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March 2017

SIDLEY GLOBALINSURANCE REVIEW

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SIDLEY GLOBAL INSURANCE REVIEW

SIDLEY GLOBAL INSURANCE REVIEWMarch 2017

The insurance industry has a global reach. Insurers and reinsurers are critically important to the world economy. They assume and transfer all manner of risk across the globe, and serve as an enormous investor base for the world’s capital markets and beyond. Risk is increasingly shared globally among traditional and new market entrants. Risk generated in one part of the world is distributed immediately across multiple continents to other market participants, whether they be other insurers, reinsurers, private equity sponsors or capital market investors. The insurance industry is constantly evolving and requires regulatory regimes and market participants to adapt on a frequent basis. Regulatory issues arising in one market may influence the way in which similar regulatory concerns are addressed in other markets. To understand the insurance industry, one must have a solid understanding of global developments. We prepared this publication as a tool to assist readers in obtaining such understanding.

We realize that no one publication could provide adequate coverage to each and every recent global development without becoming cumbersome. Accordingly, this publication attempts to provide an overview of major legal and market developments in the global insurance industry arising over the past year. We have focused on developments in the United States, United Kingdom, European Union, Asia and other markets with intense insurance activity, such as Bermuda.

This review has been produced by the Insurance and Financial Services group of Sidley Austin LLP. Sidley is one of the world’s premier law firms, with 1,900 lawyers across 20 offices in North America, Europe, Asia and Australia. Sidley is one of only a few internationally recognized law firms to have a substantial, multidisciplinary practice devoted to the insurance industry. We have more than 85 lawyers devoted to providing both transactional and dispute resolution services to the insurance industry throughout the world. Our Insurance and Financial Services group has an intimate knowledge of, and appreciation for, the insurance industry and its unique issues and challenges. Regular clients include many of the largest insurance and reinsurance companies, their investors and capital providers, brokers, banks, investment banking firms and regulatory agencies for which we provide regulatory, corporate, capital markets, securities, mergers and acquisitions, private equity, insurance-linked securities, derivatives, tax, reinsurance dispute, class action defense, insolvency and other transactional and litigation services.

We hope you enjoy this edition of the Sidley Global Insurance Review.

Attorney Advertising - Sidley Austin LLP, One South Dearborn, Chicago, IL 60603. +1 312 853 7000. Sidley and Sidley Austin refer to Sidley Austin LLP and affiliated partnerships as explained at www.sidley.com/disclaimer. Prior results do not guarantee a similar outcome. Some photos on this brochure may be of actors and not of clients or firm personnel.

This Global Insurance Review 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, an attorney-client relationship. Readers should not act upon this without seeking professional counsel.

© 2017 Sidley Austin LLP and Affiliated Partnerships (the “firm”). All rights reserved. The firm claims a copyright in all proprietary and copyrightable text in this report.

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TABLE OF CONTENTS

I. The Global Mergers and Acquisitions Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1A. North American Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1

1. Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1

2. P&C Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1

3. Life and Annuity Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2

4. Health Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2

5. Other Notable Activity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

6. Additional SIFI Activity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

7. Outlook for 2017 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

B. Europe. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

II. The Global Alternative Risk Transfer Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5A. Life and Annuity Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5

1. The State of the Reserve Financing Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5

a. PBR Adoption Update . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5

b. Adoption of Reserve Financing Model Regulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5

2. Transactions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6

a. Regulation XXX/Regulation AXXX Transactions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6

b. Embedded Value/Closed-Block Transactions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6

3. Litigation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6

B. P&C Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7

1. Catastrophe Bonds. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7

2. Traditional Reinsurers in the ILS Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7

3. Investment Manager Activity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8

4. Reinsurance Purchased for National Flood Insurance Program . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9

5. Outlook Ahead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9

C. UK’s Insurance-Linked Securities Initiative . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9

1. Insurance-Linked Securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9

a. Proposed Corporate Structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9

b. Tax Proposals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10

c. Regulatory Proposals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10

D. Traditional Capital Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10

III. The Global Longevity Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .11A. Transaction Structures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11

1. Buy-Outs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11

2. Buy-Ins . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11

3. Longevity Swaps . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11

4. Index-Based Trades . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12

B. U.S. and Canadian Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12

C. UK/European Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12

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IV. Global Regulatory and Litigation Developments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .13A. U.S. Federal Activity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13

1. Federal Reserve Board . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13

2. Federal Insurance Office . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14

a. Covered Agreement Between the U.S. and the EU . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14

b. Post-Election Role in Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

3. Financial Stability Oversight Council . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

4. Flood Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

5. Department of Labor – Fiduciary Rule Faces Uncertain Future . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16

B. U.S. NAIC and State Activity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16

1. Principle-Based Reserving . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16

a. PBR Becomes Operative . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16

b. PBR Implementation Measures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17

2. Affiliated Captive Insurers and Reserve Transactions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17

a. Adoption of Credit for Reinsurance Model Law Amendments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17

b. Adoption of A/XXX Model Regulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18

i. Shortfall Consequences . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18

ii. Small Reinsurer Exemption . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18

c. Adoption of New Version of AG 48 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18

3. Reinsurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18

a. Credit for Reinsurance Update . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18

i. Reduced Collateral Requirements Adopted as Accreditation Standard . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18

ii. Potential Changes to Qualified Jurisdiction Status . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19

4. Corporate Governance/Solvency Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19

a. Corporate Governance Annual Disclosure Model Act and Model Regulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19

b. NAIC Developing Enterprise Risk Report (Form F) Guidance Manual . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19

c. Capital Adequacy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19

i. RBC for Investment Affiliates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19

ii. RBC Initiatives Related to the A/XXX Model Regulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20

iii. Investment RBC Working Group – Changes to Asset Risk Factors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20

iv. Operational Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20

5. Unclaimed Property . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20

a. State Adoption of the National Conference of Insurance Legislators Model Unclaimed Life Insurance Benefits Act . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20

b. Update Regarding NAIC Development of Unclaimed Life Insurance and Annuities Model Act . . . . . . . . . . . . . . 20

c. NAIC Launches Life Insurance Policy Locator Application . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21

d. Settlements and Litigation Dealing with Unclaimed Life Insurance Matters . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21

i. Health Insurance Regulation – ACA Risk Corridors Litigation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21

6. Affordable Care Act . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22

7. Sharing Economy Issues – NAIC Adopted Home Sharing White Paper . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23

8. NAIC Considering Developing Model Law or Guideline Regarding Travel Insurance . . . . . . . . . . . . . . . . . . . . . . . . 23

9. NAIC Activity Relating to International Insurance Activities – NAIC Developing Group Capital Standard . . . . . . . . 23

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10. Life Insurance and Annuities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23

a. NAIC Adopts Revisions to Actuarial Guideline 49 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23

b. NYDFS Regulatory Activity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23

i. Proposed Regulation Limiting Premium Increases for In-Force Life Insurance Policies . . . . . . . . . . . . . . . . . . . 23

ii. Circular Letter Addressing Replacement Practices Involving Deferred Annuities . . . . . . . . . . . . . . . . . . . . . . . 24

11. NAIC Activity Relating to Big Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25

12. Insurer Investments/Securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25

a. NAIC’s Receivership and Insolvency (E) Task Force Asks States Not to Adopt Guideline for Stay on Termination of Netting Agreements and Qualified Financial Contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25

C. International (Non-U.S.) Insurance Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25

1. Insurers Contemplate the Impact of Brexit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25

2. Solvency II Equivalence and Credit for Reinsurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26

a. Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26

b. What is Equivalence? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26

c. Effect of Equivalence on the Reinsurer’s Status Under Solvency II for Credit Purposes . . . . . . . . . . . . . . . . . . . . . 27

d. Impact on Counterparty Default Risk Charge . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27

e. Requirements to Pledge Collateral or Locate Assets in the EEA . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27

f. Equivalence Does Not Provide a Right to Passport Services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27

3. Insurance Distribution Directive . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28

a. Summary of the Key Changes Under the IDD . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28

b. Developments in the Establishment of Delegated Acts, Technical Standards and Guidelines as Required Under IDD . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28

c. Key Proposals in EIOPA’s Technical Advice . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28

i. Product Oversight and Governance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28

ii. Conflicts of Interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29

iii. Inducements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29

iv. Suitability or Appropriateness of IBIPs. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29

d. Status and Next Steps . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29

4. Final Rules on Solvency II Remuneration Requirements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29

a. Recap of Solvency II’s Remuneration Requirements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

b. The PRA’s Guidance Under the Policy Statement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

i. Requirement for a Remuneration Policy for the Whole Undertaking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

ii. Identification of Solvency II Staff . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

iii. Process for Identifying MRTs, Engagement With Regulatory Supervisors and Recordkeeping . . . . . . . . . . . . . 31

iv. Deferral Requirements for Solvency II Staff . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31

v. Assessment of Individual, Business Unit and Firm or Group Performance for the Purposes of Calculating the Variable Remuneration of Solvency II Staff . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31

vi. Proportionality . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31

vii. Evidencing to the PRA Compliance With Solvency II’s Remuneration Requirements . . . . . . . . . . . . . . . . . . . . 31

5. Regulatory References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32

a. Scope of the New Rules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32

b. Requesting Regulatory References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32

c. Providing Regulatory References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32

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d. Updating Regulatory References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33

e. What is the Impact on Firms? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33

6. Insurance Act 2015 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33

a. New Duty of Fair Presentation (Non-Consumer Contracts Only) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33

b. Remedies for Breach of the Duty of Fair Presentation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33

c. Warranties: the Insurer’s Remedy for Breach is that its Liability is Suspended, Not Discharged . . . . . . . . . . . . . . 34

d. Warranties: Remedy for Breach of Warranty Now Contingent on Relevance to Risk of Loss . . . . . . . . . . . . . . . . . 34

e. Damages for Late Payment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34

7. Third Parties (Rights Against Insurers) Act 2010 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34

a. Right of the Third Party to Bring Proceedings Directly Against the Insurer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35

b. Right to Request Information From Insurers, Brokers and Others . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35

c. Limitations on the Defenses Available to the Insurer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35

8. EU and Member State Competition Law Enforcement Activity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35

a. EU-level Enforcement by the European Commission . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35

b. National Level Enforcement in the UK . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35

i. CMA Implementing Measures in Car Insurance Market Investigation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35

ii. CMA Digital Comparison Tools Market Study . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36

iii. FCA General Insurance “Add-On” Market Study . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36

iv. FCA Review of Annuities and Retirement Income Market Study . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36

v. FCA Consultation on Increasing Transparency and Engagement at Renewal in General Insurance Markets . . 36

vi. FCA Call for Inputs on Big Data in Retail General Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36

vii. UK CAT Judgment and Insurance for Breaches of Competition Law . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36

viii. Court of Appeal Judgment on Fee-Capping by Medical Insurers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36

c. National Level Enforcement in Austria . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36

d. National Level Enforcement in Bulgaria . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36

e. National Level Enforcement in Finland . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37

f. National Level Enforcement in France . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37

g. National Level Enforcement in Germany . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37

h. National Level Enforcement in Greece . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37

i. National Level Enforcement in Hungary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37

j. National Level Enforcement in Ireland . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37

k. National Level Enforcement in Italy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37

l. National Level Enforcement in Latvia . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37

m. National Level Enforcement in the Netherlands . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37

n. National Level Enforcement in Poland . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37

o. National Level Enforcement in Romania . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37

p. National Level Enforcement in Sweden . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38

9. Impact of the EU’s General Data Protection Regulation on the Insurance and Reinsurance Industry . . . . . . . . . . . . 38

a. Greater Enforcement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38

b. Application to Non-European Businesses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38

c. One-Stop-Shop . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38

d. Data Controllers and Data Processors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38

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e. Notice and Consent . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38

f. Accountability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39

g. Information Security and Breach Notification . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39

h. Increased Rights of Individuals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39

i. Profiling . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40

j. Transfer of Personal Data from the EEA . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40

k. Final Thoughts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40

10. China: Regulatory Developments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40

a. CIRC Agrees Memorandum of Understanding With EIOPA, and Meets With NAIC . . . . . . . . . . . . . . . . . . . . . . . 40

b. CIRC to Identify Domestic Systemically Important Insurers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40

c. Shanghai Insurance Exchange Launches With Two Investment Products . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40

d. Regulators Warn Against Reckless International Acquisitions, Although Insurers’ Overseas Asset Holdings Expected to Rise . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41

V. Cyber Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .41A. U.S. Cyber Risk Developments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41

1. U.S. Federal Activity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41

a. Advanced Joint Notice of Public Rulemaking Issued by the U.S. Department of the Treasury, the Federal Reserve and the FDIC, “Enhanced Cyber Risk Management Standards.” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41

2. NAIC Activity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42

a. Insurance Data Security Model Law . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42

b. NAIC Adopts Model Bulletin Regarding Annual Privacy Notices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42

3. NYDFS Proposed Cybersecurity Regulations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42

B. UK and Europe . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43

1. Regulatory Focus on Cyber Underwriting Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43

a. PRA Consultation Paper . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43

b. “Silent” Cyber Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43

c. Cyber Risk Strategy and Risk Appetite . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43

d. Cyber Expertise . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43

e. What are the Implications for Firms? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43

f. Lloyd’s Cyber-Attack Strategy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43

g. Where Does This Leave Firms? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44

VI. Select Tax Issues Affecting Insurance Companies and Products . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .44A. U.S. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44

1. Prospects for Tax Reform . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44

2. Inversion Guidance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45

3. New Debt/Equity Regulations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46

a. The Documentation Rule . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46

b. The Recharacterization Rule . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46

c. Observations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46

4. New Partnership Audit Rules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47

5. PFIC Guidance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47

6. Treatment of Ceding Commission . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47

7. The Advent of Principle-Based Reserving . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48

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8. International Tax Issues: The OECD BEPS Project . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49

a. Country-by-Country Reporting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49

b. Transfer Pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49

c. Multilateral Instrument . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49

B. EU/UK . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49

1. Tax Deductibility of Interest Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49

2. Reform of Loss Relief . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50

3. Changes to the Substantial Shareholding Exemption . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50

4. New Corporate Offenses of Failure to Prevent the Facilitation of Tax Evasion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50

5. UK’s Insurance Linked Securities Initiative . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50

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I. The Global Mergers and Acquisitions Market

A. NORTH AMERICAN MARKET

1. Introduction

Following 2015’s record-setting wave of mega-deals, a decline in transactional activity was perhaps to be expected, and indeed, 2016 saw a significant year-over-year decrease in aggregate deal value despite a slight increase in the total number of announced transactions. While the number of underwriter deals inched up 5% in 2016, aggregate disclosed deal value dropped 69% from approximately US$65.8 billion in 2015 to approximately US$20.5 billion in 2016.1 As an additional point of comparison, during 2015, seven deals were announced with values of US$5 billion or more, while 2016 saw just one such transaction, the US$6.3 billion proposed acquisition of Endurance Specialty Holdings Ltd. by Japan’s Sompo Holdings Inc. That said, several other notable transactions with multibillion dollar aggregate values were announced in 2016, including Fairfax Financial Holdings Limited’s US$4.9 billion proposed acquisition of Allied World Assurance Company Holdings, AG, Liberty Mutual Holding Co. Inc.’s US$3 billion proposed acquisition of Ironshore Inc., and the proposed sale of Genworth Financial, Inc. to a subsidiary of China Oceanwide Holdings Group Co., Ltd. for US$2.7 billion. These transactions are discussed further below.

The pace of deal activity was unusually slow at the beginning of 2016, with the first and second quarters seeing total aggregate deal volume of just US$1.1 billion and US$713.5 million respectively.2 During the second half of the year, there was a pronounced uptick in activity, and in fact, the three largest deals of the year, and five of the six largest transactions, were all announced after October 1. The slower overall pace in 2016 has been ascribed to a variety of factors, including stock market volatility, the Federal Reserve’s reluctance to raise interest rates and global political uncertainty surrounding the U.S. presidential election and Brexit. Once deal flow picked up in the second half of 2016, several trends noted in recent editions of the Sidley Global Insurance Review were again observable, including Asian acquirers’ continued appetite for U.S. insurance assets and further consolidation in the property and casualty (“P&C”) market.

2. P&C Market

As in recent years, in 2016, P&C transactional volume outpaced activity in the life and annuity sector. A handful of large deals drove this disparity, the most substantial being Sompo’s proposed US$6 billion-plus acquisition of the Bermuda-based insurer and reinsurer Endurance, which remains subject to regulatory approval. Sompo’s pending acquisition of Endurance represents a continuation of themes we discussed in the prior two editions of the Sidley Global Insurance Review. In the face of negative interest rates and a shrinking domestic market in recent years, Japanese insurers have been looking to the U.S. and other non-domestic markets for growth opportunities and earnings diversification benefits through acquisitions. Sompo’s 2016 announcement came on the heels of

1 2017 Insurance M&A Outlook: Will tailwinds or headwinds prevail?, Deloitte LLP (February 2017).

2 Insurers greet 2016 with lackluster M&A activity, SNL Financial (April 8, 2016) and Insurance M&A activity sluggish amid economic uncertainty, high prices, SNL Financial (October 10, 2016).

Tokio Marine Holdings Inc.’s US$7.5 billion acquisition of Texas-based specialty insurer HCC Insurance Holdings Inc. in 2015, among other recent Japanese outbound acquisitions in both the P&C and life markets. Endurance, which acquired P&C reinsurer Montpelier Re Holdings Ltd. in 2015, expects to gain scale-related advantages to navigate the prolonged soft market and diminished demand for traditional reinsurance that have driven much of the consolidation in the P&C reinsurance market in recent years.

In another instance of “selling for scale” in the P&C market, Toronto-based financial holding company Fairfax Financial announced in December 2016 an agreement to acquire Swiss insurer and reinsurer Allied World, in a transaction expected to close in the second quarter of 2017. Like the sale of Endurance and the 2015 sale of PartnerRe Ltd. to Italian conglomerate EXOR S.p.A, the sale will give Allied World greater global capabilities amidst challenging conditions unlikely to abate in the near term, as well as an owner likely to have a longer-term investment outlook than that of its selling shareholders. Fairfax is partnering with the Ontario Municipal Employees Retirement System, with the Canadian pension plan agreeing to commit US$1 billion in financing in exchange for an approximate 21% indirect ownership stake in Allied World.

Less than one year after Fosun International Ltd. acquired the remaining 80% stake in the specialty writer Ironshore that it did not previously own, Fosun agreed in December 2016 to sell its entire interest in Ironshore to Liberty Mutual. The US$3 billion transaction marks Liberty Mutual’s return to large-scale mergers and acquisitions (“M&A”) and would represent its largest acquisition since its 2008 purchase of Safeco Corp. Ironshore’s strength in excess and surplus underwriting, among its other niche businesses, seems to have been a key deal driver for Liberty Mutual. In light of A.M. Best’s decision to place Ironshore’s rating under review in 2015—a decision that A.M. Best linked to Fosun’s financial leverage—Fosun’s decision to sell Ironshore has been widely reported as being driven by the ratings challenges Ironshore has confronted as a result of exposure to Fosun’s credit profile.

In another of a series of recent strategic actions designed to improve earnings and return capital to shareholders, in August 2016, AIG announced it had entered into an agreement to sell its mortgage guaranty unit, United Guaranty Corp., to Bermuda-based Arch Capital Group Ltd. for US$3.4 billion. The acquisition, which was consummated in December, is the largest in Arch’s history. AIG ultimately decided to sell 100% of the company after contemplating an initial public offering that would have allowed it to retain a majority stake in the company.

The sponsored demutualization structure, common for a time in the 1990s but less so recently, made something of a comeback in 2016. In July, Warren Buffett’s Berkshire Hathaway subsidiary National Indemnity Co. announced an agreement to serve as sponsor-acquirer in the demutualization of Medical Liability Mutual Insurance Co., a New York-based medical malpractice insurer with a year-end 2015 book value of US$1.8 billion. Buffett has been very bullish on the acquisition, dubbing the target’s medical professional liability book a “gem” and remarking that “good things are worth waiting for” in reference to the news that the transaction is not expected to close until the third quarter of 2017. Also in 2016, National General

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Holdings Corp. served as the stand-by investor in the sponsored demutualization of Illinois-based P&C provider Standard Mutual Insurance Company, a transaction that was consummated in October. Earlier in 2016, AmTrust Financial Services, Inc., which, like National General, is controlled by the Karfunkel family, consummated the sponsored demutualization of Pennsylvania-based auto insurer ARI Mutual Insurance Company. While it remains to be seen whether this mini-wave of sponsored demutualizations continues into 2017 and beyond, industry observers have speculated that a number of smaller mutuals may be on the look-out for strategic partners in view of their insufficiently diversified books, concentration in market segments (such as auto coverage) that face long-term challenges from new technologies, capital-raising limitations and other restrictions inherent in the mutual structure.

A number of other middle market acquisitions have recently been announced or completed in the P&C sector, including National General’s acquisition of California-based Century-National Insurance Company for approximately US$315 million, which closed in June 2016, American Financial Group’s US$313.5 million acquisition of the remaining 49% of specialty writer National Interstate Corporation it did not already own, which closed in November 2016, and the US$310 million merger of United Insurance Holdings Corp. and RDX Holding LLC, the parent of American Coastal Insurance Co., which was approved by United Insurance shareholders in February 2017 but, as of this writing, remains subject to regulatory approval. 2016 also marked The Hartford Insurance Group’s first significant acquisition in several years with the July closing of its US$168 million purchase of Maxum Specialty Insurance Group, an acquisition that complements The Hartford’s existing excess and surplus lines portfolio. Additionally, in November 2016, Argo Group Holdings Ltd. announced its US$235 million acquisition of Bermurda-based specialty (re)insurer Ariel Reinsurance Ltd., which was consummated in February 2017. Also in February 2017, Markel Corp. announced an agreement to acquire Houston-based surety company SureTec Financial Corp. for approximately US$250 million, a transaction which remains subject to regulatory approval.

Finally, two large reinsurance transactions with M&A market implications were recently announced. In January 2017, AIG entered into a reinsurance agreement with Berkshire Hathaway’s National Indemnity, pursuant to which National Indemnity has agreed to provide up to US$20 billion worth of coverage on long-term risks with respect to pre-2015 commercial policies in exchange for roughly US$9.8 billion. The treaty requires AIG to pay the first US$25 billion of claims as they come due and applies to US$34 billion in AIG reserves. In addition, The Hartford also recently entered into a large cover with National Indemnity. The US$1.5 billion excess of loss transaction, which is effective December 31, 2016, provided for a reinsurance premium of US$650 million and covers adverse development on certain of The Hartford’s asbestos and environmental liability exposures.

3. Life and Annuity Market

As in 2015, 2016 saw Chinese acquirers making headlines in the life and annuity market. In October, China Oceanwide agreed to purchase all of the outstanding shares of Genworth, committing US$600 million in cash to address Genworth’s debt maturing in 2018 and another US$525 million in cash to support Genworth’s U.S. life

insurance business. China Oceanwide plans to operate Genworth as a stand-alone subsidiary and maintain its headquarters in Richmond, Virginia. The transaction remains subject to regulatory approval and is targeted to close in mid-2017. The profiles of the Chinese companies that have been targeting U.S. insurers are somewhat distinct from those of the Japanese buyers in the market. Chinese buyers have tended to be financial conglomerates, heavily invested in real estate and highly leveraged. Their interest in North American and European assets is often driven by a desire to hedge against Chinese currency valuation risk and Chinese economic volatility.

While the acquisition of Genworth suggests that the appetite of Chinese buyers for U.S. insurance assets remains robust, as we noted in the 2016 Sidley Global Insurance Review, sellers continue to harbor concerns about the execution risk associated with buyers that attract enhanced regulatory scrutiny. These concerns have not been diminished by the May 2016 announcement by China’s Anbang Insurance Group Co. Ltd that it had withdrawn its acquisition of control application filed with the New York State Department of Financial Services in connection with its still-pending US$1.58 billion acquisition of Fidelity & Guaranty Life. As of this writing, the parties had agreed on two separate occasions to extend the merger agreement’s “drop-dead” date. The most recent amendment extends that date to April 17, 2017 (subject to an automatic extension to May 31st if an Iowa public hearing has been noticed by April 17th). Under the terms of the amended merger agreement, subject to certain limitations, F&G may solicit competing offers (including offers for F&G’s New York business) prior to the termination date, but it is not permitted to enter into a definitive acquisition agreement with another buyer unless the agreement with Anbang is terminated. In addition to U.S. regulatory hurdles such as those encountered by Anbang, reports in early 2017 indicate that the China Insurance Regulatory Commission has decided to subject large outbound investments by Chinese insurers to enhanced regulatory scrutiny, posing additional execution risk related to Chinese acquirers.

Other notable life and annuity transactions included PartnerRe’s agreement to acquire Canadian and U.S. life reinsurance provider Aurigen Capital Ltd. for approximately US$286 million, a transaction announced in October and that remains subject to regulatory approval, and Nationwide Mutual Life Insurance Co.’s pending agreement (announced in September) to purchase Kentucky-based Jefferson National Insurance Co., an annuity provider that specializes in fee-based (rather than commission-based) products. Jefferson National’s chief executive has described the sale as an opportunity to achieve scale and obtain access to retirement products that complement the company’s RIA-focused business.

4. Health Market

Transactional activity in the health market in 2016 was muted following the frenzy of 2015. Notably, of the three blockbuster health transactions announced in 2016, only Centene Corporation’s US$6.8 billion acquisition of Health Net, Inc. was successfully consummated. The other two, Anthem, Inc.’s proposed US$54.2 billion acquisition of Cigna Corporation and Aetna Inc.’s proposed US$37 billion acquisition of Humana Inc., were each blocked in federal district court in early 2017 on antitrust grounds following lawsuits by the Department of Justice. While Aetna and Humana have agreed to

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go their separate ways, with Aetna reportedly paying a US$1 billion termination fee to Humana in accordance with the terms of their merger agreement, Anthem and Cigna are currently litigating the termination of their merger agreement and Anthem’s liability for a US$1.85 billion termination fee. One casualty of the termination of the Aetna-Humana merger was the proposed sale by both companies of most of their Medicare Advantage assets to Molina Healthcare Inc. for an estimated US$117 million, which had been announced in August 2016. That proposed sale was abandoned shortly after the issuance of the district court ruling blocking the Aetna-Humana merger.

In the final quarter of an otherwise quiet year for heath-care deals, WellCare Health Plans Inc. announced two noteworthy acquisitions. In October, WellCare entered into an agreement with an affiliate of Blue Shield of California to acquire Arizona-based subsidiaries of Care 1st Health Plan Inc. for approximately US$157.5 million, and the following month, announced an agreement to acquire Medicare Advantage provider Universal American Corp., in a transaction valued at approximately US$800 million. The Care 1st transaction closed in January 2017, and the Universal American transaction remains subject to regulatory approval.

Although there were few sizable “vertical” acquisitions in the health market in 2016 and early 2017, the nation’s largest health insurer in terms of annual revenue, UnitedHealth Group Inc., announced multiple horizontal acquisitions. In 2016, UnitedHealth subsidiaries announced agreements to acquire hospital and health clinic operator USMD Holdings Inc. and California-based clinic operator MSLA Management LLC. More recently, in January 2017, a UnitedHealth subsidiary entered into an agreement to acquire publicly traded Surgical Care Affiliates Inc., an operator of surgery centers and surgical hospitals based in Illinois, further diversifying the holdings of the managed care underwriting giant.

5. Other Notable Activity

Technology-based business models surfaced as a deal driver in 2016, with one particularly high-profile example being Allstate’s November 2016 agreement to acquire warranty insurer SquareTrade for approximately US$1.4 billion, a transaction that closed in January 2017. The acquisition of SquareTrade, a warranty insurance provider for mobile devices and other consumer electronics, complements Allstate’s existing initiatives to better serve its connected, internet-savvy customers. Among other notable carrier acquisitions outside the life, health and P&C sectors, in July 2016, Bermuda-based Assured Guaranty Ltd. closed its US$450 million acquisition of the parent of financial guaranty insurer CIFG Assurance North America, Inc.

6. Additional SIFI Activity

As we predicted in the 2016 Sidley Global Insurance Review, a 2015 trend that persisted in 2016 was the divestiture by large insurers that have been labeled systemically important financial institutions (“SIFIs”) of non-core assets in order to streamline operations and return capital to shareholders. Since mid-2016, American International Group, Inc. has announced multiple such transactions. In addition to its August 2016 agreement to sell United Guaranty to Arch Capital discussed above, in September, AIG announced an

agreement to sell its 20% stake in Ascot Underwriting Holdings Ltd. and related syndicate-funding subsidiary Ascot Corporate Name Ltd. to the Canadian Pension Plan Investment Board for US$1.1 billion.

In February 2016, MetLife, Inc., which had been designated as a SIFI until that designation was rescinded the following month by the U.S. District Court for the District of Columbia,3 consummated the sale of its U.S. retail adviser force to Massachusetts Mutual Life Insurance Company for an undisclosed amount. In October, MetLife, Inc. announced that it had filed for a spin-off of its U.S. life and annuity subsidiary Brighthouse Financial Inc. after abandoning plans to sell the business or pursue an initial public offering. MetLife, Inc. has positioned the Brighthouse divestiture as part of its plan to focus on businesses with more predictable cash flows and reduce its exposure to securities markets.

