United States: NAIC Adopts Landmark New Standards On Credit for Reinsurance

Last Updated: March 7 2012
Article by Joseph T. Holahan

Insurance Reinsurance Managed Healthcare Review - Spring 2012

During its Fall 2011 meeting, the National Association of Insurance Commissioners ("NAIC") adopted important changes to its Credit for Reinsurance Model Law and Regulation following years of work on this issue.

The centerpiece of the amendments is a process by which unauthorized reinsurers may qualify to post reduced collateral to satisfy state credit for reinsurance standards that apply to U.S. cedants. Other important aspects of the amendments include new regulatory notice requirements for ceding insurers concerning concentrations of risk and clauses required to be included in reinsurance agreements for ceding insurers to receive credit for reinsurance.

The amendments to the NAIC model law and regulation follow a general trend among the states and at the federal level towards modernization of reinsurance regulation. Florida, Indiana, New Jersey and New York already have adopted laws permitting unauthorized reinsurers to post less than 100% collateral if they qualify based on financial strength ratings and other factors. In 2010, Congress enacted the Nonadmitted Insurance and Reinsurance Reform Act ("NRRA") as part of the Dodd-Frank financial reform legislation. The NRRA, which became effective July 21, 2011, generally preempts the application of state credit for reinsurance laws to insurers not domiciled in the state. Thus, under the NRRA, a ceding U.S. insurer need only satisfy the credit for reinsurance requirements of its domicile state.

Major aspects of the amendments to the NAIC Credit for Reinsurance Model Law and Regulation include the following:

Regulatory Notice Regarding Cedant's Concentration of Risk

Under the amendments, an insurer must notify its domestic regulator within 30 days if reinsurance recoverables from any single reinsurer or group of affiliated reinsurers exceed 50% of the insurer's last reported surplus to policyholders or if the insurer has ceded to any single reinsurer or group of affiliated reinsurers more than 20% of the insurer's gross written premium in the prior calendar year. An insurer also must notify its domestic regulator within 30 days if, at any time, it determines it is likely to exceed these limits. The notice must demonstrate the insurer is safely managing its exposure.

The amendments do not specify what action, if any, the regulator may take following notice. Regulators likely will require a notifying insurer to implement a plan to reduce its concentration of risk, unless the insurer can demonstrate it is managing the risk appropriately on its own – for example, by obtaining appropriate collateral. Insurers domiciled in states that adopt these requirements must be certain their policies governing concentration of risk reflect these limits. They also may want to consider inserting a provision in outbound reinsurance agreements requiring the assuming insurer to give notice of mergers and acquisitions within its affiliated group so that any resulting concentrations of risk can be tracked and managed.

Contract Clauses Required to Obtain Credit for Reinsurance

The amendments add new, required contractual provisions for the ceding insurer to obtain credit for reinsurance. They also clarify an existing clause of this type. The amendments provide that the reinsurance agreement must include "a proper reinsurance intermediary clause, if applicable," stipulating that credit risk for the intermediary is carried by the reinsurer. Such a clause will be necessary where a reinsurance intermediary handles payment of reinsurance premiums or claims.

In addition, the amendments clarify that to obtain credit for reinsurance, the reinsurance agreement must contain an insolvency clause stipulating that if the ceding insurer is placed in liquidation or similar insolvency proceedings, reinsurance claims are payable directly to the ceding insurer's liquidator or successor without diminution, regardless of the ceding insurer's status. Such clauses already are standard and generally required in U.S. jurisdictions to obtain credit for reinsurance.

Finally, reinsurance agreements with a certified reinsurer must contain a funding clause requiring the reinsurer to provide security in an amount sufficient to avoid the imposition of financial statement penalty on the ceding insurer.

Reduced Collateral Requirements for Certified and Rated Reinsurers

The amendments establish a scheme whereby an unauthorized reinsurer may be "certified" and rated by the domestic state regulator of a ceding U.S. insurer. Insurers ceding to a reinsurer that has been certified will be granted full credit for reinsurance while being permitted to obtain security according to a sliding scale, with the level of required collateral varying from 0% to 100% of ceded liabilities according to the certified reinsurer's rating.

