Regardless of your view of the debate over state versus federal regulation of insurance, recent actions at the NAIC and legislative actions by the U.S. Congress, are changing the way insurance is regulated in the U.S. This article reviews the background and evolution of these significant changes and makes some predictions about the future.
Solvency Modernization Initiative
In June 2008, the National Association of Insurance Commissioners (NAIC) announced a coordinated effort to analyze the solvency regulatory framework of insurance in the U.S. The NAIC’s Solvency Modernization Initiative is reviewing five key areas:
Corporate governance and risk management;
Accounting and financial reporting; and
In order to better understand the why and what of the NAIC’s Solvency Modernization Initiative, one should first look at the European Union’s Solvency II initiative.
Solvency II is the result of almost a decade of review by the EU of the regulation of insurance. Solvency II is an entirely new, harmonized solvency regime across 27 member states, which includes the supervision and capital assessment of insurers established in the EU. Interestingly, the EU has a structural parallel to the U.S.’s 50-state regulatory regime with the overlay of the NAIC . Thus lessons might be learned from the EU Solvency II initiative.
Solvency II involves three key elements:
- Harmonize standards across the EU, including capital requirements;
- Establish a risk-based regulatory framework for all EU insurers; and
- Move to a single lead insurance supervisor for insurance groups.
Solvency II is an extremely ambitious project. The practical and commercial implications of Solvency II are far reaching; in part, because of the cross border impact on international insurance holding companies with operations in the EU (and EU established insurance holding companies with operations in other countries, including the U.S.).
The initial implementation date for EU insurers was November 1, 2012. It was subsequently extended to January 1, 2013 and is in the process of being extended again to January 1, 2014.
Element 3 above, group supervision, involves a comprehensive regime for the supervision of insurance groups, which is triggered by the presence of an European Economic Area (EEA) authorized insurer. The group regime encompasses not only group solvency requirements, but also governance, risk management, disclosure and reporting requirements. A college of supervisors is to be established for each group, consisting of national supervisors of the group entities that is headed by a designated group supervisor.
For groups with their ultimate parent in a third country (one outside the EEA), group supervision potentially applies at worldwide group level. If a third-country regulatory regime is equivalent, EEA supervisors will rely on group supervision exercised by the third-country supervisor over the third-country parent, by forming a college of supervisors led by the third-country supervisor. If not equivalent (for example, the U.S.), Solvency II rules on group supervision may be applied. (Solvency II allows some flexibility as to whether they will be applied at whole group level or at EEA holding company level.) If applied at whole group level, Solvency II group solvency will be calculated at the level of the ultimate third-country parent, and governance, risk management, disclosure and reporting requirements could also apply to the whole group, including the third-country parent. Substitute U.S. for the “third-country” in the foregoing sentence, and the source of concern for U.S. insurance holding companies with an EEA insurer becomes apparent. Also to be noted, the U.S. is not part of the first wave of countries to be evaluated for equivalency.
Equivalence under Solvency II also becomes important to international groups because it allows non-EEA insurance groups with EEA subsidiaries access to equivalent treatment in EU member states. EEA-based insurers enjoy such treatment automatically by virtue of their geographic location.
With respect to U.S. equivalence, the predecessor organization to the European Insurance and Occupational Pensions Authority (EIOPA), which is the entity charged with implementing Solvency II, highlighted a number of concerns regarding the U.S. regulatory regime, including the following:
- Lack of a single, central insurance regulator;
- Absence of any group supervisory framework; and
- Potential lack of professional secrecy that limits the exchange of information between EIOPA and the NAIC (i.e., the 50 states and various other U.S. jurisdictions). (Freedom of Information (FOI) legislation in the U.S. creates this difficulty because a guarantee of professional secrecy is required under Solvency II.)
Despite these concerns, commentators and insurance regulators (U.S. and non-U.S.) have expressed confidence that the U.S., as the largest global market, will achieve equivalence; initially, through transitional measures being currently considered by EIOPA, and ultimately through the recognition process. EIOPA has already acknowledged that because of the U.S.’s use of state regulation (in contrast to national) a different approach will be needed for the U.S. in distinction to other third-countries, thus mitigating the first two concerns noted above.
So, why is Solvency II relevant to U.S. insurers that are not part of an international insurance holding company? Because Solvency II is driving changes in U.S. state regulation. This is reflected in the NAIC’s Solvency Modernization Initiative.
