Rector Report on reforming reserve financing transactions: much work remains – 6 developments

by DLA Piper
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On June 30, 2014, the NAIC Principle-Based Reserving Implementation (EX) Task Force (PBR Task Force) held a conference call to discuss comments to the modified recommendations to the report issued by Rector & Associates, Inc. regarding reserve financing transactions (the Rector Report). One thing is clear - the original July 1, 2014 implementation deadline will not apply.

Based on the comment letters received by the PBR Task Force to the original Rector Report, modified recommendations to the Rector Report were issued on June 4, 2014.

The PBR Task Force voted to adopt the XXX/AXXX Reinsurance Framework, with New York and California voting against the adoption. Various NAIC tasks forces and working groups, such as the Life Actuarial (A) Task Force (LATF), Blanks (E) Working Group and the Executive Committee, are now assigned to develop the technical and actuarial details. 

As indicated by the vote, there is no consensus among the state regulators to support the Rector Report modified recommendations and the Framework. The industry appears just as divided. Life insurers and reinsurers that have written or reinsured term life insurance or universal life insurance with secondary guarantees should pay particular attention to the activities in the task forces and working groups. Although the Framework is unlikely to be approved without substantial modifications, if enacted as currently proposed it would have significant and likely unintended consequences. At this point, rapid implementation seems unlikely.

We have identified the following six developments in this process. 

  1. The July 1, 2014 initial implementation date is not feasible.  The Rector Report offered a nine-point framework1 with the first implementation date being July 1, 2014, for newly created financing structures.  Superintendent Torti III stated that the July 1 implementation date was no longer feasible on the June 13, 2014 PBR Task Force call; however, Rector continued to advocate for state regulators to voluntarily review applicable financing transactions under the Rector Report Framework starting on that date.

  2. The Rector Report recommendation abandoned the hazardous financial condition concept.  The original Rector Report suggested that, under the new proposals, if a ceding insurer reinsured business subject to Regulation XXX or AG38 subject to the proposal in a manner that did not comply with the new requirements, it will be presumed to be in a financially hazardous condition within the meaning of NAIC’s Model Regulation to Define Standards and Commissioner’s Authority for Companies Deemed to Be in Hazardous Financial Condition (Model 385). This designation would provide insurance regulators with the authority to take corrective actions, such as reduce the total amount of present/potential liability for policy benefits by reinsurance; reduce, suspend or limit the volume of business being accepted or renewed; or increase the insurer’s capital and surplus.  This approach was subsequently debated as some regulators argued that imposing this label on insurers would be too extreme and would have drastic consequences.  Additionally, this approach was identified, most notably by the ACLI, as potentially being preempted under the Dodd-Frank Wall Street Reform and Consumer Protection Act.

  3. Early implementation through the AOMR.  The modified recommendations of the Rector Report adopted the ACLI’s alternative proposal to use the NAIC’s Actuarial Opinion and Memorandum Regulation (the AOMR) as the “carrying rule.” The AOMR approach would establish a provision requiring that on or after a specified date, an insurance company’s appointed actuary must have concluded an examination to determine whether the company’s primary assets meet the requirements of the actuarial method and, if they do, requiring the appointed actuary to provide an unqualified actuarial opinion regarding the insurance company. If the appointed actuary determines that the company’s primary assets do not meet the requirements of the actuarial method, the actuary would be required to either (1) recommend rectifying the problem by reducing credit for reinsurance or (2) submit a qualified opinion.  This recommendation is notably broad, in that an actuary could not issue a clean opinion if any company within the holding company system has a reserve financing transaction that does not comply with the actuarial method.

    The American Academy of Actuaries (AAA) commented that the organization does not support some of the actuarial-based recommendations included in the modified recommendations, including the use of AOMR to implement the recommendations and the use of a potentially modified VM-20.  The AAA stated, the “AOMR is designed to ensure the overall adequacy of an insurer’s reserves based on asset adequacy analysis and is not designed or intended to implement reinsurance specific requirements.”  Additionally, the AAA raised concerns over language in the Framework allowing LATF to modify any of the VM-20 requirements as appropriate to implement the modified recommendations and the open question of whether the “net premium reserve” should be included in the VM-20 calculation used to determine the “Primary Security Requirement” (the recommended types of assets the ceding insurer would need to receive as collateral in at least the amount determined pursuant to the Actuarial Method).  The AAA argued that these concepts were developed for entirely different purposes (e.g., PBR reform).