7. Outlook for 2017

While articles have begun to appear speculating about the impact on the M&A market of the new presidential administration, the unpredictability of the current political landscape limits the value of such prognostications. That said, the rising interest rate environment will likely stimulate the market for certain books of business (particularly life and annuity books) while advantaging bidders with substantial amounts of “dry powder” over those that largely depend on financing. In terms of policy shifts, the Republicans recently released a draft replacement bill for the Patient Protection and Affordable Care Act (the “ACA”) and have also announced plans to repeal and/or amend the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the “Dodd-Frank Act”) (see Section IV below for further discussion regarding the ACA and the Dodd-Frank Act). Each of these potential policy changes will likely have an impact on M&A activity. With respect to the ACA, while the uncertainy surrounding the proposed ACA replacement might suggest a near-term pause in large-scale transactions, the number of motivated would-be acquirers with substantial war-chests that are back in the market following the dissolution of the Aetna-Humana merger and the significant uncertainty surrounding the Anthem-Cigna merger may suggest otherwise. Humana has already publicly announced its willingness to use a portion of the termination fee paid by Aetna to fund acquisitions. Interestingly, industry analysts speculate that Humana itself remains an attractive takeover target.

While the impact of political uncertainty is difficult to predict, some widely discussed political initiatives could have an inhibiting effect on deal activity in the insurance sector. To the extent that President Trump and the Republican-controlled Congress are successful in reducing corporate tax rates, we could well see less willingness on the part of U.S.-based buyers to pay substantial premiums for Bermuda-domiciled targets that have been attractive in part based on the benefits to U.S.-domiciled insurers of ceding reinsurance to an affiliate in a low or no-tax jurisdiction (see Section VI.A.1 below for more detailed discussion of pending tax reform). In a similar vein, reports in early 2017 indicating that President Trump may ask the Department of Labor to rescind its pending rule that would raise

3 The Department of Justice, on behalf the Financial Stability Oversight Council (“FSOC”), has appealed that decision, and as of this writing, the case was under consideration by the U.S. Court of Appeals for the D.C. Circuit.

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investment advice standards for certain retirement products (the “DOL Rule”) could mean we have, at least for the time being, seen the last of the spate of transactions driven by concerns about the impact of the DOL Rule in its Obama-era form (see Section IV.A.5 below for a discussion regarding the DOL Rule). Finally, while the Trump administration’s deregulation mindset could have an impact on the SIFI designation applied to AIG and Prudential Financial, Inc., it seems likely that at least some of the larger U.S. life insurers will continue the project of streamlining and divestment of non-core, capital-intensive assets in 2017 and beyond (see Section IV.A.1 below for additional details on potential SIFI changes).

As we have discussed in prior Sidley Global Insurance Review editions, while large strategic players have been seeking to exit the variable annuity market as a result of financial statement volatility caused by such blocks, financial buyers such as private equity funds and others that are better able to weather short-term volatility have demonstrated an interest in this asset class if the valuations are attractive. Given the continued presence of motivated would-be buyers and sellers, we expect to see additional transactional activity in the variable annuity sector. In addition, the consolidation in the P&C insurance and reinsurance markets that we have covered in the last few editions of the Sidley Global Insurance Review appears poised to continue given the conditions that have spurred such activity (i.e., a prolonged soft market, depressed demand, the advantages of scale-related leverage in negotiations with brokers and other counterparties) remain largely in place. Lastly, given the long-term challenges that technological advances and technology-based business models pose to personal lines providers (such as the impact of driverless cars on auto insurers), diversification plays may continue making headlines in 2017 and beyond.

B. EUROPE

While the result of the UK’s referendum on remaining in the European Union (“EU”) was a surprise to almost everyone, it has been no surprise that the knock-on effect of the UK’s vote to withdraw from the EU has been to slow transactional activity generally across Europe and in the UK, in particular. The period prior to the vote was a period of uncertainty and distraction, with the time following the vote only more so. Strategists within European companies appear largely in a “hold” position, waiting to see how the UK’s exit will impact the financial services sector of which London has been the historic hub. In particular, the ability of UK-based insurers to conduct business elsewhere in Europe in the absence of “passporting” rights has impeded strategies focused on acquisition activities.

The year 2016 did, however, see some volume of M&A activity. Various factors drove this activity, including the desire of management to shed underperforming units or businesses or simply to reconcile what had become cumbersome corporate structures—streamlining them to focus on core insurance businesses. For example, AIG sold various parts of its business and recently announced its intention to sell Ascot Underwriting Holdings Ltd together with its related corporate member, Ascot Corporate Name Ltd. The sale will include AIG’s interest in Syndicate 1414. AIG announced that it will invest the proceeds of the sale to enhance and expand its venture with

Ascot Underwriting Bermuda Ltd. The transaction, effectively taking business out of the UK and re-sourcing it to Bermuda, suggests one way of addressing the uncertainty plaguing the Euro-market.

Another factor which drove divestitures in 2016, in particular, was the regulatory requirement to hold significant amounts of capital and changes in the way that available capital is measured. Large financial institutions across Europe sought to streamline operations in order to find relief from the increasing demands of capital adequacy tests. Deutsche Bank’s sale of Abbey Life Assurance and AXA’s sale of its insurance brokerage, Bluefin, to Marsh further streamlined both entities while making applicable regulatory provisions less burdensome to them, as they recognized both regulatory and economic relief.

A third factor which brought buyers into the market even in the context of overall uncertainty is the devaluation of the Sterling that occurred in the aftermath of the EU referendum. The devaluation effectively made a “bargain” of UK target companies for both American and Asian purchasers—with the result not limited to the financial services sector but seen more broadly, including across the real estate market. Whether that differential will continue to draw purchasers is not clear, although there is some market expectation that the devaluation may be factored into the pricing of target companies, within the financial services sector, on a going-forward basis.

The trend of the last several years that saw a marked international interest, on the part of both strategic and financial purchasers, in Lloyd’s carriers continued in 2016. For example, prior to year-end 2016, Fairfax Financial Holdings agreed to purchase Allied World Assurance Co. for stock and cash. With fewer target companies on the market, even new operations at Lloyd’s garner interest. Further, the attractiveness of Lloyd’s vehicles continues even while Lloyd’s itself is examining how the UK’s exit from the EU will affect the manner in which Lloyd’s operates. In the tension between the uncertainty around the country’s EU exit strategy on the one hand, and the perceived desirability of the Lloyd’s vehicles on the other hand, it is the uniqueness of the Lloyd’s marketplace and its cache that continue to dominate. For this reason, valuations of Lloyd’s vehicles were strong in 2016 and should remain strong in 2017, often the function of sales conducted by an auction process.

The runoff sector, in particular, was active in 2016 with the implementation of the European market’s Solvency II Directive (2009/138/EC) (“Solvency II”), considered the major catalyst for activity in this sector either through share sales, portfolio transfers or reinsurance deals. The increased capital requirements under Solvency II and additional reporting obligations have forced firms to assess whether or not certain lines of business should be retained and the impact this will have on their core activities. The UK market has been at the center of the majority of the transactions in 2016, although there has been increased activity from Continental Europe as well. The transfer of employers’ liability exposure was a noteworthy feature of 2016. Following the reinsurance deal in 2015 in which Swiss Re reinsured Aviva’s UK employers’ liability business, Catalina Holdings UK Limited acquired AGF Insurance Limited from a subsidiary of Allianz SE in early 2016. AGF had written employers’ liability and public liability insurance in the UK and went into runoff in 1999. Later in 2016, Catalina entered into an agreement to acquire Hartford

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Financial Products International Limited and Downlands Liability Management Limited from The Hartford Financial Services Group Inc., which contained a broader range of liabilities. Other examples of activities in the UK legacy market in 2016 included Randall & Quilter’s acquisitions of The Royal London General Insurance Company Limited and four separate portfolios (including Aegon UK’s general insurance business).

Side-car transactions also showed strength in 2016 and are expected to continue to attract the interest of investors in 2017. Brit Insurance Company’s side-car vehicle, Versutus Reinsurance Company, successfully rolled over proceeds from its 2015 transaction to renew its book of business for the 2016 underwriting year. At the same time, Versutus placed securities with new investors. In the first quarter of 2017, Brit successfully placed securities, in the form of preferred shares, of another new side-car vehicle, responding to the desire for investors to come into the sector even while the more traditional avenue of acquisition is stilled, pending clarity of terms on the UK’s withdrawal from the EU.

Looking forward, it is likely that uncertainty concerning the UK’s withdrawal from the EU, which will occur within two years of the UK government invoking Article 50 of the Treaty on the EU will continue through the 2017 calendar year. The dampening effect on M&A activity across Europe from this uncertainty also seems likely to continue, although tempered by the need of individual carriers to improve operational efficiencies in a market remaining highly competitive in terms of price and volume of premium written.

II. The Global Alternative Risk Transfer Market

A. LIFE AND ANNUITY MARKET

The majority of the activity within the risk transfer market of the life insurance sector focused on perceived excess reserve requirements associated with blocks of level premium term insurance subject to Regulation XXX (“Regulation XXX” or “XXX”) or universal life products with secondary guarantees subject to Actuarial Guideline XXXVIII (AXXX) (“Regulation AXXX” or “AXXX”). There were a limited number of embedded value transactions completed as well. Although the debate around captive reinsurance transactions remained an ongoing theme for the life insurance industry, these techniques featured prominently in mergers and acquisitions, including block transfers.

1. The State of the Reserve Financing Market

a. PBR Adoption Update

As discussed in Section IV.B.1.a below on June 10, 2016, the executive and plenary committees of the National Associate of Insurance Commissioners (the “NAIC”) unanimously voted to implement Principles-Based Reserving (“PBR”) after concluding that PBR had met the minimum threshold requirement that at least 42 states, representing 75% of total life insurance premiums written in the U.S., had adopted legislation substantially similar to the NAIC’s Model Standard Valuation Law (the “SVL”). In accordance with the recommendation of the PBR Implementation (EX) Task Force, the NAIC’s Standard Valuation Manual, which sets forth the PBR methodology, was made operative as of January 1, 2017, thereby

allowing life insurers domiciled in any state that has adopted the SVL to begin using PBR for new life insurance business written on or after January 1, 2017. In order to ease the conversion to PBR, the NAIC has provided for a three-year transition period during which life insurers may, but are not required to, implement PBR. After January 1, 2020, PBR will be mandatory.

b. Adoption of Reserve Financing Model Regulation

In December, 2016, the NAIC adopted the Term and Universal Life Insurance Reserve Financing Model Regulation (the “A/XXX Model Regulation”), which will become effective in each state once adopted by such state’s insurance regulator. Prior to the adoption of the A/XXX Model Regulation, the interim regulations set forth in Actuarial Guideline XLVIII—Actuarial Opinion and Memorandum Requirements for the Reinsurance of Policies Required to be Valued under Sections 6 and 7 of the NAIC Valuation of Life Insurance Policies Model Regulation (“AG 48”) applies to life insurers using affiliated captive reinsurers (each, a “Captive”), particularly for Regulation XXX and AXXX transactions. In order to ensure consistency with the A/XXX Model Regulation, the NAIC adopted an updated version of AG 48, effective as of January 1, 2017. Once effective in a particular state, the A/XXX Model Regulation will replace AG 48.

The A/XXX Model Regulation and AG 48 apply to transactions in which a ceding company cedes policies that meet the definition of “Covered Policies” to a Captive. “Covered Policies” include those policies (i) written on or after January 1, 2015, or (ii) reinsured pursuant to a “New Reinsurance Agreement.” A “New Reinsurance Agreement” is defined as an agreement entered into (i) on or after January 1, 2015, or (ii) prior to January 1, 2015 that is amended, renewed or restructured on or after January 1, 2015, with some exceptions.

If a transaction cedes Covered Policies to a Captive that is not otherwise exempt from AG 48 or the A/XXX Model Regulation, as applicable, then reserves up to the level set forth in Standard Valuation Manual VM-20 Requirements for PBR for Life Products (“VM-20”) must be backed by “Primary Security.” The concept of “Primary Security” includes “hard assets” (cash and securities listed by the Securities Valuation Office of the NAIC (“SVO”)), and excludes synthetic letters of credit, contingent notes, credit-linked notes and other securities that operate in a manner similar to a letter of credit. Reserves that are required to be held by statute above the adjusted VM-20 level can be backed by “Other Security,” meaning any asset acceptable to the insurance commissioner of the ceding company’s domiciliary state.

The material changes to AG 48 that are included in the A/XXX Model Regulation consist of the following:

1. a narrowing of the definition of Primary Securities, such that they no longer include SVO-listed securities that are issued by the ceding company or any of its affiliates;

2. a requirement that the reinsurance agreement expressly prohibit withdrawals or substitutions of any Primary Security assets held in trust if, following such withdrawal or substitution, the fair market value of the remaining

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aggregate Primary Security (both inside and outside of the trust) would be less than 102% of the required reserves at the time of such withdrawal or substitution; and

3. a more punative penalty in the event that a ceding company fails to fully collateralize Primary Security, such that if a ceding company has a shortfall in Primary Securities, that ceding company’s credit for reinsurance will be reduced to the amount of Primary Securities actually held. This has the dire consequence of assigning no value to the Other Security. For example, assume a ceding company must hold US$100 of statutory reserves, made up of US$60 of Primary Security and US$40 of Other Security. If that ceding company experiences a shortfall such that it holds US$55 of Primary Security and US$40 of Other Security, instead of incurring a US$5 reduction in credit for reinsurance (statutory reserves, minus Primary Security actually held, minus Other Security actually held), as it would have under AG 48, the ceding company will incur a US$45 reduction in credit for reinsurance (statutory reserves, minus Primary Security actually held) under the A/XXX Model Regulation.

2. Transactions

a. Regulation XXX/Regulation AXXX Transactions

The adoption of AG 48 in the fourth quarter of 2014 and the completion of the first few AG 48 compliant transactions in 2015 provided life insurance companies with some clarity as to how transactions within the reserve financing marketplace can be accomplished. During 2016, a number of Regulation XXX/Regulation AXXX transactions were completed, all of which tended to include a few key characteristics.

From our understanding, the majority of the deals that were completed in 2016 involved risk takers financing only the excess reserves above the VM-20 level with Other Security, while the applicable insurance company self-funded the excess reserves below the VM-20 level with Primary Security. A number of factors have contributed to the insurers’ decisions to self-fund excess reserves below the VM-20 level, including the expense and complexity of obtaining third-party funding in the form of Primary Security in a captive transaction. As of the time of this writing, we are aware of only one transaction completed where the reserves in excess of the economic reserves but less than the VM-20 level have been funded by a third party.

Additionally, the bulk of the transactions that we have seen completed in 2016 financed blocks of term policies, as opposed to universal life policies, largely due to both the difficulty in establishing the VM-20 level for universal life policies as well as the limited amount of excess reserves above the VM-20 level. In addition to the types of policies being financed, we also note that most transactions have a 20-year term and remain non-recourse to the ceding company and/or its affiliates.

We have also found that in the post-AG 48 market, Regulation XXX/Regulation AXXX transactions must address possible shortfalls in

Primary Security. As discussed in Section II.A.1 above, the increased serious consequences of a shortfall in Primary Security under the A/XXX Model Regulation will further amplify the need for these types of transactions to provide solutions in the event of such a shortfall. In all of the transactions we have seen completed in 2016, the ceding insurer has borne the risk of a shortfall and the resulting loss of credit for reinsurance.

b. Embedded Value/Closed-Block Transactions

There has been little activity in the embedded value/closed-block market since the financial crisis, other than an embedded value transaction from an indirect subsidiary of RGA as well as the embedded value transactions from the Aurigen Capital Limited (“Aurigen”) group. This trend continued in 2016 with only one transaction we are aware of occurring in 2016: a note exchange offering by Valins I Limited, an indirect subsidiary of Aurigen, in connection with its 2015 offering. Pursuant to the exchange, Valins I Limited offered C$300 million in embedded value linked notes, covering a closed block of Canadian life insurance policies reinsured by Aurigen Reinsurance Ltd., to both new investors as well as to the noteholders of its 2015 embedded value notes, in exchange for the redemption of such notes. Like the 2015 Aurigen transaction, this new structure also allows for the increase in size and extension of the maturity of the notes. These features allow Aurigen the flexibility to add future new business to the facility and continuous access to capital funding to support its growth.

3. Litigation

In recent years, the use of reinsurance captives in the context of Regulation XXX/Regulation AXXX transactions has received attention from more than just the NAIC and state insurance regulators. Complaints have been filed against various life and annuity companies and reinsurers that cite violations of the Racketeer Influenced and Corrupt Organization Act in the context of captive reinsurance transactions. Additionally, a handful of class action lawsuits have been brought under New York law alleging claims of misrepresentation of the financial condition of a life insurer or the legal reserve system under which it operates in the context of captive reinsurance transactions. Cases against AXA Equitable Life Insurance Company (“AXA”) and Metropolitan Life Insurance Company (“MetLife”) were dismissed by the Southern District Court of New York for lack of standing and, in both cases, appeals were filed with the U.S. Court of Appeals for the Second Circuit (the “Second Circuit Court”). In the AXA case, the Second Circuit Court affirmed the judgment of the district court. At the time of this writing, the MetLife case remains before the Second Circuit Court.

A new lawsuit has surfaced alleging similar lack of transparency claims and seeking disclosure of information and documentation pertaining to captive reinsurance practices. The lawsuit was filed in Iowa on September 2, 2016 against Nick Gerhart, the former Iowa Insurance Commissioner, and the Iowa Insurance Division by Joseph Belth, an emeritus professor of insurance at the Indiana University Kelley School of Business and the author of a consumer’s handbook for life insurance. The complaint seeks access to financial records of Iowa insurance companies and their captive subsidiaries that are currently characterized as confidential and withheld under Iowa

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public records laws at the Iowa Insurance Commissioner’s discretion. The Iowa Insurance Commissioner had previously denied Belth’s request to disclose the financial documents to the public, explaining that the requested documents are part of insurers’ plan of operations and citing Iowa statutory and administrative provisions requiring the treatment of such plans of operations and related records to be confidential. Belth’s complaint asserts that the Iowa laws, as interpreted by the Iowa Insurance Commissioner, provide “insufficient transparency” of the financial strength of life insurers, “thereby adversely affecting the interest of shareholders, policyholders, and taxpayers.” If Belth’s suit is successful, information that insurers have expected would remain confidential (including, for example, with respect to reinsurance transaction structures and details of the terms and conditions of various financial instruments) could become publicly available.

B. P&C MARKET

The extensive use of alternative risk transfer (“ART”) products in the P&C market proved once again that the ART market is a viable alternative to traditional capital models. Alternative reinsurance capital, in the form of catastrophe bonds, reinsurance sidecar and other insurance-linked securities (“ILS”), industry loss warranties (“ILWs”) and collateralized reinsurance, reached approximately US$75 billion4 in 2016 and continued to contribute to the decline in rates in the property catastrophe reinsurance market in 2016. The following provides an overview of the global P&C ART market’s highlights and trends of 2016 and outlook for 2017. In addition to the highlights and trends described below, Section II.C of this Sidley Global Insurance Review, the “UK’s Insurance-Linked Securities Initiative,” describes recent legislative efforts in the United Kingdom (“UK”) to establish a corporate, tax and regulatory framework that is designed to facilitate the UK becoming a hub of ILS activity.

1. Catastrophe Bonds

For the second straight year, issuances of “public” 144A catastrophe bonds decreased, falling from about US$6.5 billion in 2015 to slightly under US$6 billion in 2016. However, the total “public” 144A catastrophe bond risk capital outstanding remained at near-record levels at slightly above US$24 billion. Unlike previous years, this market was atypically slow during the second quarter of 2016, which is usually the most active quarter for new catastrophe bond issuances, but saw one of the most active third and fourth quarters on record, with more than US$3 billion in new “public” 144A catastrophe bond issuances during that period. In addition to the “public” catastrophe bond transactions, over US$600 million of limit was transferred to the capital markets via “private” catastrophe bond transactions.5

2016 also brought new and less traditional types of risk to the catastrophe bond market. In May, the Credit Suisse-sponsored Operational Re bond was issued, covering Credit Suisse for losses

4 See Aon Benfield Reinsurance Market Outlook (January 2017); Willis Capital Markets & Advisory ILS Market Update (January 2017).

5 See Swiss Re Insurance-Linked Securities Market Update (February 2017); Aon Benfield Insurance-Linked Securities Year-End 2016 Update; Trading Risk “2016: a year of experimentation for the cat bond market” (December 2016); Artemis Catastrophe Bond & Insurance-Linked Securities Deal Directory at http://www.artemis.bm/deal_directory.

from bank operational risks, include events such as cyber breaches, regulatory compliance issues and rogue trader losses. Also, the first motor third-party liability bond since 2005 came to market in the form of Generali-sponsored bond Horse Capital I DAC. This bond provides protection against a deterioration in the loss ratio of Generali’s motor third-party liability business across seven countries in Europe.

The range of risks within the more traditional weather related natural-catastrophe bond market expanded as well. For example, USAA obtained a combined US$700 million of coverage via three separate bond offerings by Residential Reinsurance 2016 and Espada Reinsurance, covering a broad range of risks, including U.S. tropical cyclone, earthquake, severe thunderstorm, winter storm, wildfire, volcanic eruption, meteorite impact and “other perils.” These bonds were notable for extending the reinsurance coverage to “other perils,” thereby coming even closer into line with the “all natural perils” standard in the traditional reinsurance market.

Additionally, through the Caelus Re IV Ltd. (Series 2016-1) bond, Nationwide obtained reinsurance protection from perils including U.S.-named storm, earthquake, severe thunderstorm, winter storm, wildfire, meteorite impact and volcanic eruption across the U.S. This offering is notable for covering an unusually wide range of property damage type risks, including auto physical damage, inland marine vehicles and commercial agricultural, among others.

Although bonds covering U.S. wind and earthquake perils continued to represent a substantial portion of the market, other diversifying perils were also well represented among the 2016 transactions, including Europe windstorm, Japan typhoon and earthquake, Australia cyclone and earthquake and Canada earthquake.

2. Traditional Reinsurers in the ILS Market

New third-party capital continued to flow into the reinsurance market in 2016, although growth slowed relative to prior years. Alternative reinsurance capacity reached approximately US$75 billion in 2016 (up from approximately US$68 billion in 2015). As of December 31, 2016, alternative reinsurance capacity represented approximately 18% of the estimated US$420 billion total capital dedicated to global property catastrophe reinsurance. Some market sources predict that alternative reinsurance capacity could reach up to US$160 billion by 2020.6

Despite the decrease in the dollar volume of new catastrophe bonds, other forms of alternative capital (including collateralized reinsurance and sidecars) experienced growth in 2016. The collateralized reinsurance market experienced the most significant growth year-over-year and now represents over 50% of the overall capacity provided by the alternative markets.7 A number of existing sidecar vehicles returned to the market in 2016 with expanded issuances relative to 2015, including Versutus (sponsored by Brit), K-Cession (sponsored by Hannover Re), Silverton Re (sponsored by Aspen Re) and Eden Re II (sponsored by Munich Re). RenaissanceRe’s new vehicle, Fibonacci Re, came to the market for the first time in 2016

6 See Aon Benfield Reinsurance Market Outlook (January 2017); Willis Capital Markets & Advisory ILS Market Update (January 2017); Clear Path Analysis, “Insurance Linked Securities for Institutional Investors” (May 2016); additional sources: Guy Carpenter and A.M. Best.

7 See Aon Benfield Reinsurance Market Outlook (January 2017).

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with a US$140 million sidecar transaction. In addition, 2016 saw primary insurer Liberty Mutual turning to the sidecar market with its US$160 million Limestone Re sidecar transaction.

Compliance with the Alternative Investment Fund Managers Directive (“AIFMD”) in EU countries continues to factor prominently in sidecar and ILS fund transactions. In marketing sidecar transactions and ILS fund securities, market participants should be sure to consider potential AIFMD implications.

The reinsurance pricing environment in 2016 continued to encounter downward pressure, though the rate of decline moderated in comparison to prior years. Pricing in the alternative reinsurance market declined; however, ILS investors continued to show discipline by requiring adequate compensation for risk. M&A activity in the property catastrophe reinsurance market was quiet for the first three quarters of 2016 but surged in the fourth quarter. As discussed in Section I.A above, notable transactions announced in the fourth quarter of 2016 include the proposed acquisition of Endurance Specialty Holdings by Sompo Holdings, Argo Group’s proposed acquisition of Ariel Re (which was completed in February 2017), Liberty Mutual’s proposed acquisition of Ironshore and Fairfax’s proposed acquisition of Allied World. Some market sources predict that vibrant M&A activity could continue in 2017.8

While third-party capital has created challenges for traditional reinsurers, it has also created opportunities. Many traditional reinsurers have continued to incorporate third-party capital into their own business models by acquiring, developing or growing their own alternative capital programs, sponsoring catastrophe bonds and/or sidecar facilities, retroceding business to third-party capital providers and acting as transformers for “public” 144A and “private” catastrophe bonds. We expect to see this trend continue, as traditional reinsurers continue to explore new ways to use third-party capital to their benefit.

3. Investment Manager Activity

Challenging market conditions in 2016 impacted many of the investment manager-related reinsurers established in recent years, as well as potential new investment manager-related reinsurance ventures. In January 2016, PaCRe Ltd., the Bermuda reinsurer launched in 2012 as a venture between hedge fund manager Paulson & Co. and Bermuda reinsurer Validus Holdings, began winding down its operations. Global (re)insurer XL Catlin and investment manager Oaktree Capital Management began raising capital in early 2016 to establish Alloy Re, a Bermuda total return reinsurer; however, this venture reportedly was abandoned after the capital raise fell short of its US$600 million target.

Despite market challenges, new investment manager-related reinsurers were established in 2016. In July 2016, Harrington Re, a Bermuda reinsurer created by global (re)insurer AXIS Capital and investment manager Blackstone, completed an initial capital raise of US$600 million, including a US$100 million investment

8 See Aon Benfield Reinsurance Market Outlook (January 2017); Guy Carpenter, “Guy Carpenter Reports Moderating Reinsurance Pricing Decline at January 1, 2017 Renewals” (January 2017); Artemis, “Munich Re Notes ILS Investor Discipline in 2016, as Market Grew Again” (January 2017).

from a subsidiary of AXIS Capital and a US$50 million investment from Blackstone. A subsidiary of AXIS Capital underwrites business on behalf of Harrington Re, and Blackstone manages Harrington Re’s investments. Harrington Re received an “A-” financial strength rating from A.M. Best. According to A.M. Best, Harrington Re plans to write “a diversified, multi-line reinsurance book of business with strict limitations on property catastrophe risk.” In December 2016, runoff specialist Enstar Group launched KaylaRe, a Bermuda-based reinsurer focused on specialty reinsurance risk, backed by a US$300 million investment from Enstar, US$270 million from funds managed by investment manager Hillhouse Capital Management and US$50 million from funds managed by Stone Point Capital, a private equity firm and Enstar shareholder. KaylaRe has a quota share reinsurance arrangement with StarStone, an Enstar subsidiary, and has also assumed legacy business from Enstar. KaylaRe is expected to write third-party business in the future and may also assume additional legacy business from Enstar. Enstar manages reinsurance for KaylaRe, while Hillhouse acts as KaylaRe’s investment manager. Enstar Group had previously commenced fundraising in early 2016 for Aligned Re, a similar reinsurance start-up to be created by Enstar and investment bank UBS O’Connor; however, such venture was ultimately abandoned.

In addition to Enstar’s KaylaRe venture, newly formed Bermuda runoff (re)insurer Premia Re provides another example of third-party capital being used to support the property and casualty runoff market. Premia Re completed a US$510 million initial capital raise in January 2017, with backing from private equity firm Kelso & Company and an affiliate of global reinsurer Arch Capital. Other institutional investors, as well as the Premia Re management team and senior members of Arch, also participated in the capital raise. Premia Re will focus on insuring, reinsuring and acquiring runoff portfolios. Arch will act as a reinsurance partner for Premia Re, allowing Premia Re to participate in large global runoff transactions. Increasing runoff activity in the property and casualty (re)insurance market could create more opportunities for the ILS market in the future.

In addition to the formation of new (re)insurers, 2016 also saw investment managers and other financial institutions acquiring interests in existing ILS fund investment managers. In February 2016, global asset manager Schroders increased its ownership stake in Zurich-based ILS fund investment manager Secquaero Advisors to 50.1%. Schroders initially acquired a 30% ownership stake in Secquaero in 2013. In October 2016, Japanese trading company Mitsui & Co. agreed to acquired a 15% ownership stake in New Ocean Capital, the Bermuda-based ILS fund investment manager founded by XL Group Ltd. and Stone Point Capital. In addition, Mitsui committed to invest US$100 million in New Ocean’s private fund platform on a multi-year basis. Mitsui had invested with New Ocean since 2014. In November 2016, hedge fund manager Elliott Management Corporation agreed to acquire a controlling interest in Bermuda-based ILS fund investment manager Aeolus Capital Management, by purchasing shares from founder Peter Appel and key shareholder Allied World Assurance Company, with both sellers retaining minority interests in Aeolus. Elliott had invested with Aelous since 2012.

