Brave New World: The Dawn Of Federal Regulation Of Reinsurance

In the Press · March 13, 2009

Brave New World: The Dawn Of Federal Regulation Of Reinsurance

By: Mitchell S. King and John E. Matosky  

I.          Introduction 

The United States economy has entered troubling territory unlike anything in recent experience.  With virtually every sector of the economy in deep trouble, there appears to be a prevailing public sentiment that a primary contributor to the current financial crisis is a lack or failure of regulation in the financial industry.  The insurance industry has received its share of attention based on the near collapse and subsequent federal bailout of AIG.  As a cumulative effect of the bailouts and rescue efforts in insurance, banking, housing and auto sectors, there is growing political sentiment in favor of increased regulation of industry and an increasing belief that such regulation should come from the federal government.

The idea of federal regulation of reinsurance, or some other form of coordinated regulation, has gained traction in recent years even apart from the current economic crisis, largely in response to issues of competition and fairness in an increasingly international marketplace.  This notion is expressed in efforts by the National Association of Insurance Commissioners (NAIC) to “modernize” reinsurance regulation by eliminating or lessening the difficulties inherent in the current system of state-by-state approaches and the exclusive reliance on indirect regulation of foreign reinsurers (i.e., by the various state credit-for-reinsurance rules).  These efforts have been mirrored, to some extent, in legislative efforts during the most recent Congress, which ended in January 2009.  With states such as New York and Florida already taking steps in favor of implementing the recently-adopted NAIC proposals, it appears that a centralized approach to reinsurance regulation, perhaps in the form of federal legislation, may not be too far off in the future. 

II.        The NAIC Reinsurance Regulatory Modernization Framework Proposal    

At its winter meeting in December 2008, the NAIC adopted a conceptual framework to “modernize” reinsurance regulation by: (1) introducing a means of coordinating single-state regulation of domestic and foreign reinsurers; (2) simplifying the methods of recognizing foreign jurisdictions and potentially promoting a system of mutual recognition; and (3) liberalizing collateral requirements for reinsurers with strong financial ratings.  This framework, if fully implemented, will represent a significant departure from the current regulatory scheme.   

A.        What’s Wrong With The Current System?

Currently, there is a multi-state system for reinsurance regulation using two methods.  First, states directly regulate US reinsurers by licensing companies and, thereby, subjecting them to state solvency laws and regulations that also apply to direct insurers.  Unlike in the case with direct insurers, however, the states do not regulate the rates that reinsurers can charge nor do they require the use of any particular policy forms.             

Second, states indirectly regulate non-US reinsurers, and domestic reinsurers not licensed in the ceding insurer’s domicile state, by defining the conditions under which the ceding insurer may claim a credit for reinsurance against its insurance liabilities on its financial statements.  These credit-for-reinsurance standards typically provide that a ceding insurer may only take credit for the reinsurance of risks ceded to: (1) reinsurers that are licensed in the ceding insurer’s domicile state; (2) reinsurers that are licensed in another jurisdiction with equivalent credit-for-reinsurance standards, and that maintain an adequate surplus (typically $20 million); or (3) reinsurers that post collateral in a US financial institution in an amount equal to 100% of its US obligations.           

The new NAIC framework is meant to be an alternative approach to reinsurance regulation that answers the criticisms of the current system.  In testimony before the US Senate in support of the National Insurance Act of 2008, see infra, Franklin Nutter, the president of the Reinsurance Association of America, focused on four concerns under the current system:[2]           

First, there is a concern that the chorus of state-based regulatory systems is an anomaly in the global market that restricts the ability of US-based reinsurers to compete abroad and needlessly complicates the ability for foreign reinsurers to enter the US market.  A single regulatory voice, so the argument goes, would make US-based reinsurers more attractive to foreign regulators while also making the US system easier for foreign companies to navigate, with the result in either case being a stronger flow of capital into the US.             

The need for opening the US market to capital from existing foreign and new domestic reinsurers is readily apparent when one considers the numbers.  According to Mr. Nutter, an estimated 60% of the losses from the events of September 11, 2001 and the 2005 hurricane season in the Gulf of Mexico was absorbed by the global reinsurance industry.  To meet the capital demands following these catastrophes, 50 new reinsurers were formed with nearly $28 billion of new capital.  As Mr. Nutter explains, “[n]early all of this new capital came from US capital markets yet no new reinsurer was formed in the United States.”  Indeed, no new US-domiciled reinsurer has been formed in the past 20 years, while US premium ceded to foreign reinsurers has grown from 38% to 56% in just the last decade.  It appears that domestic capital providers are discouraged from setting up direct US operations due to the morass of the multi-state licensing system.  Many prefer to establish bases of operation outside the US, under the comparative ease of foreign regulatory systems, and to conduct business through US subsidiaries.[3]  Transporting capital through such convoluted channels only further complicates the business of regulation, and needlessly sends premiums outside the US.           

