On its current course, this year could be both the best and the worst of times for insurance. The US economy continues to enjoy steady growth, stock indices continue to reach new highs and tax reform in the US allows both life and property/casualty insurers to enjoy reduced corporate income tax rates while retaining some of the advantages the Tax Code gave their respective industries. But the industry continues to be dogged by persistent low interest rates and a soft property/casualty market that seems to be resistant to ever more frequent and severe catastrophe losses, and despite the rate reduction some insurers may face increased taxes due to other changes in the tax law, particularly those directed at non-US enterprises. Not to mention existential threats that could make existing products, distribution and corporate structures obsolete—be it disruptive technologies, the seeming indifference or outright hostility of millennials to traditional life and savings products and the old ways of buying insurance, or a hard Brexit.
This report outlines major insurance regulatory and transactional topics in the United States and the United Kingdom that we will be watching in 2018.
- Tax Reform
- US-EU Covered Agreement Prompts States to Revisit Credit for Reinsurance Rules
- Technology, Innovation and Data Privacy
- “Best Interest” Standard for Life and Annuity Sales
- Other Important Regulatory Developments for Annuities
- State Adoption of Revised Life and Health Insurance Guaranty Association Model Act
- New Connecticut Law Allowing Division of Connecticut Domestic Insurers
- Life and Annuity Reserve Financing Transactions
- Potential Changes to Reinsurance Accounting Rules
- Continued Development of Group Capital Standards
- Liquidity Risk Assessments
- Trends in US Insurance M&A
- Developments in the United Kingdom
1. Tax Reform
On December 22, 2017, President Trump signed into law the bill formerly known as the Tax Cuts and Jobs Act. Before passage of the final bill, the Senate parliamentarian ruled the name violated Senate rules, forcing the final bill to be renamed the somewhat less catchy, “To provide for reconciliation pursuant to titles II and V of the concurrent resolution on the budget for fiscal year 2018.”
The Tax Act is the most substantial overhaul of the Internal Revenue Code since 1986 and makes significant changes to how the US taxes individuals, domestic businesses and multinational businesses, including those in the insurance industry. We note a few highlights. For a more comprehensive overview, see our Legal Alert.
Corporate Tax Rates, Alternative Minimum Tax and NOLs. Most significantly, the Tax Act reduced the corporate tax rate from 35% to 21% and repealed the alternative minimum tax (AMT). The elimination of the AMT is a boon to a number of property/casualty companies that are able to utilize net operating losses (NOLs) from underwriting to reduce their net taxable income. While the Tax Act placed limits on the ability of most companies to utilize NOLs (by eliminating NOL carrybacks and limiting NOL carryforwards to 80% of taxable income), these new limitations do not apply to property/casualty companies.
Property/Casualty Reserves. The Tax Act modified the insurance reserve discounting rules, which will reduce the tax deduction for loss reserves (although the lower corporate tax rate makes the deduction somewhat less valuable than before). The Tax Act also modifies the reduction to losses incurred to take into account certain types of income that are not subject to US federal income tax, such as tax-exempt interest. Before the new rules, incurred losses were reduced by 15% of such income items. The Tax Act increases this amount to 26.25%.1 The modification is intended to keep the reduction to the reserve deduction consistent with current law by adjusting the rate proportionately to the decrease in the corporate tax rate.
Life Reserves and Other Provisions Affecting Life Companies. The favorable tax treatment for life insurance and annuities under the Internal Revenue Code remains largely unchanged. The Act does contain a number of changes applicable to life insurance companies, including perhaps most notably a reduction to the tax deduction for life insurance reserves, generally equal to 92.87% of the reserve prescribed by the National Association of Insurance Commissioners (NAIC) with respect to each contract. The Act also makes modifications to the rules governing capitalization of policy acquisition expenses, the proration rules, and to the net operating loss carryback/carryforward periods, as well as repealing special rules related to small life insurance companies, adjustments arising out of a change in basis for calculating reserves, and policyholder surplus accounts held by life insurers. Finally, the Act adds new rules related to life settlement transactions.
US shareholders of Non-US Insurers. The Tax Act expands the reach of the controlled foreign corporation (CFC) and passive foreign investment company (PFIC) rules that restrict deferral of income for US owners of non-US insurance companies, meaning that more US taxpayers that own non-US insurance companies may be subject to these complex special tax regimes, resulting in additional income inclusions for such US shareholders. Specifically, the rules narrow the scope of the insurance exception to the PFIC rules and broaden the definition of a “US shareholder” of a CFC to include a test based upon the value of ownership in the foreign entity as well as vote.
