Globalization of the insurance industry has raised concerns about the inefficiencies and inconsistencies of reinsurance regulation in the United States. The concerns vary, depending upon whether the reinsurers are domiciled in the U.S. or another country. There are currently at least five proposals for regulatory reforms that address these concerns in different ways, including separate proposals from the National Association of Insurance Commissioners (the “NAIC”) and the New York and Florida Departments of Insurance. The two remaining proposals are part of bills pending before the U.S. Congress.
This Client Alert discusses these five initiatives, compares them and comments whether any of the initiatives would resolve the concerns raised regarding the current state of U.S. regulation.
CURRENT STATE OF U.S. REINSURANCE REGULATION
Reinsurers domiciled in the U.S. are subject to solvency regulation in their states of domicile and, to a lesser degree, in the other states in which they are licensed. This solvency regulation in the state of domicile encompasses such matters as filing financial statements, risk-based capital requirements, investment restrictions and insurance holding company system requirements. In addition, reinsurers are regulated indirectly by prohibiting cedents from taking credit on their financial statements for reinsurance unless the reinsurance satisfies certain requirements. The majority of states only apply these credit for reinsurance restrictions to cedents domiciled in their states, but several (most notably New York), apply them on an extraterritorial basis to all licensed cedents.
In most states, the requirements regarding credit for reinsurance are based on the NAIC Credit for Reinsurance Model Law and Credit for Reinsurance Model Regulation (collectively, the “NAIC Model Law”). Pursuant to the NAIC Model Law, a cedent may take credit for reinsurance from reinsurers that (a) are licensed or accredited in the cedent’s domiciliary state or (b) provide collateral either in the form of a trust fund securing 100 percent of their U.S. reinsurance obligations (a “multibeneficiary trust”) or letters of credit, trust accounts or other acceptable collateral securing their obligations to the cedent. In general, U.S. reinsurers qualify for reinsurance credit on the basis of their licenses, while non-U.S. reinsurers, lacking U.S. licenses, qualify by satisfying collateral requirements.
Criticism of Current U.S. Regulation.
Non-U.S reinsurers argue that, regardless of their lack of U.S. licenses, there is no need to require well-capitalized reinsurers that are regulated by their domiciliary jurisdictions and have a history of promptly paying claims to fund 100 percent of their U.S. reinsurance obligations through multibeneficiary trusts. It is particularly frustrating to these reinsurers that these trust requirements do not reflect the financial standing of the reinsurer and apply to their gross U.S. reinsurance liabilities without reduction for retrocessions.
Another criticism of current U.S. regulation is the duplicative and sometimes conflicting regulatory burdens that result from multiple states regulating the same reinsurance transaction. Critics argue that, at a minimum, any reform should eliminate regulation by states other than the cedent’s state of domicile. More ideal, these critics argue, would be a passport approach pursuant to which each reinsurer would have the right to transact business in all states on the basis of its regulation in a single “home state.”
PASSPORT SYSTEM OF THE EUROPEAN UNION (“E.U.”)
Some critics of U.S. regulation suggest that U.S. reformers look for guidance to the passport system of reinsurance regulation under the E.U.’s Reinsurance Directive (the “Directive”), which is intended to reduce regulatory costs and facilitate cross-border reinsurance transactions. By December 10, 2007, all E.U. member nations must regulate reinsurance in accordance with the same minimum regulatory standards specified by the Directive. As a result, each member nation can have confidence in the level of regulation that will be applied to any reinsurer authorized by another member nation. Accordingly, the Directive mandates that authorization by one E.U. nation gives a reinsurer the right (passport) to transact business in all member nations without additional authorizations. Financial supervision of an E.U. reinsurer may only be conducted by the member state in which it is authorized.
In addition, the Directive restricts the right of member nations to regulate reinsurance in ways that might undermine E.U. reinsurers’ passport rights to engage in cross-border reinsurance transactions. Most notably, effective December 10, 2008, member nations are prohibited from requiring collateral for reinsurance provided by a reinsurer authorized by any other member nation. The intent of the Directive is to minimize any extraterritorial regulation of reinsurance transactions, although member nations retain certain authority regardless of reinsurers’ passport rights, e.g., with respect to the regulation of finite reinsurance transactions.
