Beginning in 2013, we have issued a series of Alerts on the controversy regarding the use of captive insurance companies to finance reserves for certain type of life insurance policies (so-called "XXX or AXXX reserves," which are widely believed to exceed reserves that are actually needed to pay claims under those policies). In our most recent Alert, "Latest Developments in Regulation XXX/AXXX Captives," we discussed the steps the National Association of Insurance Commissioners (the "NAIC") has taken to address the controversy, both temporarily, with the adoption of, among other things, a new actuarial guideline known as "AG 48" that will narrow the ways in which XXX and AXXX reserve financing transactions are structured, and permanently, with the coming adoption of a new "principle-based" system of determining reserves for life insurers (referred to as "PBR"), which, it is believed, will eliminate the excess reserve problem.

Principle-Based Reserving

The process of strengthening the regulation of captives used for life insurance and reserve financing purposes is continuing. During the NAIC Spring National Meeting, held in Phoenix, Arizona, from March 26 to March 31, 2015, the Principle-Based Reserving Implementation (EX) Task Force reviewed the status of adoption of PBR generally. The NAIC Standard Valuation Law (Model 820) provides that the PBR rules will become effective when at least 42 members of the NAIC have adopted the Standard Valuation Law as amended in 2009 by the NAIC (or substantially similar legislation) and those states represent more than 75 percent of the direct written premiums shown on life, accident and health annual statements; health annual statements; or fraternal annual statements. In addition, the valuation manual that sets out PBR rules must be adopted by at least 42 of the following 55 jurisdictions: the 50 states, American Samoa, American Virgin Islands, District of Columbia, Guam and Puerto Rico. According to a report given at the meeting, it is anticipated that PBR could become effective at the beginning of 2017.

XXX/AXXX Reinsurance Framework

With respect to the XXX/AXXX Reinsurance Framework discussed in our December 8, 2014 Alert, the Task Force received a status report outlining the progress being made on the many tasks to be completed to fully implement the Framework. According to a consultant who is familiar with XXX/AXXX business, one of the stumbling blocks to proceeding with transactions under AG 48 is the as-yet-uncompleted determination of the "RBC Cushion" required by the Framework.

Multi-State Reinsurer Definition

A byproduct of the XXX/AXXX captive issue has been the proposal to add the term "Multi-State Reinsurer" to the Preambles to Part A: Laws and Regulations and Part B: Regulatory Practices and Procedures in the NAIC's Accreditation Program Manual. There has been concern among regulators and members of the industry that a proposal now before the NAIC to amend the definition of "multi-state reinsurer" as used in the NAIC Accreditation Program Manual could have the result of subjecting "traditional" captives to capital and other requirements that would undercut their utility as risk financing vehicles. In 2014, NAIC staff proposed revisions to the Preambles to Parts A and B of the Accreditation Program Manual, which would have included "captive insurers, special purpose vehicles and other entities" that reinsure risks originally written in states other than the captive?s state of domicile in the definition of "multi-state reinsurers." By treating these entities as multi-state insurers, they would become subject to the full range of regulations applicable to commercial insurers and reinsurers. There was to be an exception for captive insurers owned by non-insurance entities for management of their "own risks"—but the scope of the exception was not clear. In response to the proposed revision, representatives of the insurance industry, as well as a number of regulators, expressed concerns about whether the change was needed at all, but in particular, whether many captives—other than those used to finance XXX and AXXX reserves—would be treated as multi-state reinsurers. Those concerns were discussed in a Duane Morris Alert, "NAIC Moving Forward on Regulation of XXX/AXXX Financing Transactions."

Captive Accreditation Standards

The NAIC has agreed that the original proposal was overbroad. At the Fall 2014 meeting, NAIC staff was directed by the Financial Regulation Standards and Accreditation (F) Committee to develop a more focused revision to "clarify the scope of the NAIC accreditation standards, including their proposed applicability to [captive insurers used in connection with] XXX/AXXX, variable annuities and [long-term care ] reinsurance." On February 25, 2015, the NAIC released for comment a proposed revision of the Preamble to Part A: Laws and Regulations (revisions to the Preamble for Part B: Regulatory Practices and Procedures, have not been completed).

The revised Preamble would create three categories of insurers/reinsurers: life/health and property/casualty insurers (that are not risk retention group captives); captive reinsurers; and other types of insurers (such as fraternal orders, title insurers and many health organizations). Part A accreditation standards would apply to life/health and property/casualty companies; risk retention groups will be subject to specified standards. The third category of insurers, those described as "other insurers," would be covered in part and excepted in part from Part A accreditation standards.

With respect to captives, it was the intent of the proposal that Part A accreditation standards would apply only to domestic captive life/health insurers, special purpose vehicles or any other entities that reinsure XXX/AXXX business, variable annuity ("VA") business and long-term care ("LTC") business that was directly written by ceding insurers in at least two states. In order to coordinate the work of the Financial Regulation Standards and Accreditation (F) Committee, the proposal provides that a captive that reinsures XXX/AXXX business in compliance with AG 48 and related requirements will be deemed to meet Part A standards.

The intent of NAIC staff was to exclude from Part A accreditation standards captives that write or reinsure business other than XXX/AXXX, VA or LTC business. Following the exposure of the proposal, however, numerous comment letters pointed out that although the intent may have been to exempt captives other than those writing XXX/AXXX, VA and LTC lines from Part A accreditation standards, nothing in the words of the proposed Preamble actually makes that clear. During the course of the NAIC Spring meeting in Phoenix, the Financial Regulation Standards and Accreditation (F) Committee considered these comments and directed NAIC staff to clarify in the proposed Preamble that the range of captive insurers that are not utilized for XXX/AXXX, VA and LTC business will not be subject to the Part A accreditation standards.