The Summer 2015 Meeting of the National Association of Insurance Commissioners (the "NAIC"), which concluded on August 18, saw further developments on issues that Duane Morris has been following. We previously reported on the controversy over confidentiality of the details of the reports required by the Own Risk and Solvency Assessment in our Alert issued on August 27, 2015. This Alert discusses the NAIC's "certified reinsurer" program, which allows certain foreign reinsurers to benefit from reduced reinsurance collateral requirements, and other international initiatives.

Reinsurance Collateral Issues

Under state insurance laws, domestic insurers are allowed to take credit for reinsurance on their statutory financial statements only if their reinsurers meet certain requirements, such as being licensed or accredited in the ceding companies' states of domicile. When, however, reinsurance is placed with reinsurers that do not meet those requirements, which includes most reinsurers that are based outside of the United States, those reinsurers are generally required to post collateral in order to secure their obligations to their ceding insurers. For many years, foreign regulators and (re)insurers have argued that these collateral requirements impose costs and restrictions on foreign reinsurers that are not imposed on many or most U.S.-based reinsurers—and similar requirements are generally not imposed on U.S.-based reinsurers doing business in foreign jurisdictions. Thus, these requirements have been viewed as being anti-competitive and protectionist.

Over time, members of the U.S. reinsurance industry and regulators who were involved in international regulatory matters became increasingly concerned that state-law collateral requirements would lead other countries to take retaliatory action against U.S. reinsurers. As a result of work by the industry and those state regulators, in 2011 the NAIC implemented a program that would allow reinsurers that are domiciled in countries that meet the requirements of the program to become "certified reinsurers," and thus, assuming other criteria are met, to benefit from reduced collateral requirements.

The certified reinsurer program has gathered momentum since its inception, as a significant number of states have already amended their laws and regulations to implement the program, and more are anticipated to act in the near future. There is, however, an element of time sensitivity: Will the actions of the states occur quickly enough to forestall retaliatory actions by the European Union? If not, U.S.-based reinsurers could face restricted access to EU markets, or be required to meet Solvency II standards. The latter would occur if the EU does not view the U.S. state-based regulatory system as being the equivalent of the regulatory system under Solvency II—of which the collateral issue would be one factor. This issue is coming to a head with the January 2016 effective date of Solvency II.

Many question whether the NAIC's certified reinsurer program will move with enough speed and uniformity to avoid retaliatory actions by the EU. A potentially more expeditious approach might be the entry into one or more "covered agreements" regarding reinsurance collateral with the EU and/or other foreign jurisdictions. A covered agreement would be negotiated by the Federal Insurance Office (the "FIO") and the United States Trade Representative (the "USTR"), with congressional oversight. The virtue of a covered agreement in this context is that it can preempt a state law when that law gives less favorable treatment to an insurer domiciled in a foreign jurisdiction that is a party to the covered agreement than the law would give a domestic insurer. In other words, the collateral issue can be resolved without having to wait for actions by the various states. Representatives of the U.S. reinsurance industry are generally of the view that a covered agreement with the EU is the best way to avoid retaliation issues.

Background

Under the pre-2012 versions of the NAIC Credit for Reinsurance Model Law (Model number 785) and Credit for Reinsurance Model Regulation (Model number 786) (the "Credit for Reinsurance Models"), domestic insurers were allowed to take credit for reinsurance on their regulatory financial statements, by establishing an asset or reducing liabilities, only if the assuming reinsurer met certain criteria, including: being licensed or accredited in the ceding company's state of domicile; being domiciled in a state (or being a branch of a foreign insurer entered through a state) that maintains standards regarding credit for reinsurance substantially similar to the Credit for Reinsurance Models, maintaining surplus to policyholders of not less than $20,000,000 and submitting to the authority of the state of the ceding insurer to examine the reinsurer's books and records; maintaining trust funds in the United States equal to a foreign reinsurer's liabilities to ceding insurers, plus trusteed surplus of $20,000,000 (with special provisions for Lloyd's syndicates); or providing reinsurance that is required by law.