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4. Reinsurance Purchased for National Flood Insurance Program

The National Flood Insurance Program (“NFIP”) was established in 1968 to provide flood insurance protection to U.S. property owners in areas at high risk for flooding. In many areas, the premiums charged by the NFIP are much lower than the actuarially sound rates that a private insurer would charge. Without sufficient premium revenue and accumulated surplus to pay claims, the NFIP has needed to borrow funds from the U.S. Treasury. Large events such as Hurricane Katrina and Superstorm Sandy have left the NFIP approximately US$23 billion in debt to the U.S. Treasury. Legislation enacted in 2012 and 2014 expressly permits the Federal Emergency Management Agency (“FEMA”), the agency responsible for administering the NFIP, to purchase reinsurance protection to help fund NFIP claims payments. In September 2016, for the first time since inception of the NFIP, FEMA purchased reinsurance protection for the NFIP covering US$1 million of losses from Transatlantic Reinsurance Company, Swiss Re and Munich Re. FEMA returned to the reinsurance market on January 1, 2017 and purchased US$1.042 billion of single-year reinsurance protection from a panel of 25 reinsurers, covering 26% of losses from a single flood event on an US$8 billion excess of US$4 billion layer. FEMA is expected to continue to grow the NFIP’s reinsurance program in the future and potentially purchase multi-year coverage, creating potential opportunities for traditional reinsurers and the ILS market. In addition, the potential for private insurers to increase their participation in the flood insurance market could create additional opportunities for traditional (re)insurers and the ILS market.

5. Outlook Ahead

Catastrophe bond broker-dealers seem to be generally optimistic about 2017 despite the continued contraction in 2016. However, the trend of large maturities will continue. Nearly US$8 billion of catastrophe bonds are scheduled to be redeemed in 2017 (compared to US$5.2 billion in 2016). Several fairly large transactions again will be required for the catastrophe bond market to meet its potential US$6 billion to US$8 billion target in 2017.9 Notwithstanding the expansion of perils noted above, we expect perils such as Florida hurricane and California earthquake to continue to dominate the catastrophe bond market in 2017.

The broader ILS market should continue to see a trend of expanding lines of business and perils in 2017 and, in particular, emerging insurance needs for flood and cyber risks are potential growth opportunities for insurers and reinsurers who have the expertise to underwrite these risks. Another potential area of growth for the ILS market may come from non-insurance corporate buyers of protection.

There is also potential for ILS market participants to become more involved in the primary insurance market, whether in the form of ILS fund investment managers providing corporate financing to primary insurers (as was the case in December 2016 when Twelve Capital provided US$30 million of financing for UPC Insurance in a private debt offering, and Fermat Capital and Hudson Structured Capital participated in a US$79.5 million private debt offering by

9 See Aon Benfield Reinsurance Market Outlook (January 2017); Willis Capital Markets & Advisory ILS Market Update (January 2017).

Heritage Insurance), the formation of managing general agents to source insurance risk (as Nephila Capital has done with Velocity Risk Underwriters) or through other strategic partnerships.

Innovations in “insurtech” (i.e., the use of technology, big data and predictive analytics to create efficiencies in insurance operations) are likely to impact the way that companies underwrite and cede risk and the way that reinsurers and ILS market participants evaluate, assume and manage risk and could potentially disrupt the (re)insurance and ILS markets.

As in 2016, we expect that ART mechanisms in the P&C market will become more prevalent in the year ahead, and the insurance asset class, as a whole, will continue to attract new participants and new capital.

C. UK’S INSURANCE-LINKED SECURITIES INITIATIVE

1. Insurance-Linked Securities

In the 2015 Budget, the Chancellor of the Exchequer announced that the UK would be looking to establish a corporate, tax and regulatory framework that would allow the UK access to the growing ILS market. As a key player in the global commercial and speciality insurance and reinsurance sectors, the UK government believes that London could make a significant contribution to the ILS market and become a leader in alternative risk transfer, if a competitive and robust regulatory and tax framework could be established.

The UK government has since published two consultations on the matter, which have focused on proposals for the corporate structure, taxation, authorization and supervision of ILS vehicles in the UK. The latest consultation, which includes two draft regulations under which the ILS regime is intended to operate, closed on January 18, 2017. In addition, the Prudential Regulation Authority (“PRA”) and the Financial Conduct Authority (“FCA”) have separately issued a joint consultation paper setting out their proposed approach and expectations in relation to the authorisation and supervision of ILS vehicles.

Both consultations are proposing fundamental changes to the UK’s corporate, tax and regulatory regimes, as outlined below.

a. Proposed Corporate Structure

The government is proposing to establish a new Insurance Special Purpose Vehicle (“ISPV”), which can take on multiple contracts for risk transfer (otherwise known as a multi-arrangement ISVP). Following suggestions in its initial consultation that the UK’s ILS framework should be built around the protected cell company (“PCC”) structure, the proposed draft regulations aim to amend company and insolvency laws to allow for the establishment of PCCs as a form of ISPV in the UK.

Under the proposed draft regulations, a PCC will be a private company limited by shares and not a public limited company, as it is considered inappropriate for ISPVs to make public offerings for investment. PCCs will comprise of a core entity and any number of cells that are needed to conduct the ILS deals it takes on. The cells do not have any legal personality. It is the core entity which performs the administrative functions of the PCC and enters into and manages transactions on behalf of the cells.

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The purpose of the PCC structure is to allow for efficient management of multiple ILS deals under one vehicle, while keeping the assets and liabilities associated with one cell completely segregated from the other cells in the PCC. Under the PCC structure, there is no longer any need for the incorporation of multiple vehicles, and cells can be added to and dissolved from the structure with a simple board resolution. The PCC will be able to issue debt and equity securities on behalf of the cells and, as is standard practice with these structures, investors will have no voting rights or means of influencing the management of the PCC.

As the PCC structure is familiar to ILS cedants, investors and arrangers, allowing for the incorporation of this type of vehicle in the UK is seen as an essential component of the proposed new regime.

b. Tax Proposals

In order for the UK to be a viable alternative to existing jurisdictions which cater ILS vehicles (most notably Bermuda), it has been considered necessary for the new ISPV to benefit from a bespoke UK tax regime. To ensure that the ISPV is internationally competitive from a tax perspective, the draft regulations currently envisage that: (i) the insurance risk transformation functions of the ISPV would be exempt from UK corporation tax; and (ii) an exemption from UK withholding tax on payments (both debt and equity) from the ISPV to non-UK resident investors. The net effect of these proposals is to ensure that the ISPV remains tax neutral.

The application of the bespoke UK tax regime will, however, be subject to certain conditions. For example, it is proposed that the regime would not be available where an investor connected with the entity from which the risk is assumed holds more than 20% of the ISPV investments.

c. Regulatory Proposals

If an applicant wishes to operate as a PCC in the UK, it will need to apply to the PRA for permission to carry out the proposed new regulated activity of insurance risk transformation. The PRA and FCA consultation paper gives a detailed description of the application process for ISVPs, which includes pre-application discussions, drafting and submitting the application forms and showing that the ISVP is fully funded.

The PRA and FCA anticipate that an approval decision will be reached for straight forward PCC applications within six to eight weeks of the application being submitted, provided that such applications are supported by good documentation and the applicants have actively engaged in the pre-application discussions. However, it is expected that PCC applications will vary in complexity and the PRA and FCA have indicated that they will allow up to six months for consideration of an initial PCC application in more complex cases.

The authorisation process for establishing new cells is fairly simple as applicants will only need to provide a further notification to the PRA of their desire to establish a new cell. New cells should not be established until an applicant has either received confirmation from the PRA that it does not object to the establishment of the cell, or

10 working days since the submission date has elapsed and the applicant has not received notification that the PRA or FCA objects to the application.

While the targeted authorization timeline of six to eights weeks for PCCs is accelerated in comparison to the authorisation timelines for general insurance undertakings in the UK, it is still slower than other jurisdictions that offer similar special purpose vehicle structures (such as Bermuda where new special purpose entities can be set up in one to two weeks). It is likely that feedback in response to the consultations will recommend that a quicker authorisation process than currently proposed should be adopted, to be in line with other jurisdictions. However, it remains to be seen whether such recommendations will be reflected in the final rules.

D. TRADITIONAL CAPITAL MARKETS

In 2016, the pace of capital markets transactions has remained fairly constant for initial public offerings (“IPOs”) and traditional debt offerings while beginning to increase in the case of funding agreement-backed note issuances.

Due in part to the unpredictability in the stock market that begain during the latter half of 2015, very few IPOs closed in the U.S. market. Most notable was the IPO of Athene Holding Ltd. (“Athene”), a Bermuda-based retirement services company that offers fixed and fixed index annuity products, reinsurance services for third-party annuity providers, and other institutional products. By raising approximately US$1.08 billion via the sale of 27 million shares for US$40 per share, the transaction marked the third largest IPO in the U.S. during 2016.

Insurance companies continue to raise funds via traditional debt offerings, typically in the form of senior note offerings. In December 2016, Arch Capital Group sold a total of US$950 million senior notes, issued in two tranches. The first tranche included 10-year notes at a rate of 4.011% and the second tranche included 30-year notes at a rate of 5.031%. The proceeds were used to fund a portion of the costs associated with its acquisition of United Guaranty Corporation. Similarly, Allstate sold a total of US$1.25 billion senior notes, with rates ranging from 3.28% for the 10-year notes to 4.2% for the 30-year notes; Voya sold a total of US$800 million senior notes, with rates ranging from 3.65% for the 10-year notes to 4.8% for the 30-year notes; and Aflac sold a total of US$700 million senior notes, with a rate of 2.875% for the 10-year notes and a rate of 4% for the 30-year notes.

Other traditional debt offerings in 2016 include AIG’s offering of US$1.5 billion 3.3% senior notes due 2021, Aon’s offering of US$750 million 3.875% senior notes due in 2025, Old Republic’s issuance of US$550 milliion 3.875% senior notes due in 2026, Progressive’s issuance of US$500 million 2.45% senior notes due in 2027, RGA’s offering of US$400 million 3.95% senior notes due in 2026, Hannover’s issuance of US$375 million 4.5% senior notes due in 2026, Radian Group’s offering of US$350 million 7% senior notes due in 2021 and American Financial Group’s offering of US$300 million 3.5% senior notes due in 2026. In addition to these more customary debt offerings, RGA completed a subordinated note offering of US$400 million 2.75% subordinated debentures due 2056.

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Funding agreement-backed note programs continue to be used by life insurance companies, allowing them to fund a portion of their institutional spread business through private placement securitization vehicles, such as global medium-term note (“GMTN”) programs. GMTN programs provide a life insurance company with flexibility in that it can issue GMTNs both to investors outside the U.S. pursuant to Regulation S and to “qualified institutional buyers” within the U.S. pursuant to Rule 144A. 2016 saw the usual participants in the funding agreement-backed notes market (which include MetLife, New York Life, Massachusetts Mutual and Principal Life) as well as the life insurance companies that entered (or re-entered) the market in the past few years (which include AIG, Reliance Standard Life Insurance Company, Protective Life and Athene). One notable new participant is Guardian Life Insurance Company of America, which returned to the market with the establishment of a funding agreement-backed GMTN of Guardian Life Global Funding, a newly organized Delaware statutory trust established to issue notes collateralized by funding agreements issued to it by Guardian Life Insurance Company of America.

III. The Global Longevity Market

The two principal sources of longevity risk are defined benefit pension schemes and books of annuity business written by life insurers. There has been a significant increase in the level of transaction activity in relation to the latter, with many European-based life insurance groups looking to hedge longevity exposure in light of the additional regulatory capital required under Solvency II in respect of annuity business. This, coupled with the continuing demand from defined benefit pension schemes, has led to the development of an active secondary market for longevity risk in which reinsurers have been the principal participants.

With increases in life expectancy in recent decades, pension schemes have increasingly been looking for methods to hedge against the risk that their members live longer than is currently predicted. The UK is the most mature market for the “de-risking” of pension schemes. This has been driven by the large number of defined benefit pension schemes in the UK and improvements in life expectancy and poor investment returns that have left many schemes in deficit. This in turn has adversely affected the balance sheets of corporate sponsors who are liable to make good such deficits. The vast majority of transactions executed to date have taken the form of traditional bulk annuity deals either in the form of pension buy-outs or involving the issue of a buy-in policy. However, longevity swaps have also now become a well-established alternative option for hedging longevity exposure.

A. TRANSACTION STRUCTURES

To put into context our review of recent developments and transactions in the longevity market, we first briefly recap below the principal longevity risk transfer methods.

1. Buy-Outs

A pension buy-out involves an insurer taking over the liability to pay all or some of the member benefits from the trustees of the relevant pension scheme. This is achieved by the insurer issuing individual annuity policies to the relevant scheme members in return for a payment of premium by the trustees, usually by way of a transfer of assets from the pension scheme to the insurer. In the case of a buy-

out, there is a direct insurance contract between the insurer and the individual scheme member; and in the event of a full buy-out, where individual policies are issued to all of the members of the pension scheme, the trustees can proceed to wind-up the scheme, with all future administration performed by the insurer. The buy-out option is, accordingly, the ultimate form of pension scheme de-risking.

2. Buy-Ins

Pension buy-in solutions were developed as a de-risking option for pension schemes that were unable to afford the often prohibitive costs of a full buy-out. Under a pension buy-in, there is no direct contractual link between the insurer and the individual scheme members. Instead, the pension scheme trustees hold the buy-in policy in their name as an investment of the scheme, and the scheme continues to deal with the payment and administration of benefits. The trustees pay a premium (usually by transferring an equivalent amount of pension scheme cash, bonds and other assets under management) and, in return, receive an income stream from the insurer to cover some or all of the scheme’s liability to pay member benefits. In the case of some of the larger buy-in transactions, trustees will also require the insurer to post collateral or otherwise secure its obligations to make payments under the policy.

3. Longevity Swaps

In their purest form, longevity swaps are derivatives and not contracts of insurance. However, it is possible to achieve the same economic effect on an insurance basis; and there have been examples of insurers issuing policies to pension schemes structured in the same way as a longevity swap. Although it is clearly important to ensure that the contract is properly structured as a derivative or insurance policy according to whether the protection provider is a bank or insurer; in either case, the core economics are very similar. In return for the pension scheme paying a fixed monthly amount to the insurer or bank, the counterparty makes a payment to the pension scheme on a monthly basis (the floating amount) referable to the benefit payable to a defined group of pensioners.

In cases where the front end arrangement involves a longevity swap with a bank as a counterparty, the longevity risk is in derivative form and not capable of being directly reinsured. In situations such as this, transformer vehicles (typically based offshore) are used to convert the derivative exposure into insurance risk that can then be reinsured.

Whereas buy-ins and buy-outs involve a transfer of inflation, interest rate, investment and longevity risk, longevity swaps offer a purer hedge against the risk of scheme members living longer than is actuarially predicted; and the fact that there is no upfront payment of a lump sum premium means that the investment, interest rate and inflation risk remain with the trustees. Accordingly, longevity swaps are typically a less expensive alternative to buy-ins and buy-outs, albeit more complex to structure and negotiate. Longevity swaps almost invariably require the two-way posting of collateral to protect against the possibility of early termination by reason of the other party’s default or insolvency. The collateral is typically based upon the present value of the covered benefits and will also include a fee element payable to the insurer/bank in the event of termination arising by virtue of trustee default.

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4. Index-Based Trades

A further alternative structure involves the purchase of longevity protection by reference to an index. Given the inherent basis risk that exists within these types of transactions, there have been relatively few index-based trades to date and these types of transactions are perhaps more likely to remain of greater interest to insurers and ILS investors than to pension schemes.

B. U.S. AND CANADIAN MARKET

Beginning with the GM and Verizon deals in 2012, the pension de-risking market in the U.S. experienced significant growth. In prior years, the market consisted primarily of one direct writer (The Prudential Insurance Company of America (“Pru”)) providing the majority of the capacity, particularly in connection with larger transactions. However, over the past couple of years, other group annuity writers have become more active in the market, in particular Massachusetts Mutual Life Insurance Company (“MassMutual”) and MetLife. We also understand that there are a variety of other participants seeking to break into this space.

In addition to the GM and Verizon deals, other very large pension de-risking transactions have been consummated, including the PPG Industries and The WestRock Company transactions (described below), each of which closed in the third quarter of 2016. Unlike the variety of transactions executed in the UK, transactions in the U.S. have generally used only the buy-out approach outlined above. According to the LIMRA Secure Retirement Institute, the pension buy-out sales in the U.S. in the first three quarters of 2016 totaled over US$8 billion, a slight increase as compared with the same period in 2015.

As mentioned above, two larger deals closed in the third quarter of 2016. PPG Industries, a paint and coatings manufacturer, entered into a longevity insurance agreement to transfer US$1.6 billion of pension benefits and annuity administration to MassMutual and MetLife. Pursuant to the agreement, PPG Industries’s pension plans will purchase group annuity contracts from MassMutual and MetLife for approximately 13,400 of its current U.S. retirees or their beneficiaries. MassMutual and MetLife will be responsible for the payment administration and obligations to make future annuity payments.

Similary, The WestRock Company, a paper and packaging solutions provider, entered into an agreement with Pru to purchase a US$2.5 billion group annuity contract for its retirees, thereby transferring pension obligations associated with approximately 35,000 retirees and their beneficiaries in the U.S. to Pru. Pru and MassMutual each provided half of the monthly benefits to the group of retirees. Like many of Pru’s previous transactions, Pru administers the group annuity payments.

In addition to the pension de-risking market, we have also seen increased activity in longevity reinsurance. In certain circumstances, the reinsurance relates to underlying pension plan risk, but in others, it relates to annuity business that is not sourced from an underlying pension plan. Further, certain of these transactions are cross-border transactions pursuant to which U.S.-domiciled reinsurers are providing longevity reinsurance to foreign ceding companies, particularly in the UK.

As in prior years, we expect these markets to continue to develop as the number of market participants grows and pension plan sponsors become more aware of the benefits of these transactions.

C. UK/EUROPEAN MARKET

Compared to the levels of activity seen in prior years, there was a marked drop in the number and size of de-risking transactions involving UK pension schemes in 2016. This was the case both for the traditional bulk annuity market (pension buy-ins and buy-outs) and longevity only hedging transactions. Market commentators have attributed this slowdown in activity to two principal factors. First, as Aon Hewitt has recently commented, since 2011 mortality rate data suggests that there has been a change in the underlying longevity experience trend with improvements since then being lower than previously anticipated. This in turn has caused a dislocation in the pricing for longevity transactions, and a number of employee benefit consultants have been advising pension scheme clients to delay de-risking transactions until improved pricing is reflected in terms offered by de-risking counterparties.

The second factor which is said to have contributed to the slowdown in UK pension scheme transaction activity in 2016 is that a number of UK life insurers who have been among the more active participants in the de-risking market have been more focused on hedging their own longevity exposure to mitigate some of the impact of Solvency II. This is also having an impact on the structure of transactions involving UK pension schemes, with an increasing number of these involving insurers providing de-risking solutions to pension schemes while simultaneously reinsuring a significant proportion of the risk from the outset of the transaction. By way of example, Zurich Insurance Group completed a number of transactions during 2016 on this basis, including the £600 million longevity swaps in relation to the Pirelli pension schemes which were reinsured to Pacific Life Re. It is likely that we will see more transactions structured on this basis through 2017. Equally, and notwithstanding Prudential plc’s decision to withdraw from the UK annuity and de-risking market, there remains a healthy capacity for de-risking transactions and it is anticipated that there will be a significant increase in the levels of activity in the coming year.

A trend that emerged in 2015 in anticipation of Solvency II coming into effect, and which has accelerated through 2016, is the increase in the number of UK and continental European life companies buying longevity protection in the form of reinsurance. While some such transactions have been structured as longevity swaps (including for example AXA France’s transaction with RGA covering £1.3 billion of liabilities), there was perhaps more activity through 2016 in the market for reinsuring longevity and asset risk by means of single premium reinsurance policies on a collateralized basis, often to reinsurers based outside the EU. This trend is set to continue, with there still being healthy levels of capacity within the life reinsurance market for longevity risk. This demand has been driven by a number of factors, but perhaps the most significant for life reinsurers with catastrophe books is that longevity risk acts as a natural hedge against mortality exposure and can create diversification benefits for regulatory capital purposes.

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Against this market backdrop, the UK’s prudential regulator, the Prudential PRA, has indicated that it is carefully monitoring the trend of UK insurers to reinsure longevity risk exposure. Following its earlier communications to the UK life insurance industry in February 2016, the PRA issued a Supervisory Statement in November 2016 entitled “Solvency II: Longevity risk transfers.” The PRA observed that where a firm reinsures to a single or only to a few counterparties, that firm can be exposed to significant concentration of counterparty default risk. The PRA emphasized that it expects firms to manage and mitigate reinsurance counterparty default risk under Solvency II, requiring firms to have a risk management system covering concentration risk management. The PRA added that it may not be sufficient to refer to the solvency capital requirement (“SCR”) components covering counterparty default risk and risk concentration; and that additional measures besides capital may be required.

The PRA also observed that it would be concerned if firms became active in this market for reasons other than seeking genuine risk transfer, and confirmed that it expects to be notified of longevity risk transfer arrangements and a firm’s proposed approach to risk management well in advance of completing such a transaction. The PRA made it clear that this notification expectation applies whether a firm is buying or selling longevity protection and is intended to facilitate the PRA’s understanding of the potential build-up of risk concentrations as a result of these transactions.

Whilst there have been some concerns expressed in the market that the PRA’s increased scrutiny of longevity risk transfer transactions may lead to a reduction in longevity risk transfer from UK insurers, it does not seem to us that this should necessarily follow. The PRA’s observations in relation to the need for there to be effective risk transfer, and for ceding companies appropriately to manage counterparty default exposure, do not represent new requirements, and have been carefully considered in any event by ceding companies and their reinsurers when structuring transactions to ensure appropriate credit for reinsurance under Solvency II. In particular, longevity reinsurance risk transfer arrangements (whether in swap form or otherwise) are typically collateralized and the quality and nature of the collateral is carefully structured in order to ensure that it effectively mitigates counterparty default risk within the requirements of Solvency II.

IV. Global Regulatory and Litigation Developments

In 2016, the global insurance industry continued to examine difficult questions regarding the interpretation and intersection of U.S. federal, state and non-U.S. insurance regulation. In the U.S., with an eye towards the potential impact of the U.S. presidential and congressional elections on financial industry regulation and healthcare, state and federal regulators continued to tackle ongoing initiatives, including the implementation of principle-based reserving for life insurers, the regulation of life insurers’ use of affiliated captive reinsurers to finance non-economic reserves, the development of standards for the global reinsurance marketplace, the regulation of unclaimed life insurance and annuity benefits, the regulation of insurer investments and financial solvency, and the development of consistent international regulatory standards. In the UK, the EU’s

long awaited Solvency II regime has been in force for over a year, but the industry now faces uncertainty regarding the impact of Brexit. In addition, there have been reforms to the English insurance contract law and developments in the regulation of insurance sales, employee remuneration requirements, competition law enforcement across the EU and the implementation of the General Data Protection Regulation (“GDPR”). In China, developments include the identification of domestic systemically important insurers, launch of the Shanghai Insurance Exchange and tightening of restrictions on insurers’ investment in equity.

A. U.S. FEDERAL ACTIVITY

1. Federal Reserve Board

In 2016, the Board of Governors of the Federal Reserve System (the “Federal Reserve”) continued to develop implementing regulations under the Dodd-Frank Act. Specifically, in June 2016, the Federal Reserve approved for public comment (a) an advance notice of proposed rulemaking (“ANPR”) regarding capital standards that would apply to insurance companies that the FSOC designates as SIFIs and to insurance holding company systems that own a bank or a thrift, and (b) a proposed rule regarding enhanced prudential standards that would apply to SIFIs. In developing both the ANPR and the proposed enhanced prudential standards, the Federal Reserve professed to take into account differences between banks and insurance companies.

The ANPR regarding capital standards proposes different capital frameworks for SIFIs and for insurance holding company systems that own a bank or thrift, respectively. With respect to SIFIs, the ANPR proposes a consolidated approach that would categorize all of an insurance firm’s assets and insurance liabilities into risk segments, apply risk factors to the amounts in each segment, and then set a minimum ratio of consolidated capital resources to consolidated capital requirements. With respect to bank holding companies and savings and loan holding companies significantly engaged in insurance activities, the ANPR proposes a building block approach that would aggregate the existing capital requirements at each subsidiary and make adjustments to address items such as accounting differences, intercompany transactions, as well as differing supervisory objectives and valuation approaches. The ANPR provided the public an opportunity to comment on the proposed conceptual framework for capital standards before the Federal Reserve began drafting a proposed rule implementing the framework.

Under the proposed enhanced prudential standards, SIFIs would be required to comply with corporate governance, risk-management and liquidity risk-management standards. The corporate governance and risk-management standards would require a SIFI to implement an enterprise-wide risk management framework, maintain a risk committee, and appoint a chief risk officer and chief actuary. The liquidity risk-management standards would require a SIFI to (a) have short- and long-term cash-flow projections, a contingency funding plan, liquidity risk limits and procedures for monitoring liquidity risk, and (b) conduct liquidity stress tests on a monthly basis and maintain a liquidity buffer sufficient to cover its net stressed cash flows over a 90-day period.

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The Federal Reserve currently supervises two SIFIs and 12 insurance holding companies that own a depository institution. (See Section IV.A.3 below regarding the recent rescission of two SIFI designations.) Comments on the ANPR and proposed rule were due in mid-August 2016. Following the results of the recent U.S. presidential and congressional elections, the scope, timing and implementation of these and other aspects of the Dodd-Frank Act remains uncertain.

2. Federal Insurance Office

a. Covered Agreement Between the U.S. and the EU

One week before the U.S. presidential inauguration, the Secretary of the U.S. Department of the Treasury (the “Treasury Secretary”) and the Office of the U.S. Trade Representative (the “USTR”) announced that after nearly a year of negotiations, they had reached agreement with the EU on the terms of a covered agreement between the U.S. and EU (the “Covered Agreement”). As required under the Dodd-Frank Act, the final legal text of the Covered Agreement was submitted to the U.S. House of Representatives and the U.S. Senate on January 13, 2017.

The Covered Agreement was negotiated pursuant to Title V of the Dodd-Frank Act (the “FIO Act”), which authorizes the Federal Insurance Office (the “FIO”) to assist the Treasury Secretary in negotiating covered agreements. A covered agreement is an agreement between the U.S. and one or more foreign governments, authorities or regulatory entities, regarding prudential measures with respect to insurance or reinsurance.

The Covered Agreement primarily addresses two areas of prudential insurance supervision: group supervision and reinsurance collateral requirements. The Covered Agreement also encourages insurance supervisors in the U.S. and the EU to share information, and a form of memorandum of understanding regarding information exchange, which insurance supervisors are encouraged to adopt, is included as an annex to the Covered Agreement.

With respect to group supervision, the Covered Agreement prohibits EU insurance supervisory authorities from applying the solvency and capital requirements under Solvency II to the worldwide operations of U.S. insurers. U.S. insurance groups that operate in an EU member country can only be supervised at the worldwide group level by U.S. insurance supervisors. Likewise, group supervision of insurers based in EU member countries is solely the responsibility of the insurance supervisory authority in the EU member country.

With respect to reinsurance collateral requirements, in a major departure from current U.S. insurance law, subject to certain conditions, the Covered Agreement prohibits a U.S. territory (i.e., state) from imposing any reinsurance collateral requirements upon an EU assuming reinsurer that would result in the EU reinsurer receiving less favorable treatment than assuming reinsurers domiciled in the state. In turn, an EU country may not impose any local presence or other similar restrictions which would result in a U.S. reinsurer receiving less favorable treatment than EU assuming reinsurers that are domiciled (or have their head office), licensed or permitted to operate in the same EU member country as the ceding insurer.

It is uncertain when, if ever, the Covered Agreement will take effect. As of this writing, the Covered Agreement remains subject to the U.S. and the EU completing their respective internal requirements and procedures necessary for it to take effect with respect to each party. Although the FIO Act does not require Congressional or Executive Branch input or approval of a covered agreement, the Executive Branch has authority to exercise such additional oversight. Therefore, it is possible that the Covered Agreement will be revised, renegotiated, or even repudiated under the administration of the new U.S. president. Additionally, the individuals holding the cabinet-level positions of Treasury Secretary and USTR have changed since the Covered Agreement was submitted to the U.S. Congress, which could also have an impact on the timing and effectiveness of the Covered Agreement. The Covered Agreement’s effectiveness also could be delayed or rescinded if Dodd-Frank is amended in a way that impacts the federal government’s (or the FIO’s) authority with respect to covered agreements. It is also likely that there will be political pressure from U.S. reinsurers that would still be subject to state reinsurance collateral requirements, and from insurers domiciled in countries such as Bermuda that have not yet negotiated a covered agreement with the U.S.

