry requires regulatory regimes to adapt on a regular basis. Regulatory issues arising in one market may influence the way in which similar regulatory concerns are addressed in other markets. To understand the insurance industry, one must have a solid grasp 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 Austin LLP is one of the world s premier law firms with approximately 1,700 lawyers and 18 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 over 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, insurancelinked 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 A. U.S. Market Life...1 a) Private Equity Buyers Drive Mergers & Acquisitions Activity in the Life Insurance Sector...1 b) Multi-Buyer Structures May Become More Common...1 c) Announcement of Disposition of Variable Annuity Blocks Health...2 a) Increased Activity in the Medicare Advantage and Medicare Supplement Segments... 2 b) Consolidation in the Medicaid Managed Care Segment...2 c) Expansion into Individual Segment Property & Casualty...3 a) Sales to Run-Off Specialists...3 b) Consolidation of Medical Professional Liability Carriers...3 c) Private Equity Interest in Insurance Brokers and Insurance Service Providers...3 d) Property & Casualty Companies Investing in Independent Asset Management Firms... 4 B. European and Asian Markets Would-Be Purchasers Chase Syndicates at Lloyd s Driving Premium Pricing Acquisitive Insurance Brokers To Drive Transactions in Attractiveness of Specialty Books Private Equity Asian Market...5 II. The Global Alternative Risk Transfer Market...6 A. Life Insurance Market Reserve Financing Transactions Embedded Value and Other Transactions Regulatory Developments...7 B. Property & Casualty Insurance Catastrophe Bond Market Highlights and Trends Response of Traditional Reinsurers to the ILS Market Growth of Hedge Fund Start-Up Reinsurers Legal and Regulatory Developments...11 a) JOBS Act...11 b) Dodd-Frank...12 ii

4 III. The Global Longevity Market...13 A. United Kingdom Buy-Outs Buy-Ins Longevity Swaps Pension De-Risking Transactions...14 B. United States General Motors Verizon Communications Inc...15 IV. The Global Capital Markets...16 A. United States Markets Legal and Other Developments Future Expectations...17 B. European Markets...17 V. Global Regulatory and Litigation Developments...18 A. Introduction...18 B. Federal Insurance Office Report...18 C. Principles-Based Reserving...19 D. Health Insurance...20 E. Life Insurance Reserves for Universal Life Products with Secondary Guarantees Contingent Deferred Annuities NAIC s Response to Use of Separate Accounts...22 F. Unclaimed Property Regulatory Issues Litigation...24 a) Private Party Class Action/Qui Tam Lawsuits...24 b) State Actions (West Virginia)...25 c) Kentucky Law and Constitutional Challenge Thereto...25 d) Reinsurance Disputes...25 G. Solvency Modernization Initiative SMI Roadmap Own Risk and Solvency Assessment Corporate Governance Working Group s Proposed Response to a Comparative Analysis of Existing U.S. Corporate Governance Requirements iii

5 H. Invested Asset Matters New Guidance Regarding Section 711 of the Insurer Receivership Model Act Other Invested Asset Initiatives...30 a) Working Capital Finance Notes...30 b) Broker Receivables Proposal...30 c) Residential Mortgage-Backed Securities and Commercial Mortgage-Backed Securities...31 d) Pledged Asset Proposal...31 e) ACLI Commercial Mortgage Loan Proposal...31 I. Global Insurance Issues Global Systemically Important Insurers and Internationally Active Insurance Groups Solvency II...32 a) U.K...32 (1) The Status of Implementation...32 (2) Readiness for Implementation...33 b) United States...33 (1) NAIC Reaction to Equivalency...34 (2) International Association of Insurance Supervisors China Insurance Regulatory Commission Progresses Development of Its Second Generation Solvency Regime...35 J. U.S. Federal Insurance Issues Dodd-Frank: Use of Swaps in Certain Transaction Structures Catastrophe Reserve Federal Proposed Legislation...37 K. U.K. Insurance Issues The End of the FSA: The Beginning of Dual Regulation Section 166 Skilled Persons Reports on U.K. Insurer Corporate Governance...38 a) Proposed Changes...39 b) Recent Trends...39 c) Preventative Measures Increasing EU/U.K. Competition Law Focus on the Insurance Sector...40 a) U.K. Office of Fair Trading Concludes Investigation into WhatIf? Private Motor Information Exchange Platform...40 b) U.K. Competition Commission Commences Market Investigation into Private Motor Insurance...41 c) OFT Launches Study of Defined Contribution Pensions...41 d) European Commission Publishes Study on Pools and the Subscription Market e) U.K. s FSA Launches Thematic Review of Annuities Market...41 L. Reinsurance Litigation: The Follow-the-Settlements Doctrine...42 iv

6 VI. Select Tax Issues Affecting Insurance Companies and Products...42 A. Prospects for Tax Reform...42 B. The Foreign Account Tax Compliance Act...42 C. Cascading Federal Excise Tax...43 D. Private Placement Variable Life/Annuity Products...43 E. Life Insurer Tax Controversies Actuarial Guidelines...44 F. Property & Casualty Tax Controversies Loss Reserves...44 G. Tax Treatment of Extra-Contractual Obligations...44 H. Limitations on What Constitutes Insurance for Tax Purposes...45 I. State Tax Issues...45 v

