2015 YEAR END REVIEW AND FORECAST FOR 2016/media/files/insights/publications/2016/0… · 2015 YEAR END REVIEW AND FORECAST FOR 2016 | 02 2015 was a challenging and transformative

2015 YEAR END REVIEW AND FORECAST FOR 2016

2015 YEAR END REVIEW AND FORECAST FOR 2016 | 02

2015 was a challenging and transformative year for the insurance industry. We saw:

• More than $200bn in mergers including mega mergers such as Anthem’s $55.2 billion acquisition of Cigna, Aetna’s $37bn acquisition of Humana and Ace’s $29.7bn acquisition of Chubb.

• Announced plans by some major carriers to dramatically restructure and rescale their businesses, in part due to regulatory changes, activist investors and harsh commercial realities.

• Further evolution of the regulatory ecosystem. This included the implementation of Solvency II, the adoption of BCR and HLA by the IAIS, changes and challenges to SIFI and G-SII designations, and expanding interest in recovery and resolution plans.

• Opportunities and challenges presented by big data and technology.

• Emerging and growing risks – such as cyber security and climate change.

• An adverse commercial and economic environment, with over-capacity, softening rates in many lines, low interest rates and low investment returns challenging profitability for every sector of the business.

Our 2015 Year End Review and Forecast for 2016 will review some of the more notable events and trends in the insurance industry over the past twelve months. Our review draws upon the work and observations of our global team of insurance transactional and regulatory lawyers. Our crystal ball is a bit clouded by the scale and speed of changes we see, but we hope this review will provide some useful insights and information as we face the New Year.

2015 YEAR END REVIEW AND FORECAST FOR 2016


TABLE OF CONTENTS

Evolution of International Insurance Regulation 04

Federal Legislative and Regulatory Developments 09

• The Federal Reserve

• Department of Labor Issues Proposed Rule Impacting life Insurance Industry

• NFIP, TRIA, Cybersecurity

• US Sanctions

NAIC and State Regulatory Developments 14

• Leadership changes and dynamics

• Substantive NAIC Actions

• Big Data

• Cyber Issues

European Regulatory and Legislative Developments 24

• Solvency II Implementation

• EU-US Regulatory Developments

• Country specific Developments

Asian Regulatory Developments 34

Australian Regulatory Developments 40

Commercial and Transactional Issues and Trends 43

• Global Trends in Insurance M&A

• Tax Updates

• Antitrust Issues

Conclusion and Forecast 52


EVOLUTION OF INTERNATIONAL INSURANCE REGULATION


he International Association of Insurance Supervisors (IAIS) continues to expand its agenda and regulatory reach. Regrettably, as the IAIS has increased its activity it has decreased its transparency and engagement with relevant stakeholders.

(See fur ther discussion below.)

IAIS Developments: ComFrame, G-SII Regulation and Insurance Core Principles

In 2015, the IAIS continued to work on three general subject areas: (i) standards for identifying and supervising Global Systemically Important Insurers (G-SIIs), (ii) the Common Framework for the Supervision of Internationally Active Insurance Groups (ComFrame), and (iii) the Insurance Core Principles (ICPs). Important activity occurred in each of these areas. As discussed fur ther below, some of these could have a significant impact on the insurance industry.

G-SII Regulation. The IAIS delivered on its promise to the Financial Stability Board (FSB) and developed its “Higher Loss Absorbency” (HLA) standards for G-SIIs. These standards were adopted by the FSB in November 2015. Based on the IAIS’s “Basic Capital Requirement“ (BCR), the IAIS touts the HLA as necessary to “reflect the greater risks that G-SIIs pose to the global financial system.” Beginning in 2019, G-SIIs will be expected to hold regulatory capital that is not less than the total required by the sum of the BCR and HLA requirements. These capital requirements apply to all group activities, including non-insurance subsidiaries. The combined BCR+HLA required capital is determined in two stages. In the first stage, an “uplift” is applied to the BCR as it was specified in 2014. The uplift is essentially 33%, with a different approach taken for regulated banking activities in recognition of the current global requirements in place in that sector. In the second stage, the HLA is calculated using a combination of a “bucket” and a “factor-based” approach. The status of a G-SII, from the perspective of regulatory required capital, is captured by its BCR+HLA Ratio, the numerator of which is the G-SII’s total qualifying capital and the denominator is its BCR+HLA requirement.

At the end of 2015, the IAIS issued two consultations regarding G-SIIs. The first was aimed at updating its methodology for identifying G-SIIs, by introducing a new “phased approach.” The intent of the phased approach is to provide firms with a greater input into the G-SII determination process and a better idea of why a firm was designated a G-SII (if not, more importantly, perhaps, direction from supervisors as to how a firm that has been determined to be a G-SII might remove that designation). The second consultation adjusts how supervisors evaluate whether a firm’s non-traditional, non-insurance (NTNI) activity presents systemic risk. Analysis of these consultations has continued into 2016, with at least one meeting with stakeholders planned for April before the consultations are finalized.

Notwithstanding the ongoing work on the G-SII designation process, the IAIS decided to remove one company (Generali) from and add another (Aegon) to the list of G-SIIs. Furthermore, in November 2016, the IAIS and FSB are expected to announce a revised list of G-SIIs using the methodology from these two consultations. Many will be waiting to see if any reinsurers make it on to the list.

ComFrame. With the development of the HLA, the IAIS has now completed two steps in its development of group-wide global insurance capital standards. The third step is the development of a risk-based group-wide Insurance Capital Standard (ICS) to be applied to Internationally Active Insurance Groups (IAIGs). This initiative began in earnest during 2015 with a consultation that closed in February 2015, and was the principal activity of the IAIS related to ComFrame during 2015.

The IAIS describes the ICS as a “group wide, consolidated capital standard applicable to IAIGs and G-SIIs.” The ICS “aims at comparability of outcomes” which the IAIS says “can contribute to a level playing field and reduce the possibility of capital arbitrage.” A detailed summary of the ICS is beyond the scope of this Annual Report, but simply stated, the ICS as currently proposed has three major components: valuation, capital resources, and the ICS capital requirement.

The IAIS received in excess of 1,500 pages of comments to the consultation last year. These ranged from support for the ICS, to acceptance that some form of ICS is inevitable, to relatively hostile criticism of the proposal. The harshest critics contend that the ICS is not realistic. These critics argue, among other things, that comparability is not achievable given the heterogeneity of global insurance businesses and the absence of a global accounting standard. Critics also argue that the ICS has too great a focus on financial stability at the expense of policyholder protection. In addition, cer tain specifics aspects of the ICS proposal, such as the disqualification of subordinated debt from what will be considered eligible capital, have been soundly criticized.

By the end of 2015, the IAIS had announced a somewhat delayed timeline for developing the ICS, potentially indicating that the IAIS may be considering a somewhat less ambitious version of the ICS from the version that was released for last year’s consultation (as discussed above). Nevertheless, the ICS remains a main objective of the IAIS. To that end, the IAIS is planning another ICS consultation in the summer of 2016, as well as several stakeholder sessions leading up to the release of the consultation document. These are likely to attract great interest from stakeholders around the world.

ICPs. The IAIS’s activity also extends broadly to all insurers through the ICPs. In November 2015, the IAIS issued updates for ICPs 4 (Licensing), 5 (Suitability [of Management]), 7 (Corporate Governance), 8 (Risk Management and Internal Controls),

T


23 (Group-wide Supervision), and parts of 25 (Supervisory Cooperation). The most significant of these changes probably pertain to ICP 23, because the IAIS established clearer rules for determining which entities are included in an insurance group, and that has important ramifications for many other aspects of insurance supervision, not the least of which is determining whether an insurance group is engaged in non-traditional and non-insurance (or NTNI) activities and the overall group-wide capital requirements.

In 2016, the IAIS intends to launch a very significant consultation on ICP 12 regarding resolution planning, which will also serve as a consultation on resolution planning provisions in ComFrame. This consultation should attract widespread attention among interested parties, because although the degree to which any insurer must engage in resolution planning is affected by the IAIS’s notion of proportionality, IAIS leadership has clearly indicated it believes all insurers should have some form of a resolution plan (as discussed below). This consultation validates a concern many insurers have expressed over the likelihood that regulatory requirements developed for G-SIIs will trickle down to other insurers – and with recovery and resolution plans this seems to be the case.

Capital Standards Versus Risk Regulation

As noted above, the IAIS’s work on the ICS has generated some heated debate. In the US, that has led to a partnership between insurers and US insurance regulators at the National Association of Insurance Commissioners (NAIC), the Federal Insurance Office (FIO), and the Federal Reserve (Team USA, as the regulators refer to themselves) to attempt to develop an alternative to the IAIS’s focus on a prescriptive capital standard.

Many interested parties were frustrated that Team USA had not made greater progress on developing an alternative to the IAIS’s proposed ICS. Indeed it was not until last summer that the NAIC floated three different alternative approaches. After internal debate and opportunity for industry comment, the NAIC settled on an approach it referred to as a “Group Capital Calculation,” strenuously distinguishing this approach from the “standards” the IAIS proposes to develop. In the words of a paper the NAIC adopted as a means of launching its effor ts to develop this calculation, the NAIC’s goal was to “construct a US group capital calculation using an RBC aggregation methodology” and would “build on existing legal entity capital requirements where they exist rather the developing replacement/additional standards.”

HLA required capital formula factors

BCR required capital exposureHLA Factors

Low Bucket Mid Bucket High Bucket

TLBCR 2015: Traditional Life insurance

6% 9% 13.5%TNLBCR 2015: Traditional Non-Life insurance

ABCR 2015: Assets

NTBCR2015: Non-Traditional insurance

12% 18% 27%NI-AUMBCR2015: Non-Insurance – Assets Under Management

NI-OBCR2015: Non-Insurance – Other

NI-RBBCR2015: Non-Insurance – Regulated banking 8.5% 12.5% 18.75%

NI-UBBCR2015: Non-Insurance – Unregulated banking 12.5% 18.75% 25%

Source: IAIS HLA Capacity for G-SIIs, Public Consultation Document (June 25, 2015)


On February 10, 2016, the NAIC’s Financial Condition (E) Committee organized a new “Group Capital Calculation Working Group” to begin the task of figuring out how to put the NAIC’s idea into practice. This will likely be one of the most closely watched initiatives of the NAIC in many years.

It remains to be seen whether the NAIC’s initiative will be joined by the Federal Insurance Office (FIO) and the Federal Reserve Bank (the Fed) or how pro-active the NAIC decides to be in urging that the IAIS revise its approach to conform with the NAIC’s initiative.

However these strategic issues are resolved, the juxtaposition of the NAIC proposal with the current ICS proposal, which the IAIS appears to favor, reveals a philosophical divide on the question of whether insurance supervisors should impose absolute capital requirements that insurers must meet exposing them to the risk of adverse actions by their supervisors if they do not, or whether the evaluation of an insurer’s capital should be conducted merely as a component of a broader risk assessment and regulation of the insurer. This debate began to emerge during 2015 and is likely to be an important element of the debate on global insurance during 2016.

Recovery and Resolution Plans

In November 2015, the FSB issued a consultative document entitled “Developing Effective Resolution Strategies and Plans for Systemically Important Insurers” (Guidance). Building on its October 2014 “Key Attributes of Effective Resolution Regimes for Financial Institutions II-Annex 2 (Resolution of Insurers)” and related iterations, the Guidance was developed in consultation with the IAIS. Although “aimed” at regulators, regulators, supervisors and resolution authorities of G-SIIs, it provides valuable insight for G-SII Crisis Management Groups (CMGs). As demonstrated below, these plans will not be easy to prepare, but will be subject to an iterative process that will impact corporate governance of G-SIIs and even non-G-SIIs over time.

Key overarching points in the Guidance include: (i) plans should make resolution feasible without severe disruption (continuity of function) and without exposing taxpayers to loss; (ii) a firm’s home resolution authority should take the lead in plan development in coordination with CMGs; (iii) plans should be underpinned by institution-specific cross-border cooperation agreements (COAGs); (iv) plans should make it possible for shareholders and unsecured creditors to absorb losses, with the aim of maintaining financial stability and, “to the fullest extent possible,” protecting policyholders; (v) plans should be firm-tailored and are “non-prescriptive” guides; (vi) while plans should respect claims priority in liquidation, they (or regulatory authorities) should have flexibility to depart from equal treatment of creditors of the same class; and (vii) policyholders may have

to absorb losses that are not covered by policyholder protection schemes (PPSs).

The Guidance identifies stabilization and restructuring tools that may be included in resolution plans, such as: sale or transfer of the insurer or its insurance portfolios to a third party, and creditor financed recapitalization (through bail-in, restructuring of insurance liabilities or write down of other liabilities and their conversion into equity). It also identifies wind-down tools that include solvent and insolvent run-off, liquidation and winding-up (with estimation of future claims). Yet another category of helps lies in stays and suspension powers. The nature of “highly substitutable” life insurance products calls for additional helps in the form of transfers of liabilities to new assuming insurers or “bridge” insurers until a solvent insurer can be found at a later date. And for property and casualty insurers, liquidation is suggested for insurers with insurance liabilities of short duration, while insolvent run-off is suggested for insurers with liabilities of “longer duration.” Harking back to 2008, stays are suggested to prevent counterparties from terminating financial products and transfer tools to preserve derivatives portfolios.

In order to ensure that a plan is truly fulsome and can be successfully implemented, the Guidance also focuses on identification of critical functions – including the ability to write new business, continuing existing cover and continuing payments falling due – as well as operational continuity in respect of critical shared services (whether finance-related or operational).

Finally, the Guidance outlines the steps that authorities need to have in place to ensure that a resolution plan can be feasibly and credibly implemented, including: developing operational resolution plans, adaptability of such plans to failure scenarios, identification of resolution triggers, cooperation agreements among group wide authorities, information systems and data requirements, and exits from the resolution process.

FSB requested comments to the Guidance. The NAIC respectfully but strongly objected, revealing a bit of a culture clash. Their objections reflect the ongoing tension between the developing national “regulation” of insurance provided under the US Treasury and FIO and the existing state regulatory system. Key objections included that the US has not yet fully implemented the Key Attributes (as FSA expressly assumed), and that the Guidance should recognize jurisdictional differences rather than aspire to theoretical strategies that are unavailable; that the Key Attributes are derived from bank resolution schemes that do not account for important differences in US insurance resolution law and practice; that the US does not have a “national” legal system of insurance resolution; that PPSs are not just a source of resolution funding but instead are critically important partners in resolution planning and administration; that equal treatment of creditors within classes is a paramount US insurer receivership


rule, not an aspiration; that the distinction between “home” and “host” regulators is problematic and should be replaced by “group-wide supervisors”; that policyholder obligations should not be restructured and PPSs should not be triggered in a solvent run-off; and that an insolvent run-off is functionally equivalent to liquidation and should be distinguished from an orderly run-off.

Despite these objections, our experience is that US state regulators are finding pragmatic solutions and developing resolution plans for insurers that operate in US and non-US jurisdictions under legal systems that are not uniform or even easily reconciled.

IAIS Searching for Balance between Equal Access and Transparency

In addition to the substantive issues discussed above, the IAIS’s interaction with stakeholders attracted extra attention during 2015, and into 2016. At the end of 2014, the IAIS abolished both its so-called “pay to play” system of charging interested industry participants significant “observer” fees, whereby a paid observer was able to attend all but a very limited number of IAIS committee and working group meetings.

In 2015, for the first time, the IAIS held “stakeholder” sessions several times during the year, but banned interested parties from all IAIS member meetings and limited the Annual Meeting to only

members and a few invited industry representatives. Interested parties (and at least some regulators, principally from the US) objected strenuously. Those objections intensified over the course of the year, because the stakeholder sessions which had been advertised as being dialogues between stakeholders and the IAIS members and staff were anything but that, as supervisors largely sat in silence in response to industry input, so there was very little dialogue on important policy issues and/or senior IAIS representatives did not attend these stakeholder meetings.

2016 looks to be different. At the first stakeholder meeting of 2016 in Basel (on the G-SII standards and NTNI consultations discussed above), supervisors were actively engaged with the stakeholders and worked hard to provide meaningful and informative (if not entirely satisfactory) responses to stakeholder questions. Moreover, in early February 2016, the IAIS announced an updated calendar with numerous stakeholder meetings around the world on the ICS, GSII and NTNI, and corporate governance. In addition, the IAIS has said that some form of stakeholder participation will occur as part of its 2016 Annual Meeting. Time will tell if this increased access to supervisors at the IAIS has any meaningful impact on IAIS decision making.

As noted above, the reduced transparency and engagement with stakeholders has not only been of concern for industry and consumer representatives, but also some regulators – particularly US state insurance regulators. (There has also been

sharp Congressional questioning on the openness and operations of the IAIS.) On February 10, 2016, the NAIC International Insurance Relations (G) Committee held a conference call to discuss how the IAIS stakeholder procedures were working in practice and ways in which they could be improved. Interested parties were able to submit ideas on ways to promote open and transparent communication by IAIS members to stakeholders, as well as receive input from all members and stakeholders to present to the IAIS. Many interested parties raised issues such as scheduling global open meetings that conflict with US regulatory meetings, like the NAIC-sponsored meetings. Commissioner McCarty reiterated the NAIC’s (and Team USA’s) commitment to transparency in the IAIS process, as well as their focus on equity issues and equal access to stakeholder forums, i.e., “steering away from winners and losers.”


FEDERAL LEGISLATIVE AND REGULATORY DEVELOPMENTS


The federal government continues to be a significant player in insurance regulation in the US The Fed has publicly supported the “Team USA” concept – cooperation among federal government agencies and various state regulators against international

regulatory bodies and influence on the US insurance market. Moreover, the Fed continues to evolve as a critical regulator in its own right. The US Congress have passed bills that strengthen the Fed’s authority in insurance regulation as well as providing more oversight mechanisms for the various executive agencies that have existing authority to undertake international negotiations on behalf of the US insurance industry. 2015 also reminded the insurance industry that executive agencies, such as the Department of Labor (DOL), with a tangential but significant authority over the insurance industry, can exercise its authority directly, which could impact the insurance industry to its surprise.

Evolution of The Federal Reserve Board

Since the adoption of the Dodd-Frank Act, the Fed has had an important insurance regulatory role. The Fed has direct supervisory authority as the consolidated supervisor of certain insurance holding companies – those which include insurers which been designated SIFIs by the FSOC, as well as those that own federally chartered thrifts or banks. In addition, it has become an important voice in insurance regulation – particularly on international issues and on topics beyond its Dodd-Frank Act mandate. In 2015, the Fed’s influence in insurance regulation on both the global and national regulatory stages developed significantly. The development of group capital standards (or the global ICS) brought representatives of the Fed, the FIO and the NAIC together as Team USA to represent the US at the IAIS. As noted above, Team USA began their work on developing capital standards, the thinking being that if they develop a US-based capital standard, the work that the IAIS will do on the ICS will be heavily influenced (if not done in concert).

Team USA insists that they would not allow developments on the international stage to undermine the state-based insurance regulatory system in the US, for example, they said that they would walk away from any covered agreements negotiation that would have that effect.

Although Team USA indicates that they will work together as global regulators develop various regimes that will affect the US insurance market, it remains to be seen how the three branches of Team USA will continue to cooperate as regulations and negotiations develop. Each branch has their own motivations. The NAIC will always maintain that they regulate 100% of the US insurance market, and fur ther that half of the top 50 insurance markets are individual US states. Nevertheless, as long as the Fed has direct supervisory authority over certain insurance companies as well as SIFIs, the Fed regulates at least one-third of the assets in the US insurance industry.

US Department of Labor Issues Proposed Rule Impacting Life Insurance Industry

On April 20, 2015, the DOL released a new proposed rule (DOL proposed rule) to change the definition of fiduciary under the Employee Retirement Income Security Act of 1974 (ERISA). On its surface, it would have gone unnoticed by the insurance industry; however, the DOL proposed rule could significantly impact certain annuity products (specifically, guaranteed lifetime income annuities). The DOL proposed rule would severely restrict access to information and education about annuities. This has been a priority for Congress and the Obama Administration. While the DOL proposed rule does not outlaw commission-based investment products, which annuities are generally sold by advisors on commission, some have argued that the DOL proposed rule’s Best Interest Contract Exemption will make commission-based sales difficult for advisors. The disclosure requirements and the heightened prospect of private litigation against advisors could force advisors away from marketing annuities altogether. The life insurance industry has reacted strongly against what many believe as a misguided rule, which would actually harm consumers. They have filed voluminous comments in response to the DOL rule making procedures and expect to see changes in the final rule.

