Principle-Based Reserves & SPVs: Regulatory Developments

In a Duane Morris Alert dated December 7, 2012, we addressed developments at the fall meeting of the National Association of Insurance Commissioners (NAIC) relating to principle-based reserves (PBR) and the draft White Paper on Captives and Special Purpose Vehicles (which are referred to in the White Paper as SPVs). March 2013 has brought further developments with respect to both subjects. Most notably, on March 14, the NAIC released the newest version of its White Paper, which to some extent, reflects further thinking on SPVs, and takes into account comments made on the earlier draft. In addition, the director of the Federal Insurance Office (FIO) recently stated that the FIO will study the use of SPVs by life insurers.

Principle-Based Reserve Implementation Task Force

In early March 2013, the NAIC introduced the Principle-Based Reserving Implementation (EX) Task Force (the PBR Task Force), with a two-fold mission: first, to serve as the coordinating body with all NAIC technical groups (e.g., Life Actuarial (A) Task Force) involved with projects related to the PBR initiative for life and health policies; and second, to further assess the solvency implications of life insurer-owned captive insurers and alternative mechanisms. The PBR Task Force was given particular responsibility to develop, maintain and oversee components of the Implementation Plan for PBR, and to create a legislative information package regarding PBR to assist states in drafting relevant legislation. The Implementation Plan contemplates the NAIC performing fiscal and operational analysis regarding implementation of PBR; developing an NAIC support and peer review system that will ensure effective and consistent implementation of the PBR framework; developing detailed charges to NAIC technical groups with respect to reporting, analysis, examination and statutory accounting standards; defining data to be collected; guiding and coordinating training for state insurance departments; and preparing accreditation-related recommendations.

In addition, the PBR Task Force is charged with reviewing the final recommendations of the Captives and Special Purpose Vehicle Use (E) Subgroup (the Captive Subgroup) in the context of the proposed PBR system, and to make further recommendations to the NAIC's Executive (EX) Committee.

The Revised White Paper on Captives and Special Purpose Vehicles

As we noted in our December 2012 Alert, the then-current draft of the white paper suggested that SPVs may constitute a "shadow insurance industry" similar to the type of shadow banking industry that contributed to the financial crisis. Commentators on the White Paper, including Duane Morris, took issue with that characterization as being needlessly inflammatory, and inconsistent with the substantial regulatory reporting requirements applicable to transactions using SPVs. Members of the Captive Subgroup involved in this project eliminated the reference to a shadow insurance industry. In addition, the revised White Paper reflects comments submitted by Duane Morris and others with respect to the White Paper's analysis of international treatment of SPVs. For example, in the comment paper that Duane Morris prepared, we suggested that the earlier draft of the White Paper had drawn unwarranted inferences from various guidance papers prepared by the International Association of Insurance Supervisors (IAIS), to the effect that any SPV owned by an insurer should be treated as the equivalent of a "commercial insurer or reinsurer" that takes on risk from the public. We pointed out that the IAIS guidance does not necessarily support the inference drawn by the drafters of the earlier White Paper.

The March 14 draft of the White Paper appears to take a somewhat more balanced approach to IAIS guidance, but it continues to implicitly equate SPVs that are used in financing the "redundant" XXX and AXXX reserves of life insurance companies with commercial insurers. We continue to differ with the Subgroup's views on this point. SPVs are not engaged in dealing with the "unrelated party policyholders or potential third-party beneficiaries," which the IAIS has identified as the basis for treating certain captives or SPVs as commercial insurers. The SPVs addressed by the White Paper are used as financing vehicles by commercial insurers, generally by taking on a carefully limited pool of risks. The SPV stands behind the sponsoring insurer, which is the entity to which the public looks to payment; it does not deal with unrelated party policyholders or third-party beneficiaries. Requiring fuller disclosure to regulators about the use of SPVs, and perhaps greater focus on how SPVs are funded, may be warranted. Simply concluding that SPVs used as financing vehicles for life insurers could be treated as commercial insurers can be viewed as missing the mark, however. As the White Paper acknowledges, there are a variety of uses for SPVs; taking a broadsword approach to SPVs may not be particularly helpful.

Overall, the revised White Paper is more clearly written, but as a matter of substance, it largely continues on the same track as the prior versions. For example, the new version continues to speak in terms of companies forming SPVs in order to "avoid statutory accounting" and continues to suggest that the adoption of PBR (or taking interim steps, such as adopting permitted accounting practices to alleviate the effects of the burdensome reserving requirements for certain term life or universal life products) will eliminate the use and need for SPVs. Although the White Paper makes a number of useful suggestions about disclosure to regulators of transactions using SPVs, and raises some issues about letters of credit and parental guarantees that merit further thought, many of the conclusions suggested by the White Paper are flawed in a number of ways. The Subgroup has opened the draft White Paper for comments until April 22, 2013.

FIO Task Force

In a related development, Michael McRaith, the director of the FIO, stated on March 13 that the FIO is looking into the use of SPVs to determine the national implications for the solvency of the life insurance industry of the use of SPVs to finance XXX and AXXX reserves. The FIO will create a task force under the Federal Advisory Commission on Insurance to be headed by the direction of William P. White, the Commissioner and agency head for the District of Columbia Department of Insurance, Banking and Securities, to study the issues raised by SPVs, with the possible goal of including its conclusions in the FIO's recommendations for improving insurance regulation. Members of the NAIC have raised issues about duplication of efforts, but Director McRaith noted that the federal authorities need to be fully informed about such issues. What may be considered the most positive aspect of the FIO task force is the fact that Commissioner White (to whom Duane Morris submitted our first comments on the earlier draft of the White Paper) has had many years of experience with captives, and is likely to bring a balanced perspective to the task force.

About Duane Morris

Duane Morris will review the newest draft of the White Paper, and will submit additional comments.

For Further Information

If you would like more information about the topics discussed in this Alert, please contact Hugh T. McCormick, Alice T. Kane, Carla C. Small, any of the members of our Corporate Practice Group, any of the members in our Insurance and Reinsurance Practice Group or the attorney in the firm with whom you are regularly in contact.