State insurance laws impose restrictions and regulatory oversight on the control of insurance companies by parent companies and related entities. Such "insurance holding company" regulation, which has been in place since at least the early 1970s, constitutes a major focus of the U.S. insurance regulatory framework.

Historically the principal features of holding company regulation- as embodied in the Insurance Holding Company System Regulatory Act (the Holding Company Act), a model law-focused on touchpoints between an insurance company and its affiliates.

The Holding Company Act, which is issued by the National Association of Insurance Commissioners, regulates insurance groups (that is, insurers plus their related entities) in large part by considering activities between the insurer and the other companies in the groups. This focus was designed to expose and deter conflicts of interest that could result in enriching a holding company at the expense of policyholders. New York's insurance holding company laws are codified in Article 15 of the Insurance Law, which, although not based directly on the NAIC model, is functionally similar.

Beginning just over a decade ago, the NAIC (which is the umbrella organization of state insurance regulators), has introduced new provisions into the Holding Company Act that focus more holistically on risks within an insurance group as a whole, as opposed to merely these touchpoints between distinct legal entities. Motivating these changes was the perception that insurers are at risk not merely from activities conducted with affiliates, but also from the character of the insurance group itself. Reputational and other risks at the parent, it was thought, can harm the insurance company even in the absence of a specific transaction or activity between them.

The principal reform, adopted in late 2010, was to regulate the "enterprise risk" of an insurance group, defined generally as any activity or circumstance involving affiliates of an insurer that, if not remedied promptly, is likely to have a material adverse effect upon the financial condition or liquidity of the insurer or its group as a whole. In 2012, a related model law, the Risk Management and Own Risk and Solvency Assessment Model Act (RMORSA), was added in order to require insurers to monitor and report on capital adequacy at the group level, not just at the regulated insurance entity itself-a key departure from prior law. New York implemented its versions of the 2010 and 2012 reforms mainly by administrative action, the Department of Financial Services' (DFS) Regulation 203 adopted in 2014.

Many other states have adopted the Holding Company Act changes and RMORSA in legislation and regulations of their own. The NAIC adopted additional amendments to the Holding Company Act, dealing with international insurance groups, levels of group capital and certain consequences of insolvency, in 2014, 2020 and 2021 respectively.

The decade in which these reforms have been in effect has seen continued involvement by financial investors, such as private equity and hedge funds, in insurance, particular in the life sector. A July 2021 special report by A.M. Best, a leading insurance industry analytics firm, indicates that aggregate capital and surplus of life insurers owned by private equity has been growing dramatically as a proportion of total capital and surplus in the U.S. life sector

A September 2021 article in The Wall Street Journal highlighted some of the policyholder-level issues associated with private equity ownership of insurers. (It is worth noting that in 2014 the New York DFS adopted even more-rigorous rules to govern private fund acquisitions of life insurers, including regulatory authority to require such funds to set up trusts to protect policyholders.)

With respect to regulatory oversight of insurers owned by funds, however, the tools provided by the 2011-2021 amendments might not be as useful as the older components of the Holding Company Act, such as regulation of inter-affiliate transactions, qualifications of holding company management and holding company leverage. These older "bread-and-butter" tools should be the principal recourse of regulators when considering fund-owned insurers.

Possible Limits of the Group Approach

As mentioned above, the concept of "enterprise risk" was designed to examine characteristics and activities of holding companies that might taint the insurer. This motivation had arisen out of the 2008 financial crisis; observers had noted that large insurance firms had affiliates engaged in non-insurance aspects of the financial world such as credit derivatives and securitization. Such businesses, it was feared, could pose a "contagion"-like effect on insurers in the group.

To be sure, funds that own insurers may be involved in numerous other activities through their other portfolio companies. This may suggest that the logic of enterprise risk is equally (if not more) applicable for these parent companies. However, funds keep portfolio companies fairly ringfenced; acquired businesses typically have no expectation of any "keepwell" or similar solvency guaranty from a fund parent. Portfolio companies maintain their distinct individual brands in the eyes of consumers.

In addition, while funds may try to achieve synergies between portfolio companies in related sectors, a fund is not trying to become an operating business itself. To be successful, a fund remains laser-focused on returning profits to investors by being a dynamic buyer and seller of businesses, rather than by becoming immersed in a single product line.

As a result, enterprise risk, in the context of insurers owned by funds, becomes less of a factor facing individual portfolio companies. Trying to identify a "contagion" that the fund can spread to the insurer is elusive, and an insurance regulator considering the integrity and strength of the insurer's holding company system would be wiser to focus on those touchpoints that can reveal real risk.

The Older 'Touchpoint' Model

In acquisitions by funds of insurance companies, regulators do, in fact, focus intently on touchpoints, suggesting the limits of utility of the enterprise risk model. By way of example, consider inter-affiliate transactions. The Holding Company Act has historically required that contracts between insurers and their affiliates be fair and reasonable. Certain categories of these contracts must be submitted to, and not objected to by, state regulators prior to becoming effective. These include intercompany service agreements, where insurers pay fees to affiliates for services.

It is not uncommon for funds that own insurers to provide insurers with services, such as investment management, for compensation, and regulators are likely to focus on the fees associated with the services to consider whether they are fair and arm's length to the insurer.

Another example is fitness of management. The Holding Company Act treats the directors and executive officers of an insurance company parent essentially as principals in the insurer itself. This means that such individuals have to undergo thorough vetting (often including investigative background checks) before they can be installed in connection with an acquisition of control. The acquirer will have to provide biographical affidavits (in a form promulgated by the NAIC) as part of its application to the regulator to be allowed to acquire control of the insurer. In many states, including New York, fingerprints are also required.

In a fund scenario, regulators have become alert to the importance of reviewing the background and credentials of director and officer equivalents- e.g., fund general partners, managing members and investment managers. Again, this rigor comes not from the enterprise risk reforms of the 2010s but from preexisting Holding Company Act provisions.

Holding company leverage refers to the reliance that a parent entity may have on dividends from the insurance company to service parent debt or other parent obligations. If such reliance is too acute, the regulator might seek to take some action to insulate the insurer's financial resources. Although holding company leverage is not expressly mentioned in the Holding Company Act, regulators have historically applied the concept in making determinations on prospective acquisitions of insurers.

An acquirer is typically required by the state regulator to present, as part of its Holding Company Act submission to acquire control (known as the Form A), a business plan for the target. (In New York, a five-year plan of operations is specifically required by item 5(b)(1) of the DFS application instructions codified at 11 NYCRR 80-1.6.) For funds, this regulatory variable may be particularly apt given the frequent use of leverage by funds in executing acquisitions.

Blasts From the Past?

It is conceivable that enterprise risk, own-risk and solvency assessment and similar group concepts could detect risks that are important to policyholders when a fund is the insurer's controlling shareholder. Funds certainly have their own distinct practices, objectives and characteristics that straddle multiple portfolio companies.

However, when it comes to identifying the kinds of contingencies and exposures most likely to move the needle on policyholder outcomes, the older touchpoint-based aspects of holding company regulation seem more likely to be deployed by regulators and better suited to the regulator's task. Given that many of these tools have been around since the 1970s, we can only hope that they don't bring back wide neckties or leisure suits along with them.

Originally published by New York Law Journal 12 November 2021.

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