Tax on payments to non-US related parties. The Tax Act also creates the so-called Base Erosion Anti-Abuse Tax or “BEAT”—a new minimum tax designed to control payments to non-US related parties that erode the US corporation’s US tax base. The BEAT is equal to 10% (5% in 2018) of most deductible payments (including premium and loss payment) to a non-US parent. The BEAT expressly applies to reinsurance premiums and is in addition to any excise tax due under the current federal excise tax. There also is no carve-out for income subject to taxation under the CFC rules or on account of having a US trade or business.
2. US-EU Covered Agreement Prompts States to Revisit Credit for Reinsurance Rules
With the covered agreement between the United States and the European Union now signed, state insurance regulators have begun the process of evaluating reforms to state credit for reinsurance rules that will be required in light of the covered agreement. This work will be a big part of the regulatory agenda for state insurance regulators throughout 2018, and full implementation of these reforms is likely to take significantly longer (the covered agreement provides that the elimination of reinsurance collateral requirements for qualified EU reinsurers is to be fully implemented within five years, although the US is required to encourage states to adopt phase-in provisions for the gradual elimination of collateral requirements).
The NAIC is currently requesting comments (due by February 6) on the following approaches to reinsurance collateral reform:
- Amending the Credit for Reinsurance Model Law and the Credit for Reinsurance Model Regulation to eliminate reinsurance collateral requirements for EU-based reinsurers meeting the conditions of the covered agreement.
- Extending similar treatment to reinsurers from other jurisdictions covered by potential future covered agreement(s) that might be negotiated pursuant to the Dodd-Frank Wall Street Reform and Consumer Protection Act.
- Providing reinsurers domiciled in NAIC Qualified Jurisdictions (Bermuda, France, Germany, Ireland, Japan, Switzerland and the United Kingdom) with similar reinsurance collateral requirements.
- Considering changes to the criteria for evaluating whether a jurisdiction should be a Qualified Jurisdiction.
- Considering additional “guardrails” relative to US cedents, such as changes to the risk-based capital (RBC) formula or new regulatory approaches to help address the increased financial solvency risks caused by the elimination of reinsurance collateral.
These issues will be discussed during a public hearing of the NAIC and its Reinsurance Task Force on February 20 in New York City. For more information on the US-EU Covered Agreement and its genesis, see our Legal Alert.
3. Technology, Innovation and Data Privacy
The impact of technology and innovation on how the insurance industry functions and services its customers will continue to be an area of focus for regulators and the industry broadly. The following are some key innovation and technology issues to watch in 2018.
Cybersecurity Regulation. 2017 marked a notable change in how regulators think about cybersecurity, shifting the focus from customer breach notification to establishing proactive cybersecurity protection requirements that all insurers must meet. The Equifax breach brought cybersecurity to the top of the regulatory agenda in a new way, and the discovery earlier this month of a global flaw in microchips is sure to bring further scrutiny. In 2018, states will be adopting their own versions of the NAIC’s recently finalized model cybersecurity law, and insurance groups will continue working to meet the requirements of New York’s already in-force cybersecurity regulations. It is possible that new requirements may also be introduced at the federal level.
InsureTech Regulation and Litigation. The industry devoted significant resources throughout 2017 considering how InsureTech solutions might disrupt existing business and operational models, but there are still many unresolved issues as more and more companies implement InsureTech solutions in the market. The NAIC and states will be focusing heavily on potential risks related to accelerated underwriting and the use of Big Data and Artificial Intelligence in insurance, including trying to determine how these issues fit into existing regulatory structures. New York’s new regulations barring auto insurers from asking applicants about their occupation or education when setting rates provides a timely example of how regulators may react to new approaches by insurers.
Focus on Biometrics. 2017 gave plenty of reasons to move beyond passwords, but the use of biometrics as a better solution for secure identification presents its own issues. Illinois, Texas and Washington State already have laws or regulations limiting and protecting biometric records (including fingerprints and facial recognition), and this issue has proven to be a favorite target of the plaintiff’s bar. Alaska, Connecticut, Montana and New Jersey are also considering legislation to regulate the collection, use and retention of biometric data. This promises to be an area of focus in 2018 as the use of biometrics becomes more ubiquitous.