Back to the NAIC’s Solvency Modernization Initiative
Notably, the first three areas of Solvency Modernization Initiative were adopted from the three key elements of Solvency II mentioned above: capital, risk management and group supervision. Under the third area, group supervision, the NAIC in November 2011 adopted a Guidance Manual for preparation of the Own Risk and Solvency Assessment (ORSA) Report. (The only open issue is how to keep the ORSA Report confidential once it is filed with the applicable state regulator.) ORSA is a concept introduced by Solvency II that describes the process used to identify, assess, monitor, manage and report the short and long term risks facing an insurer and its insurance group in order to determine the funds necessary to ensure that overall solvency needs are met.
The fourth area, accounting and financial reporting, deals with investigating the adoption of International Financing Reporting Standards (IFRS) used in Europe. In the U.S., insurers use Statutory Accounting Principles (SAP) while their corporate parents use Generally Accepted Accounting Principles (GAAP). The NAIC is in the preliminary stages of exploring whether GAAP or IFRS should replace SAP for U.S. insurers.
To note the obvious, the NAIC is positioning the 50 states to satisfy the equivalency standards of Solvency II. In the process, the NAIC will be potentially imposing on U.S. insurers, even those that are not part of an international insurance holding company, similar criteria applied to EU insurers under Solvency II.
Reinsurance Collateral Reform
The NAIC Solvency Modernization Initiative’s fifth area of focus is reinsurance. After a 15-year debate on the need for 100% security to be posted by unlicensed reinsurers of U.S. ceding insurers, in December 2008, the NAIC adopted a new Reinsurance Regulatory Modernization Framework (Framework). The Framework establishes a sliding scale of relaxed security for highly-rated unlicensed (U.S. and non U.S.) reinsurers, based on their ratings and not simply on being unlicensed. The Framework was incorporated into a proposed federal law drafted by the NAIC in September 2009, but this proposed federal law did not become part of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank). Separately, several states individually (at this time, Florida, New York, New Jersey and Indiana) have adopted versions of the Framework.
On a parallel track, in December 2010, the NAIC began the process of amending its Model Act and Regulation for Credit for Reinsurance to reflect the sliding scale for posting of collateral by unlicensed reinsurers (U.S. and non U.S.) that were rated. At the NAIC meeting in November 2011, these credit for reinsurance amendments were approved. The new amendments include a certification process for unlicensed reinsurers from “Qualifying Jurisdictions” to receive the collateral reduction. Such unlicensed reinsurers will need a minimum capital and surplus of $250 million. U.S. jurisdictions that meet NAIC accreditation standards (which includes all 50 states at present) are recognized as Qualified Jurisdictions. The question of whether a foreign country is a Qualified Jurisdiction is determined by each state regulator using a number of factors. Interestingly, the NAIC intends to publish a list of Qualified Jurisdictions to assist the states.
Unfortunately, the adoption of these amendments by each of the 50 states will be a multi-year effort with the potential for varying (even inconsistent) results at the state level. Thus development of uniform, national standards for reinsurance may not occur quickly at the state level.
B. Dodd-Frank Act
The McCarran-Ferguson Act (1945) reserves to the states the primary right to regulate insurance, unless the federal government specifically preempts state law. Dodd-Frank, adopted in July 2010, represents a significant preemption by the federal government of the state regulation of insurance. The only two prior occasions the federal government stepped into the regulation of insurance were the Graham-Leach-Bliley Act (1999) and the Terrorism Risk Insurance Act of 2002. While Dodd-Frank reaffirms that “The business of insurance will remain primarily regulated at the state level,” it has now created a new Federal Insurance Office (FIO) and regulates non-admitted insurance and reinsurance.
Federal Insurance Office
While the FIO has no statutory or regulatory authority over insurance, the FIO is charged with coordinating U.S. efforts on international insurance matters, including agreements with foreign governments. And such international agreements can preempt state insurance law.
The FIO will also collect data and investigate the insurance industry. It will issue reports with recommendations, including the possibility of expanding the federal role in insurance.
The FIO was to undertake a study and make recommendations on how to modernize and improve insurance regulation in the U.S. This report that was due on January 21, 2012. Unfortunately, as of early March 2012, the report has not yet been issued. The report was to cover 12 topics listed in Dodd-Frank (31 USC §313(p)). Five topics deal with the potential federal regulation of various aspects of the insurance business. On October 17, 2011, the FIO requested public comment on these 12 topics to assist the FIO in preparing its report. Nearly 150 written comments were received by the close of the 60-day public comment period.