Beyond the specific policy proposal, the DOL proposed rule demonstrates two important points. First, it is evidence of yet another Federal agency which can have a material impact on the insurance industry. It is probably safe to say that few insurers at the star t of 2015 had the DOL on their radar or a possible source of troublesome insurance regulatory proposals. Second, in addition to the myriad of solvency, risk management, regulatory changes that the industry faces, consumer protection laws and regulation is never far off – and is likely to increase in importance in the coming year.

The DOL published the proposed regulations for comment on April 20, 2015, with the comment period ending July 6, 2015. On August 10-13, 2015, the DOL held a four-day public hearing to discuss the proposed rule. Following the public hearing, the DOL reopened the comment period until September 24, 2015. DOL is in the process of reviewing the comments it has received on its proposed rule and determining what changes, if any, to make to the proposed regulation.

Legislative Outlook

Dodd-Frank. On May 12, 2015, Richard Shelby, the Chairman of the Senate Committee on Banking, Housing and Urban Affairs, introduced the Financial Regulatory Improvement Act of 2015 (S.1484). The bill has eight titles and includes a broad range of regulatory relief and other provisions that amend the Dodd Frank Act and several other banking laws. Title IV of the bill includes three sections directly related to insurance. Section


401 includes a Sense of the Congress provision that reaffirms McCarran-Ferguson and the system of state-based insurance regulation. Section 402 ensures that insurance policyholders would be protected from having their policies put at risk by their insurance company to shore up a distressed affiliated depository institution (this provision was subsequently included in the Consolidated Appropriations Act of 2016 and signed into law). Section 403 contains language similar to S.1086 (discussed below), which would require an additional reporting requirement and consultative measures surrounding ongoing international negotiations to create insurance regulatory standards. The bill also includes provisions that would reform the process for designating non-bank SIFIs by requiring the Financial Stability Oversight Council (FSOC) to provide more information to companies related to designation criteria and to give them more opportunities to take actions to avoid or reverse SIFI designations.

S.1484 passed out of the Senate Banking Committee along party lines with a vote of 12-10 on June 2, 2015. In 2016, we expect to see some attempts by Senate Banking Committee members to jumpstar t negotiation on a bi-partisan compromise bill. However, 2016 election politics may hamper effor ts to work out a deal.

On the other side of the US Capitol, we expect the Republicans on the House Committee on Financial Services to work on an alternative to Dodd-Frank that would repeal huge swaths of the Act and replace it with their vision for financial reform. We expect the Republican alternative bill to be introduced in the Spring of 2016. While the reform measure will have no chance to be signed into law this year, Republicans hope to use it to set the financial reform debate in 2017.

Insurance Capital Standards. The 2014 passage of The Insurance Capital Standards Act gave the Fed the flexibility to develop insurance-specific standards for those insurers subject to Fed supervision. We expect the Fed to release a Notice of Proposed Rulemaking laying out the new capital requirements for Fed-supervised insurers in the spring of 2016. At that time, there will be an opportunity for interested stakeholders to provide public comment on the rule before it is finalized. We also expect the House and Senate Committees to conduct oversight over the Fed’s rulemaking process to ensure that proposed capital standards are not bank-centric and that they are appropriately suited for the business of insurance.

International Capital Standards. In 2015, Senator Dean Heller (R-NV) and Senator Jon Tester (D-MT) introduced S. 1086, the International Insurance Capital Standards Accountability Act. The bill would create an “Insurance Policy Advisory Committee on International Capital Standards and Other Insurance Issues” – comprised of insurance experts to advise federal insurance supervisors and regulators throughout the global capital standard development phase. The bill would also require periodic reports,

testimony, updates and studies from the Fed and the Treasury on any regulatory developments at the IAIS as well as the impact of international capitals standards on US policyholders and companies. This bill is also included in Chairman Shelby’s regulatory relief bill discussed above.

On the House side in 2015, Representative Sean Duffy introduced H.R. 2141, the International Insurance Standards Transparency and Policyholder Protection Act. The bill goes a bit fur ther than S.1086 by setting negotiating objectives for US representatives in international insurance capital standard negotiations at the IAIS. The objectives are largely based on the current approach used in the United States including a focus on protection of policyholders, regulation on a legal entity basis, and use of supervisory colleges in the oversight of insurance groups. The bill would also require notice and consultation with the House Financial Services and Senate Banking Committees before and during the process of international negotiations.

In 2016, we expect the House and Senate committees to continue to monitor insurance regulatory developments overseas at the FSB and IAIS. As the IAIS moves ahead with the development of its ICS, we expect Congress to continue to pressure the Fed and FIO to resist any global capital standard that favors the consolidated, bank-like approach preferred by European regulators. We also expect bipartisan calls to improve transparency at the IAIS, in particular the opacity of the selection criteria for G-SIIs, the lack of due process to appeal those decisions, and the concern surrounding the IAIS’s recent decision to eliminate the “observer status” at the organization.

On the legislative front, we expect S.1086 to be included in any potential compromise on Chairman Shelby’s regulatory relief bill mentioned above (S.1484), which could provide an opportunity for the measure to be signed into law. We also expect the House Committee on Financial Services to introduce legislation that will attempt to merge the legislative text of S.1086 and H.R. 2141, with the purpose of passing the measure out of the House and working with the Senate to send a bill to the President. We assign a low probability that the latter strategy will result in a bill being signed into law.

Agent and Broker Licensing. The National Association of Registered Agents and Brokers Reform Act was signed into law on January 12, 2015 (passed as Title II of H.R. 26). The bill allows insurance agents and brokers who are licensed in good standing in their home states to apply for membership to the National Association of Registered Agents and Brokers (NARAB), which will allow them to operate in multiple states. NARAB will be a private, non-profit entity that will be overseen by a board made up of five appointees from the insurance industry and eight state insurance commissioners. In January of 2016, President Obama nominated four of the thir teen people needed to fill the board


vacancies, including two state insurance commissioners (South Carolina and Minnesota) and two industry representatives.

In the remainder of 2016, we expect the President to complete the nomination of the NARAB board.

Terrorism Risk Insurance. We expect the House and Senate Committees to oversee the implementation of reforms passed in the Terrorism Risk Insurance Program Reauthorization Act of 2015. One reform included in the Act directed the Treasury Secretary to establish and appoint an Advisory Committee on Risk-Sharing Mechanisms to give advice, make recommendations, and encourage the creation of nongovernmental risk-sharing mechanisms to support private market reinsurance capacity for protection against losses arising from acts of terrorism. We expect the first hearing of this Committee to be in February of 2016.

National Flood Insurance Program. In 2012, Congress passed the Biggert-Waters Flood Insurance Reform Act which reauthorized the National Flood Insurance Program (NFIP) through September 30, 2017. With the expiration of the Program approaching, we expect Congress to hold hearings about potential reforms to the NFIP. We expect the House Committee on Financial Services to hold a series of hearings on flood insurance in 2016, many of which will examine ideas and proposals that would increase the role of the private market in underwriting flood risk. Upon completion of a series of hearings, we expect Housing and Insurance Subcommittee Chairman Blaine Luetkemeyer to introduce a comprehensive flood insurance reform measure, which will set the stage for the reform debate in 2017.

Relatedly, we expect the House to pass H.R. 2901, the Flood Insurance Market Parity and Modernization Act, which was introduced by Representatives Dennis Ross and Patrick Murphy in June of 2015. The bill amends the Flood Disaster Protection Act to clarify that flood insurance offered by a private carrier outside of the NFIP can satisfy the Act’s mandatory purchase requirement. Passage of H.R. 2901 may encourage the Senate to act on companion legislation (S.1679 – introduced by Senators Heller (R-NV) and Tester (D-MT)). We assign a moderate probability that this bill will be signed into law in 2016.

Cybersecurity. With the passage of cybersecurity information sharing legislation at the end of December, attention has shifted back to the other cybersecurity priority area -- a national data security and breach notification law. We expect this will continue to be a major focus of the House and Senate committees during the second session of the 114th Congress, although it is far from clear if a compromise can be reached. In the Senate, the sponsors of the primary bills are working to resolve differences over the scope of federal preemption of state data security and breach laws as well as sectoral disputes over the notification and other compliance obligations of the various consumer data handlers including the communications and retail sectors. In the House,

although the two committees of jurisdiction have both passed data security and breach bills, significant jurisdictional and inter-industry differences remain.

US Sanctions

Economic and trade sanctions continue to a major tool in the US foreign policy toolbox, often the first and most popular option for policymakers in shaping the US response to world events. The heightened popularity of sanctions continues to generate specific and sophisticated forms of economic restrictions, presenting frequent and new challenges for the compliance departments of insurers.

Cuban Sanctions. The year began with the promulgation of significant new regulations by Treasury’s Office of Foreign Assets Control (OFAC) implementing President Obama’s surprise Cuba sanctions initiative in December 2014. The revisions to the Cuba Assets Control Regulations (CACR) significantly reduced the barriers to travel to Cuba by US citizens by generally authorizing 12 categories of travel without the need for a specific license, from professional conferences to educational tours to so-called “people-to-people” exchange tours. Overall, the loosening of travel restrictions to Cuba produced an astonishing 36% increase in the number of US travelers to Cuba in the first six months of 2015 over the same time period in 2014.

An important CACR travel liberalization impacting insurers was authorization for any US person – insurer, broker, reinsurer – to issue coverage and pay claims for global travel insurance policies insuring non-US persons travel to Cuba from a third country. Although this was initially viewed as a significant reform to help level the playing field for US insurers in overseas travel insurance markets, subsequent OFAC Frequently Asked Questions (FAQs) have provided interpretative guidance that gives a narrow reading to the definition of “global travel insurance policy.” Other significant changes to the CACR impacting insurers involved the removal of limitations on the remittance of death benefit proceeds of life insurance policies to Cuba beneficiaries. While the previous dollar limitation for remittances have been removed, life insurers must still deposit proceeds in a blocked bank account with a US domestic bank so remittances can be made from the bank, not directly by the life insurer.

In December 2015, Cuba reached a landmark agreement with foreign creditors to settle disputes involving billions of dollars in unpaid debt dating back 25 years. Although the US was not among the creditor nations participating in the agreement, the first meeting to resolve the longstanding US claims was held on December 8 between the US State Department and the Cuban Ministry of Foreign Affairs. These claims are considered by many to represent the largest single barrier to a removal of the US sanctions against Cuba. Originally the claims amounted to $1.9 billion, but now are considered to be valued at about $8 billion, including interest. US-Cuba claim negotiations is a major step


towards normalization of relations but is also a necessary step towards the lifting of sanctions under the Helms-Burton Act of 1996.

Iranian Sanctions. On July 14, 2015, the E3+3 (the United Kingdom, France, Germany, China, the Russian Federation and the United States) and Iran reached an agreement on a Joint Comprehensive Plan of Action ( JCPOA) with respect to Iran’s nuclear program. The JCPOA lifts nuclear-related sanctions against Iran in return for Iran’s agreement to suspend, terminate, and allow the monitoring of various nuclear-related activities. Sanctions relief under the JCPOA will not take effect until the International Atomic Energy Agency (IAEA) verifies Iranian compliance with its nuclear-related commitments. Known as “Implementation Day,” the IAEA announced on January 16, 2016 that Iran curbed its nuclear program enough to begin receiving relief on sanctions. Sanctions relief is limited, however, to removing EU sanctions and only those US “secondary” sanctions applicable to non-US persons. “Primary” US sanctions, applicable to US persons and corporations, remain in place following Implementation Day. Moreover, even though EU and US secondary sanctions are repealed, there is a possibility of a ‘snapback’ of those sanctions if Iran violates its nuclear commitments under the JCPOA.

It is important to recognize that US sanctions relief is limited to so-called “secondary sanctions”: prohibitions on transactions by non-US persons with Iran’s banking, energy, petrochemical, automotive and shipping sectors; trade with Iran in precious and other metals; and software for activities consistent with the JCPOA. Insurance, reinsurance and underwriting services for transactions permitted by the JCPOA are specifically authorized, but only for non-US persons. The full range of US “primary

sanctions” will continue to apply to US insurers, brokers and reinsurers following Implementation Day. OFAC has pledged to provide guidance on the implementation of the JCPOA sanctions relief provisions before Implementation Day.

Russian and Ukrainian Sanctions. The complex and highly specific Russian, Ukraine-related and Crimea Region sanctions first imposed in March 2014 continued to be an important component of US foreign policy in 2015. On July 30, 2015, OFAC fur ther expanded US sanctions in three areas, reinforcing the attention OFAC continues to pay to Russian foreign policy initiatives. First, OFAC added 35 new designations to the Sectoral Sanctions Identifications (SSI) List for entities 50% or more owned by the Russian development

corporation Vnesheconombank (VEB) and the Russian petroleum conglomerate Rosneft, both Sectoral Sanctions Identified (SSI) entities. OFAC has made clear it considered each of these entities to have already been sanctioned by operation of law under its “50% Rule,” but that it was merely providing clarifying guidance to help the public more effectively comply with existing SSI sanctions. OFAC also added 26 persons to its SDN list: 13 individuals and entities found to have supported the evasion of existing sanctions; two entities operating in the Russian arms sector; five former Ukrainian government officials or their close associates or affiliated companies; five Crimean port operators; and, one Crimean ferry operator. Finally, OFAC’s July 30 actions included an “Advisory” to warn the public about certain tactics it had identified as being used to evade sanctions imposed on the Crimea Region.

Insurance Enforcement Actions. OFAC continues to be active in scrutinizing sanctions compliance of insurers. In August OFAC announced a $271,815 civil penalty settlement with Navigators Insurance Company, a fixed-premium Protection and Indemnity (P&I) Insurer, for issuing coverage and paying indemnity claims for vessels traveling to Cuba and Iran. The settlement also involved apparent violations for providing P&I insurance coverage for 24 North Korean flagged vessels, a very narrow and little-know prohibition. OFAC eliminated the staff position of a Senior Sanctions Advisor – Insurance in 2015, but continues to manage enforcement responses to insurance transactions with personnel in its Sanctions Compliance and Evaluation unit.


NAIC AND STATE REGULATORY DEVELOPMENTS


Although there were not many state elections, there were nearly as many changes in senior personnel within insurance departments and NAIC leadership in 2015 as there were in 2014. Like 2014, these changes come at a time when

state insurance commissioners are responding to a number of significant challenges, including the continuing evolution and the ongoing work of the Fed as an insurance regulator, as well as the FIO, both as strong voices on US insurance regulatory policy. At the same time, US regulators are faced with a number of issues on the international front. Accordingly, at a time when the NAIC could benefit from stability and continuity, it is faced with substantial change and attrition.

2015 State Elections, Insurance Commissioners and the NAIC

Statewide Races. As observers of US insurance regulation know, most commissioners are appointed by governors, so gubernatorial elections can change the make-up of US insurance policy-making bodies, including the NAIC. In Kentucky, Republican Matt Bevin defeated the Democratic candidate, resulting in the Governor’s Office changing parties. Accordingly, former NAIC President-Elect Sharon Clark resigned in January 2016 and was replaced by Commissioner H. Brian Maynard on January 21, 2016.

Commissioners are elected in a number of states. Although Louisiana and Mississippi Commissioners of Insurance were up for reelection in 2015, both Commissioner Jim Donelon (LA) and Commissioner Mike Cheney (MS) were reelected.

Insurance Commissioner Resignations. A number of influential commissioners resigned for personal reasons unrelated to election results:

■ Florida. Although surviving public attempts by the Florida Governor to force his resignation last year, Commissioner Kevin McCarty announced in January 2016 that he would resign his position on May 2, 2016. A leader in the NAIC and an influential voice at the IAIS, Commissioner McCarty served as the Commissioner of Insurance in Florida for 13 years. He was appointed as chair of the International Insurance Relations (G) Committee in 2016. Commissioner McCarty has publicly said that he may be seeking a national insurance position.

■ New York. The New York Department of Financial Services (NYDFS) has been in flux after the departure of its inaugural Superintendent and a significant number of senior employees over the last seven months. In addition to executive level staff, notably Rob Easton, the former head of the Insurance Division, key employees with decades of experience, notably Michael Maffei, a senior insurance examiner, either retired or resigned for positions in the private sector. The NYDFS has been without a permanent general counsel since last February

and at one point in 2015, both the head of the Property Bureau and Life Bureau were vacant positions. In late January, Governor Mario Cuomo nominated Maria Vullo, a former partner at Paul Weiss and one of his deputies in the Office of Attorney General, to be the first permanent Superintendent since Benjamin Lawsky left in June 2015. Her appointment was greeted warmly by many in the insurance industry who hope that she will bring stability to and rebuild the NYDFS.

■ Rhode Island. Insurance Superintendent Joseph Torti III resigned from the Rhode Island Department of Business Regulation at the end of the year to assume a position with an insurance company. Torti served for more than 25 years with the Rhode Island Insurance Division, beginning his career as a senior examiner. When announced, the news took the industry by surprise.

Superintendent Torti’s resignation will have a huge impact to the NAIC. He served as chair of the Financial Condition (E) Committee, co-chair of the Principle-Based Reserving Implementation (EX) Task Force and a member of the NAIC Audit Committee, and as well as other committees and working groups. The Insurance Division’s Associate Director Elizabeth Kelleher Dwyer was named Rhode Island’s Superintendent of Banking and Insurance in mid-January.

■ Pennsylvania. Deputy Insurance Commissioner Stephen Johnson retired at the end of 2015. He was appointed in 1998 and ran the Bureau of Company Licensing and Financial Analysis and the Bureau of Financial Examinations for the Commonwealth of Pennsylvania. He also served as a member on many NAIC financial working groups, task forces and committees, including the Statutory Accounting Principles Working Group and Reinsurance Financial Analysis Working Group. Former Deputy Commissioner Johnson was a powerful voice in the NAIC’s Solvency Modernization Initiatives. Joseph DiMemmo succeeds former Deputy Commissioner Johnson. DiMemmo previously headed the Pennsylvania Department’s Office of Liquidations Rehabilitations and Special Funds.

NAIC: Shakeup in the Leadership. History seems to be repeating itself in changes in the NAIC leadership. As was the case in 2015, the most significant change in the NAIC leadership was a vacancy of the NAIC president-elect position as of January 21, 2015, due to the gubernatorial election in Kentucky. A special election for a replacement was held on February 7, 2016, and Wisconsin Insurance Commissioner Ted Nickel was elected. Immediately after, Tennessee Insurance Commissioner Julie Mix McPeak was elected NAIC Vice President, the position previously held by Commissioner Nickel. Members then elected Maine Insurance Superintendent Eric A. Cioppa to the position of Secretary-Treasurer, previously held by Commissioner McPeak. Missouri Insurance Director John M. Huff continues to serve as the NAIC’s President.


Additionally, former US Senator and CEO of the NAIC Ben Nelson announced in October 2015 that he would not renew his contract with the NAIC. Therefore, Senator Nelson’s term ended at the NAIC on January 31, 2015. Currently NAIC Chief Operating Officer and Chief Legal Officer Andy Beal was named as Acting CEO of the NAIC, while the NAIC searches for a permanent CEO.

NAIC 2016 OFFICERS

Office Officer

PresidentJohn M. Huff, Missouri Insurance Director

President-ElectTed Nickel, Wisconsin Insurance Commissioner

Vice PresidentJulie Mix McPeak, Tennessee Insurance Commissioner

Secretary – TreasurerEric A. Cioppa, Maine Insurance Superintendent

Substantive NAIC Actions

In 2015, the NAIC continued and made significant progress in the following areas:

Captives and Special Purpose Vehicles (SPVs)

Readers will recall that in July 2012 the NYDFS began an investigation into the use of captives in reinsurance transactions by 80 New York life insurance companies and their affiliated entities. In July 2013, the NYDFS issued its controversial report, “Shining a Light on Shadow Insurance: A Little-Known Loophole That Puts Insurance Policyholders and Taxpayers at Greater Risk” (the NYDFS Captive Insurance Report). The NYDFS Captive Insurance Report took the position that an insurer that reinsures through a captive that is not required to comply with the same reserving requirements applicable to the ceding insurer is an end run around solvency protections, reduces the adequacy of reserves, and fundamentally misstates the ceding insurer’s true financial condition. The Report was widely criticized by industry and by other regulators.

