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

21 However, given the significant capacity that exists within the traditional reinsurance markets, at least in the short term, the majority of secondary hedging is likely to take the form of asset-backed reinsurance and reinsurance longevity swaps. Given the costs and complexity of constructing bespoke longevity swaps, there is likely to be continuing work on the development of index-based products, although there are unlikely to be many index-based transactions in the short term given pension schemes concerns about basis risk. Further hedging by European-based life insurance groups of annuity portfolios, driven by a concern about the additional regulatory capital that may have to be held under Solvency II. Transfer of U.K. originated longevity risk to the U.S. insurance market. There have already been a number of reinsurance transactions involving U.S.-based (re)insurers hedging U.K. longevity risk; and U.S. insurers have also made strategic investments in the U.K. longevity market, as highlighted by the recently announced Mass Mutual/Rothesay Life transaction. B. United States While the United States marketplace has not been as active as the United Kingdom, a few significant transactions have been completed in the space, signaling that companies in the United States may be starting to address longevity issues. 1. General Motors On May 30, 2012, the General Motors Retirement Program for Salaried Employees, a pension plan sponsored by General Motors Company ( GM ), entered into a definitive agreement to purchase a group annuity contract from The Prudential Insurance Company of America ( Prudential Insurance ), pursuant to which Prudential Insurance agreed to guarantee the full payment of all annuity payments to approximately 110,000 of GM s salaried retirees, and assume all investment risk associated with the assets that were transferred as the group annuity contract premium. An additional approximately 13,000 retirees opted to receive a lump sum payment from GM in lieu of ongoing pension benefits. The transaction, which closed November 1, 2012, was the largest pension-risk transfer transaction completed in the United States, transferring approximately US$29 billion of pension liabilities from GM s balance sheet. As a result of the transaction, GM made an addition contribution of approximately US$2.6 billion. In this solution, Prudential Insurance holds assets supporting the group annuity contract in a separate account, accessible only for annuity payments associated with the group annuity contract. The general account of Prudential Insurance has provided a guarantee that the assets held in the separate account are sufficient to make all payments under the group annuity contract. Retirees opting to receive ongoing payments from Prudential Insurance benefit from Prudential Insurance s higher rating ( AA- from Standard & Poor s, as compared to GM s rating of BB+ ). 2. Verizon Communications Inc. On October 17, 2012, Verizon Communications Inc., along with Verizon Investment Management Corp. and Fiduciary Counselors Inc., as independent fiduciary of the Verizon Management Pension Plan (the Verizon Plan ), entered into a definitive agreement to purchase a single premium group annuity contract from Prudential Insurance, to settle approximately US$7.5 billion of pension liabilities of the Verizon Plan. The transaction closed December 10, 2012, prior to which Verizon made an additional contribution of approximately US$2.5 billion. Prudential Insurance holds assets supporting the group annuity contract in a separate account and has provided a general account guarantee with respect to these assets. Similar to the GM transaction, retirees benefit from Prudential Insurance s higher rating ( AA- from Standard & Poor s, as compared to Verizon s rating of A- ). Two Verizon retirees sought to block the transaction prior to the closing by filing a lawsuit arguing that Verizon breached its fiduciary duties by acting against members best interests and violated the Employee Retirement Income Security Act ( ERISA ) because the transfer was not authorized by the Verizon Plan documents. On December 7, 2012, the district court in Dallas struck down the 15

22 attempt by the retirees for a temporary restraining order to block the transfer, finding that the retirees failed to establish a substantial likelihood that they will prevail. Verizon did acknowledge that the transaction would strip retirees of the pension protections legislated in ERISA by the Pension Benefit Guaranty Corporation and instead provide the retirees, as annuity holders, with protection under state insurance guarantee regulations. Notwithstanding the court s denial of the retirees request for a temporary restraining order, on March 28, 2013, the court certified a class of participants, beneficiaries and/or alternate payees of the [Verizon Plan] whose benefit obligations were transferred from the [Verizon Plan] to a group annuity contract issued by The Prudential Insurance Company of America. As discussed in Section E.3 of Global Regulatory and Litigation Developments below, the NAIC has organized the Separate Account Working Group to analyze the use of separate accounts in connection with various types of insurance products. As discussed in more detail below, this working group has recommended that separate accounts be used in connection with insurance products in which the policyholder bears the investment risk, which is not always the case in group annuity contracts. In connection with future longevity transactions, the use of the separate account group annuity contracts should be reviewed in light of the working group s recommendations. IV. The Global Capital Markets A. United States Markets During the period of time immediately following the financial crisis of 2008, many insurance companies undertook capital raising initiatives, in large part due to their investment portfolio losses. Public companies generally accessed the market by using their shelf registrations for issuances of debt and equity while private companies issued surplus notes from insurance operating companies or senior notes from holding companies. This post-crisis cycle of offerings wound down by the end of In the past year, the market has seen insurance companies access the debt markets primarily for refinancing purposes. Unlike the life insurance industry, property and casualty insurers have generally found themselves in a fully or over-capitalized position. Accordingly, there has been less capital markets activity in the property and casualty industry. The issuances that did take place in 2012 were generally undertaken to take advantage of the record low interest rates, with these insurance companies using the issuance proceeds as a rainy day fund. Since the surge of capital markets offerings immediately following the crisis, some life insurance companies have returned to issuing funding agreement-backed notes. These programs provide a life insurance company flexibility to issue funding agreement-backed notes to institutional buyers within the United States pursuant to Rule 144A and outside the United States pursuant to Regulation S. Insurance companies active in this market include MassMutual, New York Life, MetLife and Principal Financial Group. Issuance range from US$300 million into the billions. Because these offerings serve as an institutional spread business, the current structures are relatively short in term. Insurers continue to employ specialty corporate finance solutions. These solutions include issuances by property and casualty insurers of catastrophe bonds and similar transactions, while the life sector has completed reserve financing and embedded value solutions. These specialty corporate finance transactions are discussed above under The Global Alternative Risk Transfer Market. 1. Legal and Other Developments Various legal developments over the past eighteen months have had an impact on capital markets transactions in the United States. For example, as described in more detail under Section B.4(a) of The Global Alternative Risk Transfer Market above, the JOBS Act contains provisions that, among other things, relax the prohibition against general solicitation and advertising in Rule 144A offerings. These provisions will become effective upon the enactment of the rules proposed by the SEC regarding solicitation and advertising in the context of private offerings, including Rule 144A offerings. Among other things, the proposed rules permit general solicitation and advertising for private securities offerings so long as (i) the issuing company takes reasonable steps to verify that purchasers are accredited investors, and (ii) all such purchasers are, 16

23 in fact, accredited investors, or the issuing company reasonably believed all such purchasers were accredited investors at the time of their purchase of the securities. At this time, the proposed rules have not been adopted by the SEC. An additional legal development affecting capital markets arose in February of 2010 when the SEC issued Releases and , which alerted insurance company issuers that they are required to make certain disclosures, including adding additional risk factors in offering documents, relating to the adverse effects of climate change and global warming on its business. This requirement has become especially relevant in light of Hurricane Sandy and various other weather-related catastrophes occurring during the past eighteen months. Publicly traded insurance holding companies have recently been enhancing the disclosure concerning their investment portfolios in their 10-Ks and 10-Qs. As a result of demands from both investors and underwriters, we have seen a trend recently to include substantially more disclosure than in the past on sovereign securities of all kinds (both European and non-european), as well as securities issued by European entities and even, in some cases, by non- European entities with significant operations in Europe. Similarly, we are seeing substantial disclosure, including in the Risk Factors section of disclosure documents, concerning the effects of the Dodd- Frank Act on the businesses of insurance holding companies and operating insurance companies. For example, many insurance entities are finding that Title VII of Dodd-Frank, dealing with derivatives, could have a material impact on their investment operations and are including Risk Factors and other disclosures to that effect. Finally, for developments regarding corporate governance, please see Section G.3 of Global Regulatory and Litigation Developments below. 2. Future Expectations The capital position of the industry seems generally to have stabilized over the past few years. Unless unforeseen major events occur, we would not anticipate a wave of general corporate financings that we witnessed following the financial crisis. Now that insurers generally have repaired any damage to their capital position following the financial crisis, we have observed that insurers are using other methods to bolster their capital position, including the sale of non-core assets. B. European Markets After a long period of quiet, non-u.s. issuers started tapping the U.S. hybrid market. The QBE Insurance Group ( QBE ) and Aviva plc ( Aviva ) transactions led the way in late 2011, after a year of primarily Asian dollar- and Euromarket-only issues of Tier 2 compliant or grandfathered Tier 1 offerings by issuers such as Old Mutual, Friends Life, CNP Assurances, Munich Re, Swiss Life, Zurich, Allianz, Scor and Prudential. Aviva issued US$400 million 8.25% Capital Securities due 2041, which was the first offering in the U.S. market of Solvency IIcompliant insurance company capital securities. The securities were SEC registered and offered to retail investors in the United States and provided Lower Tier 2 capital to Aviva under then-current U.K. insurance company capital requirements and were intended to provide Aviva with Tier 2 capital under Solvency II. QBE issued U.S. dollar and Sterling Solvency II-compliant 144A offerings. The hope was that Aviva and QBE would lead the way to a steady flow of Solvency II issuances into the United States. While AEGON N.V. followed in early 2012 with an SEC-registered transaction of 8.00% Non-Cumulative Subordinated Notes due 2042, the remainder of the capital securities primary market issues in 2012 were in the Asian dollar and Euro markets and included issuers such as Swiss Re, Assicurazioni Generali, Delta Lloyd, SCOR SE, Swiss Life Holding, CNP Assurances SA, Allianz SE, Friends Life, Hannover Re and Allianz SE. Total issuances of insurance hybrid transactions in Europe during the second half of 2012 reached EUR 6.4 billion, over 10 times higher than the level during the same period in There were also private investments, including Massachusetts Mutual Life Insurance Company s purchase of 100 million of Floating Rate Perpetual Preferred Callable Securities issued by U.K.-based privately held insurance company Rothesay Life Limited. Rothesay Life provides solutions for pension schemes seeking to mitigate financial and longevity risk and is a wholly owned subsidiary of the Goldman Sachs Group, Inc. The securities were structured to comply with the 17

24 Financial Services Authority s General Prudential Rules for Upper Tier 2 securities of insurers and Solvency II. For developments regarding Solvency II, see Section I.2 of Global Regulatory and Litigation Developments below. V. Global Regulatory and Litigation Developments A. Introduction The global regulatory landscape is changing across many industries, and the global insurance industry is no exception. U.S. insurance companies have always navigated a complex system of state-based insurance regulation. However, in the 21st Century, global insurance companies increasingly face difficult questions regarding the interpretation and intersection of U.S. federal, state and non-u.s. insurance regulations. These regulations certainly affect the structure of insurance company transactions and present other financial and operational concerns. In 2013, insurers will continue to monitor developments in the U.S., related to healthcare reform and the role and responsibilities of the FIO; in the U.K., related to Solvency II; and in China, related to the China Insurance Regulatory Commission s proposed changes to the regulatory regime in the P.R.C./China. One of the most significant changes to U.S. insurance regulation in 2013 will be the sudden predominance of health insurance regulatory issues, as states and the federal government attempt to implement the Patient Protection and Affordable Care Act (Public Law ), enacted on March 23, 2010, and its companion, the Health Care and Education Reconciliation Act of 2010 (Public Law ), enacted on March 30, 2010 (together, the Affordable Care Act ) and insurers seek rate and policy form changes. Also, application of new principles-based reserving will bring dramatic regulatory and transactional changes to the life insurance industry. However, it is the release of an insurance report by the FIO that perhaps has the greatest potential to alter the future of U.S. insurance regulation, as it attempts to address the overall merits of continued state-based insurance regulation a system that will then be probed by members of Congress when they receive the report. These and other important insurance regulatory topics are discussed in more detail below. B. Federal Insurance Office Report The insurance industry (and insurance regulators) eagerly awaits the FIO s report on modernizing and improving insurance regulation in the U.S. (the FIO Report ). The FIO was established within the Treasury Department pursuant to Title V, Subtitle A of Dodd-Frank, also known as the FIO Act (the FIO Act ). The FIO Report, as required by the FIO Act, must be submitted by the FIO s Director (former Illinois Insurance Director Michael McRaith) to the U.S. Congress. In preparing the FIO Report, the FIO Director is required to consult with the FIO s Advisory Committee, a group of individuals appointed by Treasury in November 2011 to assist the FIO in carrying out its duties. Although the FIO Act required submission of the report no later than 18 months after the FIO Act s enactment (i.e., by January 21, 2012), it now is more than one year overdue. (The FIO also missed the September 30, 2012 deadline for its Reinsurance Report, which was to evaluate the effect of domestic and international regulation on reinsurance in the U.S. and to outline ways for coordinating reinsurance supervision in the U.S. and abroad.) At a mid-march 2013 meeting of the FIO s Advisory Committee in Washington, D.C., the FIO Director stated the FIO Report would be released by July The FIO Report is highly anticipated due to its broad and comprehensive mandate. The FIO Act requires that it address and make recommendations on each of the following: (1) systemic risk regulation for insurance; (2) capital standards; (3) consumer protection; (4) national uniformity of state insurance regulation; (5) regulation of insurers and affiliates on a consolidated basis, (6) international coordination of insurance regulation; (7) costs and benefits of federal regulation of various lines of insurance (except health insurance); (8) feasibility of regulating only certain lines of insurance at the federal level (while leaving other lines regulated at the state level); (9) the ability of potential federal legislation or regulators to eliminate or minimize regulatory arbitrage; (10) the impact of regulatory developments in foreign jurisdictions; (11) whether potential federal regulation could provide robust consumer protections for policyholders; and (12) the potential consequences of regulating insurance 18