Potential Discrimination Issues in Online Behavioral Advertising. Online behavioral advertising allows advertisers to target very specific consumer and agent groups, including in some cases groups defined by age, geography, race and gender. Recent media reports have highlighted this practice on a national scale, questioning the legality of some of these practices in a variety of contexts, including recruitment advertisements. We expect this issue to garner more attention from regulators in 2018.
Blockchain in the Insurance Industry. Blockchain has been a leading buzzword for several years now, and the industry is making progress in understanding how blockchain solutions may offer opportunities to cut costs and improve service. 2018 could be a breakthrough year for this technology.
GDPR. The European Union’s General Data Protection Regulation (GDPR) goes into effect May 25, 2018. It replaces the current 20-year-old EU data protection laws, with the goal of making laws against technological developments “future proof” and harmonizing data privacy laws across the EU.
GDPR will require greater transparency and accountability from companies, and it will impose greater privacy protections for individuals. Regulators will have a range of significant sanctions to enforce compliance. For example, regulators are armed with the authority to mandate audits and to levy fines for non-compliance of up to the higher of EUR 20 million or 4% of global turnover across all business sectors.
GDPR requires a new approach to privacy and the protection of personal details and their use. Organizations will be expected to plan for privacy and integrate the principle of data minimization into their business processes.
While GDPR is not specific to insurance, insurance groups across Europe should be focusing on planning their compliance projects, as well as assessing their strategy and response to the change in risk profile. GDPR can have extra-territorial application to businesses outside of the EU in four contexts: (1) businesses that offer goods or services to individuals in the EU (even if for free); (2) businesses that monitor the behavior of individuals who are in the EU, including for purposes such as behavioral advertising; (3) businesses that provide services to EU clients that involve using personal data, for example, by hosting EU personal data on US-based services; and (4) businesses that provide centralized IT systems or data storage for their enterprise which contain personal data about employees and customers of any EU subsidiaries.
For more information on GDPR, please visit our GDPR HUB.
4. “Best Interest” Standard for Life and Annuity Sales
The partial enactment of the Department of Labor’s new Fiduciary Rule in June 2017 will continue to have ripple effects in 2018 (and beyond) on the annuity marketplace and the evolving regulation of annuities. While the Fiduciary Rule imposed a new set of impartial conduct standards on annuity sales in 2017, the Rule has also spawned significant regulatory activity related to the standards of conduct for insurance producers marketing annuity contracts. The NAIC and the New York Department of Financial Services (NYDFS) are in the process of revising their respective rules applying to the standards of conduct related to the sale of annuity contracts. The NAIC’s Annuity Suitability Working Group has proposed amendments to its Suitability in Annuity Transactions Model Regulation and requested comments on the proposed revisions by January 22, 2018, with the stated intention of reporting up to its parent committee on the proposed revisions during the NAIC Spring National Meeting in late March.
While the proposed revisions are extensive, the most prominent proposed change would be to upgrade the standard of conduct of insurance producers related to annuity contracts from a “suitability” standard to a “best interest” standard. In addition, NYDFS has proposed amendments to its suitability regulation, Insurance Regulation 187, and has requested comments on the proposed rulemaking by February 25, 2018. The NYDFS proposal departs from the DOL Fiduciary Rule and the NAIC Model Regulation by extending to life insurance as well as annuities. Like the proposed NAIC revisions, the NYDFS proposal would impose a “best interest” standard of care on insurance producers related to annuity transactions. Unlike the Fiduciary Rule, the NAIC and NYDFS proposals would apply to all contract sales, not just tax-qualified sales.
Meanwhile, the Department of Labor is in the process of reevaluating its Fiduciary Rule and could come out with proposed modified standards and exemptions in 2018. We will be watching the developments related to all of these regulatory initiatives carefully as we believe they will have a significant impact on product design, marketing strategies and risk management for the annuity marketplace in 2018. For a more comprehensive review of these issues, please refer to our Legal Alert.
5. Other Important Regulatory Developments for Annuities
In addition to regulatory initiatives related to standards of conduct applicable to annuity sales, we will be monitoring other NAIC and state regulatory developments that could affect the design and marketing of annuity products, including clarifications regarding permissible illustrations that can be used in connection with sales of fixed indexed annuities as well as how the NAIC will deal with the use of captive reinsurance in connection with variable annuity guarantees. While we don’t anticipate any specific regulatory initiatives focused on annuities emanating from FINRA or state securities regulators in 2018, we continue to carefully watch for statements and initiatives coming out of these organizations as well, given the examination and enforcement authority that they have over sales of annuity products sold through securities firms.
