A number of important developments in the regulation of (A)XXX reserve financing transactions ((A)XXX transactions) emerged during the NAIC Summer 2015 National Meeting (Summer Meeting).  Our roadmap through the NAIC’s fragmented process and the status of the actions of the various committees and working groups that focus on this issue is set out below.  

Our key takeaways from the Summer Meeting are: 

  1. Many important rules still to come.  Risk-based Capital (RBC) charges for Other Securities in (A)XXX transactions are still being determined, as is any decision as to whether to “grandfather” existing variable annuity and long term care insurance captives from the imposition of accreditation standards.  Uncertainty continues for those insurers and financing providers contemplating new (A)XXX transactions, or the future of variable annuity and long-term care blocks reinsured in captives.
  2. All-or-nothing” credit for reinsurance.  As exposed for comment, the proposed (A)XXX Credit for Reinsurance Model Regulation will deny any credit for reinsurance for certain transactions subject to the regulation if, as of March 1 following the end of any calendar year in which the regulation is in effect, the reinsurer is not posting the required amount of Primary Securities and Other Securities.  This will likely delight financing providers, as ceding companies and affiliates will likely prioritize capitalizing captives to avoid a complete loss of credit for reinsurance.  The “leveraged” effect of contributing Primary Securities to the captive would presumably incentivize cedents to prioritize the captive balance sheet over their own, reducing the likelihood that financing providers will ever have to fund their obligations in respect of Other Securities, and transferring Primary Securities into the captive and outside the regulatory purview of the cedent’s domestic regulator. 
  3. Regulatory approval.  The proposed (A)XXX Credit for Reinsurance Model Regulation would require domestic regulatory approval of reinsurance arrangements that are not exempt from the regulation.  While most financing transactions in this area involve inter-affiliate transactions that already require approval or non-disapproval of the ceding insurer’s domestic regulator under the insurance holding company act, this is a new requirement.  To the extent that a reinsurance agreement with a licensed or accredited reinsurer can lose its exemption from the proposed regulation because of a subsequent permitted practice or RBC event at the reinsurer (which is unclear on the face of the regulations), prudent cedents may consider having even their exempt reinsurance agreements with non-affiliates approved at inception, or clarifying this point with their regulator.  In the absence of regulatory clarity on whether the exemption test applies at inception or for the life of the transaction, prudent cedents may also consider representations and covenants from their reinsurers as to permitted practices and maintaining adequate risk-based capital ratios, even in traditional coinsurance agreements with licensed or accredited reinsurers.
  4. PBR may well become effective in 2017, but not end financing transactions.  While Principles-based Reserving (PBR) may well be on track to become effective in 2017 in those states that have enacted it, a survey of insurers by the Society of Actuaries released during the PBR Review Working Group revealed that none of the respondent insurers believes that PBR will eliminate the need for reserve financing transactions.  Hallway conversations with regulators revealed the same consensus.
  5. Benchmark RBC level for captivesThe RBC Shortfall rule may encourage ceding insurers to capitalize captives at 300 percent Authorized Control Level RBC to avoid reductions to their own Total Adjusted Capital.  While the life insurance statutory financial blanks are still very much in flux, they indicate the benchmark RBC level for 2016 may be set at 300 percent.

The evolving nature of NAIC’s (A)XXX regulation

The NAIC has taken a number of approaches to regulate (A)XXX transactions (the (A)XXX Reinsurance Framework).  In 2014, Rector & Associates, Inc. (Rector) issued a report containing recommendations regarding regulation of reserve financing transactions (the Rector Report), which by the end of 2014, took the form of Actuarial Guideline 48 (AG 48).1  Effective January 1, 2015, AG 48 requires a ceding company’s appointed actuary to determine as of a specified date, whether the company’s amount of Primary Securities2 meet the reserve requirements of the NAIC’s Valuation Manual Requirements for Principle-Based Reserves for Life Products (also referred to as VM-20), which is the actuarial method for determining so-called “economic reserves.”  This required level is referred to as the “Required Level of Primary Security.”  The remaining reserves may be backed by “Other Security.”3