Second, and related, the current fragmented system precludes mutual recognition by foreign regulators.  A single national regulator in the US, it is argued, would allow the US and other countries to recognize each other’s regulatory systems as reliable so that the accreditation of a reinsurer in one country would be sufficient for it to assume reinsurance in another without requiring it to pass through additional regulatory hurdles.           

Third, there is much debate concerning the need for non-US reinsurers to post collateral for purposes of the state-by-state credit-for-reinsurance rules.  Advocates for reducing the collateral requirements argue that full collateral is unnecessary in a modern, global economy and are inimical to fair competition.  Critics of reduced collateral requirements argue that lowering the requirements will dilute the financial security of US direct insurers (and their policyholders) and will weaken US regulation.  A national system of regulation, some argue, would satisfy both concerns because it would allow a rational review of the financial condition of foreign companies (without each of 50 state regulators having to become proficient in the intricacies of various foreign accounting systems) and would provide a uniform system for lowering the risk to ceding insurers and their insureds.           

And fourth, the lack of coordination between 50 separate state systems increases costs that are ultimately reflected in the premiums paid by consumers.  Moreover, the attempts by some states to apply some of their laws extra-territorially creates confusion and inconsistency.[4]  The theory is that a national structure will generally streamline the process of regulation. 

B.        Highlights of the NAIC Framework

            1.        National and Port of Entry Reinsurers

The NAIC modernization framework creates two new classes of reinsurers in the United States: (1) National Reinsurers and (2) Port of Entry (“POE”) Reinsurers.  A National Reinsurer is licensed in its domicile state and is approved by that state (its “home state”) to transact assumed reinsurance business nationwide.  It submits solely to the regulatory authority of its home state supervisor.  A POE Reinsurer is a non-US assuming reinsurer that is certified in a single state (the “POE state”) and approved by it to provide creditable reinsurance to the entire US market.  A POE Reinsurer’s certification by a POE state supervisor depends upon its organization in, and licensure by, an eligible non-US jurisdiction as determined by a newly-formed NAIC body, the Reinsurance Supervision Review Department (“RSRD”).

            2.        Reinsurance Supervision Review Department

The RSRD is a body that “will evaluate the reinsurance supervisory regimes of other countries and establish standards for a state to be certified to regulate reinsurance on a cross-border basis.”[5]  The NAIC has identified two guiding principals for the RSRD: (1) that it should be a publicly accountable entity composed of state insurance regulators; and (2) that, in determining approvals of states as home states or POE states, it will not discriminate against states strictly on the basis of low ceded premium volume.  The NAIC also contemplates tasking the RSRD with developing purposes and procedures manuals for home state and POE supervisors as well as developing sample agreements for recognition and cooperation between POE states and non-US jurisdictions.[6]

            3.        Reduced Collateral Requirements

The NAIC model is intended to be an optional framework in which reinsurers will be free to continue operating under the current state-by-state regulatory system, including the existing 100% collateral rules.  Reinsurers that choose certification as National Reinsurers or POE Reinsurers will be allowed to take advantage of liberalized collateral requirements.  Additionally, a ceding reinsurer’s domicile state (the “host state”) will be required to grant credit for reinsurance ceded to National Reinsurers and POE Reinsurers.[7]             

In order to qualify for the reduced collateral requirements, a reinsurer must maintain a minimum financial strength rating with at least two SEC-approved ratings agencies.  The reinsurer’s home state or POE state supervisor will assign it a rating corresponding with its lowest financial strength rating.  The supervisor may make downward adjustments to the reinsurer’s rating to reflect negative experience with the reinsurer’s business practices in dealing with cedents, its reputation for failing to make prompt payments of valid claims, or based on the fact that there have been regulatory actions against it. 