When a reinsurer (domestic or foreign) did not meet one of the criteria above, a domestic ceding insurer could take credit for reinsurance on its statutory financial statements only to the extent assets were held as security, or collateral, for the performance by the reinsurer of its obligations under the reinsurance agreement. Under both previous and current versions of the Credit for Reinsurance Models, the security may consist of: assets held by or on behalf of the ceding insurer, as under a modified coinsurance or funds-withheld reinsurance arrangement; assets held in trust; or qualifying letters of credit. The security must be held in the United States and be subject to withdrawal by, and under the exclusive control of, the ceding insurer. For trusts, the assets must meet certain criteria, and the trustee is required to be a qualified U.S. financial institution. Letters of credit are required to be issued or confirmed by a qualified U.S. financial institution.

These credit for reinsurance provisions have been controversial for a number of years, since European and other non-U.S. reinsurers are generally required to post collateral. In contrast, domestic reinsurers can avoid collateral requirements by being licensed or accredited in the states of their ceding insurers. Moreover, subject to some exceptions, collateral requirements are not imposed on U.S.-based reinsurers by European or most other jurisdictions. As a result of this regulatory inequality, many foreign governments and reinsurers were of the view that although their markets were open to United States-based reinsurers, the costly collateral requirements, which were not imposed on most U.S.-based reinsurers, were anti-competitive. After years of discussions between the NAIC and regulators from the EU and other jurisdictions, in 2008, the NAIC adopted a "Reinsurance Regulatory Modernization Framework Proposal" that addressed reinsurance collateral issues; it included, among other reforms, a proposal for a federal statute that would both "preserve state-based regulation of reinsurance on a cross-border basis [and] promote uniformity of regulation throughout the NAIC member jurisdictions." Following the Framework Proposal, some states acted on their own to reduce reinsurance collateral requirements. Although the Framework Proposal as such did not proceed, it, and the actions of the individual states, led the NAIC's Reinsurance Take Force and Financial Condition (E) Committee to amend the Credit for Reinsurance Models to address the collateral issue. In addition, the United States Congress enacted the Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub.L. 111–203, which was signed by President Obama on July 21, 2010 (commonly referred to as "Dodd-Frank"). As a result of these activities, two related movements have developed.

Certified Reinsurers

The first movement is the NAIC's "certified reinsurer" program, pursuant to which reinsurers can benefit from reduced collateral requirements. According to the NAIC:

Recognizing the potential for variation in collateral requirements across states makes planning for collateral liability more uncertain and thus potentially more expensive, state regulators have been working together through the NAIC to reduce collateral requirements in a consistent manner commensurate with the financial strength of the reinsurer and the quality of the regulatory regime that oversees it. The NAIC passed amendments to the NAIC Credit for Reinsurance Model Law (#785) and Credit for Reinsurance Model Regulation (#786) (Credit for Reinsurance Models) in 2011. Once implemented by a state, the amendments will allow foreign reinsurers to post significantly less than 100% collateral for U.S. claims, provided the reinsurer is evaluated and certified. Individual reinsurers are certified based on criteria that include, but are not limited to, financial strength, timely claims payment history, and the requirement a reinsurer be domiciled and licensed in a qualified jurisdiction.

In order to become certified for this purpose, a reinsurer must be domiciled in a "qualified jurisdiction." A foreign country can attain this status if it applies to the NAIC, and after a thorough review of the "appropriateness and effectiveness" of the country's insurance regulatory system, both initially and on an ongoing basis, and taking into account the "rights, benefits and the extent of reciprocal recognition afforded by the non-U.S. jurisdiction to reinsurers licensed and domiciled in the U.S.," the jurisdiction is placed on a list maintained by the NAIC. To date, Bermuda, France, Germany, Ireland, Japan, Switzerland and the United Kingdom have achieved qualified jurisdiction status.