The NAIC Committees charged a number of task forces and working groups with tasks to develop and implement the (A)XXX Reinsurance Framework, thereby fragmenting the process.  In addition to the (A)XXX Reinsurance Framework, the NAIC recently charged new groups to focus on imposing similar requirements on variable annuity and long term care reinsurance transactions involving captives.  The NAIC groups working on the (A)XXX Reinsurance Framework include: the Life Actuarial (A) Task Force; the Blanks (E) Working Group; the Life Risk-Based Capital (E) Working Group; the Capital Adequacy (E) Task Force; the Reinsurance (E) Task Force; the Statutory Accounting Principles (E) Working Group; the Financial Condition (E) Committee; and the Financial Regulation Standards and Accreditation (F) Committee. 

The discussion below highlights key developments in the various NAIC groups as of the Summer Meeting.  For a complete status of the various NAIC groups work on the (A)XXX Reinsurance Framework, please click here.

1. Many important rules still to come

a. Adoption of three proposals regarding the RBC shortfall; however, RBC charges remain on hold 

The Capital Adequacy (E) Task Force adopted three proposals related to the (A)XXX Reinsurance Framework:

  • Qualified Actuarial Opinion Impact on Interest Rate Risk and Market Risk in the RBC formula  – This proposal changes an interrogatory on LR027 Interest Rate Risk and Market Risk.  This interrogatory allows companies submitting an unqualified opinion to receive a one-third reduction in the Interest Rate Risk and Market Risk factors in the RBC calculations.  It was modified to prevent an opinion qualified solely due to the direction in AG 48, which is line of business specific, impacting all lines of business.
  • Primary Securities Shortfall – This proposal adds a new schedule showing the primary security shortfall by individual cession.  The cumulative amount of primary security shortfall, with no offset for any surpluses, is then taken as a dollar-for-dollar addition to the reporting company’s Authorized Control Level.
  • RBC shortfall – This proposal adds a new schedule which shows the RBC calculation by individual captive, which would apply to the ceding company’s RBC calculation.  The RBC Shortfall of the captive is the difference between the Total Adjusted Capital and the Benchmark RBC level (which is set at 300 percent for each captive).  The cumulative amount of the captives’ RBC shortfalls, with no offset for any surpluses, is then taken as a dollar-for-dollar reduction to the reporting ceding company’s Total Adjusted Capital.

The Task Force must continue work on the consolidated RBC.  The consolidated column on the RBC Shortfall schedule is still XXXd out with the exception of the shortfall amount.    

The Capital Adequacy Working group also adopted its 2016 charges, which include determining whether asset charges for the forms of “Other Security” should be developed or otherwise accounted for in the RBC shortfall calculation.  This charge undoubtedly reflects the Life Risk Based Capital Working Group’s decision earlier this year to defer consideration of whether to incorporate consideration of Other Securities into the RBC shortfall or into a stand-alone proposal until 2016 due to its complexity and lack of time given the other proposals. 

b.     Proposal to disclose the RBC of (A)XXX captives exempted from AG 48  

The PBR Implementation Task Force discussed a letter from the Life RBC Working Group, which requested disclosure of the RBC of special purpose financial captives which are engaged in (A)XXX transactions that are exempted from AG 48.  Currently disclosure requirements would not apply to captives exempted from AG 48.  Co-Chair of the PBR Implementation Task Force Superintendent Torti agrees with this proposal, especially since the Life RBC Working Group is looking into implementing this disclosure with respect to variable annuity and long term care financing transactions.  Superintendent Torti asked the industry to put together a framework for variable annuities that may be expanded. 

Representatives from the life insurance industry working on these projects commented that it would be impossible to have such a disclosure ready for 2015 reporting.  They are already working hard to meet the deadline to develop the complicated formula for the RBC shortfall for any particular captive and developing such a disclosure would be misleading, because the framework for (A)XXX transaction and the resulting RBC calculation is completely different from the way RBC would work with respect to variable annuity financing transactions.