  4. Recourse transactions identified as an issue. Raising a new issue, the modified recommendation proposed that the NAIC evaluate the risk-transfer rules applicable to reserve financing transactions pertaining to XXX/AXXX business to make sure they appropriately apply to situations where parental or affiliate guarantees are used to keep insurance risk within the holding company system even if the reinsurance arrangement involves an unrelated third party.

  5. RBC asset charge.  The modified recommendations include a proposal that the RBC instructions are amended to ensure at least one party to the reserve financing transaction holds and appropriate RBC “cushion” and that the Capital Adequacy Task Force determine an appropriate RBC asset charge relative to “Other Security.”  The recommendation is proposed to become effective as of December 31, 2015, but we note that both the AAA and ACLI comment letters severely question this approach and its consistency with existing risk-based capital regulation.
     
  6. Public disclosure.  The modified recommendation proposed that the NAIC require public disclosure of key information pertaining to reserve financial transactions. This supplemental filing, developed by the Blanks (E) Working Group, is recommended to be effective for filings as of December 31, 2014.

The AOMR approach may include traditional reinsurance arrangements

The AOMR approach to implement the modified recommendations includes language that raises questions regarding the possible impact of the Rector Report recommendations on traditional reinsurance programs.  Exhibit 3 of the modified recommendations to the Rector Report, regarding Actuarial Guidelines, may impact traditional reinsurance arrangements by forcing ceding companies who have coinsurance or YRT reinsurance programs placed with traditional licensed or accredited reinsurers that utilize certain permitted accounting practices or certain RBC impairments to either reduce credit for reinsurance or face an additional RBC charge.

To avoid this result, ceding insurers (as well as traditional assuming reinsurers) would likely want to review future reinsurance contracts subject to the proposed AOMR to determine whether the ceding insurer would have contractual rights to require the assuming reinsurer to post additional collateral.  Interestingly, the proposed AOMR would not apply this result to certified, as opposed to licensed or accredited, reinsurers.

Conclusion

There is a lot more work to be done for the Framework to be implemented, especially by year’s end (and one might question which year).  In our experience, initiatives like this typically take the NAIC years, and not months, to complete. Valid comments on the Framework that had been raised prior to the June 30 call were not addressed at all, and the technical and actuarial issues will need to be hammered out on the task force and working group levels. 

At the same time, life insurers and reinsurers that have written or reinsured term life insurance or universal life insurance with secondary guarantees should pay particular attention to the activities in the task forces and working groups. We expect that the specter of potential federal regulation of the insurance industry, as well as several zealous regulator and industry advocates, will continue to drive this process forward. There is always the possibility of prompt action, and if action is prompt, it may not be measured.


1 (1)The ceding insurance company should only get credit for reinsurance if it retains (on a funds withheld or trust basis) “Primary Assets” in an amount approximately equal to what the statutory reserve would be under PBR. (2) The remainder of the credit for reinsurance may be supported by any assets approved by regulators for both the ceding insurance company and the assuming insurer, subject to certain regulatory protections and oversight. (3) Full risk-based capital (RBC) calculations using traditional NAIC methodology should be performed by at least one party to the financing transaction. (4) Key information about the use of financing transactions and assets supporting such transactions should be publicly disclosed. (5) Ceding insurance companies and their auditors should determine compliance with the requirements of the framework on an annual basis. (6) All reinsurance involving Triple X and AXXX reserves is within the initial scope of the framework; however, exemptions are provided for most traditional reinsurance arrangements (including for arrangements with reinsurers that follow NAIC accounting and RBC rules). (7) The concept of “financing” the reserves at the ceding insurance company level (without the use of reinsurance) is theoretically viable, but more work remains before recommendations can be made as to how to implement the concept. (8) The proposed effective dates for the new requirements. (9) A new “[Triple X] and AXXX Model Reinsurance Regulation” should be an accreditation standard to “codify” the requirements of the framework.

 

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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