Report of the NAIC Interested Persons

 

In June 2006, the Interested Persons (IPs)[1] submitted a comprehensive report to the NAIC Reinsurance Task Force (RTF) which contained, among other matters, Core Principles and Standards, an outline of potential new regulatory structures, a list of potential incremental approaches to collateral reduction along with pros and cons to each and an analysis of the impact of The Hague Convention on the recognition and enforcement of US judgments abroad.

Because there are a number of new regulators on the RTF since that report was delivered and because the RTF is tasked with two charges for which the June 2006 report is relevant, the IPs have extracted excerpts of that report in this brief overview.

 

I. CORE PRINCIPLES AND STANDARDS

The following Core Principles and Standards were submitted to the NAIC Reinsurance Task Force in the Interested Persons’ Report dated June 2, 2006. They reflect the core principles and standards of some of the Interested Persons (IPs), while others submitted a modified version.

CORE PRINCIPLES AND STANDARDS for an Alternative US Reinsurance Regulatory Framework

Submitted by the Interested Persons to the NAIC Reinsurance Task Force

June 2, 2006

1. Single Regulator for Reinsurance — The complexity and global nature of the reinsurance market requires that the direct and indirect supervision of reinsurance be regulated in a manner so that no reinsurer or reinsurance transaction is regulated by more than one regulator in the US.

2. Solvency of Cedents – Any alternative system should maintain strong standards to protect the solvency of US ceding insurers.

3. Pre-emption and Enforcement Authority — A reinsurance framework should identify the applicable jurisdiction and controlling regulator for the relevant reinsurance market, to ensure consistent application of reinsurance regulatory requirements. There must be pre-emption and enforcement authority at a central point to ensure that the authority of the single regulator is given effect.

4. Consistent Application of Rules – A reinsurance regulatory framework should provide rules that can be applied uniformly and in a consistent manner. Reinsurance rules, when applied to similarly situated market participants, should produce comparable results.

5. Efficiency and Effectiveness – A reinsurance regulatory framework should promote efficiency and effectiveness.

6. Assessing Financial Strength of Reinsurers — There should be a mechanism to efficiently and effectively assess the financial strength of reinsurers, whether those reinsurers are domiciled in the US or abroad.

7. Regulatory Equivalence — The system must provide for recognition of substantially equivalent regulatory standards and enforcement across competent regulatory jurisdictions.

8. Balance — Any system must reach a proper balance between “goals” that are in tension:

a. Solvency Protection – Having a regulatory structure in the reinsurance business environment that is focused on assuring the solvency of reinsurers is appropriate. Overemphasis on this goal can result in a business environment that is so rigid that it forces out competent competitors (e.g., regulatory burdens make it costly that the capital can be deployed more effectively in other endeavors.

b. Access to capital – The regulatory environment should provide sufficient flexibility so that reinsurers can attract capital from all reasonable sources. Conversely, the regulatory structure cannot be so lax as to permit entry by competitors that will not have the capacity and capabilities for sustained, successful business operations over the long periods required of reinsurers.

9. Principles-Based Regulation – The system should be based on the concept of principles as opposed to rules-based regulation.

10. Global Capital and Risk Management — A supervisory framework that supports global capital and risk management, taking into account capital adequacy, assessment of internal controls and effective corporate governance. Implicit in this principle is the recognition of qualifying economic capital models, including a move toward implementation of a system that encompasses this approach in the US.

11. Evaluation of Assets and Liabilities on an Integrated Basis — Evaluation of assets and liabilities should be carried out on an integrated basis when assessing the impact of risk factors on a firm’s available and required economic capital.

12. Assessment of Risk – A reinsurance regulatory framework should not only take credit risk into account, but should also address all risks.

13. Assessing Risks on an Aggregate Basis — Risks should be assessed on an aggregated basis, taking into account the relationships (correlations) between them, as opposed to assessing each risk on a stand-alone basis.

14. Promote Sound, Competitive and Open Market – A new system should promote a sound competitive and open insurance and reinsurance marketplace which avoids market distortions.