We are also watching a number of potentially important developments from the US Securities and Exchange Commission (SEC) that could impact variable annuities and other registered annuity contracts in 2018. Based on its current agenda, the SEC plans to consider this year the adoption of a summary prospectus form for variable annuity contracts and a streamlined statutory prospectus for those contracts as well as an exemptive rule that would allow insurers and funds to deliver underlying fund shareholder reports to variable product owners electronically. We also are hopeful that the SEC will take steps in 2018 to provide some significant relief from some of the more onerous current disclosure and financial statement requirements applicable to offering non-variable annuity contracts that are registered as securities.
6. State Adoption of Revised Life and Health Insurance Guaranty Association Model Act
On December 21, 2017, the NAIC Executive Committee/Plenary Committee approved the revisions to its Life and Health Insurance Guaranty Association Model Act governing assessments for long-term care insurance (LTC). Among other things, the amendments: (1) expand the assessment base for LTC policies; (2) add HMOs to the assessment base; (3) split the liability for an LTC insolvency by allocating 50% to life and annuity insurance companies and 50% to health insurance companies; and (4) clarify that guaranty associations have the authority to file for premium rate increases.
These revisions were precipitated by the insolvency of Penn Treaty, a large LTC company in Pennsylvania. Health companies, which typically don’t write much LTC were, under the law, assessed for most of the Penn Treaty shortfall despite the fact that life companies wrote the bulk of the LTC policies.
In response to regulator concerns about this inequity, the life insurance industry worked in concert with a coalition of health carriers on these amendments, which will result in a 50/50 split with health carriers on a prospective basis when there is an LTC company insolvency.
Now that the NAIC has adopted the revised Life and Health Insurance Guaranty Association Model Act, the action in 2018 will be in the states. The coalition will work to get it enacted on a uniform basis but, because each state’s health market is unique and because the HMOs are opposed, passage of the revised model—especially uniform passage—will be a challenge.
7. New Connecticut Law Allowing Division of Connecticut Domestic Insurers
A new Connecticut law allowing a Connecticut domestic insurance company to divide into two or more resulting insurance companies provides yet another tool for insurance companies to restructure their business to separate books of business—whether to sell to a third party or to manage separately in dedicated entities.
Conceptually, the law (Public Act No. 17-2) is intended to act as the reverse of a merger, in that the dividing insurer separates into two or more resulting insurers, with such resulting insurers succeeding to the assets and liabilities of the dividing insurer by operation of law.
The law will allow Connecticut insurers to isolate legacy blocks of business into new entities, facilitating the disposition of such business through the sale of the new insurance company’s stock (most likely by merger) rather than the original insurance company’s assets. An entity sale is beneficial in that it eliminates the administrative complexity, ongoing obligations, and long-term compliance and counterparty risk associated with an asset deal typically consummated via indemnity reinsurance.
This year may present the first opportunity for the law to be tested, and it will be interesting to see the extent and nature of any legal challenges in response to a proposed division. The statute is similar to the Pennsylvania statute used by CIGNA Corp. over two decades ago to divide its legacy and ongoing property/casualty businesses following a downgrade. That division survived legal challenges by policyholders, competitors and reinsurers. Among other things, they claimed policyholders were exposed to a greater risk that insufficient assets would be available to meet policy obligations once profits from ongoing businesses were separated, and that policyholder consent was required for the transfer of their policy obligations.
Although other practical applications of the law are not yet entirely clear, its most obvious application is for administering under-performing businesses in run-off, or otherwise housing legacy lines of business separate from other company business. In this regard, the law is an alternative approach to the Rhode Island regulations (230-RICR-20-45-6.1 et seq.) that establish a court-supervised proceeding for the transfer of run-off portfolios of commercial property/casualty insurance business (other than workers’ compensation) or property/casualty reinsurance business to an insurance carrier specifically licensed in Rhode Island for such purpose. The law also offers a method for the orderly winding up of such business pursuant to a court-sanctioned “commutation plan.” The first license for a dedicated run-off insurer was issued under the Rhode Island regulation to ProTucket Insurance Company in March 2017.
8. Life and Annuity Reserve Financing Transactions
Reserve financing transactions will continue to be subject to an evolving regulatory landscape in 2018.