Concern about the use of captives and SPVs to finance redundant life insurance reserves continued to occupy regulators’ attention in 2015. The NAIC worked on developing Actuarial Guideline (AG) 48 into a Model Law, while various NAIC committees, subcommittees, working groups and task forces worked on the various aspects of formalizing AG 48 and providing for

its implementation. AG 48 defines the rules for new term life (XXX) and universal life (AXXX) reserve financing transactions executed after January 1, 2015. On January 8, 2016, the NAIC Executive (EX) Committee and Plenary adopted additional revisions to the Credit for Reinsurance Model Law (#785) reflecting the guidance in AG 48.

NAIC Develops AG 48-Based Model Law. Actuarial Guideline 48 (AG48) was adopted by the NAIC Executive Committee and Plenary, effective January 1, 2015. It was intended to be interim guidance for XXX/AXXX reserve financing transactions through captive arrangements until PBR becomes effective. AG 48 requires a ceding company’s appointed actuary to determine, as of a specified date, whether the company’s amount of Primary Securities meet the reserve requirements of the NAIC’s Valuation Manual Requirements for Principle-Based Reserves for Life Products (also referred to as VM-20), which is the actuarial method for determining so-called “economic reserves.” This is referred to as the “Required Level of Primary Security.” The remaining reserves may be backed by “Other Security.”

The Capital Adequacy (E) Task Force adopted three proposals related to the AXXX Reinsurance Framework:

■ Qualified Actuarial Opinion Impact on Interest Rate Risk and Market Risk in the RBC formula. This proposal changes an interrogatory on LR027 Interest Rate Risk and Market Risk. If a company submits an unqualified actuarial opinion, the interrogatory would result in the company receiving a one-third reduction in the Interest Rate Risk and Market Risk factors in the RBC calculations. It was modified to prevent an opinion qualified solely due to the direction in AG 48, which is line of business specific, impacting all lines of business.

■ Primary Securities Shortfall. This proposal adds a new schedule showing the primary security shortfall by individual cession. The cumulative amount of primary security shortfall, with no offset for any surpluses, is then taken as a dollar-for-dollar addition to the reporting company’s Authorized Control Level.

■ RBC shortfall. This proposal adds a new schedule which shows the RBC calculation by individual captive, which would apply to the ceding company’s RBC calculation. The RBC Shortfall of the captive is the difference between the Total Adjusted Capital and the Benchmark RBC level (which is set at 300% for each captive). The cumulative amount of the captives’ RBC shortfalls, with no offset for any surpluses, is then taken as a dollar-for-dollar reduction to the reporting ceding company’s Total Adjusted Capital.

The Task Force must continue work on the consolidated RBC. The consolidated column on the RBC Shortfall schedule will contain an automatic ‘xxx’ with the exception of the shortfall amount.


The Capital Adequacy Working group also adopted its 2016 charges, which include determining whether asset charges for the forms of “Other Security” should be developed or otherwise accounted for in the RBC shortfall calculation. This charge undoubtedly reflects the Life Risk Based Capital Working Group’s decision earlier this year to defer consideration of whether to incorporate consideration of Other Securities into the RBC shortfall or into a stand-alone proposal until 2016 due to its complexity and lack of time given the other proposals.

Proposal to Disclose the RBC of AXXX Captives Exempted from AG 48. The Principle-Based Reserving (PBR) Implementation (EX) Task Force discussed a letter from the Life RBC Working Group, which requested disclosure of the RBC of special purpose financial captives which are engaged in AXXX transactions that are exempted from AG 48. Currently disclosure requirements would not apply to captives exempted from AG 48. There was support from the PBR Implementation Task Force to pursue this request, although there was pushback from the life insurance industry – stating that it would be impossible to have such a disclosure ready for 2015 reporting.

The underlying issue is financing versus volatility of results. It has been asserted that if the NAIC imposes the same disclosure developed for variable annuities on AXXX captives, then the companies will end up with misleading numbers. Other ideas being considered include reviewing consolidated results for all captive transactions with a ceding company instead of individual transactions. Regulators indicated they may want to go back and fully develop the consolidated view instead of doing the same with individual transactions. Even that approach may not eliminate the timing concern because the NAIC still needs to fix the consolidated column for 2015 reporting. The bottom line for regulators is the concern that special purpose financial captives do not use RBC rules and regulators intend to correct that.

Imposition of accreditation standards on certain captive insurers

The Financial Regulation Standards and Accreditation (F) Committee (F Committee) drafted new language for the Part A Accreditation Preamble that would provide that certain captive insurers, special purpose vehicles, and other entities assuming insurance business would be subject to the general accreditation standards, but the application would be limited to only the following lines of reinsurance business: (1) AXXX policies (as

defined under AG 48) to apply to those policies that are required to be valued under Sections 6 or 7 of the NAIC Valuation of Life Insurance Policies Model Regulation (Model #830); (2) variable annuities valued under Actuarial Guideline XLIII—CARVM for Variable Annuities (AG 43); and (3) long-term care insurance valued under the NAIC Health Insurance Reserves Model Regulation (Model #10).

The F Committee adopted the Accreditation Preamble with respect to captive insurers that assume business written in AXXX transactions, effective January 1, 2016. The F Committee voted to continue to monitor the work of NAIC groups as it considers certain issues with respect to variable annuities and long term care, such as grandfathering of variable annuities and LTC assuming entities; safe harbors; and the effective date of the accreditation requirement.

Draft AXXX Reinsurance Framework Model Regulation deviates from AG 48. The AXXX Captive Reinsurance Regulation Drafting Group drafted the following:

■ The Credit for Reinsurance Model Law Amendment. Four alternatives were exposed throughout the year. An Option 1 Amendment would authorize the commissioner to issue a regulation on AXXX (i.e., only with respect to reinsurance of non-universal and universal life insurance with secondary guarantees). An Option 2 Amendment would expand the commissioner’s authority to also apply to variable annuities and long term care reserve financing transactions. An Option 3 would provide a commissioner with the broadest discretion


to specify by regulation requirements for reserve credit with respect to any particular types of reinsurance arrangements. The Reinsurance Task Force ultimately adopted an Option 4 on January 8, 2016, which was an amalgamation of the three previously described options. Option 4 would give a commissioner authority to issue regulations applying to reinsurance of XXX/AXXX life products, variable annuities with guaranteed death or living benefits, long term care products or “such other life and health insurance and annuity products as to which the NAIC adopts model regulatory requirements with respect to credit for reinsurance.”

■ The AXXX Credit for Reinsurance Model Regulation. The Model Regulation is based on AG48. The key issue being considered is what happens if a covered transaction does not meet the requirements of AG 48 because of a shortfall in Primary Security. Proposals included:

– The all-or-nothing approach – the ceding company receives no credit for reinsurance for the AXXX transaction. The majority (but not all) of the drafting group supports this approach.

– Dollar-for-dollar reduction of credit for reinsurance.

– Percentage reduction of credit for reinsurance.

– Primary Security Limitation – only receive credit for reinsurance on the amount of primary securities held.

Although on October 26, 2015, the Reinsurance Task Force, through a majority vote, elected to draft the Model Regulation using the all-or-nothing consequence option, the members agreed to continue to discuss this approach and the alternative options throughout 2016.

Captive Litigation. The NYDFS Captive Insurance Report referenced above inspired putative class action lawsuits against two of the insurers named in the Report, MetLife and AXA. The claims arise out of the contention, borrowed from the Report, that reinsuring through captives subject to less rigorous reserving requirements, is fundamentally deceptive.

By mid-2015, lawsuits had been filed against MetLife, AXA Equitable and Lincoln National. By the end of 2015, two of the class actions suits had been dismissed. In the AXA case, the Southern District of New York dismissed the putative class action for lack of standing, ruling that the plaintiffs had suffered no identifiable, immediate, ar ticulable and concrete harm. In the MetLife case, the Court, citing the AXA case, rejected similar arguments on the same grounds: the plaintiffs lacked standing under Article III of the US Constitution to bring this claim because they failed to have any cognizable injury.

Reinsurance Developments

Status of Adoption of the NAIC Credit for Reinsurance Model Laws. The 2011 revised Credit for Reinsurance Model Law (#785) and Model Regulation (#786) allow the reduction of collateral required to be posted by unauthorized assuming reinsurers that meet certification requirements. As of January 16, 2016, 32 states had adopted the 2011 revisions to their credit for reinsurance statutes and/or regulations, representing more than 66% of direct insurance premium written in the US across all lines of business (although it must be noted that far fewer states have adopted the implementing regulations, so the impact of the new rules is more limited). The NAIC had been pushing states to adopt the Model Law and Model Regulation and touting the success in getting states to adopt the new Model Law. In addition, the NAIC voted to make the new collateral rules a part of the accreditation standards.

States that Adopted the 2011 Revisions to both Model Law #785 and Model Regulation 786 (19 States)

Alabama, California, Colorado, Connecticut, Delaware, Florida, Georgia, Iowa, Indiana, Louisiana, Maryland, Missouri, New Hampshire, New Jersey, New York, Ohio, Pennsylvania, Rhode Island and Virginia

States that Adopted the 2011 Revisions to Model Law #785 Only (13 States)

Arkansas, Arizona, District of Columbia, Hawaii, Massachusetts, Maine, Montana, North Dakota, Nebraska, New Mexico, Nevada, Vermont and Washington

Qualified Jurisdiction (E) Working Group. Reduced reinsurance collateral requirements apply only to certified reinsurers that are licensed and domiciled in a “qualified jurisdiction.” While the designation of qualified non-US jurisdictions is left to the individual states, the Model Law and Regulation provide for the NAIC to create and maintain a list of Qualified Jurisdictions. Individual states must take this NAIC list into account when designating a qualified jurisdiction. The NAIC did not add any additional jurisdictions to the list in 2015. Although no jurisdictions were formally reviewed by the NAIC in 2015, Sweden’s application is currently under review.


Reinsurance Financial Analysis (E) Working Group. The Reinsurance Financial Analysis Working Group (RE-FAWG) was formed to establish a peer review process to allow “passporting,” a process (equivalent to that in Europe) by which a reinsurer’s cer tification by one state would allow other states to certify that reinsurer without undergoing a separate review and approval process. Even if the RE-FAWG issues a recommendation, the states are not mandated to follow the recommendation. More than 30 reinsurers have been approved for passporting to date.

Additionally, the RE-FAWG (and ultimately the Reinsurance Task Force and NAIC membership) adopted important revisions to the Uniform Application for Certification of Reinsurers. Creation and development of the checklist is to ensure that a reinsurer’s application for certification is complete, based on the requirements of the Model Law and Model Regulation.

Principles Based Reserving Implementation

Principle-Based Reserving Revised Standard Nonforfeiture Law for Life Insurance (Model #808) Revised Standard Valuation Law (Model #820) (PBR), which we have discussed in previous editions of this review, will be implemented over approximately three years and for new business once at least 42 states (a supermajority) representing 75% of total US premium adopt the revisions to the Standard Valuation Law. As of January 13, 2016, 39 states, representing 73% of nationwide premiums, have adopted the revised model laws. The PBR Implementation Task Force is currently considering proposals to determine the actual operative date of PBR (i.e., determining whether those states have enacted substantially similar terms and provisions as the SVL). If the thresholds are met by July 1, 2016, PBR could become operative as early as January 1, 2017.

STATES THAT HAVE ADOPTED PBR ARE: Arkansas, Arizona, California, Connecticut, Delaware, Florida, Georgia, Hawaii, Illinois, Indiana, Iowa, Kansas, Kentucky, Louisiana, Maryland, Maine, Michigan, Missouri, Mississippi, Montana, North Carolina, North Dakota, Nebraska, New Hampshire, New Jersey, New Mexico, Nevada, Ohio, Oklahoma, Oregon, Rhode Island, South Dakota, Tennessee, Texas, Virginia, Vermont, Wisconsin and West Virginia.

Corporate Governance

Model Holding Company Act and Own Risk Solvency Assessment Update. The Insurance Holding Company System Regulatory Act (#440) (HCA Model Act); and the Insurance Holding Company System Model Regulation (#450) (HCA Model Regulation) became NAIC accreditation standards, effective

NAIC LIST OF QUALIFIED JURISDICTIONS (as of January 1, 2016)

JURISDICTIONREINSURANCE SUPERVISORY AUTHORITY

LEAD STATE For Regulatory Cooperation and Information Sharing

BermudaBermuda Monetary Authority

Florida

France

Autorité de Contrôle Prudentiel et de Résolution

California will act as the Lead State, on an interim basis, until a bilateral memorandum of understanding with New York has been updated, at which time New York will begin acting as the Lead State

GermanyFederal Financial Supervisory Authority

California

IrelandCentral Bank of Ireland

Delaware

JapanFinancial Services Agency

California

Switzerland Financial Market Supervisory Authority

Connecticut

United Kingdom

Prudential Regulation Authority of the Bank of England

New York

Each state will be designated for five years (absent a material change in circumstances), after which each insurance regulator will be re-evaluated.


January 1, 2016. As of January 13, 2016, the 2010 revisions to the HCA Model Act were adopted in all states. The NAIC Executive and Plenary Committee adopted a one-year exposure period, beginning on January 1, 2016, for the 2014 revisions to the Insurance Holding Company System Regulatory Act (#440), which include authority for state insurance regulators to act as group-wide supervisors, to be included as Part A Accreditation Standards.

The Risk Management and Own Risk Solvency Assessment Model Act (#505) (ORSA), which includes the ORSA Summary Report filing requirement, went into effect on January 1, 2015. Large- and medium-size US insurers and insurance groups are required to regularly perform an ORSA and file a confidential ORSA Summary Report of the assessment with the regulator of each insurance company upon request, and with the lead state regulator for each insurance group whether or not any request is made. An ORSA filing provides an enterprise-wide, detailed description of the entity’s risk management system, an identification of its key risks in normal and stressed environments, an assessment of its capital adequacy for the risks in normal and stressed environments, and identification of prospective risks.. As of January 13, 2016, 35 states adopted the ORSA Model Act, as an additional Par t A accreditation standard (e.g., adopting the significant elements or something substantially similar) effective January 1, 2018.

Corporate Governance Model Act. The Corporate Governance Annual Disclosure Model Act (#305) and Model Regulation (#306) were adopted by the NAIC Executive Committee and Plenary at the end of 2014. The model act and regulation require all insurers to submit a confidential Corporate Governance Annual Disclosure (CGAD) to its lead state and/or domestic regulator by July 1 each year. The models are intended to be effective January 1, 2016.

The models do not mandate the form of the CGAD, but require insurers to submit information in four key areas:

■ Corporate governance framework and structure, including the rationale for the size and structure of the board of directors (board) and the roles of the chief executive officer and chairman of the board

■ The policies and practices of the board and key committees, including appointment practices, maintaining independence, the frequency of meetings held, evaluation and

performance review of board members and how the qualifications, expertise and experience of board members meet the needs of the insurer/insurer group

■ The policies and practices for directing senior management, including a description of suitability standards, the insurer’s code of business conduct and ethics, processes for performance evaluation, compensation and corrective action and plans for succession and

■ The processes by which the board, its committees and senior management ensure an application of an appropriate level of oversight to critical risk areas impacting the insurer’s business activities.

In completing the annual disclosure, the insurer may reference other existing documents, such as the ORSA Summary Report, holding company act Form B or Form F filings, US Securities and Exchange Commission (SEC) proxy statements or foreign regulatory reporting requirements.

The model law and model regulation were adopted as an accreditation standard by the Financial Regulation Standards and Accreditation (F) Committee. As of January 13, 2016, five states have adopted the Model Act – California, Indiana, Iowa, Louisiana and Vermont – and on state adopted the Model Regulation. One state has the Model Act and two states have the Model Regulation under formal legislative and/or regulatory consideration, respectively.


Model Audit Rule. In 2014, the NAIC adopted revisions to the Annual Financial Reporting Model Regulation (Model #205) (known as the “Model Audit Rule”), requiring large insurers to have an internal audit function. The revisions require individual insurers writing more than US$500 million or insurance groups writing more than US$1 billion in annual premium to maintain an internal audit function providing independent, objective and reasonable assurance to the audit committee and management regarding the insurer’s governance, risk management and internal controls. The function is required to be organizationally independent from management and required to report at least annually to the audit committee on the results of internal audit activities.

The 2014 revisions to the Model Audit Rule were adopted by the NAIC Executive (EX) and Plenary Committee for a one year exposure period star ting on January 1, 2016, with the goal of becoming an accreditation standard. As of January 13, 2016, four states had adopted the revisions – Georgia, Indiana, Ohio and Virginia – and one additional state has legislative or regulatory action formally under consideration.

Property and Casualty Price Optimization

“Price optimization,” sometimes referred to as adjusting premium based on consumer price sensitivity, has been the subject of much debate and scrutiny at the NAIC. The NAIC Auto Insurance (C/D) Study Group began to study “price optimization” in auto insurance in 2013. Consumer advocates contend that consideration of consumer response to price increases unfairly penalizes policyholders that do not shop coverage and violates basic rate making principles. Industry, on the other hand, points out that rate making and factor selection always require the exercise of business judgment that includes consideration of the impact of rate changes on consumers.

In early 2015, Study Group referred the issue to the NAIC Casualty Actuarial and Statistical (C) Task Force to perform any additional research necessary on the use of price optimization, including studying regulatory implications, and to respond to the Study Group with a report or white paper documenting the relevant issues. Despite the suggestion by both industry and certain regulators that one more round of exposure and comment was needed, the Task Force issued its Price Optimization White Paper (White Paper) at the Fall, 2015 Meeting, subject to certain modifications to be made by staff before presentation to the NAIC Property and Casualty (C) Committee (C Committee). The White Paper, as modified, was approved by the C Committee at the Fall meeting on November 21, 2015. It is expected to be presented to the Executive (EX) Committee for approval at the Spring 2016 National Meeting.

The White Paper recognizes that there is no single or even widely accepted definition of price optimization and that there

are varying types or methods of price optimization that may be used in ratemaking and expressly declines to propose a definition. The White Paper acknowledges that insurer judgment is an inevitable part of the rate setting process and recommends that the selection of a proposed rate between current and indicated based, as well as common market disruption techniques such as capping and transitional rules, be recognized and allowed. The White Paper also recommends that states not allow rating practices which cannot be shown to be cost-based or that otherwise fail to comply with a state’s rating laws. The White Paper proposes that regulators consider issuing clarifying bulletins, enhance filing requirements, and incorporate certain questions into the rate filing process. The appendixes to the White Paper provide model language for a bulletin and for questions to insurers during the rate filing process.

It remains to be seen what impact the White Paper will have. Prior to the adoption of the White Paper by the C Committee, sixteen states had issued regulatory guidance with respect to the use of price optimization. No state has amended its bulletin in response to the White Paper. Since its adoption, four states – Colorado, Connecticut, Alaska, and Missouri – have issued bulletins addressing the use of certain “price optimization” techniques, but none has wholesale adopted the “model” bulletin language included in the White Paper. For example, the Missouri bulletin, issued on January 15, 2016, does not define price optimization or prohibit any particular rating practice. Rather, it reminds insurers of the applicable rating laws and informs them that insurers may be asked to identify and explain their use of price optimization in personal lines rate filings.

STATES THAT HAVE ISSUED BULLETINS OR OTHER GUIDANCE RELATED TO PRICE OPTIMIZATION (as of publication): Alaska, California, Colorado, Connecticut, Delaware, the District of Columbia, Florida, Indiana, Maine, Maryland, Minnesota, Missouri, Montana, New York, Ohio, Pennsylvania, Rhode Island, Vermont, Virginia, and Washington

Big Data

Price optimization has been the first, but will not be the last, area of focus by the NAIC with respect to the collection and use of big data by insurers. At the request of NAIC funded consumer representatives, the NAIC Market Regulation and Consumer Affairs (D) Committee (D Committee) held a hearing on the use of consumer data in settling property and casualty claims at the NAIC 2015 Summer National Meeting. Following that hearing, the Center for Economic Justice urged that D Committee to adopt a specific charge to examine the use of big data, citing


the issuance of the UK Financial Conduct Authority (FCA) of a “Call for Inputs: Big Data in Retail General Insurance,” which seeks information on how big data affects consumer outcomes and business competition and how the FCA’s regulatory framework may affect developments in big data.

