United States: Insurance Industry Development For Fall 2008

Essex v. Zota: Florida Surplus Lines Exemption Under Attack
By Austin B. Neal and Kevin G. Fitzgerald

The broad exemption historically applied to surplus lines insurance under Florida law was recently called into question by the decision of the Florida Supreme Court (Court) in Essex Insurance Company v. Mercedes Zota (Case No. SC06-2031). In Essex, the Court answered one of five questions certified to it by the United States Court of Appeals for the Eleventh Circuit: Whether the provisions embodied in Section 626.922, Florida Statutes (requiring surplus lines insurers to issue and deliver insurance policies) or Section 627.421 (requiring licensed insurers to deliver insurance policies to insureds within a specified timeframe) require a surplus lines insurer to deliver the policy directly to an insured and not just to the insured's agent. The Court answered in the negative, upholding the common law rule that delivery to the insured's agent was sufficient.

Though not necessary for the Court to reach its decision, the Court also addressed the scope of Florida's surplus lines exemption. Chapter 627 of the Florida Statutes contains Florida's rating law as well as content and filing requirements for policy forms and most other policyholder-related provisions historically applicable to licensed, admitted insurers. In Essex, Florida's highest court held that the exclusionary provision of Section 627.021(2), Florida Statutes, was intended to exempt surplus lines insurance only from the rating law, and not from all of the other provisions of Chapter 627. Based upon its interpretation, the Court found that both Section 627.421 and Section 627.428 (allowing for the award of attorney's fees) were applicable to surplus lines insurance.

The Florida Office of Insurance Regulation (Office) is currently reviewing the decision in Essex to determine what additional regulation, if any, of surplus lines insurers the decision requires. While Essex limited the breadth of the express statutory exemption, it is possible that the regulation of surplus lines insurers contained in Part VIII of Chapter 626, Florida Statutes, will ultimately be determined by the Office to preempt at least the fundamental form regulation from which surplus lines insurers have traditionally been exempt. While reluctant to do so thus far, the Office is being encouraged to issue a memorandum clarifying its interpretation of Essex and any additional regulations that may result. It also appears likely that industry, the Office, or both, will seek to have the decision addressed in the 2009 regular legislative session.

At the current time, it does not appear that the Office will accept surplus lines forms for approval even if they are filed. Consequently, it is probably not practicable for surplus lines insurers to attempt to comply with all of forms filing provisions of Chapter 627, Florida Statutes, pending further instructions from the regulator. However, surplus lines insurers should be aware of the potential application of Sections 627.421 and 627.428, Florida Statutes. Furthermore, surplus lines insurers should be aware that Essex could well lead to the exposure of surplus lines insurers to additional provisions of Chapter 627, including nonrenewal restrictions (in addition to those already applicable under Section 626.9201, Florida Statutes), claims settlement requirements, and other such provisions.

Recent Developments

On August 18, 2008, the Eleventh Circuit Court of Appeals rendered a decision in CNL Hotels v. Twin City Fire Insurance Company (WL 3823898) in which it applied Essex to reverse a summary judgment by determining that an endorsement under a surplus lines policy was not valid because it had not been filed and approved pursuant to the forms filing requirements of Chapter 627, Florida Statutes. In so doing, the Eleventh Circuit realized the worst-case scenario for application of Essex — that surplus lines insurance forms will now be treated just like admitted policy forms, and be subjected to all of the same requirements.

The decision in CNL Hotels confirms that it will not be possible to defer action to counter the Essex decision until the 2009 Florida legislative session in March. Decisions like CNL Hotels will attract attention from the trial bar, and it is likely that there will be further litigation and decisions prior to the session. For that reason, several insurers, among them Lloyd's and AIG, have filed this week amicus briefs in conjunction with a motion for reargument filed in the CNL Hotels case. The Office appears to be moving toward making a more meaningful and official statement of its position with regard to surplus lines form regulation after Essex, and toward that end has filed an amicus brief in CNL Hotels.

Surplus lines insurers have agreed to meet in early October 2008 to discuss Essex, its progeny past and anticipated, and additional steps to be taken both in the courts, with the regulator, and in the 2009 session. Foley has been asked by the National Association of Professional Surplus Lines Offices, Ltd. (NAPSLO) to participate on the panel for that meeting. The Florida House may seek to address Essex in a reviser's bill. Because such a bill may or may not address the industry's concerns regarding Essex, we will be closely monitoring this development.

Foley will provide further details regarding the proposed meeting as well as continuing information regarding the action to be taken by insurers and the Office in CNL Hotels, in upcoming periodic alerts.

Fisher v. United States
By Richard Bromley and A. John Richter

The United States Court of Federal Claims (Court) recently decided the case of Fisher v. United States, Fed. Cl. No. 04-1726T (August, 2008), in which it rejected the long-held position of the Internal Revenue Service (IRS) that the basis of stock received by a policyholder in a demutualization is zero.