The NAIC Variable Annuities Issues (E) Working Group (VAIWG) will be considering significant changes to the statutory framework aimed at removing or mitigating the motivation for insurers to engage in captive reinsurance transactions for variable annuities. The proposed changes, which were recommended by consulting firm Oliver Wyman based on two quantitative impact studies performed by the firm, were discussed during the NAIC’s Fall National Meeting in December 2017 and are now subject to a comment period lasting until March 2. If approved, the recommendations would enact a wide range of changes to C3 Phase II capital requirements and AG43 reserve requirements aimed at improving alignment between these standards and reducing the complexity of variable annuity statutory balance sheet and risk management.
In the meantime, some states have adopted regulatory amendments or exercised regulatory discretion in a manner that obviates the need for annuity insurers to engage in captive transactions. For example, Connecticut recently implemented changes to its regulations to reflect recent amendments to the NAIC’s Synthetic Guaranteed Investment Contracts Model Regulation and Separate Accounts Funding Guaranteed Minimum Benefit Under Group Contracts Model Regulations. The changes have the effect of recalibrating the statutory reserve for the applicable products such that it no longer may be necessary to finance a portion of the statutory reserve for certain stress scenarios.
Reserve financing transactions for new term business and universal life with secondary guarantees (XXX/AXXX) are expected to wane once principles-based reserving (PBR) requirements are fully implemented by January 1, 2020. In the meantime, captive activity is likely to continue, particularly by insurers looking to refinance existing blocks of business into more efficient transaction structures. For AG 48 grandfathered policies, insurers have been moving away from funded solutions and letters of credit in favor of less expensive structures involving credit-linked notes and excess of loss reinsurance agreements. These transactions, however, could be impacted by recent regulatory developments. First, the Base Erosion Anti-Abuse Tax (BEAT) (discussed above) could have an impact on transactions directly or indirectly involving affiliated offshore reinsurers. Although most reserve financing transactions were moved onshore years ago, some insurers have kept those offshore reinsurance arrangements in place, and some of the current structures involve a back-end retrocession by the financing provider to an offshore entity. In addition, the NAIC’s Group Capital Calculation (E) Working Group is considering the treatment of XXX/AXXX captives in the group capital calculation, and this treatment could affect the motivation for insurers to engage in reserve financing transactions involving captives.
9. Potential Changes to Reinsurance Accounting Rules
In 2018, the NAIC’s Statutory Accounting Principles Working Group (SAPWG) will continue its work on proposed changes to Statutory Statement of Accounting Principles (SSAP) 61R, 62R and Appendix A-791. These proposed changes were meant to address concerns some regulators had regarding specific short-duration health insurance contracts that purportedly contain material risk limiting features but which were reported as meeting SAP risk transfer requirements even though they do not qualify under GAAP. The changes initially were exposed as “non-substantive.” However, the proposed changes are not limited to short-duration health contracts, and industry participants and the American Academy of Actuaries (AAA) disagreed with the “non-substantive” characterization, believing the changes as proposed could significantly change the accounting and reporting for many life, health and property/casualty reinsurance contracts.
After reviewing the industry comments on the proposed changes to the risk transfer requirements, the SAPWG agreed that further work was needed before any changes to SSAP 61R, 62R or Appendix A-791 are made. The SAPWG indicated that it would create two working groups comprised of NAIC staff and interested party representatives (one for life and health, and the other for property/casualty) to consider these issues further. The SAPWG intends to have the working groups hold a series of informal, bi-weekly drafting calls over the next several months to refine the proposal. As part of this assessment, both groups will consider if changes are necessary or if the current rules, properly applied, can adequately address the concerns. The SAPWG hopes to have the working groups’ reviews complete and ready for consideration at the NAIC’s 2018 Spring National Meeting.
Changes, if any, to SSAP 61R or SSAP 62R could have important implications for reinsurance transactions.
10. Continued Development of Group Capital Standards
In 2018, US and international regulators are expected to continue their work to develop group capital standards for insurance groups. Although full implementation of a group capital standard is likely still two to three years away, significant strides were made in 2017 and more are expected in 2018. The following is an update on the work being done at the NAIC and the International Association of Insurance Supervisors (IAIS).
a. NAIC Works to Develop Group Capital Calculation Tool
Since the global financial crisis, state insurance regulators have been challenged with both increased intervention by the federal government and by the development of global regulatory standards that are not aligned with the approach taken in the United States. In international regulatory fora, state insurance regulators and the NAIC continue to highlight standards that are incompatible with current US policy. State risk-based capital (RBC) standards present the clearest example. The US insurance regulatory framework is, at the same time, in the process of adapting to group supervision and capital assessment. This process is currently being driven by the NAIC Group Capital Calculation Working Group (Working Group).