On December 11, 2016 the D Committee added the following new charge for 2016, which was adopted by the Executive (EX) Committee and Plenary on December 17, 2016: “Explore insurers’ use of big data for claims, marketing, underwriting and pricing. Explore potential opportunities for regulatory use of big data to improve efficiency and effectiveness of market regulation. If appropriate, make recommendations no later than the Fall National Meeting 2016 for 2017 charges for the D Committee to address any recommendations identified by the 2016 exploration.”

On the life side, the Life Actuarial Task Force (LATF) has been asked to consider the review of what some have described as an emerging trend in accelerated life underwriting using predictive analytics and complex. During the NAIC 2015 Summer National Meeting a representative of the Society of Actuaries reported on this trend and requested that LATF consider a charge to revisit VM-51 to collect data from insurers in order to understand how their accelerated underwriting processes work, including collecting information on the algorithms and data being used. LATF has agreed that the Experience Rating (A) Subgroup will consider the expansion of the VM-51 data collection requirements.

It remains to be seen how the NAIC will react to the Federal Trade Commission of its report entitled: “Big Data: A Tool for Inclusion or Exclusion? Understanding the Issues” (FTC Report). The FTC Report discusses the Fair Credit Reporting Act and its application to insurers’ use of big data and report specifically advises insurance underwriters to review “Questions for Legal Compliance” and other considerations contained in the FTC Report regarding big data use for insurance purposes.

Cyber Issues

Cybersecurity has become not only an increasingly important line of business but also an emerging threat to insurance companies as cyber-threats have become increasingly sophisticated. Insurance companies have been responding by strengthening or offering new cyber risk products to help commercial insureds manage this growing area of risk. Insurance companies also have also been

high profile victims, most notably Anthem Inc., the second-largest health insurer in the US. Anthem announced that on January 27, 2015, it discovered that hackers breached its databases containing personal information for about 80 million customers and employees. The avalanche of regulatory scrutiny both is unprecedented and continues.

The NYDFS was first to individually respond to the Anthem breach by issuing two reports on cybersecurity threats in the insurance industry, the first in 2014 and the second in February of 2015. In its Report on Cyber Security in the Insurance Sector (NYDFS Cyber Report), the NYDFS surveyed the cybersecurity practices of 43 insurers, including health insurance, property and casualty, and life insurance providers, with collective assets just over $3 trillion. The insurers shared their cybersecurity programs and, where applicable, their enterprise risk management reports (which are required as of 2014 for some insurers under New York State insurance regulations). The NYDFS Cyber Report contained several positive findings.

According to the NYDFS Cyber Report, over 80% of insurers surveyed reported that they: have cyber-security breach notification plans; par ticipate in information-sharing organizations; use industry standard security technologies; have increased their information security budgets over the past three years; have corporate governance procedures that include well-rounded participants from all important parts of an organization (e.g., IT, compliance officers, general counsel, CEOs); and have a designated information security executive.

The NYDFS identified need for improvement in key areas. It found that over half the insurers reported having experienced no


cyber security breaches in the three years preceding the survey. Respondents that had experienced breaches reported causes that ranged from malware, hacking, and email (i.e., phishing) scams to gaining control of network computers (e.g., botnets). Forty percent of respondents reported that they believe they should modify existing cybersecurity strategies to address new and emerging risks. The department concluded that insurers continue to be challenged by the sophistication of cybersecurity threats and the speed at which technology is changing (a common theme in many sectors). Two additional interesting findings were that the largest insurers did not necessarily have the most robust and sophisticated cyber-defenses, and only 14% of respondents’ CEOs receive monthly briefings on information security.

Consequently, the NYDFS urged insurers to implement the following measures:

■ monthly reporting of information security issues to senior management

■ at least quarterly reporting of information security issues to boards of directors and CEOs, plus ad hoc reports

■ avoid relying primarily on penetration testing to determine whether vulnerabilities exist. According to the department: “Ongoing vulnerability scanning is as − if not more − important than penetration testing to identify known weaknesses and potential exposures.”

On November 9, 2015, DFS announced that it was continuing to consider adopting new regulations to develop a comprehensive cyber security framework for banks and insurance companies. According to DFS, the planned regulations would create specific requirements for cyber security policies and procedures, third-party vendor management, multi-factor authentication, chief information security officers, application security, cyber security personnel and intelligence, audits, and notice of cyber security incidents. The announcement was addressed to several different regulatory agencies and advisory groups, including the NAIC, and invites analysis and discussion on developing consistent regulations.

At the national level, the NAIC formed the Cybersecurity (EX) Task Force for purposes of monitoring emerging cyber risks, their impact on the industry and whether regulatory action will be required. In April, the NAIC released 12 “Principles for Effective Cybersecurity: Insurance Regulatory Guidance” intended to provide uniform guidance to state insurance regulators. Among the principles is a recommendation to provide guidance that is “flexible, scalable, practical and consistent with nationally recognized efforts such as those embodied in the National Institute of Standards and Technology (NIST) framework issued in 2014.”

Further, on December 17, 2015, the Task Force released the “NAIC Roadmap for Cybersecurity Consumer Protections”

(the Roadmap), which will function as a consumer bill of rights and will be incorporated in the planned NAIC cybersecurity model act/regulation. The Roadmap lays out the protections that consumers should receive from insurance companies, agents, and other businesses when they collect, maintain, and use consumers’ personal information but acknowledges that not all of the protections exist under current state law. Specifically, the Roadmap provides that a consumer has the right to:

■ know what kinds of personal information are collected and stored by the insurance company, agent or any business it contracts with;

■ expect the insurance company to have a privacy policy that explains its data practices including how consumers’ personal information is protected and what choices they have about the data;

■ expect the insurance company to take reasonable steps to prevent unauthorized access to consumers’ personal information;

■ receive a notice from the insurance company, agent or business it contracts with if the consumer’s personal information is breached no later than 60 days after a breach is discovered;

■ receive at least one year of identity theft protection paid for by the insurer or agent if the consumer’s personal information is breached; and

■ receive credit report fraud alerts, place a credit freeze on his/her credit report, and get information resulting from the data breach removed from his/her credit report.

Recent court decisions are concerning. For example, in Remijas v. Neiman Marcus Group, 794 F.3d 688 (7th Cir. 2015), a US Circuit Court of Appeals made it much easier for plaintiffs in data breach cases to avoid motions to dismiss class action lawsuits for failure to allege actual harm to class members. The overwhelming body of decisions in data breach consumer class actions have required proof of actual harm from a data breach in order for plaintiffs to have standing to sue and on this basis dismissed most cases quickly. The 7th Circuit departed from this precedent. The court accepted a theory first recognized in the Central District of California that simple fear of potential future harm is enough to establish standing to sue. This raises the prospect that consumer class actions in plaintiff-friendly courts in Illinois and California will be able to survive motions to dismiss and impose (or at least threaten) heavy eDiscovery costs on defendants that have suffered data breaches


EUROPEAN REGULATORY AND LEGISLATIVE DEVELOPMENTS


European Union Developments

EU US Regulatory Dialogue – Or Not?

The EU and the US are the two largest insurance markets in the world – by far. They are home to 8 of the 9 G-SIIs and to many leading/global insurance groups. The EU and US also share a long history of regulatory cooperation. In some notable cases, they share a common language for business and regulation and a stated belief in the goals of open and competitive markets and effective but efficient regulation.

Given these facts, one might expect a tranquil, mutually supportive co-existence. And it must be said that there are some areas of significant cooperation between these two giant insurance markets. But there is also a level of friction which is, to say the least, sub-optimal.

The notable issues facing this important regulatory relationship include:

■ The development of possible global capital standards for internationally active insurers

■ The implementation of Solvency II and its equivalence determinations

■ The long standing thorn, in the side of the Europeans – i.e., US reinsurance collateral requirements

■ A battle for leadership on the global regulatory stage

■ Complications due to the evolving US State/Federal regulatory structure and how the US interacts with non-US regulators.

The challenges faced within the insurance industry are echoed in tensions in connection with bank capital requirements, regulation of derivative clearing houses and other areas.

Choice of Court and Judgment Enforcement Agreements. With effect from July 5, 2015, the EU (including the UK and Ireland but not Denmark) has approved the Hague Convention of June 30, 2005 on Choice of Court Agreement (Convention). The Convention offers provisions giving effect to choice of court agreements in international commercial cases where the parties agreed to an exclusive choice of court for resolving their disputes and provisions requiring the courts of par ticipating countries to recognize and enforce judgments under such agreements (excluding consumer and personal matters and a short list of additional exclusions.)

Insurance and reinsurance contracts are specifically addressed in the text of the Convention, which provides that such contracts are not excluded from the scope of the Convention even if they relate to a matter to which the Convention otherwise does not apply.

The Convention allows jurisdictions to declare that certain matters are not subject to the Convention as adopted in that jurisdiction. Matters dealing with asbestos, natural resources, and joint ventures have been of noted concern among particular countries during negotiation of the Convention. The EU adopted a declaration to preserve the protective jurisdiction rules available to the policyholder, the insured party or a beneficiary in matters relating to insurance under Regulation (EC) No 44/2001. The exclusion is limited to what is necessary to protect the interests of the weaker parties in insurance contracts. The exclusion does not cover reinsurance contracts, agreements entered into after a dispute has arisen, agreement concluded between policyholders an d insurers domiciled or habitually resident in the same state, or insurance contracts relating to “large risks” (defined by risk nature/type or policyholder business size). The EU may at a later stage reassess whether, in light of experience in applying the Convention, the declaration needs to be maintained.

Solvency II Update – Third Country Equivalence

Third country equivalence was a key issue for the international insurance market in 2015, as a number of countries outside the EU (named ‘third countries’) were granted full or provisional equivalence under Solvency II. Equivalence decisions determine that a third-country regulatory regime achieves the same outcome as Solvency II according to the criteria set in the Solvency II framework. The European Commission when assessing the prudential regime of a third country can find that it is fully equivalent to Solvency II standards (for an indefinite period), provisionally equivalent (for a period of 10 years extendable for successive 10 year periods) or temporarily equivalent for a limited period (until December 31, 2020 extendable for another year).

A finding of equivalence is possible under three headings of Solvency II: reinsurance (relevant to third country (re)insurers), solvency capital calculation (relevant to EU (re)insurers with operations in third countries) and group supervision (relevant to (re)insurance groups domiciled in a third country with (re)insurance operations in the EU).

Why is Equivalence Important?

■ Reinsurance. Equivalence under this heading allows (re)insurers based in equivalent third countries to be treated by EU supervisors no less favorably than EU reinsurers. By way of example, an EU supervisor could not require reinsurers authorized in equivalent third countries to post collateral to support their obligations owed to an EU insurer. This places equivalent third country firms on a level playing field with EU firms as (re)insurers of equivalent third countries must be treated in the same way as European (re)insurers.


In the absence of an equivalence decision, EU supervisors may impose additional requirements on such third country reinsurers. This means that EU supervisors could impose collateral requirements, thus placing the non-EU reinsurer at a competitive disadvantage to EU reinsurers (and those non-EU reinsurers in equivalent third countries).

■ Solvency capital calculation. A finding of equivalence under this heading allows EU (re)insurers holding 20% or more of the capital or voting rights in (re)insurers based in equivalent third countries to carry out the solvency calculation for those entities under the rules of the third country, instead of Solvency II which could produce a higher capital requirement.

Therefore, equivalence under this heading is not relevant for (re)insurers with head offices in such equivalent third countries.

■ Group supervision. If a (re)insurance group is headquartered in an equivalent third country, EU supervisors must rely on the group supervision exercised by the equivalent third country regulator and should exempt the third-country group from group supervision at the ultimate level of the European Union.

However, any such exemption is to be considered by the EU group supervisor on a case by case basis and will only be granted if the EU group supervisor, in consultation with the other supervisors, is satisfied that the exemption would result in the group being more efficiently supervised by the third country group supervisor alone, rather than both the third country group supervisor at the ultimate holding company level and the EU group supervisor at the ultimate level of the EU subgroup.

In addition, the EU group supervisor must also be satisfied that supervision of the group by the third country group supervisor would not impair the supervisory activities of the EU supervisory authorities concerned in respect of their individual responsibilities. It is yet to be seen how EU regulators will work together with equivalent third country regulators to allow group supervision to work in practice.

Which third countries are deemed equivalent? Switzerland, Bermuda (with exception on special purpose vehicles) and Japan were granted full equivalence, which means that they are considered equivalent for reinsurance, solvency capital calculation and group supervision under Solvency II for an undetermined period.

Australia, Bermuda, Brazil, Canada, Mexico and the USA, were found provisionally equivalent for solvency capital calculation.

Implication of Solvency II – Is the US Equivalent or not? In 2015, the EU – US regulatory relationship was dominated by issues surrounding the final steps in implementing the Solvency II regulatory regime in Europe, including determinations on temporary or permanent equivalence status for a number of

countries – except the US. Although the EU did grant the US equivalence for the purposes of EU groups with US subsidiaries the EU did not recognize the US as equivalent for the purposes of group supervision, professional secrecy (i.e., confidentiality surrounding regulator-to-regulator communications) or reinsurance regulation. This has set up the possibility (but not certainty) that EU regulators could assert certain group wide solvency authority over US groups operating in the EU, could require reinsurance collateral from US reinsurers of EU ceding companies and take other adverse action against US companies. If they do, it is likely that US regulators will not sit idly by, but take some form of retaliatory action against EU groups in the US.

This unhappy state of affairs comes about in part because the US regulators refused to request that the US be reviewed for equivalence purposes. Meanwhile, the EU asserted that if one does not ask, they do not review. An unhelpful, some might say thoroughly avoidable, stalemate, but one that led to the result with which EU and US insures are now faced.

Implication of Solvency II – EU US Covered Agreements Negotiations. In an effor t to resolve this deficiency – and to address the equally vexing (and long simmering) issue of US reinsurance collateral for EU reinsurers, the EU and the US have agreed to enter into negotiations concern a possible “covered agreement“ under the authority provided in the Dodd Frank Act, which granted the US Trade Representative (USTR) and Secretary of the Treasury the authority to negotiate prudential regulatory agreements with other countries. The negotiations would be the first exercise of Treasury’s authority to negotiate insurance-related agreements with foreign powers. US state regulators have been assured a voice in the process. Nevertheless, the covered agreement could lead to the preemption of state insurance laws across the country with little or no ability for the states or even Congress to stop its execution and effectuation.

The intent to commence the negotiations regarding a possible covered agreement was (as required) formally notified to Congress in November. The European Commission, which will lead the negotiations for the EU, has received its negotiating authority from the EU Parliament. So the stage is set for serious discussions, which appeared to have commenced on February 18, 2016. The US and EU representatives met in Brussels on 18-19 February “to discuss a future bilateral agreement relating to prudential insurance and reinsurance measures.” It is nevertheless uncertain how long these negotiations will take and what the final result will be. Many industry representatives, on both sides of the Atlantic, hope that they will move relatively quickly and will conclude with positive agreements and a new foundation on which to establish a productive level of cooperation and accommodation between EU and US regulators.


What is the outlook? The European Insurance and Occupational Pensions Authority (EIOPA) will continue to monitor the regulatory landscape of the countries deemed equivalent to ensure that their prudential regulatory standards continue to meet Solvency II standards. The impact of equivalence is yet to be seen in practice, especially for reinsurance and group supervision.

Although EU supervisors have always had the discretion to require third country reinsurers to post collateral for reinsurance arrangements with EU ceding companies, in practice the posting of collateral has historically been viewed as a commercial requirement by ceding insurers. Whether Solvency II will lead to more EU member states implementing collateral requirements into their regulations is yet to be seen.

It is also expected that (re)insurance groups headquartered in equivalent third countries will push for group supervision to be carried out by their home regulators and it is yet to be seen how EU regulators will respond to this new scenario of group supervision involving third country supervisors.

Equivalence under solvency capital calculation will benefit those EU (re)insurers with operations in equivalent third countries as it intends to avoid duplicate reporting requirements for such (re)insurers’ subsidiaries (i.e., under local rules and under Solvency II). As such, a finding of equivalence under this head will be of less significance for third country (re) insurance groups.

Solvency II Update – European Overview

The European regulatory landscape in 2015 was dominated by preparation for full implementation of Solvency II on January 1, 2016.

Transposition into Member States’ national law. 2014 had seen the completion of significant regulatory work by the European Commission and EIOPA, including the adoption of Omnibus II (which amended the Solvency II directive to bring it into final form), publication of the Solvency II Delegated Regulation, and the issuance of EIOPA guidelines and Implementing Technical Standards. In 2015 the baton was passed to supervisors in individual EU Member States as the intended March 31 date for transposition of Solvency II into national law approached.

In the course of 2015, progress towards transposition was uneven. The majority of Member States missed the March 31, 2015 deadline in whole, or in part. In some jurisdictions, Solvency II has had to give way to other legislative priorities. By late December, seven Member States had still only partially transposed the directive and three, Bulgaria, Cyprus and Greece, had not transposed it at all, (so in approximately a third of the Member States, regulators were carrying out Solvency II preparatory work, and approaching full implementation with no, or an incomplete, legislative framework in place). The Commission commenced formal infringement proceedings against

a number of member states in November and December, and has threatened to refer those that do not ultimately comply, to the European Court of Justice.

EIOPA. Although EIPOA has continued to publish technical standards and guidelines as the preparatory phase moves towards a conclusion, its own focus is shifting towards supervision of regulators in each member state, to ensure consistent and convergent implementation of Solvency II.

Its Chairman, Gabriel Bernadino, has said that he sees its role going forward as challenging the work of national supervisors themselves, through inspections and visits, rather than EIOPA becoming a substitute regulator dealing with insurers directly. EIOPA’s aim is to create a common European regulatory culture of strong but fair supervisory authorities.

Implementation by Insurers. The key issue, of course, is how well prepared is the industry. The number and range of affected insurance entities across Europe makes this difficult to assess (around 4000 firms are believed to be subject to Solvency II across the EU). Those insurers’ progress towards Solvency II readiness ahead of the implementation date seems to have been uneven.

Insurance Europe, the federation of national insurance industry bodies, asser ted in August that a “clear majority” of their surveyed members “were making good progress in implementing the first two pillars of Solvency II”, notwithstanding concerns about the extent of new regulation, the burden presented by reporting obligations and perceived “gold plating” at the level of Member States. Insurance Europe said the majority of insurers felt that risk management and governance had already been improved as a result of the introduction of the new regime. However, other research in September found that more than half the European insurers surveyed thought they would meet their obligations; meanwhile, a substantial minority were uncertain whether they would be ready. Only two thirds of insurers surveyed had prepared an ORSA; and of those, half had not yet had it approved by their supervisor.

United Kingdom

Flood Re

The Flood Reinsurance (Scheme Funding and Administration) Regulations 2015 (SI 2015/1902) and the Flood Reinsurance (Scheme and Scheme Administrator Designation) Regulations 2015 (SI 2015/1875) (“Flood Regulations”) came into force on November 11, 2015. These regulations establish a flood reinsurance scheme (“Flood Re”) which has an intended life span of 25 years. Its main purpose is to provide commercial insurers with the opportunity to purchase subsidized reinsurance against


flood risk where they are not prepared to underwrite that flood risk themselves. Two key features of Flood Re are that it will offer capped premiums and an initial maximum excess of £250 or higher. There are a number of properties which are excluded from cover by Flood Re including commercial property, all mixed use property and all purpose-built blocks of flats. These properties will instead have to rely on market driven premiums and excess covers for flood coverage.

The Flood Regulations are fleshed out by the scheme document issued by Flood Re (dated June 22, 2015), however Prudential Regulation Authority (PRA) approval is still required before Flood Re is able to offer flood cover. The timeframe for approval has not yet been set out, however the Department of Environment, Food and Rural Affairs (DEFRA) has indicated that it expects Flood Re to be operating by April 2016, subject to PRA approval. Insurers are said to be trialing the system internally.