25 companies on a federal level, including the effect on the operation of state insurance guaranty funds. Speculation on why the FIO Report is overdue ranges from partisan politics to bureaucratic red tape to whether it is feasible to fairly and comprehensively address so many complex topics in one report. One topic in particular federal protections for insurance consumers may be a political hot button that needs to be carefully worded in the report. Another is potential criticism of coordination of state insurance regulators in general, including criticism of the NAIC, the organization through which state insurance regulators coordinate on regulatory issues. It is likely that the FIO Report was delayed pending the 2012 Presidential election, the challenge to the Affordable Care Act and the late February 2013 confirmation of a new Secretary of Treasury, to allow the Secretary s input before the FIO Report is submitted to Congress. The FIO s authority extends to all lines of insurance except health insurance, long-term care insurance (except that which is included with life or annuity insurance) and crop insurance. Even in the absence of the FIO Report, the FIO has a potentially significant assignment, through which it may be a catalyst for future U.S. regulatory changes. While the FIO has no statutory or regulatory authority over insurance, it is charged with coordinating U.S. efforts on international insurance matters (including agreements with foreign governments, which can preempt state insurance law in certain circumstances) and collecting information on and monitoring the insurance industry (including access to affordable insurance). C. Principles-Based Reserving After more than a decade of discussion, in late 2012, the NAIC took the final step toward adopting principles-based reserving ( PBR ) for life insurers. In 2009, the NAIC adopted revisions to the Model Standard Valuation Law (the Valuation Law ) allowing for principles-based reserving, rather than rules-based reserving. Since that time, adoption of the Valuation Law by individual states had been on hold pending the NAIC s finalization of the accompanying Standard Valuation Manual (the Valuation Manual ). On December 2, 2012 at its meetings in National Harbor, Maryland, a required supermajority of the NAIC s Executive/Plenary Committees voted to adopt the Valuation Manual, signaling the NAIC s commitment to move forward on PBR. It was a narrow vote that passed with only one more than the minimum number of votes required for approval. A principles-based approach to reserving is a more case-by-case, rather than one-size-fits-all, approach to reserving that takes into consideration an insurer s specific circumstances, including claims experience and internal forecasts. PBR would replace the current rules-based reserving that can result in excessive reserves. One of the intended effects is to obviate the need for life insurers to carry redundant or non-economic reserves for certain term and universal life business (XXX and AXXX reserves) that exceed amounts necessary to satisfy liabilities. The historic vote at the Fall National NAIC meeting followed attempts by insurance regulators in some states (particularly California and New York) to delay a final vote and to encourage additional discussion of the relative benefits of PBR and potential pitfalls. Such concerns were detailed in letters delivered by insurance regulators in California and New York to fellow NAIC members during the week leading up to the Fall National NAIC meeting. The letters questioned, among other things, the availability of state and NAIC resources to implement and regulate PBR and potential risks to consumers posed by lower reserves required by PBR. At least one state (New York) lobbied against passage up until the time of the vote, and the required supermajority approval was only narrowly obtained. (The Executive/Plenary Committee vote passed with 43 jurisdictions voting for adoption, eight jurisdictions (California, Guam, Maryland, New Mexico, New York, North Carolina, Oregon and Wyoming) voting against adoption, two states (Minnesota and Oklahoma) abstaining, and three jurisdictions not in attendance.) With the NAIC s adoption of the Valuation Law and the Valuation Manual, the future of PBR will be determined by state adoption of the Valuation Law and state implementation efforts, which will likely be influenced by ongoing NAIC activity. Individual states will still need to adopt PBR. As of this writing, it appears that only seven states have initiated efforts to adopt PBR. Ratification of PBR will require adoption by 42 states representing 75% of written 19

26 premium volume. If that benchmark is met by July 1, 2013, PBR would be effective as early as January 1, Future NAIC activity related to PBR will be coordinated by the newly created executive-level Joint Working Group of the Life Insurance and Annuities (A) and Financial Condition (E) Committees. In addition, the Principles-Based Reserving Implementation Plan (the PBR Plan ) adopted by the Principles-Based Reserving (E) Working Group (before the Executive/Plenary Committee s historic vote on PBR) will likely serve as an important guide for navigating next steps in PBR implementation. While the NAIC has created a specific task force (the Principles-Based Reserving Implementation (EX) Task Force), that task force s first meeting (scheduled for March 12, 2013) was cancelled. The PBR Plan identifies certain policy decisions that need to be made in order to ensure that states and the NAIC have appropriate resources for PBR implementation and regulatory review. The scope of the PBR Plan includes, but is not limited to: surveying states regarding financial and personnel resources required to support PBR; establishing an NAIC Actuarial Resource to further develop PBR reserve requirements; establishing an Actuarial Analysis Working Group to operate similarly to the Financial Analysis (E) Working Group, but with respect to PBR issues; collection and reporting of statistical data related to PBR; and training state insurance department staff charged with overseeing PBR. Although industry participants should expect that full PBR implementation could take a number of years for states to accomplish, industry participants should nonetheless continue to monitor developments related to PBR, including opportunities to shape policy underlying this momentous shift in reserving requirements. D. Health Insurance The health insurance industry is busy preparing to implement the many changes to the U.S. healthcare system that will take effect within the next twelve months as a result of the Affordable Care Act. In its June 28, 2012 decision, the Supreme Court of the United States upheld the individual mandate imposed by the Affordable Care Act as a constitutional exercise of Congress taxing power, but struck down as unconstitutional the Medicaid expansion provisions of the Affordable Care Act. In the wake of the Supreme Court s decision and the results of the 2012 presidential election, there is little doubt that healthcare reform, as mandated by the Affordable Care Act, will be implemented. Accordingly, in 2013, the health insurance industry will be monitoring the flurry of state and federal activity that is already underway to see such implementation to completion. The implementation of healthcare reform has renewed the old debate regarding state versus federal regulation of the business of insurance. At the Fall National NAIC meeting, Gary Cohen, the Director of the Center of Consumer Information and Insurance Oversight ( CCIIO ), a division of the Centers for Medicare & Medicaid Services ( CMS ), emphasized that CCIIO and CMS aspire to collaborate with states to enforce the Affordable Care Act and view the states role in such enforcement as analogous to states enforcement of the Health Insurance Portability and Accountability Act of 1996 ( HIPAA ). However, state regulators generally only have power to interpret and enforce state laws and regulations. Unlike HIPAA, the Affordable Care Act does not specify a method and timeframe for states to adopt enabling legislation for state regulators to enforce the Affordable Care Act s requirements. At the Fall National NAIC meeting, the NAIC adopted two new model acts (the Individual Market Health Insurance Model Act and the Small Group Market Health Insurance Model Act) that do, in fact, implement many of the Affordable Care Act s requirements that become effective in 2014 with respect to individual and small group health insurance. To ensure that state legislatures may enact the model acts as state law during the 2013 legislative session, the Regulatory Framework (B) Task Force decided to adopt these model acts despite the fact that the U.S. Department of Health & Human Services ( HHS ) had not yet promulgated final rules pursuant to the Affordable Care Act, which final rules may affect the provisions of the 20

27 model acts. Regardless of whether a state adopts the new model acts or other related enabling legislation, if CMS determines that a state has failed to substantially enforce a provision of the Affordable Care Act, CMS is empowered to enforce such provision and has authority to impose certain penalties (including a maximum civil monetary penalty of US$100 per day, per affected individual) on any non-compliant health insurer. This has led some in the health insurance industry to anticipate that in some states, federal regulators, and in others, state regulators, will have primary charge over Affordable Care Act enforcement. The confusion regarding state and federal implementation of healthcare reform carries over to the Affordable Care Act-mandated health insurance exchanges. Under the Affordable Care Act, beginning October 1, 2013, each state must have an operational health insurance exchange capable of enrolling customers for the 2014 annual enrollment period. States may operate their own state-based exchange, partner with the federal government to run a state-federal partnership exchange or elect to default to the federally facilitated exchange. As of March 2013, CMS had conditionally approved 17 states (California, Colorado, Connecticut, Hawaii, Idaho, Kentucky, Maryland, Massachusetts, Minnesota, Nevada, New Mexico, New York, Oregon, Rhode Island, Utah, Vermont and Washington) and the District of Columbia to operate a state-based exchange, 7 states (Arkansas, Delaware, Illinois, Iowa, Michigan, New Hampshire and West Virginia) had submitted an application for a partnership exchange and CMS had conditionally approved the application of all such states, and the remaining 26 states elected to default to the federally facilitated exchange. CMS rejected the application of the Commissioner of Insurance of the Mississippi Insurance Department for a state-based exchange due to the Mississippi governor s opposition to a state-based exchange. In order to participate in the exchanges, health insurers will have to ensure their plans provide certain essential health benefits prescribed by the federal government (or more restrictive standards prescribed by the states). Participating health insurers likely will be required to pay a monthly user fee to the state and/or federal government, as applicable, for participating in the exchanges. These and other issues affecting the business of health insurance post-affordable Care Act implementation are subject to additional regulations to be proposed and finalized by HHS. States and insurers continue to express concern that more and final information is required from the federal government to ensure timely compliance with the Affordable Care Act s requirements. Given the amount of work to be done during the remainder of 2013 and the constant flow of new and changing information that must be incorporated into that work, health insurers should reach out to experts in the field to stay abreast of these developments. E. Life Insurance 1. Reserves for Universal Life Products with Secondary Guarantees In September 2012, the NAIC adopted revisions to AG 38. The revisions to AG 38 concern reserving for universal life products with secondary guarantees and address regulatory concern over the sufficiency of reserves established by insurers for certain new universal life products with secondary guarantees. Specifically, concerns related to the possibility that such reserves might not fully reflect the benefits of the secondary guarantees, especially when they are calculated using particular premium payments made to keep policies in force. Following adoption of the AG 38 revisions, additional work continues on interpretations involving AG 38. In October 2012, the NAIC s Financial Condition (E) Committee established the Emerging Actuarial Issues (E) Working Group, which responds to questions of application, interpretation and clarification of AG 38. The Working Group will adopt by consensus formal interpretations on issues presented before it, and such interpretations will then be reported to the Financial Condition (E) Committee, which, after such adoption, will direct the NAIC s Financial Analysis (E) Working Group to follow the interpretations in performing its reviews of the reserving methodologies under AG 38. In December 2012, the Financial Condition (E) Committee adopted the first series of Actuarial Interpretations, which address two reserving methodologies (alternative and primary) applied to existing business, the application of certain reserve requirements to asset caps and minimum premiums for secondary guarantee requirements. 21

28 Also, in December 2012, the NAIC released an RFP soliciting proposals for an actuarial consulting firm to review reserve methodologies used by insurers subject to AG Contingent Deferred Annuities The NAIC is finalizing its work on so-called contingent deferred annuities ( CDAs ), a product that attracted regulatory attention in late While CDAs differ in structure, they are usually presented by an insurer as an annuity (or synthetic guaranteed investment contract) containing a guarantee of lifetime withdrawal benefits to a mutual fund investor where funds are neither owned nor maintained by the insurer. Some insurance regulators expressed concerns about these products from both an actuarial and regulatory perspective, including an insurer s lack of ownership or control of underlying invested assets and whether the product should be characterized as financial guaranty insurance. An NAIC subgroup of the Life and Annuities (A) Committee was created to examine actuarial issues, potential consumer issues, reserving and capital considerations. Initially, the NAIC s focus was on how CDAs should be classified and what regulatory framework should apply to them. Early on, a majority consensus emerged that CDAs be treated as annuities from a regulatory perspective although some regulators considered them to be more of a hybrid, albeit under a regulatory framework for annuities. The Life and Annuities (A) Committee voted to adopt the subgroup s recommendation that CDAs be regulated as variable annuities for the purpose of market regulation and consumer protection. Existing laws that apply to variable annuities may need to be revised to clarify that they also apply to CDAs. The following definition of CDA was approved by the Life and Annuities (A) Committee: an annuity contract that establishes an insurer s obligation to make periodic payments for the annuitant s lifetime at the time designated investments, which are not owned or held by the insurer, are depleted to a contractually-defined amount due to contractually-permitted withdrawals, market performance, fees and/or other expenses. The NAIC will continue to evaluate the adequacy of existing laws and regulations applicable to the solvency of life insurers that issue CDAs. 3. NAIC s Response to Use of Separate Accounts Separate accounts were initially established so that assets backing certain insurance products (such as variable annuities and variable universal life products) in which the policyholder bears the risk of the investments would be administered and managed separate and apart from those of the general account. The rationale behind this approach was to ensure that the investment risk borne by such policyholders/contractholders was insulated from the investment risk borne by the insurer with respect to the other assets it held in support of general account insurance products or otherwise. Since their establishment, the range of uses for separate accounts has expanded dramatically to cover an assortment of hybrid and other insurance products. The NAIC has established a Separate Account Risk Working Group (the SARWG ) that is in the process of analyzing the use of separate accounts for such other products. The SARWG s current proposal, that has not yet been finalized, takes a strict view with respect to what types of products should be eligible to use separate accounts based on such products characteristics. The SARWG has initially recommended that, in accordance with the guidance provided by generally accepted accounting principles that insulation with respect to separate accounts is best attributed to products where the investment risk is borne by the contract holder. Under such recommendation, in order for a product to be afforded separate account insulation, (a) the insurer must (as a result of contractual, statutory or regulatory requirements) invest the funds held with respect thereto as directed by the contract holder or in accordance with specific investment objectives or criteria, and (b) all investment performance, net of fees, must (as a result of contractual, statutory or regulatory requirements) be passed through to the contract holder. F. Unclaimed Property 1. Regulatory Issues Every state has unclaimed property laws that declare money, property and other assets to be abandoned after a dormancy period, typically three to five years. The property is then turned over to the state, which assumes responsibility for finding 22