The Working Group’s charge is to construct a US group capital calculation using an RBC aggregation methodology while monitoring international capital developments and considering group capital developments by the Federal Reserve Board, both of which may help inform the construction of a US group capital calculation. Begun in 2015, the Working Group has met continuously since then and, on October 31, 2017, asked for comment on its proposed treatment in its calculation of: (1) non-insurance entities, (2) captives and permitted practices, and (3) surplus notes and subordinated debt. All comments were due January 15, 2018, with field testing of the calculation expected to begin in spring 2018.
The Chairman of the Working Group has repeatedly stated that the group capital calculation is being developed as a “tool” to assist state insurance regulators in analyzing the financial condition of the group. However, its purpose and scope have not been adequately outlined to the satisfaction of insurance industry participants. Nevertheless, the group capital calculation took on added significance when, on September 22, 2016, the US and the European Union announced they had formally signed a covered agreement. In addition to eliminating reinsurance collateral requirements for qualified EU reinsurers (discussed above), the covered agreement provides that an insurance or reinsurance group will be subject to worldwide group supervision only in its “home” jurisdiction, and not in other jurisdictions where it operates. The covered agreement anticipates that the group capital calculation/assessment will be in use in 2023 in order to allow US companies to take advantage of the exemption from host jurisdiction group capital requirements.
b. Global Insurance Capital Standard
Integral to its continuing efforts to develop the Common Framework for the Supervision of Internationally Active Insurance Groups (ComFrame), the IAIS has been working to finalize a risk-based global insurance capital standard (ICS). ICS will apply to all internationally active insurance groups (IAIGs) unlike the already finalized capital requirements for Global Systemically Important Insurers (G-SIIs).
The ICS Version 1.0 released for extended field testing in July 2017 describes the “ultimate goal” for “a single ICS that includes a common methodology by which ICS achieves comparable … outcomes across jurisdictions,” and includes the following “key elements”: valuation, capital resources and capital requirements. The ICS Version 1.0 extended field testing exercise involved extensive data requests from participating IAIGs and was designed to elicit technical and policy issues for the IAIS to resolve in an ICS Version 2.0 for implementation with ComFrame, currently scheduled for 2019. Regulators and interested parties identified a number of issues, including a divergence in preferred valuation methodologies between the US and Europe and the desire of many companies to be permitted to use their own internal capital models (as EU insurers are permitted to do under Solvency II).
At the IAIS’s 2018 annual conference and general meeting held in Kuala Lumpur, Malaysia, and following a preliminary stakeholder meeting on ICS Version 1.0 at which greater clarity was requested from the IAIS on implementation issues, the IAIS reached what was characterized as a “unified path to convergence on group capital standards.” Specifically, the IAIS agreed that implementation of ICS Version 2.0 will be conducted in two phrases—a five-year “monitoring period” during which ICS will be confidentially reported to group-wide supervisors but will not be used as a basis for supervisory action, followed only then by full implementation.
In what were viewed as concessions to US regulators and European insurance groups, the first phase of ICS Version 2.0 will, in addition to the required standard reporting, permit additional reporting using both GAAP Plus valuation and internal capital models. Such additional reporting will be considered by the IAIS for inclusion in ICS following the monitoring period. A similar concession was reached with regard to the RBC aggregation methodology currently under development by US regulators. Ted Nickel, Wisconsin Insurance Commissioner and President of the NAIC, praised the agreement as a “remarkable accomplishment, achieved through a lot of give and take.”
11. Liquidity Risk Assessments
The NAIC’s Financial Stability (EX) Task Force (FSTF) established the Macro-Prudential Initiative (MPI) in August 2017. It is a logical continuation of the Solvency Modernization Initiative, a forerunner project to enhance the credibility of the state system of insurance regulation. The MPI was organized to undertake a review of the state regulators’ toolbox and assess what existing data, metrics and analysis are available to support and enhance macro-prudential monitoring. After reviewing federal and international activities in macro-prudential surveillance and regulation for a few years, the FSTF identified four areas for potential enhancements: liquidity assessment, recovery and resolution, capital stress testing and exposure concentrations. A decision was made to initially focus on liquidity.
In August 2017, a new Liquidity Assessment (EX) Subgroup was appointed, and a work plan was adopted to review existing public and regulator-only data related to liquidity risk, identify any gaps based upon regulatory needs, and construct a liquidity stress testing framework proposal for consideration, including the proposed universe of companies to which the framework will apply.