7 I. The Global Mergers & Acquisitions Market A. U.S. Market 1. Life Mergers and acquisitions activity in the life insurance sector remained strong in 2012, as private equity buyers continued to pursue acquisitions of fixed annuity businesses. Activity is expected to remain strong in 2013, as several large blocks of business are reportedly on the auction block. With the types of large, diverse books of business reportedly up for sale, multi-buyer structures may become more common in In addition, the announcement of two notable variable annuity acquisition transactions in the past several months may portend more activity in this area in a) Private Equity Buyers Drive Mergers & Acquisitions Activity in the Life Insurance Sector Private equity buyers drove mergers and acquisitions activity in the life insurance sector during In particular, while the current low interest rate environment continues to limit investment returns and has led to a down-sizing by several life insurance companies of their fixed annuity business and prevented many strategic buyers from actively pursuing acquisitions in the fixed annuity market, private equity buyers have continued to demonstrate a strong appetite for transactions involving fixed annuity businesses. Several large deals either closed or were announced during 2012, with Apollo Global Management and Guggenheim Partners being the most active buyers. Athene Holding, which is controlled by Apollo, completed its acquisition of Presidential Life Corporation (parent of Presidential Life Insurance Company) in December Apollo also announced, in December 2012, the US$1.55 billion pending acquisition by Athene Holding of Aviva plc s U.S. life insurance and annuity business. Also, in December 2012, Guggenheim announced its US$1.35 billion pending acquisition of Sun Life s U.S. life insurance and annuity business (which includes a large fixed annuity block of business). With several other fixed annuity books reportedly up for sale, look for this strong activity to continue into As private equity buyers continue to pursue acquisitions of insurance companies, whether in the life insurance sector or other insurance sectors, private equity buyers should become familiar with the regulation of insurance holding company systems generally, and private equity buyers with sovereign wealth fund investors should be cognizant of statutory limitations that exist in a number of states regarding ownership or control of insurance companies by foreign governments. b) Multi-Buyer Structures May Become More Common As many large divestitures involving diverse books of business are being announced by life insurance companies in today s market, there continues to be an opportunity for buyers to partner together to jointly bid on transactions involving books of business for which a single strategic or economic buyer may not have the appetite to assume. For example, multi-buyer transaction structures similar to Athene Holding s 2011 acquisition of Liberty Life Insurance Company, in which Protective Life partnered with Athene Holding and acquired the mortality business of Liberty Life Insurance Company, may become more common as buyers seek to acquire targeted books of business. In addition, buyers seeking acquisition financing are continuing to turn to the reinsurance market to obtain such financing; some buyers have structured acquisition transactions involving reinsurance partners whereby the buyer would cede a quota share of the acquired business (including, in some cases, 100% of particular lines) to one or more reinsurance partners in exchange for a cash ceding commission, which would then be used to fund a portion of the acquisition purchase price. As such multi-buyer structures become more prevalent, sellers may seek more involvement and control in how bidders form such partnerships to allow the seller the ability to pick a combination of buyers that provides maximum value to the seller. Multi-buyer acquisition structures require both buyers and sellers to consider unique regulatory, tax, structural and other issues in evaluating the optimal deal structure for a given transaction. As these types of multi-buyer acquisition structures become more commonplace in the insurance sector, buyers and sellers with an understanding of these issues and the flexibility to evaluate and react quickly to such structures will be best positioned to execute deals in today s environment. 1

8 c) Announcement of Disposition of Variable Annuity Blocks The financial statement volatility associated with variable annuity blocks has led several life insurance companies to discontinue new sales of variable annuity products and other life insurance companies to announce their desire to exit the variable annuity market altogether. Non-strategic, financial buyers, such as private equity funds and others that do not have the same short term financial statement pressures as strategic buyers and are able to better weather short term equity market and earnings volatility, may drive interest in variable annuity blocks in After several years of inactivity in the variable annuity segment, two notable transactions were announced in the past several months. First, in December 2012, Guggenheim announced its pending acquisition of Sun Life s U.S. life insurance and annuity business, which consists primarily of variable annuity risk. Second, in February 2013, Berkshire Hathaway announced that it would assume 100% of up to US$4 billion of Cigna s variable annuity exposure. Because of the operational issues inherent in managing a variable product business, including the administration of separate accounts, buyers and sellers in the variable annuity segment should be prepared to address regulatory and structuring issues that are specific to acquisition transactions involving blocks of variable business, particularly reinsurance transactions where the separate accounts relating to the variable business are required to remain with the ceding company. 2. Health Activity in the health insurance sector was strong in 2012, with several transactions involving Medicare Advantage, Medicare Supplement and Medicaid managed care providers being completed or announced during the year. a) Increased Activity in the Medicare Advantage and Medicare Supplement Segments Demographic changes in the U.S. are expected to trigger increased demand for Medicare Advantage and Medicare Supplement products in the coming years. The expected increase in demand for such products has driven activity in the Medicare Advantage and Medicare Supplement markets as major managed healthcare companies seek to increase their presence in these expanding markets. Cigna Corporation acquired platforms in the Medicare Advantage and Medicare Supplement markets through the completion of two transactions in 2012: in January 2012, Cigna Corporation completed its US$3.8 billion acquisition of HealthSpring Inc., which expanded Cigna s presence in the senior benefits segment by adding HealthSpring s platform of Medicare Advantage plans to Cigna s senior products platform, and in August 2012, Cigna Corporation completed its acquisition of Great American Supplemental Benefits Group from American Financial Group Inc., which further expanded Cigna s presence in the senior benefits segment by adding Medicare and other supplemental benefits products to its senior products platform. Aetna Inc. also expanded its footprint in the Medicare Supplement business through its acquisition of Continental Life Insurance Company and American Continental Insurance Company from Genworth Financial Inc. in late As the major managed healthcare companies expand their Medicare Advantage and Medicare Supplement businesses, companies with small Medicare Advantage and Medicare Supplement books of business that lack the scale of the major managed healthcare companies may seek to exit the market, which could further contribute to increased activity in the health insurance sector in b) Consolidation in the Medicaid Managed Care Segment Several factors contributed to increased activity in the Medicaid segment during 2012, as managed healthcare companies sought to expand their Medicaid managed care business. First, the U.S. Supreme Court upheld several aspects of the Patient Protection and Affordable Care Act, including the provisions providing for a major expansion of Medicaid eligibility. Second, demographic and economic factors in the U.S. are expected to give rise to an uptick in Medicaid recipients. Third, as the number of eligible Medicaid participants continues to rise, states are expected to engage major managed healthcare companies, which have the benefit of scale, to manage their expanding Medicaid programs. All of these factors led to strong activity in the Medicaid segment in WellPoint Inc. enhanced its presence in the Medicaid managed 2

