United States: NAIC Proposes Tougher Risk-Based Capital Requirements And Disclosures On Investment Affiliates, Reserve Funding Transactions

 Two proposals recently circulated by the National Association of Insurance Commissioners (the "NAIC") highlight changes in the risk-based capital ("RBC") regime that could significantly impact deal activity in the insurance space. The proposals would require:

  • property-casualty insurers to hold additional capital against investments held through the insurer's subsidiaries; and
  • life insurers that employ captives to manage A-XXX risks (that is, reserves associated with universal life policies with supplemental guarantees, such as "no lapse" policies), to disclose the impact of these arrangements on the insurer's RBC.

Both proposals are the subject of comment solicitations currently pending from the NAIC. If either proposal becomes adopted, insurers could be motivated to seek alternative deal structures or techniques to address the relevant RBC hit or disclosure obligation.

Investment Affiliates for Property-Casualty Companies

The NAIC's Capital Adequacy Task Force is currently deliberating on whether to ascribe a capital charge to "investment affiliates" of property-casualty insurers and has recirculated a proposal to impose such a charge. The NAIC defines an "investment affiliate" as any affiliate of the insurer, other than a holding company, that is engaged or organized primarily to engage in the ownership and management of the insurer's investments. An insurer might use an investment affiliate for administrative purposes or as a "blocker" for legal, tax or other motivations.

Currently, the RBC charge for a property-casualty insurer's investment in an investment affiliate is based on the RBC of the underlying assets, prorated to account for such insurer's degree of ownership of these underlying assets. This "look through" approach assumes that the charge for an investment affiliate should be the same as if the insurer held the assets directly. The insurer's equity interest in the affiliate itself is thus disregarded, and the insurer does not incur a capital charge in respect of such equity interest (ordinarily, insurers must hold more capital against equity investments than debt).

In its Oct. 1 release, the Task Force would abandon this "look through" approach and impose an RBC charge for an investment in an investment affiliate to be based upon a certain, as of yet undetermined, percentage multiplied by the carrying value of the investment affiliate's common and preferred stocks and bonds. According to the proposal, the current capital charge of zero cannot be "verified" and therefore is not justified as an automatic matter.

While the NAIC has not yet proposed a specific percentage associated with such capital charge, any change may have significant implications for how insurers structure merger and acquisition transactions, joint ventures and other structured investments in their asset portfolios. The benefits of using an investment subsidiary (administrative simplicity, legal remoteness, etc.) would have to be weighed against the incremental capital cost, potentially frustrating such benefits.

This change to the RBC regime is already being applied to health insurers. At the NAIC's March 29, 2015, Spring National Meeting, the Task Force adopted the proposal to amend the RBC standards with respect to health insurers, whereby now a health insurer's investment in an investment affiliate will incur a charge of 0.300. Accordingly, health insurers are required to set an RBC charge for an investment in an investment affiliate equal to 30 percent of the investment affiliate's carrying value. In addition, a working group of the Task Force is currently considering whether the investment affiliate charge ought to be uniform across life, P&C and health lines.

The deadline to submit comments to the NAIC on the re-exposure draft of the P&C investment affiliate RBC requirement is Oct. 30, 2015, and such proposal is likely to be considered at the NAIC's Fall National Meeting in November.

Reserves for Universal Life With Supplemental Guarantees Reinsured by Captive/H3>

The NAIC's Principle-Based Reserving Implementation Task Force is proposing that life carriers be required to disclose, as part of their annual statement reporting, certain effects on RBC of the carrier's use of reinsurance to an A-XXX captive.

By way of background, historically A-XXX policies have been subject to overly conservative reserving requirements under the NAIC's standard valuation law and related regulations, including so-called Regulation XXX/A-XXX. These requirements are in the process of being relaxed by state regulators pursuant to the emerging "principle-based reserving" ("PBR") regime, in which more discretion could be used in valuing policies rather than strict formulas. (Under the Reg. XXX/A-XXX formulas, reserves were ascribed by time segments over the life of the policy to account for changes in premium levels and benefits, creating redundancies as compared with "standard" reserving techniques that were based on present value over the entire, unsegmented life of the policy.)