29 the rightful owners. In many instances, however, the rightful owner is never located, and the state is then permitted to use the abandoned property for state budgetary purposes. With increased budget constraints, state regulators have shown renewed vigor in enforcing unclaimed property laws. For the life/annuity insurance industry, this activity has had an unsettling effect. Life insurers are generally required to pay claims only after receiving notice and due proof of death. These are contractual and, often, statutory requirements. Absent such notice and due proof of death, a life insurer historically had no affirmative obligation to ascertain whether an insured was alive or dead, and it was common industry practice to undertake to contact a policyholder when the insured attained the policy s limiting age. If a policyholder was not located at that time, then the policy death benefits would be remitted to the state after expiration of the dormancy period. State unclaimed property regulators have initiated audits of life insurers claims practices with a view to determining whether use of the Death Master File (the DMF ) described below will reveal insureds who have died and for whose policies no claim has been made, thus clearing the path to remittance of the death benefits to the state if a beneficiary cannot be located within a certain amount of time. The DMF is a database maintained by the U.S. Social Security Administration (the SSA ). It includes over 89 million records of deaths reported to the SSA. Notably, there are concerns over its accuracy and completeness. A version of the DMF has been publicly available, for a fee, since the mid-1990s, but it previously had not been suggested to be a method of notice to life insurers of a death or the commencement of a statutory dormancy period. The DMF has often been used by insurers for anti-fraud purposes, to verify dates of death, or to identify deceased annuitants in the payout phase for whom benefits would terminate. In the past, some life insurers used the DMF with respect to annuitants, but not life insurance policyholders, which caused consternation among insurance regulators, and, in response, the NAIC created the Investigation of Life/Annuity Claims Practices Task Force (the Task Force ) in The Task Force has been investigating life claims settlement practices and potential violations of unfair claims practices for failure to effectuate prompt, fair, and equitable settlements of claims in which liability has become reasonably clear. In two states, public hearings were held by the insurance and unclaimed property regulators respecting the compliance practices of two companies, while numerous market conduct examinations and/or state unclaimed property investigations and audits were commenced against a host of life insurance companies. Some of these investigations and audits led to regulatory settlements with the Task Force and to global resolution agreements with the unclaimed property auditors or regulators. In some cases, the investigations have resulted in the payment of millions of dollars in examination costs and in the remittance of unclaimed property with interest. However, a number of such matters are not concluded and many insurers are considering their options for responding. Some insurers that settled have announced increases in reserves for examination and related costs, as well as the costs of locating and paying beneficiaries. The costs of reforming internal claims procedures and computer systems in order to implement use of the DMF have added to the economic exposure for settling life insurers. The latter costs may be incurred by many, if not all, life insurers over time due to changes in regulatory interpretations of the claims settlement practices laws, as well as changes in such laws in a number of states. The prospect of implementing these changes in a short time frame and on a companywide basis can result in significant costs and operational hurdles. Therefore, life insurers and trade associations are looking at these matters closely. Several states recently have addressed these unclaimed property issues through the legislative process. The National Conference of Insurance Legislators drafted a Model Unclaimed Life Insurance Benefits Act (the NCOIL Model ), which NCOIL Model (or a bill otherwise requiring use of the DMF) has been enacted in three states (Alabama, Kentucky, and Maryland) and introduced in several others (Massachusetts, Montana, Nevada, New Mexico, North Dakota, Rhode Island, Tennessee, and Vermont). New York also enacted a law requiring use of the DMF. The law is applicable to life insurers domiciled in New York and to every life insurance policy issued or delivered in New 23

30 York by an authorized foreign insurer. (See Chapter 495 of the Laws of New York, 2012.) A clarifying amendment was pre-filed, as Assembly Bill 1831, in early The New York Department of Financial Services also promulgated Regulation No. 200 as an emergency matter, requiring use of the DMF or a similar database. This followed the issuance in July 2011 of a Section 308 letter to all New Yorkauthorized life insurers, notifying them that the use of the DMF or a similar database was required and mandating certain reports to be filed in Notably, the New York approach reflected in Chapter 495 and Regulation 200 differs from the NCOIL Model approach in a number of respects and is more comprehensive in its scope. One important feature of the NCOIL Model and the laws enacted to date is their retroactive approach. They require use of the DMF with respect to all in-force business, rather than with respect to policies issued after the date of the legislation. Another key compliance matter is that the NCOIL Model does not limit its scope to policies issued or delivered in any particular state and, therefore, insurers are potentially subject to conflicting and overlapping rules on timing, frequency, matching methods and other aspects of using the DMF. As a result, there have been a number of challenges to and corresponding proposals to amend the NCOIL Model and related states laws. Regulators, life insurers, and trade associations are actively monitoring these issues, and we expect continued activity in this area throughout Litigation a) Private Party Class Action/ Qui Tam Lawsuits Private litigation over unclaimed property practices of life insurance companies continued in In City of Westland Police and Fire Retirement System v. MetLife Inc., et al., 1:12-CV LAK (S.D.N.Y. May 14, 2012), a group of MetLife stockholders filed a putative class action shareholder suit in 2012, following MetLife s unclaimed property settlement with insurance regulators the prior year. The allegations are that by failing to use the DMF to determine whether life insurance policyholders may be deceased and hence benefits may be due, MetLife understated its reserves and overstated its profitability in its financial reports. A ruling in February 2013 dismissed certain counts against MetLife s officers and directors, but the suit otherwise continues. In Andrews et al. v. Nationwide Mutual Insurance Co. et al., 2012 WL , No (Ohio Ct. App. Dist. 8 Oct. 25, 2012), the appellate court affirmed the trial court s dismissal of an action brought by policyholders of insurance policies currently in force alleging that the defendants, Nationwide Mutual Insurance Company and Nationwide Life Insurance Company, breached their duty of good faith and fair dealing by failing to use the DMF to annually investigate whether any insureds had died during the prior year, where the defendants had not received a death claim. The trial court had dismissed the action on the dual grounds that the plaintiffs had no standing to bring the action and the plain language of the defendants life insurance policies (which stated that the defendants would pay the death benefits upon receipt of due or satisfactory proof of death) precluded the suit. The appellate court affirmed, finding that the defendants had not breached their duty of good faith and fair dealing by failing to incorporate the DMF into [their] account servicing practices when [they are] not contractually or legally obligated to do so. The court further stated that [i]n the absence of legislative or administrative regulatory action, we will not import additional unspoken duties and obligations onto Nationwide that will conflict with the parties contracted terms. Another common theory for private unclaimed property suits against insurance companies is qui tam or false claims act actions. These actions allow for a private individual, or whistleblower, with knowledge of fraud against the government to bring suit on behalf of the government. A successful whistleblower may receive a portion of the damages recovered, which may include treble damages and attorneys fees, making the cause of action a popular one for plaintiff s attorneys. A pair of such qui tam actions filed by a private unclaimed property recovery group was resolved in Total Asset Recovery LLC v. MetLife, Inc., et al., Case No L (Ill. Cir. Ct. Cook Cty., filed January 24, 2011); Total Asset Recovery LLC v. MetLife, Inc., et al., Case No. 27-CV (Minn. 4th Dist., filed January 31, 2011). The complaints, filed in Illinois and Minnesota against both MetLife and Prudential, 24

31 alleged that the insurers failed to escheat unclaimed life insurance proceeds. The Illinois action was withdrawn in September On New Year s Eve 2012, the Minnesota court dismissed that action, finding no personal jurisdiction over MetLife, that the claims were not pled with particularity, and that the Minnesota False Claims Act, effective July 1, 2010, did not apply to the unclaimed property law violations alleged in the complaint, which occurred only in 2009 and prior. b) State Actions (West Virginia) A new front was opened in unclaimed property litigation last year, when the West Virginia State Treasurer filed suit against dozens of life insurance companies for unclaimed property violations. See, e.g., State of West Virginia ex. Rel. John D. Perdue v. Prudential Insurance Company of America, 12-C-287 through 12-C-296 (W. Va. Putnam Cty., filed Sep. 20, 2012). In the complaint, the West Virginia Treasurer alleges that the duty of good faith and fair dealing requires the insurers to use the DMF or other means to determine if policyholders are deceased or three years past the applicable limiting age mandating payment to the West Virginia Unclaimed Property Fund. This appears to be the first time a state official has claimed that existing law mandates life insurance companies to affirmatively search for deceased policyholders. c) Kentucky Law and Constitutional Challenge Thereto The Bluegrass state is home to another area of recent development in life insurance unclaimed property litigation. In 2012, the State of Kentucky enacted the Unclaimed Life Insurance Benefits Act (the ULIBA ), which is based on the NCOIL Model. See KY. REV. STAT. ANN The law amends the Kentucky Insurance Code effective January 1, 2013 to impose an affirmative duty on life insurers to seek out evidence that insureds have died, even where no claim has been received from a beneficiary or the insured s estate. If the insurer is unable to locate a beneficiary, the insurer must escheat the proceeds within three years. Three life insurance companies brought a constitutional challenge to the ULIBA in November United Ins. Co. of Am, et al. v. Kentucky Dep t of Ins., et al., Civil Action No CI-1441 (Ky. Cir. Ct. Franklin Cty, filed Nov. 8, 2012). The insurers sought a declaration that the ULIBA applies only prospectively, to new business issued on or after the ULIBA s effective date, consistent with Kentucky s statutory presumption against the retroactive application of new laws. Alternatively, if the ULIBA were construed to have retroactive effect and to apply to existing in-force business as well, the insurers sought a declaration that the ULIBA substantially impairs existing contract rights and thereby violates the Contracts Clause of the United States and Kentucky Constitutions. On April 1, 2013, the Franklin County Circuit Court granted the Commonwealth of Kentucky s motion for summary judgment. The order was final and appealable; the court also stayed enforcement of the statute for ten days to allow for post-judgment or interlocutory relief. d) Reinsurance Disputes Unclaimed property law developments are also fertile ground for reinsurance disputes. While no decisions have been publicly reported, we are aware of several private reinsurance arbitrations concerning, for example, reinsurer challenges to ceding company changes in unclaimed property practices where the subject reinsurance contract requires prior reinsurer approval of any changes to claim handling guidelines. Reinsurance issues may also arise over extra-contractual obligation coverage for fines and penalties imposed upon a cedent for escheat non-compliance, payments made in the absence of a formal claim and applicability of ex gratia claims defenses thereto, coverage for additional expenses not originally contemplated in pricing (such as periodic checks of the DMF), and whether reinsurance treaties cover policies in force at the time of treaty commencement but later found to have been subject to escheat prior to that time. G. Solvency Modernization Initiative 1. SMI Roadmap The NAIC has been working for several years on its Solvency Modernization Initiative project (the SMI ), which is a project to examine and update the U.S. insurance solvency framework and review international insurance supervisory principles and developments for potential use in the U.S. system. The SMI project has five overarching aspects: capital requirements, governance and risk management, 25

32 group supervision, statutory accounting and financial reporting, and reinsurance. A revised SMI Roadmap was issued in December 2012, outlining the SMI project s progress to date and the policy direction and priorities for SMI activities through The updated SMI Roadmap lists as key completed activities, among others: updates to the Insurance Holding Company System Regulatory Model Act and Model Regulation to enhance group supervision (which as of March 2013 have been enacted and/or promulgated in ten states: California, Connecticut, Indiana, Kentucky, Louisiana, Nebraska, Pennsylvania, Rhode Island, Texas and West Virginia); adoption of the Own Risk and Solvency Assessment Guidance Manual, as further described in Section G.2 of Global Regulatory and Litigation Developments below (the NAIC also adopted the accompanying Risk Management and Own Risk and Solvency Assessment Model Act in 2012); completion of the Existing U.S. Corporate Governance Requirements paper in 2011 and the draft Proposed Response to a Comparative Analysis of Existing U.S. Corporate Governance Requirements was exposed for comment during 2012, as further described in Section G.3 of Global Regulatory and Litigation Developments below; adoption of the Valuation Manual for life insurance principles-based reserving, as further described in Section C of Global Regulatory and Litigation Developments above; and adoption of the Credit for Reinsurance Model Act and Regulation (which have been enacted and/or promulgated in eleven states as of March 2013: California, Connecticut, Delaware, Florida, Georgia, Indiana, Louisiana, New Jersey, New York, Pennsylvania and Virginia), as further described in Section A.3 of The Global Alternative Risk Transfer Market above. On the agenda for 2013 are updates in capital requirements and the risk-based capital formulas (including adding a property and casualty catastrophe risk charge and defining safety levels and time horizons for the risk-based capital calculations and aiming for consistency among the formulas); completion of the implementation plan for life insurance principles-based reserving (see Section C of Global Regulatory and Litigation Developments above); a new NAIC working group to provide advisory support to the states in review of nonadmitted reinsurers applications to become certified reinsurers and for collateral reduction (see Section A.3 of The Global Alternative Risk Transfer Market above) and the reexamination of collateral levels in the revised Credit for Reinsurance Model Act and Regulation (see Section A.3 of The Global Alternative Risk Transfer Market above). 2. Own Risk and Solvency Assessment Insurers continue work on meeting new risk management and reporting requirements set forth in the NAIC s Risk Management and Own Risk and Solvency Assessment Model Act (the ORSA Model Act ), adopted by the NAIC in September The ORSA Model Act requires that insurers maintain a specific framework for identifying, assessing, monitoring, managing and reporting on the material and relevant risks associated with the insurer s (or insurance group s) current business plans. An insurer must undertake an internal risk management review no less often than annually (but also at any time when there are significant changes to the risk profile of the insurer or its insurance group) in accordance with the ORSA Guidance Manual (the ORSA Manual ) and prepare a summary report ( ORSA Report ) assessing the adequacy of the insurer s risk management and capital in light of its current and future business plan. (Prior to adopting the ORSA Model Act, the NAIC adopted the ORSA Manual in March 2012, detailing the specific procedures involved in preparing an Own Risk and Solvency Assessment ( ORSA ).) ORSA is part of the NAIC s overall Solvency Modernization Initiative, in particular its post-2008 focus on group supervision and enterprise risk management. Overall, regulators view the ORSA initiatives as providing a new method to evaluate solvency, beyond risk-based capital measures. It is also expected that having ORSA (and SMI more 26

