In last month’s edition, we examined some of the threshold regulatory issues involved in acquiring a U.S.-based insurance company. We turn now to the related topic of ancillary transactions that may be integral to the main M&A transaction and constitute part of the underlying motivation for the acquirer’s investment. While an exhaustive discussion of the issues arising from these arrangements is beyond the scope of this article, what follows is an overview of the main deal considerations that funds should be alert to when entering into insurance company acquisitions or divestitures that have an ancillary component.
Two prime examples of such arrangements are (i) investment management or similar service agreements and (ii) reinsurance agreements. As to the first, an acquirer may intend that the target insurer enter into agreements with the acquirer for the provision of certain services in exchange for compensation. In the second example, an acquirer may wish to cede some of the target company’s in-force risks to an affiliate of the acquirer. In other reinsurance cases, an acquirer may wish to monetize redundant reserves (in the case of a life insurer) at the target company by ceding them to a new captive reinsurer funded in part by third-party investors. In each of these hypothetical cases, it is critical to the acquirer that these ancillary transactions be in place immediately at the closing of the acquisition; without these components of the transaction, the entire deal’s objective from the acquirer’s standpoint could be frustrated.
In addition to regulating acquisitions, the Insurance Holding Company Act (the National Association of Insurance Commissioners, or “NAIC,” model law that we examined in our last issue) places restrictions on the ability of insurers to transact business with affiliates. The Act as in effect in any given state may vary from the NAIC model, but in general all states impose some version of these restrictions. For example, any transaction between an insurer and an affiliate must be “fair and reasonable.” In addition, certain types of affiliated transactions over a certain size must be submitted to the regulator 30 days before they become effective. These include all “management agreements, service contracts…and all cost- sharing arrangements.”
Consequently, for a private fund to acquire an insurer and then seek to provide services to the insurer in exchange for fees (such as brokerage or investment management services), the fund will need to navigate the Holding Company Act requirements concerning affiliate transactions insofar as these will be affiliated relationships from and after the closing of the sale. For instance, if the fund wishes for such an arrangement to be in place immediately upon closing, it will typically not be sufficient to file the service agreement with the regulator on the day of closing. Under the Act, 30 days’ prior notice to the regulator will have to be given. Even beyond that, however, because the service arrangement is contemplated as part of the acquisition, the fund would be well-advised to refer to this proposed arrangement in the Form A and, ideally, submit the proposed form of service agreement at such earlier time. In other words, the fund should undertake to obtain the regulator’s approval of the service agreement as part of the Form A approval. If this is not done, the regulator may take the view that he is approving the acquisition alone and may therefore require a Form D filing concerning the service agreement to be made upon closing. This would delay, potentially, the effectiveness of the service arrangement and also carry regulatory risk. The regulator might take this view anyway, even if the affiliate agreement is submitted at the time of the Form A. However, in this event the fund can at least build approval of that agreement into the regulatory closing condition of the contract (about which more below), thus applying some leverage on the regulator to approve the agreement.
Turning to reinsurance, an acquirer may intend for the target insurer, upon closing, to cede risk to an affiliate insurer already owned (or newly established) by the acquirer. This may be attractive in order to relieve capital strain, to balance portfolios as between legal entities, to monetize excess reserves, to maximize risk-based capital ratios or for other reasons. Recent years have seen funds and other acquirers propose novel securitization and similar transactions as part of acquisitions of life insurance companies in order to achieve one or more of these objectives. Key to these efforts often is the use of special-purpose captive reinsurers to absorb these risks and accept funding from third parties, a practice that has drawn regulatory scrutiny in recent transactions.
In order to maximize the likelihood that the regulator considers the entire transaction as a whole, the acquirer should indicate to the regulator the importance of the ancillary transactions to the success of the deal. Critically, this must include (i) a substantiated narrative and quantitative argument as to why the transaction is fair to policyholders and (ii) particularly in the case of services, a discussion of rates being charged by arms’ length parties for similar services in the marketplace for purposes of comparative analysis. Another key factor that will affect execution is the allocation of risk between the parties (as set forth in the transaction documents) associated with the approval. A buyer will typically not be required under a contract to close if regulatory approval is meaningfully conditioned such that the basic terms of the deal are frustrated. However, a seller can, of course, seek to limit the buyer’s optionality by negotiating a “burdensome condition” threshold that attaches at the highest point possible. Exactly how much conditionality the buyer should be compelled to accept, and still be required to close, can be a major point of contention in negotiations. Once finalized, of course, the allocation of this risk, as memorialized in the contract, will be fully visible to the regulator, which can in turn affect the dynamics of the regulatory process itself.