15. Claims Payment – Timely claims payment is a fundamental goal and an improved system should assess claims paying ability, including the enforcement of US judgments, as well as the reinsurer’s willingness to abide by its contractual obligations.

16. Access to Financial Information — Supervisors should have access to all financial information and must recognize that some such information may be proprietary and must remain confidential.

17. Financial Statement Transparency – Appropriate reporting and disclosure of the reinsurer’s financial condition including information encompassing risk management and risk assessment practices.

15. Preserve Insurer Choice – The system should preserve the ability of US cedents to access reinsurance capacity by choosing to do business with either US or non-US reinsurers. It should preserve the rights of cedents and reinsurers to negotiate terms and conditions of contracts, including collateral where it might not otherwise be required.

16. Applicability to all Participants and Transactions – A reinsurance regulatory framework should address captives, pooling arrangements, fronting and intercompany reinsurance agreements.

18. Transition – There should be an effective transition mechanism between the current system and any medium term approach that is consistent with the core principles. Absent mutual agreement of the parties, any reduction in collateral requirements will only apply prospectively.

II. REGULATORY FRAMEWORKS

The participants reviewed potential regulatory frameworks in light of these core principles. That review included the following structures:

• Expansion of the Risk Retention Act to include reinsurance

• Optional Federal Charter (OFC)

• Federal regulation other than OFC (a “federal vetting system”)

• Single state regulator (through federal law with a federal oversight function or through interstate compact)

• Self-regulation

Ultimately, the IPs focused on the following three potential structures as being most responsive to the core principles:

• Single State Regulator (through federal law and with a federal oversight function)

• National Vetting Agency

• Optional Federal Charter

A summary of those structures, as submitted in June 2006, are outlined below:

SINGLE STATE REGULATOR

The following structure is modeled, in part, on the current European Union structure. It incorporates the concept of “single state” regulation with a Federal oversight function. This provides for a single point for establishment of laws and regulations governing the reinsurance industry coupled with state regulation of the reinsurance transaction. It retains the expertise of state regulators while ensuring uniformity.

The proposal contemplates establishment of a certification mechanism so that those states that have the resources, expertise and experience to regulate reinsurance can do so as a “home state regulator” which will have complete jurisdiction over its domestic reinsurers. Reinsurers supervised by certified home states would be able to provide reinsurance nationwide and ceding companies would be allowed to take credit for such reinsurance. The proposal also contemplates the creation of a mediation system to resolve disputes among insurance regulators regarding reinsurance issues.. And, it incorporates an enforcement mechanism to ensure that both “home states” and “host states” regulate in accordance with established laws, regulations and standards.

National Reinsurance Commission

The National Reinsurance Commission (NRC) is created as an agency of Treasury, governed by the National Reinsurance Commissioner which shall be a Presidential appointment with Senate confirmation. The Commissioner shall have a term of 5 years. The duties of the NRC shall include:

• Propose new laws and regulations governing reinsurance regulation;

• Certify state insurance departments as qualified home state reinsurance regulators pursuant to established standards;

• Oversight of state insurance departments to ensure that both home states and host states are regulating in accordance with established laws, regulations and standards and corresponding enforcement mechanisms for failure to do so;

• Establish a complaint and dispute resolution process to resolve differences between interested persons and entities, which may include a mediation process to resolve issues among state insurance departments;

• Negotiate mutual recognition agreements with non-U.S. regulators pursuant to established standards; and

• Promote regulatory and market practices and procedures that result in global financial efficiencies while maintaining the security and soundness of the U.S. marketplace.

Legislative Framework

The laws establishing both the structure and the substance of reinsurance regulation would be set out in the enabling legislation with a traditional authorization to enact rules consistent with the legislation. Federal legislation would pre-empt inconsistent state statutes and regulations including the ability of a state insurance department to refuse credit for reinsurance to a ceding insurer utilizing a qualified reinsurer or from imposing contractual or other requirements upon that reinsurer other than those permitted by Federal law or regulation.