33 generally) in place will increase the chances of the U.S. insurance regulatory system being viewed as equivalent for purposes of Solvency II. A key issue during the ORSA Model Act development process involved coordination of regulators reviewing ORSA Reports, especially where reports are submitted by insurance groups that have insurers domiciled in many jurisdictions. Industry, and eventually regulators, agreed that requiring review coordination through a lead state would prevent potentially conflicting and duplicative responses to multiple requests for information. The final version of the ORSA Model Act incorporates this lead regulator approach. For insurers that are part of an insurer group (i.e., a holding company system), risk assessments can be done at the group level, and ORSA Reports would be filed by the insurer group with its lead regulator, addressing each insurer in the group. Group reports can also be broken down by category (e.g., one report filed for property and casualty insurers in the group and a separate report for life insurers in the group), to the extent the insurers operate under different enterprise risk management frameworks. The domiciliary regulators of other insurers within the group may also request a copy of the ORSA Report. Another key issue was assuring confidentiality of ORSA Reports and supporting materials, due to their unique and sensitive nature. By way of comparison, the Form F disclosures in Enterprise Risk Reports (filed with insurers annual holding company act registration (Form B) statements) focus upon recent and current developments that could affect an insurer s risk-based capital status or financial condition, whereas ORSA evaluates current and future risk management issues, future solvency positions and strategic plans. Further, Form F-type information will often be available in SEC filings and other publicly available documents, whereas ORSA Reports will be based largely upon sensitive, internal company documents. The NAIC agreed that confidentiality is paramount, and the extensive confidentiality sections of the ORSA Model Act provide that all materials, including the ORSA Report, provided to a state insurance department pursuant to the ORSA Model Act are proprietary and contain trade secrets and are considered confidential, privileged and not subject to state freedom of information/sunshine acts. The ORSA Model Act further provides that ORSA materials are not subject to subpoena or discovery or admissible in evidence in any private civil action (except to further a regulatory or legal action brought as part of the state insurance commissioner s official duties). Furthermore, the material may not be made public without the prior written consent of the insurer. A state insurance commissioner may share ORSA materials with other state, federal and international financial regulatory agencies, including members of any supervisory college, the NAIC and any third-party consultants designated by the commissioner, if the recipient agrees in writing to maintain the confidentiality and privileged status of the ORSA-related materials and verifies in writing the legal authority to maintain confidentiality. In terms of content, ORSA Reports are high-level summaries of an insurer s ORSA and will include information concerning an assessment of: (a) the insurer s risk management framework; (b) risk exposures; and (c) the insurer group s capital to support its risks and a prospective solvency assessment. ORSA Reports can draw from materials prepared for other purposes, including documents provided to regulators in foreign jurisdictions. Smaller insurers (generally insurers with less than US$500 million in annual premiums, which are part of an insurer group with less than US$1 billion in annual premiums) may be exempt from the ORSA Model Act, including preparing an ORSA and filing an ORSA Report. Notwithstanding the premium tests, state regulators may nevertheless require ORSA Reports in certain circumstances, such as an insurer s risk-based capital falling below the company action level, or if requested by federal agencies or international insurance supervisors. The ORSA Model Act has an effective date of January 1, However, the effective date for ORSA requirements in a particular state will depend on each state s legislature s adoption of the ORSA Model Act. To guide insurers and regulators in preparing ORSAs, the NAIC continues to revise the ORSA Manual to address a variety of legal and practical issues. Recently proposed revisions would require insurers to: (a) identify the basis of accounting for their ORSA Reports (GAAP, SAP, or IFRS, each as defined in Section I.2(b) of Global Regulatory and Litigation Developments below); (b) 27

34 explain the scope of their ORSAs so it is clear which entities within the group are included; (c) summarize material changes to their prior year ORSAs; and (d) compare group capital to the previous year s group capital. State regulators are conducting ORSA Feedback Pilot Projects through the NAIC, wherein insurers voluntarily submit ORSA Reports (subject to a confidentiality agreement) for regulatory review. After reviewing the reports, regulators provide high-level feedback to the insurance industry on the reports. An ORSA Feedback Pilot Project was completed in 2012 and a second one is under way, with ORSA Reports due for comment by September 30, Corporate Governance Working Group s Proposed Response to a Comparative Analysis of Existing U.S. Corporate Governance Requirements The Corporate Governance (E) Working Group (the CGWG ) was charged with analyzing the requirements, regulatory initiatives and best practices of the states, other countries and regulators, and the insurance industry to identify insurance corporate governance principles. In connection therewith, the CGWG compared U.S. insurance industry corporate governance standards to non-u.s. standards in an attempt to determine whether the U.S. standards meet international standards and whether enhancements are needed. The results of such analysis were recorded in the Proposed Response to a Comparative Analysis of Existing U.S. Corporate Governance Requirements (the Corporate Governance Proposal ). The Corporate Governance Proposal included a two-page summary of proposed enhancements to U.S. insurance company corporate governance and disclosure, including a detailed exhibit of new and enhanced disclosures. The CGWG has continued its discussions during 2013, including: (a) the substance of Exhibit A, which requires certain disclosures and reporting with respect to an insurer s corporate governance framework, processes and activities, including suitability of officers and directors; (b) Exhibit B, which adds certain officer, director and employee compensation disclosures to the Supplemental Compensation Exhibit to the Annual Statement; and (c) Exhibit E, which is a referral to two other NAIC working groups (the Financial Analysis Handbook Working Group and the Financial Examiners Handbook Technical Group), suggesting a long-term study in order to develop a common assessment methodology to be used in the examination process to review and assess corporate governance. The CGWG also discussed and revised other open issues under the Corporate Governance Proposal and prepared a number of referrals to other NAIC groups suggesting corporate governance considerations that might be included in the other groups tasks. Notably, as has been the case with other aspects of the SMI project, such as the recent updates to the Insurance Holding Company System Regulatory Model Act and Model Regulation (see Section G.1 of Global Regulatory and Litigation Developments above) and the adoption of the ORSA Model Act (see Section G.2 of Global Regulatory and Litigation Developments above), the industry has raised concerns regarding whether regulators will treat confidentially the information disclosed pursuant to the proposed additional reporting requirements. In follow-up conference calls to discuss the open exhibits, the CGWG has considered several options to address these concerns, including the possibility of drafting a new model act on confidentiality. As an alternate option to address concerns related to confidentiality, the CGWG introduced the idea that companies might disclose corporate governance standards in the annual risk-based capital reports and thereby benefit from existing risk-based capital laws that include strong confidentiality protections. While this was an unusual suggestion, the CGWG explained that the Capital Adequacy Task Force, which has oversight of the risk-based capital laws and formulas, is studying the addition of operational risk to the risk-based capital formulas. To do this, the NAIC Risk-Based Capital for Insurers Model Act already would be open for amendment, while development of an entirely new model act on confidentiality would take significant time. Therefore, it may be possible to add corporate governance to the risk-based capital filings at the same time as operational risk is being added. Because many regulators view corporate governance as a form of solvency protection, and risk-based capital measures solvency, some view the risk-based capital report as a potentially convenient and confidential way for insurers to deliver this 28

35 information to regulators. As adopted in March 2013, the Capital Adequacy Task Force s Working Agenda includes the CGWG s suggestion that insurer corporate governance practices be included in risk-based capital filings. (In addition, at the recommendation of the New York State Department of Financial Services, the Capital Adequacy Task Force s Working Agenda also includes, in connection with reserve financing transactions, consideration of whether and how business ceded to unauthorized reinsurers might be reflected in an insurer s risk-based capital. See Section A.3 of The Global Alternative Risk Transfer Market above for information regarding related regulatory developments.) On its March 22, 2013 conference call, the CGWG returned to an earlier position and voted to prepare a request for model law development for a model that will both mandate the filing of the Exhibit A information and provide for its confidentiality. The topic remains under discussion as part of the NAIC s push toward evaluating enterprise risk and similar concepts in the wake of the 2008 financial crisis. The Corporate Governance Proposal will be updated and then is expected to be adopted at the Spring National NAIC meeting. During the continued dialogue, the industry should advocate for confidential treatment of additional disclosures and limitations on any duplication between the proposed disclosures (related to corporate governance standards and operational risk) and existing required disclosures. H. Invested Asset Matters 1. New Guidance Regarding Section 711 of the Insurer Receivership Model Act The NAIC is considering adopting new guidelines to Section 711 ( Section 711 ) of the Insurer Receivership Model Act ( IRMA ) that, if adopted by the states, would provide for an automatic one business day stay order upon the appointment of a receiver with respect to an insolvent insurance company. During such stay, it is contemplated that the receiver would be permitted to assign all rights and obligations of the insurance company under its qualified financial contracts to a third party, without the consent of the counterparty. This is similar to the power granted to a conservator or receiver of insolvent federally insured depository institutions under the Federal Deposit Insurance Act ( FDIA ). Section 711 currently provides counterparties to netting agreements and qualified financial contracts (collectively, QFCs ) with insurance companies protections similar to those afforded to counterparties to QFCs with entities subject to the U.S. Bankruptcy Code or with federally insured depository institutions under the FDIA. QFCs are broadly defined, and generally include most derivative transactions, as well as repurchase, reverse repurchase and securities lending transactions. Section 711 provides that, unlike most other types of transactions, a counterparty to a QFC with an insurance company subject to a state delinquency proceeding shall not be stayed or prohibited from exercising its termination, liquidation or close out netting rights under such QFC. In addition, subject to certain limitations, Section 711 provides that a counterparty specifically is authorized to exercise its setoff and closeout netting rights during the delinquency proceeding, and to exercise its rights under any pledge, security, collateral, reimbursement or guarantee agreement or arrangement, or any other similar security arrangement or other credit enhancement relating to one or more QFCs. Thus, Section 711 provides counterparties to QFCs with insurance companies with a requisite level of certainty regarding the process and procedure for terminating QFCs and settling any amounts due to the counterparties under QFCs. While Section 711 is, in part, based on the insolvency provisions of the FDIA (12 U.S.C et seq.), the NAIC, in drafting Section 711, did not adopt the provisions of the FDIA which provided for (a) a one business day stay period, during which each counterparty to QFCs would not be permitted to terminate, liquidate, accelerate or close out such QFCs based on the institution s insolvency and (b) the ability of the receiver to transfer the QFCs to another party during the stay period without the counterparty s consent. Under the FDIA, once the QFCs are transferred, the counterparty cannot use the insolvency of the transferor institution as grounds for termination of the QFCs. Interestingly, Section 711 does provide for certain protections to a counterparty in the event a receiver assigns its QFCs, even though Section 711 never granted the receiver the one business day stay period during 29

