Changes To NAIC Reinsurance Collateral Requirements

Issue Discussed: Security

Submitted by Meghan L. Rhatigan

Date Promulgated: December 7, 2008

Issue Discussed: Summary of the National Association of Insurance Commissioners’ (“NAIC”) planned changes to the collateral funding requirements of alien reinsurers.

On December 7. 2008, the NAIC Plenary Committee adopted a new reinsurance regulatory framework that, when implemented, will significantly alter the collateral funding requirements for alien reinsurers. This brief summary will examine the existing regime, take a glimpse at several alternative frameworks that were proposed along the way and, finally, examine the proposal that ultimately was adopted by the NAIC Plenary Committee.

Current Regime

Until the recently adopted framework is implemented, the current regulatory regime, which is governed by the NAIC’s Credit for Reinsurance Model Law and Credit for Reinsurance Model Regulation, will remain in effect. Under this regime, in order for U.S. cedents to take financial statement credit for the reinsurance protection they purchase, any unlicensed or unaccredited alien reinsurers they contract with must put forward acceptable forms of collateral. The current regime requires these non-U.S. reinsurers to post collateral equal to 100% of the reinsurance obligations assumed. This requirement for “unauthorized” or “unaccredited” reinsurers does not take into account the financial strength of the foreign reinsurer or the regulatory environment of the country in which that reinsurer is domiciled. Over the last several years, this collateral requirement increasingly has been viewed as inequitable.

As a result of the growing dissatisfaction with the current regime, the NAIC decided to explore alternative forms of regulation. On March 5, 2006, the NAIC asked its Reinsurance Task Force to work on “develop[ing] alternatives to the current regulatory framework, including the use of collateral within the U.S. and abroad.” The directive suggested that the Task Force “[c]onsider approaches that account for a reinsurer’s financial strength regardless of domicile [and] variations in state law and regulation relative to reinsurance contracts, financial reporting, etc” (the “March Directive”).

Series Of Proposals

Since receiving the March Directive, the NAIC Reinsurance Task Force has drafted a series of proposals that suggested various alternatives to the current regulatory regime. Its first attempt culminated in the “NAIC Reinsurance Evaluation Office – Proposal to Grant Credit for Ceded Reinsurance” (the “REO Proposal”), which was presented in December 2006. The REO Proposal included the creation of a NAIC Reinsurance Evaluation Office, which would have evaluated the financial condition of domestic and foreign reinsurers (based primarily on ratings from national rating organizations, such as Moody’s and Standard & Poor’s), as well as the regulatory regime in the reinsurer’s home country and the reinsurer’s reputation for the payment of claims. Ultimately, each reinsurer would be assigned to one of six classes, REO-1 through REO-6. Those reinsurers placed in the highest class, REO-1, would not be required to post any collateral for doing business with U.S. cedents, while those placed in lower classes would be obligated to post collateral in 20% increments (i.e. REO-2 would post 20% collateral, while REO-6 would post 100%). The REO Proposal eliminated any distinctions between U.S. and non-U.S. reinsurers. As a result, it arguably disincentivized reinsurers from maintaining and/or obtaining a license to operate in the United States. After receiving numerous negative comments about the REO Proposal, the Task Force went back to the drawing board.

On September 7, 2007, the Task Force presented an amended proposal, the “Draft Proposal to Grant Recognition of Regulatory Equivalence to Non-U.S. Insurance Supervisors” (the “RSRD Proposal”), which retained benefits for U.S.-licensed reinsurers, while alleviating some of the burden to post collateral on non-U.S. reinsurers. For domestically licensed reinsurers, the proposal would have allowed the reinsurer to choose a state to serve as its “home state regulator.” As long as that reinsurer complied with its home state’s applicable laws and regulations, it would have been permitted to assume reinsurance business in all other states. Further, for alien reinsurers, the RSRD Proposal would have permitted them to be “certified” by a “point of entry state” that would allow the reinsurer to post less than 100% of its assumed liabilities in collateral if certain criteria were met.

Certification would have involved the cooperation of U.S. insurance regulators and the newly created NAIC Reinsurance Supervision Review Department (“RSRD”). A non-U.S. reinsurer could have become “certified” only if it was licensed in its domiciliary country, and the RSRD determined that the domiciliary country had a regulatory regime in place that was “functionally equivalent” to the United States’ framework. Regulatory “equivalence” would have been determined with an eye toward nine central principles, the application of which would have required, among other things, (1) an evaluation of the regulatory framework in the foreign jurisdiction and the outcomes that it produced, (2) a determination of whether U.S. insurance regulators could secure a cooperation agreement, such as a mutual recognition agreement, that would require the sharing of information about foreign reinsurers and cooperation with respect to the supervision and investigation of non-U.S. reinsurers, and (3) an assessment of whether U.S. regulators would be able to enforce U.S. laws against non-U.S. reinsurers, as stipulated in reinsurance agreements.

