Monday, 18 May 2015 WRN# 15.05.18 The

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Monday, 18 May 2015

WRN# 15.05.18

The WRNewswire is created exclusively for AALU Members by insurance experts led by Steve Leimberg, Lawrence Brody and Linas Sudzius. WRNewswire #15.05.15 was written by Tom Korb on the AALU staff. __________________________________________________________________________________ Topic: NAIC Rules on Captive Reinsurance Transactions and Principle-Based Reserving CITES: NAIC Actuarial Guideline XLVIII (December 16, 2014); “Rector & Associates, Inc. Modified Recommendations June 4, 2014: Exhibit 1—XXX/AXXX Reinsurance Framework” (August 17, 2014); “Report of Rector & Associates, Inc. to the Principle-Based Reserving Implementation (EX) Task Force (February 17, 2014); Initial Report of Rector & Associates, Inc. to the Principle-Based Reserving Implementation (EX) Task Force (September 13, 2013); Captives and Special Purpose Vehicles: An NAIC White Paper, NAIC Captive and Special Purpose Vehicle Use (E) Subgroup of the NAIC Financial Condition (E) Committee (June 6, 2013); Shining a Light on Shadow Insurance, New York State Department of Financial Services (June, 2013). SUMMARY: On December 16, 2014, the National Association of Insurance Commissioners (“NAIC”) adopted reserve financing rules for certain captive reinsurance transactions—NAIC Actuarial Guideline XLVIII (“AG 48”). These rules apply to most level-term contracts (known as “XXX”) and universal life with secondary guarantee (known as “AXXX”) contracts issued on or after January 1, 2015. Because the new rules apply at the ceding insurance company level, they apply even if the captive is located offshore. AG 48 has the effect of grandfathering captive reinsurance transactions for pre-2015 business if on December 31, 2014 that business was already ceded to a captive and part of a financing transaction, although carriers are required to satisfy certain requirements. AG 48 rules provide greater uniformity and rigor for XXX/AXXX-type captive reinsurance transactions. They require that the ceding company hold “Primary Security” at roughly the level of reserves expected to be established under principle-based reserving (“PBR”). This Primary Security is limited to traditional “hard” assets and cannot include instruments such as letters of credit and parental guarantees which have raised concerns. Even evergreen, unconditional letters of credit are excluded from counting as primary security. In addition, other rules will increase disclosures for all XXX and AXXX captive reinsurance transactions, including grandfathered transactions. The rules established in AG 48 are slated to sunset when the credit for reinsurance laws have been changed to permanently implement the rules. While the new rules are intended to be consistent with the NAIC’s commitment to implementing PBR, by design they operate whether or not PBR becomes effective. PBR becomes effective after 42 states representing 75% of premium adopt it. The PBR effective date could take place sooner, but currently appears likely to occur by 2017 or sometime thereafter. To date, 28 states, representing 44.8% of gross premiums have enacted PBR legislation.