A reinsurer domiciled in a qualified jurisdiction may then become "accredited" if it meets certain criteria set out in the Credit for Reinsurance Models, and, in addition, has acceptable ratings from two or more recognized rating agencies. A reinsurer will be assigned a rating, ranging from Secure -1 to Vulnerable - 6 depending on the ratings from the agencies, and the reduction of collateral will be determined by that rating. Under the Credit for Reinsurance Models, the security required for a reinsurer with a Secure -1 rating is 0, increasing in steps—10%, 20%, 50%, 75%—to 100% for a reinsurer with a Vulnerable - 6 rating. Accreditation is done on a state-by-state basis, although the NAIC has also established a peer review system that provides foreign reinsurers an opportunity for a "passport" throughout the United States. The NAIC's Reinsurance Financial Analysis (E) Working Group (known as "RFAWG") has been assigned the task of "facilitat[ing] passporting of certified reinsurers and address[ing] issues of uniformity among the states with respect to the certification and assignment of collateral levels by the states."

As of August 1, 2015, 32 states have passed legislation, representing more than 66 percent of direct U.S. premium, to implement the revised NAIC Credit for Reinsurance Models and an additional five states have indicated their plans to do so in the near future, which would raise the total market coverage to 93 percent. As of August 1, 2015, 26 foreign reinsurers have been certified under this peer review system.

Covered Agreements

The second movement is a product of "The Federal Insurance Office Act of 2010," which is part of Title V of Dodd-Frank. The newly created FIO, a part of the United States Department of the Treasury, has among other powers and responsibilities, the authority—subject to congressional oversight—to enter into "covered agreements" with foreign jurisdictions regarding specified insurance and reinsurance matters. As noted above, the significance of covered agreements is that they can preempt state laws that are inconsistent with those agreements.

A covered agreement is a specific type of international agreement defined by the FIO as:

written bilateral or multilateral agreement regarding prudential measures with respect to the business of insurance or reinsurance that is entered into between the United States and one or more foreign governments, authorities, or regulatory entities and relates to recognition of prudential measures with respect to the business of insurance or reinsurance that achieves a level of protection for insurance or reinsurance consumers that is "substantially equivalent" to the level of protection achieved under State insurance or reinsurance regulation.

Covered agreements are to be negotiated jointly by the FIO and the USTR with foreign authorities. These agreements must provide consumer protections substantially equivalent to those under state law. To be substantially equivalent, the outcome of the agreement must provide at least the same level of consumer protections as those contained in state laws and regulations. Further, prior to initiating negotiations, during the negotiations and before entering into a covered agreement, the Secretary of the Treasury and the USTR must jointly consult with the House Financial Services Committee, the House Committee on Ways and Means, the Senate Finance Committee and the Senate Banking Committee. A covered agreement can enter into force only when the FIO and the USTR jointly submit the proposed covered agreement to the committees listed above. There is a layover period of 90 days specified in the law.

A state insurance measure (such as local versions of the Credit for Reinsurance Models) can be preempted if the FIO Director determines that:

1) The measure results in less favorable treatment of a non-U.S. insurer domiciled in a foreign jurisdiction that is subject to a covered agreement, than a U.S. insurer domiciled, licensed, or admitted to do business in that state; and 2) the measure is inconsistent with a covered agreement. FIO must follow procedures laid out in the Dodd-Frank Act to use the preemption authority.

Notwithstanding the NAIC's activities on reinsurance collateral, international regulators and other participants in the insurance/reinsurance industry have expressed a substantial interest in a covered agreement solution. In an appearance before the Subcommittee on Housing and Insurance of the House Financial Services Committee (the "House Subcommittee") on November 18, 2014, the Director of the FIO, Michael McRaith, described the EU and U.S. Insurance Project, which is designed to "promote cooperation between insurance regulators," and stated that: "A central issue being addressed by the Project is that of a covered agreement for reinsurance and reinsurance collateral requirements." In addition, group supervision and confidentiality/professional secrecy were identified as other subjects for covered agreements.

