The second session of the 4th annual Runoff Deal Market Forum focused on some of the less obvious legal, regulatory and NAIC developments that will likely impact the runoff deal landscape. The esteemed panel included Mayer Brown partner Larry Hamilton who heads the firm’s US Insurance Regulatory & Enforcement group, James Mills, Vice President and Legal Counsel of Enstar US, and Andy Schallhorn, the Deputy Commissioner of Financial Regulation and Chief Actuary for the Oklahoma Insurance Department. A replay of this presentation can be viewed on the AIRROC On Demand platform.
Credit for Reinsurance
James Mills started off the discussion by addressing the recent reforms to the credit for reinsurance Model Act. Before delving into the specifics and for context purposes, he provided the historical background to the US credit for reinsurance and collateral requirement regulatory framework. Reinsurance recoverables are recognized on a cedent’s statutory financial statements as an asset or a reduction of liabilities if certain requirements are met. The accounting treatment is based in part on whether the recoverables are collateralized. In the past, reinsurance collateral requirements were mainly driven by whether or not the reinsurer was “authorized” or “unauthorized.” “Authorized” generally meaning a domestic reinsurer and “unauthorized” meaning a non-US reinsurer. However, over time it became clear that reinsurance capacity needed to be extended beyond what was available in the US. This led to the NAIC’s adoption of its 2008 Reinsurance Regulatory Modernization Framework proposal, which recommended implementation through federal legislation. This was the genesis for Congress passing the Nonadmitted and Reinsurance Reform Act of 2010, which was a significant step towards reforming reinsurance collateral requirements. Although the framework was different from the NAIC’s framework, it allowed the NAIC to proceed forward and continue development of reinsurance collateral reforms.
At around this same time, the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) was enacted which established the Federal Insurance Office (“FIO”) as part of the US Department of the Treasury. Under the Dodd-Frank Act, the FIO was authorized to coordinate federal efforts and develop federal policy on international insurance matters, which ultimately led to the negotiation of the Covered Agreements; bilateral agreements between the US and the EU and later, the US and the UK due to Brexit. The Covered Agreements eliminated reinsurance collateral requirements for qualifying reinsurers domiciled in the EU or the UK.
The NAIC’s reform efforts continued with the 2011 amendments to the Credit for Reinsurance Model Law which created a new category of reinsurers called “Certified Reinsurers” that were permitted to post reduced reinsurance collateral according to a sliding scale based on the financial strength and business practices of the reinsurers. This framework provided for the establishment of qualified jurisdictions in which non-US reinsurers domiciled or licensed in qualified jurisdictions can submit to a certification process to be deemed a Certified Reinsurer. So far there are seven qualified jurisdictions: Bermuda, France, Germany, Ireland, Japan, Switzerland and the UK. South Korea is currently under consideration. Certified Reinsurers are allowed to post less than 100% collateral and still enable an authorized insurer to qualify for full reserve credit with respect to reinsurance contracts renewed or entered into on or after January 1, 2011, or the date the reinsurer becomes certified.
To align the Model Act with the Covered Agreements, the NAIC adopted Amendments to the Model Act in 2019. The 2019 Amendments pave the way for state legislatures to bring their credit for reinsurance laws into compliance with the Covered Agreements collateral reduction provisions by September 2022, thereby avoiding potential federal preemption of these laws. Only reinsurance agreements entered into, amended or renewed on or after the effective date of the state statute encompassing the 2019 Amendments are eligible for reinsurance collateral elimination and only with respect to losses incurred and reserves reported on or after the later of the date on which the assuming reinsurer has met all eligibility requirements and the effective date of the reinsurance agreement. So far 33 US jurisdictions have adopted the 2019 Amendment updates; good progress has been made and the US is on track to avoid preemption and FIO’s intervention.
The 2019 Amendments also established a framework for jurisdictions that are not subject to in-force Covered Agreements and that meet the requirement for accreditation under the NAIC financial standards and accreditation program to be recognized as reciprocal jurisdictions. Reciprocal jurisdictions are subject to the same collateral elimination treatment as under the Covered Agreements. So far, there are three reciprocal jurisdictions: Bermuda, Japan and Switzerland.
The reforms to the credit for reinsurance and collateral requirement regulatory framework are undoubtedly complex. Therefore, it will likely be necessary for ceding insurers to weave their way through the thicket and rely on more than one of the various categories of reinsurers when claiming statutory reinsurance credit, especially for those insurers ceding legacy and runoff business.
NAIC Investment-Related Initiatives
Up next was Larry Hamilton who discussed the investment-related initiatives of the NAIC. Insurance companies are always looking at ways to increase yield on their investments. However, they are sensitive to the Risk Based Capital (“RBC”) treatment as higher yielding investments often incur a higher capital charge. Under RBC formulas that dictate how much capital must be set aside to support various liabilities, equities are considered riskier than bonds and incur a higher capital charge. Bonds receive an RBC charge based on the NAIC designation assigned to them, with NAIC-1 being the highest and NAIC-6 the lowest. Insurers want their investments to be treated as bonds because of the more favorable capital treatment and thus the ability to have an investment treated as a bond and the NAIC designation assigned to that bond have huge implications.
The two NAIC subgroups that are involved in these categorizations and designations are: the Statutory Accounting Principles Working Group (“SAP Working Group”) and the Valuation of Securities Task Force (“VOS Task Force”). The SAP Working Group makes the rules for determining whether a security is treated as a bond. Recently, they have been concerned with investments that have been structured to look like a bond, but really do not have the characteristics of a bond.