If the Covered Agreement becomes effective, the U.S. federal government will take an active role in eliminating state reinsurance collateral requirements for EU assuming insurers (within five years) by applying the agreement on a “provisional” basis before the five-year deadline, pressing states to reduce collateral each year by 20%, and preparing for federal preemption of state laws that still require collateral for reinsurance cessions to EU-domiciled insurers. Under the FIO Act, a state insurance measure can only be preempted by a covered agreement if the FIO Director determines that (a) the state insurance measure “results in less favorable treatment of a non-U.S. insurer domiciled in a foreign jurisdiction that is subject to a covered agreement than a U.S. insurer domiciled, licensed, or otherwise admitted in that State;” and (b) the state insurance measure is “inconsistent with a covered agreement.” Before making any determination that the preemption standard has been satisfied, the FIO Director must follow the notification process (which includes an opportunity for public comment) outlined in Dodd-Frank.

Further, there is an incongruity between the prohibition against a state imposing reinsurance collateral requirements that are less favorable than those applicable to a ceding insurer domiciled in the state and the preemption standard, which is satisfied (in part) if a state measure imposes reinsurance collateral requirements that are less favorable than those applicable to a ceding insurer domiciled, licensed or otherwise admitted in the state. Further, it is possible that a determination that the Covered Agreement preempts a state’s reinsurance collateral requirements would result in an EU reinsurer receiving more favorable treatment than a U.S. reinsurer that is not domiciled, licensed or otherwise admitted in the ceding insurer’s state of domicile.

For these and other reasons, the NAIC has been concerned with the effect that a covered agreement may have on state reinsurance collateral requirements. At its Fall 2016 National Meeting, the NAIC’s Financial Condition (E) Committee (the “(E) Committee”) exposed a proposal prepared by NAIC staff for contingency regulatory plans

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to protect U.S. consumers from “potential adverse impact” that may result from the Covered Agreement. The NAIC has worked for over 10 years to reform reinsurance collateral requirements through amendments to its Credit for Reinsurance Model Law and Model Regulation that establish reduced collateral requirements for “certified reinsurers” and has recently voted to make the certified reinsurer provisions an accreditation standard. (See Section IV.B.3.a.i below.)

b. Post-Election Role in Insurance

Michael McRaith, who had served as the Director of the FIO since its inception in 2011, resigned effective January 20, 2017, upon the inauguration of Donald Trump as President of the U.S. Following the results of the recent U.S. presidential and congressional elections, the fate of the FIO is uncertain.

The Dodd-Frank Act established the FIO within the U.S. Department of the Treasury (the “Treasury Department”) to monitor all aspects of the insurance industry and lines of business other than certain health insurance, certain long-term care insurance and crop insurance. The Dodd-Frank Act also added a voting, independent member with insurance expertise to the FSOC. Neither the FIO nor the independent member with insurance expertise performs a regulatory function. This structure has been criticized as creating overlapping and conflicting federal insurance positions.

House Republicans have proposed consolidating these positions by creating a new independent insurance advocate position within the Treasury Department to coordinate federal efforts on the prudential aspects of international insurance matters, including among other things, representing the U.S. in the International Association of Insurance Supervisors, assisting in the negotiations of covered agreements and assisting in the administration of the Terrorism Risk Insurance Act. It is unclear what impact such changes might have on the implementation of the recently negotiated covered agreement between the U.S. and the EU. (See Section IV.A.2.a above.)

3. Financial Stability Oversight Council

Precedential ground was set in 2016 with respect to SIFI designations. On June 28, 2016, the FSOC voted to rescind the SIFI designation of General Electric Capital Corporation, the predecessor of GE Capital Global Holdings, LLC (“GE Capital”). Explaining that “GE Capital has fundamentally changed its business” through divestitures, a transformed funding model and a corporate reorganization, the FSOC determined that material financial distress at GE Capital would no longer pose a threat to U.S. financial stability.

In addition, on March 30, 2016, MetLife, Inc. won its suit against the FSOC when the U.S. District Court for the District of Columbia held that the FSOC acted arbitrarily and capriciously in issuing MetLife, Inc.’s SIFI designation. The court overturned the SIFI designation on grounds related to the process the FSOC employed in designating MetLife, Inc. as a SIFI (including failure to consider the costs the designation would impose on MetLife, Inc.). The FSOC has appealed the decision, and in the future, the FSOC presumably will amend its process to address the issues described in the court’s decision.

The FSOC’s published rationale for its decision to rescind GE Capital’s SIFI designation and the U.S. District Court’s decision to overturn

MetLife, Inc.’s SIFI designation may provide a roadmap for other companies seeking to avoid a SIFI designation. However, House Republicans have proposed reforming the FSOC’s role, including by revoking the FSOC’s authority to designate SIFIs.

The FSOC was established under the Dodd-Frank Act to provide recommendations to the Federal Reserve concerning risks to U.S. financial stability caused by the activities of large bank holding companies and non-bank financial companies. Pursuant to this authority, since 2013, the FSOC has assigned the SIFI designation to a total of four companies (American International Group, Inc., GE Capital, Prudential Financial, Inc. and MetLife, Inc.). A company designated as a SIFI becomes subject to supervision by the Federal Reserve and to enhanced prudential standards approved by the Federal Reserve. (See Section IV.A.1 above for a summary regarding proposed enhanced prudential standards.)

4. Flood Insurance

In 2016, federal and state insurance regulators accelerated discussions on reforming the NFIP, which will expire on September 30, 2017, unless reauthorized. The NFIP is a federal program created by the National Flood Insurance Act of 1968 and administered by FEMA. The NFIP has three components: to provide flood insurance, to improve floodplain management and to develop maps of flood hazard zones. It attempts to address the lack of private insurance coverage and the increasing amount of flood-related federal disaster assistance. Under the NFIP, property owners in participating communities can buy subsidized insurance to protect against flood loss.

The NFIP was last reauthorized in July 2012 through the Biggert-Waters Flood Insurance Reform Act (“BW-12 Act”). The NFIP was designed without a reinsurance mechanism and is currently estimated to be over US$23 billion in debt. Many—including FEMA—have called for sweeping reforms.

Congress has asked for NAIC input on improving the NFIP and is particularly interested in encouraging the growth of flood insurance in the private market. In December 2016, a U.S. House subcommittee distributed a draft document to guide the reform discussions, entitled “Principles for Flood Insurance Reauthorization and Reform” (“Draft Flood Reauthorization Principles”). The document urges that the NFIP be reauthorized before its expiration (a new expiration date is not suggested) and offers suggestions on how to place the NFIP on sound fiscal footing, such as: (a) using reinsurance or capital markets alternatives to diversify risk across multiple markets; (b) enhancing risk assessment tools and mapping to determine more accurate premiums; (c) providing greater transparency and consumer choice; (d) providing mapping standards for FEMA and non-government entities and giving communities additional avenues to bypass the FEMA mapping to use more updated community data and technology; and (e) passing related legislation, the Flood Insurance Market Parity and Modernization Act (“H.R. 2901”). FEMA has stated that it will be considering whether to use catastrophe bonds if pricing is more competitive than reinsurance.

On April 28, 2016, the U.S. House passed H.R. 2901, which addresses the current requirement for mandatory flood insurance coverage on high flood risk properties when mortgages on such properties are

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backed by a federal guarantee. The NFIP has been providing most of such coverages and H.R. 2901 is intended to increase the amount of privately issued policies and to give state insurance regulators more flexibility to determine what is acceptable coverage. Current law requires that private flood insurance meet certain criteria and that it provide coverage “at least as broad as” coverage offered by the NFIP. H.R. 2901 would also allow homeowners to be considered by FEMA to have maintained “continuous” insurance coverage even if they leave the NFIP program to obtain private insurance but end up returning to NFIP at a later date. The bill also clarifies that both admitted and non-admitted (i.e., surplus lines) insurers may provide private market flood insurance coverage. H.R. 2901 is currently being considered by the U.S. Senate, which referred the bill to its Committee on Banking, Housing, and Urban Affairs on May 6, 2016.

The NAIC is providing input on both the Draft Flood Reauthorization Principles and H.R. 2901. On December 12, 2016, the NAIC’s Property and Casualty (C) Committee (the “(C) Committee”) passed, and referred to the NAIC’s Government Relations Leadership Council, recommendations concerning reform of the NFIP. Once approved by the NAIC, the recommendations will be forwarded to federal legislators for their consideration.

As discussions continue on NFIP reform and reauthorization, a joint group of federal agencies proposed a rule10 in November 2016 addressing the BW-12 Act’s requirement that regulated lending institutions accept certain private flood insurance policies in addition to policies made available by FEMA. The proposed rule would assist lenders in identifying policies they are required to accept and clarifies that lenders retain discretion to accept private flood insurance policies that do not meet the criteria for mandatory acceptance, provided certain conditions are met. On January 6, 2017, the NAIC submitted a comment letter urging that the proposed rules specify that personal lines residential insurance policies offered by surplus lines insurers (which may offer consumers additional coverage features or greater limits than the NFIP at a more affordable price) would be accepted for purposes of satisfying the mandatory insurance requirement in H.R. 2901. The rules currently stipulate that nonresidential commercial lines policies offered by surplus lines insurers may be accepted by lenders, but do not specify whether personal lines residential insurance policies offered by surplus lines insurers may be accepted. The NAIC noted that surplus lines insurers are currently providing much of the flood insurance coverage (including residential personal lines) available in the private market.

Public policy concerns about the role of the federal government in providing flood insurance are at the heart of the debate on NFIP reform. While there is broad agreement on increasing the role of private flood insurers, that can only happen with an NFIP transition to actuarially sound pricing. To date, the potential impact on low-income property owners has been a serious impediment in this process.

10 Notice of Proposed Rulemaking, Loans in Areas Having Special Flood Hazards-Private Flood Insurance, 81 Fed. Reg. 78,063, 78,073, issued November 7, 2016 by the Federal Reserve Board, the Comptroller of the Currency, the Federal Deposit Insurance Corporation, the Farm Credit Administration and the National Credit Union Administration.

5. Department of Labor – Fiduciary Rule Faces Uncertain Future

On April 6, 2016, the U.S. Department of Labor (“DOL”) issued an amendment to DOL regulations defining the term “fiduciary” (the “Fiduciary Rule”) that would significantly expand who is considered a “fiduciary” for purposes of the Employee Retirement Income Security Act of 1974, as amended (“ERISA”), by including individual retirements accounts (“IRAs”) within its scope, and revised the exemptions to the prohibited transaction provisions of the Internal Revenue Code of 1986, as amended (the “Code”), thereby materially affecting, among other things, the manner by which financial advisers can recommend proprietary investments or receive certain types of transaction-based compensation. The amendment to the definition of fiduciary and the changes to the exemptions to the prohibited transaction provisions of the Code are expected to fundamentally change the way insurance companies do business and could limit the types of investments that can be sold to certain plans and IRAs.

The DOL originally designated April 10, 2017 as the Fiduciary Rule’s applicability date in order to provide insurance companies an opportunity to review current business practices, make appropriate changes and evaluate whether certain investments should no longer be offered to certain plans and IRAs. However, on March 2, 2017, the DOL published a proposal, subject to a 15-day comment period, to extend the April 10, 2017 applicability date for 60 days (“Proposed Extension”).

The Proposed Extension references President Trump’s memorandum, issued on February 3, 2017, directing that the Secretary of Labor examine the Fiduciary Rule to determine whether the Fiduciary Rule “may adversely affect the ability of Americans to gain access to retirement information and financial advice” (the “Memorandum”). The Memorandum also directed the acting Secretary of Labor to prepare an updated economic and legal analysis of the impact of the Fiduciary Rule and stated that, if he determined that the Fiduciary Rule would have a negative impact, he is to issue a proposed rule rescinding or revising the Fiduciary Rule, subject to notice and comment. Ostensibly, the Memorandum only calls for a review of the Fiduciary Rule, but the White House has given strong indications that it disagrees with the Fiduciary Rule as written.

The Proposed Extension invites comments on the proposed 60-day delay, the questions raised in the Memorandum, and generally on questions of law and policy concerning the Fiduciary Rule.

B. U.S. NAIC AND STATE ACTIVITY

1. Principle-Based Reserving

a. PBR Becomes Operative

On June 10, 2016, the NAIC’s Executive and Plenary Committees unanimously voted to implement PBR by making the NAIC’s Standard Valuation Manual (the “Valuation Manual”) operative effective January 1, 2017. At the time of the vote, 49 states (representing 76.17% of total U.S. life insurance premiums) had passed PBR legislation that was deemed “substantially similar” to the SVL, thus exceeding the minimum threshold (42 states/72% of total U.S. life insurance premiums) required to make PBR operative. The minimum threshold was exceeded after California—a key state due to its

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significant amount of life insurance premiums (6.79% of total U.S. life insurance premiums as of October 5, 2016)—enacted PBR legislation on October 8, 2015.

As of early March 2017, the only NAIC jurisdictions (with life insurance premiums) that have not passed PBR legislation are Alaska, the District of Columbia, Guam, Massachusetts and New York. New York, which, of these states, has the highest level of life insurance premiums (9.2% of total U.S. life insurance premiums as of October 5, 2016), had been vocal in opposing PBR until July 6, 2016, when the newly appointed Superintendent of the New York State Department of Financial Services (the “NYDFS”) announced that New York would adopt PBR. According to the Superintendent, New York would apply a January 2018 effective date for PBR, rather than 2017, and had formed a working group to address next steps. However, as of early March 2017, New York has not yet introduced any legislation (or proposed regulations) concerning PBR. In December 2016, the NAIC’s Financial Regulation Standards and Accreditation (F) Committee (the “(F) Committee”) exposed (for a 60-day comment period ending February 8, 2017) a proposal prepared by the Life Actuarial (A) Task Force (“LATF”) identifying the “significant elements” of PBR that must be adopted by states in order to maintain NAIC accreditation.

At this juncture, most life insurers are still working on PBR valuations and, according to some surveys, many will be using the three-year transition period (ending 2020) before moving to reserve calculations that use PBR exclusively. A survey by the Society of Actuaries reported that only 15 insurers would use PBR for at least one product in 2017. Insurers are also waiting for Internal Revenue Service (“IRS”) rulings concerning the tax deductibility of reserves calculated using PBR.

b. PBR Implementation Measures

Although PBR is now “operative,” the NAIC and state insurance departments continue their work to implement PBR. Most of this work is coordinated through the NAIC’s Principle-Based Reserving Implementation (EX) Task Force (the “PBRI Task Force”) in accordance with a PBR Implementation Plan adopted in April 2016 or through the NAIC’s PBR Review (EX) Working Group. PBR implementation includes:

• Creating the experience reporting framework that must be included in reserve calculations as required by the Valuation Manual. The NAIC will most likely serve as the entity for collecting and disseminating insurers’ experience data and assessment and collection of fees (which may extend to insurers that are not using PBR).

• Adjusting annual statement blanks and instructions for PBR reporting.

• Increasing actuarial support for states in their analysis of PBR valuations and ensuring uniform application of PBR requirements.

• Developing risk-focused examination procedures for PBR and software used for financial analysis, actuarial review and a central repository of PBR information.

• Calibrating insurers’ PBR models, and conducting peer and quality reviews of PBR calculations. This work is being coordinated through the newly formed Valuation Analysis (E) Working Group.

• Evaluating the results of a PBR pilot project involving 12 participating insurers in order to assist regulators and insurers with reserve calculations using PBR.

• Evaluating risk-based capital (“RBC”) requirements in light of valuation changes and PBR’s impact on capital.

• Developing education and legislative briefs with the assistance of consultants.

• Testing PBR net premium reserve and deterministic reserves and evaluating potential modifications to reserve methodology and Standard Valuation Manual VM-20 Requirements for Principle-Based Reserves for Life Products. This work is being coordinated through LATF.

2. Affiliated Captive Insurers and Reserve Transactions

Pending full implementation of PBR, interim regulations specific to life insurance reserve financing transactions are being developed pursuant to the NAIC’s XXX/AXXX Reinsurance Framework (the “Framework”) and Actuarial Guideline XLVIII—Actuarial Opinion and Memorandum Requirements for the Reinsurance of Policies Required to be Valued under Sections 6 and 7 of AG 48, each adopted in November 2014. In connection with implementing the Framework and AG 48, in 2016, the NAIC finalized and adopted certain amendments to the Credit for Reinsurance Model Law (the “CFR Model Law”), the A/XXX Model Regulation, and a new version of AG 48. A description of each of these implementing measures follows below. For a discussion of certain RBC and capital adequacy-related changes related to implementation of the Framework and AG 48, see Section IV.B.4.c below.

a. Adoption of Credit for Reinsurance Model Law Amendments

On January 8, 2016, the NAIC adopted amendments to the CFR Model Law to provide state insurance commissioners with the authority to adopt regulations implementing the NAIC’s A/XXX Model Regulation and AG 48. Such amendments provide state insurance commissioners the authority to adopt such regulations as they relate to: (A) life insurance policies with guaranteed non-level gross premiums or guaranteed non-level benefits; (B) universal life insurance policies that have provisions resulting in a policyholder’s ability to keep a policy in force over a secondary guarantee period; (C) variable annuities with guaranteed death or living benefits; (D) long-term care policies; and (E) such other life and health insurance and annuity products as to which the NAIC may adopt model regulatory requirements that make reference to credit for reinsurance. Regulations may apply to any treaty covering: (1) policies issued on or after January 1, 2015; and/or (2) policies issued prior to January 1, 2015 if risk pertaining to such pre-2015 policies is ceded in connection with a treaty, in whole or in part, on or after January 1, 2015.

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The CFR Model Law amendments also contain a so-called “professional reinsurer” exemption, which provides that a regulator’s authority to promulgate a regulation does not apply to cessions to a reinsurer that qualifies as a certified reinsurer in certain states, or is licensed and/or accredited in a certain number of states and meets minimum capital and surplus requirements (US$250 million). The exempted reinsurer must be either: (a) licensed in at least 26 states; or (b) licensed in at least 10 states, and licensed or accredited in a total of at least 35 states.

It is expected that the (F) Committee will make adoption of the amendments to the CFR Model Law an accreditation standard. The (F) Committee is scheduled to consider such accreditation at the NAIC’s Spring 2017 National Meeting in April 2017.

b. Adoption of A/XXX Model Regulation

On December 13, 2016, the NAIC’s Executive and Plenary Committees adopted the A/XXX Model Regulation, which applies to life insurance reserve financing transactions pending full implementation of PBR. As adopted, the A/XXX Model Regulation resolved in favor of the industry two significant issues that were discussed during the A/XXX Model Regulation drafting process: (i) how a shortfall in Primary Securities or Other Securities (terms defined under AG 48) should affect credit for reinsurance (“CFR”); and (ii) whether to include a so-called “small reinsurer exemption” in addition to the so-called “professional reinsurer” exemption included in the CFR Model Law. Although the A/XXX Model Regulation has not, as of early March 2017, been formally submitted to the (F) Committee for its consideration, it is expected that the (F) Committee will make adoption of the A/XXX Model Regulation an accreditation standard.

i. Shortfall Consequences

Where a shortfall in Primary Securities or Other Securities exists and such shortfall is not remedied within a designated amount of time, the A/XXX Model Regulation, as adopted, provides that CFR will be permitted up to the amount of Primary Securities held by the cedent. Thus, the “all or nothing” approach, which was proposed in the first draft of the A/XXX Model Regulation and whereby no CFR would be permitted in the event of any shortfall in Primary Securities or Other Securities, was ultimately rejected.

ii. Small Reinsurer Exemption

As adopted, the A/XXX Model Regulation includes an exemption for cessions to a reinsurer that (i) is not an affiliate of the cedent; (ii) is not licensed as a captive or similar entity in any state; (iii) is licensed or accredited in at least 10 states; and (iv) has RBC of at least 500% (after accounting for the financial impact of any permitted accounting practices). This exemption was adopted at the recommendation of several interested parties because the A/XXX Model Regulation is designed strictly for captive reinsurance transactions. As such, without the additional exemption, the A/XXX Model Regulation would inappropriately apply to treaties with small, traditional reinsurers that do not meet the size and licensing requirements of the so-called “professional reinsurer” exemption (see Section IV.B.2.a above), which is also included in the A/XXX Model Regulation.

c. Adoption of New Version of AG 48

When it adopted the A/XXX Model Regulation, the NAIC also adopted a new version of AG 48, effective January 1, 2017. AG 48 is intended to implement the A/XXX Model Regulation, but was adopted (in December 2014) before the A/XXX Model Regulation was drafted. During the process of drafting the A/XXX Model Regulation, regulators and interested parties raised issues that were not addressed (or fully clarified) in AG 48, such as application of the so-called “small reinsurer” exemption and the consequences for cedents that experience a shortfall in Primary Securities or Other Securities (terms defined under AG 48). Because these issues were resolved in the final A/XXX Model Regulation, revisions to AG 48 were needed for the sake of consistency.

In most states, AG 48 will cease to be effective when a state enacts the A/XXX Model Regulation. However, a small number of states will likely adopt the A/XXX Model Regulation on a “prospective basis,” such that it will apply only to ceded policies issued on or after the effective date. In such states, AG 48 will continue to be the authoritative guidance for policies issued prior to the effective date of the A/XXX Model Regulation.

3. Reinsurance

a. Credit for Reinsurance Update

i. Reduced Collateral Requirements Adopted as Accreditation Standard

Effective January 1, 2019, the certified reinsurer provisions from the NAIC’s 2011 amendments to the Credit for Reinsurance Model Law and Model Regulation (the “Amended CFR Model Law”) will be an accreditation standard. Accordingly, those states that have not enacted reinsurance collateral reform will need to pass a law that is substantially equivalent to the Amended CFR Model Law in order to maintain NAIC accreditation.

As of January 12, 2017, 35 states have adopted the Amended CFR Model Law or otherwise allow for a reduction in posted collateral from an unauthorized reinsurer that is approved by states as a “certified reinsurer.” However, as discussed above in Section IV.A.2.a, it is possible that an individual state’s collateral requirements could be preempted with respect to reinsurance cessions placed with certain unauthorized reinsurers (i.e., reinsurers domiciled in countries that have entered into a covered agreement with the U.S.). In fact, the NAIC’s recent decision to make the certified reinsurer provisions of the Amended CFR Model Law an accreditation standard was motivated primarily by the prospect of a covered agreement leading to federal preemption of state insurance regulation addressing reinsurance collateral matters. Specifically, the NAIC took this action in an effort to promote state uniformity and strengthen the NAIC’s argument against the necessity of international agreements between U.S. and foreign regulators that could preempt state reinsurance collateral laws that are inconsistent with such covered agreements.

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ii. Potential Changes to Qualified Jurisdiction Status

The Reinsurance (E) Task Force (the “RTF”) is considering whether to re-evaluate the “Qualified Jurisdiction” status of certain EU countries. The action follows reports by U.S.-based reinsurers of new restrictions they are facing by regulators in Germany, France, the UK and Ireland when accessing reinsurance markets in such countries. Each of these countries has been deemed a “Qualified Jurisdiction” for purposes of the reduced collateral requirements established under the Amended CFR Model Law. The new restrictions appear to involve attempts by EU regulators to apply Solvency II to U.S.-based reinsurers operating in the EU. The RTF has suggested that the re-evaluation of the “Qualified Jurisdiction” status of these countries is justified by language in the Amended CFR Model Law that provides that a “Qualified Jurisdiction” should be one that cooperates with U.S. regulators and affords reciprocal recognition to U.S.-domiciled reinsurers. If a country is no longer considered a Qualified Jurisdiction, an insurer domiciled in such country would no longer qualify as a “certified reinsurer” and would be subject to increased reinsurance collateral requirements applicable to unauthorized reinsurers that are not “certified reinsurers.”

It is unclear whether or how the RTF’s suggested re-evaluation will proceed in light of the Covered Agreement. The Covered Agreement makes clear that Solvency II’s solvency and capital requirements will not apply to the worldwide operations of U.S. insurers and that an EU country is prohibited from imposing local presence or other similar restrictions to the extent they result in a U.S.-based reinsurer receiving less favorable treatment than EU-based assuming reinsurers. Although the parties have agreed on the “final legal text” of the Covered Agreement, it is uncertain when, if ever, the Covered Agreement will take effect. (See Section IV.A.2.a above for a more detailed discussion of the Covered Agreement.)

4. Corporate Governance/Solvency Issues

a. Corporate Governance Annual Disclosure Model Act and Model Regulation

As of early March 2017, 12 states (California, Connecticut, Florida, Indiana, Iowa, Louisiana, Montana, Nebraska, New Hampshire, Ohio, Rhode Island and Vermont) have adopted laws based on the Corporate Governance Annual Disclosure Model Act and Model Regulation (the “Corporate Governance Models”), which were adopted by the NAIC in 2014. The Corporate Governance Models impose a new reporting requirement on insurers and insurance groups but do not impose any new substantive corporate governance requirements. The first corporate governance annual disclosure is typically due by June 1 of the year the new law becomes effective in a state.

The Corporate Governance Models contemplate that an insurer that is a member of an insurance group should submit the report to its “lead state.” However, as adopted by the states, the law applies to all insurers domiciled in the state, regardless of whether or not the lead state for the applicable insurance group has also adopted the Corporate Governance Models. Given the limited number of states that have adopted the Corporate Governance Models to date,

insurers may find themselves with domestic companies obligated to file reports, notwithstanding the fact that a lead state has not yet adopted the Corporate Governance Models.

b. NAIC Developing Enterprise Risk Report (Form F) Guidance Manual

In late 2016, the Group Solvency Issues (E) Working Group exposed for comment a draft Enterprise Risk Report (Form F) Guidance Manual (the “Form F Manual”). The Form F Manual is intended to guide insurers and state insurance regulators in preparing and reviewing Enterprise Risk Reports (“Form F”) filed with a “lead state” annually. However, interested parties have expressed concerns that the current draft of the Form F Manual would expand reporting requirements under Form F (to include, for example, risks that are less than “likely” to occur if they have the potential to materially impact the insurance holding company system and risks that would be material if not for mitigation strategies that have been put in place) and limit insurers’ ability to cross-reference relevant portions of their publicly held parent company’s SEC filings.

The Form F filing requirement was included in the 2010 amendments to the NAIC Insurance Holding Company System Regulatory Act and NAIC Insurance Holding Company System Model Regulation (the “Holding Company Model Laws”). The amendments to the Holding Company Model Laws included a Form F template for insurers to use when submitting Enterprise Risk Reports. For NAIC-accreditation purposes, the filing requirement became effective as of January 1, 2016, and NAIC-accredited lead states are now receiving and reviewing Form F filings.

c. Capital Adequacy

i. RBC for Investment Affiliates

In December 2016, the NAIC, though its Capital Adequacy (E) Task Force (the “CA Task Force”), changed the way RBC is calculated for a property-casualty insurer’s ownership of Type 7 Investment Affiliates (entities that own or manage an insurer’s investment). The RBC charge will now be a fixed factor (0.225) multiplied by the carrying value of the investment affiliate’s common stock, preferred stock and bonds. Previously, the RBC charge was based on the RBC charge of the underlying assets of the investment affiliate, which were pro-rated based on the degree of ownership. Under the prior “look through” approach, it was assumed that the RBC charge should be the same if the insurer held the assets directly and the insurer’s actual equity interest in the affiliate was disregarded. A capital charge of “0” was generally applied to the insurer’s equity interest in the investment affiliate. (An RBC charge would only apply to investments in bonds and preferred stocks of investment affiliates to the extent that the RBC of the affiliate exceeded the book/adjusted carrying value of the affiliate’s common stock.) Regulators supported the new charge because the prior approach, which generally resulted in a capital charge of “0,” could not be verified.

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ii. RBC Initiatives Related to the A/XXX Model Regulation

Now that the A/XXX Model Regulation has been adopted, the CA Task Force and its Life Risk-Based Capital (E) Working Group are revising RBC-related requirements to make them consistent with the A/XXX Model Regulation. For example, amendments to the instructions for “Calculation of Authorized Control Level RBC and Reinsurance Primary Security Shortfall By Cession” are necessary now that, under the A/XXX Model Regulation, in the event of such a shortfall, CFR is permitted up to the amount of Primary Securities held by the cedent. The instructions will now state that the RBC calculation is not required for treaties covered by the state equivalent of the A/XXX Model Regulation, as such treaties that do not meet the requirements of the A/XXX Model Regulation must directly establish a liability for the difference between the CFR taken and the actual Primary Security held.

iii. Investment RBC Working Group – Changes to Asset Risk Factors

In early 2016, the NAIC began discussing the treatment of asset risk factors in all RBC formulas. In May 2016, the Investment Risk-Based Capital (E) Working Group (the “Investment RBC Working Group”) distributed “A Way Forward” document recommending that bond factors for RBC designations be updated to expand from six to 20 (with the exception of residential and commercial mortgage-backed securities modeled by the NAIC). Consideration would also be given to keeping the six designation system, with updated factors for non-life RBC statements. In June 2016, the Investment RBC Working Group decided to focus efforts on changes in the life RBC formula, although more recently, the Investment RBC Working Group discussed bringing property-casualty and health insurers into the process. Interested parties have expressed concerns that an increase in life RBC could result in incentives to purchase below investment grade bonds.

iv. Operational Risk

The NAIC continues efforts to include an “operational risk” component to RBC formulas for health, life and property-casualty insurers. Under current proposals, a new RBC charge would account for operational risk to the extent it is not already reflected in existing RBC risk categories. At this juncture, the focus is on two types of operational risk—growth risk and basic operational risk. Growth risk would result in an additional charge if there were an increase in premiums exceeding a certain percentage threshold. The basic operational risk charge would go into effect only if it exceeds the current business risk charge and would be a percentage of total RBC. The Operational Risk (E) Subgroup is working on changes to the 2017 RBC formulas for basic operational risk, which it intends to expose for comment in April 2017. An “informational” operational risk charge was previously included in insurers’ 2015 and 2016 RBC reports.