A key U.S. trade group, the Reinsurance Association of America (the "RAA"), has advocated covered agreements not only between the United States and the EU, but also with other major reinsurance trading partners, such as Japan, Switzerland, Bermuda and Australia. In written testimony to the House Subcommittee on February 4, 2014, the President of the RAA stated that although the organization and its members support the recent revisions to the Credit for Reinsurance Models regarding certified reinsurers, and the organization has "worked vigorously" to secure their adoption by the states, "it is clear that it will take many years for these changes to be adopted by all of the states." The RAA statement noted that changes to the Models are not an accreditation standard; thus, individual states are not bound to adopt the Models. Moreover, under the Models, individual states will, based on the NAIC's list of qualified jurisdictions, make a determination of the equivalence of each country's reinsurance regulation to the regulation in the state making the determination. The RAA's conclusion was that "covered agreements, based on federal statutory and constitutional authority, between the U.S. and countries or governmental bodies representing major (re)insurance trading partners provide the preferred approach for addressing the basis of regulatory equivalence and appropriate regulatory security." Representatives for Lloyd's of London echoed at least one of the RAA's concerns in a letter to the NAIC dated July 22, 2015, pointing out that by not making adoption of the Credit for Reinsurance Models an accreditation standard, there is a continuing risk of delay and variance between state laws.

As Director McRaith's statement about the EU and U.S. Insurance Project pointed out, there appears to be equally strong interest in the EU in one or more covered agreements. On April 21, 2015, the European Council issued a mandate to the European Commission to negotiate an agreement with the United States on reinsurance. "An agreement with the US will greatly facilitate trade in reinsurance and related activities," said Janis Reirs, minister for finance of Latvia and president of the European Council. "It will enable us for instance to recognise each other's prudential rules and help supervisors exchange information." International trade groups, such as the Global Reinsurance Forum, which represents reinsurers from the U.S., the EU, Switzerland, Japan and Bermuda, have also voiced support for the covered agreement approach.

The NAIC fundamentally disagrees with the views of the FIO, the EU and many in the insurance and reinsurance industry on covered agreements. At a hearing of the House Subcommittee held on April 29, 2015, Florida Insurance Commissioner and past NAIC President Kevin McCarty noted the actions of the states in adopting the Credit for Reinsurance Models (discussed above), and stated: "In spite of extensive state responsiveness and action, the Treasury Department has expressed an interest in initiating discussions with the European Union on a preemptive 'covered agreement' regarding reinsurance collateral." He added: "The NAIC is not convinced that a preemptive covered agreement, relating only to the issue of reinsurance collateral, is necessary given our clear and continuing progress on this issue" and "we believe preemption of state law by federal agencies should always be a last resort." The substance and intensity of Commissioner McCarty's remarks was reiterated many times in the course of the NAIC Summer Meeting. More recently, in a press release on August 28, 2015, John Huff, the Director of the Missouri Department of Insurance, and President-elect of the NAIC, noted that "A covered agreement that preempts the states could only be justified if there was no progress on the question of reinsurance collateral, but states have made dramatic progress in this area." Director Huff also pointed out that while many have a concern over the issue of "equivalency" under Solvency II, "it will take as long as 16 years [for Solvency II] to be entirely phased in." He pointedly observed: "There are very strong consumer protections in the Dodd-Frank Act related to potential preemption. These statutory provisions will be utilized by state regulators to ensure that U.S. consumers remain protected by state laws and any discussions on further collateral reduction should be conducted responsibly and constructively."

What Is at Stake?

Preservation of the state-based insurance regulatory system is one of the core principles of the NAIC. Thus, the NAIC appears to face an existential issue. Representatives of the NAIC contend that the long history of state regulation of insurance, with its focus on consumer protection, led to the success of the domestic industry in weathering the 2008 financial crisis, and that the NAIC and the domestic industry are well-positioned for the future. The NAIC sees the FIO (as well as the Federal Reserve and other agencies) as encroaching on its role as the primary regulator of the U.S. insurance industry. The reinsurance collateral/covered agreement issue can be seen as a battle to preserve that role; if this battle is lost, what is next? Federal regulation of insurer solvency? On the other hand, will the state-based regulatory system meet the EU's equivalency standard without federal involvement?

If you have any questions about this Alert, please contact Hugh T. McCormick, Alice T. Kane, Cameron F. MacRae III, any member of our Insurance - Corporate and Regulatory Practice Group or the attorney in the firm with whom you are regularly in contact.

Disclaimer: This Alert has been prepared and published for informational purposes only and is not offered, nor should be construed, as legal advice. For more information, please see the firm's full disclaimer.