The VOS Task Force oversees the Securities Valuation Office (“SVO”), which is responsible for assessing the credit quality of securities. In recent years the VOS Task Force became apprehensive that the credit risk assessment of certain types of investments by the credit rating providers do not accurately reflect the risk to policyholders. Under the filing exemption rule, certain investments automatically receive an NAIC designation equivalent to their credit rating from a NAIC-recognized credit rating provider. Although the filing exemption system is beneficial to all parties in that it streamlines the process, the question is whether certain of these investments should get the automatic exemption or whether they should be submitted for review and assignment of an NAIC designation by the SVO.
One of the investments targeted by the SAP Working Group are structured notes that do not have principal protection. Commencing in April of 2019, if a bond or note does not offer full principal protection, that instrument will not be considered a bond but instead will be considered a derivative. The reason being is that the repayment of principal is based on some underlying asset or other index and thus does not meet the criteria for favorable capital treatment.
One of the SVO initiatives dealt with a category of principal protected securities (“PPS”) that, beginning January 1, 2021, have been removed from the filing-exempt category. PPS now need to be filed with the SVO for analysis and the assignment of an NAIC designation, rather than automatically receiving a designation based on a rating agency rating. The designations that the SVO will assign to these PPS investments are generally expected to be lower than the rating assigned by the credit rating agencies. The upshot is that there will be a significant increase in the RBC charges associated with holding these securities.
The VOS Task Force also became wary of private letter rating securities. Beginning January 1, 2022, when insurers file a security with a private letter rating with the SVO, they will need to file the rating rationale report from the rating agency to provide a window into the methodology used to arrive at the private rating. Based on what the SVO learns from reviewing the rationale reports, it may come back to the VOS Task Force with further recommendations regarding the treatment of private letter rating securities. In the meantime, this review process will also give the SVO an opportunity to flag any securities (such as PPS) that are not filing-exempt, or any securities that it believes are not entitled to bond treatment.
Finally, the VOS Task Force has also expressed concerns about “bespoke securities.” Due to their private nature, the SVO is concerned that there is not as much market discipline in evaluating these securities and assessing the investment risk for regulatory purposes. The SVO has suggested in an “issue paper” that it should get to review the legal agreements underlying “bespoke securities” and make a decision on whether the rating agency rating is acceptable for determining the NAIC designation or whether the security needs to be filed for an SVO-determined designation. That proposal is not yet formally before the VOS Task Force, but it could be taken up in the future.
Ceding insurers must pay close attention to these changes and the changes on the horizon, as the NAIC is not likely to grandfather these investments but rather provide a transition period for insurers to reposition their portfolios.
Long-Term Care Insurance
Andy Schallhorn closed out the presentation by providing an overview of the NAIC’s initiatives with respect to Long-Term Care (“LTC”) Insurance. There are lots of LTC blocks of business that are in runoff or will be in runoff soon. The NAIC formed the Long-Term Care Insurance Task Force (the “LTC Task Force”) in 2019 and charged the Task Force with two major goals: a state-based rate review process and presenting options for consumers to reduce benefits in situations where the premiums are no longer affordable. The LTC Task Force, in turn, established two subgroups to achieve these goals: the Multistate Rate Review Subgroup (the “Rate Review Subgroup”) and Long-Term Care Insurance Reduced Benefit Options Subgroup (“RBO Subgroup”).
The Rate Review Subgroup is working to develop a consistent state-based approach for reviewing LTC insurance rate increase filings that will result in an actuarially justified rate increase process that will be timely and will eliminate cross-state rate subsidization. The process is referred to as the multistate actuarial long-term care insurance review process or MSA framework. The Rate Review Subgroup is conducting a pilot project in which a multistate actuarial review team reviews rate filings from several insurers and develops a Rate Advisory Report that provides an analysis and a recommendation for individual state’s insurance departments. The proposed rate increase in a Rate Advisory Report for a particular state is merely a recommendation, not a requirement and, therefore will not be binding on any state. The Rate Review Subgroup has also drafted an outline for the MSA framework, which has been distributed for comment.
With respect to the reduced benefit options, the RBO Subgroup formulated and adopted two sets of principles: the RBO Principles and the RBO Consumer Notices Principles. The RBO Principles provide guidance to state regulators for evaluating RBO offerings and addresses issues such as the fairness and equity for policyholders that elect a RBO or that choose to accept the rate increase, communication clarity with policyholders and regulatory requirements for an insurer to offer certain RBOs. Some of the other principles adopted deal with guidance on regulators’ consideration of the potential impact of reduced benefits on remaining policyholders in the block, the insurer’s finances and/or the impact on Medicaid budgets, as well as innovation, particularly where an outcome of improved health and lower claim costs are possible and the types of RBOs in lieu of rate increases.
The RBO Consumer Notices Principles seek to provide guiding principles to LTC insurers and state regulators in evaluating the quality of consumer notices and other RBO materials presented to policyholders.
Finally, the LTC Financial Solvency Subgroup is focused on financial and actuarial monitoring efforts. They are charged with monitoring work performed by other NAIC solvency working groups and assisting in the timely multi-state coordination and communication of the review of the financial condition of LTC insurers. At the 2021 Spring National Meeting, industry trends have been identified that could impact reserve levels and rates. Their work in this area is ongoing and further reporting on their progress is slated for the 2021 Summer National Meeting.