The underlying issue is financing versus volatility of results.  If the NAIC imposes the same disclosure developed for variable annuities on (A)XXX captives, then the companies will end up with misleading numbers.  Some other ideas being considered include reviewing consolidated results for all captive transactions with a ceding company instead of individual transactions.  Regulators indicated they may want to go back and fully develop the consolidated view instead of doing the same with individual transactions.  Even that approach may not eliminate the timing concern, because the NAIC still needs to fix the consolidated column for 2015 reporting.  The bottom line for regulators is the concern that special purpose financial captives do not use RBC rules and regulators intend to correct that.

c.     Imposition of accreditation standards on certain captive insurers

The Financial Regulation Standards and Accreditation (F) Committee drafted new language for the Part A Accreditation Preamble that would provide that certain captive insurers, special purpose vehicles, and other entities assuming insurance business would be subject to the general accreditation standards, but the application would be limited to only the following lines of reinsurance business: (1) (A)XXX policies (as defined under AG 48) to apply to those policies that are required to be valued under Sections 6 or 7 of the NAIC Valuation of Life Insurance Policies Model Regulation (Model #830)); (2) variable annuities valued under Actuarial Guideline XLIII—CARVM for Variable Annuities (AG 43); and (3) long-term care insurance valued under the NAIC Health Insurance Reserves Model Regulation (Model #10).

The F Committee adopted the Accreditation Preamble with respect to captive insurers that assume business written in (A)XXX transactions, effective January 1, 2016.  The F Committee voted to continue to monitor the work of NAIC groups as it considers certain issues with respect to variable annuities and long term care, such as grandfathering of variable annuities and LTC assuming entities; safe harbors; and the effective date of the accreditation requirement.

2. Draft (A)XXX Reinsurance Framework Model Regulation deviates from AG 48, exposed for comment

The (A)XXX Captive Reinsurance Regulation Drafting Group drafted the following, which were exposed for comment by the Reinsurance Task Force:

  • The Credit for Reinsurance Model Law Amendment.  Two alternatives were exposed.  Option 1 Amendment authorizes the commissioner to issue a regulation on (A)XXX.  Option 2 Amendment expands the commissioner’s authority to also apply to variable annuities and long term care reserve financing transactions. 
  • The (A)XXX Credit for Reinsurance Model Regulation.  The Model Regulation is based on AG48.  The key issue being considered is what happens if a covered transaction does not meet the requirements of AG 48 because of a shortfall in Primary Security.  Proposals include:
    • The all-or-nothing approach – the ceding company receives no credit for reinsurance for the (A)XXX transaction.  The majority of the drafting group supports this approach; however, it is not unanimous.
    • Dollar-for-dollar reduction of credit for reinsurance.
    • Percentage reduction of credit for reinsurance.
    • Primary Security Limitation – only receive credit for reinsurance on the amount of primary securities held.

Industry commented that consideration of the four possible “consequences” differs from AG 48, which has only two remediation options – (i) add hard assets or (ii) a dollar-for-dollar reduction in credit for reinsurance.  Regulators who spoke in favor of the all-or-nothing approach argued that it is necessary to discourage non-compliance with AG 48.  Companies that seek to finance part of their reserves are being granted a “privilege,” and that such a privilege should only be granted if the company fully complies with the applicable requirements, including the requirement that it hold Primary Security in an amount equal to or in excess of the Required Level of Primary Security.  Industry argued, on the other hand, that the NAIC’s approach must recognize that unavoidable shortfalls will occur, pointing out that daily interest rate fluctuations can cause a shortfall and then the company would have to sell assets in a depressed economic environment.  In response, Superintendent Torti stated he is open to considering a de minimis shortfall to address rate fluctuations.

Comments on the exposures are due by September 30, 2015.

3. Principles Based Reserving Implementation

PBR will be implemented over approximately three years and for new business once at least 42 states (a supermajority) representing 75 percent of total US premium adopt the revisions to the SVL.  As of the Summer Meeting, 36 states, representing 60 percent of premium, have adopted the revised model laws.  The PBR Implementation Task Force is currently considering proposals to determine the actual operative date of PBR (i.e., determining whether those states have enacted substantially similar terms and provisions as the SVL).  Given the number of states close to enacting PBR by the end of the year, it is a possibility that 39 states representing 73 percent of premium will have enacted PBR by the end of 2016.  If the thresholds are met by July 1, 2016, PBR could become operative as early as January 1, 2017.

See our earlier alert on the Rector Report here