36 which the receiver is permitted to assign the QFCs. Specifically, Section 711 provides that in transferring QFCs, the receiver must transfer to one party all QFCs between a counterparty or any affiliate of the counterparty and the insurer that is the subject of the proceeding, including (i) all rights and obligations of each party under each QFC and (ii) all property, including any guarantees or other credit enhancement, securing any claims of each party under each QFC. In 2012, the NAIC, through the IRMA Section 711 Subgroup of the Receivership and Insolvency (E) Task Force, undertook to reexamine Section 711 to consider whether states should continue to adopt such provisions. As a result of its examination, the subgroup made several recommendations, including a recommendation that the Receivership and Insolvency (E) Task Force develop guidelines that provide that states that adopt Section 711 must also adopt provisions allowing for the aforementioned one business day stay, during which the receiver would be permitted to transfer QFCs to a third party without the permission of the counterparty, and the counterparty would not be permitted to terminate such agreement or transactions provided the transferee remains in compliance with the terms of the QFCs. The work of the subgroup is continuing in 2013 under the Federal Home Loan Bank Legislation Subgroup of the Receivership and Insolvency (E) Task Force. While the broker/dealer community may be familiar with this provision with respect to depository institutions subject to the FDIA, to the extent the provision was adopted by the states, this would be a new power granted to the receiver of an insolvent insurance company. 2. Other Invested Asset Initiatives There are many invested asset initiatives currently under consideration in 2013, including the following: a) Working Capital Finance Notes State insurance regulators have been working through the NAIC on accounting, risk-based capital and other guidance to allow for insurer investments in so-called working capital finance investments ( WCFIs ). WCFIs involve the purchase of shortterm obligations generated from the delivery of goods to buyers and payment obligations set forth in resulting invoices. While WCFIs are usually a commercial bank investment, WCFIs will be a permitted insurer investment (admitted asset) subject to certain risk-based capital, statutory accounting and reporting requirements. Such requirements are currently being developed through several NAIC groups, including the Securities Valuation Office ( SVO ), Valuation of Securities Task Force, Capital Adequacy Task Force, Blanks Working Group and Statutory Accounting Principles Working Group. In March 2013, these task forces and working groups exposed for comment certain proposed guidance (including revisions to SSAP No. 20 Nonadmitted Assets), as well as proposed risk-based capital and annual statement reporting requirements for WCFIs. As of March 19, 2013, discussions were ongoing regarding appropriate risk-based capital factors and some regulators questioned the relationship between the relatively high rates of return and the risk associated with WCFIs. Some interested parties (including the American Council of Life Insurers (the ACLI )) believe an appropriate capital charge for WCFIs would be the same applied to investment-grade short-duration fixed income investments (the same capital charge assigned to other assets that carry the NAIC 1 or 2 designation). At this juncture, final guidance on WCFIs will not likely be issued before the Spring National NAIC meeting in April The Capital Adequacy Task Force is still addressing risk-based capital requirements and the accounting and reporting guidance related to WCFIs are still works in progress in other NAIC working groups (including the Blanks Working Group and Statutory Accounting Principles Working Group). b) Broker Receivables Proposal A proposal by the ACLI to change risk-based capital treatment of assets involving sales through a broker/ custodian is currently under consideration by state regulators at the NAIC. The assets in question are those sold late in the year, left unsettled at year end and reflected as a receivable balance subject to a generic 6.80% risk-based capital charge (pretax and pre-covariance). In proposing alternate treatment, the ACLI submits that the current charge can be overly punitive for low-risk assets unsettled sales, and overly beneficial for high-risk assets unsettled sales. 30

37 c) Residential Mortgage-Backed Securities and Commercial Mortgage-Backed Securities Since 2009, Residential Mortgage-Backed Securities ( RMBS ) and Commercial Mortgage-Backed Securities ( CMBS ) held by insurers have been valued using specific financial models created by third-party vendors, instead of relying upon traditional Nationally Recognized Statistical Rating Organizations. In late 2012, the NAIC s Valuation of Securities Task Force and SVO finalized changes to the macroeconomics, scenarios and risk-weighting for such models. The changes were sought in order to add a more conservative approach to the modeling process for these securities. Throughout the process, the parties debated the necessity of the modeling changes, particularly concerns about impact on insurer risk-based capital and whether the changes reflect an unnecessarily negative view of the RMBS and CMBS markets. d) Pledged Asset Proposal The NAIC s Capital Adequacy Task Force is considering a proposal to modify risk-based capital factors for insurers with a large proportion of restricted/pledged assets on their balance sheets, including assets subject to repurchase and reverse purchase agreements and assets pledged as collateral. At the upcoming Spring National NAIC meeting in April 2013, the NAIC s Restricted Assets Subgroup and Statutory Accounting Principles Working Group (the SAP Working Group ) will consider adoption of Accounting Disclosures for Restricted Assets (Ref# ), which would capture additional information concerning restricted assets in notes to financial statements and expand accounting disclosures in SSAP No. 1 (paragraph 17b). The initiative stems from a request from the NAIC s Financial Analysis (E) Working Group that the SAP Working Group research and address guarantees and other financial activities having pledge-like restrictions that might require clarifying SAP guidance and/or annual statement instructions. The Financial Analysis (E) Working Group also sought assistance in forming additional disclosures on restricted assets to identify when insurers: (1) close out of restricted arrangements prior to year-end and (2) use general account assets to support separate account investments as collateral. Research included a review of insurer responses to general interrogatory #25 (assets not under the exclusive control of the company) in comparison to Note 21C (amount and nature of assets pledged to others as collateral required by SSAP No. 1, paragraph 17b). e) ACLI Commercial Mortgage Loan Proposal The NAIC is considering a proposal by the ACLI (the ACLI Proposal ) that would change the risk-based capital formula applied to commercial mortgages in good standing held by life insurers, particularly the formula s Mortgage Experience Adjustment Factor. The proposal also recommends utilizing new ways of assessing credit risk (for example, using loan-level information). The C-1 risk-based capital component of a life insurer s portfolio of commercial mortgage loans would be determined using a process similar to the one currently used for assigning capital charges to corporate bonds (individual loans grouped into risk cohorts based on credit quality indicators and capital requirements assigned to each cohort). Such grouping would depend on ranges of debt service coverage and loan-to-value metrics. The ACLI Proposal contains standardized amortization period methodology, S&P s updated methodology for commercial mortgages, a proposal for agricultural business/farm loans and revised asset valuation reserve factors. While regulators are, overall, favorably disposed toward the ACLI Proposal, they have some outstanding concerns, including a potential 30% decrease in overall risk-based capital that could result from implementing the ACLI Proposal and the amortization feature in the ACLI Proposal. Some regulators expressed their preference for a more conservative approach. Regulators and interested parties will continue to discuss the proposal at the upcoming Spring National NAIC meeting in Houston. I. Global Insurance Issues 1. Global Systemically Important Insurers and Internationally Active Insurance Groups The International Association of Insurance Supervisors ( IAIS ) issued a Public Consultation Document in May 2012 containing a proposed assessment methodology to identify Global Systemically Important Insurers ( G-SIIs ), a 31

38 subset of global systemically important financial institutions. The IAIS developed the methodology to identify any insurers whose distress or disorderly failure, because of their size, complexity and interconnectedness, would cause significant disruption to the global financial system and economic activity. The IAIS methodology involves the collection of data and an assessment of collected data using an indicator-based approach. The five primary indicators are size, global activity, interconnectedness, non-traditional and noninsurance activities, and substitutability. Of the five, the paper notes that non-traditional insurance activities and non-insurance financial activities are potential drivers of systemic importance of insurers and thus have the greatest impact upon failure. The assessment methodology was developed for use by the Financial Stability Board (which is coordinating the overall project for the G20 group of nations to reduce moral hazard posed by globally systematically important financial institutions) and national authorities, in consultation with IAIS, to identify G-SIIs. For more information on the activities of the Financial Stability Board, see Identification as a G-SII would likely result in the application to the entity of three mandatory policy measures issued by the IAIS: (a) enhanced supervision (more intensive and coordinated supervision), (b) effective resolution (improving supervisors ability to resolve the G-SII in an orderly manner if it becomes insolvent) and (c) a requirement of higher loss absorption capacity, with the goal of reducing moral hazard and negative effects stemming from a potential disorderly failure of a G-SII. The three measures are detailed in a draft Consultation Document and in a set of Frequently Asked Questions, each issued by the IAIS on October 17, The Consultation Document includes an implementation timeframe, which calls for the first G-SIIs (if any) to be designated in April 2013, with annual designations thereafter. In a separate project, IAIS issued a Draft Common Framework for Supervision of Internationally Active Insurance Groups ( ComFrame ) in July ComFrame is an international framework for integrated and multilateral group-wide supervision. It builds on the IAIS Insurance Core Principles that apply to all insurance companies and insurance groups, but contains requirements for supervisors that are intended to result in greater cooperation and coordination for Internationally Active Insurance Groups. However, U.S. and EU regulators are currently deadlocked over two key issues at the center of ComFrame negotiations: (i) whether to implement global capital standards and (ii) who should act as lead regulator for large international insurers. Regulators in Europe have tended to support a common global approach, whereas U.S. regulators have argued in favor of the current system in which capital standards are set at the subsidiary level in respective jurisdictions. The identification of a lead regulator is a sensitive topic. 2. Solvency II a) U.K. (1) The Status of Implementation The delay in the implementation of Solvency II has been much publicised and has attracted significant criticism from the (re)insurance industry, as yet another deadline slips and pushes the implementation date closer to Solvency II was originally due to be transposed into national law by Member States on October 31, 2012 and firms were due to implement the rules from November 1, However, a Quick Fix Directive pushed the transposition date of Solvency II to June 30, 2013 and extended the date by which firms are due to comply until January 1, It is now widely recognised by the industry as well as by the European Commission and the European Insurance and Occupational Pensions Authority ( EIOPA ) that the current transposition and implementation dates are no longer realistic. The delays to Solvency II have been caused by prolonged negotiations of the Omnibus II Directive, the directive which is intended to amend Solvency II. The adoption of Omnibus II has in turn been delayed by an impact assessment that is underway in relation to the effect of Solvency II on insurance products with long-term guarantees. With this assessment in progress, a crucial vote in the European Parliament on Omnibus II has been postponed once again and is now scheduled for October 22, 2013, making the June 30, 2013 transposition date impossible to achieve. 32

39 With a 2016 implementation date or, as some may argue, a 2017 date or beyond appearing more likely, what are the possible outcomes for Solvency II? Will Solvency II be diluted to some degree or effected incrementally? On December 20, 2012 EIOPA published a list of best practices in the form of an opinion on Solvency II interim measures. The opinion was prepared in response to the uncertainty surrounding Solvency II implementation, about which EIOPA expressed concern that it may force regulators to develop different national solutions contradicting the convergent and consistent approach intended by Solvency II. The opinion sets out a list of actions that national regulators should undertake, which should be in place on January 1, 2014, relating to key aspects of Pillars 2 (governance and risk management) and 3 (supervisory reporting and public disclosure). The opinion refers to the key areas of Solvency II that need to be addressed in the run-up to implementation, namely, the system of governance, pre-application of internal models and reporting to supervisors. EIOPA has also stated that it intends to publish guidelines addressed to national regulators on how to proceed in the interim phase leading up to Solvency II implementation. Each regulator will have two months from the time the guidelines are issued to confirm whether or not it complies with or intends to comply with the guidelines. Clearly the intention is to maintain the momentum notwithstanding the continuing uncertainty and delay. However, there is still the question which some have raised in this uncertain climate what are the consequences of Solvency II not being implemented at all? Adhering to the current regime, which EIOPA has referred to as an outdated and fragmented supervisory system, would not seem to be a viable option at this point. Faced with such a prospect, EIOPA s objective of fostering supervisory convergence is likely to be frustrated, with 27 Member States adopting varying levels of new regulatory supervision. (2) Readiness for Implementation A number of surveys have been conducted in recent years to determine the effect of Solvency II on (re)insurers with regard to structural changes made, cost and internal modeling, amongst other issues. (Re)insurers continue to bemoan the increasing cost of compliance caused by these incessant delays, and interestingly, surveys have suggested that in a number of EU countries, many insurers would not have been ready for a January 1, 2014 implementation date. Much of the focus of insurers has been placed on fulfilling Pillar 1 (capital adequacy) requirements with the emphasis less focused on Pillars 2 (governance and risk management) and 3 (supervisory reporting and public disclosure). With no certain implementation date in sight, it is unclear how insurers will use the additional time available to them. Bearing in mind that EIOPA s interim guidelines are soft regulation, insurers do not have to fear that they will be subject to sanctions for non-compliance. Setting a realistic timeline for implementation now has to be a primary objective in Europe, if it is to avoid losing credibility on the international stage. Insurers are losing confidence and patience on a regime that has been in the making for 10 years. Guidelines may be welcome, but a realistic proposal on timing would seem to be helpful. If the Financial Services Authority s current view and its successor s future view is a guide to the regulator s commitment to Solvency II, then the message is that Solvency II is coming, and (re)insurers need to ensure that they are ready whenever it arrives. According to recent surveys, there is still a great deal of preparation to be done. Firms cannot afford to delay necessary actions now; the process, although delayed, is forging ahead. b) United States As discussed in Section I.2(a) of Global Regulatory and Litigation Developments above, Solvency II is the result of a decade of review by the EU of the regulation of insurance. Solvency II is an entirely new, harmonized solvency regime across 27 Member States, which includes the supervision and capital assessment of insurers established in the EU. Interestingly, the EU has a structural parallel to the U.S. s 50-state regulatory regime with the overlay of the NAIC. Yet, the interplay between these two regimes has created some challenges (and resulting friction). One element of Solvency II is group supervision of multi-national insurance groups, which is triggered by the presence of a European Economic Area ( EEA ) authorized insurer. Group supervision encompasses not only group solvency requirements, 33