9 care segment by completing its US$4.9 billion acquisition of Amerigroup Corporation in December Aetna Inc. announced in August 2012 that it had entered into an agreement to acquire Coventry Health Care, Inc., which will expand Aetna s Medicaid management business. The factors referenced above should continue to drive activity in c) Expansion into Individual Segment There may also be a move toward expansion in the individual healthcare segment in connection with the implementation of the Affordable Care Act (as defined in Section A of Global Regulatory and Litigation Developments below), which is expected to lead to increased demand for individual healthcare products. Increased activity in 2013 may develop, as health insurance companies seek to expand their presence in the individual segment and position themselves to take advantage of this expected increase in demand. In addition, transaction opportunities may arise as noninsurance companies look to enter the individual healthcare market, including through partnerships with health insurance companies to offer health insurance products to their customer base. 3. Property & Casualty In contrast to activity in the life and health insurance sectors, activity, in the property and casualty sector was sluggish in Valuations in the property and casualty sector continue to be low and are impeding activity, as sellers remain hesitant to sell for a price that is less than book value. Distressed sellers have resorted to transactions involving runoff specialists, as the ability to find strategic buyers in the current environment continues to be strained. However, the December 2012 announcement of Markel Corporation s acquisition of Alterra Capital Holdings Ltd. for approximately US$3.13 billion illustrates that major strategic deals can be done in the current environment. In addition, activity in certain pockets within the overall property and casualty sector, including medical professional liability and insurance brokers, remained strong during a) Sales to Run-Off Specialists Transactions involving buyers that specialize in the acquisition and management of run-off blocks of business, such as the acquisition by Enstar Group Limited of SeaBright Holdings, Inc., which was completed in February 2013, will continue to be a viable alternative for sellers in distressed situations, as the ability to find strategic buyers in the current environment continues to be strained. b) Consolidation of Medical Professional Liability Carriers Large medical professional liability carriers have been active and are driving consolidation in the medical professional liability market. A number of factors are contributing to the continued consolidation in the medical professional liability insurance market, including favorable underwriting performance and reserve development resulting from tort reform measures, strong capital positions, a soft market that makes organic growth difficult and the continued trend of doctors migrating from smaller private practices to large hospital groups. Several transactions have been completed or announced since January Medical Protective Company completed its acquisition of Princeton Insurance Company in January ProAssurance Corporation completed its acquisition of Independent Nevada Doctors Insurance Exchange in December 2012 and its acquisition of Medmarc Insurance Group, which was structured as a sponsored demutualization, in January Finally, MMIC Group Inc. announced in February 2013 that it had entered into an agreement to acquire Utah Medical Insurance Association (the proposed acquisition of Utah Medical Insurance Association by The Doctors Company, which was announced in October 2012, was terminated by Utah Medical Insurance Association in favor of a superior bid by MMIC Group Inc.). c) Private Equity Interest in Insurance Brokers and Insurance Service Providers Activity involving insurance brokers and insurance service providers remained strong in In addition to numerous small to mid-size transactions being consummated in 2012, continued private equity interest in the insurance brokerage and insurance services sector drove a few noteworthy large transactions. In particular, several large 3

10 insurance brokers and insurance services providers that were acquired by private equity buyers during the period from 2005 to 2007 were sold to other private equity buyers in In April 2012, New Mountain Capital LLC completed its acquisition of AmWINS Group Inc. from Parthenon Capital Partners in a US$1.3 billion recapitalization. Onex Corp. completed its US$2.3 billion acquisition of USI Insurance Services from Goldman Sachs Capital Partners in December In November 2012, Kohlberg Kravis Roberts & Co. L.P. announced that it had entered into an agreement to acquire Alliant Insurance Services from Blackstone. d) Property & Casualty Companies Investing in Independent Asset Management Firms Property and casualty insurance companies seeking to diversify earnings in the current soft market have shown interest in investing in independent asset managers, some of whom focus on insurance-linked securities or specialty property and casualty-related exposures, as an asset class. Allied World Assurance Company has been especially active, announcing in October 2012 that it had acquired a minority ownership interest in MatlinPatterson, announcing in December 2012 that it had acquired a minority ownership interest in Aeolus Capital Management and announcing in January 2013 that it had acquired a minority ownership interest in Crescent Capital Group LP. In addition, Transatlantic Holdings Inc. announced in December 2012 that it had acquired a minority stake in Pillar Capital Holdings. B. European and Asian Markets The year 2012 was sluggish across both the life and property and casualty sectors in terms of M&A activity across Europe, although, consistent with the situation in the U.S. market in 2012, M&A activity in the sector increased in the fourth quarter in number of transactions announced. While various factors contributed to the downturn (from 2011) in the number of transactions concluded, two leading factors were, first, the continuing spread in valuations between what prospective purchasers were willing to pay and what interested sellers were willing to accept; and, second, continuing uncertainty in the financial markets generally and in the eurozone in particular. One year later, that same dynamic on valuations appears to have become a factor in causing a reverse trend: driving increased M&A activity in 2013, as certain sellers come under greater pressure to address the depressed valuations of their shares. Further, with interest rates remaining at historically low levels, insurers are relegated to pursuing solutions that yield economies of scale. The property and casualty sector, in particular, is positioned for a continuation of the upward tick from the fourth quarter of 2012 in transactions, given the benign nature of the 2012 loss year, which kept pricing static at the January 2013 renewal period. This is forcing insurers to act strategically to achieve returns that underwriting alone and further given the context of a low interest rate environment cannot deliver. Particular pressure is seen on the small to mid-sized insurers, which are being forced to consolidate with other companies to achieve economies of scale. On the life side of the sector, in February 2013, Irish Life Group Ltd announced its sale to Power Corp. of Canada, and Aegon NV announced its acquisition of 50% of Unnim Vida SA de Seguros Y Reaseguros, signaling the strategy of participants in the sector to either consolidate or sell. 1. Would-Be Purchasers Chase Syndicates at Lloyd s Driving Premium Pricing Syndicates at Lloyd s remain highly desirable, given their finite number, with those which come to the market purchased at premium prices. The year 2012 saw, among other activity, Flagstone Reinsurance Holdings sell Flagstone Syndicate Management Limited (formerly Marlborough Underwriting Agency Limited) and Flagstone Corporate Name Limited (sole member of Syndicate 1861) to ANV Holdings, a Dutch entity supported by third-party capital from the Americas. The sale was effected by an auction which drew bids from multiple prospective purchasers, with private equity broadly represented. Currently, an auction is underway for Atrium Underwriters Limited (managing agency), which again has drawn strong interest from a list of bidders considered by the market to have material financial resources, including private equity. Because ownership of a syndicate permits further diversification of risk profile, syndicates have been a favored target by, in particular, participants in the Bermuda marketplace. 4