In connection with these reforms, new guidelines have been issued by the NAIC in recent months governing reserve financing arrangements, in which a life company, seeking capital relief from the onerous reserving requirements of Reg. XXX/A-XXX, cedes XXX or A-XXX risks to a reinsurer, often a captive. The NAIC's Actuarial Guideline XLVIII ("AG 48") sets forth the actuarial framework for establishing reserves for these transactions, and the proposed Non-Universal Life and Universal Life with Secondary Guarantees Credit for Reinsurance Model Regulation governs the "credit for reinsurance" available for such transactions (i.e., the ability to treat such reinsurance as an asset on the cedent's balance sheet).

Generally, under these proposals, when ceding XXX or A-XXX reserves to a reinsurer (e.g., a captive), an insurer will be able to claim balance sheet credit if (i) certain high-grade assets ("Primary Security") are posted to secure liabilities up to a threshold referred to as the "Required Level of Primary Security" and (ii) other assets, as permitted by the applicable regulator, are posted to secure liabilities in excess of that threshold up to the full statutory level (i.e., the Reg. XXX/A-XXX-mandated level). In other words, the entire statutory reserve need not be secured by the highest-grade collateral specified in the law; only the Required Level of Primary Security is required to be so collateralized. This level is determined actuarially pursuant to AG 48, and not pursuant to the strict formulas of Regulation XXX/A-XXX, and thus represents the incorporation of principle-based reserving into the credit-for-reinsurance arena.

In September, certain revisions to RBC calculations became effective incorporating these changes. Under these revisions, a life company would be required to hold more capital against reinsurance transactions or captives where (i) Primary Security is insufficient, (ii) nonadmissible assets (i.e., assets that are statutorily ineligible for surplus) exceed the portion of statutory reserves not covered by the Required Level of Primary Security and (iii) nonadmissible assets are being used to secure such financing transactions.

Under the proposal that is the subject of the pending comment solicitation, a life company would be required to disclose the effects of these new RBC items on its overall Total Adjusted Capital ("TAC"). Specifically:

  • For each captive for which non-admissible assets exceed the difference between the total statutory reserve and the Required Level of Primary Security, requiring a downward RBC adjustment, the captive and the dollar amount of this shortfall must be identified.
  • The insurer must specify its TAC for the current year, along with sum of TAC plus the total of the RBC shortfalls shown in item 1 above. The NAIC intends for this to "provide perspective on how much the TAC has been impacted by any captive RBC shortfalls," as opposed to merely showing the resulting net TAC (already required in the annual statement).
  • For each reinsurer for which Primary Security is insufficient to fully secure the Required Level of Primary Security (a "Primary Security Shortfall"), the insurer must disclose (i) the name of the reinsurer and the amount of Primary Security Shortfall and (ii) the total shortfall from that exhibit across all reinsurers.
  • The insurer must specify the sum of the RBC charges it has incurred for certain letters of credit, parental guarantees and similar arrangements that are ineligible for credit for reinsurance. According to the NAIC, this is intended to "provide perspective on the amount of certain non-admitted assets associated with the ceding company's A-XXX/XXX business, relative to the overall size of the ceding company."

The Task Force has solicited comments on this proposal with a deadline of Oct. 14. The adoption of these disclosure requirements could have an in terrorem effect on life insurers structuring reserve funding transactions, insofar as any defect in a transaction from a credit-for-reinsurance standpoint would have to be specifically identified, rather than merely being one of numerous, unidentified factors in the calculation of RBC. This, in turn, might increase demand for high-quality reserve assets and more efficient execution in A-XXX contexts, as principle-based reserving continues its lengthy evolution.

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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