40 but also governance, risk management, disclosure and reporting requirements. A college of supervisors is to be established for each group, consisting of national supervisors of the group entities that is headed by a designated group supervisor. For groups with their ultimate parent in a third country (one outside the EEA), group supervision potentially applies at the worldwide group level. If a third-country regulatory regime is considered equivalent, EEA supervisors will rely on group supervision exercised by the thirdcountry supervisor over the third-country parent, by forming a college of supervisors led by the third-country supervisor. If not equivalent (for example, the U.S.), Solvency II rules on group supervision may be applied to the third-country parent. Equivalence status will be granted where the European Commission considers that the third country has a solvency regime of a similar robustness to Solvency II. For transitional equivalence, the European Commission must consider that the third country is committed to achieving an equivalent risk-based regime within five years. Substitute U.S. for the third-country in the foregoing sentence, and the source of concern for U.S. insurance holding companies with an EEA insurer becomes apparent. Solvency II is relevant to U.S. insurers that are not part of an international insurance holding company because Solvency II is driving changes in U.S. state regulation. This is reflected in the NAIC s Solvency Modernization Initiative, described in Section G of Global Regulatory and Litigation Developments above, which was announced in June As indicated above, SMI is reviewing five key areas: (A) capital requirements, (B) corporate governance and risk management, (C) group supervision, (D) accounting and financial reporting, and (E) reinsurance. Notably, the first three areas of SMI were adopted from the three key elements of Solvency II: capital, risk management and group supervision. The fourth area, accounting and financial reporting, deals with investigating the adoption of International Financing Reporting Standards ( IFRS ) used in Europe. In the U.S., insurers use Statutory Accounting Principles ( SAP ) while their corporate parents use Generally Accepted Accounting Principles ( GAAP ). The NAIC is in the preliminary stages of exploring whether GAAP or IFRS should replace SAP for U.S. insurers. SMI s fifth area of focus is reinsurance. After a 15-year debate on the need for 100% security to be posted by unlicensed reinsurers of U.S. ceding insurers, in December 2008, the NAIC adopted a new Reinsurance Regulatory Modernization Framework (the Framework ). The Framework establishes a sliding scale of relaxed security for highly rated unlicensed (U.S. and non-u.s.) reinsurers, based on their ratings and not simply on being unlicensed. In November 2011, the NAIC amended its Model Act and Regulation for Credit for Reinsurance to reflect the sliding scale for posting of collateral by unlicensed reinsurers (U.S. and non-u.s.) that are rated. Unfortunately, the adoption of these amendments by each of the 50 states will be a multi-year effort, with the potential for varying (even inconsistent) results at the state level. Thus, development of uniform, national standards for reinsurance may not occur quickly at the state level. As a result of the foregoing initiatives, the NAIC is positioning the 50 states to satisfy the equivalency standards of Solvency II. In the process, the NAIC will be potentially imposing on U.S. insurers, even those that are not part of an international insurance holding company, similar criteria to that applied to EU insurers under Solvency II. The EU s Solvency II, the NAIC s SMI and Dodd-Frank s FIO are all influencing the evolving regulation of insurance in the U.S. The interplay of these actions reflect the consequences of the globalization of insurance. They will, however, also have an effect on U.S. insurers that are not a member of an international insurance holding company, because these actions have resulted or will likely result in the potential for increased capital requirements, preparation of ORSA Reports and application of reduced collateral requirements for reinsurance ceded to highly rated, unlicensed reinsurers. (1) NAIC Reaction to Equivalency In early 2012, EIOPA graciously agreed to title the equivalency project as the US-EU Mutual Regulator Understanding Project (the Project ) and to describe it as simply a part of a 10-year discussion between EU regulators and the NAIC 34

41 called the EU-US Dialogue Project. The steering committee of the Project was composed of three EU representatives and three U.S. representatives. The Project identified seven topics to investigate: (a) professional secrecy/confidentiality, (b) group supervision, (c) solvency and capital requirements, (d) reinsurance and collateral requirements, (e) supervisory reporting, data collection and analysis, (f ) supervisory peer reviews, and (g) independent third-party review and supervisory on-site inspections. Technical committees were formed for each topic. The reports from the seven technical committees (each between pages) were issued as part of a 130-page report under the EU-US Dialogue Project banner in December 2012 titled, Comparing Certain Aspects of the Insurance Supervisory and Regulatory Regimes in the European Union and the United States. A detailed project plan will be developed in Some of the items that might be pursued include new accounting principles. Some of these are consistent with the projects being pursued through SMI. Because Solvency II has been slowed, if not stalled, SMI may be the engine that drives the enhancement of the U.S. insurance regulatory regime for purposes of international insurance holding companies. (2) International Association of Insurance Supervisors Solvency II drove the NAIC to, and Dodd-Frank mandated that the FIO, focus on international insurance regulatory developments. This naturally led to an enhanced and revitalized role for the IAIS, some of whose recent activities are discussed in Section I.1 of Global Regulatory and Litigation Developments above. As a consequence there has been greatly increased interaction between the NAIC and the IAIS, and the FIO is also involved. Two representatives of the NAIC and the Director of the FIO are members of IAIS. While FIO s membership and activity is expected due to its statutory requirements, the NAIC has simultaneously increased the activities of its International Insurance Relations (G) Committee in the past few years, including introduction of a new International Regulatory Cooperation Working Group, attendance at various international meetings and conferences and active participation in the EU-US Mutual Regulator Understanding Project (discussed in greater detail in Section I.2(b)(1) of Global Regulatory and Litigation Developments above). Further, the NAIC has increased its cross-border activities by negotiating and entering into Memoranda of Understanding with various countries, in some cases on a multilateral basis. It is unclear how such Memoranda of Understanding will be implemented in light of the FIO s statutory mandate to address international insurance issues and to enter into agreements with foreign governments. This is an important matter that will be carefully watched by non-u.s. (re)insurers and U.S. state regulators. 3. China Insurance Regulatory Commission Progresses Development of Its Second Generation Solvency Regime The China Insurance Regulatory Commission (the CIRC ) announced last year its intention to construct a risk-based second generation solvency regime over a period of three to five years. The CIRC intends that this will improve protection for policyholders and encourage more robust and efficient risk management within the Chinese insurance industry. China s current solvency regime employs a fixed-formula approach to capital requirements. The CIRC considered that a new risk-based framework was necessary in light of the global financial turmoil in recent years. In its initial working timetable, the CIRC aimed to carry out research and development with a view to completing a draft regime by the end of 2014, and after further testing and revisions, implementation from The CIRC recently announced that progress had been made on the initial stages of development. CIRC work groups covering the following areas have already reported their findings, or would do so in the first half of 2013: analysis of China s current regime; comparison of the current regime to the United States risk-based capital regime and Solvency II; preparation of an overall framework for the regime; 35

42 property and casualty sector underwriting risk model research and testing; life insurance sector underwriting risk model research and testing; and asset risk model research and testing. The CIRC intends the regime to consist of three pillars: Pillar 1, capital adequacy: balance sheet standards, capital requirements, capital ratio standards and other regulatory measures; Pillar 2, risk management: comprehensive risk management requirements and regulatory supervision, inspection of the company s capital and risk management; Pillar 3, information reporting: transparent reporting of solvency measures and requirements to disclose information publicly. This three-pillar framework strongly resembles the structure of the EU s Solvency II package, the implementation of which has been repeatedly delayed, but is now expected in 2015 or The CIRC has expressed an interest in achieving convergence with international regulatory trends, citing the banking sector s Basel III, the core principles of the IAIS, reforms by the NAIC, as well as Solvency II. The CIRC has stressed that its new regime will be designed to take into account the developmental and fast-growing nature of the Chinese insurance industry and will not blindly follow existing systems such as those in Europe and the U.S. However, China is currently one of several countries being considered for transitional equivalence under Solvency II. The CIRC recently reported that it had been engaging with the EU s insurance regulatory authority, EIOPA, and has been responding to equivalence assessment questionnaires. If China s solvency regime qualifies for equivalence, this could benefit Chinese reinsurers operating in the EEA and China-based (re)insurers with subsidiaries in the EEA. EEA Member States would be obliged to treat reinsurance contracts between EEA insurers and reinsurers in China in the same manner as equivalent reinsurance procured from EEA reinsurers; and Member States would not be able to limit the credit for reinsurance for purposes of the cedant s regulatory capital. Similarly, Member States would be prohibited from pledging of assets by Chinese reinsurers to cover unearned premiums and outstanding claims provisions, or to require the localization within the EEA of assets representing reinsurance recoverables. Chinese groups holding or wishing to acquire EEA (re)insurers would also benefit from not facing the possibility of Solvency II supervision at the level of a China-based parent. EEA Member States would rely on the group supervision exercised by the CIRC in relation to a parent located in China. EEA supervisory authorities would play a role in the supervision of the group, but the CIRC would lead the process. In the absence of equivalence, the parent could be required to conform to Solvency II capital requirements on a group-wide basis for the group. For additional detail regarding Solvency II, see Section I.2 of Global Regulatory and Litigation Developments above. J. U.S. Federal Insurance Issues 1. Dodd-Frank: Use of Swaps in Certain Transaction Structures In response to the financial crisis, Title VII of Dodd-Frank ( Title VII ) was adopted to increase transparency and provide comprehensive regulation of the derivatives industry. Title VII regulates not only derivatives products, but also requires the registration of certain providers and participants in the derivatives markets and splits the regulatory authority under Title VII between the CFTC and the SEC. Title VII s impact on the insurance industry is twofold. First, Title VII s comprehensive regulation is impacting over-the-counter ( OTC ) derivatives transactions typically used by insurers as part of their asset management and investment functions. Second, Title VII is affecting a number of alternative risk transfer arrangements. Title VII prohibits the execution of swaps between parties who are not eligible contract participants ( ECPs ) and then generally requires that all such swaps be cleared through a central clearinghouse and traded on an exchange or swap execution facility ( SEF ), to the extent that clearinghouses, exchanges and SEFs accept the particular type of swap. To the extent any swap is not accepted for 36

43 clearing by a clearinghouse, Title VII requires that all such uncleared swaps be subject to mandatory minimum margin requirements. Title VII also requires that all swap transactions be reported to a central data repository. Finally, Title VII requires participants in the swap market that constitute Swap Dealers, Major Swap Participants ( MSP ), Introducing Brokers ( IB ), Futures Commission Merchants ( FCM ), Commodity Trading Advisers ( CTA ), and CPOs, as well as Associated Persons of any such entity, to register with the CFTC. There are also similar registration requirements that apply with respect to the SEC and similar types of entities involved with security-based swaps. Depending on the level of activity involving swaps and the availability of exemptions under the CFTC s rules, some insurers (or their affiliates) may be required to register as an MSP, CTA, IB or CPO as a result of Title VII. Additionally, registered Swap Dealers and MSPs are subject to extensive internal and external business conduct standards, which impose a variety of disclosure, suitability and verification and policing standards on such registered entities, as well as minimum capital requirements. As a result of extensive business conduct requirements and the margin, clearing and exchange trading requirements, it is likely that insurers will find it more complex, burdensome and costly to execute traditional OTC derivatives transactions in connection with their asset management and investment functions. Further, because of these issues, as well as the bifurcation of certain swap markets between cleared and uncleared structures, there may be less liquidity in the market for certain types of products, which will affect availability and pricing as well. The cornerstone of Title VII is its broad definition of swap, which encompasses a number of agreements and transactions that traditionally would not have been considered to be a derivative. Although excluding certain securities transactions and physical delivery arrangements, the definition of swap includes any agreement, contract or transaction that provides for any... payment... that is dependent on the occurrence, nonoccurrence, or the extent of the occurrence of an event or contingency associated with a potential financial, economic or commercial consequence. Further, Section 722 of Title VII preempts any state regulation of swaps as insurance. In response to concerns raised by the insurance industry, the CFTC and SEC adopted by regulation a non-exclusive insurance safe harbor, which has the effect of excluding transactions that fall within it from the swap definition. However, because the insurance safe harbor is narrowly drafted to only include certain insurance products offered by insurers licensed in the U.S., there are a number of insurance and reinsurance arrangements typically used in the alternative risk transfer market that are not able to satisfy the insurance safe harbor. As a result, there is some level of uncertainty regarding these transactions and the implications under Title VII. If such transactions are considered to be swaps under Title VII, then they will be subject to the reporting, recordkeeping, margin and other requirements under Title VII. Further, certain investment vehicles, funds or collective investment pools (including potentially the SPVs in catastrophe bond structures) that enter into such transactions may also be considered Commodity Pools under the CFTC s regulations, which are required to be operated by a registered CPO. See Section B.4(b) of The Global Alternative Risk Transfer Market above. Additionally, the ECP requirement may also pose challenges for SPV-type entities (or other thinly capitalized vehicles including segregated cell companies) desiring to enter into transactions that could be characterized as swaps under Title VII. 2. Catastrophe Reserve Federal Proposed Legislation An old proposal to amend federal tax law to permit insurance companies to hold tax-deferred catastrophe reserves resurfaced at the Fall National NAIC meeting, albeit with a new twist it would only apply to insurers domiciled in the District of Columbia. In connection with its 2012 charge to monitor federal action concerning tax-deferred catastrophe reserves or catastrophe pools and the impact on risk-based capital, the Catastrophe Risk (E) Subgroup considered the new proposal, under which the FIO would administer a national program of tax-deferred catastrophe reserves. One goal of the program is to encourage U.S. insurers to hold and invest onshore assets that otherwise might be held on a tax-advantaged basis offshore. U.S. Representative Eleanor Holmes Norton, D-District 37

