United States: Latest Developments In Regulation Of XXX/AXXX Captives

The National Association of Insurance Commissioners (the "NAIC") is forging ahead with its work on captive insurance companies used by life insurance companies to finance reserves required under current regulations; these reserves are commonly referred to as "XXX reserves" for certain term life insurance policies, and "AXXX reserves" for certain universal life insurance policies. We last addressed the NAIC's actions in a Duane Morris Alert entitled " NAIC Moving Forward on Regulation of XXX/AXXX Financing Transactions," dated August 29, 2014. In that Alert, we described the newly-adopted XXX/AXXX Reinsurance Framework (the "Framework"), which was introduced by Neil Rector of Rector and Associates, Inc. ("Rector") in response to a charge from the NAIC to develop regulatory responses to the use of captive insurers to finance XXX and AXXX reserves. This Alert discusses actions on the Framework taken since then, concluding with the NAIC 2014 Fall National Meeting, which was held from November 16–19, 2014.

Actuarial Guideline 48

The purpose of the Framework is to "further[ ] an action plan to develop proposed changes to the insurer/captive regulations specific to XXX/AXXX transactions." As a key part of the action plan called for in the Framework, in June, Rector introduced a draft "Actuarial Guideline XLVIII—Actuarial Opinion and Memorandum Requirements for the Reinsurance of Policies Required to be Valued under Sections 6 and 7 of the NAIC Valuation of Life Insurance Policies Model Regulation (Model 830)" (referred to as "AG 48").

The Principle-Based Reserving Implementation (EX) Task Force (the "Task Force") held a series of conference calls in October and November, along with an in-person meeting on November 7, 2014, to consider comments on the draft by regulators, industry representatives and other interested parties. These meetings and calls culminated in the adoption of AG 48 by the Task Force, with a recommendation that AG 48 be adopted by the NAIC as a whole by the end of 2014, so that it will be effective on January 1, 2015. Although AG 48 was not finally adopted at the Fall Meeting, it is anticipated that it will be by the end of 2014 in Executive Committee/Plenary conference calls.

AG 48 is seen as the linchpin of the NAIC's efforts to regulate the use of captives for XXX/AXXX reserve financings until principle-based reserving ("PBR") requirements become generally effective. The core concept of AG 48 (and of the Framework generally) is that some portion of XXX and AXXX reserves are "excessive," or "redundant," in the sense that they exceed reserves computed on a more realistic basis, but that PBR reserving methods will eliminate that redundancy. The question before the Task Force is how to deal with the redundant reserves in the interim. Some regulators (particularly the New York Department of Financial Services and the California Insurance Department), as well as some industry members, would like to end the use of captives altogether. Indeed, New York also opposes PBR, and has taken steps to reduce some of the redundancy in reserves under current regulations. Other regulators and industry members have taken a range of views, from advocating for no changes to attempting to craft a middle ground. AG 48 reflects the latter approach.

It is of particular note that during the course of the November 7 meeting, the chairman of the Task Force stated that the goal is not to end XXX/AXXX reserve financing transactions; rather, the Task Force's goal is to eliminate certain perceived problems that have arisen in XXX and AXXX financing transactions, such as the use of letters of credit ("LOCs") or parental guarantees, rather than traditional admitted assets, to back reserves. At the same time, companies will be allowed to continue to finance the redundant portion of the reserves (determined under AG 48 principles) on a more controlled basis, until PBR is effective.

The adoption of AG 48 is viewed as an interim step in developing a more comprehensive approach to the use of financing transactions for XXX and AXXX reserves. As a "second stage" solution, the NAIC Reinsurance Task Force will seek Executive Committee permission to create a new model regulation incorporating AG 48 principles, and to amend the existing Credit for Reinsurance Model Act (Model 785). Although many in the life insurance industry believe that some level of redundancy will continue to exist under PBR, under the new regulation, companies will be required to fund the full statutory (PBR) reserve with assets that meet the requirements of AG 48, which would appear to eliminate any financial incentive to use captives to finance reserves.