5. Unclaimed Property

a. State Adoption of the National Conference of Insurance Legislators Model Unclaimed Life Insurance Benefits Act

As of early 2017, 24 states had enacted legislation based on the National Conference of Insurance Legislators (“NCOIL”) Model Unclaimed Life Insurance Benefits Act (the “NCOIL Model”) to require insurers to perform searches of the Social Security Administration’s Death Master File (the “DMF”) in order to become aware of potentially deceased insureds, annuitants and owners of polices, annuities or retained asset accounts. The applicable states are Alabama, Arkansas, Florida, Georgia, Idaho, Illinois, Indiana, Iowa, Kentucky, Maryland, Mississippi, Missouri, Montana, Nevada, New Mexico, New York, North Carolina, North Dakota, Pennsylvania, Rhode Island, Tennessee, Utah, Vermont and West Virginia.

Thirteen of the states (Florida, Idaho, Illinois, Iowa, Maryland, Montana, Nevada, New York, North Dakota, Pennsylvania, Rhode Island, Vermont and West Virginia) enacted laws that apply retroactively (i.e., to existing life insurance policies); six of the states (Alabama, Arkansas, Georgia, Indiana, Kentucky and Mississippi) enacted laws that apply prospectively (i.e., to life insurance policies issued after the effective date of the laws); and five of the states (Missouri, New Mexico, North Carolina, Tennessee and Utah) enacted laws that apply asymmetrically. “Asymmetric” application refers to laws providing that insurers that did not use the DMF prior to a specified date (usually the law’s effective date) need only perform comparisons of the DMF with respect to insureds, annuitants and owners of policies, annuities or accounts issued on or after the specified date; for all other insurers, the law would apply retroactively to policies, annuities and accounts that had been issued before the specified date.

b. Update Regarding NAIC Development of Unclaimed Life Insurance and Annuities Model Act

The future of the NAIC’s work to develop a model law addressing unclaimed life insurance and annuity benefits is uncertain and likely will be decided by the Life Insurance and Annuities (A) Committee (the “(A) Committee”) during the Spring 2017 NAIC National Meeting. During a conference call in early March 2017, the Unclaimed Life Insurance Benefits (A) Working Group (the “Working Group”) decided that it will not make any recommendation to the (A) Committee regarding the draft Unclaimed Life Insurance and Annuities Model Act (the “NAIC Draft Model”), as prepared by the Unclaimed Benefits Model Drafting (A) Subgroup (the “Drafting Subgroup”) and revised by the Working Group. Instead, at the Spring 2017 NAIC National Meeting, the Working Group plans to (a) report to the (A) Committee that the Working Group has not been able to develop clear consensus regarding the contentious issue of whether the NAIC Draft Model should apply retroactively and (b) seek guidance from the (A) Committee regarding how to proceed.

Throughout the model law development process, whether the law should apply retroactively to all in force policies has been—and continues to be—a contentious issue. Notably, the version of the NAIC Draft Model that the Drafting Subgroup submitted to the

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Working Group provided for retroactive application of the law to all in force policies (as well as certain lapsed policies), but would allow an insurance commissioner to grant a waiver from the law’s requirements for insurers that demonstrate that “compliance would result in financial hardship to the insurer or is not cost effective.” Among the factors the commissioner would be permitted to consider in determining whether to grant such a waiver is whether the insurer previously engaged in asymmetric conduct (i.e., searched the DMF with respect to annuity contracts, but not life insurance policies). As a nod to the constitutional law issues presented in litigation related to states adopting the NCOIL Model on a retroactive basis, the NAIC Draft Model that the Drafting Subgroup submitted to the Working Group included a drafting note that advises each state to “conduct its own legal analysis and review of its laws, case law and any other relevant authority to determine whether, and in what circumstances, retroactive laws are permitted in the state and whether the statute must expressly provided that it is intended to be retroactive.” However, in December 2016, the Working Group voted to revert to a prior version of the applicability section of the NAIC Draft Model, which would present states with three options related to the applicability of the law: prospective application, retroactive application or asymmetric conduct application.

It has been approximatley three years since the (A) Committee was charged with studying the unclaimed life insurance benefits matter. The (A) Committee appointed the Working Group, then chaired by Tennessee. The Working Group first met in March 2014. In March 2015, after analyzing the matter for a year, the Working Group submitted a request to develop a new NAIC model law to address the issue. Upon approval of such request in the Spring of 2015, the Working Group appointed the Drafting Subgroup, chaired by California, to prepare the new model. Following an almost nine-month process of comparing the provisions of two possible approaches (i.e., the NCOIL Model and the “Lead States” Model Act), on November 16, 2015, the Drafting Subgroup exposed for public comment an initial draft of the NAIC Draft Model. The public comment process continued in 2016, and in August 2016 the Drafting Subgroup finally submitted the NAIC Draft Model to the Working Group for its consideration.

The current version of the NAIC Draft Model is largely based on the NCOIL Model, with some differences based on the requirements contained in the related regulatory settlement agreements that regulators have entered into with several insurers. Nearly half of the states have adopted a version of the NCOIL Model (see Section IV.B.5.a above), and it is expected that additional states will adopt the NCOIL Model before any state is in a position to adopt the NAIC model (if any) on this issue.

c. NAIC Launches Life Insurance Policy Locator Application

In November 2016, the NAIC launched its Life Insurance Policy Locator Service, a tool that allows consumers to locate benefits from life insurance policies and annuities on a national basis by submitting a single request through the NAIC. Participating insurers compare their records against the information the consumer submits in the request (such as the deceased person’s name, date of birth, last known address and Social Security number) to determine whether the

company issued a life insurance policy or annuity to the deceased. If a company has relevant information, it responds directly to the consumer that submitted the inquiry. The service is free to consumers. The NAIC decided to pursue the development of the national tool after a growing number of states implemented state-specific “lost policy finder” services. Published advice on searching for lost life insurance has also become available on the websites of numerous state insurance regulators and life insurance trade groups.

d. Settlements and Litigation Dealing with Unclaimed Life Insurance Matters

In 2016, four additional life insurance companies or affiliated groups entered into multistate insurance regulatory settlements with insurance regulators. The same companies also entered into multistate settlements with unclaimed property agencies and auditors. This brings the total publicly announced multistate settlements to 24 insurance regulatory and 29 unclaimed property agency settlements, with two insurer groups having been determined to be in compliance (and therefore, no insurance regulatory settlements were entered into). In addition to the multistate settlements, some states are individually pursuing similar investigations of life and annuity insurers.

Cases examining the extent to which regulators may compel life insurers to produce in-force policy records for a comparison against the DMF are progressing towards resolution. In United Ins. Co. of. Am. v. Frerichs, No. 15-CH-998 (Ill. Cir. Ct. Jan. 19, 2017), an Illinois trial court granted the voluntary dismissal of certain insurers’ objections to the DMF-matching efforts of a State Treasurer and its contract auditor in light of passage of a new Illinois law that provides guidance on life insurers’ obligations to use the U.S. Social Security Administration’s Death Master File (DMF). A counterclaim by the Treasurer seeking a declaration that the Treasurer has the statutory authority to conduct an examination of the companies, either directly or through a contract auditor, remains pending.

Similarly, in Yee v. American Nat’l Ins. Co. (ANICO), No. 13-144517 (Cal. Ct. Aug. 18, 2016), the parties settled their claims and the case was dismissed following a California Court of Appeals ruling that reversed a lower court’s injunction against ANICO concerning whether the California Controller has the statutory authority to compel production of a life insurer’s in-force file.

Finally, in Thrivent Financial for Lutherans v. Yee, No. CGC-13-535156 (Cal. Super. Ct. Jul. 30, 2015), the California Controller dismissed with prejudice its action against an insurer following a trial court ruling denying the Controller’s motion for a preliminary injunction to compel the insurer to produce in-force policy records for a DMF search. The insurer has appealed the dismissal, and the matter remains pending on appeal.

i. Health Insurance Regulation – ACA Risk Corridors Litigation

Since early 2016, 19 lawsuits—including one that has been certified as a class action—have have been filed by insurers against the U.S. government for failure to pay amounts that would be owed them under the formula found in the ACA’s risk corridors statute and regulations. The risk corridors program was intended to protect

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insurers from extreme gains and losses during the initial years that major substantive changes were implemented under the ACA. Under the program, qualified health plans with lower-than-expected claims are required to make payments to CMS, while plans with higher-than-expected claims receive payments from CMS. For the 2014 program year, insurers collectively incurred US$2.87 billion in losses exceeding the risk corridor boundaries but ended up owing only US$362 million from excess profits. CMS capped payments out at payments in, and paid only 12.6 cents on the dollar to insurers for payments owed in 2014. For 2015, insurers incurred another US$5.7 billion in losses covered under the risk corridors program, but owed only US$95 million in charges, all of which was applied towards the 2014 obligation by the Government. Combined, this puts the aggregate risk corridors payment shortfall at over US$8.2 billion, with 2016 year results still yet to come.

These cases were all filed in the Court of Federal Claims, with one court ruling in favor of the insurer and another ruling in favor of the Government. A third case survived a motion to dismiss by the Government on procedural grounds, but did not involve a ruling on the merits. One of the cases is now pending before the U.S. Court of Appeals for the Federal Circuit.

6. Affordable Care Act

On March 6, 2017, Republicans introduced a pair of budget reconciliation bills (in the Ways and Means Committee and the Energy and Commerce Committee of the U.S. House of Representatives) collectively known as the American Health Care Act (the “AHCA”), to repeal and replace parts of the ACA. The AHCA would, among other things:

• repeal an ACA provision that restricts the amount of money a health insurer may deduct from its taxes annually for highly compensated employees (deduction currently is capped at $500,000);

• repeal, as of the end of 2017, several of the ACA’s taxes, including the tax on brand-name prescription drug manufacturers, the medical device tax and the tax on health insurers;

• repeal (retroactively for years beginning with 2016) the ACA’s penalties associated with the individual and employer mandates;

• transition the existing ACA premium subsidies to refundable, advanceable, age-adjusted tax credits (with income limitations);

• expand and enhance how health savings accounts could be used;

• phase out the ACA’s Medicaid expansion (including the enhanced federal funding for the expansion provided to states under the ACA) and transition the Medicaid program to a per capita cap system, a change that would fundamentally alter the Medicaid program;

• increase permissible age variable in premium rates such that beginning in 2018, insurers would be permitted to charge older customers up to five times as much as younger customers, compared with the 3-1 ratio in place under the ACA;

• replace the ACA’s individual mandate with a new continuous coverage requirement, under which individuals who fail to maintain continuous coverage would be penalized with a 30% increase in premiums for one year; and

• create a Patient and State Stability Fund to provide states with up to US$100 billion from 2018 through 2026 to assist with respect to high-cost, high-risk individuals.

The AHCA does not include specific changes to the ACA’s ban on pre-existing condition exclusions, the prohibition on health status as a factor in underwriting, expanded dependent coverage up to age 26, nondiscrimination rules, maximum out-of-pocket limitations or the ban on annual and lifetime caps.

As of mid-March 2017, the House Energy and Commerce Committee and the House Ways and Means Committee have each completed the markups of their respective portions of the AHCA and voted to advance the legislation to the House Budget Committee to be combined into a single bill.

To repeal and replace the ACA, both the House and the U.S. Senate must approve legislation. However, the minority party could block such legislation in the U.S. Senate through filibuster, which requires 60 votes to overcome. Republicans have only 52 Senators, so congressional leaders hope to pass the AHCA via the budget reconciliation process. Reconciliation is an expedited process that allows the U.S. Senate to consider certain tax, spending and debt legislation with limited amendments. Filibusters are not allowed, and passing a reconciliation bill requires only 51 votes. It is expected that House staff will work with U.S. Senate staff to address outstanding issues related to the Byrd Rule before the AHCA legislation is brought to the House floor for a vote. The Byrd Rule allows Senators to block legislation from being passed under the budget reconciliation process if it contains language that is not germane to the federal budget.

Republican Congressional leaders have indicated that they expect to pass the AHCA before Easter. However, maintaining support among Senate Republicans appears to be increasingly difficult, as more than half a dozen GOP Senators have raised concerns with the bill. For example, Sens. Rand Paul, R-Ky., and Mike Lee, R-Utah, joined conservative leaders in the House Freedom Caucus in mid-March to oppose the House bill because they do not believe the legislation does enough to repeal the ACA. Other Senators, including Tom Cotton, R-Ark., and Lindsey Graham, R-S.C., called on leadership to slow down the repeal-and-replace process.

In the meantime, on January 24, 2017, President Trump issued Executive Order 13765, “Minimizing the Economic Burden of the Patient Protection and Affordable Care Act Pending Repeal” (the “EO”). The EO directs the Department of Health and Human Services and other relevant federal agencies to take actions within their

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authority and discretion “to minimize the unwarranted economic and regulatory burdens of the [ACA],” including actions “to waive, defer, grant exemptions from, or delay the implementation of any provision or requirement of the [ACA] that would impose a fiscal burden on any State,” or that would impose “a cost, fee, tax, penalty, or regulatory burden on individuals, families, healthcare providers, health insurers, patients, recipients of healthcare services, purchasers of health insurance, or makers of medical devices, products, or medications.” The EO does not identify specific ACA provisions to be waived, deferred or delayed, nor does the EO change any statutory provisions or existing regulations. However, the EO could have a near-term impact on agency enforcement of the ACA, such as potential waivers of individual mandate penalties.

Additional Sidley resources on navigating ACA reform can be found at http://www.sidley.com/en/sidley-pages/health-matters-navigating-aca-reform.

7. Sharing Economy Issues – NAIC Adopted Home Sharing White Paper

At its Fall 2016 National Meeting, the NAIC adopted a white paper entitled “Insurance Implications of Home-Sharing: Regulator Insights and Consumer Awareness,” outlining insurance coverage issues in the sharing economy for home rentals. This short white paper discusses coverage under typical homeowners and renters policies, the implications of legal restrictions on short-term home rentals, and coverage options made available by home sharing companies.

8. NAIC Considering Developing Model Law or Guideline Regarding Travel Insurance

Through the Travel Insurance (C) Working Group, the NAIC is considering whether to develop “a model law or guideline to establish appropriate regulatory standards for the travel and tourism insurance industry.” Many states have adopted a version of the NCOIL Limited Lines Travel Insurance Model Act (the “NCOIL Travel Model”), which generally addresses licensing requirements related to selling, soliciting or negotiating travel insurance. In November 2016, NCOIL proposed amendments to the NCOIL Travel Model. As amended, the NCOIL Travel Model would provide a comprehensive framework for regulating travel insurance and other travel-related products, prescribing rules related to, among other things, premium taxes, form and rate filing, the competitiveness of the travel insurance market, and related sales practices (including a prohibition against requiring consumers to opt out of the purchase of travel insurance). The NAIC is reviewing the proposed amendments to the NCOIL Travel Model. It remains to be seen whether the NAIC will collaborate with NCOIL regarding the proposed amendments to the NCOIL Travel Model or whether the NAIC will develop its own travel insurance model law or guideline.

9. NAIC Activity Relating to International Insurance Activities – NAIC Developing Group Capital Standard

The NAIC is developing a group capital calculation for U.S. regulators to use in evaluating risks and the financial position of an insurer’s holding company system. The group capital calculation is intended to provide regulators with a consistent method of calculating group

capital and will serve as a baseline quantitative measure for group risks. While regulators currently analyze U.S. insurance groups, they do not have a consolidated financial measure in performing their analyses.

The group capital calculation will be based on RBC aggregation methodology. Throughout 2016, the Group Capital Calculation (E) Working Group (the “GCC Working Group”) has considered various proposals (including from insurers and trade groups) regarding how to address various challenges in creating a group capital calculation. Such challenges and key decisions include: (a) the scope of entities to be included within the group capital calculation; (b) how to aggregate legal entity capital requirements from other jurisdictions and those legal entities not subject to existing capital requirements; (c) whether and to what extent a holding company’s senior debt will be counted toward available group capital; (d) how to avoid double counting when aggregating available capital for each legal entity; and (e) how stress testing could be used in connection with the group capital calculation.

According to its current timeline, the GCC Working Group anticipates that it will propose an initial version of the group capital calculation at some point during the first half of 2017, that the first round of field testing will begin during the second half of 2017, and that the final version of the group capital calculation will be adopted by the NAIC by the end of 2018.

10. Life Insurance and Annuities

a. NAIC Adopts Revisions to Actuarial Guideline 49

On December 13, 2016, the NAIC adopted revisions to Actuarial Guideline XLIX (“AG 49”), which governs illustrations for indexed universal life (“IUL”) insurance policies. The primary purpose of AG 49 is to create a uniform methodology for determining the annual rate of index-based interest used to calculate policy values included within IUL policy illustrations in order to create a more realistic view of how a product may perform over time. The revised version of AG 49, which became effective March 1, 2017, applies to all IUL policies. AG 49 previously applied only to illustrations for IUL policies sold on or after September 1, 2015 (but not to in-force policies as of such date).

b. NYDFS Regulatory Activity

i. Proposed Regulation Limiting Premium Increases for In-Force Life Insurance Policies

In November 2016, the NYDFS announced proposed regulations that would impose new requirements on life insurers with respect to increases in the cost of insurance (“COI”) and premiums for life insurance policies and annuities delivered or issued for delivery in New York (the “Proposed Regulations”). The NYDFS is particularly concerned about the effect of premium increases (or reduced benefits) on in-force, older life insurance policies and annuities, such as those owned by senior citizens and other persons on fixed incomes. Violations of the Proposed Regulations would be deemed an unfair method of competition or an unfair or deceptive act and practice under the New York Insurance Law.

The Proposed Regulations focus on the non-guaranteed elements (“NGEs”) of a life insurance policy or annuity. NGEs are aspects of a

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policy or annuity that an insurer can alter at its discretion and which affect policy charges and credits, including interest crediting rates, expense and benefit charges, COI rates, equity index participation rates and caps under fixed indexed annuities. Elements that are not at an insurer’s discretion, such as the pass-through of variable fund returns, are not affected under the Proposed Regulations.

The NYDFS has asserted that some insurers are not implementing premium increases in accordance with NYDFS-approved policy provisions and that the New York Insurance Law only allows life insurers to increase the COI on in-force policies “when the experience justifies it and only in a way that is fair and equitable.” Accordingly, the Proposed Regulations would require insurers to submit a notification to the NYDFS at least 120 days prior to implementing any change in the current scale of NGEs that may have an adverse effect on policy values causing an increase in premium or reduction in benefits, other than a change in a credited interest rate based entirely on changes to the insurer’s expected investment income.

Notably, the Proposed Regulations go well beyond requiring notices of premium increases and also:

• List practices by insurers that are either permitted or prohibited when insurers assign policies into policy classes (to determine NGEs).

• Require insurers to establish board-approved criteria for determining NGEs. The criteria must include certain requirements such as regular reviews (at least every five years) of anticipated experience factors and NGEs.

• Impose certain rules concerning readjustments to NGEs relating to differences in anticipated experience factors with respect to expenses, mortality, investment income, policy claims, taxes, lapses and persistency.

• Require that insurers issue specific disclosures to policy owners in applications, illustrations and/or policy forms. For example, 60 days before making a change in an NGE scale, an insurer would be required to disclose the change to the policyholder.

• Alter policy form filings so they include board-approved criteria for determining NGEs, and a signed actuarial memorandum addressing NGEs. The actuarial memorandum must include a statement to the effect that the anticipated experience factors described in the memorandum are “reasonable assumptions” and are the basis for determining the scale of NGEs, and that the actuary is familiar with the current requirements in New York for NGEs.

Under the Proposed Regulations, an insurer may not consider reinsurance or other third-party agreements when changing NGEs if the result would be an adverse impact on an existing policy. Further, when an insurer has assumed or acquired a block of business, its procedures for readjusting NGEs for such block of business may not be less favorable to policyholders than those used by the original insurer.

In recently filed class actions, policyholders have alleged that insurers have committed a breach of contract by increasing life insurance

premiums. State insurance regulators across the country have received an increasing number of consumer complaints regarding increases in COI, and it is possible that other states will adopt regulations similar to the Proposed Regulations to address such concerns. As of early March 2017, we are not aware of any other state proposing regulations similar to the NYDFS’s Proposed Regulations.

The comment period for the Proposed Regulations expired on January 17, 2017 and the NYDFS has not yet published or responded to the comments it has received from industry, consumer groups and other interested parties.

ii. Circular Letter Addressing Replacement Practices Involving Deferred Annuities

On December 8, 2016, the NYDFS published a Circular Letter titled “Unsuitable Deferred-to-Immediate Annuity Contract Replacements and Betterment of Rate Calculations” (the “Circular Letter”) addressed to life insurance companies and insurance producers reminding them of their obligations under the New York Insurance Law with respect to suitability reviews and consumer disclosures. The Circular Letter was the result of the NYDFS’s investigation of industry practices involving sales or replacements of annuities. According to the NYDFS, while conducting examinations (both regularly scheduled and targeted), the NYDFS found “troubling” practices involving replacement of deferred annuities with immediate annuities. Specifically, the NYDFS alleges that licensees have been recommending replacements without first considering lost benefits and/or without showing customers a comparison between the income benefits of the existing annuity and the proposed replacement.

The Circular Letter addresses instances where an insurer replacing an annuity requests, but does not receive, information from the issuer of the existing annuity enabling it to provide a customer with necessary income comparisons. According to the NYDFS, in such instances, the replacement insurer can process the replacement (if it is otherwise suitable), but the replacement insurer must document the request for information and report to the NYDFS the replaced insurer’s refusal to provide the necessary information.

The Circular Letter also addresses requirements under the New York Insurance Law that annuity contracts contain a statement that the annuity benefits, at the time of their commencement, will not be less than what would be provided by the application of a certain amount (as described in the New York Insurance Law) to purchase any single consideration immediate annuity contract offered by the insurer at that time to the same class of annuitants. The NYDFS directs that insurers, regardless of whether it is in the context of a proposed replacement, establish a procedure to ensure that consumers receive the highest amount of income available in connection with the annuitization of an in-force deferred annuity contract. Insurers must also perform a comparison of (1) the income benefit derived from the guaranteed annuitization factors included in the existing annuity contract, and (2) the income benefit derived from the insurer’s annuitization factors available for new sales. According to the NYDFS, the insurer should use the factors that provide the consumer with the larger income benefit.

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11. NAIC Activity Relating to Big Data

The NAIC is exploring “insurers’ use of big data for claims, marketing, underwriting and pricing” and “potential opportunities for regulatory use of big data to improve efficiency and effectiveness of market regulation.” As an initial step in the NAIC’s exploration of this topic, the Big Data (D) Working Group held a public hearing on April 3, 2016 to hear presentations from four panels representing the perspectives of academics, industry, consumers and state insurance regulators, respectively. Going forward, the Market Regulation and Consumer Affairs (D) Committee (the “(D) Committee”) has appointed a new Big Data (D) Task Force (the “BDTF”) to continue to gather information to assist state insurance regulators in obtaining a clear understanding of what data is collected, how it is collected and how it is used by insurers and third parties in the context of marketing, rating, underwriting and claims. This includes an evaluation of both the potential concerns and benefits for consumers and the ability to ensure that data is being used in a manner compliant with state insurance statutes and regulations. The BDTF will also explore opportunities for regulatory use of data to improve the efficiency and effectiveness of insurance regulation. If appropriate, the BDTF is authorized to recommend modifications to model laws and regulations that overlap with insurers’ use of big data.

Consumer groups object to insurers’ use of big data out of concerns that predictive analytics may be used as a discrimination tool against certain types of consumers. The industry has previously objected to the NAIC’s efforts in this area as unnecessary because regulators have the authority to review insurers’ use of big data under existing laws and regulations.

12. Insurer Investments/Securities

a. NAIC’s Receivership and Insolvency (E) Task Force Asks States Not to Adopt Guideline for Stay on Termination of Netting Agreements and Qualified Financial Contracts

Previously, the Receivership and Insolvency (E) Task Force (the “RITF”) adopted a “Guideline For Stay on Termination of Netting Agreements and Qualified Financial Contracts” (the “Stay Guideline”), which recommends that states that adopt Section 711 of the NAIC Insurer Receivership Model Act (“IRMA”) also consider adopting a 24-hour stay on the ability of swap counterparties to terminate or close-out swaps with insurers in receivership. However, the applicable provisions of certain federal rules define qualifying master netting agreements but do not recognize a state’s insurance receivership law allowing a stay on termination of netting agreements and qualified financial contracts. NAIC staff is coordinating with the Federal Deposit Insurance Corporation (the “FDIC”) and other federal agencies to correct the current conflict between the Stay Guideline and applicable federal rules. Until the NAIC resolves the issue with the federal rules, the RITF has asked states not to consider adoption of the Stay Guideline.

The RITF adopted the Stay Guideline in order to match the 24-hour stay that applies to banks under the Federal Deposit Insurance Act (the “FDIA”). The 24-hour stay applicable to banks under the FDIA is a well-recognized and practical provision in light of the fact most bank receivers are appointed on a Friday afternoon, and the bank is

typically resolved over the course of the weekend. The practicality and utility of a 24-hour stay in the context of an insurer receivership (which typically moves much more slowly than a bank receivership) raises significant questions.

One of the primary benefits of a state adopting IRMA Section 711 provisions is that insurers domiciled in such states are then able to execute swap and derivatives transactions with banks at lower costs because such swaps and derivatives transactions qualify for netting treatment. However, under recently adopted federal rules, the applicable banking regulators only recognize a swap or derivatives agreement as a qualified netting agreement if:

“the agreement provides the [bank] the right to accelerate, terminate and close-out on a net basis all transactions under the agreement and to liquidate or set-off collateral promptly upon an event of default, including upon an event of receivership or insolvency, liquidation, or similar proceeding… provided that, in any case any exercise of rights under the agreement will not be stayed or avoided under applicable law… other than under the FDIA, Title II of the Dodd-Frank Act or under any similar insolvency law applicable to [Government Sponsored Entities]” (emphasis added).

Because the applicable provisions of the federal rules do not recognize stay periods such as those recommended by the RITF in the Stay Guideline, insurers domiciled in states that adopt the Stay Guideline will likely be subject to the same higher costs that banks are required to impose with counterparties that are not able to net their swap and derivative transactions under a qualifying netting agreement.

C. INTERNATIONAL (NON-U.S.) INSURANCE ISSUES

1. Insurers Contemplate the Impact of Brexit

On June 23, 2016, the UK voted by referendum to leave the EU, with a majority of 52% in favor. To formally begin the process of leaving the EU, the UK government must give notice to the EU of its desire to leave under Article 50 of the Treaty on European Union. At the time of this writing, the UK government has announced that it will provide such formal notification on March 29, 2017. Under the Article 50 procedure, the UK will have a window of two years to negotiate the terms of its relationship with the EU following Brexit, subject to any agreed extension.

How this relationship will be structured remains to be determined. Significantly for the insurance industry, the UK government has announced that the UK will not be part of the European Single Market following Brexit. One of the consequences of this is that UK firms are at risk of no longer benefiting from passporting rights. “Passporting” is the system that allows firms in one EU member state to provide services into another member state without the need for authorisation by the local regulators. This would also affect EU insurers that currently underwrite UK business.

It is possible that the UK will be able to negotiate a special arrangement which allows its financial industry to continue to have free access to the EU market. However, the uncertainty regarding the continuation of the passporting regime has prompted many insurers and other financial services firms to engage plans to move some of

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their operations to other EU countries in order to ensure their ability to continue to service their EU businesses. These include: Lloyd’s of London, which receives approximately 11% of its income from the European Economic Area (“EEA”), and is currently considering the optimal location for an EU hub; AIG, which recently announced that it will be establishing a subsidiary in Luxembourg; and UK-headquartered insurer Beazley, which plans to expand its Dublin office and establish a new insurance subsidiary there. Whether others follow suit depends on whether, and how quickly, an accommodation can be reached for the UK financial services industry.