11 2. Acquisitive Insurance Brokers To Drive Transactions in 2013 Across the board, U.K. brokers, in particular, are seen as being acquisitive throughout 2013, with smaller bolt-on transactions being preferred. An underlying reason for buyer appetite is the renewed confidence of the banking sector in the stability of the brokerage industry and its fee-generating capacity the cash-generative nature of the business allowing them to cope with debt. Further, certain of the larger brokers have brought down their level of debt following the 2008 financial crisis. Gallagher International, the U.K. affiliate of Arthur J. Gallagher, the world s fifth largest insurance broker, is an example of a broker pursuing an acquisition strategy; recent purchases include brokers Acumus and Blenheim Park, as well as managing general agent of Contego Underwriting. 3. Attractiveness of Specialty Books Specialty insurers and reinsurers are seen as attractive targets in the current year for larger entities, which are seeking to differentiate themselves from their competitors at a cost to them that may be considered, from a historical perspective, conservative; that is, companies continue to show reluctance to bet the bank and are instead being careful to hold onto cash, reflecting caution in light of extending turbulence in the Eurozone marketplace. Overall, insurers and reinsurers are expected to remain cautious in terms of pricing: on the buy side, given continuing fragility in global markets, purchasers are expected to guard their balances sheets at the same time that they seek opportunities to acquire niche underwriting teams that will be accretive to revenue. On the sale side, specialty underwriters are viewed as the crown jewels of the hour given the relatively lowcost enhancement they can provide to larger writers through diversification of risk thus it is expected that they will not go cheaply relative to book value. Among potential target companies are those in central and eastern Europe, to which international insurers show signs of greater receptivity. 4. Private Equity Private equity, attracted by the historically low valuations of insurers and reinsurers in the sector, continues to drive M&A activity, both directly and indirectly. For example, in December 2012 Aquiline Capital Partners LLC announced its agreement to acquire Equity Syndicate Management Ltd. Further, private equity is seen standing behind certain high-profile, and acquisitive, new entrants, which entrants are led by industry veterans. The interest of private equity in the sector is expected to extend beyond risk-bearing entities to include retail brokers, wholesale brokers, MGAs and captive managers, all of which present fee-generating opportunities and as such offer an attractive, non-correlated revenue stream to private equity portfolios. 5. Asian Market Growth in the Asian insurance market is expected to be one of the key features of industry growth overall in 2013, further intensifying 2012 growth which saw a 24% increase over 2011 in the number of announced transactions. The largest transaction of the 2012 year worldwide was the sale by HSBC of its 15.6% stake in Chinese insurer Ping An Insurance (Group) Co. of China Ltd to Charoen Pokphand Group for US$9.39 billion. Additional 2012 sales touching the Asian market included that of ING Group NV (life insurance, general insurance, pension and financial planning units in Hong Kong, Macau and Thailand) and the disposition of Kyobo Life Insurance Co. Ltd (24%) by Daewoo International Corp. Singapore, in particular, is attracting attention as insurers and reinsurers seek a base of operations that offers political stability, sophisticated infrastructure and relatively easy ingress and egress. Consequently, M&A activity initiated both within and without Asia is expected to include target entities, in both the life and P&C sectors, which provide a foothold in Asia for new entrants. In the China-specific market, there is a divide between market entry for direct writers compared to market entry for reinsurers, which enjoy lower entry barriers largely due to the small number of domestic Chinese reinsurers. Given the imbalance in the number of insurers compared with reinsurers (there being far fewer reinsurers providing capacity for a growing number of Chinese primary writers), the opportunity for growth in the reinsurance sector is particularly apparent. Following China s joining of the World Trade Organization in 2011, the Chinese insurance regulator eased regulations for 5

12 both foreign property casualty and life writers, and in 2012 the number of primary writers increased. Given the demand for reinsurance capacity, it is expected that more growth, in terms of foreign investment, will be seen in the reinsurance sector of the market. Of the nine reinsurers registered in China, three are Chinese domestic and six are foreign. Of the foreign reinsurers, three are German, one is Swiss, one is from the U.K. (Lloyd s) and one is French. At the close of the 2012 year, the Swiss reinsurer accounted for 33% of market share. II. The Global Alternative Risk Transfer Market A. Life Insurance Market In 2012, the pace of reserve financing transactions continued, with the bulk of these transactions involving 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 or AG 38 ). Transaction sizes ranged generally from US$250 million to US$1 billion. 1. Reserve Financing Transactions Reserve financing transactions seek to finance the perceived excess reserves associated with certain types of term and universal life business. The excess reserves are reserves required by law that are viewed to exceed the reserves actuarially determined to be economically necessary for the block of business. In this form of specialty corporate finance, insurers isolate the subject business through reinsurance to an affiliated captive reinsurer. Premiums received by the insurance company are used to fund the economic portion of the reserves while the captive reinsurer secures the excess reserves using various methods. In these transactions, the ceding company obtains the approval (or, if applicable, non-disapproval) of its domiciliary insurance regulator. Also, the insurance regulator of the jurisdiction in which the captive reinsurer is organized reviews the transaction and capital levels of the captive reinsurer prior to granting the captive reinsurer an insurance license to conduct its business. Below are the trends observed in this market over the past few years: Transition to Non-Recourse Structures. Similar to the reserve securitization market developed prior to the financial crisis, the general approach to these types of financings has been to limit recourse to the captive reinsurer. Some of the transactions include features that reduce the captive reinsurer s exposure to extreme asset defaults or catastrophic levels of mortality claims. Furthermore, the tax structures have migrated towards cashless tax sharing agreements. Stand-By Capital Structures. Given the limited recourse nature of these solutions, many transactions require the stand-by provider to provide collateral that funds reinsurance payments after the captive reinsurer has used available funds. Stand-by capital may take the form of bank letters of credit or capital funding solutions. The Use of Limited Purpose Subsidiaries. A number of states have adopted limited purpose subsidiary statutes and regulations that allow ceding companies to establish captive reinsurers in the same home state as the ceding company. The transaction remains subject to the review of the ceding company s regulator and provides the ceding company with additional methods to collateralize the excess reserves, such as parental credit enhancement. New Participants in the Market. As the need for funding has increased over the years, insurers have entered into solutions with various types of financial institutions. Initially after the financial crisis, bank letters of credit served as the dominant structure. Over time, other financial institutions that serve the market, such as reinsurers, have provided capacity to the banks and also directly transacted with insurers. The Use of These Techniques in Other Contexts. In addition to specialty corporate financing with respect to organic business, these solutions have been used to provide 6