Effect on U.S. Reinsurers. Recently, John Oxendine, the Georgia Insurance Commissioner and the Chair of the NAIC’s Reinsurance Task Force, questioned the extent to which the E.U. reinsurance market is open to U.S.-domiciled reinsurers. In fact, the Directive does not extend its passport regime to U.S. reinsurers that are not authorized by an E.U. member nation. As a result, member nations are free to impose collateral and other requirements on such U.S. reinsurers as they see fit. At present, only three E.U. members (France, Spain and Portugal) require collateral of non-E.U. reinsurers. After December 10, 2007, all E.U. member nations will be prohibited from applying collateral requirements to E.U. reinsurers, but they could continue to apply them to U.S. and other non-E.U. reinsurers.
However, the Directive allows the European Commission to negotiate mutual recognition agreements with non-E.U. member nations to facilitate market access for each party’s reinsurers under “equivalent” regulatory conditions. It is unclear how this provision of the Directive would apply to the U.S. where reinsurance is regulated at the state and not the national level. Nonetheless, assuming that this difficulty is overcome, such an agreement might protect U.S. reinsurers from the application of collateral requirements in the E.U. while protecting E.U. reinsurers from the application of U.S. collateral requirements.
NAIC’S REINSURANCE REGULATORY MODERNIZATION PROPOSAL
Under pressure from conflicting interests within the reinsurance industry as well as from the threat of federal regulation of insurance, the NAIC has, over a period of years, been considering possible revisions to the NAIC Model Law. To date, this activity has generated significant discussion and a few proposals for reform but no consensus as to how to reform the current system or even whether reform is necessary. In September, 2007, the NAIC’s Reinsurance Task Force released the NAIC’s latest proposal (the “NAIC Reform Proposal”) for comment. This proposal contemplates (a) a reduction in the amount of collateral (multibeneficiary trusts or letters of credit, trust accounts or other acceptable collateral provided to individual cedents) required of well-capitalized non-U.S. reinsurers and (b) other reforms intended to streamline reinsurance regulation.
Evaluating Non-U.S. Jurisdictions. In order to qualify for reduced collateral requirements pursuant to the NAIC Reform Proposal, a non-U.S. reinsurer must be domiciled in a jurisdiction having a regulatory regime that is “functionally equivalent” to U.S. regulation. Functional equivalence would be determined by a newly-organized Reinsurance Supervision Review Department of the NAIC (the “RSRD”), using a flexible, principles-based approach that would examine both processes and outcomes under non-U.S. regulatory regimes. (See the discussion of principles-based regulation in our Client Alert, dated November 8, 2007, entitled New York Insurance Department Releases Draft of Principles-Based Regulation.) The proposal contemplates that any such determination would be made on a reciprocal basis by both U.S. and non-U.S. regulators with the result that the reinsurers of each jurisdiction would enjoy access to the other’s reinsurance market on equal terms. The proposal also contemplates that there would be a mutual recognition agreement with the non-U.S. jurisdiction providing for the cooperation of that jurisdiction with U.S. regulators regarding supervision of its reinsurers doing business in the U.S. and enforcement actions involving such reinsurers.
This aspect of the NAIC Reform Proposal dovetails well with the provisions of the Directive that contemplate similar mutual recognition agreements. However, it is not clear that the E.U. would be willing to provide the degree of cooperation among regulators that the NAIC’s proposal seems to require. In addition, various states may balk at the broad discretionary powers that the proposal seems to confer on the RSRD with respect to making determinations of functional equivalence and negotiating mutual recognition agreements. Critics of the proposal have also questioned the constitutional authority of the RSRD to negotiate binding agreements with foreign governments and asked for clarity as to who would enter into such agreements for the U.S. – the various states, state insurance regulators or, perhaps, the federal government.