By design, the substantive requirements of AG 48 do not apply to reinsurance transactions with certain categories of reinsurers which prepare their financial statements in compliance with the NAIC Accounting Procedures Manual without certain material deviations from statutory accounting principles. Certified reinsurers are also excluded. AG 48 does not apply to the utilization of captive reinsurance transactions for other business, such as variable annuities and long-term care insurance. Finally, AG 48 has an exception if the domestic regulator of the carrier utilizing the captive reinsurance transaction discloses its determination—a determination made after consultation with the NAIC Financial Analysis Working Group—that associated risks are clearly outside of the intent and purpose of AG 48. RELEVANCE: Given industry and public attention, AALU members may receive questions from clients and advisors on reserving and the use of captive reinsurance transactions. Some life insurance carriers use captives, which are wholly-owned subsidiaries or affiliates, as a means of addressing what they view as “non-economic” reserves that result from conservative statutory accounting requirements in order to try to further goals of competitive product pricing and efficient allocation of capital. Statutory reserving requirements are intentionally conservative because of the long-term nature of promises and the central importance of protecting policyholders. Many within the industry and the regulatory community have agreed that some reserving conservatism exists, but there has not been agreement about the degree of conservatism—particularly with regard to products like term life insurance or universal life insurance policies with secondary guarantees. Over the past few years, because of the potential impact on consumers relative to product pricing, risk and availability and challenges from non-uniform state insurance solvency regulation, there has been extensive examination and consideration of the use and proper oversight of captive reinsurance transactions by a variety of groups. These include the NAIC, state insurance departments, federal regulators, international authorities, the life insurance industry, rating agencies, and the broader public. The challenge in determining the appropriate level of reserves and the mechanisms for ensuring compliance comes in part from recognition that: (1) holding reserves too low could increase the risk of insolvency; while (2) holding reserves too high could increase costs unnecessarily—although a myriad of factors affect pricing. As AG 48 is implemented, the impact undoubtedly will continue to be carefully scrutinized. After seeing results, it will become clearer whether AG 48 balances the considerations above by likely increasing costs while meaningfully increasing safety and the strength of the state insurance regulatory system through greater rigor, uniformity, and disclosure. It will also bear watching whether the stronger regulation and increased transparency has some positive impact on evaluations of credit worthiness and financial strength. In addition, it will be worth monitoring the level of uniformity in state application of AG 48, the consequences of non-compliance and how exemptions are interpreted. As noted above, AG 48 rules attempt to incorporate PBR standards. The movement toward principlebased reserving should, in theory, diminish the use of captive reinsurance transactions. This will ultimately depend in part on the extent to which conservatism is built into principle-based reserving such that reserves are considered “non-economic” under that methodology. The development of AG 48 focused on XXX/AXXX captives. There has been far less NAIC and industry attention to and understanding of the utilization of captives by some insurers for reserves related to variable annuities (“VA”) and long-term care (“LTC”). However, it should be noted that the regulators in the states of the domiciled company and the captive do pay attention to these types of captives as they are required to approve the transactions according to state laws. The use of captives for these purposes is different and much less understood by the NAIC than captive insurance transactions

for XXX/AXXX reserves and any approach will be different than AG 48. Given that fact, the decision to exempt VA and LTC captives from AG 48 appears sensible. However, in light of concerns raised by federal authorities and others, the NAIC has proposed coverage of VA and LTC captive regulation within the NAIC’s accreditation standards. The American Council of Life Insurers (“ACLI”), certain carriers, captive associations, regulators and other interested parties have submitted comments providing various input on the accreditation standards proposal, including proposing ways to try to prevent problems before the pertinent accreditation standards are finalized. In contrast to term and universal life captive reinsurance, where the NAIC could develop a captive regulatory framework based on PBR as the future regulatory standard, the NAIC has not yet agreed there should be changes to the existing valuation and capital standards for VA and LTC business, nor made judgments pertinent to the use and regulation of VA and LTC captive transactions. At its spring 2015 national meeting, the NAIC established a VA issues working group to oversee the NAIC’s efforts to study and address, as appropriate, regulatory issues resulting in VA captive transactions. Current NAIC reserve, asset valuation, and capital requirements have a mixture of book value and market value accounting, which can produce artificial volatility and unpredictability of statutory requirements. USE AND REGULATION OF LIFE INSURANCE XXX/AXXX CAPTIVE REINSURERS A reinsurance captive for XXX/AXXX reserves is a wholly-owned subsidiary or affiliate of a life insurance company that takes on some of the insurance risks of that company. Captive reinsurance companies are formed under state captive laws or in offshore jurisdictions and are prohibited from issuing policies directly to the public. These laws include, for example, reporting, capital, and reserve requirements. Regulators have been seeking to understand the reason why insurers form captives and have been examining the implications on solvency and transparency of the use of captives that are subject to different standards than the standards which are applicable to life insurance companies which issue policies to the public. Captive transactions are subject to review by both the insurance company’s state regulator and the captive company’s state regulator. Rating agencies also routinely review these transactions to determine the impact on the life insurance company. Pertinent rules—particularly NAIC Actuarial Guideline XXXVIII (“AG 38”), regarding reserving requirements for term life products and secondary guarantees—have resulted in companies being required to hold what some consider to be overly conservative levels of reserves for these types of risks. The use of captive reinsurers has increased as a way some life insurance companies manage conservative reserve requirements. The use of captives potentially can help insurance companies offer products at lower prices to consumers, although many other factors also impact product pricing. Under existing law and practice (in effect prior to AG 48), each captive arrangement has been reviewed by the domiciliary state of the captive as well as the domiciliary state of the life insurance company. Below is an example of the workings of a captive insurance transaction under pre-AG 48 laws and practice: 