To be eligible for certification, a reinsurer must meet the following criteria: (1) be domiciled and licensed in a "qualified jurisdiction;" (2) maintain capital and surplus of no less than $250 million; (3) maintain financial strength ratings from two or more acceptable rating agencies; (4) submit to the jurisdiction of the certifying state and agree to provide security for 100% of its liabilities attributable to cessions by U.S. insurers if it resists enforcement of a final U.S. judgment; (5) agree to provide certain informational filings, including notice within 10 days of any regulatory action taken against the reinsurer, an annual list of disputed and overdue reinsurance claims regarding U.S. cedants and annual audited financial statements and auditor's report; and (6) comply with any other requirements established by the certifying state. If a reinsurer applying for certification has been certified by another state accredited by the NAIC, the regulator may defer to that state's certification.

The amendments call for the state regulator to publish a list of "qualified jurisdictions," which are jurisdictions that may serve as the domicile for a certified reinsurer. The NAIC will publish a list of jurisdictions it considers to be qualified, which many states may follow. All U.S. jurisdictions that are accredited by the NAIC will be recognized as qualified automatically. Non-U.S. jurisdictions will be evaluated for qualified status based on a number of factors, including the effectiveness of reinsurance supervision, including financial surveillance; whether the jurisdiction accords reciprocal rights to U.S. reinsurers; any documented evidence of problems with the enforcement of U.S. judgments in the jurisdiction; and the jurisdiction's agreement to share information and cooperate with the state regulator with respect to certified reinsurers.

Certified reinsurers will be rated by the certifying state. The maximum rating that a reinsurer may be assigned will be correlated to the reinsurer's financial strength ratings as set forth in Table 1.

The amendments direct the regulator to use the lowest financial strength ratings assigned to the reinsurer in arriving at a rating. Other factors the regulator may consider include the reinsurer's business practices, its reputation for prompt payment of claims based on an analysis of cedants' Schedule F reporting, its financial condition and the liquidation priority of claims in its domicile. The regulator also may review the reinsurer's NAIC annual statement blank schedule concerning reinsurance ceded and assumed or for non-U.S. reinsurers a new annual Form CR, which will be required for certified companies. If a reinsurer has been rated by another state accredited by the NAIC, the regulator may defer to that state's rating.

As shown in Table 1, the ratings follow a scale of 1 through 6. Varying levels of collateral are required to ensure credit for reinsurance, depending on the reinsurer's rating as follows: Secure - 1 (0%), Secure - 2 (10%), Secure - 3 (20%), Secure - 4 (50%), Secure - 5 (75%), Vulnerable - 6 (100%). Thus, for example, an insurer ceding to a reinsurer rated "Secure - 1" will earn full credit for reinsurance even if it obtains no collateral from the reinsurer. An insurer ceding to a reinsurer rated "Vulnerable - 6" will need to obtain collateral for 100% of the ceded liabilities to obtain full credit for reinsurance.

The amendments' reduced collateral provisions for a certified reinsurer will apply to reinsurance agreements entered into on or after the effective date of the certification. In addition, the amendments state that any reinsurance agreement entered into prior to the effective date of certification that subsequently is amended and any new reinsurance agreement covering risk for which collateral previously was provided will qualify for reduced collateral only with respect to losses incurred and reserves reported from and after the effective date of the amendment or new agreement. The amendments' limited effectiveness with respect to in-force business could make it difficult for parties to take advantage of them for existing reinsurance arrangements.

For unauthorized reinsurers who use a multi-beneficiary trust to meet collateral requirements, the amendments permit the reinsurer to reduce the amount of trusteed surplus if it has permanently discontinued underwriting new business secured by the trust for at least three years and the state regulator with primary regulatory oversight of the trust authorizes the reduction based on a risk assessment. In addition, the amount of trusteed surplus is lower for a multi-beneficiary trust established by a certified reinsurer.

NAIC model laws, of course, do not have the force of law in any U.S. jurisdiction. Therefore, at this point the amendments essentially constitute a recommendation by the NAIC to the states. Although many states adopt laws following NAIC models in whole or in part, it remains to be seen how many states will adopt the amendments. This dynamic would change if the NAIC were to make adoption of the amendments a condition of state accreditation, in which case all states almost certainly would adopt them in full. Nevertheless, because changes to NAIC accreditation standards generally take at least four years to become effective, any such development is a long way off.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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