44 of Columbia, has introduced similar legislation (that has not been enacted) on two prior occasions. As of the date of publication, no new federal legislation on this issue has been introduced in Congress. Of continuing importance to insurers that monitor this issue will be the proposed administrator of the program and potential non-tax costs to the industry resulting from the program. K. U.K. Insurance Issues 1. The End of the FSA: The Beginning of Dual Regulation Major reform to the way financial services would be regulated in the U.K. came April 1, 2013, as this date marked the disbanding of the Financial Services Authority (the FSA ) with the majority of its functions transferred to two new regulators: the Prudential Regulation Authority (the PRA ) and the Financial Conduct Authority (the FCA ). Although the majority of firms previously regulated by the FSA now have the FCA as their sole regulator under the new regime, firms which the U.K. government regards as systemically important, such as banks, insurers and major investment firms, are now dual-regulated (that is, subject to regulation by both the PRA and the FCA). Each of the PRA and FSA will work to achieve different objectives and act separately with the firms that they regulate, but both will coordinate internally to share information and data. The PRA issued a paper in October 2012 setting out its intended approach to regulating insurers. This paper described the PRA s two complementary statutory objectives with respect to its supervision of insurers. First, it will promote the safety and soundness of the firms it supervises, and, second, and specifically for insurers, it will promote the protection of those who are or may become policyholders. The PRA is to take a forward-looking approach to assessing an insurer s ability to meet its obligations. There had been criticism of the FSA in the past that it was reactive rather than proactive in its approach to regulation, and this new position adopted by the PRA is seeking to address such criticism. It is a key principle underlying the PRA s approach that it does not seek to operate a zero-failure regime. Despite this, a certain level of resilience to failure will be required of all insurers, as would be expected. Another feature of the PRA s supervisory approach is that it is clearly based on judgment rather than narrowly rules-based, taking into account a wide range of possible risks to its objectives by using a risk assessment framework. The framework is intended to capture three key elements: (A) the potential impact that an insurer could have on financial stability and policyholders, both by the way it carries on its business and in the event of its own financial failure; (B) the external context in which an insurer operates and the business risks it faces which might affect the viability of the firm; and (C) any mitigating factors. From an international perspective, it is the PRA s role to supervise overseas insurers operating in the U.K., as well as U.K. groups operating abroad. In order to engage effectively with overseas regulators in supervising cross-border firms, the PRA will enter into memoranda of understanding with those regulators to facilitate the sharing of confidential information. In contrast to the PRA, the FCA is responsible for the conduct regulation of financial services firms. An approach paper issued in June 2011 stated that the FCA will have the single strategic objective of protecting and enhancing confidence in the U.K. financial system. Its operational objectives include: securing an appropriate degree of protection for consumers and promoting efficiency and choice in the market for financial services. The FCA s primary purpose is to ensure that consumers are treated fairly in their dealings with insurers and to promote effective competition. 2. Section 166 Skilled Persons Reports on U.K. Insurer Corporate Governance The recent adverse economic environment has exposed inadequacies in the governance and risk management structures adopted by some firms operating in the insurance sector and the wider financial services community. In response, and prior to the regulatory reorganization noted in the prior section, the U.K. s FSA has adopted a more intensive approach to supervision and has commissioned a growing number of skilled person reports pursuant to section 166 of the Financial Services and Markets Act This entitles the FSA to require an authorised firm to provide it with 38

45 a skilled person report on any matter about which the FSA has required or could require the provision of information or production of documents (a Section 166 Notice ). In many cases, a skilled person report will be commissioned in order to address a specific concern (or number of concerns) that the FSA has identified during the course of a routine Advanced Risk Responsive Operating Framework ( ARROW ) supervisory visit to a firm. The key purpose of such a report is to enable the FSA to determine whether the firm needs to take certain steps to mitigate any identified risks or whether the firm has breached a regulatory requirement. Under the current regime, in its Section 166 Notice, the FSA can either nominate a skilled person to compile the report or approve a skilled person proposed by the firm in question. The skilled person is appointed by, and contracts with, the firm directly. Any person proposed by the firm must appear to the FSA to have the skills necessary to produce a report on the matter concerned. In the case of a skilled person report commissioned to examine a firm s systems and controls, an independent firm is usually instructed to carry out a detailed review and produce a report setting out its findings. The review stage will typically involve a combination of time-consuming interviews and the provision of a significant amount of documentation, both of which have the potential to interrupt and intrude upon the firm s business. Furthermore, the cost of appointing a skilled person to produce a report falls on the firm that the FSA requires to make the appointment. The process can be extremely expensive, in part because the skilled person instructed will carry out a comprehensive review in order to ensure that its final report will withstand the most granular level of scrutiny in the event of enforcement action. In the financial year, for example, the FSA commissioned 111 skilled person reports at an average cost of 281,081. The costs per report ranged from 2,975 to 3,000,000. The number of skilled person reports commissioned has proliferated since and continues to increase on an annual basis, and the FSA has indicated that it expects the emphasis on Section 166 Notices, as a means of regulating firms governance arrangements, to continue. a) Proposed Changes The FSA proposes to amend the Section 166 regime in two key respects. First, to reflect the forthcoming split of the FSA into separate PRA and FCA divisions, both the PRA and the FCA would be authorised to commission skilled person reports via Section 166 Notices. Second, the FSA proposes that either the PRA or the FCA should be entitled to appoint a skilled person to carry out a review and contract with the skilled person directly, rather than through the firm concerned, and to recover the costs of the skilled person from the regulated entity. This would place a firm at a significant disadvantage should the relevant regulator decide to appoint a skilled person directly, as the firm would relinquish control over the selection of a skilled person and the already considerable costs associated with the process. b) Recent Trends FSA-authorised firms are obliged to comply with the provisions relating to corporate governance contained in the FSA Handbook, including the high-level Principles for Businesses and the requirements of the section Senior Management Arrangements, Systems and Controls. In addition to these provisions, the FSA has repeatedly emphasized the importance of effective corporate governance in its publications to the market and in the enforcement action it has taken against firms showing significant deficiencies. The criteria that the FSA will apply when considering the strength of a firm s governance arrangements include the manner in which strategy and risk appetite are determined, the quality of reporting lines between a firm s management and board of directors, and the level of effective discussion and independent challenge at board level. Significant failures to take account of the FSA s guidance in this area can lead to expensive repercussions, both in responding to a Section 166 Notice and any related enforcement action. The FSA has imposed a number of financial penalties on insurers for serious failures in corporate governance and control arrangements. 39

46 c) Preventative Measures In light of the FSA s renewed focus on corporate governance, together with its increasing use of Section 166 Notices as a tool for measuring a firm s compliance with its regulatory obligations, insurers should consider taking proactive steps to review their internal processes and structures. Such steps could include a formal internal assessment of governance practices against the relevant provisions of the FSA Handbook and the FSA s recent publications in this area; for example, to determine whether there is an appropriate balance of skills at board level or whether the formulation of strategy could be better documented. Moreover, while not strictly applicable to insurance companies other than those with a premium listing on the London Stock Exchange, firms should consider assessing their corporate governance by reference to the U.K. Corporate Governance Code. Indeed, for Lloyd s managing agents, the principles and standards on Governance in Lloyd s Franchise Standards are based on the precursor to the U.K. Corporate Governance Code, the Combined Code. For those operating combined Lloyd s and company market platforms, reviewing corporate governance frameworks in light of the U.K. Corporate Governance Code should ensure a consistent approach across U.K. operations, while also helping to evidence compliance with FSA regulatory requirements. As a further measure, insurers could consider commissioning a Board Effectiveness Review, whereby an independent firm is appointed to carry out a comprehensive examination of a company s governance arrangements and make written recommendations to a company s board of directors, if necessary. For the boards of Lloyd s managing agents, such a review facilitates compliance with the Lloyd s Franchise Standards, which require those boards to undertake a formal and rigorous annual evaluation of their own performance. It has also become increasingly common for the FSA to compel insurance companies, through the ARROW risk mitigation programme, to commission and act upon the recommendations of an independent Board Effectiveness Review in order to avoid the risk of being served with a Section 166 Notice. Board Effectiveness Reviews need not involve the input of the FSA and are confidential, although the independent firm s written report, and evidence that the company has taken steps to give effect to the recommendations included in the report, can be used to demonstrate to the FSA that the company actively monitors its corporate governance obligations and takes remedial action where appropriate. This can help to minimise the likelihood that a company will be subjected to the disruption and costs of being served with a Section 166 Notice. 3. Increasing EU/U.K. Competition Law Focus on the Insurance Sector The past eighteen months have seen a further significant increase in EU competition authority enforcement activity in the insurance sector. A number of ongoing sector-wide inquiries and individual investigations will progress in the course of 2013 and may result in enforcement action of significance to multiple types of life and non-life cover. The most significant developments at a pan-eu-level, and at a national level in the U.K., include the following. a) U.K. Office of Fair Trading Concludes Investigation into WhatIf? Private Motor Information Exchange Platform In December 2011, the U.K. Office of Fair Trading ( OFT ) concluded its investigation into an information exchange platform used by several brokers and almost all insurers writing motor insurance cover in the U.K. The platform initially provided for the regular exchange of individualised information on premiums, but was modified in the course of the OFT s investigation to ensure that recent premium-related data were only shared among insurers where they were aggregated across multiple providers. In an early press release regarding the case, the OFT stated that it believed the WhatIf? Private Motor information exchange platform was just one of several information exchanges operating across the life and non-life sectors and advised insurers participating in such exchanges to check compliance with competition laws. In the past eighteen months, a number of information exchange platforms in the insurance sector have ceased operating, or been revised to ensure they are competition law compliant. 40

47 b) U.K. Competition Commission Commences Market Investigation into Private Motor Insurance On September 28, 2012, the OFT formally requested the U.K. Competition Commission ( CC ) to conduct a detailed Market Investigation into the U.K. Private Motor Insurance sector. The OFT concluded that there were reasonable grounds for suspecting that features of the sector s operation distorted competition and gave rise to increased costs to insurers (estimated by the OFT at 225 million in 2011). In its September 2012 decision to refer the sector to the CC, the OFT identified two particular (and related) issues of concern: (i) the fact that an at-fault driver s insurer has little or no control over how or at what cost repair and replacement vehicle services are provided to not-at-fault drivers; and (ii) the suggestion that insurers of not-at-fault drivers (as well as brokers, credit hire companies, and others) take advantage of the at-fault driver s insurer s lack of control, including by charging higher prices for repair and car hire services and by generating additional revenues through referral fees and rebates. Market Investigations in the U.K. can take up to two years and can have a number of possible outcomes, including the imposition of behavioural or structural remedies aimed at addressing aspects of the market that the CC considers anti-competitive. c) OFT Launches Study of Defined Contribution Pensions In February 2013, the OFT announced the launch of a market study (often a precursor to a full CC Market Investigation) to examine whether competition between defined contribution ( DC ) workplace pension scheme providers is set up to work in the best interests of savers. The OFT has said it will examine: (i) how pension providers compete with one another and how the market may develop over time; (ii) whether there is sufficient pressure on pension providers to keep charges low: (iii) the extent to which information about charges is made available to savers; (iv) whether smaller firms receive appropriate help and advice in setting up and maintaining workplace pension schemes; and (v) the barriers to switching between schemes. The OFT is set to complete its study in August If the OFT elects to refer the DC pension market to the CC, a detailed CC Market Investigation could take up to two years and could have significant consequences for DC pension providers, including the imposition of behavioural or structural remedies. d) European Commission Publishes Study on Pools and the Subscription Market On February 11, 2013, officials at the European Commission s Directorate General for Competition ( DG Comp ) published an Ernst & Young study regarding the dynamics of competition around co (re)insurance pools and ad hoc co (re)insurance agreements on the subscription market. Ernst & Young s study, commissioned by DG Comp in November 2011, departs from the findings in the regulator s 2007 Sector Inquiry into Business Insurance by emphasizing a number of pro-competitive aspects of the ad hoc subscription market. However, the study also appears to criticise a number of co(re)insurance pools for failing to conduct (adequate) competition law assessments of their activities. While a full DG Comp (or national competition authority) investigation into the operation of the subscription market may seem less likely given the study s findings, it is possible that the results of the study might lead agencies to look more closely at pool participations in the future. e) U.K. s FSA Launches Thematic Review of Annuities Market In January 2013, the FSA launched an investigation into the U.K. s annuity market. In a move that could lead to competition agency action in the future, the FSA said its review would look at whether retirees were losing out by not shopping around for annuities on retirement (only 40% of retirees take the so-called open market option, with the remainder simply accepting the annuity offered by their pension provider). The FSA has said that the first phase of its review will look at: the level of detriment consumers suffer from not shopping around, and whether there are firms or particular groups of consumers where this detriment is more likely to occur. This will involve a pricing survey across all annuity providers, and will compare the rates available to retirees through different channels, including those offered via the open market option and those only available to a company s existing policyholders. The second phase of the review will 41