Single U.S. Passport System

Reinsurers would have a choice as to which certified state would act as their home state regulator and as long as the reinsurer complies with applicable laws and regulations of the home state, it can automatically do business in all other states (host states). Cross border business of reinsurers domiciled in jurisdictions outside the U.S. would be effected through a port of entry of a certified home state regulator pursuant to mutual recognition agreements negotiated by the NRC.

NATIONAL VETTING AGENCY

The National Vetting Agency proposal is, for the most part, an extension of the Single State Regulator proposal. It adds a federal oversight entity (the US Reinsurance Agency) to qualify or certify (“vet) assuming insurers and/or jurisdictions’ reinsurance regulation.

US Reinsurance Agency

A new federal law would create a new agency in the US Treasury Department charged with three types of responsibilities related to reinsurance:

• Certify US state insurance departments as qualified home state regulators pursuant to standards that the law establishes;

• Certify non-US jurisdictions as “competent,” pursuant to the same standards; and

• License reinsurers and insurers to conduct a reinsurance business nationally, also pursuant to standards established in the law.

An insurer wishing to assume reinsurance could choose any one of those ways to operate in the US, under uniform national regulation.

The US Reinsurance Agency would have responsibilities to:

• propose national laws and regulations governing reinsurance;

• establish minimum standards and capabilities necessary for a jurisdiction to be certified as a reinsurance regulator,

• certify jurisdictions as being qualified reinsurance regulators,

• elaborate and maintain standards for determining if an assuming insurer is qualified to be licensed to conduct a reinsurance business nationally;

• manage a complaint and dispute resolution process,

• negotiate mutual recognition with non-U.S. jurisdictions, and

• promote an efficient reinsurance regulatory environment.

Legislative Framework

The laws establishing both the structure and the substance of reinsurance regulation would be set out in the legislation to a large extent. Federal legislation would pre-empt the ability of a state insurance department to refuse credit for reinsurance to a ceding insurer utilizing a qualified reinsurer or from imposing contractual or other requirements upon that reinsurer other than those permitted by Federal law or regulation.

OPTIONAL FEDERAL CHARTER

This option would permit insurers assuming reinsurance to become federally chartered. It would also permit state-chartered insurers to become federally licensed to assume reinsurance. Insurers assuming reinsurance with a federal charter or a federal license would operate pursuant to federal standards. State supervision of federally chartered or federally licensed assuming insurers would be preempted. The federal reinsurance commissioner would be authorized to promulgate rules, directed to give due consideration to the public interest in providing secure and sufficient reinsurance capacity in the US and to the need for promoting effective and fair competition, and charged with promoting the international competitiveness of US reinsurers.

National Reinsurance Office

The National Reinsurance Office and the position of Commissioner of Reinsurance would be created within the US Department of Treasury. The Office and the Commissioner’s powers would be patterned after the Office of Thrift Supervision and its Director. The Commissioner’s position would be a Presidential appointment with a five-year term. The Office would be funded with assessments on federally chartered and federally licensed assuming insurers. The Commissioner’s duties would include:

• Regulating charter conversions;

• Establishing licensing, accounting, auditing, and corporate governance standards;

• Examining federally chartered and federally licensed assuming insurers for solvency;

• Approving the establishment of a self-regulatory organization;

• Negotiating mutual recognition agreements with non-US supervisors; and

• Assuring fair and effective competition.

Legislative Framework

The law establishing the new framework would preempt the authority of a state insurance department to:

• Refuse credit for reinsurance to an insurer ceding to a federally chartered or federally licensed insurer;

• Impose contractual or other requirements on reinsurance agreements with federally chartered or federally licensed assuming insurers; or

• Examine the solvency of a federally chartered assuming insurer.

The law would also prohibit states from discriminating against federally charted insurers, federally licensed insurers, or any parties to reinsurance agreements with them.