Assuming the “functional equivalence” test was met, the U.S. insurance regulator in the “point of entry state” would have then categorized the applicant reinsurer into one of five classes (Class 1 through Class 5). In addition to the regulatory regime in place in the home country, the categorization would have also taken into account the reinsurer’s financial strength, its claims payment history, market behavior, and other similar criteria. Under the RSRD Proposal, those reinsurers who received the highest financial ratings from organizations such as A.M. Best, Standard & Poor’s, Moody’s and Fitch, would have been placed in Class 1, while those with less stellar financial ratings would have been put in lower classes. Under this proposal, a Class 1 Reinsurer would have been rewarded for its sound financial status and could have reduced its collateral requirement to as little as 60%. Foreign reinsurers with lower financial ratings would have received less significant breaks in their collateral requirements, with Class 2 Reinsurers having to post 70% collateral; Class 3, 80%, and Class 4, 100%. The Class 5 designation would have been reserved for domestic reinsurers that had sub-par financial performance and correspondingly low financial ratings.

The RSRD Proposal stood in marked contrast to the REO Proposal. Unlike the REO Proposal, the RSRD Proposal maintained a significant advantage for U.S.-based reinsurers, requiring a U.S.-based reinsurer to post collateral only if it received a Class 5 rating, based on a poor financial rating. Furthermore, under the RSRD proposal, all non-U.S. reinsurers would have still been required to post at least 60% collateral, even if they were financially rated higher than their U.S.-licensed counterparts.

Reinsurance organizations across the globe submitted comments on the proposal. Like the REO Proposal, the RSRD Proposal was met with a flurry of criticism from a variety of sources. As expected, many non-U.S.-based organizations expressed negative views of the continued disparate treatment of U.S. versus non-U.S. reinsurers. Others criticized it for departing from the March Directive which sought alternatives that accounted for “a reinsurer’s financial strength regardless of domicile.” This backlash caused the Reinsurance Task Force to revisit its proposal once again.

The Adopted Proposal – The Modernization Framework

The proposal that finally won the approval of the NAIC Plenary Committee is called the Reinsurance Regulatory Modernization Framework (the “Modernization Framework”). It was drafted by NAIC Reinsurance Task Force and is essentially a hybrid of the REO and RSRD Proposals. In short, “[t]he proposal creates two new classes of reinsurers in the United States: U.S.-domiciled national reinsurers and non-U.S.-based port of entry (“POE”) reinsurers, and introduces modified collateral requirements for eligible reinsurers. The proposal also establishes a new framework for state-based reinsurance regulation based on the concepts of supervisory recognition, single-state licensure for U.S. reinsurers and single-state certification for non-U.S. reinsurers from approved jurisdictions.”

Like the RSRD Proposal, the Modernization Framework envisions the creation of a Reinsurance Supervision Review Department, or RSRD, which will be tasked with evaluating the reinsurance supervisory regimes of other countries and the creation of a list of jurisdictions eligible to be recognized by POE states. A reinsurer will not be able to become certified as a “POE reinsurer” unless the reinsurer is licensed by a non-U.S. jurisdiction that the RSRD has recommended as eligible for recognition. Similarly, the RSRD would evaluate the systems of reinsurance regulations in U.S. states, and only those reinsurers domiciled in RSRD-approved states would qualify as “national reinsurers”. A second major component of the RSRD’s responsibilities will be to develop criteria that will be used to determine which states can serve as home state and/or POE supervisors. These determinations would be made on the basis of the state’s resources, expertise, and experience in regulating reinsurance on a cross-border basis. The states that the RSRD deems qualified would act as the sole U.S. regulator for the reinsurers within their domain.

The home state and POE supervisors will be responsible for assigning reinsurers to one of five classes, and this class determination will ultimately determine how much collateral, if any, the reinsurer needs to post. Placement in a particular class will take into account factors such as the financial strength rating the reinsurer has received from entities such as A.M. Best, Moody’s, Standard & Poor’s and Fitch, as well as the reinsurer’s history of compliance with its reinsurance contractual terms and obligations, its business practices in dealing with ceding companies, its reputation for prompt payment of claims, and other similar attributes. The collateral requirements for reinsurers placed in each class are outlined in the table below.

Now that the Modernization Framework has been adopted by the Plenary Committee, the next hurdles the NAIC will face are the Framework’s implementation and execution. In the words of New Jersey Banking and Insurance Commissioner Steven M. Goldman, chair of the NAIC Reinsurance Task Force, “[t]his proposal sets forth a conceptual framework only…Now, we must focus on developing the specifics of this new regulatory regime and taking the appropriate legislative steps to make the proposal a reality.”

The NAIC has recommended that implementation take place through federal enabling legislation. During these challenging financial times, it remains to be seen how quickly U.S. Congresspersons will move on adopting any proposed legislation, especially that which contemplates reducing existing collateral requirements. In any event, implementation of any collateral changes are likely at least a couple of years off. Thus, although the vote taken by the NAIC Plenary Committee in early December represents an important step in effecting change in the U.S. reinsurance industry, its impact will, by no means, be felt immediately, and we will have to stay tuned to see how the implementation progresses.

*Meghan L. Rhatigan is an associate in the litigation department at the Boston law firm of Choate, Hall & Stewart LLP.