The insurance company has ceded risk and reserves to the captive, which in turn has taken on the full liability associated with the risks ceded.

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To determine the portion of the statutory reserves it assumed which can be financed, the insurance company determines economic reserve liabilities (or best estimate expected loses with provisions for adverse deviations) and often has obtained an independent third-party actuarial review of the formula and assumptions used to determine the economic reserve. These are reviewed with state regulators.

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A reinsurance transaction between a ceding company and a captive follows the “Credit for Reinsurance” rules applicable to any other reinsurance transaction. For the insurance company to receive reserve credit for the risks ceded to a non-licensed or non-accredited captive, the captive must have provided collateral for the benefit of the insurance company. Collateral must have met regulatory requirements for the insurance company to take credit. Generally, reserve requirements have been divided between “economic” and “non-economic” portions. Economic reserves have been backed by normal admitted assets, sometimes in the form of funds withheld or a credit for a reinsurance trust. Non-economic reserves—thought to be less likely to be needed to pay policyholder liabilities—sometimes have been permitted to be backed by nontraditional forms of collateral, including conditional letters of credit and guarantees by the insurance company holding company, or a letter of credit issued by a third-party bank and held by the captive for the benefit of the insurance company.

REGULATORY EXAMINATION OF XXX/AXXX CAPTIVE REINSURANCE TRANSACTIONS IN DEVELOPING AG 48 Before formulating, refining and adopting AG 48, regulators extensively examined how XXX/AXXXtype captives are used, how reinsurance transactions are regulated, and possible concerns, including: (1) adherence to strict statutory reserve requirements; (2) potential risk to insurance companies and their policyholders; (3) potential to inappropriately improve insurers’ balance sheets; and (4) potential harm from inadequate transparency and disclosure and lack of uniformity among the states. In one report in June 2013 on its investigation, the New York State Department of Financial Services (“NYSDFS”) characterized captive reinsurance transactions as “shadow insurance” and raised concern about potential risk to policyholders—particularly in circumstances in which risk was ceded to captive reinsurers, but the insurance companies remained subject to claims, conditional letters of credit, or parental guarantees. It urged other regulators to conduct investigations, increase disclosure requirements and consider a moratorium during examination of this area. Since its report, it should be noted that the NYSDFS has continued to oppose PBR and has opposed AG 48. Even as recently as April 2015 the NYSDFS submitted a letter criticizing life insurer captives use, discussed during a Senate Banking Committee hearing on insurance regulation. However, the NYSDFS has acknowledged potential conservatism in the required level of life insurance reserves and put forward its own proposal as an alternative to PBR which would reduce these reserves. Since at least 2012, with the above concerns in mind, the NAIC has been giving careful study to the use and proper regulation of captive reinsurance transactions. The NAIC Principle-Based Reserving Implementation (EX) Task Force (“PBRI Task Force”) has coordinated pertinent projects. The PBRI Task Force evaluated a June 6, 2013 NAIC sub-committee white paper and recommendations regarding potential solvency implications of the use of captives. It adopted a framework set forth in a June 14, 2014 report prepared for the NAIC by Rector & Associates, Inc. The NAIC Life Actuarial (A) Task Force (“LATF”) subsequently developed and applied that framework in fashioning and refining rules set forth in AG 48. The NAIC Executive/Plenary Committee adopted AG 48 on December 16, 2014.