Exemptions from AG 48

The Framework is not intended to apply to "conventional" reinsurance transactions, even when they include XXX and AXXX policies. Accordingly, AG 48 exempts reinsurance transactions with reinsurers that meet the following criteria: they must be licensed, accredited or maintain trust funds in the United States; they must prepare their statutory financial statements in compliance with the NAIC Accounting Practices and Procedures Manual without any material deviations from statutory accounting principles ("SAP"); and they must not be subject to certain events under the risk-based capital ("RBC") rules. In addition, AG 48 exempts certain "certified" reinsurers (reinsurers that meet certain ratings and other requirements). Moreover, AG 48 allows the ceding insurer's domiciliary regulator to determine, after consultation with the NAIC's Financial Analysis Working Group ("FAWG"), that a particular transaction is outside of the intended scope of AG 48. In such cases, the regulator must publicly disclose that it has exempted a transaction, and include a summary of the transaction, although it is not required to disclose the names of the parties. It is important to note that the application of AG 48 is not limited to the use of captive reinsurers—any reinsurer that does not fall under one of the exemptions, and reinsures policies with XXX or AXXX reserves, will be subject to the new rules.

Grandfathering

The original draft submitted by Rector proposed limiting the application of AG 48 to policies with XXX or AXXX reserves issued on or after January 1, 2015, and ceded to a reinsurer under a reinsurance agreement that does not meet one of the exemptions described above (such policies are referred to in the draft as "Covered Policies"). The effect of this definition would be to "grandfather" all pre-2015 business (i.e., exclude all pre-2015 policies from the new rules, even if they are reinsured in a financing transaction after the effective date of AG 48).

Recognizing that the "base" proposal would be opposed by some regulators and industry members, the Rector draft set out two alternative proposals. One would have essentially frozen XXX and AXXX financing transactions as of the end of 2014, subject to relatively minor post-2014 changes. Both California and New York, as well as some large life insurers, expressed a preference for this alternative. The other would have allowed changes to existing reinsurance agreements, but would neither allow new reinsurance agreements covering policies with XXX or AXXX reserves after the end of 2014 nor would it allow the addition of new policies to a pre-2015 reserve financing transaction, regardless of the issue date of the policies.

The compromise position adopted by the Task Force is reflected in the introduction to AG 48, which states that "the provisions of this Actuarial Guideline are not intended to apply to policies that were issued prior to 1/1/2015 if those policies were included in a captive reserve financing arrangement as of 12/31/2014." Thus, Section 4.B. of AG 48 grandfathers all pre-2015 reserve financing transactions, but any post-2014 financing transactions for XXX or AXXX policies, including those issued before January 1, 2015, will be subject to the Framework regime.

Primary and Other Security

In order to ensure that any XXX or AXXX transaction requires the funding of a conservative, but reasonable, level of reserves with "hard" assets, AG 48 calls for the use of the "Actuarial Method" to determine a "Required Level of Primary Security" for the Covered Policies. The Actuarial Method is the "Requirements for Principle-Based Reserves for Life Products" included in the NAIC Valuation Manual (VM-20), subject to certain modifications for purposes of AG 48. In other words, the Actuarial Method is used to approximate the portion of XXX or AXXX reserves that would be required under the new PBR regime. The Required Level of Primary Security must be funded with the following types of assets, which qualify as "Primary Security":

  • Cash.
  • Securities listed by the NAIC's Securities Valuation Office (the "SVO") meeting the requirements of Section 3.B. of the NAIC Credit for Reinsurance Model Law (Model 785) (which includes securities deemed exempt from filing under the Purposes and Procedures Manual of the SVO), and are otherwise admitted assets under relevant law, but not including:

    • any synthetic letter of credit;
    • contingent note;
    • credit-linked note; or
    • other similar security that operates in a manner similar to a letter of credit.
  • For assets retained by the ceding insurer in a modified coinsurance or funds-withheld reinsurance arrangement, Primary Security can include:

    • commercial loans in good standing (CM3 quality or higher);
    • policy loans; and
    • derivatives acquired in the normal course and used to support and hedge liabilities pertaining to the actual risks ceded under the reinsurance agreement.

The types of assets listed as Primary Security reflect concerns by regulators about the use of LOCs to back XXX and AXXX reserves. One of the perceived concerns in existing transactions is the use of "conditional" LOCs; i.e., LOCs that are subject to various limitations on draws. Although industry representatives argued for the use of "unconditional" LOCs of the type that are currently allowed under the credit for reinsurance rules set out in Section 3.C. of Model 785, regulators are concerned about imposing another credit risk into the types of assets to be used as Primary Security.

AG 48 would allow "Other Security" to be held to back the redundant portion of the XXX or AXXX reserves. Other security is defined as any asset, including assets that would qualify as Primary Security, that is acceptable to the ceding insurer's domiciliary regulator.