Rating Non-U.S. Reinsurers. Under the NAIC Reform Proposal, non-U.S. reinsurers domiciled in functionally equivalent jurisdictions may apply for certification by a “port of entry” state. The proposal does not clarify how states qualify as port of entry states, but each port of entry state must follow guidelines supplied by the RSRD in reviewing reinsurers for certification. When certifying a reinsurer, a port of entry state would assign it a rating, taking into account the reinsurer’s financial strength ratings from rating organizations such as A.M. Best and Moody’s as well as other criteria, such as the reinsurer’s history of paying claims in a timely fashion and the quality of regulation in its domiciliary jurisdiction. By allowing the port of entry states to evaluate the quality of regulation in non- U.S. jurisdictions, the proposal appears to permit the port of entry state to secondguess both the determinations of functional equivalence made by the RSRD and the efficacy of the mutual recognition agreements negotiated by the RSRD.
The amount of collateral required of non-U.S. reinsurers would depend on the ratings they receive from their port of entry states. The proposal provides that the collateral provided individual cedents in the form of letters of credit or otherwise for the liabilities ceded under particular reinsurance agreements would range from 60 percent to more than 100 percent of those liabilities depending on the reinsurer’s ratings. In addition, although the provisions of the proposal applicable to multibeneficiary trusts could be clearer, it appears that the collateral requirements for such trusts would range from the funding of 60 percent of all of the U.S. reinsurance obligations required of the highest-rated non-U.S. reinsurers to the funding of more than 100 percent of such obligations that may be required of the lowest-rated non-U.S. reinsurers. The proposal mentions that U.S. reinsurers would also be rated but provides no explanation of how this would occur. Only the lowestrated U.S. reinsurers would be required to provide collateral.
The collateral provisions of the NAIC Reform Proposal have generated considerable controversy. Trade groups representing U.S. cedents have questioned why any reduction in current collateral requirements is appropriate for non-U.S. reinsurers that decline to obtain U.S. licenses or accreditations and put U.S. cedents to the risk of having to enforce their contract rights abroad. On the other hand, non-U.S. reinsurers claim that the proposal is unfairly discriminatory in that it maintains differential collateral requirements favoring U.S. reinsurers over non-U.S. reinsurers with equal or better ratings. The proposal’s provisions regarding collateral appear to represent a compromise between the demands of both sides that pleases neither.
Extraterritorial Regulation. The NAIC Reform Proposal characterizes its approach to reinsurance regulation as a passport system under which there would be a single regulator (the port of entry state for a non-U.S. reinsurer or the “home state” selected by a U.S. reinsurer) for each reinsurer. However, the proposal does not deliver on this promise. Instead, it would subject reinsurers to multi-state regulation by expressly allowing each state to exercise regulatory authority over the reinsurance transactions of cedents domiciled in the state, including making adjustments to the collateral requirements fixed by a non-U.S. reinsurer’s port of entry state. Moreover, the proposal does not expressly ban extraterritorial regulation by states other than the cedent’s domiciliary state.
Next Steps. The exposure of the NAIC Reform Proposal for comment last September generated a host of criticisms and questions. In response, the Reinsurance Task Force backed away from many of the more controversial features of the proposal. On November 8, 2007, it issued a two-page “Framework Memorandum” that submits to further discussion and analysis a broad range of issues, such as the appropriate collateral levels, the extent of the regulatory authority to be retained by the cedent’s domiciliary state and how uniformity among the states should be addressed. The proposed “framework” includes three major points: a commitment to the use of the RSRD to determine which non-U.S. jurisdictions qualify to enter into mutual recognition agreements; a single-state regulator system for U.S. reinsurers that in some unspecified way would address “inappropriate” extraterritorial regulation; and a single-state regulator system for non-U.S. reinsurers in which port of entry states would be subject to minimum uniform standards. The modest scope of these three points leaves the substance of the NAIC proposal very much in doubt.
Both the Reinsurance Task Force and the Financial Condition (E) Committee recently approved the Framework Memorandum at the NAIC’s Winter meeting. If it is also approved within the next month or so by the NAIC Plenary, the Task Force will begin work on resolving all open issues and revising the NAIC Model Law accordingly. However, given the broad scope of the remaining issues, it is impossible to predict whether agreement will ever be reached on a final set of reforms and, if so, how closely the final document would resemble the original proposal released last September.