III. INCREMENTAL APPROACHES TO COLLATERAL REDUCTION

In their June 2006 report, the IPs also looked at potential incremental collateral reduction efforts. Generally, incremental steps are opposed by most IPs for various reasons as set forth in the June 2006 report. Because the following is relevant to the charges before the Reinsurance Task Force, we have provided excerpts from the June 2006 report addressing the rating of reinsurers based on either a regulatory or rating agency determination of financial strength and affiliate transactions.

Weighted Financial Strength Rating Based on Rating Agency Designation

This approach would recognize the financial strength of reinsurers based on a sliding scale of collateral ( between 50 and 100 percent) using the financial strength ratings of the reinsurer as determined by rating agencies.

Pro —

• The financial strength of each reinsurer would be analyzed (e.g., risk-adjusted approach)

• Reinsurers would post collateral based on their financial strength rather than a “one size fits all” approach.

• Cedents would have responsibility for the choices they make in terms of counter parties.

• This approach recognizes that there are issues other than financial strength that need to be addressed in any comprehensive approach, such as enforceability and diversification. Nevertheless, it provides a relatively straight-forward assessment of financial strength which lends itself to an incremental step while providing substantial security in that interim period.

Con —

• Analysis would have to be ongoing and continuous requiring the reinsured/broker follow the rating changes and in the event of a rating downgrade, require collateral increases at a difficult time for the reinsurer.

• There was opposition to relying on rating agency designation including the subjectivity of their ratings and the lack of accountability or oversight of their determinations

• Although some point to the reliance on ratings for investments as precedent in this area, there are additional limitations on investments, e.g., statutory asset limitations, RBC charges, junk bond limitations, valuation method for p/c side. This is not the case with reinsurance which does not have an available re-sale market.

Additional Comments:

• This could result in increased security from some market participants.

Weighted Financial Strength Rating Based on Financial Indicators

This approach would provide a sliding scale of collateral requirements based on a reinsurer’s financial strength utilizing financial indicators as opposed to relying solely on rating agency designations.

Pro —

• The financial strength of each reinsurer would be analyzed (e.g., risk-adjusted approach).

• Reinsurers would post collateral based on their financial strength rather than a “one size fits all” approach.

• Cedents would have responsibility for the choices they make in terms of counter parties.

• A sliding scale of financial strength would be based on financial indicators.

Con —

• It might be difficult to determine financial strength using various, different accounting systems.

• Who would perform the analysis if not rating agencies?

Additional Comments:

• This could result in increased security from some market participants.

Qualifying Cessions and Retrocessions to Affiliates

Credit for reinsurance may be granted with reduced or eliminated collateral, subject to domestic regulatory discretion. This option would require consideration of amending holding company laws to ensure that uncollateralized affiliate transactions are not found to be in violation of the “fair and reasonable” standard by virtue of the lack of collateral. It is noted that holding company laws currently incorporate a credit worthiness analysis; however, more discussion needs to take place on this point. Further consideration needs to be given to the appropriate definition of “affiliate” to determine whether the holding company definition, or some other definition, should be used.

Pro —

• Affiliate transactions are subject to regulatory review under state holding company laws. That review provides a higher standard of regulatory scrutiny by subjecting the transaction not only to the typical risk transfer and other requirements imposed on unaffiliated reinsurance transactions, but to a standard that requires that the transaction be fair and reasonable, result in surplus that is reasonable in relationship to liabilities, etc.

• The investment of substantial capital in the US licensee represents a real commitment of the unlicensed entity to the US market. The value of that asset may be subject to attachment by US regulators upon established statutory grounds.

• Although unlicensed, the affiliate reinsurer has subjected itself to a substantial degree of US regulatory scrutiny pursuant to the applicable holding company system act, both at the time of acquisition and on an ongoing basis.

• All material affiliate reinsurance contracts must be submitted to the US licensee’s domestic regulator for prior approval which approval can be subject to regulatory conditions including, presumably, collateral sufficient to satisfy regulatory concerns.

• Violation of the applicable holding company act requirements may result in substantial penalties, including criminal penalties in the case of willful violations.