48 explore whether the way firms offer annuities helps, or inhibits, shopping around. From April 1, 2013, both phases of the review will be supervised by the FCA. L. Reinsurance Litigation: The Follow-the-Settlements Doctrine Ruling in a closely watched reinsurance dispute, New York s highest court recently addressed the standard by which the decisions of ceding companies are judged when allocating settlements under their direct policies and then presenting those payments to their reinsurers for indemnification. Putting a novel gloss on the venerable followthe-settlements doctrine, the New York Court of Appeals, in United States Fid. & Guar. Co. v. American Re-Insurance Co., 2013 WL (Feb. 7, 2013), determined that, to be binding on reinsurers as a matter of law, a ceding company s allocation must be one the ceding company would have arrived at as if the reinsurance did not exist. Previously, no court had articulated the standard by which a ceding company s allocation decisions are to be judged in precisely this manner. Applying this standard to the ceding company s allocation of an underlying asbestos settlement, the Court of Appeals concluded that the ceding company s decision not to allocate any portion of the settlement to its bad faith exposure was not binding on the treaty reinsurers given that, at the time of the settlement, the ceding company faced bad faith claims at trial for allowing default judgments to be entered against its insured. The Court of Appeals also concluded that the ceding company s decision to allocate or assign a certain dollar value to a particular type of asbestos claim was not binding on the reinsurers (even though the insured and the ceding company had agreed on the values) because, among other reasons, it could not conclude that such a settlement valuation would have been made as if the reinsurance did not exist given that the insured s expert had previously valued those claims at less than half that amount (which was below the retention). Finally, the Court of Appeals concluded that the ceding company s allocation of the entire settlement payment to the policy effective in 1959 was binding on the reinsurers because California law, which governed the policies, allowed allocation of all asbestos claims to a single policy year. VI. Select Tax Issues Affecting Insurance Companies and Products A. Prospects for Tax Reform Congressional leaders of both parties have endorsed the concept of a 1986-style tax reform effort that would reduce the corporate tax rate and achieve revenue-neutrality, or even revenue growth, by broadening the corporate tax base. One seemingly certain target for base-broadening will be offshore insurers or reinsurers. Versions of a proposal commonly known as the Neal Bill have been discussed and debated for several years. This proposal and a variant supported by the Obama Administration would disallow deductions for certain reinsurance premiums paid by a U.S. ceding company to a foreign affiliate. This proposal has been promoted by a group of U.S.-based property and casualty insurers who argue that the current system puts them at a competitive disadvantage as compared with the U.S. insurance operations of non-u.s. parent companies. It is uncertain what other reforms targeted at offshore insurers and reinsurers may emerge if and when Congress takes up fundamental tax reform. If Congress takes up individual tax reform, insurance-related tax expenditures may be targeted for limitation or repeal. The largest of these is the tax-free status of employer-provided health coverage. In addition, the tax-deferred inside build-up of life and annuity products is often noted as a significant source of annual revenue loss to the Treasury and, therefore, could be the subject of Congressional debate. B. The Foreign Account Tax Compliance Act Final regulations issued January 17, 2013 provided long-awaited guidance under the Foreign Account Tax Compliance Act ( FATCA ). FATCA imposes a 30% withholding tax on any withholdable payment made to (i) a foreign financial institution ( FFI ) that does not have a FATCA compliance agreement with the Internal Revenue Service (the IRS ), or (ii) a non-financial foreign entity that does not provide certification regarding its substantial U.S. owners (if any). A FATCA compliance agreement requires an FFI to collect information about its U.S. account 42

49 holders, share the information with the IRS, and withhold on payments to so-called recalcitrant account holders who fail to provide certain information. Withholdable payments include a wide variety of payments of U.S. source income (subject to FATCA withholding starting in 2014), as well as the gross proceeds from sale or redemption of stock or debt obligations that could give rise to U.S. source interest or dividend income (subject to FATCA withholding starting in 2017). Many in the industry hoped that all insurance and reinsurance premiums would be excluded from withholdable payments, but the IRS took the opposite approach, as the regulations clarify that insurance and reinsurance premiums are within the definition. One positive aspect of the final regulations is some further clarity on whether a foreign insurance company will be an FFI required to enter into a FATCA compliance agreement with the IRS. Generally, a foreign insurance company will be an FFI only if it issues annuity contracts or other products having cash value. Details are still emerging, as the IRS works to develop the forms and certificates that will be used to document FATCA compliance, the model agreements that FFIs will need to enter into, and Intergovernmental Agreements ( IGAs ). Where the IRS enters into an IGA with a foreign country, that foreign government will deal with FFIs based in that country, and the foreign government, in turn, will share information with the IRS, eliminating the need for each FFI in that country to have its own agreement with the IRS. Both U.S. and foreign insurance businesses have significant work ahead of them in 2013 to get ready for the 2014 effective date of FATCA. C. Cascading Federal Excise Tax Validus Reinsurance, Ltd., of Bermuda, filed a federal tax refund action in the District Court for the District of Columbia in January 2013, challenging the IRS so-called cascading excise tax position. Validus Reinsurance, Ltd. v. United States, Case No. 1:13-cv (D.D.C. January 25, 2013). The cascading excise tax refers to the IRS position that the 1% Federal Excise Tax ( FET ) on reinsurance of U.S. risks by foreign reinsurers can be imposed an unlimited number of times. For example, when U.S. insurance risk is ceded to a reinsurer in a non-treaty jurisdiction such as Bermuda, the 1% FET is imposed on the gross reinsurance premium paid in the transaction. According to the IRS, another 1% FET is imposed if the Bermuda reinsurer retrocedes all or part the business to another non-treaty reinsurer. The IRS literally takes the position that FET may be imposed an unlimited number of times with respect to the same U.S. insurance risk. The IRS position represents an extraordinary assertion of U.S. taxing power over business entities that do not conduct business in the U.S. and transactions that occur entirely outside the U.S. The District Court could decide the Validus challenge within the current year, and the losing party would seem likely to appeal, stretching the controversy into Meanwhile, the IRS is continuing its aggressive enforcement campaign by conducting examinations of reinsurers doing business in the offshore market. Some offshore reinsurers have been voluntarily complying with the IRS position since a 2008 amnesty. Most affected companies, whether filing and paying the cascading FET voluntarily, or paying IRS audit assessments, are protecting their rights by filing refund claims of the cascading FET they have paid. The industry will be watching the Validus case closely. D. Private Placement Variable Life/Annuity Products Under the fiscal cliff legislation and the Affordable Care Act, the highest individual federal income tax rate is now 39.6%, plus the new 3.8% add-on tax on investment income of high-income taxpayers. At the same time, fund managers who have deferred receipt of compensation under various arrangements are seeing that deferral come to an end due to other limitations of tax law, or for nontax reasons. In this environment, we have seen a recent surge of interest in private placement variable life insurance and variable annuity products, as recent developments generate renewed interest in tax-advantaged methods of investing the wealth of high net worth individuals. The products most desired by this demographic will not be retail-type variable products available off the shelf. Rather, 43

50 advisors will be working to structure variable product platforms that may involve sophisticated hedge-fund style investment strategies. E. Life Insurer Tax Controversies Actuarial Guidelines The IRS lost a round in the courts in 2012 when the U.S. Court of Appeals for the Sixth Circuit ruled that NAIC Actuarial Guideline 33 ( AG 33 ) could be applied for tax purposes to annuity contracts issued before Am. Fin. Group and Consol. Subsidiaries v. United States, 678 F.3d 422 (6th Cir. 2012). AG 33 is an interpretation of the Commissioners Annuity Reserve Valuation Method, issued in 1995 and applicable for statutory accounting purposes to all annuity contracts issued after The IRS argued that tax reserves for contracts issued before 1995 had to be computed using pre-ag 33 principles. The court ruled against the IRS. Several other Actuarial Guidelines that generally produce higher statutory reserves have been issued since Many life insurers have applied such guidelines for tax purposes the same way they do for statutory purposes, to both outstanding contracts and newly issued contracts. The American Financial court was not a court of national jurisdiction, and the IRS appears unwilling to give up the position that new Actuarial Guidelines can be applied for tax purposes only to new business. Life insurers are likely to face continuing IRS controversy over these issues. F. Property & Casualty Tax Controversies Loss Reserves Every IRS audit of a property and casualty insurer includes at least a preliminary review of whether the company s loss reserves may have been overstated, above and beyond the fair and reasonable estimate required by Treasury Regulations. Loss reserves (for known unpaid claims, incurred but not reported claims, and unpaid loss adjustment expenses) represent the largest expense deduction in an insurer s tax return, and IRS agents often propose 9-digit loss reserve haircuts for large insurers. In recent years the IRS has attacked perceived reserve redundancy by labeling it implicit margin essentially, the use of conservative actuarial assumptions. This strategy will get its first court test in a case that was tried in the Tax Court in 2012 and remains pending decision (Acuity). G. Tax Treatment of Extra-Contractual Obligations On August 31, 2012, the U.S. Court of Appeals for the Seventh Circuit partially reversed a decision of the U.S. Tax Court dealing with the tax treatment of extra-contractual obligations ( ECOs ). State Farm Mut. Auto. Ins. Co. v. C.I.R., 698 F.3d 357 (7th Cir. 2012). The court s decision was based expressly on the amicus brief filed on behalf of five property and casualty insurance trade associations. The Seventh Circuit held that ECOs, other than punitive damage awards, are subject to the same tax-deductibility standards as other insurance claims. These compensatory ECOs are therefore deductible on an estimated reserve basis like other incurred but unpaid losses, and are not subject to the all events or economic performance rules that govern normal business expenses. The State Farm case involved about US$200 million in punitive damages and related interest, and US$1 million of compensatory ECOs for mental anguish of the claimant in a bad faith lawsuit. The Tax Court held that the entire award was a normal business expense deductible only when paid. While the parties arguments were focused primarily on the punitive damages, the associations amicus brief focused entirely on the US$1 million of compensatory ECOs. The Court of Appeals stated: We affirm the Tax Court s decision regarding the punitive damages... With regard to the compensatory damages portion of the award, however, we agree with amici insurance associations and reverse the Tax Court. Extra-contractual obligations like the compensatory damages for bad faith have long been included in insurance loss reserves, and clear guidance from the NAIC, which the federal tax statutes essentially incorporate for key details of taxing insurance companies, supports that result. The State Farm decision is a strong endorsement of the Seventh Circuit s 1992 decision in Sears, Roebuck & Co. v. C.I.R., 972 F.2d 858 (7th Cir.1992), where the court held that unpaid losses in mortgage guaranty insurance must be determined for tax purposes according to the standards used in the NAIC Annual 44

51 Statement, because Congress expressly adopted those standards for insurance companies in Section 832 of the Internal Revenue Code. In State Farm, the court strongly reaffirmed Sears, and stated: We agree with State Farm that the NAIC-approved annual statement provides the rule for computing deductible loss reserves under section 832, at least where the NAIC has in fact provided a rule.... Congress commanded use of the NAIC instructions to compute underwriting income, and then clarified in section 846 that what the NAIC says is an unpaid loss for annual statement purposes controls for tax purposes, as well. The court said that compensatory ECOs are part of insurance losses under clear NAIC guidance, and reversed the Tax Court on that basis, stating: Compensatory damages in bad faith lawsuits against insurers are included in unpaid loss reserves under authoritative NAIC annual statement guidance, and are thus properly included in deductible unpaid losses under section 832. As to punitive damages, the court stated: The NAIC guidance we relied upon above regarding compensatory damages does not apply to punitive damages.... The relevant guidance is at best ambiguous. The court affirmed the Tax Court decision as to the punitive damages portion of the award. State Farm is an important development for any taxpayer relying on an Annual Statement conformity principle to support the tax treatment of a particular item. The IRS has indicated its continuing strong disagreement with State Farm. H. Limitations on What Constitutes Insurance for Tax Purposes The IRS is pursuing several pending controversies in which it argues that transactions are not insurance for tax purposes and the entities involved are not insurance companies for tax purposes. For example, a real estate or equipment leasing company can buy residual value insurance to protect against all or part of the economic loss resulting from the market value of leased property at the end of the lease term being less than the leasing company assumed (or hoped) it would be. The IRS does not believe this risk of economic loss is an insurance risk because it does not stem from a discrete casualty event. Recently filed Tax Court litigation is pending on this issue (R.V.I. Guaranty Co., Ltd and Subsidiaries v. Comm r, Doc. No (U.S.T.C. filed on November 8, 2012)). If these transactions are not insurance for tax purposes, and the company selling the protection is not entitled to be taxed as an insurance company, the premiums paid for the protection could be fully taxable upon receipt with no deduction allowance for any unearned premium or unpaid loss reserves. In addition, litigation is in progress relating to captive insurance programs that do not involve sufficient risk distribution in the eyes of the IRS (Rent-A-Center, Inc. and Affiliated Subsidiaries v. Comm r, Doc. No (U.S.T.C. filed on September 29, 2010); Securitas Holdings Inc. and Subsidiaries v. Comm r, Doc. No (U.S.T.C. filed on September 28, 2010)). The IRS has long asserted that meeting this standard for insurance tax treatment requires an unspecified minimum number of insured legal entities that transfer similar types of insurance risk to the captive insurer. If there are too few insureds adding risk and premiums to the pool, or if the amounts of risk and premium are too concentrated in one or a few insureds, then the IRS has asserted that the arrangement does not provide risk distribution and is not insurance for tax purposes. This IRS position has not previously been tested in court. I. State Tax Issues State legislative sessions are in full swing, keeping much of the industry focused on proposed tax legislation. In a search for additional revenue, state governments are looking for new and creative ways to expand the tax base. Some states have introduced proposals to expand the sales tax base to cover services, including insurance-related services such as sales (agent commissions), marketing and claims adjustment and adjudication. Spearheaded by the Multistate Tax Commission, other states are considering a dramatic expansion of the income tax base to tax income earned by partnerships and other pass-through entities that are owned by insurance companies, which in most states are subject only to premium tax and not also to income tax. Finally, states are considering increasing tax rates or adopting new tax structures (e.g., Nevada s margins tax). 45

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