STANDARDS/SAFEGUARDS ESTABLISHED BY AG 48 The intent of AG 48 is to address the concerns that have been raised about XXX/AXXX-type captive reinsurance transactions by taking steps, which among other things, establish uniform, national

standards for reserve financing arrangements to ensure that required levels of hard assets categorized as “Primary Security” are held by or on behalf of the ceding insurer. Key elements of the XXX/AXXX reserve framework are as follows: 

Ceding insurer must establish reserves to be secured by Primary Security. The level of established reserves is equal to that required using the principle-based reserving standards established by the NAIC’s Valuation Manual 20 (“VM-20”), with certain modifications. VM-20 requires the reserve to be the greatest of a formula based net premium reserve (“NPR”), a deterministic reserve, and a stochastic reserve. Blocks of business can be excluded from portions of the calculation if they are not sensitive to interest rate changes. The deterministic reserve is a single scenario based on a one standard deviation shock in interest rates using company specific insurance assumptions. The stochastic reserve uses the same calculation but is across many different economic scenarios. AG 48 does not require the stochastic calculation for term insurance since the liability cash flows are not interest sensitive. In addition, the NPR reserve in AG 48 includes adjustment factors to reflect generally improved mortality experience compared to the previous NAIC 2001 Valuation Table.

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Ceding insurer must receive collateral for reserves in hard assets categorized as “Primary Security” by AG 48. Primary Security includes cash and permissible securities listed by the NAIC Securities Valuation Office. It excludes synthetic letters of credit, contingent notes, credit-linked notes or other securities similar to letters of credit. Even evergreen, unconditional letters of credit are excluded. While it may not be completely accurate, conceptually, it may be useful to think of the hard assets required for Primary Security as a rough regulatory proxy for what many term as the “economic” portion of reserves that are most needed to secure policy obligations.

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The portion of the statutory reserve which exceeds the Required Primary Security may be collateralized by assets characterized as “Other Security” by AG 48. Other security includes assets which are acceptable to the insurer’s domestic regulator. In some states, this may include letters of credit, credit-linked notes, and, in some instances, parental guarantees. While it may not be completely accurate, conceptually, it may be useful to think of the looser standards for “other security” as a rough regulatory proxy for what many view as the “non-economic” portion of reserves that are less likely to be needed to secure policyholder obligations.

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A qualified actuarial opinion will be required if the primary security requirement is not met. The NAIC is finalizing changes to the risk-based capital (“RBC”) calculations that will create an RBC disincentive to the extent the primary security requirement is not met. Ultimately, once the credit for reinsurance laws are changed to permanently implement the XXX/AXXX reserve financing framework, the ceding insurer may receive reduced or no reserve credit to the extent the primary security requirement is not met if remedies (outlined in AG 48) are not chosen.

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One of the parties to the financing transaction must hold a risk-based capital “cushion” in certain situations. Note: the NAIC Capital Adequacy Task Force has been tasked with developing an appropriate RBC cushion when the assuming reinsurer does not file an RBC report using the NAIC RBC formula and instructions. That task force will also develop asset charges for forms of “other security” allowed as capital under AG 48.

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The reinsurance agreement must be approved by the ceding insurer’s domestic regulator.

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New disclosure requirements for reinsurance transactions must be met. This will include new NAIC 2015 Supplemental XXX/AXXX Reinsurance Exhibits.

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Audited financial statements of the ceding insurer must include a note regarding compliance with AG 48 and the NAIC XXX/AXXX Reinsurance Model Regulation. Note that the NAIC Statutory Accounting Principles (E) Working Group has been tasked with the development of the required note reference above to the audited financial statement.

DISCLAIMER This information is intended solely for information and education and is not intended for use as legal or tax advice. Reference herein to any specific tax or other planning strategy, process, product or service does not constitute promotion, endorsement or recommendation by AALU. Persons should consult with their own legal or tax advisors for specific legal or tax advice. _____________________________________________________________________ The AALU WRNewswire and WRMarketplace are published by the Association for Advanced Life Underwriting® as part of the Essential Wisdom Series, the trusted source of actionable technical and marketplace knowledge for AALU members—the nation’s most advanced life insurance professionals.