The Subgroup met once a month through year-end, and in December 2017, the FSTF exposed the Subgroup’s Baseline Blanks Proposal and Note Blanks Proposal to expand the product category breakouts in the blue blank, as well as to establish notes disclosures for life products similar to what exists for annuity disclosures. The Subgroup is also working to develop a liquidity stress testing framework for large life insurers, and is considering capital stress testing and ways to enhance current disclosures of counterparty credit risk. The FSTF also adopted a referral letter to the Receivership and Insolvency (E) Task Force requesting that it consider aspects of the state insurance regulatory recovery and resolution regime that could be further enhanced.
The target date for completion of the Liquidity Assessment Subgroup’s charge is spring 2018, after which other areas for potential enhancement are expected to come into focus to further the regulatory objectives of the MPI.
12. Trends in US Insurance M&A
a. Expectations for 2018
Post-election political and regulatory uncertainty has seemingly abated somewhat since the beginning of 2017, and investor confidence remains strong. The lessening of those restraints should bode well for a more robust insurance M&A environment in 2018. While 2017 was a year of improved insurance company prices and fewer attractive targets, the continued lack of organic growth potential in the insurance sector, coupled with the need to improve efficiencies and leverage, should finally accelerate M&A activity. Using capital for share buybacks is simply not a long-term strategy.
This activity may take one of three forms: (1) substantial combination of similar businesses in order to gain operational and capital efficiencies, (2) a continued divestiture of non-core assets to remove their capital strain and their distraction, and (3) more interest in InsureTech and other technologies as insurers accelerate their enhancement of alternative and efficient distribution, data collection and analytics, customer experience, and service and operational efficiency. With respect to InsureTech, an increasing number of transactions are expected to be full enterprise deals, not just strategic or tactical investments, because insurers need the technology, and some may seek the cultural disruption such a deal may provide to its existing enterprise.
Many of these deals may involve US companies on both sides. The high values that US properties will garner should limit foreign acquires from many countries, other than Japan (and we believe that Japanese investors will continue to seek growth outside of Japan).
b. Continued Private Equity Investment in Insurance
As in recent years, 2018 is likely to see the continued trend of private equity investment in the US insurance space, as private equity firms continue to seek opportunities to deploy ready cash and pursue returns on insurance investment assets in the context of rising interest rates. In the last several weeks alone, a group backed by Blackstone closed its acquisition of Fidelity & Guaranty Life, The Hartford announced an agreement to sell its annuity business to a consortium of private equity investors, Fortress Investment Group announced the sale of its stake in OneMain Financial to an Apollo-backed consortium, and Voya Financial agreed to sell its closed block variable annuity business to an investment group led by private equity funds. The increased clarity around the conditions (such as capital requirements and operational requirements) that insurance regulators are likely to impose on private equity-backed acquirers also contributes to this trend.
c. Update on Pension Risk Transfer Transactions
The pension risk transfer market remained strong in 2017, and we anticipate that these transactions will continue to occur at the same, or an even greater, rate in 2018. The combination of low interest rates, increased longevity and rising Pension Benefit Guaranty Corporation premiums have caused many plan sponsors to freeze their defined benefit plans and consider engaging in a pension risk transfer. S&P 1500 sponsored pension plans have an estimated aggregate funded status of 84% and an estimated aggregate deficiency of $375 billion as of December 31, 2017.
Due to the recently passed tax bill, many plan sponsors are likely to consider accelerating contributions in order to take advantage of higher deductions and avoid increases in the after-tax cost of pensions. A plan sponsor increasing pension plan funding is often a precursor to the purchase of a group annuity contract. These increased contributions should have the effect of increasing the funded status of plans, which should, in turn, accelerate investment policy changes to de-risk financials and result in an increase in the number of pension risk transfers.
13. Developments in the United Kingdom
In the UK (and across Europe), the greatest focus for insurance and reinsurance groups will be planning for and dealing with the developing position in relation to the UK’s withdrawal from the EU. This has wide-ranging impacts on how insurance groups (particularly, commercial property/casualty insurance groups) operate across Europe, and many will need to restructure (see below). However, it will also impact the capacity of regulators as they deal with the evolving nature of discussions and input into reorganizations and portfolio transfers. This trend may affect the ability to do transactions that require regulatory input and may affect the timing of new legislation.
The terms of the UK’s exit from the EU continues to take up a lot of time for (re)insurance groups that are based in the UK but operate across Europe, and groups that are based in other parts of Europe and operate in the UK.