If the NAIC amends the Model Law, those amendments will not be effective until they are adopted into law by the individual states. Given the controversy surrounding the proposed reforms, it is highly doubtful that any such amendments would be adopted in all states. However, because the NAIC Model Law is part of the package of insurance legislation that states must adopt in substance in order to qualify for accreditation by the NAIC, there is likely to be considerable pressure to adopt these reforms.
PROPOSED NEW YORK AND FLORIDA RULES
Apparently frustrated by the lack of substantive progress at the NAIC level, insurance regulators in both New York and Florida have recently released draft rules reducing their states’ collateral requirements. Regulators in both states have stated that these draft rules are intended to increase reinsurance capacity and ultimately help stabilize their states’ insurance markets, which have suffered in recent years because of exposure to terrorism and hurricane risks.
Like the NAIC Reform Proposal, both of these draft rules would provide relief from collateral requirements based on a reinsurer’s financial ratings. Under the draft rules, this relief would be provided in the form of a credit on the cedent’s financial statements expressed as a percentage of the liabilities ceded to the rated reinsurer. This percentage would range from 100 percent for the highest-rated reinsurers to 0 percent for the lowest-rated reinsurers. The cedent would be relieved of the need to collateralize its reinsurance to the extent of such a credit.
Such a credit would not reduce the amount that a reinsurer would have to maintain in a multibeneficiary trust. It appears that under the laws of both states, any such trust would still have to be funded in amount equal to 100 percent of the reinsurer’s gross U.S. reinsurance obligations.
However, a reinsurer with the highest ratings would not have to maintain a multibenficiary trust in order for a cedent to take full credit for its reinsurance on financial statements filed in these two states since the cedent would receive credit equal to 100 percent of those liabilities based on the reinsurer’s ratings. Under the proposed rules, cedents that purchase reinsurance from reinsurers with lower ratings that do not maintain multibeneficiary trusts would have to obtain letters of credit or other acceptable collateral from those reinsurers to secure the portion of their ceded liabilities remaining after application of the credit attributable to the reinsurer’s ratings.
Unlike the NAIC Reform Proposal, both draft rules rely exclusively on ratings provided by commercial rating organizations, such as A.M. Best and Moody’s, and not on any rating performed by a department of the NAIC such as the proposed RSRD. Like the NAIC Proposal, both rules would require the evaluation of the regulatory systems of non-U.S jurisdictions. Under the New York rule, non-U.S. reinsurers would only be entitled to relief from collateral requirements if they are domiciled in a jurisdiction that enters into a memorandum of understanding with the New York Superintendent addressing such matters as information sharing, regulatory equivalence and enforceability of judgments. Under the Florida rule, such relief is only available if the Florida Commissioner determines that the non-U.S. reinsurer’s domicile has a satisfactory regulatory regime and acceptable accounting systems and would enforce U.S. judgments and arbitral awards. In addition, other requirements would have to be met as a condition of qualifying for the credits provided under these rules. For example, the New York rule would require that reinsurers maintain surplus in excess of $250 million, while the Florida rule would require surplus of over $100 million.
Neither New York nor Florida has the authority to relieve cedents domiciled in other states from the collateral requirements of those states. Absent a change in their own laws, such other states will continue to require that such cedents only take credit for reinsurance from unlicensed reinsurers that provide collateral in the form of either (a) multibeneficiary trusts securing 100 percent of their gross U.S. reinsurance liabilities or (b) letters of credit or other collateral securing 100 percent of the liabilities assumed from the cedents. Thus, without a change in the collateral requirements of all states where cedents are domiciled, unlicensed non-U.S. reinsurers will be required to maintain funding of their multbenficiary trusts at current levels.