• Holding company laws require the submission of substantial information about the entire holding company system and the controlling entity. This allows regulators to better understand the impact and fairness of the transaction rather than simply reviewing the contract itself.

• The likelihood of a contentious relationship developing between affiliated parties is considered less than that with unaffiliated parties, thereby reducing the probability of disputes regarding reinsurance recoverables.

• Permitting affiliate transactions to be uncollateralized follows the direction of international regulatory efforts focused on greater recognition of and reliance on group supervision and flexibility in allowing groups to better manage their global risks and capital management.

• This option applies equally to property/casualty and life transactions.

Con —

It was noted that there could be potential abuses through fronting. If this incremental option is pursued by regulators, further consideration needs to be given to this concern. However, others believe that sufficient safeguards are already provided in the holding company laws, as noted in the “pro” section, which would prevent such abuses.

IV. Excerpt from IP Report of September 9, 2006

In addition to the June 2006 IP report, the IPs submitted a report to the RTF on September 9, 2006 which responded to the rating proposal which was then under consideration. While the IPs noted that the REO Proposal now under consideration has been modified, the following section from the September 2006 report remains relevant. While the September 2006 report also addressed other elements of the rating proposal, this section addressed only the structure of a rating mechanism established through the NAIC.

Section 2. — Establishment of Reinsurer Rating Organization

The concept of a Reinsurer Rating Organization (RRO), organized and administered by a non-governmental body such as the NAIC, raises a number of difficult issues and concerns. Some in the IPs observed that even if only a fraction of the several thousand assuming reinsurers listed on U.S. annual statements sought RRO review, the resources necessary to process timely evaluations on a periodic basis (and provide due process on appeals) would be substantial. Others believe the RRO would create additional liability exposure for the NAIC because the NAIC does not have the statutory and sovereign immunities generally applicable to a government agency. Additionally, any such delegation to the NAIC or a body created by it, would require changes to every state credit for reinsurance law – an effort that many believe will be difficult and may not be successful. Moreover, some have expressed concern that a statutory delegation of governmental authority to the NAIC may be unconstitutional. Others in the IPs believe that it would be possible to address these issues in a way that would limit or eliminate the liability concern and pass constitutional muster. They note that both the SVO and the IID have performed similar analytical functions without challenge.

A rating proposal does not work on an individual state basis because the uniformity of rating that determines the amount of collateral required could not be achieved. Although an interstate compact is another mechanism available to the states which could overcome the liability and constitutional issues mentioned above, the practical problem of achieving enactment in all jurisdictions is significant. [2]

One alternative recently suggested by a group of non-U.S. reinsurers is to charge the NAIC Reinsurance Task Force with the responsibility of maintaining certain lists. In order to avoid creation of a rating entity, the proposal makes the amount of collateral formula-driven so that a cedent can apply the formula based on the required lists maintained by the Reinsurance Task Force. Some on the IPs believe that this formula driven approach, which provides little to no discretion for commissioners, is inappropriate. Others on the IPs believe the concept is worthy of further consideration. Delegation of substantive regulatory determinations to the Task Force is problematic for the same reasons mentioned with respect to the RRO. The practical problem of requiring a change to every state law also applies to this alternative.

Another alternative to the RRO is the establishment, through federal law, of a national commission as the rating entity. This approach would overcome the constitutional and liability issues mentioned above as well as the practical problem of changing every state’s law. It would also achieve the necessary uniformity to ensure that an individual reinsurer is not given conflicting ratings. Some in the IPs support this approach while others do not support a federal role of any nature. Some IPs do not support a single regulator whether it is at the federal or state level. Others believe that a single regulator for reinsurers is a fundamental change that needs to be made to the current U.S. regulatory system.

Additional issues identified by the IPs are funding of such a commission (which would presumably be imposed on those seeking a rating) and to whom a rating would be given (e.g., to individual legal entities or affiliated groups; to Lloyd’s as a market or on a syndicate basis).

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