Both Primary Security and Other Security may be held by the ceding company in a funds withheld or modified coinsurance arrangement, or they may be held by the reinsurer in a trust that qualifies for credit for reinsurance purposes generally, except that both Primary Security and Other Security held in a trust are valued according to SAP, as if the assets were held in the ceding insurer's general account (although affiliate investment limitations do not apply to Other Security).

Qualified Actuarial Opinion

AG 48 requires the ceding company's appointed actuary to analyze any transaction in which Covered Policies are reinsured to determine: (i) if funds consisting of Primary Security are held in an amount at least equal to the Required Level of Primary Security, and (ii) if funds consisting of Other Security are held in an amount at least equal to the remaining portion of the XXX or AXXX reserves. In the event that a reinsurance agreement relating to Covered Policies does not meet these requirements (or certain "Remedial Options" are applicable), the appointed actuary will be required to issue a "qualified actuarial opinion."

Related Matters

A number of other activities relating to the Framework are under way. The NAIC adopted a Supplemental XXX/AXXX Reinsurance Exhibit to be part of the 2014 Annual Statement. The Life Risk-Based Capital Working Group has been addressing issues relating to an "RBC Cushion" for insurers ceding XXX or AXXX business to reinsurers when the assuming insurer does not file an RBC report. The Working Group is also charged with developing RBC charges for Other Security; these charges could be incorporated in the RBC Cushion. Also, the Working Group is charged with considering whether existing RBC treatment of qualified actuarial opinions is appropriate; the Working Group is of the view that the current RBC treatment of qualified actuarial opinions would not be appropriate in the case of a shortfall of Primary Security under AG 48, and that the better answer is to adjust the RBC ratio. Finally, the Financial Regulation Standards and Accreditation (F) Committee is reviewing amendments to the Financial Analysis Handbook relating to XXX and AXXX transactions.

Multi-State Reinsurers

As was also discussed in our August 29 Alert, the NAIC's Financial Regulation Standards and Accreditation (F) Committee is considering amending the preambles to Part A and Part B of the NAIC Accreditation Program Manual to add a new term, "multi-state reinsurer," which is defined as a reinsurer that is licensed in only one state (and thus would not be treated as a multi-state insurer under the current rules), but that reinsures business originated by its ceding insurers in other states. The effect of this amendment would be to require states that are accredited by the NAIC to subject these reinsurers to the full range of NAIC regulatory requirements that currently apply to multi-state insurers. For this purpose, proposed language that was circulated by the Committee at the Spring 2014 NAIC meeting would have defined the term to include "captive insurers, special purpose vehicles and other entities," which means that a captive that reinsures any risk arising outside of its state of domicile would be covered. The proposal noted that captive insurers owned by non-insurance entities for management of their own risks would not be included in the new definition. The application of the new regulatory regime for multi-state reinsurers was intended to apply to reinsurers entering into multi-state reinsurance agreements on or after July 1, 2014, or to reinsurers under existing reinsurance agreements covering business written on or after January 1, 2015.

That proposal generated numerous comment letters, many of which were negative; some commented that the change was not needed at all, and others noted that the proposed definition could sweep in more than the primary target, XXX and AXXX captives. In response, NAIC staff was directed to revise the definition to limit its effect to captives reinsuring policies with XXX or AXXX reserves, variable annuities and long-term care insurance. In addition, the revised definition was to state that any multi-state reinsurer used in an XXX or AXXX transaction that meets the terms of the Framework will be deemed to meet NAIC accreditation standards.

In a memorandum dated November 13, 2014, the Committee noted that NAIC staff believes that the current version of the preambles reflects years of add-ons and revisions to the extent that it makes it "difficult (if not impossible) to simply add a section on Multi-State Reinsurers that both adequately and transparently addresses the proposed revisions." As a result, staff has been directed to prepare new and completely revised preambles that will clarify the scope of the accreditation standards, including their applicability to XXX/AXXX transactions, and to reinsurance of variable annuities and long-term care insurance. The revised preambles (referred to during the Fall Meeting as a "straw man") are due to be available for exposure and comment by the end of 2014.

If you have any questions about this Alert, please contact Hugh T. McCormick, K. Oliver Rust, Cameron F. MacRae III, any member of our Insurance - Corporate and Regulatory Practice Group or the attorney in the firm with whom you are already in contact.

Disclaimer: This Alert has been prepared and published for informational purposes only and is not offered, nor should be construed, as legal advice. For more information, please see the firm's full disclaimer.

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