Another consequence of the UK leaving the Single European Market is that in theory the UK authorities will no longer be subject to EU insurance regulation. In particular, it leaves open the possibility that UK regulators will be free to make changes to the solvency regime applicable in the UK post-Brexit. The EU-wide Solvency II regime finally came into force in January 2016, after more than 10 years of planning and negotiations, but UK insurers continue to call for revisions to certain aspects, and the UK government has been taking evidence from the industry as part of an inquiry into EU insurance regulation. Common criticisms include overly burdensome data reporting requirements and excessive market-risk capital charges for certain asset classes, such as asset-backed securities and investments in infrastructure.

Life insurers providing annuities and other long term guarantee products have also been particularly affected by the requirement to hold an additional risk margin, intended to represent the cost that would be incurred if the insurer had to offload its liabilities to another insurer. Its design has resulted in very large additional reserving requirements, and many life insurers have looked to cede their existing business to reinsurers outside of the EU and in some cases have ceased writing new business. Prudential plc, for example, took the decision to pull out of the annuity market entirely earlier this year, having already announced that they would cease underwriting bulk annuity transactions.

Few in the UK industry are calling for a wholesale rejection of the Solvency II framework, not least given the costs already incurred in implementing it, which are estimated at more than £3 billion. The Association of British Insurers has called for revisions to be made to the regime as soon as possible, regardless of the Brexit negotiations, which could take several years to reach a conclusion. It has claimed that some of the reforms could be achieved through changes to the way the UK regulators implement the regime, although in other areas changes would require agreement at the EU level.

The UK may also seek to be treated as an “equivalent” regime under Solvency II post-Brexit, particularly if it does not succeed in obtaining market access via passporting rights. A regime may be granted equivalent status in three areas: reinsurance (see Section IV.C.2 below), group solvency and group supervision. Equivalence would be helpful for UK reinsurers carrying on cross-border business into the EU, and would simplify group regulation for groups operating both in the UK and in the EU. But equivalence by itself would not allow UK firms to carry on business in the EU without local regulation.

Nevertheless, many in the industry would like to see the UK have the flexibility to determine its own regulatory regime, for the

reasons outlined above. This means the UK is likely to negotiate simultaneously for free access for its insurers to the EU market and for the freedom to alter certain aspects of Solvency II. It is difficult to predict what the outcome will be.

2. Solvency II Equivalence and Credit for Reinsurance

a. Introduction

With Solvency II in force since January 2016, equivalence continues to be a topic of interest to reinsurers based in countries outside the EEA, referred to as “third countries” using the Solvency II terminology. Certain jurisdictions have worked to secure equivalent status, making changes to their own regulatory regimes in the process, while others have been granted equivalence on a provisional or temporary basis. The U.S. may be afforded much of the same benefits as equivalence, depending on whether the Covered Agreement is adopted by the U.S. and the EU. Meanwhile in the UK, the Brexit vote means that the UK will be considering seeking equivalent status on leaving the EU.

As we explain below, equivalence means that local regulators are prevented from discriminating against reinsurers based in the relevant jurisdiction. However, in terms of the credit for reinsurance afforded to cedants under the Solvency II rules, the reinsurer’s financial strength and the extent to which the reinsurance is collateralized have greater weight.

b. What is Equivalence?

Where a third country is granted equivalence for reinsurance (pursuant to Article 172 of the Solvency II Directive), reinsurance contracts entered into with reinsurers in that jurisdiction must be treated in the same manner as contracts entered into with EEA reinsurers.

A third country may be granted equivalence in two other areas:

• Group solvency (Article 227): This relates to EEA groups with third country subsidiaries, and provides for such groups to apply the local capital requirements for their subsidiaries located in a third country, instead of applying a Solvency II calculation.

• Group supervision (Article 260): This relates to the group supervision of EEA firms with parents situated in a third country. Equivalence allows EEA supervisors to rely on the group supervision conducted by the regulators in that third country.

It is possible for a country to be granted equivalent status for one or two areas without being granted equivalence for all three. Currently the US, Australia, Brazil, Canada and Mexico have all been granted equivalence on a provisional (10-year) basis for group solvency, but not for reinsurance or group supervision. Japan has been granted equivalence on a temporary basis for reinsurance (until December 31, 2020), as well as equivalence on a provisional basis for group solvency. Bermuda and Switzerland have been granted equivalent status in all three areas (with the exception of captives and special purpose insurers in Bermuda).

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c. Effect of Equivalence on the Reinsurer’s Status Under Solvency II for Credit Purposes

Solvency II applies certain threshold requirements in order for a cedant to take a reinsurance arrangement into account in its calculation of the SCR. Under the standard formula, the reinsurer must be either:

• an EEA reinsurer;

• a reinsurer from a jurisdiction deemed equivalent for reinsurance (Article 172); or

• a reinsurer with a credit rating of credit quality step 3 or better (equivalent to Standard and Poor’s BBB/AM Best B+ rating).

Thus, a third country reinsurer may qualify through being located in an equivalent jurisdiction. But, equally, a reinsurer that is rated credit quality step 3 or better qualifies, whether or not it is located in an equivalent jurisdiction.

And even where none of the above applies (i.e., where the reinsurer is a third-country reinsurer in a non-equivalent jurisdiction and is unrated or rated below credit quality step 3), the cedant may still claim credit to the extent that the risk exposure is covered by collateral arrangements. Therefore, credit should also be available where the reinsurance is collateralized, regardless of equivalence, such as in the case of fully collateralized ILS transactions or collateralized longevity and other life reinsurance transactions.

d. Impact on Counterparty Default Risk Charge

Solvency II requires cedants to calculate a counterparty default capital risk charge to reflect reinsurer credit risk in the SCR. The calculation is based on a function of the loss given default (i.e., the exposure to the reinsurer) and the probability of default.

Where the reinsurer is rated, the probability of default is determined using the reinsurer’s external credit rating, irrespective of whether the reinsurer is located in an equivalent jurisdiction. For example, a reinsurer with an S&P “AA” rating is allocated a probability of default of 0.01%, under the standard formula.

Where the reinsurer is unrated and located in a third country, the probability of default does vary depending on whether it is located in a jurisdiction which is equivalent. Unrated reinsurers from equivalent jurisdictions are subject to a 0.5% probability of default under the standard formula, whereas reinsurers from non-equivalent jurisdictions are subject to a 4.2% probability of default. For the purposes of the probability of default calculation, “equivalence” is defined in the Solvency II Regulations by reference to Article 227 (group solvency), rather than Article 172 (reinsurance), and accordingly reinsurers from those jurisdictions that are provisionally equivalent for group solvency benefit in this context.

If the reinsurer posts collateral, this will then serve to reduce the counterparty default capital charge. Thus, in fully collateralized transactions, equivalence should not be material to the calculation. A high counterparty default charge can also be mitigated if the reinsurer is able to secure a guarantee from a rated affiliate, or a letter

of credit, in which case the credit rating of the guarantee provider or the issuer of the letter of credit may be used instead of the reinsurer’s rating.

e. Requirements to Pledge Collateral or Locate Assets in the EEA

As mentioned above, equivalence for reinsurance under Article 172 requires that EEA regulators treat reinsurance with a reinsurer in the third country in the same way that they would for reinsurance entered into with an EEA reinsurer.

More specifically, Solvency II prohibits EEA authorities from requiring the pledging of assets by reinsurers based in equivalent third countries to cover unearned premiums and outstanding claims (Article 173) and prohibits them from requiring assets representing reinsurance recoverables to be held in the EEA (Article 134).

Although most EEA regulators do not require collateral to be posted by third country reinsurers as a matter of course, the risk that regulators could impose such obligations, or other regulatory or administrative burdens, is a consideration for reinsurers in non-equivalent jurisdictions. Again, this risk is less significant for collateralized reinsurance, including much of the ILS market and collateralized life/longevity transactions, where collateral is posted by the reinsurer in any event.

f. Equivalence Does Not Provide a Right to Passport Services

Finally, it is important to note that being based in an equivalent jurisdiction does not mean a third country reinsurer has a right to provide reinsurance across the EEA without regard to local authorisation requirements.

An EEA reinsurer (or insurer) is able to use its home state’s authorisation to “passport” into other EEA states, either through cross-border services or by establishing a branch, without requiring an additional authorisation locally. However, a finding of equivalence does not enable third country reinsurers to benefit from passporting rights.

This is an issue that will be brought into focus during the Brexit negotiations. The UK will be subject to Solvency II up to the point of exit and, although it may decide to make certain alterations to the regime thereafter (see Section IV.C.1 above), it is likely to be granted equivalent status by the EU. However, that will not of itself enable UK insurers and reinsurers to continue to take advantage of the EEA passporting regime.

Third country reinsurers are required to obtain regulatory authorisation in each EEA state where they carry on regulated activities. Reinsurers are usually able to avoid falling within the regulatory regime by keeping all activity that relates to the business offshore. This is an issue that always needs to be considered by reference to the relevant local regulatory regime and in particular whether that regime’s requirements for authorisation are governed by the location of the risk as distinct from the place where the reinsurance business is carried on.

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3. Insurance Distribution Directive

On December 14, 2015, the European Council formally adopted the Insurance Distribution Directive (the “IDD”). The IDD will replace the Insurance Mediation Directive 2002/92/EC (the “IMD”) and introduce refreshed minimum regulatory standards for insurance sales in the EU. The IDD came into force on February 22, 2016 and the deadline for member states to transpose the IDD into their national laws is February 23, 2018.

The IMD has been part of the EU regulatory landscape since January 14, 2005. An overhaul of the IMD provisions was prompted by: inconsistency in the way the IMD regime had been implemented by Member States; development of a more complex insurance market and product offerings since the IMD was enacted; and a greater focus on consumer protection across all financial sectors since the 2008 financial crisis.

a. Summary of the Key Changes Under the IDD

The key amendments under the IDD are set out below:

• Direct sellers to be in scope: The IDD will apply not only to intermediaries but also to insurers that sell directly to their customers, including sales through aggregator websites, and certain ancillary sales (collectively, “distributors”). This extension of scope reflects the view that consumer protection should be the same regardless of the channel through which customers buy an insurance product.

• Enhanced professional requirements and internal policies: The IDD includes provisions that ensure a high level of competency and continuing professional development among insurance distribution firms and their employees. This includes the requirement for a minimum of 15 hours per year for professional training and development and the documentation and regular review of internal policies and procedures relating to competency and continuing development.

• “Customer’s best interests” principle; conflict management and product governance rules: The IDD introduces a general principle that insurance intermediaries and distributors must “always act honestly, fairly and professionally in accordance with the best interests of its customers,” and they are not to remunerate, incentivize or assess the performance of their employees in a way that conflicts with this duty. It also requires insurers and intermediaries that design insurance products to maintain, operate and periodically review the product approval process.

• New remuneration disclosures: The IDD requires that insurance intermediaries and distributors now disclose certain information about the nature of remuneration received, the basis of fees and whether any commission or other type of arrangement exists, prior to the conclusion of a contract.

• New cross-selling rule: In the context of the IDD, a “cross-selling practice” involves an insurance product being offered together with a non-insurance product or service as part of a package or the same agreement. The new requirements

relating to this practice vary depending on whether the insurance product is the main or ancillary product within the package and include, for example, a requirement to inform the customer whether it is possible to buy the different components separately, among others.

• Enhanced sales standards for insurance-based investment products (“IBIPS”): Under IDD, distributors of IBIPs will have: (i) increased disclosure requirements relating to the nature and risks associated with the IBIP; (ii) a requirement to assess the appropriateness of an IBIP for each customer (for non-advised sales); (iii) conduct suitability assessments (for advised sales); and (iv) an obligation to provide periodic reports to customers.

b. Developments in the Establishment of Delegated Acts, Technical Standards and Guidelines as Required Under IDD

The IDD gives the European Commission (the “Commission”) the power to adopt delegated acts relating to: (i) product oversight and governance (“POG”); (ii) management of conflicts of interest; (iii) the conditions under which inducements can be paid or received; and (iv) the assessment of suitability and appropriateness and reporting to customers. Delegated acts can be implemented as either Commission delegated regulations or decisions. It is anticipated that the IDD delegated acts would take the form of Commission delegated regulations, meaning they would apply directly to Member States without the requirement for transposition into national law.

On February 24, 2016 the European Commission asked the European Insurance and Occupational Pensions Authority (“EIOPA”) to provide technical advice on the possible IDD delegated acts. EIOPA has since published its final technical advice on February 1, 2017, outlining its proposals for the delegated acts. As part of the process, EIOPA published a consultation paper on the draft technical advice and held a public hearing with key stakeholders in September 2016 to discuss the issues that were under consultation.

c. Key Proposals in EIOPA’s Technical Advice

i. Product Oversight and Governance

POG arrangements are intended to place consumer interests at the centre of the life cycle of a product, from design and manufacturing to actually distributing the product to the market and such arrangements should be applied by all manufacturers of insurance products. EIOPA has extended its Preparatory Guidelines on POG (which currently apply to insurance distributors) to include any insurance intermediary that acts as a manufacturer of insurance products. In doing this, the technical advice explicitly clarifies the qualities that make an insurance intermediary a manufacturer of insurance products, rather than a distributor. It also specifies the level of granularity that is expected from manufacturers when defining their target market, which will depend on the type of product, the risk profile and the insurance coverage and sets out further detail on elements such as product testing, distribution channels and product monitoring and review.

In addition to setting out the POG specifications for manufacturers of insurance products, the technical advice also gives further detail

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on what is expected of insurance distributors that advise on and distribute insurance products which they do not manufacture, in order to provide effective product oversight and governance.

ii. Conflicts of Interest

EIOPA’s technical advice details the potential situations in which a conflict of interest may arise between an insurance distributor and its customers in the course of advising on and selling IBIPs. For example, situations where an insurance distributor were to make a financial gain or avoid a financial loss to the detriment of the customer or situations where an insurance distributor were to receive a financial or other incentive to favor one customer over another, would constitute a conflict of interest.

The technical advice also requires that insurance distributors take appropriate measures to avoid and manage any situations where there is a risk of a conflict of interest. They should implement and maintain a conflicts of interest policy, which should identify the circumstances where a conflict of interest may arise for that entity and specify the procedures to follow in order to manage and prevent such conflicts of interest from arising. If needed, insurance distributors can disclose conflicts to avoid any harm to customers, but EIOPA has made it very clear that disclosure should be viewed as a step of last resort and only used in circumstances where all organizational and administrative measures have been exhausted and are not sufficient to effectively prevent or manage a conflicts of interest situation. EIOPA would consider over-reliance on disclosure to indicate a deficiency in a firm’s conflicts of interest policy.

iii. Inducements

The IDD requires insurance distributors to apply the following general rules: (i) they must identify all inducements that are paid in connection with a product distribution; and (ii) they must establish adequate procedures and organizational measures to determine whether such inducement will have a detrimental impact on their customers. The technical advice gives guidance on the types of organizational arrangements and procedures insurance distributors should implement to be compliant with the IDD.

While the IDD does set out the parameters of what constitutes an inducement, it does not contain an explicit definition of inducement. Accordingly, EIOPA has clarified in the technical advice that an inducement is “any fee, commission or any other monetary or non-monetary benefit which is paid or provided in connection with the distribution of an insurance-based investment product or any ancillary service to or by any party except the customer or a person on behalf of the customer,” which corresponds with the Commission’s intention that inducements should apply to third parties only and not in relation to payments made internally by a firm to its employees.

In addition, and in line with the Commission’s request, EIOPA has also specified the criteria that an insurance distributor should use to determine whether inducements will have a detrimental impact on the quality of the services it provides to its customers. EIOPA makes it very clear that the list of criteria is non-exhaustive and is only intended to provide insurance distributors with guidance on

assessing the risk of a detrimental impact on the quality of the service they provide and how to recognize such risks; it is not intended to be a prohibition on inducements.

iv. Suitability or Appropriateness of IBIPs

In order to ensure effective consumer protection, EIOPA is of the opinion that assessing the suitability and appropriateness of a product for a particular customer is one of the most important regulatory obligations for insurance distributors. Accordingly, the technical advice states that it is essential that an insurance distributor selling IBIPs to customers gathers appropriate information from its customers to carry out a suitability and appropriateness assessment of the IBIP(s) for that customer. It also provides clear guidance on the type of information to be obtained in the assessment and the method for obtaining it. The type of information to be obtained includes an understanding the customer’s objectives, their financial situation and their knowledge and experience of the products.

The technical advice clarifies that the suitability and appropriateness assessment is only required for the distribution of complex IBIPs, therefore the sale of non-complex IBIPs can take place without such assessments being carried out. As part of the technical advice, EIOPA specifies the criteria to identify non-complex IBIPs which will help insurance distributors that sell IBIPs to recognize when they will have to conduct a suitability and appropriateness assessment.

d. Status and Next Steps

The technical advice is viewed as a key step in moving towards a better framework for governance in the sale of insurance products across Europe. The Commission is hoping to finalize the delegated acts by autumn 2017 to give the market clarity on the new rules as soon as possible and it is likely that these delegated acts will be based on EIOPA’s final technical advice. Accordingly, the recommendations in the technical advice will be relevant to insurance intermediaries and insurers affected by the IDD and should be included in any preparations that are being made ahead of the transposition of IDD into national law.

As it is unlikely that the UK will have left the EU by the transposition date, insurance intermediaries and insurers should continue to prepare on the basis that the IDD will be transposed into national UK law by February 23, 2018, and that they will therefore be subject to its provisions.

4. Final Rules on Solvency II Remuneration Requirements

Since last year’s publication of the Sidley Global Insurance Review, which outlined the Solvency II remuneration requirements that are contained in Article 275 of the European Commission Delegated Regulation (EU) 2015/35 (the “Solvency II Regulation”), the PRA has issued a policy statement (PS22/16) (the “Policy Statement”), including its final supervisory statement (SS10/16) (the “Supervisory Statement”), which was published in August 2016, which sets out its expectations of how compliance with the remuneration requirements under Solvency II might be achieved.

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The Policy Statement applies to significant (PRA Category 1 and 2) Solvency II firms, but the PRA comments that smaller (PRA Category 3-5) firms may use it as guide when reviewing their remuneration policies and practices against Solvency II’s requirements.

a. Recap of Solvency II’s Remuneration Requirements

Article 258(1)(l) of the Solvency II Regulation requires Solvency II firms to adopt a written remuneration policy, in respect of which Article 275(1) sets out the following overarching governance requirements:

• A (re)insurer’s remuneration policy and practices must: (i) align with its business and risk management strategy, and the long-term interests and performance of the undertaking as a whole; and (ii) aim to avoid conflicts of interest.

• The remuneration policy must apply to all employees and contain specific arrangements relating to: (i) members of the (re)insurer’s administrative, management or supervisory body; and (ii) persons who either effectively run the firm or could potentially have a material impact on its risk profile. (For this purpose, the persons to whom these specific arrangements apply are referred to as “Solvency II staff”.)

• There should be clear, transparent and effective governance of the remuneration policy.

• Where appropriate, given the size and internal organization of the (re)insurer, an independent remuneration committee must be established to oversee the design and implementation of the remuneration policy.

• The remuneration policy must be disclosed to each employee.

Article 275(2) of the Solvency II Regulation sets out the following specific requirements for Solvency II staff:

• The fixed and variable components of remuneration should be balanced so that the fixed element represents a sufficiently high portion of the total remuneration.

• Performance-related variable remuneration should be based on a combination of individual performance (including both financial and non-financial metrics), business unit performance and overall performance of the (re)insurer or the group to which it belongs.

• A substantial portion of the variable remuneration should be deferred for a period of at least three years, depending on the nature of the business, its risks and the activities of the relevant employees.

• The measurement of performance must include a downwards adjustment for exposure to current and future risks.

• Termination payments must relate to performance over the whole period of activity and must not reward failure.

• Solvency II staff must not use personal hedging strategies or remuneration and liability-related insurance which would undermine the risk alignment effects embedded in their remuneration arrangement.

b. The PRA’s Guidance Under the Policy Statement

The Policy Statement addresses the following key points.

i. Requirement for a Remuneration Policy for the Whole Undertaking

Entities within the same Solvency II group do not need to have the same remuneration policy, but any material differences between: (i) the remuneration arrangements for Solvency II staff identified in non-EEA entities; and (ii) the remuneration arrangements for other group Solvency II staff must be reported and explained to the PRA. The PRA accepts that modifications to the remuneration policy may be necessary to accommodate jurisdictional restrictions.

The PRA will be keen to see a high degree of consistency across individual policies to enable the remuneration policy to be controlled at the group level. Risk management and internal control systems should also be applied consistently across all entities within the Solvency II group (including non-Solvency II entities, such as service companies). Material risks identified at a group level should be reflected appropriately in the design of remuneration arrangements across all group entities.

ii. Identification of Solvency II Staff

Solvency II staff should include the following individuals:

• Board members.

• Executive committee members.

• Senior Insurance Manager Function (“SIMF”) holders and Significant Influence Function (“SIF”) holders.

• Key Function holders (“KFH”) for risk management, compliance, actuarial and internal audit as well as any other function “of specific importance to the sound and prudent management of [the firm’s] business, such as the investment function, IT function or a claims management function,” including not only group heads but also individuals with “significant levels of responsibility” at regulated entity level and across material business lines.

• Individuals able to take material risks or influence material risk taking, in each case, determined by reference to the risk profile specific to the firm (“MRTs”). The PRA provides the following examples of MRTs:

{ Voting committee members responsible for overseeing risk-taking activities (e.g., setting risk appetite limits) across the firm, group or material business lines.

{ Senior staff members working within key functions (who are not necessarily KFHs) with significant levels of responsibility for monitoring adherence to the firm’s risk

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appetite and framework (especially if charged with overall responsibility for their function within a material division or business line).

{ Individuals operating within the constraints of committee-set limits where the risk-taking authority and level of decision-making responsibility attached to their role have the potential to significantly increase the risk of harm to the firm in reasonably foreseeable adverse scenarios.

{ Senior staff members who perform activities on behalf of a Solvency II firm that have a material impact on the risk profile of either: (i) that firm and/or another Solvency II entity within the group; or (ii) the group as a whole.

The PRA emphasizes the importance of the individuals to whom the Senior Insurance Managers Regime applies being identified as Solvency II staff.

iii. Process for Identifying MRTs, Engagement With Regulatory Supervisors and Recordkeeping

Firms should be able to point to an identification process for MRTs, which applies consistent materiality thresholds (e.g., a quantitative risk threshold (monetary or other metrics) for underwriting limits relative to the firm’s overall risk). Firms can engage with their PRA supervisor before finalizing that process.

Records should be kept of the assessments made and the final list of MRTs identified for each performance year.

iv. Deferral Requirements for Solvency II Staff

With respect to Article 275(2)(c) of the Solvency II Regulation (which requires that a “substantial portion” of variable remuneration must be deferred for a minimum of three years), the Supervisory Statement states as follows:

• A “substantial portion” of variable remuneration (looking at the total amount rather than the amount of distinct variable remuneration awards) is very unlikely to be less than 40%.

• “Variable remuneration” should be read as the aggregate amount awarded in a given performance year from bonus plans, long-term incentive plans (“LTIPs”) and/or any other variable remuneration plans in which the individual participates.

• With respect to timing, “there is no flexibility … for Solvency II firms to elect a shorter period.” The natural life cycle of the business and associated risks should inform the length of the deferral period. The variable remuneration must then vest no faster than pro-rata from year one. Multiperiod schemes can operate within the same deferred bonus plan or LTIP.

With respect to the requirement under Article 275(2)(e) of the Solvency II Regulation for firms to apply downwards adjustments to awards of variable remuneration, the PRA expects firms to consider whether they should reduce the value of all or part of deferred

variable remuneration based on ex post risk adjustments prior to awards vesting and to be able to do so (e.g., by reducing current year awards) where appropriate.

v. Assessment of Individual, Business Unit and Firm or Group Performance for the Purposes of Calculating the Variable Remuneration of Solvency II Staff

Article 275(2)(b) of the Solvency II Regulation requires the total amount of variable remuneration to be based on a combined assessment of individual, business unit and firm or group performance. With respect to performance measurement, the Supervisory Statement states as follows:

• The requirement to incorporate into incentive plans non-financial (as well as financial) metrics for measuring performance should focus at the individual level. Non-financial metrics should include the extent to which the individual adheres to effective risk management and complies with regulatory requirements relating to the activities he or she undertakes.

• Individual performance assessment should be based on a balanced scorecard, such that the weightings attached to profit measures (e.g., net income) or value creation measures (e.g., total shareholder return or return on equity) are restricted.

• It is appropriate for firms to have a degree of flexibility as to how they satisfy the requirement for the measurement of performance to include a downwards adjustment for exposure to current and future risks. Nonetheless, firms should be prepared to show the PRA how they have taken into account the risks they face in the short to long term and the cost of capital when determining variable remuneration at aggregate and individual level.

vi. Proportionality

The PRA will try to avoid the potential for disproportionate outcomes across sectors. Specifically on the subject of disapplying provisions on deferral, the PRA comments in the Supervisory Statement that, when assessing a firm’s compliance with Solvency II’s remuneration requirements, it will take as an indicator of proportionality the UK banking sector’s circumstances of disapplication (which provide for the prescriptive requirements on deferral to be disapplied where the individual has total remuneration of no more than £500,000 and has been awarded variable remuneration of no more than 33% of his or her total remuneration), notwithstanding that Solvency II does not provide for such disapplication of the deferral requirements.

vii. Evidencing to the PRA Compliance With Solvency II’s Remuneration Requirements

The PRA has designed a Remuneration Policy Statement (“RPS”) reporting template for Category 1 and 2 firms, which includes a Solvency II staff list table, for firms to use in order to demonstrate their compliance with Solvency II’s remuneration requirements. It is, however, open to firms to document their remuneration policies differently.

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For Category 1 and 2 firms with an accounting reference date of December 31, 2016, the PRA requested submission of the RPS (or equivalent document) by October 31, 2016. For firms with an accounting reference date later than December 31, 2016, the RPS (or equivalent document) should be submitted no later than 10 months after the end of the preceding financial year.

5. Regulatory References

The PRA and the FCA have separately issued final rules and guidance on requirements to request and provide employment references containing information on a candidate’s conduct and fitness and propriety (referred to as “regulatory references”) when recruiting individuals to perform certain functions.

The first tranche of rules on regulatory references came into force on March 7, 2016 as part of the senior insurance managers regime and were, in large part, a continuation of the requirements under the approved persons regime.

a. Scope of the New Rules

The new rules came into force on March 7, 2017 and will apply to (re)insurers and UK branches of third-country undertakings within the scope of Solvency II, as well as to the Society of Lloyd’s and managing agents and insurance special purpose vehicles.

The requirements to obtain and provide references will apply in respect of the “relevant functions” as follows:

• PRA senior insurance management function holders (e.g., the Chief Executive Officer or the Chief Finance Officer);

• FCA controlled functions;

• Key function holders (“KFH”) who are senior persons effectively running an insurer or who have responsibilities for key functions at the insurer; and

• Notified non-executive directors (“NED”) whose appointment is not subject to regulatory pre-approval, but where the appointment is subsequently notified to the regulator.

b. Requesting Regulatory References

The previous rules required firms that were considering hiring a candidate to perform a relevant function to take reasonable steps to obtain references from that candidate’s current and previous employers covering the past five years. The new rules extend the period for requesting references to the previous six years of employment and also broaden the scope to include candidates being considered for a KFH role.

The requirement to request references extends to employers in overseas firms. While the requirement is to take reasonable steps to obtain the necessary information, local legal restrictions may make this requirement difficult to satisfy. However, the PRA notes in its policy statement that it will “take into account any demonstrable relevant legal impediments when assessing whether firms are complying with this requirement.”

With respect to intra-group hires, the PRA recognizes that it would be disproportionate to obtain full regulatory references when appointing an individual from a firm which is part of the same group. However, this requirement is only relaxed where the group’s internal policies and procedures allow the firm that is seeking to hire the candidate access to all the information it requires to assess the candidate’s fitness and propriety (subject to any applicable laws).

c. Providing Regulatory References

Where a regulated firm receives a request from another regulated firm to provide a reference in respect of a candidate seeking to perform a relevant function, the regulatory reference must be provided using a mandatory template. In addition, it must also include information on breaches of the PRA’s or FCA’s conduct standards and Statements of Principle and Code of Practice for Approved Persons (“APER”) or any other relevant historic rules, but only where such breach has resulted in disciplinary action.

The disciplinary action relating to the breaches is limited to the period in the six years preceding the request for a regulatory reference or between the date of the request for a regulatory reference and the date the reference is given. Firms are also required to disclose whether they concluded that the candidate was not fit and proper to perform a function at any point in the six years prior to the request for a regulatory reference together with the facts that led to such conclusion.