13 acquisition financing in the M&A context. Also, these solutions have been used to fund perceived redundancies in other types of business not subject to Regulation XXX or Regulation AXXX. 2. Embedded Value and Other Transactions Prior to the financial crisis, the last embedded value transaction completed in the United States was the US$2.5 billion MetLife closed block offering underwritten by Goldman Sachs. Since the financial crisis, the embedded value market has been significantly less active than the reserve financing market. In 2011, Aurigen Re completed a C$120 million offering of embedded value notes. The notes securitized profits from a closed block of life reinsurance business. Unlike most of the embedded value securitizations executed prior to the financial crisis, the Aurigen embedded value securitization did not include credit enhancement from a third party. In addition to funded embedded value transactions, banks have provided letters of credit solutions for closed blocks of business established by former mutual insurance companies. In these financings, letters of credit were used to provide capital to support these blocks, allowing the insurance companies to use previously allocated assets for general corporate purposes. Over time, profits from these blocks of business are used to reduce the size of the letters of credit. Insurers also completed catastrophic mortality transactions and medical loss transactions. However, these transactions have represented a small portion of the current overall life alternative risk transfer market. 3. Regulatory Developments In the past eighteen months, a number of regulatory developments have had an impact on reserve financing transactions. One such development was Title V of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd- Frank Act or Dodd-Frank ), known as the Nonadmitted and Reinsurance Reform Act of Among other things, Title V of the Dodd-Frank Act preempted the application of a non-domiciliary state s credit for reinsurance rules (the Home State Rule ). Both California and New York have explicitly acknowledged the Home State Rule (see Section 1101(c) of the California Insurance Code and Regulation 20 of the New York Insurance Law, respectively). Essentially, the Home State Rule restricts one state from exercising extra-territorial authority over an insurance company domiciled in another state regarding particular subjects, such as credit for reinsurance matters and reinsurer insolvency regulation. Additionally, as described in more detail under Section J.1 of Global Regulatory and Litigation Developments below, the broad and expansive definition of a swap in Title VII of the Dodd-Frank Act could be interpreted, under certain circumstances, to apply to certain insurance and reinsurance products. Accordingly, participants in the market must be mindful of whether the swap rules and regulations apply to certain features in these transactions. (Please see Section J.1 of Global Regulatory and Litigation Developments below.) In addition to the regulatory developments associated with the Dodd-Frank Act, the National Association of Insurance Commissioners (the NAIC ) has established a working group to study the use of captive reinsurers by affiliated insurance companies. The working group, known as the Captives and SPV Use (E) Subgroup of the Financial Condition (E) Committee (the Subgroup ), has focused on the reserve financing of level premium term and universal life products with secondary guarantees. The Subgroup 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 captive reinsurers. The exposure draft of the White Paper includes the following recommendations: Accounting Considerations. The Subgroup recommends that a new group be appointed to study the accounting issues relating to Regulation XXX and Regulation AXXX perceived redundancies and to determine whether, for situations not addressed by AG 38, a solution should be reached (as an alternative to ceding the Regulation XXX and Regulation AXXX reserves to affiliated captives), pending implementation of principles-based reserving. Confidentiality. The Subgroup recommends that the NAIC study the issue of confidentiality of commercially owned captives and special 7

14 purpose vehicles ( SPV ), including reasons for and against confidential treatment of such entities (or types of information pertaining to such entities). A recommendation is also included for further work to ensure that the domestic states of insurance companies or groups receive information, on a confidential basis from the captive regulator, regarding captive and SPV use by affiliates. Access to Alternative Markets. The Subgroup supports access to alternative risk transfer methods, such as the capital markets, and recommends that the NAIC s Special Purpose Reinsurance Vehicle Model Act #789 be updated. International Association of Insurance Supervisors Standards. The International Association of Insurance Supervisors issued a Guidance Paper on the Regulation and Supervision of Captives that recognizes captives of SPVs owned or controlled by insurers or reinsurers, when used similarly to commercial reinsurance, should be regulated as such. The Subgroup recommends close monitoring of developments of standards, principles, and guidance by the International Association of Insurance Supervisors and considers appropriate enhancements to the U.S. captive and SPV regulatory framework. Credit for Reinsurance Model Enhancements. The Subgroup recommends that another NAIC working group study the variability (including conditionality and order of drawing) in the terms of letters of credit or other security devices that collateralize a captive s obligations that may not provide the same protections envisaged in the NAIC s Credit for Reinsurance Model Law. As of the time of this publication, the White Paper has not been completed by the Subgroup. Upon completion, the Subgroup will submit the White Paper to the Financial Condition (E) Committee for evaluation and determination of next steps. Recently, the Federal Insurance Office (the FIO ), established pursuant to the Dodd-Frank Act, has indicated that it is monitoring the use of captive reinsurers by the industry. The FIO has called for the creation of a task force by the Federal Advisory Committee on Insurance regarding these captives. Finally, please see Sections C and E.1 of Global Regulatory and Litigation Developments below for a detailed discussion regarding principles-based reserving and Regulation AXXX reserves. In the short term, in light of developments in both these areas, we do not anticipate that the industry will experience significant relief from perceived excess reserve requirements. B. Property & Casualty Insurance The convergence of traditional reinsurance and capital markets capacity and the growth of the insurance-linked securities ( ILS ) market continued throughout 2012 and the first quarter of Capital markets-backed alternatives to traditional reinsurance protection, such as catastrophe bonds, sidecars, industry loss warranties and collateralized reinsurance vehicles, are increasingly becoming part of insurers and reinsurers risk management programs, with the alternative risk transfer market now accounting for as much as 16% of total property catastrophe risk transfer limits purchased. (See Marsh Risk Management Research, United States Insurance Market Report 2013 (February 2013).) The following provides an overview of recent trends in the ILS market, the impact of the ILS market on traditional reinsurers, the growing presence of hedge funds in the reinsurance market and recent legal and regulatory developments impacting the ILS market. 1. Catastrophe Bond Market Highlights and Trends Catastrophe bond issuances in 2012 totaled US$6.25 billion, representing an increase of more than 35% from 2011 and making 2012 the second largest issuance year to date (behind only 2007). (Property Casualty 360, Insurance Linked Securities Continue Growth Despite Sandy January 15, 2013 (Source: Aon Benfield Securities, Inc.).) A total of 27 catastrophe bond transactions were completed in 2012, with an average issuance size of US$227 million per transaction, compared to 23 transactions in 2011 with an average of US$190 million per transaction. (Swiss Re Insurance-Linked Securities Market Update, January 2013.) In addition to an increasing number of transactions, 2012 also saw the largest single tranche, single peril catastrophe 8