UK insurers currently are able to access the European Economic Area (EEA) through passporting rights under the Solvency II directive. This regime allows a UK insurer to write insurance business in other EEA states either on a cross-border services basis or through the establishment of a branch. Similarly, EEA insurers can access the UK market through the same passporting rights.
If the terms of the UK’s exit do not permit some form of grandfathering of existing passporting rights or transitional recognition of such rights, UK insurers and EEA insurers accessing the UK market must consider carefully how they will continue to operate their business models and what they will do about legacy business. Most of these groups have already considered restructuring their businesses. The options include transferring books of cross-border insurance business, establishing branches and subsidiaries in the UK or in EU local jurisdictions (with subsequent transfers of books into such subsidiaries), or changing UK undertakings incorporated in the legal form of a European company to a local domicile.
There is great support for a deal between the EU and the UK covering insurance. For example, the UK Treasury Committee, as part of its review of Solvency II’s impact on the UK insurance industry, recommended that a bespoke reciprocal agreement with the EU, along the lines of the Swiss agreements or a more extensive version of the US-EU covered agreement, should be put in place to cover cross-border contracts post-Brexit. Nevertheless, the European Insurance and Occupational Pensions Authority (EIOPA) recently published an opinion paper reminding financial services regulators and insurance firms to take all necessary steps to ensure service continuity for cross-border insurance risks underwritten before the UK formally withdraws from the EU. A number of insurance groups are already starting the process to effect group restructures in anticipation of a “worst case” scenario.
We will watch with interest as the political discussions develop, but we expect to see a number of reorganizations taking place over the next year.
b. Neon Illuminates the ILS Pathway?
In the UK, we have seen the first insurance-linked securities (ILS) transaction, following the introduction of the UK’s new ILS regulatory regime. Neon Underwriting has launched the first ILS vehicle in the UK, NCM Re (UK PCC) Ltd (NCM Re), and has raised third-party capital to support the transaction.
The UK’s Risk Transformation Regulations 2017 and the Risk Transformation (Tax) Regulations 2017 were approved by a cross-party government committee on November 29, 2017, and came into force in December 2017. These regulations make up the UK’s ILS legislation. The regulations amend UK company and insolvency law to create a corporate, regulatory and tax regime for UK-domiciled insurance special-purpose vehicles (ISPVs) to effect insurance-linked securities transactions.
The regulations allow such ISPVs to take the form of protected cell companies (PCCs), which had not previously existed under UK law. Interestingly, the regulations also exempt ISPVs/PCCs from corporate tax on insurance risk transformation profits and provide a complete withholding tax exemption for non-UK investors.
The aim of this new legislation is to grow the size and scope of the ILS market in the UK, and is driven by the growth in popularity of ILS over the last two decades. The London market is now well-placed to act as a location for ILS transactions.
c. FCA Market Study into Wholesale Insurance Brokers
On November 8, 2017, the UK Financial Conduct Authority (FCA) launched a market study to assess how competition is working in the wholesale insurance broker sector, and to assess how brokers influence competition in the underwriting sector. The FCA has stated that the purpose of the study is to “ensure that the sector is working well, and fosters innovation and competition in the interests of its diverse range of clients.” The FCA believes that effective competition contributes to ensuring London remains an international center for insurance.
The Terms of Reference of the FCA’s market study describe the wholesale insurance sector as one which caters to large, complex or specialist risks that usually require an element of bespoke pricing and coverage, and risks that are often placed with Lloyd’s syndicates and London insurance market companies. The study will address three main topics (and cover both direct insurance and reinsurance):
Market power – do individual broker firms possess market power and if so is this harming competition? Conflicts of interest – what conflicts exist in the sector and what is their effect on competition and firm conduct? Broker conduct – to what extent does this affect competition in the broker sector? Could some actions risk excluding firms from the underwriting sector?
These are many of the same issues that were at the core of investigations by US insurance regulators and state attorneys general, led by then-New York Attorney General Eliot Spitzer, nearly 15 years ago.
Responses to the issues covered by the study are to be provided by January 19, 2018, and it is anticipated that an interim report will be published in the fall of 2018. This interim report is likely to include preliminary conclusions and may identify potential solutions to address concerns raised which could include enforcement actions or a referral to the UK Competition and Markets Authority.
This study, coupled with the European Commission’s recent investigation into the aviation insurance industry, reflects the increased focus and scrutiny being placed on the insurance broker sector.