As well as specifying mandatory information, there is also the opportunity for firms to make further disclosures in the “all relevant information” section of the template. In its policy statement, the PRA has helpfully provided guidance on what this might include. The disclosures in this section could be used to provide further background on a breach disclosed in the “mandatory information” section, for example, “mitigating circumstances and/or subsequent corrective action or good conduct by the individual.” Disclosures in this section will also need to cover the previous six years, however, where the disclosures relate to serious matters, these will not be subject to a time limit. The PRA has set out some non-exhaustive examples of what matters may be considered serious enough to fall within this section, three of which are set out below:

• a serious breach of rules directly applicable to the individual (i.e., the regulators’ conduct rules);

• misconduct that resulted in enforcement action by the regulators against the firm and/or the individual concerned;

• conduct that would have caused the firm providing the reference to dismiss the individual in accordance with its internal code of conduct if it had been discovered while the individual was still working there.

Firms are required to comply with their legal obligations when considering what and how much information to include in a regulatory reference. In preparing a reference, firms owe a duty to their former employee and the recipient to “exercise due skill and care,” therefore references “should be true, accurate, fair and based on documented fact.”

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d. Updating Regulatory References

There is a further requirement for firms to revise regulatory references they had given in the previous six years if those firms become aware of matters that would cause them to draft the reference differently were they to draft it now.

Despite some respondents to the PRA’s consultation paper (CP36/15) suggesting that the six-year period was unduly burdensome, the PRA considers that in order for the requirement “to be effective in preventing the recycling of individuals with poor conduct records throughout the financial services sectors, it must cover a relatively long period.” The six-year period for updating regulatory references should start on the date when the individual’s employment with the firm terminates; this includes any relevant notice periods, garden leave or equivalent. The requirement to update references only applies to references given from March 7, 2017 onwards.

One point to note is that, notwithstanding the six-year updating period, if sufficiently serious, disclosures in a regulatory reference may include misconduct or other matters that occurred more than six years ago, but which firms only became aware of during the six year updating period.

In the event that an individual moves firms multiple times in the six year updating period, the PRA has confirmed that firms providing an updated reference will only be required to provide it to the individual’s current employer and not to any other employers that the individual may have had since leaving the firm providing the reference and joining the current employer.

e. What is the Impact on Firms?

The disclosure requirements for these new rules are two-pronged for firms. On the one hand, firms should now be sufficiently informed when considering a candidate, enabling it to determine whether the individual is fit and proper to perform the required role. On the other hand, firms also have the additional administrative burden of maintaining their records on previous employees for the relevant time period to ensure continuing compliance with the new rules. Coupled with this potentially onerous duty is the judgment-based decision on how much to disclose in these references, which could require external advice to ensure firms do not breach their legal obligations. Firms should consider whether an internal review needs to be undertaken for adopting a consistent approach to matters that may need to be disclosed in the references they give as well as assessing whether their internal processes need upgrading to manage the additional record-keeping.

6. Insurance Act 2015

A major overhaul of English insurance contract law entered into force last year in the form of the Insurance Act 2015, applying to contracts entered into on or after August 12, 2016. In this section, we summarize the key changes and highlight some of the uncertainties around the impact on underwriting, policy wording and claims handling.

Parties to non-consumer insurance contracts will be free to contract out of most of the reforms contained in the Act, provided that if the insured’s rights are negatively affected, the term will only be valid if

the insurer has taken sufficient steps to draw it to the attention of the insured before the contract is entered into and its effect is clear and unambiguous.

a. New Duty of Fair Presentation (Non-Consumer Contracts Only)

A new “duty of fair presentation” now covers the insured’s duty to disclose material facts and not make material misrepresentations.

The insured must disclose every material circumstance that it knows or ought to know, but can now discharge this duty by disclosing sufficient information to put a prudent insurer on notice that it needs to make further inquiries for the purpose of revealing those material circumstances. The insured must also disclose matters in a manner that is reasonably clear and accessible.

The Act also provides that an insured “ought to know what should reasonably have been revealed by a reasonable search of information available to the insured.” The intention of the provision is to encourage insureds to put in place better internal information processes. But many insureds (and reinsureds), and their brokers, have naturally been looking to clarify or otherwise limit this requirement, for example, by agreeing the scope of the information available to the insured.

b. Remedies for Breach of the Duty of Fair Presentation

The insurer’s “all or nothing” remedy of avoiding the contract for an insured’s non-disclosure or misrepresentation is now superseded by a matrix of remedies intended to be more proportionate to the breach. If the insured deliberately or recklessly breaches the duty of fair presentation, the insurer will still be entitled to avoid the policy and refuse all claims and will not be required to return any premium. If the breach is not deliberate or reckless, the remedy depends on how the insurer would have treated the contract had it been given the relevant information:

• Where the insurer would not have entered into the contract on any terms, the insurer will still be entitled to avoid the policy and refuse all claims, returning the premium.

• If the insurer would have entered into the contract but would have charged a higher premium, the insurer will not be entitled to avoid the policy but will have a right to reduce any claim payment proportionately.

• Where the insurer would have entered into the contract on different terms, other than premium terms, the insurer will not be entitled to avoid the policy but will have a right to treat the contract as though entered into on those different terms.

The logic of requiring proportionate changes to policy terms or reductions to claims payments where the insured has innocently failed to disclose material facts is clear in theory. However, it introduces a new degree of uncertainty for insurers in claims handling. The extent to which insurers will, in practice, be prepared to dispute claims for innocent non-disclosure by reference to the hypothetical terms on which they would have underwritten the policy remains to be seen.

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c. Warranties: the Insurer’s Remedy for Breach is that its Liability is Suspended, Not Discharged

Prior to the reforms, a breach of warranty by the insured would discharge the insurer from all future liability under the policy as from the date of the breach. Technically the insurer could refuse payments in respect of events occurring after the insured rectified the breach.

The Act addresses this by providing that a breach of a warranty will only affect the insurer’s liability in relation to events occurring after the breach and before the breach has been rectified. In other words the insurer’s liability will be suspended during the period when the breach is occurring, but if that breach is rectified so that the insured is in compliance, the insured would be entitled to claim for subsequent events.

d. Warranties: Remedy for Breach of Warranty Now Contingent on Relevance to Risk of Loss

The Insurance Act 2015 now provides that the insurer may not refuse a claim on account of a breach of warranty if the insured can show that the breach did not increase the risk of loss.

For example, where an insured suffers loss through burglary, but has breached a warranty that it would maintain a fire alarm in working order, the insured should be able to show that had the alarm been operational it would have made no difference to the risk of burglary, and therefore the insured should be able to make a claim under the policy.

Previously, an insurer would be discharged from future liability upon a breach by the insured, regardless of whether the breach was relevant to the loss, which was widely thought to be commercially counterintuitive and unfair.

Linking the breach to the risk of loss is, however, a new concept in English law and is likely to prove a fertile area for dispute. The Insurance Act 2015 specifies that the insured must show that the non-compliance “could not have increased the risk of loss which actually occurred in the circumstances in which it occurred.” The drafting of this provision has been criticized for lack of clarity. Although it may be reasonably obvious that the test is satisfied in the burglary situation described above, there will no doubt be circumstances where this is less clear cut.

e. Damages for Late Payment

Following a recent amendment to the Act, insurers will be subject to an implied term that they must pay claims within a reasonable time, applying to contracts entered into on or after May 4, 2017. For the first time under English law, it will allow a policyholder to claim compensation for losses resulting from an insurer’s delay, in addition to any interest owed on the claim amount. This introduces a number of uncertainties.

For example, in order to claim damages, general contract law principles require that the policyholder will need to show that the insurer’s late payment caused the policyholder to suffer a loss that was reasonably foreseeable. This is a question that will be decided by the courts on a case-by-case basis.

Another significant area of uncertainty is what constitutes a “reasonable” amount of time to pay out a claim. The Act provides that a reasonable time includes a reasonable time to investigate and assess the claim, and gives a non-exhaustive list of possible factors that may influence a court, including (i) the type of insurance, (ii) the size and complexity of the claim, (iii) the insurer’s compliance with regulation and (iv) factors outside the insurer’s control. However, again the question will only be determined on a case-by-case basis given the huge variation in the time it takes to investigate and assess different types of claim. Where practicable, insurers may wish to negotiate the inclusion of a definition of “reasonable time” in the contract in order to reduce the risk of dispute.

The Act also provides that if the insurer shows that there were reasonable grounds for disputing the claim, the insurer does not breach the term merely by failing to pay the claim while the dispute is continuing. What constitutes “reasonable grounds” will again be a matter for the court, and this uncertainty may put pressure on insurers to settle disputed claims. Industry representatives have voiced concerns that this could lead to an increase in speculative claims, particularly in relation to large and complex claims.

Insurers will be considering the following practical issues:

• Internal documentation: The possibility of late payment actions increases the importance of implementing effective procedures for documenting the handling of claims and, in particular, recording the reasons for any delays.

• Contracting out: Underwriters will need to consider their commercial approach to contracting out or otherwise limiting exposure contractually where possible.

• Reinsurance: Reinsurance wordings should be reviewed; outwards reinsurers may or may not be prepared to provide cover for liability for late payment.

• Claims control: Insurers should consider the risk of liability where they do not have control of claims and may therefore be exposed to mishandling by a third party. This may be relevant, for example, in the case of a following insurer on the subscription market, an insurer taking an excess layer or an insurer which has relinquished control to its reinsurer. Parties to these arrangements may wish to agree how such risk will be allocated.

7. Third Parties (Rights Against Insurers) Act 2010

The Third Parties (Rights Against Insurers) Act 2010 improves the position of third parties that have a liability claim against an insolvent insured, replacing the 1930 Act of the same name. It came into force on August 1, 2016 and applies where either the insured’s insolvency proceedings have commenced or the insured’s liability was incurred on or after that date. The key changes brought in by the 2010 Act are summarized below.

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a. Right of the Third Party to Bring Proceedings Directly Against the Insurer

The principal reform brought in by the 1930 Act was to transfer the rights of an insolvent insured under a liability policy directly to the third-party claimant, so that in theory the claimant would not be prejudiced by having to prove in the insolvency of the insured and potentially receiving a reduced payment. However, the third party was required to establish the insured’s liability before it could enforce its right to payment from the insurer.

Under the 2010 Act, a third party may now bring proceedings directly against the insurer, without first having to obtain judgment against, or settlement with, an insolvent insured. The third party may seek to establish the claim against the insured and the insurer’s liability under the policy in the same proceedings.

A third party may now also bring proceedings against the insurer where the insured company has been dissolved, without having to first restore the insured to the register of companies.

b. Right to Request Information From Insurers, Brokers and Others

Third parties also previously faced difficulties in obtaining information with respect to whether the liable party had insurance, and the details of such insurance, prior to establishing the insured’s liability. These difficulties were substantially reduced following the 2004 case Re OT Computers, where the Court of Appeal ruled that the third party had a right to obtain information from the insured upon its insolvency, and did not need to establish liability first.

Now, under the 2010 Act, a third party may request information relating to an insurance policy from any person where the third party reasonably believes that it has a liability claim, that the claim is covered by an insurance policy and that such person is able to provide the information.

Insurers and brokers should note that the recipient must provide any such information (where it is able to do so) within 28 days. The information that may be requested includes the identity of the insurer, the terms of the contract, details of any proceedings that have commenced and the extent to which any aggregate limit has already been used.

c. Limitations on the Defenses Available to the Insurer

The 2010 Act also introduces several limitations on the defenses available to the insurer, aimed at preventing the insurer from denying liability on certain “technical” grounds:

• The insurer may not require that the insured fulfill a condition in the policy (for example, a claims notification condition) where the condition has been fulfilled by the third party.

• The insurer may not rely on a condition that requires the insured to provide information or assistance where the insured cannot fulfill such condition because the insured has died (if an individual) or has been dissolved.

• The insurer may not rely on a condition that requires the insured to pay the liability claim before being entitled to payment under the insurance (a “pay first” clause). In the case of marine insurance, this rule is limited to claims for personal injury or death.

8. EU and Member State Competition Law Enforcement Activity

a. EU-level Enforcement by the European Commission

On March 17, 2016, the Commission published a report on the functioning of the EU’s Insurance Block Exemption Regulation (“BER”), in which the Commission concluded that the strict conditions for the creation of the BER no longer seemed to be met. On December 13, 2016 the Commission announced that it had decided not to prolong or amend the BER, which expires on March 31, 2017. The expiry of the BER means that insurers and reinsurers must “self-assess” the compatibility with EU competition rules of arrangements that would otherwise have benefited from the safe harbor created by the BER. The Commission has indicated that it is considering whether to issue new, sector-specific guidelines, to complement its existing guidelines on horizontal co-operation agreements.

In addition to its work on the BER, in June 2016 the Commission published a study on the role of digitalization and innovation in a single market for retail financial services and insurance. The study examined the types of providers and consumers engaged in cross-border sales and certain remaining barriers, such as limited interoperability and regulatory divergence. In June 2016 the Commission also published an inception impact assessment on the Motor Insurance Directive (2009/103/EC). The assessment indicates that the Commission will establish an interservice steering group, with the participation of the Directorate-General for Competition, to determine whether to extend the scope of compulsory liability insurance.

b. National Level Enforcement in the UK

Although the Commission did not initiate any EU-level insurance-related cases in the course of 2016, there has continued to be significant enforcement activity at a national level, especially in the UK. The UK’s main competition authority, the Competition and Markets Authority (“CMA”), has continued its insurance-related investigations. Its fellow regulator, the FCA, acquired full, “concurrent” powers to enforce EU and UK competition law on April 1, 2015, and has also stepped up its investigatory activity in relation to the insurance sector.

i. CMA Implementing Measures in Car Insurance Market Investigation

On August 1, 2016 the final provisions of the CMA’s Private Motor Insurance Order (“Order”) entered into force, requiring insurers to supply formulae for calculating discounts and both price comparison websites (“PCW”) and insurers to supply certain standard information concerning no-fault claims. The Order’s other key provision, prohibiting insurers and PCW from entering into agreements that

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contain most-favored nation clauses, already entered into force on April 19, 2015. Insurers and PCW are required to submit regular compliance statements under the Order.

ii. CMA Digital Comparison Tools Market Study

On September 29, 2016 the CMA launched a market study into digital comparison tools (“DCT”), including price comparison websites and smartphone apps, in order to understand how DCT enable consumers to compare products and services on quality and price, and to help them to switch between suppliers of home insurance, credit cards, broadband, and flights. An interim report is expected in March 2017, followed by publication of a final report in September 2017.

iii. FCA General Insurance “Add-On” Market Study

The FCA introduced a series of new rules and guidance following the publication in July 2014 of its general insurance “add-on” market study. By September 2015 three of the four remedies proposed by the market study had already been introduced. In March 2016 the FCA published a response to feedback received on its fourth proposed remedy, a requirement to publish claims information, and undertook to launch a pilot program, the results of which (including data on acceptance rates and average pay-outs by firms) the FCA published in January 2017.

iv. FCA Review of Annuities and Retirement Income Market Study

In July 2016 the FCA commenced a review of the retirement income sector, following the UK government’s pension reforms in April 2015. In November 2016 the FCA also opened a consultation on a rule to require firms to include price comparisons in their pre-sale disclosure to annuity customers. A policy statement is anticipated during spring 2017, with new rules entering into force in September 2017. Her Majesty’s Treasury has also announced that the prototype of a pensions dashboard proposed by the FCA is expected to be in place by March 2017.

v. FCA Consultation on Increasing Transparency and Engagement at Renewal in General Insurance Markets

On March 4, 2016 the FCA’s consultation closed on rules requiring firms to disclose the previous year’s premium on renewal notices and to provide text to encourage consumers to shop around, including an additional message for consumers who renew their policies four or more times. The final rules, published in August 2016, apply from April 1, 2017 to both insurers and intermediaries who deal with the consumer at the point of renewal in relation to general insurance products which are provided to retail consumers in the UK.

vi. FCA Call for Inputs on Big Data in Retail General Insurance

In a report published in September 2016, the FCA found that the increased use of data and data analytics software by insurers is “broadly having a positive impact on consumer outcomes,” but also

identified two areas where increased use of “Big Data” may have the potential for mixed outcomes: (i) risk segmentation, which the FCA believes could leave some consumers unable to obtain or afford insurance, and (ii) price discrimination based otherwise than on the risk insured. The FCA has committed to undertake further targeted studies in this area.

vii. UK CAT Judgment and Insurance for Breaches of Competition Law

In July 2016 the UK Competition Appeal Tribunal held in Sainsbury’s Supermarkets Ltd v MasterCard Inc that the principle of ex turpi causa, which may prohibit a claimant from recovering damages for the consequences of its own wrongful acts, can also apply to an infringement of competition law, so long as such infringement is negligent or deliberate. Although the principle arose as a defense to a damages claim, elsewhere the English courts have held that it can also operate to preclude a claim by an insured party for an indemnity under an insurance policy.

In July 2016 the Court of Appeal of England and Wales held that the capping of consultants’ fees by certain private medical insurers had the potential to distort competition, but that it had seen no evidence of such an effect. The court also held that it should be anticipated that the actions of the insurers, as buyers of the consultants’ services, would benefit policyholders in the form of lower premiums. The case concerned a challenge to a CMA order in October 2014 requiring healthcare operators and consultants to publish information about consultants’ fees.

viii. Court of Appeal Judgment on Fee-Capping by Medical Insurers

In July 2016 the Court of Appeal of England and Wales held that the capping of consultants’ fees by certain private medical insurers had the potential to distort competition, but that it had seen no evidence of such an effect. The court also held that it should be anticipated that the actions of the insurers, as buyers of the consultants’ services, would benefit policyholders in the form of lower premiums. The case concerned a challenge to a CMA order in October 2014 requiring healthcare operators and consultants to publish information about consultants’ fees.

c. National Level Enforcement in Austria

In March 2016 the Austrian competition authority, the Bundeswettbewerbsbehörde (“BWB”), discontinued its sector inquiry into the healthcare industry due to funding shortages. To date, the inquiry had identified potential vertical restrictions between hospitals and insurances companies.

d. National Level Enforcement in Bulgaria

In September 2016 the Bulgarian Commission for the Protection of Competition (“CPC”) opened proceedings against nine insurance companies for alleged resale price maintenance. The CPC indicated that agreements between insurers and intermediaries reviewed as part of its earlier market study of the insurance sector contained clauses which indirectly restricted intermediaries from determining their discounts to end customers or which required the consent of the insurer.

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e. National Level Enforcement in Finland

On May 4, 2016 the Finnish Competition and Consumer Authority (“KKV”) published a market study which found that improvements are needed in the country’s insurance market for road haulage companies in order to promote consumer switching. Hauliers cited the time needed to compare services and to negotiate a new deal as reasons for limited switching, and the KKV stated that it would continue to monitor the market.

f. National Level Enforcement in France

On February 18, 2016 the French Cour d’appel upheld a decision by the French competition authority, the Autorité de la concurrence, to reject a complaint against a public health insurance fund for refusing to provide unencrypted historical patient data to the complainant for use in a drug study, as the insurer was acting in its capacity as a provider of a public service.

On October 24, 2016 the Autorité also rejected a complaint by a dental union (“CNSD”) alleging that health insurer Santeclair had colluded with dentists in its own network to publish statements suggesting that certain cheaper treatments would suffice in place of more expensive ones offered by CNSD dentists. The complaint was rejected for insufficient evidence.

g. National Level Enforcement in Germany

In October 2016 the Federal Cartel Office published a white paper on the scope for enforcement of consumer protection rules by antitrust authorities, such as rules to promote transparency in price comparison in a number of industries, including insurance.

h. National Level Enforcement in Greece

On February 16, 2016 Greece’s competition authority, the Hellenic Competition Commission (“HCC”), announced that it would reconsider adopting an infringement decision against four insurers alleged to have colluded over car repair costs. The HCC’s order against the insurers to pay fines totaling €32.4 million in 2009 was annulled by the Athens Administrative Court.

i. National Level Enforcement in Hungary

On September 26, 2016 the insurers Generali and Allianz and an insurance broker of Peugeot brand dealers offered commitments to the Hungarian Competition Authority, the Gazdasági Versenyhivatal (“GVH”), in order to end an investigation into alleged fixing of vehicle repair fees and conditional bonus payments for brokers who met certain insurance product sales targets.

On July 31, 2016 a Hungarian appeal court upheld a fine of €580,000 against importers of car paints for colluding to increase the amount which insurers would reimburse. Garages connected with the importers supplied the paints to insured parties. Insurers reimbursed the garages on the average cost of materials, which the importers had systematically under-reported.

j. National Level Enforcement in Ireland

In September 2016 the Irish Competition and Consumer Protection Commission (“CCPC”) issued witness summons and information requests to motor insurance providers and insurance industry groups in Ireland, as part of an investigation into open statements made by industry participants signaling their upcoming increases in motor insurance premiums.

k. National Level Enforcement in Italy

In October 2016 Italy’s competition authority, the Autorità Garante della Concorrenza e del Mercato (“AGCM”), opened an in-depth investigation against the Italian consortium CODIPRA, which the AGCM alleged to have abused a position of dominance in the agricultural insurance sector by seeking to exclude its only competitor, Coop di Italia, from the market, through exclusive dealing agreements and discounts for use of insurance brokerage services supplied by CODPRA’s subsidiary Agriduemila.

On December 15, 2016 the AGCM also launched an in-depth investigation against twelve leading Italian insurance companies, including Unipol and Assicurazioni Generali, in respect of open statements made by the companies to the motor vehicle insurance market. The AGCM alleges that the separate statements, which predicted prices increases, may eliminate uncertainty in the insurers’ respective future pricing strategies.

l. National Level Enforcement in Latvia

In December 2016 the Lativian Competition Council (“CC”) published results of a research project which identified the Latvian insurance sector as among the sectors on which the CC would focus its enforcement efforts.

m. National Level Enforcement in the Netherlands

In February 2016 the Dutch Competition Authority, the Autoriteit Consument en Markt (“ACM”), published a study that found that the Dutch health insurance market was at risk of tacit collusion, due to market concentration and certain regulatory transparency rules. In June 2016 the ACM published guidelines on collective procurement of prescription drugs, which set out a new safe harbor for purchasing agents of hospitals and health insurers, and in September 2016 called upon health insurers to increase transparency for their customers on the tariffs charged for hospital treatments. In January 2017 the ACM published a report in which it identified barriers to entry into the Dutch health insurance market.

n. National Level Enforcement in Poland

In December 2016 Poland’s Office of Competition and Consumer Protection began an investigation into motor insurance companies over alleged price fixing, following substantial increases in third-party insurers’ prices.

o. National Level Enforcement in Romania

In February 2016 the Romanian Competition Council (“RCC”) published the results of a sector inquiry into the automotive insurance market. The RCC found substantial price increases, market

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concentration, and high barriers to entry, and recommended a number of actions to be taken by the Financial Supervisory Authority and Romanian Actuary Society to promote transparency.

p. National Level Enforcement in Sweden

In July 2016, the Swedish Competition Authority, the Konkurrensverket, closed an investigation into the practice by the Swedish Insurance Federation of recommending that its members should not pay commissions to independent brokers of casualty insurance, following the Swedish Insurance Federation’s withdrawal of the recommendation.

9. Impact of the EU’s General Data Protection Regulation on the Insurance and Reinsurance Industry

After almost four years of negotiations, drafting and discussions, the GDPR entered into force in May 2016. Businesses, including insurance companies, now have until May 25, 2018 to meet the new requirements under the GDPR. The GDPR aims to harmonize data protection legislation across the EEA, making compliance for (re)insurance companies that operate in multiple EEA jurisdictions easier. However, in order to achieve this, the GDPR introduces a number of new requirements that will have a significant, and sometimes onerous, impact on (re)insurance companies. The GDPR is also likely to still be relevant to (re)insurance companies based in the UK despite Brexit, as the GDPR will become law in May 2018, which may be before the UK withdraws from the EU, and even after withdrawal, the GDPR will continue to apply to UK companies that process data on EEA residents. Some of the key provisions of the GDPR that are of particular relevance for the insurance and reinsurance industry are summarized below.

a. Greater Enforcement

The GDPR introduces an aggressive enforcement regime with administrative fines of up to 4% of a company’s annual worldwide turnover (gross revenue) or €20 million, whichever is the higher. In addition, Data Protection Authorities (“DPAs”) will also have significant investigative and corrective powers, such as the ability to impose a temporary or definitive ban on processing personal data, or to issue reprimands to controllers and processors (see below) for infringing the provisions of the GDPR. Further, any organization aiming to protect the data protection rights of individuals will be able to submit a complaint to a national DPA and bring actions on behalf of individuals. To reduce the risk of these sanctions being imposed, (re)insurance companies will need to carefully review the provisions of the GDPR and determine how they will ensure compliance.

b. Application to Non-European Businesses

The GDPR extends the territorial scope of data protection legislation to include data controllers and processors based outside the EEA that process personal data of EEA residents, where the processing is related to: (i) the offering of goods or services to EEA residents; or (ii) the monitoring of their behavior. Therefore, if a U.S. or other non-EEA (re)insurer underwrites risk for or issues policies to companies or individuals in the EEA, or they monitor an insured’s behavior, they will come within the scope of the GDPR and must comply with its

provisions. This means that international (re)insurance companies are likely to come within the scope of EEA legislation and therefore such organizations will now need to review their data processing policies and protections to ensure that they are GDPR compliant.

c. One-Stop-Shop

The GDPR introduces a new “one-stop-shop” mechanism where businesses will ordinarily be accountable to one single lead DPA in the EEA country where the data controller has its main establishment. The lead DPA is required to cooperate with all “concerned” DPAs to reach a consensus on any decision, and where no consensus can be reached, the case can be referred to the newly formed European Data Protection Board (“EDPB”) which will issue a binding opinion. In exceptional circumstances, a “concerned” DPA can adopt provisional measures and request an urgent opinion from the EDPB. This may be beneficial to (re)insurance companies that operate across the EEA, as they will only have to ordinarily report to and deal with one supervisory authority for data protection issues that effect their cross-border operations. The Article 29 Working Party published guidance to assist companies in determining the identity of their lead DPA in December 2016. The guidance states that where a company does not have an establishment in the EU (e.g., based in the U.S.), the one-stop-shop principle does not apply and the company must deal with DPAs in every EU Member State in which it is active as well as appoint a data protection representative in one EU Member State.

d. Data Controllers and Data Processors

The GDPR keeps the current distinction between “data controllers” and “data processors” under the Data Protection Directive. With respect to the (re)insurance industry, it is likely that (re)insurance companies will be treated as data controllers. This is on the basis that, for example, (re)insurance companies, in many circumstances, determine what data of their customers and employees is to be collected, and for what purposes this data is to be used for. As a result of being classified as a data controller (relative to being classified as data processor), (re)insurance companies become responsible for complying with the majority of the obligations under the GDPR. (Re)insurance companies often use many vendors and the GDPR substantially broadens the obligations that must be contractually imposed on processors by controllers. Therefore, it is likely that many contracts that (re)insurance companies have entered into or will enter into with vendors, that will continue past May 2018 will need to reflect these enhanced requirements.