Table 1

Financial Strength Ratings

Rating

AM Best

S&P

Moody’s

Fitch

Secure – 1

A++

AAA

Aaa

AAA

Secure – 2

A+

AA+, AA, AA-

Aa1, Aa2, Aa3

AA+, AA, AA-

Secure – 3

A, A-

A+, A, A-

A1, A2, A3

A+, A, A-

Secure – 4

B++, B+

BBB+, BBB, BBB-

Baa1, Baa2, Baa3

BBB+, BBB, BBB-

Vulnerable – 5

B., B-, C++, C+, C, C-, D, E, F

BB+, BB, BB-, B+, B, B-, CCC, CC, C, D, R

Ba1, Ba2, Ba3, B1, B2, B3, Caa, Ca, C

BB+, BB, BB-, B+, B, B-, CCC+, CC, CCC-, DD



As shown in Table 1, above, a reinsurer’s rating can range from “Secure – 1” (the best) to “Vulnerable – 5” (the worst).  The amount of collateral the reinsurer must post increases as its rating approaches the bottom of the range – a “Secure – 1” reinsurer is not required to post any collateral, while a  “Vulnerable – 5” reinsurer must post 100% collateral.  As a result, a reinsurer’s collateral requirements may increase should it experience a deterioration of its financial condition.[8]  As shown in Table 2, below, the requirements are more liberal for US reinsurers than for non-US reinsurers.

Table 2

New NAIC Collateral Requirements

(National Reinsurer vs. POE Reinsurer)  

Rating

National Reinsurer

POE Reinsurer

Secure – 1

0%

0%

Secure – 2

0%

10%

Secure – 3

0%

20%

Secure – 4

75%

75%

Vulnerable – 5

100%

100%

III.       State Efforts 

To date, two states (Florida and New York) have undertaken changes to their reinsurance regulatory rules in the direction of the NAIC framework.  These state efforts may be harbingers of what is to come in other states.

A.        Florida

Under former Florida law, a non-admitted reinsurer must post 100% collateral for its obligation in order for its reinsurance to be creditable by a Florida domestic insurer.  In 2007, the Florida legislature passed a law enabling the insurance commissioner to establish lower collateral requirements for financially sound foreign reinsurers.  The new Florida rule, 69O-144.007, F.S., which was adopted in September 2008, allows eligible reinsurers to post reduced collateral if they (1) are in good standing with their domestic regulators; (2) maintain a surplus in excess of $100 million and (3) meet certain credit ratings.  Similar to the NAIC framework, collateral requirements are reduced for qualifying reinsurers based on financial strength ratings, such that the very highest rated companies need not post any collateral.  Any reinsurer not meeting the eligibility requirements will still need to post 100% collateral as under the former rule.

B.        New York

Under current New York law, unauthorized insurers are required to post 100% collateral.  A pending New York proposal, an amendment to 11 NYCRR 125 (Regulation No. 20), would make changes similar to the Florida rule except that New York would require the reinsurer to maintain a $250 million surplus.             

Both the Florida rule and the New York proposal contain requirements that the reinsurance contracts contain certain provisions such as insolvency clauses and service-of-suit clauses.   

IV.       Recent Glimpses of Federal Regulation of Reinsurance 

The NAIC is forthright with its acknowledgement that full implementation of its modernization framework will require federal legislation.  The need is two-fold.  First, federal legislation may be required in order to ensure universal participation by the states – and to eliminate the risk that one or a few recalcitrant or dilatory states could get in the way by failing to adopt the framework, or to adopt it completely.  Second, there are constitutional concerns created by the possibility of states entering into agreements with each other or with foreign governments.  The Compact Clause of the US Constitution, Art. I, § 10, requires Congressional consent before states enter into such agreements.[9]           

During the 110th Congress (January 3, 2007 to January 3, 2009), four bills affecting reinsurance received consideration: (1) the Nonadmitted Insurance & Reinsurance Act of 2007; (2) the National Insurance Act of 2007; (3) the Insurance Information Act of 2008; and (4) the Reinsurance International Solvency Standards Evaluation Board Act of 2008.  These bills likely provide a preview of what may be in store from future federal legislative efforts.

A.        Nonadmitted Insurance & Reinsurance Act of 2007

The Nonadmitted Insurance & Reinsurance Act of 2007 passed unanimously in the House, but was not brought to a vote in the Senate.  The bill sought to establish national standards for regulating surplus lines and reinsurance.  On the reinsurance side, it would preserve the exclusive responsibility of the reinsurer’s domicile state for regulating the reinsurer’s financial solvency.  It also would require all states to grant credit for insurance if the ceding insurer’s domicile state recognizes such credit. 