Senior Insurance Managers Regime

In November 2014, the PRA and Financial Conduct Authority (FCA) issued a series of three joint consultation papers (CP26/14, CP7/15 and CP13/15) relating to the new senior insurance managers regime (SIMR). Following this in August 2015, the PRA and FCA issued a supervisory statement (SS35/15) and a document setting out answers to questions they have received on the documents previously issued. The overall aim of the SIMR is to encourage individuals to take more responsibility for their actions and to make it easier for both firms and regulators to hold individuals to account through a clear allocation of responsibilities. The reforms are also intended to bring the insurance sector in

line with the banking sector approved person’s regime – the “Senior Managers Regime”.

The SIMR comes into force in two stages: the elements required to be in force for the recent implementation of Solvency II in the UK were implemented on January 1, 2016 and the remaining elements will come into force on March 7, 2016.

Approved Persons Regime. The new approved persons regime set out by the SIMR will apply to those people who effectively run the business of the company or who have responsibility for important, critical areas of the business. As with the existing approved persons regime, most senior executive directors and non-executive directors will need to be approved by the PRA and FCA before star ting their role.

Fitness and Propriety Standards. Article 42 of Solvency II contains requirements relating to the fitness and propriety of individuals. The SIMR compels insurers to make sure that all those who effectively run the firm or hold a key function have the professional qualifications, knowledge and experience for sound and prudent management of the business, as well as being of good repute and having integrity.

Prescribed Responsibilities. Solvency II recognizes that the appropriate and transparent allocation of oversight and management responsibilities within each firm and group is a key facet of good governance. In accordance with this, the PRA requires firms to allocate a number of ‘prescribed responsibilities’ to one or more persons who have been approved to perform a Senior Insurance Management Function (SIMF) by the PRA or a Significant Influence Function (SIF) by the FCA. The prescribed responsibilities allocate responsibility for (amongst others) ensuring that there is a fit and proper assessment of the firm’s culture, integrity of financial reporting and effectiveness of whistleblowing procedures. These are intended to ensure that responsibilities for key activities affecting governance are clearly delineated.

Governance Maps. The SIMR requires firms to compile and maintain a governance map which records the position and names of the individuals who effectively run the firm and key functions within the firm. The governance map can be a single document or a series of documents which outlines significant management responsibilities and reporting lines. Matters reserved for the board should be included and the governance map should be updated quarterly.


Insurance firms will spend 2016 coming to grips with the implementation of the SIMR. A lack of clear guidance has left firms grappling with the identification of those persons who effectively run the business. It appears that the implementation of the SIMR will be a work in progress, with firms relying on the input of their supervisors to confirm whether their approach has been the right one.

Insurance Distribution Directive

The European Parliament and the European Council have adopted a text of the Insurance Distribution Directive (IDD). The IDD updates the 2002/92/EC Insurance Mediation Directive (IMD) to take into account developments in the insurance market since its implementation. The European co-legislators are in the final stages of approving the IDD. It is anticipated that it will be published in the Official Journal of the EU in January/February 2016 and it is expected to enter into force 20 days after publication. Member States are likely to be required to transpose the IDD into national laws and regulations the first half of 2018.

Although the IDD is intended to enhance and harmonize the regulation of insurance mediation across Europe, it is a minimum harmonization directive and, as such, Member States can “gold plate” the requirements, which could result in an unleveled playing field for those intermediaries in Member States that implement stricter requirements. The IDD is also designed to make it easier for firms to trade cross-border and to strengthen policyholder protection, market integration and competition.

Key provisions of the IDD.

■ The scope of the IMD has been widened, to cover insurance and reinsurance distribution carried out by insurers and reinsurers as well as intermediaries.

■ Member States must ensure that insurance intermediaries and insurance and reinsurance undertakings that sell directly to customers, act honestly, fairly and professionally in accordance with the best interests of their customers when carrying out distribution.

■ Insurance and reinsurance intermediaries are still required to be registered by an authority in their home Member State. Insurers, reinsurers and their employees are not required to be separately registered as insurance intermediaries in order to carry on distribution.

■ Employees of intermediaries, insurers and reinsurers carrying out distribution activities are required to have at least 15 hours of professional training per year. This will apply to managers and to employees responsible or directly involved in distribution.

■ Member States shall lay down rules to ensure that the remuneration policies applicable to employees of

intermediaries, insurers and reinsurers do not conflict with their duty to act in the best interests of customers.

■ The directive requires intermediaries, insurers and reinsurers to disclose the nature and basis of the remuneration (e.g., fee and commission based remuneration) and the amount of fees payable directly by the customer (or the method for calculating it) prior to entering into a contractual arrangement. The distribution of insurance of large risks, reinsurance and distribution to customers which are considered ‘professional clients’ pursuant to Directive 2014/64/EU (such as entities authorized or regulated to operate in the financial markets, large undertakings, national or regional governments) are exempt from these disclosure requirements.

■ Insurers, reinsurers and intermediaries (which are involved in the development of insurance products to be offered to customers) shall have processes in place to approve and review insurance products, to ensure that consumer needs are met and that the distribution strategy remains appropriate.

It is likely that the changes brought by IDD will improve the services provided to customers. Firms will need to ensure that their processes have been amended to comply with the new regulation, which is likely to impact in regulatory compliance costs.

Capital Extractions by Run-off Firms within the General Insurance Sector – November 2015

In November 2015, the PRA published a consultation paper on capital extractions by general insurance run-off firms. The paper proposes a supervisory statement which sets out the PRA’s expectation of compliance with its prudential requirements. The draft statement sets out the factors that senior management of general insurance firms in run-off should take into account when considering making a request to the PRA to extract capital from the firm during the course of a run-off. This statement also explains the approach the PRA takes when considering such requests.

PRA Expectations. This draft statement is updated to reflect changes to the PRA Rulebook that will occur under Solvency II and non-directive firms (NDF) regimes coming into force on January 1, 2016. Senior management and boards of run-off firms wishing to extract capital must consider such proposals carefully and be satisfied that the financial position after the proposed extraction will still remain adequate for the duration of the run-off. The PRA expects a run-off firm to:

■ undertake a thorough review of its capital position to assess the adequacy of its financial position after the proposed extraction which includes a review of its Solvency Capital


Requirement and overall solvency needs for firms subject to the requirements of Solvency II;

■ consider expected future progress of the run-off over (as a minimum) the next 3-5 years based on realistic assumptions, in turn founded on factors such as claims, reserve development and investment income;

■ seek board approval for the extraction;

■ address any concerns the PRA has before implementing its proposal; and

■ in the case of Solvency II firms, seek to hold capital to manage and mitigate the risks identified in the ORSA (and capital extractions should be considered accordingly).

The updates to this draft statement do not represent a change in PRA policy but do set expectations of how the ORSA should be used when making decisions about whether to apply for a capital extraction. Par ticularly, firms should not seek a capital extraction that would bring the level of capital below its overall solvency needs as set out in the firm’s ORSA, even if this figure is above the solvency capital requirement.

Next Steps. The PRA seeks comments by January 20, 2016. The impact of the PRA’s approach remains to be seen, but the run-off sector continues to express significant concerns with respect to the PRA’s view of the sector and that capital extractions weaken policyholder protection, despite only surplus capital being extracted after stringent solvency requirements have been satisfied.

Insurance Act

The Insurance Act received royal assent in February 2015. When it comes into force in August 2016 it will affect the first significant statutory update of English and Scottish law relating to non-consumer insurance contracts in a hundred years. It will apply to reinsurance as well as direct insurance and it will also have a major impact on the law relating to policies taken out by consumers. The Act will reform principles which have been applied by the English Courts since the 1700’s. Its broad effect will be to re-balance the law in favor of policyholders, and it will have radical consequences for how the UK and London insurance and reinsurance markets do business.

The Act requires the attention of all (re)insurers whose contracts are written subject to English law. Underwriting departments are addressing the need to train their teams on the new law and the drafting of underwriting guidelines, policy wordings and proposal forms. Claims teams will need to understand a new environment

of rights and remedies. Provisions of the act are relatively complex, and there will inevitably be disputes over its application in coming years, at least until its principles have been clarified in Court decisions.

Significant changes include:

■ Disclosure. the Act will replace the pre-contract duty on non-consumer insureds to disclose all matters that would be considered material by a ‘prudent’ underwriter with a duty to “make a fair presentation.”1 Under this new duty, a failure to disclose all material circumstances will not necessarily matter if what is disclosed would put the prudent insurer on notice that it needs to make fur ther enquiries that would reveal all material circumstances. To qualify as a fair presentation, information will have to be provided in a reasonably clear and accessible manner (no more data dumping). It will also introduce proportionate remedies for failure to make such a fair presentation. Currently insurers and reinsurers can avoid a contract completely where there has been material non-disclosure regardless of what they would have done had proper disclosure been given – under the new law the Court will impose a remedy reflecting what would have happened if a fair presentation had been made.

■ Warranties. under current English insurance law, if a policy term is characterized as a warranty, the insurer can treat itself as discharged from liability following a breach, even if the breach was irrelevant to any loss that has occurred and even if the loss occurs after a breach is rectified. The Act will make all warranties suspensory – so coverage will be reinstated if a breach has been rectified. It will restrict the effect of certain warranties and other terms intended to reduce the risk of loss of a particular kind or at a particular time/location, so the insurer will not be able to rely on a breach of such a term to avoid paying a claim if the breach could not have increased the risk of the loss which actually occurred. It will also outlaw “basis of contract” clauses which convert pre-contract statements (e.g., in a proposal form) into warranties. Changes to the law in respect of warranties2 will apply to consumer as well as non-consumer insurance.

■ Fraudulent claims. the act will clarify the consequences of a fraudulent claim both for the claim itself and for the policy under which it is made; the whole claim will be forfeit and the insurer will have the right to terminate the coverage from the date of the fraudulent claim. These changes will also apply to both consumer and non-consumer insurance.

■ Contracting out. the elements of the legislation relating to consumer insurance are compulsory, but (save in relation to basis of contract

1 The duty of disclosure in English law consumer contracts was abolished in the Consumer Insurance (Disclosure and Representations) Act 2012

2 Such clauses have been described as “despicable” by the English judiciary and have already been outlawed in consumer insurance by the Consumer Insurance (Disclosure and Representations) Act 2012.


clauses which will be outlawed completely) insurers will be able to contract out with business insureds. Whether contracting out is commercially viable for insurers remains to be seen.

Insurers to be liable for damages for late payment. During the Insurance Act’s progress through Parliament there was pressure to include a further right for an insured to recover damages from insurers for unreasonable late payment of claims (a measure which was not then supported by the UK Government). The principle of English (but not Scottish) law which denies damages for late payment has long been seen as unfair to policyholders. Since the UK election in May 2015 this proposal has resurfaced with the support of the new Secretary of State for Business, Sajid Javid. An amendment to the Insurance Act has been included in a government bill and is currently being debated in Parliament where concerns have been raised that a cause of action for late payment would require insurers to keep their books open for an extended period after the policy claim itself has settled. To balance the interests of insurers and policy holders, the Government has proposed restricting claims for late payment to one year following settlement.

The statutory timetable is uncertain but Government support means that this further change to the law will almost certainly be made in due course.

Rights for third party claimants. The Insurance Act also includes provisions to address technical shortcomings in the Third Parties (Rights against Insurers) Act 2010 (Third Parties Act). The Third Parties Act is intended to make it easier for a third party with a liability claim against an insolvent insured to enforce directly against the insolvent’s insurer. Although the Third Parties Act has been on the statute book for more than five years it has not yet been brought into force. However it can now be expected to come into force in the near future.

Removal of restrictions on annuities

In March 2015, George Osborne (Chancellor of the Exchequer) announced that the government would extend pension freedoms to around 5 million people who have already purchased an annuity. Currently, those wanting to sell their annuity income to a buyer face a 55% tax charge, or up to 70% in certain cases. The changes introduced mean that from April 6, 2017, the government will remove tax restrictions on buying and selling existing annuities to allow existing annuity-holders and future annuity-holders to sell the income they receive from their annuity without unwinding the original annuity contract and they will be taxed only at their marginal rate when selling their annuity income. Those annuity-holders will then have the freedom to use that capital as they want by taking it as a lump sum, or placing the capital into drawdown to use the proceeds gradually.

FCA activity in 2015

It has been a busy year for the FCA, ending on a note of uncertainty with the departure of Martin Wheatley, whose former role as CEO of the FCA, at the time of writing, is yet to be filled permanently. Some of the other significant developments are considered below.

New competition powers take effect. Effective April 1, 2015, the FCA acquired new functions and powers in relation to competition, including:

■ Powers to conduct market studies and make references to the Competition and Markets Authority (CMA).

■ Powers to investigate and enforce against breaches of UK and EU competition law.

From April 1, 2015, onwards, the FCA is able to carry out a market study wherever it appears that a particular area of the market is not functioning in the interests of consumers or market users more generally.

The CMA is still the UK’s principal competition authority, and the FCA’s new powers are concurrent with the CMA’s enforcement powers. However, it may be anticipated, in light of the FCA’s new powers and given that the FCA is under a duty to share information with the CMA, that FCA-regulated firms could now be subject to increased information requests and associated regulated activity. The FCA has invested significant resources towards its competition team, which suggests an expected level of activity and market studies.

The FCA has always had a duty to promote competition in the interests of consumers and the CMA has had these same competition powers since 1998, so notwithstanding these changes, regulated firms will not be subject to additional requirements, but a different body will have the power to exercise those powers.

Thematic review TR15/7 – Delegated authority: Outsourcing in the general insurance market. The FCA found that insurers do not always treat delegated arrangements as outsourcing and improvements are needed to improve insurers’ due diligence and management of such arrangements.

Only a minority of firms that were sampled had treated externally delegated underwriting as a form of outsourcing and had applied a risk-based approach to the selection of third parties. These firms, in taking such an approach, considered the extent of the outsourcing arrangement and the level of authority being delegated. In contrast, a number of firms had not treated such arrangements as outsourcing and their risk appetite and approach was unclear.

In many cases, the FCA noted that insufficient focus and consideration has been given to how the interests of customers might be impacted by outsourcing. As a result, insurers who did not appropriately assess the ability of third-party outsourcing


vendors to provide products and services to customers presented potential risks to customers. For example, customers might experience inadequate or unexpected performance of the product. In addition, some intermediaries undertaking product design activities were found not to recognize the extent of their responsibilities as product providers, and in many cases, there was found to be insufficient oversight of the performance of products and delivery of services.

Overall, the FCA indicated that improvements are needed in firms’ due diligence and the way they manage such outsourced arrangements, in particular a requirement to adequately consider and assess potential customer outcomes. The likely impact on firms who are not compliant with FCA requirements is that they will be required to allocate additional resources (both in terms of FTE and cost) to such arrangements. Consideration should also be given as to whether existing contractual arrangements should be reviewed, amended or renegotiated as they come up for renewal (depending on the extent of any issues identified).

2016 outlook. In the coming year it is likely that investigations and enforcement activity will focus increasingly on individuals as much as on firms. The drive for individual accountability, most notably in the form of the extended Senior Managers’ Regime is evidence of this. Following the FCA’s thematic review on outsourcing and delegated authority arrangements, a continued focus on product governance and oversight is likely to be seen.

In particular, with the increased use of big data by insurers, outsourcing services to the cloud and a focus on cyber risk and insurance, as well as investments in fintech, we can expect to see more start-ups, product innovation and the FCA to remain focused on customer outcomes in this evolving market.

Brexit – possible British withdrawal from the European Union

May 2015 saw David Cameron’s Conservatives win a parliamentary majority at the UK General election on a manifesto promising an in-out referendum on UK membership of the EU before the end of 2017. The referendum is now expected to take place in the course of this year. There is significant public and parliamentary support for a break from Europe, including among a number of cabinet ministers. The insurance industry therefore needs to be prepared for a “Brexit” in the event of an out vote, which will lead to considerable uncertainty around how they do business in the UK and London Markets.

Any out vote would likely be followed by negotiations. Whether it would be possible for UK insurers to passport into EU jurisdictions, and reciprocal rights for EU insurers passporting into the UK, would have to be worked out. EU regulators might well be prepared to recognize the strength of UK regulation by recognizing UK equivalence for Solvency II group capital purposes, but that can’t be guaranteed. The concern for the UK industry is that the prospect of an exit may lead to insurers and reinsurers from outside Europe choosing other European centers over London to access European markets, and to existing players relocating.

Generally, therefore, the UK industry is supportive of Britain staying in. Industry leaders have described exit from the EU as “bad for business”, and “disastrous for London and the UK”.

FCA and competition oversight

Competition Infringements. In January 2015, the FCA published a consultation paper (CP15/1) seeking views on a draft version of its Competition Act guide, a draft version of its market studies guide, and proposals to introduce rules to SUP 15.3 on disclosures that firms should make to the FCA on competition infringements.

In July 2015, the FCA published a policy statement (PS15/18) in which it laid out its final policy on the issues considered in CP15/1. On the same date it also published the final versions of the Competition Act guide (FG15/8) and the market studies guide (FG15/9), as well as the FCA Handbook instrument, the Competition Law Infringement (Disclosure) Instrument 2015 (FCA 2015/38), containing amendments to SUP 15.3. The FCA revised its proposals for SUP 15.3 to clarify that the obligation on firms to disclose competition infringements only applied to “significant” infringements.


Guaranteed Asset Protection Insurance: Competition Remedy Update. In June 2015, the FCA published policy statement PS15/13 which included feedback on 2014’s CP14/29 and set out final rules. The rules are intended to empower consumers when making decisions about purchasing add-on guaranteed asset protection insurance (“GAP”) and limit the point-of-sale advantage of add-on distributors. Firms distributing GAP insurance in connection with a motor vehicle will now be required to provide customers with prescribed information to help them shop around, as well as a deferral period; as a result, GAP insurance cannot be introduced and sold on the same day. The FCA hopes that this will result in more informed consumers and improved competition between add-on and standalone distribution channels.

POLAND

Pro-consumer changes

The Polish insurance market in 2015 saw the introduction of many pro-consumer reforms, which seems to be the beginning of a general trend that is expected to continue into 2016. The Polish Parliament adopted several pro-consumer acts, including the amendment of the Protection of Competition and Consumers Act, the Act Concerning the Complaints Handling Procedure by Financial Service Providers and Financial Ombudsman and the Insurance and Reinsurance Activities Act, which implemented the Solvency II Directive. Together these acts aim to enhance consumer empowerment.

Unit-linked products

Poland’s Office of Competition and Consumer Protection (UOKIK) concluded several special agreements relating to consumer rights violations by certain insurance products offered in the form of a capital fund by some insurance companies operating in Poland.

In the proceedings pending before the President of the UOKIK, several insurance companies committed to significantly reduce the charges for termination of existing policies and eliminate those products from their offering. The companies with whom the President of the UOKIK concluded the agreements were the first insurers to submit proposals for corrective actions leading to the immediate elimination of the market practices which undermine the collective interests of consumers.

KNF guidelines for insurance companies

The Polish Financial Supervision Authority (KNF) has continued to regulate insurance companies and has issued Guidelines regarding the process of establishing the insurance technical reserves. In addition, IT guidelines were adopted, and will be effective on January 1, 2017. KNF also introduced a new approach to the fair treatment of consumers, preparing the drafts of guidelines of the management of insurance products and adequacy to consumers’ needs of insurance products.

Claims Handling

For the first time, in 2015 Polish drivers had the opportunity to make use of direct claims adjustment offered by several insurers (referred to as BLS). Instead of the injured party having to seek compensation from the insurer of the driver who caused the accident, the injured party’s insurer will take care of the damaged car directly. This process is much simpler for motor insurance customers. As a consequence, the Polish Insurance Association (Polska Izba Ubezpiecze ) prepared a set of standard form agreements for direct claims adjustment for the whole market. It is expected that the introduction of direct claims adjustment should put an end to the price war in the Polish motor insurance market as the quality of assistance should become more important to the client than the total price of the motor insurance.

Establishment of Financial Ombudsman

The Financial Ombudsman Act was adopted in 2015. This Act regulates the process of complaints handling by insurance companies as well as the principal of automatic recognition of the complaints if insurers fail to provide an answer during a 30-day period. In accordance with the Act, the mediation procedures will be run by the Financial Ombudsman.