Factual Background

Plaintiff-policyholder purchased a participating life insurance policy from Sun Life Financial, Inc. (Sun Life), a mutual life insurer. The policyholder's ownership rights under the policy included the ability to vote on matters submitted to participating policyholders, to participate in the profits of the company (i.e., to receive annual dividends representing the profit, if any, not retained in surplus), and to participate in any distribution of demutualization or liquidation benefits. These ownership rights could not be sold separately and would be extinguished upon termination of the policy.

Sun Life subsequently adopted a plan of demutualization under which policyholders retained their insurance coverage and could elect either to receive stock in the new holding company or to sell the shares issued in connection with a planned initial public offering. Plaintiff-policyholder elected the latter option and received cash. In connection with the demutualization, Sun Life received rulings from the IRS that (i) policyholders would recognize no gain or loss on the deemed exchange of their ownership rights in Sun Life solely for company stock, and (ii) the basis of company stock received by Sun Life policyholders in the deemed exchange would be "the same as the basis of the ownership rights surrendered" in exchange for the stock, i.e., "zero" basis.

Plaintiff-policyholder, who opted for sale of the stock and receipt of cash therefore, reported the full amount of cash received, unreduced by any basis adjustment, on its federal income tax return. It then filed for refund of the tax paid and brought an action in the Court of Federal Claims, alleging that it had realized no capital gain on the sale of the shares because the proceeds were offset by plaintiff's basis in the stock.

The Court's Decision

The Court found, based upon expert testimony, that the policyholder's ownership rights in the mutual life insurance company, which were given up by the policyholder in exchange for shares of stock received in the demutualization transaction, had a value that was not ascertainable separate from the policyholder's basis in its life insurance policy. Accordingly, the Court applied the so-called "open transaction" doctrine to hold that the plaintiff-policyholder did not receive any income on the sale of the stock because the amount received by the plaintiff-policyholder in that sale was less than its cost basis in the insurance policy as a whole. Thus, the plaintiff-policyholder prevailed in its argument that it had realized no capital gain on the sale of the stock.

Implications of Court's Decision

This decision is appealable to the United States Court of Appeals for the Federal Circuit. Given the decision's potentially broad implications with respect to basis of assets received by policyholders in other insurance company demutualization transactions (including, perhaps, transactions involving demutualizations of nonlife mutual insurance companies), it seems not unlikely that such an appeal will be taken by the Government. Pending the final outcome of the Fisher case, individual policyholders who have received stock or stock rights in an insurance company demutualization transaction should consider taking appropriate steps to protect their rights in the event they have paid tax with respect to the sale of such stock or stock rights.

Reinsurance Modernization Proposal Set to Advance
By Brian S. Kaas and Sarah E. Molenkamp

State insurance regulators at the National Association of Insurance Commissioners (NAIC) continue to surge forward in working out the details of a substantial overhaul of the collateral requirements applicable to reinsurers. The proposed collateral requirements, which seek to tie collateral obligations to a reinsurer's financial strength and licensure status, would apply to certain domestic and non-U.S. reinsurers. The proposal represents the most sweeping change to reinsurance collateral requirements in years. Despite opposition by certain members of the insurance industry, the proposal remains on track for adoption by the NAIC later this year.

1. Current Collateral Requirements

Current reinsurer collateral requirements are imposed under state credit for reinsurance regulations. Generally speaking, these regulations require U.S. insurers to obtain acceptable forms of collateral from non-licensed or non-accredited reinsurers in order to take financial statement credit for reinsurance ceded to these reinsurers. In these situations, credit for reinsurance is permitted only in an amount equal to collateral posted by the reinsurer. Conversely, ceding companies that cede risks to reinsurers that are licensed or accredited in the ceding company's state of domicile are permitted to take full financial statement credit without obtaining any collateral from the reinsurer. In other words, existing regulations focus exclusively on a reinsurer's licensing or accreditation status with no consideration given to the reinsurer's financial strength or stability.

2. Proposed Regulatory Framework

The proposed framework would create an alternative regulatory scheme to streamline the process for regulating reinsurers. States with the appropriate regulatory capacity would be allowed to serve as the sole U.S. regulator of a reinsurer writing assumed business in the United States. In order to qualify as a home state or point of entry (POE) supervisor, a state must meet a set of standards advanced by the NAIC Reinsurance Supervision Review Department (RSRD). The RSRD would establish a metric for analyzing whether a state has the resources, expertise, and experience to regulate reinsurance on a cross-border basis.