15 bond ever placed, with first-time sponsor Citizens Property Insurance Corporation, Florida s last-resort property insurer ( Florida Citizens ), sponsoring the US$750 million Everglades Re Ltd. transaction providing Florida hurricane coverage on an indemnity basis. Total catastrophe bonds outstanding at year-end 2012 reached a new record of US$16.5 billion. (Aon Benfield Securities, Inc. Reinsurance Market Outlook: Reinsurance Capacity Growth Continues to Outpace Demand, January 2013.) Despite the relatively large amount of new issuances in 2012, investor demand exceeded supply, resulting in 80% of transactions tightening pricing and/or upsizing. A number of repeat sponsors accessed the catastrophe bond market in 2012, including AIG, Allianz, the California Earthquake Authority, Chubb, Hannover Re, Munich Re, Swiss Re, Travelers and USAA, among others. In addition, 2012 saw several first-time sponsors enter the market, including Country Mutual Insurance Company ( Country Mutual ), North Carolina Farm Bureau ( NCFB ) and U.S. state government-run insurers of last resort, Louisiana Citizens Property Insurance Corporation and Florida Citizens. Superstorm Sandy tested the ILS market in 2012 and, although it caused declines in secondary market pricing for certain catastrophe bonds with Northeast wind exposure, investor interest in the primary catastrophe bond market remained strong, as demonstrated by the successful placements of USAA s Residential Re Ltd. Series 2012-II and AIG s Compass Re Ltd. Series , both of which involve U.S. wind exposure, at pre-sandy rates in the months following Sandy. Market sources view the resilience of sponsors and investors in the wake of Sandy as an indicator of the health and stability of the ILS market. From a structural perspective, the ILS market has continued to evolve over the past 18 months to better balance the needs of sponsors and investors, with the market demonstrating a higher tolerance for non-standard transaction structures and features. The following are a few examples of the ways in which the ILS market has evolved in response to input from both sponsors and investors: Reducing Basis Risk. The ILS market has seen an increase in the number of transaction structures and features designed to reduce the basis risk for sponsors. For example, the use of indemnity triggers increased significantly in 2012, with over US$3.2 billion of indemnity catastrophe bonds issued (compared to approximately US$1.4 billion issued in 2011), representing the largest annual issuance of indemnity catastrophe bonds in the history of the ILS market. In fact, repeat sponsors Liberty Mutual (Mystic Re III Ltd.) and Travelers (Long Point Re III Ltd.), who had previously utilized industry loss triggers in their prior transactions, shifted to indemnity triggers for their 2012 issuances. According to market sources, indemnity triggers now account for over 50% of outstanding catastrophe bond risk capital. (Swiss Re Insurance-Linked Securities Market Update, January 2013.) One factor contributing to this trend is the growing sophistication and reinsurance knowledge of ILS investors (in particular dedicated ILS funds, which have been reported to account for over 60% of ILS investment capital). The current ILS investor base has the resources and experience necessary to understand the risks in which it is investing. As a result, investors have been willing to accept more complex indemnity structures that better meet sponsors coverage needs, so long as they are provided the information needed to evaluate the underlying risk portfolio and make an informed investment decision. Increasing Investors Access to Information. As a corollary to the increase in indemnity triggers noted above, 2012 also saw an increase in the level of information provided to investors in indemnity catastrophe bond transactions. Sponsors of indemnity transactions are providing more disclosure around the underlying risk portfolio and more detailed exposure data. Enhanced modeling information, such as event loss tables and company loss files, is also being provided to investors more frequently. Creating New Opportunities for Growth. Although U.S. wind exposure continued to dominate the catastrophe bond market in 9

16 2012, several transactions featured non-peak perils (such as severe thunderstorm, Canada earthquake, Caribbean hurricane, Mexico hurricane and earthquake and Japan earthquake), unique combinations of perils, regional exposure and different types of payout structures (such as structures offering annual aggregate and second event coverage), providing investors with opportunities for diversification. As investor demand continues to outweigh supply in 2013, there is room for the market to expand even further to cover new perils (potentially including flood, marine, aviation, agriculture and terrorism) and new geographic regions (including Asia, Australia and New Zealand). In addition, innovative transaction structures are creating opportunities for new sponsors to enter the catastrophe bond market. Below are two examples of 2012 transactions that create potential opportunities for growth:»» Mythen Re Ltd. Series , Class A. Swiss Re obtained coverage for U.S. hurricane and U.K. extreme mortality risk through the issuance of a single tranche of notes (rather than through two separate issuances/ tranches), thereby allowing Swiss Re to take advantage of more favorable pricing resulting from the unique multi-peril structure and save on transaction costs. The transaction was well-received among investors, as U.K. mortality risk provided an opportunity for diversification.»» Combine Re Ltd. As its name suggests, the Combine Re transaction provided two insurers, Country Mutual and NCFB, with the opportunity to access the catastrophe bond market through a single combined catastrophe bond transaction for which Swiss Re acted as a transformer. Country Mutual received US$100 million of aggregate coverage for U.S. hurricane, earthquake, thunderstorm and winter storm events (excluding California, Florida and North Carolina), and NCFB received US$100 million of aggregate coverage for North Carolina hurricane, earthquake, thunderstorm and winter storm events. This type of structure, which allowed Country Mutual and NCFB to save on transaction costs, could provide opportunities for other regional insurers to take advantage of the catastrophe bond market. These trends illustrate the commitment by sponsors, investors and architects of ILS transactions to advance the ILS market in ways that are mutually beneficial to both sponsors and investors, which has been a driving force behind the market s continued growth and success. 2. Response of Traditional Reinsurers to the ILS Market While some view the ILS market as a threat to the traditional reinsurance market, many traditional reinsurers have embraced the ILS market as a way to create additional capacity, write business off of their own balance sheets, generate fee income and ultimately improve the value they are able to offer their clients. In the past 18 months, third-party capital management has become an increasingly important aspect of many reinsurers business models, with reinsurers recognizing that they can leverage their underwriting and insurance management expertise to put third-party capital to use in their underwriting operations, thereby profiting both from the resulting premiums and capital management fees. The following provides an overview of a few of the ways in which reinsurers are accessing and utilizing third-party capital. Sidecars have continued to provide reinsurers with an important source of reinsurance and retrocessional capacity. Market sources have estimated sidecar capacity in 2012 to be between US$ billion. In addition, in the first quarter of 2013, three existing sidecars from RenaissanceRe (Upsilon Re II), Alterra (New Point V) and Validus (AlphaCat Re 2013) were renewed or expanded, and Everest Re (Mt. Logan Re) and Argo (Harambee Re Ltd.) both successfully launched new sidecar transactions, with Argo s Harambee Re positioned to become the first sidecar to underwrite both insurance and reinsurance business. In addition to sidecars, many reinsurers, including Amlin, Hannover Re and SCOR, have established ILS funds to capitalize on the high level of investor interest in the ILS market, particularly from large-scale investors such as hedge funds and 10