PENDING FEDERAL BILLS
Two bills introduced in Congress in 2007 include provisions addressing reinsurance regulation. The National Insurance Act of 2007 (the “NIA”), which provides insurers with the option of electing federal regulation, has been introduced in both the Senate (S. 40) and the House of Representatives (H.R. 3200). In addition, on June 25, 2007, the House unanimously adopted the Nonadmitted and Reinsurance Reform Act of 2007 (the “NRRA”), which would reform regulation of both the surplus lines insurance market and the reinsurance market. A companion bill (S. 929) to the bill adopted by the House (H.R. 1065) has been introduced but not brought to a vote in the Senate. For more detailed discussions of the NIA and NRRA, please consult our prior Client Alert, dated June 21, 2007, entitled Optional Federal Charter Bill Reintroduced, and our Client Alert, dated July 28, 2006, entitled Federal Proposals On Surplus Lines Insurance and Reinsurance.
National Insurance Act. The NIA would permit both direct insurers and reinsurers, including non-U.S. reinsurers, to obtain federal licenses and thus subject themselves to federal rather than state regulation. The NIA does not specifically address reinsurance collateral requirements but requires the adoption of rules governing reinsurance cessions by federally-licensed cedents to reinsurers lacking federal licenses. H.R. 3200, though not S. 40, requires that those rules impose “security standards,” which suggests that federallylicensed cedents may be denied credit for reinsurance provided by reinsurers without federal licenses in the absence of some collateral.
The NIA would also restrict the ability of states to regulate reinsurance ceded by statelicensed insurers to federally-licensed reinsurers. It prohibits states other than the cedent’s domiciliary state from restricting credit for reinsurance ceded by a state-licensed cedent to a federally-licensed reinsurer, if the cedent’s domiciliary state allows the credit. In addition, it requires that the cedent’s domiciliary state regulate credit for reinsurance ceded to a federally-licensed reinsurer as if the reinsurer were domiciled in that state. The apparent intent of this provision is to bar any state from imposing collateral requirements on federallylicensed reinsurers on the basis of their lack of a state license, since all insurers are licensed in their states of domicile. The NIA also restricts the ability of states to regulate the wording of reinsurance agreements with federally-licensed companies.
As a result of these restrictions on state regulation, federally-licensed reinsurers would enjoy passport rights to operate across the country largely free of state regulation. However, because the NIA does not extend similar rights to reinsurers without federal licenses, the result would be a patchwork of state and federal regulations whose application would vary depending on whether the parties to any reinsurance transaction have federal, state or no U.S. licenses.
Nonadmitted and Reinsurance Reform Act. The NRRA does not provide for federal licensing of insurers or reinsurers. Its provisions regarding reinsurance are designed to restrict reinsurance regulation to the domiciliary state of the cedent. The NRRA provides that if a reinsurance transaction qualifies for credit for reinsurance in the cedent’s domiciliary state and that state is accredited by the NAIC, then no other state may deny the cedent such credit. The NRRA also preempts the laws of states other than the cedent’s domiciliary state to the extent that they would apply to the reinsurance agreements of such cedents, for example by preempting restrictions on the ability to agree on the arbitration of disputes. In addition, the NRRA provides that if a reinsurer is domiciled in a state accredited by the NAIC, that state shall be solely responsible for regulating its solvency.
While the NRRA provides relief from the extraterritorial application of state reinsurance regulations, it applies no other restrictions on the application of state collateral requirements (including requirements pertaining to multibeneficiary trusts) nor does it provide passport rights to reinsurers that would allow them to operate across the country under a single regulatory regime.
None of the five proposals discussed in this Client Alert promises to resolve the ongoing controversy over the burdens imposed by current collateral requirements and the extraterritorial regulation of reinsurance. In response to criticisms, the NAIC has effectively thrown out the substance of its proposed reforms so that it is unclear what, if any, solutions it may eventually offer. The reforms proposed by New York and Florida will have minimal effect unless and until other states adopt reforms reducing their collateral requirements. While both the NIA and the NRRA offer some relief from the extraterritorial regulation of reinsurance transactions, neither the NIA nor the NRRA provide any relief from collateral requirements for unlicensed reinsurers. This patchwork of incomplete and ineffective proposals reflects the fact that even after years of debate among regulators and interested parties on the defects of the current regulatory system, there is still no consensus on the extent of the problems or the appropriate way to address them.