The proposal would create two new classes of reinsurers in the U.S., "national reinsurers" and "POE reinsurers." Classification as a national reinsurer would be available to companies licensed and domiciled in a home state and approved by that state to transact reinsurance business across the United States, while submitting solely to the regulatory authority of the home state supervisor for purposes of its reinsurance business. Similarly, a POE reinsurer is a non-U.S. reinsurer organized under a recognized jurisdiction that would be certified in a port of entry state and approved by such state to provide reinsurance to the U.S. market. Reinsurers with a minimum capital and surplus requirement of $250 million would be eligible to take advantage of the proposed rules and qualify as a national or POE reinsurer. Reinsurers also could opt out of the new classifications and continue to operate under the existing credit for reinsurance provisions.

3. New Collateral Requirements

The crux of the credit for reinsurance plan lies in the shift in collateral requirements that would apply to both national and POE reinsurers. Thus, under the proposed framework, a home state or POE supervisor would assign each reinsurer one of five ratings (Secure-1, Secure-2, Secure-3, Secure-4, or Vulnerable-5) based upon factors such as the reinsurer's financial strength rating, compliance with reinsurance contractual terms and obligations, business practices, regulatory action against the reinsurer, the reinsurer's reputation and the reinsurer's annual filings with the NAIC. The reinsurer would then be required to post the corresponding collateral calculation based upon this rating. The regulatory scheme suggests a sliding scale whereby those reinsurers with the highest rating have no collateral requirements and those with the lowest rating must post 100 percent collateral. Because of the stiff U.S. reinsurance regulatory requirements in place designed to ensure the integrity and stability of the U.S. financial system, collateral requirements for national insurers would be waived for those rated by their home state supervisor as Secure-3 or above.

The home state or POE supervisor will have the authority to suspend, amend, or withdraw a reinsurer's rating at any time. Consequently, if a reinsurer's rating improves, it will be able to use new collateral requirements prospectively; however, if the rating declines, it will be required to meet the collateral requirements applicable to its new rating for all business it covers as a national or POE reinsurer.

The proposed scheme incorporates a sunset provision that calls for mandatory review of the policy two years after its first full year of operations. At that point, the RSRD will be required to evaluate the effectiveness of the collateral requirements for both national and POE reinsurers and make recommendations for any changes to the policy.

In addition to their certification and oversight role, the RSRD will be tasked with facilitating communication and dispute resolution between home state, host state, POE and other supervisors, and will serve as the repository for relevant data concerning both U.S. and non-U.S. reinsurers and the reinsurance market. The RSRD is further charged with evaluating the supervisory regimes of the non-U.S. jurisdictions, both initially and on an ongoing basis, and maintaining a list of jurisdictions eligible to be recognized by POE states.

In order to protect state-based regulation of reinsurance on a cross-border basis and promote uniformity of regulation, the reinsurance task force is recommending the enactment of federal enabling legislation. The federal legislation would provide appropriate authority to the RSRD, facilitate mutual recognition and reciprocity and ideally allow for negotiation of reciprocal recognition abroad for reinsurers licensed and domiciled in the United States.

4. Next Steps

It is expected that the NAIC reinsurance task force will vote on the proposed model framework at the Fall NAIC Meeting to be held September 2008 in Washington, D.C. Upon adoption by the reinsurance task force, the proposal would be presented to the NAIC Financial Condition (E) Committee also at the Fall NAIC Meeting. Upon adoption by the Financial Condition (E) Committee, the proposal would proceed to the NAIC Plenary for consideration at the Winter NAIC Meeting scheduled for early December 2008.

Leveling the Playing Field: The Florida Cabinet Approves Florida's New Credit for Reinsurance Rule
By Austin B. Neal

On September 16, 2008, the Florida Cabinet sitting as the Financial Services Commission granted its final approval of Florida's revised credit for reinsurance regulations. Proposed Rule 69O-144.007 — Credit for Reinsurance From Eligible Reinsurers, was adopted unanimously after significant lobbying on both sides by U.S. and alien reinsurers.

The Proposed Rule implements Section 624.610(3)(e) of the Florida Statutes, enacted by the Florida Legislature in 2007, which authorizes the Insurance Commissioner to establish lower collateral requirements for alien reinsurers that are highly rated, financially sound, and regulated by an eligible jurisdiction. Under current law, no matter what their financial ratings, U.S.-licensed and Florida-accredited reinsurers are not required to post collateral to enable a ceding insurer to take credit for reinsurance on its financial statements. Conversely, alien reinsurers, no matter their financial strength and ratings, are required to post 100 percent collateral.

The new law and the rule implementing it are designed to "level the playing field" by allowing non-U.S. reinsurers to post less than 100 percent collateral if approved by the commissioner. "As a safeguard, the Office always will do a thorough analysis of a reinsurer's financial condition, claims paying and compliance history and regulatory environment before any collateral reduction is permitted," assured Deputy Insurance Commissioner Belinda Miller.

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.