17 pension funds. Recently, Validus Re opened up its internal ILS funds to third-party investors for the first time, raising over US$200 million of third-party capital. Munich Re, which manages its own internal ILS funds using in-house capital, has also indicated that it is considering launching an ILS fund open to third-party investors. Market sources expect to see more reinsurer-backed ILS funds in the coming years. Reinsurance broker Aon Benfield Securities, Inc. has predicted that in five years, more than half of the world s top reinsurers will manage ILS funds for investors. Bermuda-based reinsurer Montpelier Re launched a London-based asset management platform offering ILS products to third-party investors. Montpelier Re has also completed an initial public offering of Blue Capital Global Reinsurance Fund, a closed-end feeder fund that will invest in collateralised reinsurance-linked contracts and other investments exposed to catastrophe risk via a segregated account. Blue Capital Global Reinsurance Fund became the third ILS fund admitted to the Specialist Fund Market of the London Stock Exchange (after CATCo and DCG Iris). In addition to Montpelier Re, a number of other Bermuda reinsurers formed asset management affiliates or invested in third-party asset managers in Examples include the strategic partnership of insurance group Allied World Assurance Company Holdings and Aeolus Capital Management Ltd., a Bermuda-based asset manager, and the formation of Lancashire Capital Management by Lancashire Holdings. These asset managers invest third-party capital in instruments with returns linked to property catastrophe reinsurance, retrocession and ILS instruments. 3. Growth of Hedge Fund Start-Up Reinsurers In the past 18 months, the reinsurance market has witnessed the formation of three Bermuda start-up reinsurers backed by well-established hedge funds seeking a more permanent source of capital: Third Point Reinsurance Company Ltd. Formed in late 2011 as the reinsurance venture of hedge fund Third Point LLC (founded by Daniel Loeb in 1995) with more than US$750 million of capital. PaCRe, Ltd. Formed in April 2012 as a joint venture between Validus Re and hedge fund manager Paulson & Co. (founded by John Paulson in 1994) with US$500 million of privately funded capital, including US$50 million provided by Validus Holdings. S.A.C. Re, Ltd. Formed in July 2012 as the reinsurance venture of hedge fund S.A.C. Capital Advisors, L.P. (founded in 1992 by Steven Cohen) with US$500 million of capital. These companies have followed the lead of Greenlight Capital Re Ltd., a Cayman Islands-based reinsurer established in 2004 by hedge fund manager and founder of Greenlight Capital LLC, David Einhorn. Unlike traditional reinsurers, which typically invest conservatively and seek to profit primarily from underwriting results, these reinsurers typically prefer insurance risk with lower severity and higher frequency and invest in assets with higher return potential through funds managed by their hedge fund manager affiliates. 4. Legal and Regulatory Developments a) JOBS Act The Jumpstart Our Business Startups Act ( JOBS Act ), which was signed into law in April 2012, contains several provisions that may be relevant to ILS market participants. Among other things, the JOBS Act directs the Securities and Exchange Commission (the SEC ) to revise Rule 144A and Regulation D under the Securities Act to permit general solicitation and general advertising in connection with Rule 144A and Rule 506 offerings, so long as the securities are sold only to persons that the issuer reasonably believes to be qualified institutional buyers (in the case of Rule 144A offerings) or accredited investors (in the case of Rule 506 offerings). In addition, the revisions to Regulation D will require the issuer in a Rule 506 offering to take reasonable steps (as determined based on the facts and circumstances of the transaction) to verify that purchasers of the securities are accredited investors. In August 2012, the SEC proposed amendments to Rule 144A and Regulation D, as required by the JOBS Act. Such amendments will not become effective until the SEC has completed its rulemaking process and adopted final rules. At this time, it is not clear when such final rules will be adopted or whether any changes will be made to the rules as currently proposed. 11

18 Catastrophe bond transactions are typically structured as Rule 144A offerings, and ILS funds frequently rely on the Rule 506 safe harbor when offering shares of their funds. In order to preserve the applicable exemption from SEC registration, current market practice is for ILS transaction parties and ILS funds to avoid publicity or advertising of any kind related to the transaction, which is one reason that ILS funds do not typically include information about their funds on publicly accessible areas of their websites. Once effective, the JOBS Act could change the way in which ILS transactions are marketed and the way in which ILS funds seek to raise capital. By giving ILS participants flexibility to publicly advertise and solicit investor interest (through newspapers, websites, social media, or otherwise), the JOBS Act could help to raise awareness about the ILS market and open the market up to new classes of investors. b) Dodd-Frank Another regulatory issue currently impacting the ILS market is whether issuers of catastrophe bonds or sidecar securities are commodity pools under the Commodity Exchange Act (the CEA ) and therefore subject to regulation by the Commodity Futures Trading Commission ( CFTC ). As a result of amendments made to the CEA, under Title VII of Dodd-Frank, the CEA was amended to add a new definition of commodity pool, and the commodity pool operator definition was expanded, both of which now include any form of enterprise operated for the purpose of trading in commodity interests, including swaps. Unless otherwise exempt, a commodity pool must be operated by a commodity pool operator ( CPO ) that is registered with the CFTC. Final rules published by the CFTC and the SEC, which became effective on October 12, 2012, broadly defined a swap to include, among other things, contracts that provide for payments that are dependent on the occurrence or extent of the occurrence of a contingency associated with a potential financial, economic or commercial consequence. On its face, this definition could be read to include insurance and reinsurance products, including reinsurance and retrocession agreements entered into in connection with catastrophe bond or sidecar transactions; however, the CFTC/SEC final rules provide a non-exclusive insurance safe harbor to exclude certain products regulated as insurance from the definition of swap. In order to qualify for the insurance safe harbor, an agreement, contract or transaction must: (i) (x) either be an Enumerated Product listed in 17 CFR 1.3(xxx)(4)(i)(C), which list includes, among other types of products, property and casualty insurance and reinsurance thereof, or (y) satisfy the Product Test, which requires the agreement, contract or transaction to have certain key attributes of an insurance agreement (e.g., the beneficiary must have an insurable interest, losses must occur and be proved and payments must be limited to the value of the insurable interest); and (ii) the provider of the agreement, contract or transaction must satisfy the Provider Test, which requires, among other things, that the provider be subject to U.S. state or federal insurance supervision. (For a detailed summary of the insurance safe harbor requirements, please see Sidley Update, August 7, 2012: com/cftc-and-sec-finalize-key-dodd-frank- Product-Definitions-Ushering-in-Implementation- Phase-of-US-OTC-Derivatives-Regulatory- Reforms /.) Notably, catastrophe bond or sidecar transactions with non-u.s. cedents do not satisfy the Provider Test and are therefore outside the scope of the insurance safe harbor. The insurance safe harbor is non-exclusive, meaning that an agreement, contract or transaction that fails to satisfy the insurance safe harbor requirements is not necessarily a swap. Rather, whether such an agreement, contract or transaction would be considered a swap would require further analysis based on the applicable facts and circumstances. However, for agreements that do not fall within the insurance safe harbor, there is greater uncertainty and an increased risk that the agreements will be recharacterized as a swap under Dodd-Frank. In addition, the insurance safe harbor provision includes a grandfathering clause, which excludes any agreement, contract or transaction entered into on or before October 12, 2012 from the definition of swap if it satisfied the Provider Test at the time it was entered into (without having to satisfy the Product Test ). As noted above, catastrophe bond or sidecar transactions with non-u.s. cedents do not satisfy the Provider Test and are therefore unable to take advantage of the grandfathering clause. 12