ASIAN REGULATORY DEVELOPMENTS


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Amendment of Insurance Law

Followed by the revision in April 2015 in response to the revision of PRC Company Law, the PRC Insurance Law is being amended again, with key changes including greater coverage, consumer protection, funding opportunities and corporate governance.

On October 14, 2015, the Legislative Affairs Office of the State Council published the Decision on Amending the PRC Insurance Law (Draft for Comments) (Draft), prepared by the China Insurance Regulatory Committee (CIRC), six years after the last large-scale revision of the Insurance Law. The Draft focuses on regulating the business scope of insurance companies and the use of insurance assets, as well as introduces a new regulatory system for insurance overall.

The aim of the amendment is to deregulate, promote innovation and exercise the full potential of the insurance market, as well as to provide a comprehensive regulatory mechanism and enforce stricter penalties for wrongdoing.

Expanded coverage and consumer protection. The Draft has included pensions, internet insurance, catastrophe insurance and insurance trading platforms in its coverage of the industry.

The Draft requires an emphasis on consumer protection. It adds rules for personal information protection, a cooling-off period for life insurance and stipulates administrative punishments for “misleading solicitation” and “unreasonable refusal to [process a] claim”, both of which are major disputes in the Chinese insurance business.

Increased use of insurance funds. The Draft fur ther relaxes the operation of insurance-registered capital and offers more financing channels. It specifies that insurance companies no longer need to set aside more capital if their guarantee funds reach RMB 200 million and enables them to offer equity, debt and other financing instruments approved by the CIRC. These changes address the insurance companies’ need for operating capital as well as their challenge of having insufficient funds.

The Draft allows for the investment of insurance funds in equity, asset management businesses and derivatives for risk assessment purposes. In fact, several regulations and documents published by the CIRC have already broadened the scope of investment.

Enhanced corporate governance responsibilities. The Draft enhances insurance companies’ corporate governance responsibilities and provides stricter rules for shareholders and actual controllers. It specifies that CIRC approval is required to change an insurer’s actual controller that represents over 5% of the capital or equity, in order to prevent unqualified investors in insurance companies from purchasing shares. The CIRC’s

stricter criteria for the identity of shareholders is in line with past practice and is especially important now, given the dynamic M&A environment and investment activities regarding insurance companies’ equity.

Establishment of reinsurance registration system

CIRC issued the Circular on Issues concerning the Implementation of the Reinsurance Registration Administration (CIRC [2015] No. 28) (Reinsurance Circular), with effect as of January 1, 2016.

Registration system. In order to supervise the reinsurance market of China and help domestic cedants better understand the qualifications of overseas reinsurers and reinsurance brokers, the Reinsurance Circular introduces a reinsurance registration system (the System), and provides that all domestic cedants, reinsurers and reinsurance brokers who transact with domestic cedants shall register in the System. Registered institutions shall meet a number of qualification standards and satisfy the information disclosure requirements provided by the Reinsurance Circular. Once qualified, the registered institutions are automatically entered into an effective list in the System and PRC insurance institutions can only transact with reinsurers and reinsurance in such list.

Peer recommendation. Before being registered in the System, overseas reinsurers and reinsurance brokers shall be recommended by a PRC reinsurer or a reinsurer broker that has been registered at the CIRC. Each recommendation is valid for three years. Before the expiration of a recommendation, the overseas institution can nominate the original domestic institution, or another domestic institution to renew the recommendation.

In recent years, overseas reinsurers and foreign-invested reinsurers registered in China have taken up nearly 2/3 shares of China’s reinsurance market. However, during the development of the domestic market, overseas reinsurers have not been covered by the supervision of the CIRC. The System to be established imposes strict requirements for the overseas market players, and increases their compliance costs to participate in the reinsurance market of China.

New rules on PE funds

CIRC issued the Notice on Matters Related to the Establishment of Insurance Private Equity Funds on September 10, 2015 (PE Notice). The private equity industry will benefit from the policy changes under the PE Notice, and welcomes a number of new players with deep pockets.

Previously, the main policy governing the investment of insurance capital in private equity (PE) funds was the Provisional Measures for Equity Investment with Insurance Funds issued by the CIRC on July 31, 2010. Pursuant to the interim measures, insurance capital could invest in PE investment funds meeting certain requirements only in their own capacity as an active investor. Insurance capital

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which was acting as a passive investor was unable to actively sponsor and manage a private equity fund. Under the PE Notice, insurance capital is now able to directly form and manage private equity funds. Insurance capital can also act as a sponsor that establishes a fund and as its active manager, unlike the previous passive role it was required to take.

In addition to oversight from the CIRC, a private equity fund established by insurance capital is subject to oversight in accordance with the Provisional Measures for the Supervision and Administration of Private Investment Funds, issued by the China Securities Regulatory Commission in 2014. The fund is also required to comply with the trial Measures for the Registration and Filing of Private Equity Fund Managers issued by the Asset Management Association of China (AMAC), as well as other self-regulatory rules issued by the AMAC.

New regulation on internet insurance business

As a result of the rapid growth of internet insurance, the CIRC issued the Circular on the Interim Measures for the Supervision of Internet Insurance Business (the “Internet Insurance Measures”) on July 22, 2015, which came into force on October 1, 2015, and will be valid for three years. The Measures are not applicable to reinsurance business.

The Internet Insurance Measures introduce new requirements for insurance institutions and their self-operating and third-party Internet platforms conducting online sales of insurance. The aim is to ensure that these platforms are transparent to consumers and enable the development of the Internet insurance industry.

The Measures provide that if insurance institutions intend to develop Internet insurance services through third-party Internet platforms, these third-party Internet platforms should obtain qualifications for conducting insurance business.

Insurance institutions may provide online insurance services in locations where they do not have physical presence, provided that they possess the relevant internal control capabilities and can meet the service needs of consumers. This applies to a limited category of insurance products, including:

1. Personal accident insurance, term life insurance and ordinary whole life insurance;

2. Household property insurance, liability insurance, credit insurance and guarantee insurance with an individual as the policyholder or the insured;

3. Property insurance; and

4. Other types of insurance stipulated by the CIRC.

This could be seen as advantageous for the business development of Internet insurance institutions as the removal of geographical operating restrictions. However, even though this new rule applies to life insurance, in practice it may be difficult to sell such insurance products online as it is comparatively complex and requires direct contact between insurance agents and clients.

Guidance for Internal Control of Insurance Funds

CIRC issued the Guidance for the Internal Control of Insurance Funds (“GICIF”) and Application Guidelines for Internal Control of Insurance Funds No. 1 to 3 (for bank deposits, fixed-income investment, equities and equity funds respectively, “Application Guideline”) on December 7, 2015, which take effect on January 1, 2016.

GICIF and its Application Guidelines are applicable to PRC insurance group (holding) companies, insurance companies and insurance assets management companies. They set out the requirements for the internal control of insurance funds, including but not limited to controlling environment, risk assessment, decision-making control and financial control.

According to CIRC’s news release regarding the GICIF, CIRC will issue the Application Guidelines for real estate investment, insurance assets management, outbound investment and derivatives investment in succession.

CIRC tightening controls for insurance companies

In a meeting held by the CIRC on December 29, 2015, CIRC expressed that it would tighten regulations for insurers to reduce the risks from equity investments.

In 2015, several insurance firms were making aggressive equity investments with leveraged trading which could endanger their ability to meet financial obligations. CIRC warned of the emerging risks along with the rising number of market players and the expansion of their investment channels.

The regulator’s warning came after a number of insurance companies aggressively purchased equities in the public market through leveraged trading, raising concerns about their liquidity and investment risks. In response to the risk, CIRC issued the Circular of the China Insurance Regulatory Commission on Issuing the Standards for the Disclosure of Information on the Utilization of Funds by Insurance Companies No.3: Acquisition of Listed Company’s Shares Disclosure, which provides for the disclosure standards in the event that an insurance company holds or jointly holds together with its affiliates 5% of the shares issued by a listed company.


ASEAN Economic Community – Are We Ready?

The much-anticipated goal was to implement the ASEAN Economic Community (‘AEC’) by December 31, 2015, thereby forming a single market and production base across ASEAN member countries (‘AMC’). As we embark on the new year of 2016, however, economic integration still seems some way off. The insurance industry will have many opportunities to explore and challenges to overcome as the AMC continue their progress to integrate the market across the ASEAN region.

The ASEAN Economic Blueprint and the Insurance Industry

In November 2007, the ASEAN leaders adopted the ASEAN Economic Blueprint (‘Blueprint’) to serve as a master plan in guiding the implementation of the AEC by December 31, 2015. At that time, ‘free flow of services’ was one of the five agreed core focus areas in the implementation of a single market. According to the Blueprint, there would be substantially no restrictions to ASEAN suppliers in providing services and establishing companies across national borders within the region, subject to domestic regulations.

The Blueprint stipulates that the liberalization of insurance services will cover four ‘modes’ of supply for the delivery of services in cross-border trade, which consist of:

■ ‘Cross-border supply’ e.g., an insurer based in Singapore writing policies for policy holders based in Indonesia;

■ ‘Consumption abroad’ e.g., a policy holder based in Malaysia travelling to Singapore to buy a policy from an insurer based there;

■ ‘Commercial presence’ e.g., an insurer based in Singapore writing policies in Thailand through the Singapore insurer’s Thai branch or subsidiary; and

■ ‘Presence of natural persons’ e.g., an insurer based in Singapore managing a claim through an employee working in Thailand.

The member states have agreed that there should be no restrictions to the first two of these four modes, with exceptions due to bona fide regulatory reasons only, such as public safety, which will be subject to agreement by all ASEAN member countries on a case-by-case basis. Despite the December 31, 2015 goal, liberalization of these two modes is far from complete. The cross-border supply of insurance services and cross-border consumption of insurance services are still widely restricted in the AMC.

For the third of these modes, ‘commercial presence’, foreign (ASEAN) equity participation of not less than 70% should be allowed for the services sectors and other market access limitations should be progressively removed, a goal which has not yet been met across the board.

Finally, in a move towards the implementation of the last mode, ‘presence of natural persons,’ the ASEAN agreement on the Movement of Natural Persons was signed in November 2012 to facilitate the conduct of natural persons engaged in the trading of goods, services, and investment between member states. The scope of this agreement is a limited measure affecting the temporary entry or stay of persons of a member state, into the territory of another member state. This will cover business visitors, intra-company transferees and contract service suppliers, but does not apply to measures regarding residency or employment on a permanent basis.

Opportunities for the Insurance Industry

The ASEAN Economic Blueprint will encourage an increase in cross-border trade within ASEAN, which we anticipate will directly boost demand for commercial lines such as trade-credit, marine and surety insurance business.

Insurance penetration rates in ASEAN markets are generally low (less than 6% according to the Swiss Re Sigma Report, 2013). With increasing awareness, low penetration rates and strong economic growth prospects, we would expect the demand for life and accident and health insurance products to grow.

We anticipate that the surging digitalization in ASEAN will change the marketing landscape from the traditional agencies and brokerage models to digital mass-distribution of insurance products.

As the insurance industry opens up in ASEAN, there will be the free flow of key skilled employees among member states to support growth. The anticipated free movement of key skilled labor would also aid the development of the financial and regulatory framework of the AMC.

Challenges to Liberalization

There is no formalized institution, such as the European Commission, to push through reforms and execute agreed policies. The ASEAN Secretariat supports the implementation of ASEAN initiatives. However, the AMC coordinates the effor ts to liberalize and reform local markets among themselves with regard to the AEC.

As can be expected in emerging markets, the AMC are progressing economically and socially at different rates, reflecting the political, social and operational factors of each member country. There is also no uniform regulatory framework; therefore, insurers engaging in cross-border supplies will be subject to market conduct, consumer protection, data privacy, cyber security, and tax laws applicable to the local jurisdiction of each member country.


The Future. Advances towards the implementation of the AEC are varied among the AMC. Local state regulations remain heavy, par ticularly in the AEC goal areas of cross-border supply and consumption of insurance services.

In the AEC Blueprint 2025 adopted by the ASEAN Leaders at the 27th ASEAN Summit on November 22, 2015, it is provided that the immediate priority is to complete the implementation of measures unfinished under the AEC Blueprint 2015 by the end of 2016. The continuing commitments of Cambodia, Lao People’s Democratic Republic, Myanmar and Vietnam (CLMV) under the AEC Blueprint 2015 up to 2018 are also incorporated under the AEC Blueprint 2025. The key measures of the Blueprint 2025 are to:

(1) promote deeper penetration in insurance markets through the ASEAN Insurance Integration Framework (‘Framework’), with greater risk diversification, deeper underwriting capacity, improved and strengthened insurance sector supervision and regulatory frameworks. Under the Framework, insurance companies in ASEAN will be able to offer Marine, Aviation and Goods in International Transit (‘MAT’) insurance across the region and help to spur intra-ASEAN trade;

(2) promote the expansion of distribution channels which improve access to and reduce cost of financial services, including mobile technology and micro insurance; and

(3) promote strong health insurance systems in the region.

To facilitate the implementation of the AEC, what is par ticularly required from the AMC is convergence of regulatory frameworks, consistency across the region and improvements in prudential standards. However, barriers to achieving those goals still need to be overcome, including:

■ Differences in maturity of regional markets;

■ Protectionist attitudes; and

■ The logistical and language issues that surround the filing of policies on an international scale.

What cannot be underestimated is the scale of the opportunities the AEC can offer to the insurance industry, which should open up a market incorporating 10 countries and 600 million people. The harmonization of regulatory regimes across the ASEAN region could lower costs substantially when it comes to cross-border trade in the insurance industry, as complexity is reduced and efficiency increases.

Opportunities in electronic selling as a distribution method are also expected to open up across the region, in line with the AEC’s ‘e-ASEAN’ objective. The deep penetration of tablets and smartphones across the region presents ripe opportunities for e-commerce, which the Asian insurance industry has yet

to exploit. The principles of the free movement of persons provided by the AEC should encourage the movement of talent and knowledge across the insurance industry, as well as making fur ther efficiencies possible in the form of outsourcing.

Despite the delay in implementation of the AEC, it will nevertheless be advantageous for insurance businesses to have a clear strategy in relation to the upcoming changes, and to be positioned in such a way to take full advantage of the opportunities offered when the time comes. The insurance industry depends on an open trading environment, and the introduction of the AEC should eventually allow insurance businesses to share information and spread risk across a global market place.

HONG KONG

The Insurance Companies (Amendment) Ordinance 2015 bringing an Overhaul to the Industry

The Insurance Companies (Amendment) Ordinance (the Amendment Ordinance) has been enacted on July 10, 2015 to amend the Insurance Companies Ordinance (Cap.41) (ICO).

At present, under the ICO, the Office of the Commissioner of Insurance (OCI) is empowered to grant authorization to insurers and to exercise prudential regulation over insurers. Insurance intermediaries, such as individual agents, brokers and insurance agencies, are regulated under a self-regulatory regime administered by three Self-Regulatory Organizations (SROs), namely Professional Insurance Brokers Association, the Hong Kong Confederation of Insurance Brokers and the Hong Kong Federation of Insurers. Banks which carry out insurance intermediary activities are also subject to supervision by the Hong Kong Monetary Authority.

The key legislative amendments to the ICO cover the following topics:

■ Establishment of the Independent Insurance Authority (‘IIA’). To align with international practice, the IIA, being an authority independent of the Hong Kong Government, will be established. The Chief Executive of Hong Kong has appointed Dr. Moses Cheng Mo-chi as the Chairman of the IIA and seven persons as non-executive directors for a term of three years from December 28, 2015 to December 27, 2018.

The IIA will undertake essential preparatory work without regulatory powers. The target is for the IIA to replace the OCI by the end of 2016 and take over the supervision of insurance intermediaries from the three SROs in 2017 or 2018.

■ Statutory licensing regime for insurance intermediaries. The IIA is responsible for licensing and regulating insurance intermediaries. The five types of insurance intermediary licenses mirror the ones under the existing SROs, namely


insurance agency license, individual insurance agent license, insurance broker company license, technical representative (agent) license, and technical representative (broker) license. Similar to the regulatory regime under the Securities and Futures Ordinance (Cap.571), the Ordinance requires a person to be licensed to carry out “regulated activities.” “Regulated activities” have been defined to cover a wide range of activities, including negotiating or arranging a contract of insurance, inviting or inducing a person to enter into a contract of insurance, inviting or inducing a person to make a material decision, and giving regulatory advice on any one of the insurance related matters listed in the Ordinance ranging from making of an insurance application, to termination of insurance, to the exercise of a right under an insurance contract.

■ Conduct regulations and roles of responsible officers. Licensed insurance intermediaries will be required to observe certain standards of conduct. The Ordinance merely sets out the principles of these conduct requirements; details will only be provided in subsidiary legislation and fur ther non-statutory guidance in due course. Each corporate licensee should be required to appoint a responsible officer (a concept mirroring the notion of “responsible officer” under the Securities and Futures Ordinance (Cap.571) and the Mandatory Provident Fund Schemes Ordinance (Cap.485)). Such responsible officer will be responsible for ensuring that internal controls and procedures are in place in compliance with the conduct requirements and are observed by all intermediaries engaged by the corporate licensee.

Each authorized insurer should appoint a responsible officer to ensure systems are in place for securing compliance by its appointed insurance agents within the conduct requirements. An authorized insurer can only appoint an individual as a key person in control functions (i.e., risk management, financial control, compliance, internal audit, actuarial, intermediary management, etc.) upon the IIA’s approval.

■ Investigative and disciplinary powers. The Ordinance confers powers on the IIA to undertake inspections and investigations into the conduct of insurers and intermediaries. Inspectors

are empowered to enter business premises, inspect and make copies of business records and documents, and require an answer to be verified by statutory declaration. The IIA is also empowered to impose disciplinary sanctions against licensed insurance intermediaries, the responsible officers and insurers for misconduct, and to prosecute offences summarily.

■ Establishment of the Insurance Appeals Tribunal (IAT). The IAT independent of the IIA will be established to review IIA’s disciplinary decisions upon application. The IAT has the power to award costs, so as to discourage abuse of the appellate process to stall disciplinary sanctions.

The establishment of an independent watchdog will bring Hong Kong in line with international practice. This should result in better protection of insurance policyholders and enhance confidence in the industry. However, with the IIA being armed with extensive inspection, investigative and disciplinary powers, conduct of the insurers and intermediaries will come under increased scrutiny going forward. Insurers and intermediaries should take this as a timely opportunity to review and revamp their internal compliance systems to ensure that the risks of carrying out insurance business are effectively managed.


AUSTRALIAN REGULATORY DEVELOPMENTS


ustralia – Insurance Regulation Updates and Pending Reforms

Numerous reforms affecting the insurance industry saw progress in 2015. Retail life insurance, firm culture and

financial services were all targeted in a number of regulatory changes and proposed regulatory changes.

The pending reform of the Retail Life Insurance Sector

In December 2015, the Federal Government released draft amendments to the life insurance remuneration arrangements under the Corporations Act. The draft Corporations Amendment (Life Insurance Remuneration Arrangements) Bill 2015 (the Amendment Bill) targets conflicting remuneration for benefits paid on life risk insurance products, to “better align the interests of consumers and those providing advice.”

The Amendment Bill is the product of the Financial Systems Inquiry and a report by ASIC into the retail life insurance industry. The report identified a number of concerning trends in the industry, in particular the link between the quality of advice and commissions paid to life insurance advisors.

The proposed changes further distinguish the retail life insurance market from the general insurance product market.

For example, the Amendment Bill provides that benefits paid in relation to life risk insurance products will be subject to the general ban on conflicted remuneration going forward. This is the case until the Australian Securities Investment Commission (ASIC) specifies exemption criteria and the products satisfy those requirements. The proposed requirements relate to allowable commission and clawback arrangements. General Insurance products have a general exemption from the conflicted remuneration provisions.

The reforms make both allowable commission and clawback requirements precursors to the conflicted remuneration exception. Maximum upfront allowable commissions are proposed and clawback arrangements act to remove incentive to rewrite policies to obtain further commission.