While it is difficult to predict the direction insurance regulation will evolve, particularly, when politics and emotion come into the discussion, it is likely the status quo will not remain unchanged. The unpublished FIO report on the modernization and improvement of insurance regulation in the US will provide insight on the initiatives the FIO (and the US Treasury) will undertake with respect to insurance regulation. Two possible areas of change are expansion of the FIO’s role in international insurance (particularly with respect to reinsurance) and reconsideration of the State Modernization and Regulatory Transparency Act (SMART Act), federal legislation introduced in 2004, but not enacted. The SMART Act provided for a state-national partnership on insurance. Some of the goals were to ease the multistate licensing of producers and a move to open-competition (by the gradual removal of prior approval of rates). While the NAIC was opposed to the SMART Act when it was introduced, the passage of 7 years and the launching of its Solvency Modernization Initiative, indicates the NAIC might take a different view today of some aspects of the SMART Act.
Title V of the Dodd-Frank Act has changed the non-admitted insurance and reinsurance landscape in the United States. Title V, called the Non-Admitted and Reinsurance Reform Act (NRRA), although adopted as part of Dodd-Frank on July 21, 2010, did not become effective until July 21, 2011. In contrast to the rest of Dodd-Frank, the NRRA was non-controversial even though it introduced uniform, nationwide standards for non-admitted insurance and reinsurance. For unlicensed insurers and ceding insurers/reinsurers, the changes have reduced regulatory hurdles and changed the playing field.
Significantly, the NRRA establishes that an insured’s home state has exclusive authority to regulate the placement of multi-state risks on a non-admitted basis, including, surplus lines and certain forms of self-procurement. No state, other than the insured’s home state, may require a surplus lines broker to be licensed in order to sell, solicit or negotiate surplus lines insurance. The NRRA also provides for the pre-emption of state laws and regulations that apply to non-admitted insurance sold, solicited or negotiated with an insured whose home state is in another state. This eliminates the extra-territorial jurisdiction asserted by some states over non-admitted business, particularly surplus lines. Finally, only the insured’s home state will be permitted to collect premium taxes for non-admitted insurance. The U.S. Congress encouraged the states to enter into an interstate compact to create a uniform standard to allocate surplus lines taxes for multi-state risks. The states, however, were unable to do so by the effective date of the NRRA and continue to debate over two competing interstate compacts. It may well be the states will default to a simple, single-state tax approach; i.e., the home state keeps 100% of the taxes, which, ironically, will be uniform.
The NRRA also provides that states cannot prohibit a surplus lines broker from placing business with a non-admitted insurer that is listed on the Quarterly Listing of Alien Insurers maintained by the International Insurers Department (IID) of the NAIC. As a result, non-admitted alien insurers can now maintain surplus lines eligibility in all U.S. states through a single filing with the IID. State by state filings should be eliminated.
The U.S. Comptroller General is obligated to conduct a study of the surplus lines market under the new NRRA which is due in January 2014. The report may suggest further federal action in the regulation of the surplus lines market.
The NRRA establishes single-state regulation of reinsurance; i.e., the domiciliary state of the ceding insurer (31 USC §531(b)) and the assuming reinsurer (31 USC §531(b)). For the ceding insurer, the NRRA expressly preempts the extraterritorial application of any non-home state’s credit for reinsurance rules (31 USC §531(a)).
For the assuming reinsurer, only its domiciliary state (for U.S. reinsurers) or a port of entry state (for non-U.S. reinsurers) is allowed to regulate the financial solvency of the reinsurer (31 USC §532(a)). The mechanism for such regulation is set forth in the recent amendments to the NAIC Model Act and Regulation for Credit for Reinsurance discussed above. The coordination between the actions of the federal government in adopting the NRRA and the states through the NAIC’s amendments to the Credit for Reinsurance Model Act and Regulation, indicates the possibility of further joint regulation of reinsurance. This is consistent with the purpose of the SMART Act discussed above.
The FIO will be issuing a report on how global reinsurance affects the U.S. insurance in September 2012. The FIO will also prepare a January 2013 report on the impact on a state regulator’s access to reinsurance information relating to domiciliary ceding insurers in light of the NRRA. These reports may suggest further action in the reinsurance area.
The EU’s Solvency II, the NAIC’s Solvency Modernization Initiative, and Dodd-Frank’s FIO are all influencing the evolving regulation of insurance in the U.S. The interplay of these actions reflect the consequences of the globalization of insurance. They will, however, also have an affect on U.S. insurers that are not a member of an international insurance holding company because these actions may result in the potential for increased capital requirements, possible need to prepare ORSA reports, and application of reduced collateral requirements for reinsurance ceded to highly rated, unlicensed reinsurers. Finally, the new FIO is likely to be a catalyst for future U.S. regulatory changes.
NOTICE: This article has been prepared by Sidley Austin LLP for informational purposes only and does not constitute legal advice. This information is not intended to create, and receipt of it does not constitute, a lawyer-client relationship. Readers should not act upon this without seeking advice from professional advisors.