19 Because of the uncertainty surrounding Title VII of Dodd-Frank and the potential consequences for the ILS market, the Securities Industry and Financial Markets Association, as well as other industry groups and law firms active in the ILS market, have requested interpretive guidance and confirmation from the CFTC that certain ILS vehicles will not be regulated as commodity pools under the Title VII of Dodd-Frank. If such relief is not granted by the CFTC, ILS vehicles using an agreement that is a swap under Title VII of Dodd-Frank (i.e., does not qualify under the insurance safe harbor) will likely be a commodity pool. As a commodity pool, such an ILS vehicle will need to have a registered CPO, and such CPO would then be subject to extensive reporting, disclosure, recordkeeping and other requirements, many of which are not compatible with the operation of a traditional ILS vehicle. However, CFTC exemptions may be available for certain commodity pool ILS vehicles. CFTC Rule 4.13, a de minimus exemption, exempts commodity pools from having a registered CPO and from essentially all of the reporting and disclosure requirements. The other exemption is under CFTC Rule 4.7, known as a registration lite. Under Rule 4.7, the CPO would not be exempt from certain auditing and reporting requirements relating to the commodity pool ILS vehicle, but the requirements are significantly reduced and more manageable. For additional information regarding issues raised by Title VII of Dodd-Frank, please see Section J.1 of Global Regulatory and Litigation Developments below. III. The Global Longevity Market A. United Kingdom According to figures published by the International Monetary Fund in 2012, on a global basis the aggregate value of private defined benefit pension liabilities totals US$23 trillion. With marked increases in life expectancy in recent decades, it is little wonder that pension schemes have increasingly been looking for methods to hedge against the risk that their members live longer than is currently predicted. The U.K. is the most mature market for the de-risking of pension schemes. This has been driven by the large number of defined benefit pension schemes in the U.K. and improvements in life expectancy and poor investment returns that have left many such schemes in deficit. This in turn has adversely affected the balance sheets of corporate sponsors who are liable to make good such deficits. The vast majority of transactions executed to date have taken the form of traditional bulk annuity deals either in the form of pension buy-outs or involving the issue of a buy-in policy. A further alternative first became available to the market in 2009 with the Babcock/Credit Suisse longevity swap. Since then there have been a number of high value transactions structured on a similar basis. To put into context our comments on the current state of the U.K. longevity market and the trends we see emerging, we briefly set out below the key distinguishing features between buy-ins, buy-outs and longevity swaps. 1. Buy-Outs A pension buy-out involves an insurer taking over the liability to pay all or some of the member benefits from the trustees of the relevant pension scheme. This is achieved by the insurer issuing individual annuity policies to the relevant scheme members in return for a payment of premium by the trustees, usually effected by way of a transfer of assets from the pension scheme to the insurer. In the case of a buy-out, there is a direct insurance contract between the insurer and the individual scheme member; and in the event of a full buy-out, where individual policies are issued to all of the members of the pension scheme, the trustees can proceed to wind-up the scheme, with all future administration being performed by the insurer. The buy-out option is accordingly the purest form of pension scheme de-risking. 2. Buy-Ins Pension buy-in solutions were developed as a de-risking option for pension schemes that were unable to afford the often prohibitive costs of a full buy-out. Under a pension buy-in, there is no direct contractual link between the insurer and the individual scheme members. Instead, the pension scheme trustees hold the buy-in policy in their name as an investment of the scheme, and the scheme usually continues to deal with the payment and administration of benefits. The trustees pay a 13

20 premium (usually by transferring over an equivalent amount of pension scheme cash, bonds and other assets under management) and, in return, receive an income stream from the insurer to cover some or all of the scheme s liability to pay member benefits. In the case of some of the larger buy-in transactions, trustees will also require the insurer to post collateral or otherwise secure its obligations to make payments under the policy in particular to cover the possibility of the insurer s insolvency or default. The amount of collateral required will be based on the net present value of the insured benefits (on a best estimate mortality basis). 3. Longevity Swaps In their purest form, longevity swaps are derivatives and not contracts of insurance. However, it is possible to achieve the same economic effect on an insurance or reinsurance basis; and there have been a number of examples of insurers issuing policies to pension schemes structured in the same way as a longevity swap. Although it is clearly important to ensure that the contract is properly structured as a derivative or insurance policy according to whether the protection provider is a bank or insurer; in either case, the core economics are very similar. In return for the pension scheme paying a fixed monthly amount to the insurer or bank the counterparty makes a payment to the pension scheme on a monthly basis (the floating amount) referable to the benefit payable to a defined group of pensioners. Whereas buy-ins and buy-outs involve a transfer of inflation, interest rate, investment and longevity risk to an insurer, longevity swaps (in insurance or derivative form) offer a much purer hedge against the risk of scheme members living longer than is actuarially predicted; and the fact that there is no upfront payment of a lump sum premium is consistent with the fact that the investment, interest rate and inflation risk remains with the trustees. Accordingly, longevity swaps are typically a less expensive alternative than buy-ins and buyouts, albeit much more complex to structure and negotiate. Longevity swaps almost invariably require the two-way posting of collateral to protect against the other party s default or insolvency. The collateral is typically based upon the present value of the covered benefits and will also include a fee element payable to the insurer/bank in the event of termination arising by virtue of trustee default. 4. Pension De-Risking Transactions Over the last months, there have been strong levels of activity within the U.K. market in terms of the number and size of pension de-risking transactions. The highlights have included Prudential plc s buy-in with the West Midlands Integrated Transport Authority in a deal worth over 272 million. This was the first buy-in transaction involving a U.K. local government pension scheme and raises the possibility that other local authorities may follow suit. In terms of longevity swap transactions, 2012 did not see the same level of activity as the very busy 2011, although it was still notable for the Aegon/Deutsche Bank s longevity swap covering 12 billion of the Dutch insurer s reserves. There was also significantly increased activity in 2012 at the reinsurance level, with a number of direct insurers hedging their own longevity books. A good example of a transaction falling into this category was Munich Re s 300 million reinsurance longevity swap protecting a block of business insured by Pension Insurance Corporation. More recently, Legal & General announced in February 2013 that it had completed an insurance longevity swap with the BAE Pension Scheme covering 3.2 billion of liabilities and simultaneously hedged 70% of its exposure under a reinsurance longevity swap with Hannover Re. As for what may develop in the remainder of 2013, we anticipate the following: With pension trustees not being so occupied with triennial reviews this year, there could be a significant increase in the overall volume and size of pension de-risking transactions in the U.K. market, with a series of high value pension buy-ins and longevity swaps. Strong demand from the reinsurance market for longevity risk as a natural hedge against mortality exposure and creating diversification benefits for regulatory capital purposes. Increasing interest in longevity risk from the capital markets (and in particular ILS funds), attracted by an asset class that is largely uncorrelated to the financial markets. 14