The Amendment Bill also facilitates ongoing reporting to ASIC under its existing powers in the Corporations Act, which the regulator will use to review the new arrangements in 2018.

ASIC has released a consultation paper (CP 245) in response to the Amendment Bill setting out its position regarding industry reforms. ASIC endorses a number of the proposals in the Amendment Bill including restructuring commissions and clawback arrangements.

A two-year transition period was included in ASIC’s proposal to allow businesses to adapt to the new regime. This position is premised on the strong correlation found by ASIC between high upfront commissions and poor advice.

ASIC has also flagged its intention to undertake information-gathering pursuant to its powers in section 912C of the Corporations

Act to require information from life insurers, including regarding exited policies, remuneration data and lapse rates.

The Amendment Bill likely signals the last significant development arising out of the Future of Financial Advice reforms that commenced in 2010.

2016 Reforms

In October 2015, the Federal Government released its response to the Financial Systems Inquiry adopting the bulk of the 44 recommendations made by the Inquiry. The time available to introduce legislation for these reforms may be challenging given that there is likely to be a Federal election in the second half of 2016.

It is expected that the bulk of the reforms in the insurance sector through 2016 will be a product of the recommendations of the Financial Systems Inquiry.

The reforms anticipated may include expanding ASIC’s power to intervene in financial product development and withdraw or modify products from the market that are harmful. It is expected there will be a number of enhancements of ASIC’s powers in the market.

A review aimed at considering how ‘ASIC uses its current resources and powers to deliver its statutory objectives and assess ASIC’s ability to perform as a capable and transparent regulator’ is also underway. It was expected that the review panel, chaired by Karen Chester, would deliver their report by the end of 2015, but it has yet to be delivered.

Once the review is complete, it is expected that draft legislation will be released for consultation addressing ASIC’s powers and other recommendations of the Financial Systems Inquiry.

Finalizing the FOFA reforms

In June 2015, the federal government announced fur ther refinements to the Future of Financial Advice laws (FOFA laws). The regulation introduces technical refinements to target a number of unintended consequences and ensure consistency with other legislation. Other than the changes to the retail life insurance industry, it is not anticipated that there will be any fur ther significant changes to the FOFA laws.

ASIC to regulate culture of firms

In June 2015, ASIC Chairman Greg Medcraft used his address to the Senate Estimates Committee to propose new strategies to target the correlation between poor firm culture and poor conduct in the financial industry.

These strategies include the regulation of culture through risk-based surveillance reviews, the implementation of the ‘communication, challenge and complacency’ framework and the ability to pursue officers for civil penalties where the firm culture is responsible for administrative breaches.

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New Zealand – Insurance Regulation Updates and Pending Reforms

2015 was a year of incremental development of New Zealand’s prudential supervision regime (introduced in 2010), with some major policy development affecting insurers in the pipeline.

Prudential supervision

Insurers carrying on business in New Zealand must be licensed and are supervised by the Reserve Bank of New Zealand under the Insurance (Prudential Supervision) Act 2010. The year began with the revised solvency standards for life and non-life insurance business becoming effective. The revised standards reflect extensive consultation on a range of issues including the quality of capital and regulatory treatment of financial reinsurance and the treatment of guarantees and off-balance sheet exposures.

In February 2015 the Bank issued its review findings on the quality of risk governance of insurers. While the Bank was generally happy with the insurers sampled, a small minority were found to have risk governance weaknesses and an inadequate program of improvement underway. Generally, the Bank recommended that insurers focus on the “behavioral aspects of risk governance”; for example, how can communication processes and incentives be honed/tailored to support the risk management framework.

2015 also saw developments in the collection of information by the Bank from insurers. Consultation took place on a range of forms and information returns including an insurer foreign business return. This applies to New Zealand incorporated insurers with foreign insurance or inwards reinsurance business exceeding NZ$10 million and 10% of their total insurance business. The Bank’s New Zealand Data Collections webpage contains the latest version of the forms.

Review of Earthquake Commission Act

New Zealand has a national disaster insurance scheme established by the Earthquake Commission Act. In summary, among other things, the scheme currently insures land damage and the first $100,000 of residential building damage. Following the Canterbury earthquakes, a review of the scheme was announced in 2012 and a discussion paper was ultimately released by the Government last year. The proposals are intended to improve the claims management experience for EQC claimants, particularly during large claims events such as the Canterbury earthquakes. A key proposal is that future EQC claimants would lodge claims with their private insurer rather than with EQC as is presently the case. Another proposal is to limit the existing EQC land coverage, and extend the EQC building coverage to include features of the current EQC land coverage relating to any necessary earth works to repair or rebuild the building or access to it. This would involve raising the cap on cover from $100,000 to $200,000.

Submissions on the paper closed in September 2015, and are presently being considered by the Government. It is expected that a bill will be introduced into Parliament in the first half of this year.

Review of Fire Service Levy

In New Zealand, the Fire Service is funded by a levy collected through building, contents and motor insurance policies. In May 2015 the Government released a discussion document calling for submissions on a review of the Fire Service. This included a review of whether the Fire Service should continue to be funded through insurance, or whether there should be a shift to a mixed funding model, with contributions from the Government and motor vehicle sector. Draft legislation is expected to be introduced for public consultation in 2016.

Reform of insurance contract law

The common law duty of disclosure still applies in New Zealand without significant statutory modification, despite numerous reports and announcements over the last twenty years of pending reform. While not formally announced, the Minister of Commerce and Consumer Affairs has indicated that this reform is likely to proceed once the review of the Earthquake Commission Act is completed.

Fair Insurance Code

Although legislative reform of insurance contract law may be some way off, the revised Fair Insurance Code came into effect on January 1, 2016, and binds all insurers who are members of the Insurance Council of New Zealand. It sets a higher benchmark than the previous code, requiring enhanced communication and best practice timeframes from insurers, as well as a requirement to act reasonably in relation to non-disclosure.

Financial services reform

Insurance is a financial product for the purpose of the regime regulating financial advice. The regime has been in place for around five years and has been criticized for being confusing and ultimately not providing consumers with access to improved financial advice. Issues around commission levels and the potential for conflicts of interest have also been contentious. An issues paper was released in July 2015, and at the end of 2015, an options paper was released by the Minister of Commerce and Consumer Affairs. Submissions remain open on the key aspects of the paper until the end of February. A range of different packages are proposed, from minor modifications to major changes, including removing the distinction between different categories of advice and/or creating a new category of adviser who would essentially be a salesperson and not required to put the customer first. With regard to commissions, it appears likely that improved disclosure will be required rather than outright bans on certain types of commission.


COMMERCIAL AND TRANSACTIONAL ISSUES AND TRENDS


lobal Trends in Insurance M&A in 2015 and a Look Ahead

To many people looking back on 2015, it will be the year of the megamergers; the year that insurers

stole the M&A headlines. And we would agree – but there are also a number of other developments and trends that have caught our interest.

Driven by factors such as regulatory pressures with the prospect of Solvency II on the horizon, a difficult economic environment and low debt funding costs, there is no doubt that 2015 saw significant market consolidation. But it has also been a year in which non-insurance companies have made significant overtures to the industry: the likes of Exor, the Agnelli family’s wide-reaching investment company; Apollo, the asset and investment managers; and insurance derivative products are drawing investors with the promise of greater stability in an uncertain macro-economic climate.

In addition, we saw an increase in activity from investors outside of the traditional European and US markets making moves into the more established insurance markets. Asian and South American investors drove deal activity in 2015, as we had anticipated last year.

In this review, we share a number of our observations of the insurance M&A market in 2015:

(1) M&A continued to accelerate and deal values are up;

(2) The growing insurance markets outside of ‘traditional’ regions continued their push into Europe;

(3) Insurers are increasingly focused on their run-off business;

(4) The ground is shifting for Insurance Linked Securities (ILS) in the UK;

(5) The annuities market is changing, and longevity transactions are here to stay.

M&A has continued to accelerate and deal values are up

Significant acquisitions by primary insurers put insurance M&A at its highest level in years, including: Ace’s acquisition of Chubb ($29.7bn); Tokio Marine’s acquisition of HCC Insurance ($7.5bn); MS&AD Insurance Group Holdings’ acquisition of Amlin ($5.3bn); Meiji Yasuda Life Insurance Company’s acquisition of Stancorp Financial Group ($5bn); Sumitomo Life Insurance Co.’s acquisition of Symetra Financial Corp. ($3.8bn); Fosun completing its acquisition of Ironshore ($1.84bn); Anbang Insurance Group’s acquisition of Fidelity & Guaranty Life ($1.6bn); as well as the significant mergers in the health insurance sector, mentioned above.

Equally, consolidation in the broker market was also a mark of 2015, led by Willis in its acquisitions of Towers Watson ($18bn) and a majority stake in Miller Insurance Group (undisclosed), followed closely by the merger of Hyperion Insurance Group and RK Harrison – the former becoming around 50% larger as a result.

Not to be left behind, one of the most active areas of the market was attributable to consolidation of reinsurers, with the XL-Catlin merger ($4.35bn) kicking off a year for reinsurance, punctuated by the Axis-Exor-Partner Re talks, with Exor, traditionally a non-insurance focused investment group, eventually acquiring Partner Re for $6.9bn.

At the end of the third quarter, global insurance M&A activity had reached $200bn (Moody’s) and we have seen such activity continue throughout the final quarter of 2015 and into the new year.

What does this mean? The continued convergence in the insurance market will likely lead to more competition and a flattening out of pricing of instruments, perhaps leading to more innovation in the structuring of deals, valuation of assets, and even more investment activity by private equity firms and new entrants into the M&A market.

Looking ahead to 2016… The immediate impact of Solvency II on M&A transactions was the increased activity of 2015, with record volumes and values of insurance M&A, driven in particular by P&C and reinsurance megadeals. We expect to see this continue into 2016 as the industry looks to achieve greater capital efficiency, as more parties – in particular those investors outside of the insurance industry – become more accustomed to M&A valuations in a Solvency II world, where valuing a target insurer will be more complicated than before.

Interest rates at low levels, global climate effects and catastrophes causing unprecedented losses, new entrants and foreign investment into US and Europe’s insurance markets are all pieces of a mosaic that indicates a notable shift in how capital and risk are balanced across the insurance sector.

That said, the harmonization of Solvency II across Europe, and those jurisdictions who have been granted equivalency (such as Bermuda), should in principle make M&A more attractive – to insurers and non-insurers. After a period of Solvency II acclimatization, we expect insurance deal activity to rise yet fur ther in 2016 as the search for capital efficiency, diversification of risks and synergies continues. In particular, with the insurance industry and capital markets meeting more frequently and in more significant transactions, we expect to see increasingly diverse market players and cross-border transactions: asset managers and hedge funds strengthening their positions in the insurance and annuities markets.

G


The growing insurance markets outside of ‘traditional’ regions are continuing their push into Europe and the US

Developing markets, par ticularly in Asia, Latin America and Africa, continue to attract investment from the US and Europe. Examples include Zurich acquiring a 51% participation in Santander’s insurance operations in Brazil, Mexico, Chile, Argentina and Uruguay, and AXA’s acquisition of 50% of Chinese motor insurer Tian Ping Auto Insurance. There is a marked reverse trend reflecting an increase in momentum throughout 2014 and into 2015, such that a number of Asian investors have invested capital into Europe and the US, despite slow growth rates in these markets.

Fosun, a leading Chinese investment group, is a prime example, with more than one third of Fosun’s total assets invested in the insurance industry. Following acquisitions of state-owned Caixa Seguros, Portugal’s largest insurance group; a stake in Ironshore, the NYSE-listed Bermudan reinsurer; and the US property casualty insurer Meadowbrook Insurance Group Inc., Fosun has continued its expansion into the established insurance markets with the acquisition of the remaining shares of Ironshore in 2015. This is a trend that we see continuing despite certain hurdles, as these investors benefit from a greater track record and familiarity with deal execution in the western markets. The potential growth of this trend is also, in part, due to certain changes in regulation that have allowed Chinese firms more flexibility to pursue overseas M&A opportunities.There is no doubt that 2015 was a year of significant insurance M&A activity, but the trend that seems most interesting to us, being part of a global organization,

is that the tides of M&A activity are turning – or, at least, we are seeing more deals flow both ways.

What does this mean? Insurers that want to avoid acquisition may wish to consider innovative strategies to link into the markets that have excess capital for investment. Investment into technology may make inbound investment more attractive and increase asset valuation. With these new market entrants, taking on a new level of business risk in order to effectively compete in this new shifting market may become an imperative.

Insurers take stock of their core/ non-core business

With increased obligations in terms of risk management and onerous administrative and documentation requirements, to apply the same process as is used on core business to run-off portfolios can

be challenging and costly. There is, therefore, potentially a considerable shift in the cost/ benefit analysis when considering compliance with regulatory requirements, as well as the associated additional management time and cost.

2015 saw a significant number of portfolio transfers of active and, in particular, run-off business; so much so that, in the UK, the PRA issued a statement early in the year, pre-warning the market of likely capacity issues that would impact the timetables for such transfers. The need to prepare for a Solvency II environment means insurers have been focusing on the implications of compliance with Solvency II and its impact on their strategy in terms of portfolios in run-off. A number of major transactions involving environmental loss books of business are in contemplation by insurance heavyweights, with Aviva having kick-star ted the market by agreeing to a $1bn plus reinsurance deal with Swiss Re. Very recently, Allianz have continued the trend and announced a $1.1bn legacy reinsurance transaction with run-off specialist Enstar. We expect other billion-dollar legacy books to come to market in 2016, but there may be an issue as to capacity of firms to take on such books and a limited number ‎of credible buyers at this end of the scale.

The ground is shifting for Insurance Linked Securities (ILS)

A product of convergence between the insurance industry and capital markets, ILS can remain relatively stable in such an uncertain environment, as it is not affected by such macro-economic conditions in the same way as other asset classes – instead, the underlying risk is tied to major natural catastrophes.


With continued economic uncertainty, ILS could be a safe haven for institutional investors in particular in 2016, and those looking to diversify their risk.

In the March 2015 Budget, the government announced its intention to promote the UK as an attractive corporate, legal and tax environment in which to build the market for ILS. The focus will be in developing attractive structures for ILS vehicles and managers to be domiciled in the UK. There was a volatile end in the investment markets in 2015, with uncertainty in the global financial markets spurred on by low US interest rates and a slowing Chinese economy.

While ILS issuance was flat or slightly down from all-time highs in 2014, we continue to see more non-insurer sponsors of cat bonds and ILS. Corporate and especially governmental and semi-governmental agencies have joined the rank of cat bond sponsors; the $700 million Alamo Re Series 2016-1 transaction sponsored by Texas Windstorm Insurance Association, in which GC Securities acted as initial purchaser, was the largest cat bond of 2015.

Not just in the UK, ILS products are an increasingly attractive asset class to pension funds both for relative yield, which has finally begun to equalize with similarly rated high yield bonds, and diversification from the capital markets to catastrophe risk. In addition, the line between ILS funds and reinsurers continues to blur, with the advent of rated pure-play reinsurers and fronting carriers in US coastal states backed by ILS. The issuance of cat bonds and other ILS funds as a useful diversifying risk tool has proliferated, and with interest rates at global historic lows, investors continue to look for yield in these alternative risk transfer instruments. Further, with continued extreme weather patterns around the globe, not only are cat bonds proliferating but sidecar issuance to add additional risk-bearing capacity are receiving unprecedented attention. Hedge and private equity funds are increasingly entering into joint ventures with existing reinsurers to provide alternative investment capabilities, which creates a strong competitive environment for the conventional reinsurance model, which features low yields or fixed-income assets. These partnerships are a departure from prior stand-alone reinsurers sponsored by hedge funds.

What does this mean? Pricing for property catastrophe insurance has undergone a sea change, while untested by a major catastrophe or a rising interest rate environment, to some degree this change seems irreversible.

The annuities market is changing, and longevity swaps are here to stay.

From April, the government’s pensions freedoms became effective; in 2016, restrictions on selling of existing annuities will also be lifted. This has led to a marked change in consumer

behavior and significant uncertainty for insurers as to the future volumes of annuities sales. Adding to this the capital requirements of holding annuity portfolios and implementation of Solvency II, insurers have been looking to dispose of non-core portfolios, including Equitable Life’s sale to Canada Life ($1.35bn), Zurich’s portfolio sale to Rothesay Life ($1.88bn) and the sale of the majority of Friends Life’s business to Aviva ($5.6bn). This activity, however, is not solely the product of UK political and economic changes: MetLife also announced recently that it was exploring spinning off its annuity business in the United States because of financial pressures brought about by increased regulation. Indeed, annuities transactions are becoming equally attractive to investment by non-insurance groups, such as Athene Holding’s (a subsidiary of the Apollo investment and asset management group) acquisition of Delta Lloyd Deutschland AG and its subsidiaries.

What does this mean? For insurers, the closing of certain doors has spurred innovation in other areas. The reduced volumes of individual consumer annuities and Solvency II have led to increased competition in the bulk annuities market, and reinsurers’ appetite for longevity transactions has grown alongside. Significant transactions include Heineken’s $3.71bn longevity swap with Friend’s Life; Prudential’s £2.9bn deal with Legal & General; and the burgeoning partnership between Zurich Assurance and Mercer, which is set to be a template for future successes at the lower-value, more volume end of the market. We expect to see more activity at both ends of the spectrum in 2016; however, we have also seen increased regulatory scrutiny of these transactions, par ticularly in the U.K.

In the US the Department of Labor’s proposed rules for retirement advisors may have a profound effect on the sale of retirement products and especially variable annuities. While European life (and other) insurers confront publishing their first set of Solvency II results, many US life insurers are reconsidering their distribution models – even as three of them confront issues related to their designation as significant financial institutions, which has already led to one annual spin-off.

The Property/Casualty Market

In the property/casualty industry, we have seen a proliferation of capital markets transactions – ILS led to a plethora of M&A transactions among reinsurers. Will this continue among the direct insurers? While direct insurers have enjoyed more favorable headwinds and better results than reinsurers to date, we expect to see heightened scrutiny of return on equity and capital efficiency at all levels of the (re)insurance cycle. There is also the prospect of accelerated technological change in the industry. Silicon Valley has taken on interest not only in insurance, but also in technologies, such as driverless cars, that could have a profound effect on the industry.


Tax Updates

Proposed PFIC Regulations Still Permit Planning Opportunities for Offshore Reinsurers

In late April, the IRS released proposed regulations (the proposed regulations) addressing the purported abuse by hedge funds of establishing/sponsoring offshore reinsurance vehicles designed to avoid the passive foreign investment company (PFIC) rules. To avoid imposition of the harsh PFIC rules (which generally impose an interest charge on any deferred taxes as well taxation at the highest applicable ordinary income rates), offshore vehicles take the position that they qualify under the exception to the definition of “passive income” under the PFIC rules for income derived in the active conduct of an insurance business. In short, the rules emphasize that (i) more than half of the reinsurer’s business during a taxable year must be the reinsuring of risks underwritten by insurance companies, (ii) the reinsurer’s income on its reserves must be reasonable and not in excess of those necessary to meet its insurance obligations, and (iii) officers and employees of the reinsurer must carry out significant and meaningful activities. These proposed regulations are not effective/applicable until published as final, which is a good factor because there are many questions, both old and new, left unanswered.

A foreign corporation is a PFIC if either (i) 75% or more of its gross income for the taxable year is passive income or (ii) on average 50% or more of its assets produce passive income or are held for the production of passive income (“passive asset test”). For purposes of applying the passive income test, except as provided in regulations, “passive income” does not include any income that is derived in the active conduct of an insurance business by a corporation that is predominantly engaged in an insurance business and which would be subject to tax under the insurance company provisions of the Internal Revenue Code (the Code) if the corporation were a domestic corporation. The proposed regulations purport to “clarify” the terms “active conduct” and “insurance business,” but leave many more questions unanswered than answered. Importantly, the proposed regulations also ignore the requirement that a corporation must be “predominantly engaged” in an insurance business.

■ “Active conduct” requires officers and employees of the corporation to carry out “substantial managerial and operational activities.” However, officers and employees of related entities do not count in meeting this test. As such, companies that rely solely on independent service providers likely will not be treated as conducting the required active business.

