On April 12, 2011, Arizona Governor Jan Brewer signed into law HB2113 relating to Qualified Financial Contracts. Essentially, the bill adopts Section 711 of the National Association of Insurance Commissioners ("NAIC") Insurer Receivership Model Act. Arizona permits domiciled life insurers to enter into certain derivative transactions with major financial institutions in order to hedge long-term investment and interest rate risk. Such contracts are generally referred to as Qualified Financial Contracts ("QFC") which are tied to interest or currency rate changes over time. The NAIC adopted the Insurer Receivership Model Act in 20061 and, in doing so, established a framework for how QFCs can be terminated when an insurer is placed into Receivership. While the Model Act itself has been adopted in 4 states,2 the Arizona Legislation simply enacts Section 711 of the Model Act that deals solely with QFCs in the context of a Receivership setting.
Generally, such contracts involve both the International Swaps and Derivatives Association Master Agreements and attendant Credit Support Annexes which govern the posting of collateral between the insurer and the institutional counterparties to the transaction. Generally, counterparties to such transactions are large banks and investment banks, such as JPMorgan, Citibank, Bank of America, Deutsche Bank, Societe Generale, Goldman Sachs, Barclays, etc. These contracts are also referred to as "Netting Agreements," because when the QFC is terminated, the value of the elements to the transaction are offset against one another ("netted") so that one party will owe the other a net amount upon the termination of the transaction. Netting Agreements typically provide self-help provisions so that collateral can be drawn upon at the time of termination of the contract based upon which party is owed an amount under the contract.
Prior to the adoption of HB2113, an insurer placed into Receivership in Arizona resulted in an injunction being issued against all parties to any contracts with the insurer restraining the exercise of any self-help provision under such contracts.3 The result would be that the QFC counterparty would be treated as a general creditor without the right to terminate the QFC on a net basis. This meant that Arizona life insurers would be charged a higher amount by a counterparty to provide the hedging protection that the QFC offers.
HB2113 defines a Netting Agreement as a contract that includes a Master Agreement involving one or more QFCs that provides when the netting, liquidation, setoff, termination, acceleration or close out of future payment or delivery obligations arises.4
It defines a QFC as a Commodity Contract, Forward Contract, Repurchase Agreement, Securities Contract, Swap Agreement or any similar Agreement that may be determined by the Director of Insurance.5 The bill also defines a Forward Contract, Repurchase Agreement, Securities Contract and Swap Agreement as having the same meanings as set forth in the Federal Deposit Insurance Act 12 USC Section 1821(e)(8)(d).6
HB2113 states that an injunction upon Application by the Director of Insurance under the Arizona Receivership Law does not operate to enjoin or prohibit the netting, liquidation, setoff, termination, acceleration or close-out of obligations under a Netting Agreement or QFC.7 The legislation specifically provides that no one shall be enjoined or prohibited from exercising its contractual right to cause the termination or close out of the obligation under a Netting Agreement or QFC with an insurer because of the insolvency, financial condition or default of the insurer.8. Moreover, the right to offset or net out the payment amount in connection with the QFC for the counterparty that is domiciled in the United States or a foreign jurisdiction approved by the Securities Valuation Office of the NAIC cannot be similarly enjoined or prohibited.9 The bill requires the net or settlement amount owed by a non-defaulting party to an insurer, against which a proceeding has been commenced, to be transferred to the Receiver for the insurer on termination of a Netting Agreement or QFC even if the insurer is the defaulting party and despite any walk-away clause in the Agreement itself.10 The legislation prohibits the Receiver from voiding the transfer of funds under a Netting Agreement or QFC including any Collateral or Guarantee Agreement unless such transfer was made with the actual intent to hinder, delay or defraud the insurer.11
HB2113 requires that the Receiver of the insurer either must repudiate all Netting Agreements or QFCs between the insurer and a counterparty or none of the Agreements may be repudiated.12 Thus, the intent is to not permit a Receiver to pick and choose different Agreements with the same counterparty to repudiate. The legislation states that any claim of a counterparty arising from the Receiver's repudiation of a Netting Agreement or QFC shall be determined as if the claim had arisen before the date of commencement of the proceedings placing the company into Receivership.13 Damages are to be measured as direct compensatory damages determined as of the date of the repudiation of the Netting Agreement or QFC.14 The Act states that its provision are not applicable to persons who are affiliates of the insurer that is the subject to the proceeding.15 It applies all rights that a counterparty may have under a Netting Agreement or QFC based upon whether the general account or separate account assets are available to the counterparties under the specific Agreements.16
An illustration as to how the termination of a Netting Agreement under HB2113 between an insurer and an institutional counterparty would work is as follows:
Party A (the insurance company) and Party B (institutional bank) enter into an interest rate swap based on the S&P500 pursuant to the Master Agreement where the current termination value is $100 in favor of Party A (the insurance company). If Party A (the insurance company) goes into receivership and Party B (institutional bank) elects to terminate the transaction under the Master Agreement, Party B would owe Party A the $100 termination payment.
If the scenario is switched and Party B (institutional bank) goes into bankruptcy, then Party A (the insurance company) could access the $100 of collateral under the Master Agreement under Federal Bankruptcy Law.17 The result being that HB2113 "levels the playing field" for institutional counterparties and insurers thus making it more palatable for institutional counterparties to do business with insurers and accept interest rate or investment risk under insurance contracts.
The enactment of Section 711 of the NAIC Insurer Receivership Model Act provides important guidance to Arizona domiciled life insurers and financial institutions with whom they negotiate derivative contracts designed to hedge investment and interest rate risk. It promotes the public policy of obtaining important protections for such risks and assuring such protections are priced at a reasonable market value unimpeded by the