B.        National Insurance Act of 2007

 The National Insurance Act of 2007 would have established an optional federal charter for insurers – similar to the dual federal and state banking system.  Federally-chartered insurers would operate under the regulatory authority of the Office of National Insurance, which the act would create within the Treasury Department.  The Presidentially-appointed Commissioner would have regulatory powers and imperatives consistent with the NAIC model laws and regulations.  The Commissioner would be empowered to license non-US insurers to provide reinsurance, and to establish credit-for-reinsurance regulations.  The act would require states to recognize credit for reinsurance ceded to either a “national” insurer or a federally-licensed reinsurer. 

C.        Insurance Information Act of 2008

The Insurance Information Act would have created an Office of Insurance Information (“OII”) within the Treasury Department.  The intent of the proposed legislation was to foster uniformity among state insurance regulations, ostensibly as a step toward clarifying US insurance policy to the international community.  It would also require the OII to develop a federal policy with respect to international insurance matters.

D.        Reinsurance International Solvency Standards Evaluation Board Act of 2008

The Reinsurance International Solvency Standards Evaluation Board Act would appear to have served the same purpose as the RSRD under the NAIC framework.  It would have created a non-governmental board, appointed by the President, to evaluate foreign (and domestic) reinsurance supervision systems.  The purpose of such evaluation would have been to determine whether such systems provide adequate financial security standards to allow mutual recognition.

 V.        Conclusion

Due to the adoption of the NAIC modernization framework, as well as the developing political will for greater federal regulation in all aspects of the financial industry, federal regulation of reinsurance appears to be a growing possibility.  Federal regulation is not a foregone conclusion, however, as demonstrated by the recent legislative failures.  Moreover, as a practical matter, federal legislation is probably years away.  There are currently no pending versions of the four bills discussed above, or anything similar.[10]  Neither has the White House expressed a desire for such legislation as part of its agenda.  Yet, the recent efforts in Florida and New York have set gears to work.  The industry and, importantly, other state regulators will be watching the experience of those two key states closely. 


[1]  Mitchell S. King is a partner and Chair of Prince Lobel’s Insurance and Reinsurance Practice Group.  John E. Matosky is an associate in the firm’s Insurance and Reinsurance Practice Group.  Any views expressed in this paper are exclusively those of the authors and not the firm nor its clients.  Copyright 2009, Mitchell S. King and John E. Matosky.

[2]   See Testimony of Franklin W. Nutter, Pres. of Reins. Assoc. of Am., “State of the Insurance Industry: Examining the Current Regulatory and Oversight Structure” before U.S. Senate Comm. on Banking, Housing and Urban Affairs (July 29, 2008). 

[3]   Of course, there may be other factors (tax implications, etc.) influencing the decision to set up operations abroad, which are beyond the scope of this discussion.

[4]   Thirteen states apply at least some of their regulatory laws extra-territorially (meaning that an insurer’s domicile state will assert that its laws apply to the way the insurer conducts its business nationwide): California, Florida, Kentucky, Maryland, Michigan, New Jersey, New Mexico, New York, Pennsylvania, Texas, Utah, Virginia and West Virginia.  

[5] NAIC, “Reinsurance Reform Moves Ahead: Modernization Proposal Adopted; Guiding Principals Ratified.” (Dec. 7, 2008). 

[6]  The International Association of Insurance Supervisors has also issued guidelines for regulators making recognition assessments of foreign supervisory regimes.  See IAIS Guidance Paper on the Mutual Recognition of Reinsurance Supervision (Oct. 2008).   

[7]  The host state, however, will retain its authority under existing laws to determine whether the reinsurance contract transfers risk from the cedent to the reinsurer.  

[8]  Some may argue that it is counter-productive to require a struggling company, at the very moment when it needs liquidity the most, to post more of its funds as collateral, but the public policy underlying this approach appears to be one of favoring the financial security of the ceding insurer which would see its risk of reinsurer default increase if left without adequate collateral.  

[9]   In particular, the Compact Clause provides that “No State shall, without the Consent of Congress … enter into any Agreement with another State, or with a foreign Power[.]”  U.S. Const. art. I, §10. 

[10]   Note, however, that Rep. Darrell Issa (R-CA) has introduced a bill (HR 74) to establish a Federal Oversight Commission to study the “financial crisis of 2008” and to recommend corrective actions.  The bill calls for an investigation of the stock market, the housing market, credit rating agencies and “the financial services sector, including hedge funds, private equity and the insurance industry.”  HR 74, § 5(a)(1)(B)(v).