■ The proposed regulations define the term “insurance business” to mean the business activity of “issuing insurance and annuity contracts” and the “reinsuring of risks underwritten by

insurance companies,” together with “investment activities and administrative services” that are “required to support or are substantially related to” insurance contracts issued or reinsured by the foreign insurance company. An investment activity is any activity engaged in to produce income of a kind that generally is passive income. Investment activities will be treated as required to support or as substantially related to insurance or annuity contracts issued or reinsured by the foreign corporation to the extent that “income from the activities is earned from assets held by the foreign corporation to meet obligations under the contracts.” Under the proposed regulations, no method is provided to determine the portion of assets held to meet obligations under insurance and annuity contracts.

■ The proposed regulations do not define what it means to be “predominantly engaged” in an insurance business. Importantly, this exclusion was intentional on the IRS’ par t and ignores the requirement specified in the Code’s exception to the PFIC passive income test.

The insurance industry submitted comments to Treasury and the IRS suggesting, among other things, that measuring an insurance company’s assets-to-liabilities ratio would be a better, more objective measure of its legitimacy than what was suggested in the proposed regulations. As noted above, the proposed regulations raise new questions and leave old questions unanswered. For instance, the proposed regulations do not provide any meaningful test for what it means to “derive” income from the active conduct of an insurance business and do not explain what “substantial managerial and operational activities” are for purposes of meeting the active insurance test. Also, it is not clear how companies in run-off would be treated; we note that the proposed regulations include “investment activities and administrative services” that are “required to support or are substantially related to” insurance contracts issued or reinsured. The IRS has, in the past, addressed companies in run-off, but not in this context.

Residual Value Insurance is “Insurance” for Tax Purposes

In September 2015, the Tax Court ruled in R.V.I. Guaranty Co. Ltd. V. Commissioner, 145 T.C. No. 9 (2015) (“R.V.I.”) that residual value insurance contracts providing businesses protection from an unexpected decrease in the market value of particular assets are considered “insurance” for federal income tax purposes. The terms “insurance” and “insurance contract” are not defined in either the Code or the Treasury Regulations promulgated thereunder. To be treated as insurance, a policy must contain four elements originally described by the Supreme Court in Helvering v. LeGierse, 312 U.S. 531 (1941): (1) risk shifting, (2) risk distribution, (3) insurance in the commonly accepted sense, and (4) “insurance risk.” Prior case law had not provided the insurance industry with significant guidance on the fourth prong of this test with respect to residual value contracts.


Generally, residual value insurance contracts protect an insured party against loss in the event that assets insured under the policy have an actual value at lease termination lower than the insured value specified for the assets under the policy. Residual value insurance contracts are intended to insure against risk that property value will decline more rapidly than expected, rather than to insure against normal wear and tear. These contracts typically require a single premium payment at the inception of the contract dependent on how much risk the taxpayer assumed. Furthermore, the contracts usually include standard terminology and policy provisions typical of insurance policies.

In R.V.I., the taxpayer, a Bermuda-incorporated insurance company, elected to be treated as a domestic corporation under Code Section 953(d). The taxpayer insured leasing companies, manufacturers, and financial institutions with residual value insurance contracts for assets such as passenger vehicles, commercial real estate, and commercial equipment. These contracts were treated as insurance for regulatory purposes by all states in which the taxpayer and its affiliates sold products. The Internal Revenue Service (IRS) challenged the treatment of the contracts as “insurance” for federal income tax purposes and concluded that the taxpayer was not an “insurance company” entitled to compute its taxable income under Code Section 832.

On September 21, 2015, the Tax Court ruled that the taxpayer had properly treated its residual value insurance contracts because such contracts met the four-prong test: (1) risk shifting, (2) risk distribution,(3) insurance in the commonly accepted sense, and (4) “insurance risk.” Importantly, the Tax Court rejected arguments raised by the IRS that the policies entailed mere “investment risk” (and not insurance risk) and were analogous to investors who purchase put options to protect their stock. In its opinion, the Tax Court noted the differences between the contracts and derivative contracts. Because the premium charged by the taxpayer was rarely more than 4% of the insured value, the taxpayer was exposed to underwriting risk that the premiums charged would be insufficient to cover the claims payable. The Tax Court ultimately concluded that, while the policies had some features that differ from “standard” insurance policies, they constituted insurance contracts for federal tax purposes.

R.V.I. provides additional cer tainty to insurance companies who issue residual value insurance contracts that such contracts are considered insurance for federal tax purposes. Also, R.V.I. clarified that payouts under insurance policies need not be immediate

after the fortuitous event to qualify as insurance for federal income tax purposes.

Year-End Legislation and its Impact on the Insurance Industry – The Protecting Americans from Tax Hikes Act of 2015

Just before recessing for the holidays, Congress passed the Protecting Americans from Tax Hikes Act of 2015 (“PATH Act”). President Obama signed the Path Act on December 18, 2015. The PATH Act, unlike past “extenders” legislation, makes permanent over 20 major tax provisions in addition to extending and revising other key tax provisions. Among those provisions that have been permanently extended are Code section 871(k) (relating to certain dividends from regulated investment companies) and sections 953 (relating to exempt insurance income earned by controlled foreign corporations) and 954 (relating to certain foreign base company income earned by controlled foreign corporations). In addition, the PATH Act significantly revised Code section 831(b) (relating to elections by certain small insurance companies to be taxed on only investment income). Each of these revisions will have a noticeable impact on the insurance industry.

■ Section 871(k). most, if not all, money market funds are structured as regulated investment companies (“RICs”) for US federal income tax purposes. A RIC is an entity that meets certain investment and distribution requirements and that elects to be taxed under a special tax regime. An entity that is taxed as a RIC can deduct amounts paid to its shareholders as dividends, and in this manner, tax on RIC income is generally not paid by the RIC but rather by its shareholders. If the dividends are paid to foreign shareholders, they are generally treated as ordinary income by the gross-basis tax regime under Code sections 871(a) and 881(a) and are subject to withholding by the payor under Code Sections 1441 and 1442.


Structured insurance products and financial instruments often secure payment obligations by posting collateral, which is invested in money market funds. Under a temporary provision of prior law, a RIC that earned certain interest income which generally would not be subject to US tax if earned by a foreign person directly could, to the extent of such net interest income, designate dividends it paid as derived from such interest income for purposes of the treatment of a foreign RIC shareholder. The consequence of that designation was that such dividends were not subject to gross-basis US tax and the RIC was exempt from withholding requirements on such dividends. Similar rules applied with respect to the designation of certain short-term capital gain dividends.

These temporary, taxpayer-favorable provisions had been set to expire with respect to any taxable year after December 31, 2014, but the PATH Act reinstates and makes permanent the rules exempting from gross-basis tax and withholding of such tax the interest-related dividends and short-term capital gain dividends received from a RIC.

■ Section 831(b). in lieu of the tax otherwise applicable, cer tain property and casualty insurance companies may elect to be taxed only on taxable investment income. The election is available to mutual and stock companies with net written premiums or direct written premiums (whichever is greater) that do not exceed a certain dollar limit.

The PATH Act modifies the section 831(b) election eligibility rules by increasing the amount of the limit on net written premiums or direct written premiums (whichever is greater) from $1,200,000 to $2,200,000 and indexing this amount for inflation star ting in 2016. The PATH Act also adds diversification requirements to the eligibility rules—an insurance company meets the diversification requirement if no more than 20% of the net written premiums (or, if greater, direct written premiums) of the company for the taxable year is attributable to any one policyholder (related policyholders/members of the same controlled group are treated as one policyholder). If the company does not meet this 20% requirement, a second test applies which is satisfied if no family member—either “spouse or lineal descendant (including by adoption)”—of the policyholder’s owner owns assets in the captive insurance company in a percentage higher than the family member’s ownership in the policyholder (subject to a de minimis rule). Information pertaining to the diversification requirements must be reported to the IRS on an annual basis. The provision is effective for taxable years beginning after December 31, 2016.

■ Sections 953 and 954. under the subpart F rules, 10%-or-greater US shareholders of a controlled foreign corporation (“CFC”) are subject to US tax currently on certain income earned by the CFC, whether or not such income is distributed to the shareholders. The income subject to current inclusion under the subpart F rules includes, among other

things, foreign base company income and insurance income. Foreign base company income includes, among other things, “foreign personal holding company income” which generally consists of dividends, interest, royalties, rents, and annuities.

Subpart F insurance income includes any income of a CFC attributable to the issuing or reinsuring of any insurance or annuity contract in connection with risks located in a country other than the CFC’s country of organization. Subpart F insurance income also includes income attributable to an insurance contract in connection with risks located within the CFC’s country of organization, as the result of an arrangement under which another corporation receives a substantially equal amount of consideration for insurance of other country risks. Furthermore, investment income of a CFC that is allocable to any insurance or annuity contract related to risks located outside the CFC’s country of organization is taxable as subpart F insurance income.

Prior to the PATH Act, several temporary exceptions exempted the aforementioned income from inclusion under the Subpart F rules. For example, an exception applied for certain income that is derived in the active conduct of an insurance business (i.e., predominantly engaged in such business and conducting substantial activity with respect to such business). An exception also applied for certain income of a qualifying branch of a qualifying insurance company with respect to risks located within the home country of the branch if cer tain requirements were met. Another exception applied for certain income of certain CFCs or branches with respect to risks located in a country other than the United States. In the case of a life insurance or annuity contract, reserves for such contracts were determined under rules specific to the temporary exceptions.

Pre-PATH Act law also permitted a taxpayer in certain circumstances to establish that the reserve of a life insurance company for life insurance and annuity contracts was the amount taken into account in determining the foreign statement reserve for the contract (reduced by catastrophe, equalization, or deficiency reserve or any similar reserve). Originally set to expire at the end of the 2014 tax year, the PATH Act made permanent the temporary exceptions from subpart F foreign personal holding company income, foreign base company services income, and insurance income for certain income that is derived in the active conduct of an insurance business.

IRS Concedes with Validus Ruling that Foreign-to-Foreign Retrocession Contracts not Subject to FET

In May 2015, the US Court of Appeals for the District of Columbia affirmed in Validus Reins. Ltd. v. United States, 786 F.3d 1039 (D.C. Cir. 2015) (“Validus”) that the Code Section 4371(3) federal excise tax (FET) on policies of reinsurance does not apply to foreign-to-foreign retrocession policies. In conformity


with the Validus decision, the IRS has revoked its prior Revenue Ruling 2008-15, 2008-12 IRB 633, in which it took a contrary position. The revocation is contained in Revenue Ruling 2016-3, 2016-3 IRB 1, and provides certainty to the reinsurance industry that the government will follow the Validus decision and that the obsoleted Revenue Ruling 2008-15 should be disregarded.

Under Code Sections 4371, et seq. the FET is imposed on each policy of insurance, indemnity bond, annuity contract or policy of reinsurance issued by any foreign insurer or reinsure. A “policy of reinsurance” is defined as any policy or other instrument by whatever name called whereby a contract of reinsurance is made, continued or renewed against, or with respect to, any of the hazards, risks, losses or liabilities covered by contracts taxable under paragraph (1) or (2) of section 4371. A policy of reinsurance covering any of the contracts stated-above is taxed at a rate of 1% of the premium paid on the policy of reinsurance covering any of the contracts stated-above.

In Revenue Ruling 2008-15, the IRS took the position that the FET on policies of reinsurance applies to wholly foreign retrocession policies unless the issuing reinsurer is entitled to an exemption from tax under an income tax treaty with the United States. Thus, following Revenue Ruling 2008-15, the IRS could have theoretically applied the Code Section 4371(3) excise tax in perpetuity if it were allowed to impose the tax on wholly foreign retrocession policies. Expectedly, the reinsurance industry fought this ruling since its issuance as an overreach of regulatory power.

In Validus, the D.C. Circuit, in a 3-0 decision, affirmed the lower court’s ruling, but on narrower grounds. The District Court had concluded that Code Section 4371(3), by its plain language, did not apply to retrocession transactions. This taxpayer-friendly conclusion could have led to a potential abuse where taxpayers could structure around the FET by reinsuring within the US and then retroceding those same risks offshore. The D.C. Circuit concluded that the text of Code Section 4371 was ambiguous with regard to wholly non-US retrocessions and that the ambiguity should be resolved by reference to the presumption against extraterritoriality established in Morrison v. National Australia Bank Ltd., 561 U.S. 247 (2010). The D.C. Circuit found that there was no clear indication that Congress intended the FET to apply to premiums paid with respect to wholly foreign retrocessions, and as a consequence, held that it did not.

In December 2015, the IRS issued Revenue Ruling 2016-3 explaining that it will no longer apply the 1% FET on policies of reinsurance issued by one foreign reinsurer to another foreign insurer or reinsurer under the situations described in Revenue Ruling 2008-18. Validus and Revenue Ruling 2016-3 constitute a significant victory for the reinsurance industry in 2015.

Antitrust Issues

There were no new significant antitrust trends for the insurance industry in 2015. However, we believe that information sharing and coordinated conduct will become a heightened enforcement issue in the future.

At the same time, merger enforcement activity has become increasingly aggressive. This may not be a factor in the life and P&C markets, which are relatively unconcentrated, but could be a decisive factor in concentrated sub-markets, such as healthcare.

Joint action in the insurance industry

Last year, we noted a major insurance antitrust action in Auto Body Shop Antitrust Litigation. This was a consolidation of two dozen separate antitrust cases brought by auto repair shops against most of the leading auto insurers in the United States. The significance of that case is the allegations of parallel conduct, including price fixing and group boycotts, in the insurance industry.

Summed up quickly, the claim was that one leading insurer created bogus, ar tificially low “market rates” for body shop repair work; refused to pay more; boycotted body shops that didn’t accept the low rates; and that other insurers follow the both leader’s rates and its “boycott” of the higher priced body shops.

The original complaint was dismissed in June 2014. The amended complaint was dismissed in January 2015. The plaintiffs filed a second amended complaint was filed in February 2015; the defendants moved to dismiss in March; and in August, the judge adopted his magistrate judge’s report and dismissed the antitrust claims with permission to file a third amended antitrust complaint. On September 23, he dismissed the antitrust claims with prejudice.

The case was decided on pleading standards. The judge held that the allegations of conspiracy were entirely conclusory. As part of that ruling, the judge rejected the “conscious parallelism” claim. Conscious parallelism occurs when competitors in the same market behave similarly in response to the same competitive conditions. Courts have ruled conscious parallelism cannot by itself support a conspiracy claim because each individual company may have had a genuine, independent, self-interested reason for responding to the same competitive conditions.

However, there are cases when collective industry behavior can support claims of conspiracy. In particular, while the sharing of sensitive competitive information is not illegal in itself, it can be used as evidence of conspiracy.

Several of our clients have discussed with us the use of electronic sharing of real- time competitor insurance rates through third-party subscription services. Knowing your competitor’s rates


has the potential to create more aggressive price competition, which benefits consumers. On the other hand, there have been court cases that concluded that widespread industry sharing of current rates resulted in stabilized prices and static competition. There are obviously a number of factors that affect the outcome, including the degree of concentration in the market. However, the more comprehensive the scope of price sharing, the more compelling the argument could be that the sharing of current prices might be an anti-competitive practice.

We recommend caution in using price-sharing services, and suggest that, before subscribing, you may want to conduct your own antitrust analysis of the potential impact on your markets.

Mergers in the Insurance Industry

Government merger enforcement activity continues to be aggressive, with more transactions in more industries being challenged. This includes transactions below the Hart-Scott-Rodino (H-S-R) filing level of $76.3 million. (Hart-Scott-Rodino is merely in reporting statute. Transactions that do not meet H-S-R reporting requirements are still subject to the antitrust laws, including the merger provisions, and there have been many cases where the government has challenged and even litigated transactions below the H-S-R threshold.)

The Federal Trade Commission and the Department of Justice’s joint report on 2013-2014 H-S-R merger filings (released August 2015) showed 61 insurance mergers, with six transactions being investigated, and two going to second requests.

Market concentration is one of the key factors affecting whether a merger is likely to be investigated or challenged. There are many insurance markets that are unconcentrated, and mergers in those markets are unlikely to be problematic. But a possible earmark of a problem in any potential merger is whether a competitor is considered either a “maverick” (a company that threatens to disrupt existing competitive practices) or a company that has some new or innovative product. The government has brought a number of recent merger challenges based on one of these two theories.

Some markets, such as health insurance, are becoming increasingly concentrated, and mergers in those markets are likely

to generate regulatory interest at a minimum. This is true even though Federal policy, expressed in the Affordable Care Act, would seem to support the efficiencies and economies of scale that come from integration. The Anthem-Cigna and Aetna-Humana deals are two recent examples of large health insurance merger transactions that have triggered Congressional investigations, with accusations that the mergers would be a threat to consumers and to competition.

Smaller transactions in specific healthcare insurance sub-markets can be even more highly concentrated, and those mergers are extremely likely to be reviewed with a critical eye. We do not believe this enforcement trend would change even if the Republicans were to win control of the White House in the 2016 elections.

Those considering mergers in any of these areas should be prepared for a rigorous econometric analysis of their markets as part of the antitrust clearance process. In any event, anyone thinking of a possible merger in any market should consult with antitrust counsel before any analysis or documentation begins.


CONCLUSION AND FORECAST

The pace and scale of change for the insurance industry has never been greater. We are not alone in the assessment that the insurance industry is at an inflection point. The trajectory for individual companies and the industry overall will be determined by numerous commercial, regulatory and legal factors, and by how adept (or not) insurers are in responding to these forces.

Most importantly, we believe that winners and losers will be determined by:

• The ability to innovate. This includes adopting/harnessing technology and reacting to industry disruptors, of which there are many.

• The impact of new capital rules, including Solvency II and new Federal Reserve capital rules ( when they are issued.) We think the implications – and indeed perhaps the unintended consequences of these new rules – are just being realized.

• The evolution of the ILS market and further convergence of insurance and capital markets – including the expansion of this capital markets into long tail lines.

• The facility – and will – to adopt business plans in light of changing consumer demands and macro-economic factors. Some will choose to weather the storm and hope for more favorable trading conditions. Others will respond to what is perceived as the new normal.

• The management of capital

• Successful – or failed – attempts to enter new geographic markets and the ability to manage new and in many cases profoundly different cultural, legal and regulatory environments. This is not easy to get right and is a challenge facing those moving East to West and West to East.

• Risk appetite, underwriting skills and imagination in searching out and pricing currently uninsured or underinsured risks.

• Integration plans. The dramatic level of M&A activity in 2015 sets the stage for the greater challenge – the successful integration of the acquired businesses. Is it a well-known truth that signing and closing an M&A transaction is the relatively easy part of M&A. Putting two companies together, combining operating systems and management and eliminating duplication, but capturing the much talked about synergies of the deal, is the most difficult. Many of the transactions last year (and in 2014) were transformative. It will take time – years in some cases – to see if the transformation was positive or negative. History teaches us that many combinations do not work as planned.

• The continued pace of regulatory change.

These issues and many more present some significant challenges to the industry, but also opportunities. It seems safe to forecast that virtually no insurer can afford to simply stay the course and continue to do what it has always done. Insurers manage risk. They need to manage change more than ever.


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For more information

This publication reflects the work and experience of many within our global insurance team. The principal authors are:

If you have any questions or comments regarding this Insurance Sector 2015 Year End Review and Forecast for 2016, or would like fur ther information about these evolving areas of law, please let us, or your DLA Piper relationship partner, know.

William C. MarcouxNew [email protected]

Peter S. [email protected]

Stephen W. [email protected]

Paul ChenNew York and Silicon [email protected]

David LuceNew [email protected]

Kathleen A. [email protected]

Carla SmallNew [email protected]

Tim [email protected]

Rebecca [email protected]

PK [email protected]

Melanie [email protected]

Joyce ChanHong [email protected]

Heng Loong CheongHong [email protected]

Roy [email protected]

Peter [email protected]

Samantha O’[email protected]

Marcella [email protected]

Magdi [email protected]

Jim HalpertWashington, [email protected]

Sydney WhiteWashington, [email protected]

Steven LevitskyNew [email protected]

Steven R. PhillipsWashington, [email protected]

David J. BrummondWashington, [email protected]

Clifford RobertiWashington, [email protected]

Gerald RokoffNew [email protected]

Michael GreenbergNew [email protected]

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