In addition, the GDPR introduces the concept of joint and several liability for controllers and processors, meaning that individuals can claim for compensation from either the controller or processor in the event of non-compliance with relevant GDPR requirements. Therefore, documenting how liability will be apportioned in these events will now be extremely important, and contracts between controllers and processors will need to take this into account, as well as mechanisms to resolve any disputes.

e. Notice and Consent

The GDPR has increased the thresholds for obtaining consent to process personal data, including the consents of children. Consent must now be freely-given, informed, clear and affirmative, rather

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than implicit and tacit. Data controllers must also be able to prove that they have received such consent from an individual for each processing operation they undertake. This could be problematic for (re)insurance companies, as they may process data for many different operations or for ancillary purposes. For example, an insurance company that underwrites health insurance may be required to ensure that it obtains express consent for processing health data about an individual, even though the primary purpose of the processing is related to performance of an insurance contract. A controller may be able to “grandfather” its existing consents beyond May 2018 only if the consent would satisfy the more onerous requirements of the GDPR. Given the duration of many (re)insurance contracts, companies may need to re-consent individuals, which may be a difficult and expensive exercise. In addition, the GDPR sets out new requirements as to the information that should be provided in data privacy notices, such as the contact details of the data controller, the legal basis of processing, the data retention period and so on. As a result of these increased requirements, (re)insurance companies will need to update and amend their policies, consents and customer materials to ensure they obtain the requisite level of consent from individuals for each operation where data is processed and provide the correct information in data privacy notices. This could be a costly and time consuming administrative burden for (re)insurance companies.

f. Accountability

The GDPR sets out enhanced accountability principles, including the requirement for organizations to implement data protection policies, to maintain a detailed record of processing activities, to conduct privacy impact assessments and to implement data protection by “design” and “default.” An organization will be required to conduct a privacy impact assessment where data processing uses new technologies and is likely to result in a “high risk” for individuals. Evaluating personal data based on automatic processing (such as profiling), processing sensitive personal data on a large scale or systematically monitoring a publically accessible area on a large scale are all examples of when a privacy impact assessment would be required. In addition, consultation with the DPA may also be required, where processing would result in a high risk. As much of the personal data held by (re)insurance companies would be considered sensitive personal data (as (re)insurance companies often need information regarding health prior to issuing a policy) and profiling is used in certain insurance functions (such as underwriting), it is likely that many (re)insurance companies will be required to carry out a privacy impact assessment. These requirements add an additional compliance step for (re)insurance companies, which will need to be budgeted for in cost and time.

g. Information Security and Breach Notification

All organizations must implement appropriate technical and organizational security measures, particularly if sensitive personal data is processed (e.g., health data, or racial or ethnic origin data). Furthermore, after becoming aware of a security breach, depending on the level of risk, data controllers will be required to notify both their national DPA and the individuals adversely affected by the security breach, without undue delay and, where feasible, not later than 72 hours after the data controller becomes aware of the security breach. Given that insurance companies process a lot

of sensitive personal data about individuals (particularly health insurance companies), such organizations are an attractive target for hackers, therefore insurance companies should define and document a security breach response plan and update their IT-systems to ensure they have adequate safeguards in place to protect against potential cyber attacks. The GDPR introduces a definition of pseudonymization, which was undefined in previous legislation. Pseudonymization (e.g., the processing of personal data in a way that can no longer be attributed to a individual without the use of further information) is now a formally recognized security technique and (re)insurance companies that do not already use this technique may wish to consider whether to introduce it. Nonetheless pseudonymized data is regarded as “personal data” and will be subject to the GDPR.

h. Increased Rights of Individuals

Two of the more controversial rights introduced under the GDPR include, the “right to be forgotten” (or the “right to erasure”) and the “right to data portability.” The “right to be forgotten” allows individuals (including children) to ask for their personal data to be deleted in certain circumstances, such as when the processing is no longer necessary or the individual withdraws consent. Data controllers and processors must comply with such requests unless certain derogations apply. In addition, where a controller is required to erase personal data which it has made public, the controller must take reasonable steps to inform other controllers that are processing such personal data, that the individual has requested erasure by such controller of any links to, or copies or replications of, such personal data. (Re)insurance companies will need to carefully assess this new right to be forgotten and determine how they will deal with requests to be forgotten and when the derogations to this right can be relied upon. (Re)insurance companies may need to keep personal data to comply with legal or regulatory obligations, or to be able to pay out on a policy at a later stage. However, whether such legal or regulatory obligations will come under one of the derogations is still uncertain and (re)insurance companies should therefore keep an eye on how this right will be exercised in practice and ensure that frontline staff are equipped to deal with these requests appropriately.

The “right to data portability” allows individuals to request copies of their personal data from data controllers or processors, so that they can transfer their data to another provider. To facilitate the operability of this right, controllers should ensure that personal data is processed in a machine-readable, structured and commonly-used format, where this is technically feasible. In guidance recently published by the Article 29 Working Party, it states that there should be a focus on “interoperable” systems where controllers should provide as many metadata with the data as possible at the best possible level of granularity, to reserve the precise meaning of exchanged information. This could be problematic for insurers and their intermediaries, as many hold personal data on different systems depending on the stage at which the data is processed. For example, they might have a separate system for underwriting or a separate system for dealing with claims. Also, given the nature of insurance policies and how long they might be in issue for, many insurance companies may store personal data on older systems that might not be compatible with newer systems, making interoperability difficult. Accordingly, this right could expose insurance companies to large administrative burdens, as they would need to update and amend their processing

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systems to ensure they are standardized and interoperable. Development of interoperable formats to enable data portability is actively encouraged in the GDPR and the guidance published by the Article 29 Working Party, and therefore, in order to mitigate the impact of this new right, the (re)insurance industry should start developing strategies to determine how they will deal with it.

i. Profiling

The GDPR introduces new restrictions on data controllers carrying out profiling. Profiling is any form of automated processing of personal data consisting of the use of personal data to evaluate certain personal aspects relating to a natural person, in particular to analyze or predict aspects concerning that natural person’s performance at work, economic situation, health, personal preferences, interests, reliability, behavior, location or movements. Data subjects now have a right not be subject to a decision based solely on automated processing (including profiling), which produces legal effects on, or significantly affects an individual; unless the profiling (i) is necessary for the performance of a contract; (ii) has been authorized by Member State law; or (iii) is conducted with the explicit consent of the individual, and appropriate safeguards are implemented (Profiling and automated decision-making cannot be applied to children). This restriction could potentially extend to virtually all forms of data analytics including positive forms of profiling. This right will have a huge impact on the (re)insurance industry, as the underwriting process uses platforms that are designed to price risk, allocate premiums automatically and systematically process information about individuals. In addition, the (re)insurance industry uses Big Data projects to assist in market analysis, targeted marketing and fraud detection, all forms of automatic processing. The new restriction on profiling is likely to add additional burdens for (re)insurers that undertake these types of processing activities and in light of this, (re)insurers should review their current profiling activities to ensure compliance with the GDPR.

j. Transfer of Personal Data from the EEA

The GDPR maintains the current restriction on transferring personal data to countries outside the EEA that are not considered to have an adequate level of protection, such as the U.S. It also retains existing data transfer solutions, such as EU standard data protection clauses (also referred to as model contracts), the use of Binding Corporate Rules and the recently adopted EU-U.S. Privacy Shield.

k. Final Thoughts

It is clear that the GDPR will significantly impact the way in which the insurance industry processes personal data. While harmonization of data protection across the EEA will reduce the cost of the administrative burden that results from legal fragmentation, some of the key changes will require insurance companies to make policy or other administrative changes, which will be costly in the short-term. It is important for the insurance industry to understand their obligations under the GDPR and start making the requisite policy, procedural, technological or other changes to ensure compliance. Failure to do so could result in significant sanctions and liabilities.

10. China: Regulatory Developments

a. CIRC Agrees Memorandum of Understanding With EIOPA, and Meets With NAIC

The CIRC took steps during 2016 to maintain close relationships with regulators in the EU and the US. In June, the CIRC signed a Memorandum of Understanding with EIOPA, establishing a framework for collaboration and exchange of information. The two regulators agreed to build mutual understanding in particular of each other’s solvency regimes, China’s Risk Oriented Solvency System (“C-ROSS”) and Solvency II, and determined to set up an annual working programme and a task force of experts, as well as regular exchange of information on supervisory requirements and practices.

Meanwhile, in July, CIRC representatives met their counterparts at the NAIC, along with delegates from the U.S. Trade Representative, the U.S. Department of Commerce, and the U.S. insurance industry to discuss a range of issues including C-ROSS, the NAIC’s group capital calculation, natural catastrophes, reinsurance and cybersecurity.

John M. Huff, the President of the NAIC at the time, stated following the meeting that the “open dialogue and regulatory cooperation between our two markets are crucial for the future success of insurance in both countries.” With the Chinese insurance market destined to become the second largest in the world, convergence between the Chinese regime and those of the EU and the U.S. will become increasingly important to the global industry over the coming years. China was involved in some early discussions with the EU concerning potential equivalence under Solvency II, although mutual recognition of regimes for the purposes of cross-border business does not appear to be contemplated at present.

b. CIRC to Identify Domestic Systemically Important Insurers

The CIRC is in the process of establishing a regime for identifying domestic systemically important insurers (“D-SIIs”). Those identified will be required to comply with enhanced requirements in the areas of corporate governance, risk management and solvency capital, and will need to formulate recovery and resolution plans.

This initiative mirrors the approach agreed at the international level by the G20 in respect of global sytemically important insurers, and implemented by the Financial Stability Board (“FSB”). The FSB has been working with the International Association of Insurance Supervisors, as well as national authorities, to develop the new requirements, and the enhanced capital requirements, known as “higher loss absorbency”, are scheduled to be implemented from January 2019.

The CIRC has been gathering data from large domestic insurers with a view to producing a list of D-SIIs, and has produced draft Interim Measurers governing the regulation of D-SIIs for public consultation.

c. Shanghai Insurance Exchange Launches With Two Investment Products

The Shanghai Insurance Exchange (“SHIE”) launched in June 2016 as a joint stock company. Authorities in Shanghai hope the project will help to make the city an international hub for insurance business.

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The SHIE has been set up to facilitate trading of insurance products, a market for reinsurance capacity, and financing of insurance businesses, and is headed by the former head of the CIRC’s insurance funds department, Zeng Yujin. The founding shareholders, most of which are insurers or their affiliates, were reported to have injected initial capital of ¥2.235 billion to get the project off the ground.

The SHIE’s first products were launched in November 2016, with two securities being issued to investors on a new insurance asset management platform. One was an asset backed security backed by a portfolio of policy loans made by China Pacific Life. The other was a debt product issued by Taiping Asset Management to raise capital for investment in local public-private projects. The combined value of the issued securities was reported to be ¥7.88 billion.

The goal is for the exchange to develop ultimately into an internationally significant center for insurance business. Overseas reinsurers and capital markets investors may be interested to see whether the exchange succeeds in establishing markets for reinsurance products and insurance securitizations, and what form those may take, potentially offering new avenues into the Chinese market.

d. Regulators Warn Against Reckless International Acquisitions, Although Insurers’ Overseas Asset Holdings Expected to Rise

Chinese media recently reported statements made by CIRC vice chairman Chen Wenhui, warning the industry against making reckless overseas investments. The Chinese government is also reported to be considering measures aimed at capping the size of international acquisitions made by state owned companies, and increasing scrutiny of larger acquisitions where the target is not within the group’s core business, owing to concerns over the large capital outflows resulting from recent overseas acquisitions by Chinese groups.

In January this year, the CIRC also reduced the limit applied to insurers’ equity investments, from 40% of total assets down to 30%, and announced it would require insurers to obtain approval for acquisitions of controlling stakes, in efforts to encourage insurers to act as strategic investors rather than short term speculators in stock markets. The limit was previously raised from 30% to 40% in July 2015 to help mitigate sharp falls in the stock market at the time.

However, Chinese insurers are likely to continue to increase their overseas investments. A recent survey carried out by BNP Paribas found that Chinese insurers are expecting to invest US$100 billion overseas over the next three years, according to media reports. Insurers are restricted to investing a maximum of 15% of their assets abroad, but according to CIRC statistics only 2% of insurance assets are currently invested overseas.

V. Cyber Risk

A. U.S. CYBER RISK DEVELOPMENTS

Cyber risk is one of the most serious global risks, and “cybersecurity” is a top priority of both private companies and government entities. Cybersecurity generally focuses on the protection of computers, networks, programs and data from unintended or unauthorized access or destruction. In the insurance context, cybersecurity

measures focus on safeguarding insurance consumers’ personal information, which is particularly sensitive because it often contains Social Security numbers, financial information and medical information.

Following the unprecedented number of high-profile cyber attacks in 2014 and 2015, the insurance sector (including regulators, insurers and other entities that handle insurance-related data) significantly increased efforts to improve cybersecurity. Highlighted below are recent regulatory developments in the insurance sector concerning cybersecurity. These developments have encouraged insurance companies (like all financial services providers) to review and refine their information security practices and corporate governance protocols related to cybersecurity to meet the rising regulatory and compliance demands in the insurance and financial services sector.

1. U.S. Federal Activity

a. Advanced Joint Notice of Public Rulemaking Issued by the U.S. Department of the Treasury, the Federal Reserve and the FDIC, “Enhanced Cyber Risk Management Standards.”

On October 19, 2016, a joint group of federal agencies (the Federal Reserve, the Office of the Comptroller of the Currency and the FDIC) issued a joint advance notice of proposed rulemaking titled, “Enhanced Cyber Risk Management Standards” (the “Cyber ANPR”). The Cyber ANPR proposes enhanced cyber risk management standards (the “Enhanced Standards”) that would apply to “Covered Entities” that are large, interconnected entities regulated by the issuing agencies and to such entities’ service providers. The Cyber ANPR proposes Enhanced Standards in the following five areas: (1) cyber risk governance; (2) cyber risk management; (3) internal dependency management; (4) external dependency management; and (5) incident response, cyber resilience, and situational awareness.

Although the Cyber ANPR does not define “Covered Entities,” SIFIs could be included because they are under the supervision of the Federal Reserve. Whether SIFIs are included will depend on the size thresholds and other factors the federal agencies decide to apply for purposes of the new regulation. In the Cyber ANPR, the federal agencies seek comment regarding whether they should broaden or narrow the scope of Covered Entities, and whether they should consider alternative size thresholds or the risk posed to the safety of the financial sector and U.S. economy as a whole. The Cyber ANPR also asks whether the federal agencies should consider the number of connections that an entity has to other entities in the financial sector, rather than asset size.

The proposal is still in its early stages, but the Cyber ANPR suggests that the Enhanced Standards would apply to the systems of all Covered Entities and an additional, “higher set of expectations” referred to in the Cyber ANPR as “sector-critical standards” would apply to systems of Covered Entities that are critical to the functioning of the financial sector.

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2. NAIC Activity

a. Insurance Data Security Model Law

The NAIC’s Cybersecurity (EX) Task Force (the “Cybersecurity Task Force”) is drafting a new model law addressing cybersecurity entitled “Insurance Data Security Model Law” (the “IDS Model Law”). The current draft of the IDS Model Law would apply to insurance licensees, defined as all licensed insurers, producers and other persons licensed or required to be licensed, or authorized or required to be authorized, or registered or required to be registered pursuant to state insurance laws. The IDS Model Law is intended to establish the exclusive standards for data security and breaches applicable to insurance licensees in states adopting the IDS Model Law. The current draft of the IDS Model Law provides that it should not be construed as superseding any state law or regulation except to the extent it is considered inconsistent with the IDS Model Law, and there is no such inconsistency if the protection the state law affords a person is greater than the protection provided under the IDS Model Law.

After releasing a discussion draft in March 2016, the Cybersecurity Task Force held a two-day drafting session in May 2016. In August 2016, the Cybersecurity Task Force exposed for comment a second draft of the IDS Model Law. At this juncture, the Cybersecurity Task Force is considering additional comments received on the second draft of the IDS Model Law, and a drafting group is in the process of preparing a third draft.

Individual insurers, trade groups, state regulators and legislators have submitted extensive comments on the drafts of the IDS Model Law. Overall, comments on the IDS Model Law have focused on three concerns: exclusivity, uniformity and workability. With respect to exclusivity, interested parties have urged that the NAIC ensure that the IDS Model Law contains the exclusive state standards for data breach notifications and required security measures applicable to insurance licensees. With respect to uniformity, interested parties are concerned that all state insurance commissioners would be entitled to review, edit and approve notices of breaches sent to consumers, which would undercut uniformity, as well as delay investigation and remediation of a breach. With respect to workability, interested parties have criticized certain sections that could hamper the implementation and enforcement of the IDS Model Law. For example, it has been argued that unless a “harm to consumers” trigger is applied for reporting purposes, reporting could unnecessarily alarm consumers and even desensitize them such that consumers might ignore serious data breach notices. Some have argued that the IDS Model Law does not make entirely clear the specific information that a licensee must provide to insurance commissioners and, therefore, a licensee may end up devoting resources to preparing commissioner notifications that would detract from a licensee’s focus on, and efforts to, investigate/remediate a breach and inform customers.

b. NAIC Adopts Model Bulletin Regarding Annual Privacy Notices

The NAIC’s (D) Committee adopted a model insurance department bulletin regarding annual privacy notices required under the federal Gramm-Leach-Bliley Act (“GLBA”). To conform with recent GLBA amendments included in the Fixing America’s Surface Transportation Act (the “FAST Act”), which took effect December 4, 2015, the

bulletin clarifies that an insurance department licensee is not required to provide GLBA annual privacy notices if certain conditions set forth in the FAST Act are satisfied. These conditions are that the licensee: (i) shares non-public personal information (“NPI”) with non-affiliated third parties only in accordance with applicable laws that do not trigger an opt-out right; and (ii) has not changed its policies or practices regarding the disclosure of NPI since the last privacy notice sent to consumers.

3. NYDFS Proposed Cybersecurity Regulations

On February 16, 2017, the NYDFS issued a final regulation titled, “Cybersecurity Requirements for Financial Services Companies,” outlining minimum requirements for NYDFS-regulated entities to address cybersecurity risk (the “Cybersecurity Regulation”). The Cybersecurity Regulation applies to a broad range of entities in the banking, insurance and financial services industries, including insurance producers and premium finance companies (collectively, the “Covered Entities”). A limited exemption from some requirements is provided for small entities based on number of employees, revenue and total assets of such entity.

The Cybersecurity Regulation is the first of its kind—no other state insurance department has adopted similar cybersecurity measures, and even the NAIC is still working on its own cybersecurity model law. (See Section V.A.2.a above.) The Cybersecurity Regulation is extensive and goes well beyond safeguarding customer information. It also covers business continuity, system availability, quality assurance and other operational factors. In fact, the definition of “Information Systems” is so broad that it includes not just computer/electronic information, but could also impose requirements on telephone exchange systems and even potentially HVAC systems.

Under the Cybersecurity Regulation, Covered Entities must maintain a cybersecurity program to ensure the confidentiality, integrity and availability of the Covered Entity’s information systems (the “Cybersecurity Program”). The Cybersecurity Program must address responses to technological developments and evolving threats, as well as “Cybersecurity Events,” defined as acts (or attempts, successful or not) to gain unauthorized access to, or to disrupt or misuse, a Covered Entity’s information systems or information stored thereon.

The Cybersecurity Regulation applies a “risk-based” approach to the cybersecurity requirements of Covered Entities. In the original version of the Cybersecurity Regulation (published in September 2016), the NYDFS applied cybersecurity requirements on a more “one size fits all” basis, which did not account for significant variations among entities’ business models and operations, information systems and risk profiles. Under the final version of the Cybersecurity Regulation, the Cybersecurity Program must be designed to account for such variations and must reflect a “Risk Assessment” conducted by the Covered Entity.

The Cybersecurity Regulation became effective when it was published in the New York State Register on March 1, 2017. Covered Entities have 180 days from the effective date to comply, except that additional transitional periods are allowed for certain provisions.

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B. UK AND EUROPE

1. Regulatory Focus on Cyber Underwriting Risk

With cyber attacks on the increase globally both in terms of scale and impact, the PRA and the Society of Lloyd’s have undertaken separate reviews to understand the challenges facing the insurance industry and the risks arising from underwriting cyber insurance.

a. PRA Consultation Paper

In November 2016, the PRA issued a consultation paper (CP39/16) setting out its expectations for the management of cyber insurance underwriting risk. Cyber underwriting risk is defined in the paper as “the set of prudential risks emanating from underwriting insurance contracts that are exposed to losses resulting from a cyber-attack.”

The consultation paper applies to all UK non-life (re)insurance firms and groups within the scope of Solvency II as well as the Society of Lloyd’s and managing agents (collectively, “Solvency II firms”).

Having undertaken a thematic review between October 2015 and June 2016 with a variety of stakeholders (including (re)insurers, cyber security and technology firms and catastrophe modeling vendors), a number of potential issues facing the insurance industry came to the fore, which the PRA is seeking to address by way of a supervisory statement (included in the consultation paper).

The overarching theme is that the PRA expects firms to be able to “identify, quantify and manage cyber underwriting risk,” both with respect to risks arising from affirmative cyber insurance policies, such as data breach products, and also in respect of “silent” cyber risk. “Silent” cyber risk is referred to in the PRA’s consultation paper as risks that arise from cyber exposure within “all risks” and other liability insurance policies that do not explicitly exclude cyber risk.

b. “Silent” Cyber Risk

In order to reduce the exposure to “silent” cyber risk, the PRA expects Solvency II firms to “robustly assess and actively manage their insurance products,” paying particular regard to this kind of exposure and to introduce measures to reduce unintended exposure, such as setting aside capital in respect of “silent” cyber risk. In addition to setting aside a capital provision, the PRA suggests other measures firms could introduce, such as:

• offering explicit cover and adjusting the premium to reflect the actual risk;

• inserting wording exclusions;

• setting specific limits of cover; and

• clarifying policy wording as to whether cyber cover is included in the particular product.

c. Cyber Risk Strategy and Risk Appetite

The PRA expects firms to have clear strategies in managing the risks arising where firms write affirmative cyber cover and/or where they are exposed to “silent” cyber risk. The PRA is clear that any such strategies must be owned by the Board and should include both a quantitative and qualitative focus, for example establishing rules for

line sizes and aggregate limits for geographies and industries. The PRA expects the strategy and risk appetite statements to be reviewed on a regular basis and for firms to produce internal management information for review and sign-off by the Board.

d. Cyber Expertise

The PRA recognizes that firms in the cyber risk space require an investment in expertise in this field and therefore expects firms that are materially exposed to this risk to continue to develop their knowledge, especially since it is an area that is constantly evolving. The PRA also expects that this knowledge should be fully aligned to the associated level of risk and growth targets and should cover all three lines of defense: business, risk management and audit.

Although it is likely that external advice in relation to cyber risk will be obtained, the PRA is keen to emphasize that firms are still ultimately responsible for the management of these risks with the Board having appropriate oversight of the controls in this area. This addresses a particular aspect of the thematic review which showed that there had been insufficient investment by firms in developing their internal knowledge of cyber risk, due to a combination of the early stage of development of a firm’s cyber product and the dearth of professionals with the requisite cyber underwriting expertise.

e. What are the Implications for Firms?

The PRA’s review has revealed that most firms do not have the appropriate tools to “monitor, manage and mitigate” cyber underwriting risk. As a corollary, policyholders with traditional property and casualty policies may not have contract certainty as to whether or not cyber risk falls within the cover.

The costs to firms of implementing the PRA’s proposals will depend upon whether they are addressing affirmative or “silent” cyber risk. The PRA notes that costs relating to affirmative cover should be proportionate to the size of the cyber book, but should take into account future growth targets. In relation to “silent” cyber risk, where there is a need to address internal knowledge, the PRA expects the costs to be relatively consistent across all firms. However, costs could differ somewhat depending on the nature of the mitigation technique a firm uses, such as applying exclusions and policy limits on the one hand and developing pricing models on the other hand.

The consultation closed on February 14, 2017, and the PRA will now be considering any feedback received before issuing its supervisory statement.

f. Lloyd’s Cyber-Attack Strategy

In June 2016, Lloyd’s published a paper focusing on “insurance losses arising from malicious electronic acts” referred to as a “cyber-attack.” The paper outlines Lloyd’s cyber-attack strategy, an initiative which has been developed in response to the increasing frequency of cyber-attacks and the escalating costs of managing breaches. The growth of cyber-attacks will inevitably lead to new business opportunities for the Lloyd’s market, but also brings inherent risk.

As with the PRA’s consultation paper, the Lloyd’s paper also highlighted the two-pronged nature of cyber risk emerging from cover written through specific cyber insurance policies (for data

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loss, data breaches or cyber extortion, for example) and separately through “traditional” policies (property, marine, casualty) where a cyber-attack can potentially cause a loss.

The first step of the Lloyd’s strategy was to ask syndicates to provide details of their risk management frameworks for cyber-attacks as well as their risk appetites and the factors that are considered for underwriting and pricing cyber risk. The second step required syndicates to develop and report their own internal “cyber-attack scenarios” to consider the worst-case accumulations of (re)insurance exposure to cyber risk.

Based on the cyber-attack scenarios submitted by the syndicates, three primary considerations emerged when syndicates were designing scenarios:

• What is the motive for the attack?

• Which sectors in society are being targeted?

• Who is carrying out the attack?

If the attacks relate to data itself which is targeted for financial gain, then notionally this can be quantified and managed by appropriate underwriting. However, if an attack occurs on account of a political agenda, for example, then this is of course more difficult to quantify and will expose syndicates to unforeseen accumulations of risk.

On the basis of these findings, Lloyd’s has set out the next steps in its strategy, which include: consulting the market to ensure that there is an understanding and appropriate pricing of cyber-attack risk; additional reporting; and specific reviews of syndicates’ cyber-attack risk-management frameworks.

Lloyd’s has also set out a number of objectives it is seeking to achieve by December 31, 2017, including:

• supporting the advancement of cyber-attack (re)insurance cover, which is appropriately underwritten and capitalized;

• encouraging the use of appropriate exclusions and/or sub-limits for cyber-attacks;

• developing an understanding of the accumulation risk of cyber-attacks, both in respect of affirmative and “silent” cyber;

• ensuring that syndicates’ capital models and Lloyd’s Internal Model represent cyber-attack risk, as a matter of good practice; and

• reducing the potential for the accumulation of silent cyber-attack exposure by identifying classes of business that could give rise to this type of risk and implementing pricing and capital-setting policies.

g. Where Does This Leave Firms?

Escalating cyber-attacks will inevitably lead to an increase in businesses seeking cover, particularly with the forthcoming implementation of the EU’s Network Information Security Directive and GDPR, which both come into force next year, with the latter

introducing mandatory security breach reporting and potentially substantial fines for non-compliance. Further detail on the impact of the GDPR on the insurance industry is set forth above in Section IV.C.9.

VI. Select Tax Issues Affecting Insurance Companies and Products

A. U.S.

1. Prospects for Tax Reform

With Republicans controlling both houses of Congress and the White House, the stage may be set for fundamental corporate tax reform in 2017, presumably with a January 1, 2018 effective date.

The focus of leading reform proposals to date has been on:

• Reduction of the 35% corporate tax rate to a rate in the 15–20% range.

• Full expensing of capital expenditures.

• Disallowing deductions for net interest expense.

• Repeal of the corporate alternative minimum tax (“AMT”).

• “Border adjustment.”

• “Territoriality” (no U.S. tax on dividends of earnings from foreign subsidiaries).11

Reform proponents generally say they would like reform to be revenue-neutral over a 10-year measuring period. The first two items above—the significant tax rate cut, and full expensing—would would be major revenue losers. Revenue-neutrality would thus depend in large part on two other major items listed above, the disallowance of interest deductions and border adjustment.

Border adjustment has been by far the most controversial tax reform idea under discussion. Border adjustment entails excluding revenue from exports from the tax base, and disallowing any tax benefit for the purchase of any business inputs that are imported. For example, a major retailer of imported consumer goods like WalMart would be taxable on its gross revenue from domestic U.S. sales with no allowance for the cost of imported goods sold. Border adjustment encourages exports and penalizes imports, though many economists say it would rapidly result in appreciation of the U.S. dollar against other currencies and leave the balance of trade essentially unaffected. Proponents of border adjustment argue that it would encourage domestic production and thus bolster domestic employment.

Major impediments stand in the way of the U.S. adopting a border-adjusted corporate tax, including complexity, unfamiliarity, and

11 Under the House Republican “Blueprint” this would be applicable to future foreign earnings. Existing retained earnings in foreign subsidiaries would be deemed repatriated to the U.S. parent over a period of years and taxed at a special low rate. In contrast, candidate Trump proposed deemed repatriation of past earnings along with the opposite of territoriality going forward, proposing that all earnings of foreign subsidiaries be taxed in the U.S. on a current basis (net of the indirect foreign tax credit), similar to the existing “subpart F” regime for certain forms of passive and mobile income including insurance and reinsurance income.

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political opposition from importers. Senate Republicans have already said border adjustment lacks sufficient support to pass in the Senate. President Trump has made contradictory statements on the idea.

In addition, many commentators believe the proposed border-adjusted tax would violate international trade agreements and would be successfully challenged before the World Trade Organization (“WTO”). Border adjustment is a common feature of value-added taxes (“VATs”), where border adjustment is permitted under WTO standards because VATs are considered “indirect” taxes. “Direct” taxes are not permitted to be border-adjusted under WTO standards, and critics say the proposed U.S. tax would still be a “direct” tax on corporate income.

Reform proponents have claimed that full expensing and the disallowance of interest expense would make the new tax more of a “cash flow” tax than a profits tax and therefore an “indirect” tax that can be border-adjusted. However, most commentators are saying that the tax would still be considered a “direct” tax on corporate income because corporations would still be allowed a full deduction for all employee wage and benefit costs. By contrast, there is no such deduction under a VAT, which essentially takes the form a tax on business gross receipts.

It remains completely unclear at this writing whether or how a border-adjusted tax system would be applied to insurance and other financial services. A border adjustment provision that disallowed any deduction for reinsurance premiums paid to a foreign reinsurer—i.e., “imported” reinsurance—would have a dramatic impact on existing structures that cede risk to Bermuda and other offshore markets, whether those reinsurers are non-controlled foreign corporation (“CFC”) affiliates of the ceding company or unrelated reinsurers. In addition, in any tax reform debate where lawmakers are searching for revenue-raisers, the so-called “Neal bill” could gain some traction—a proposal introduced in many previous Congresses to disallow deductions for P&C reinsurance premiums paid to a foreign affiliate under common ownership with the ceding company.

The prospect of tax reform with border adjustment, or other targeted provisions addressed to offshore reinsurance, casts a cloud over business combinations that might otherwise be structured on an “inversion” basis12 and place a domestic insurance group under a foreign holding company, positioned to cede reinsurance to a brother-sister affiliate doing business in a low- or no-tax jurisdiction. Commentators have noted, however, that the greatest disincentive to further “inversion” activity may simply be a reduction of the U.S. corporate tax rate from one of the highest rates in the world to one of the lowest.

It also remains completely unclear at this writing what approach lawmakers might take toward (i) the existing “subpart F” regime for insurance and reinsurance profits of foreign affiliates that are CFCs and (ii) the existing federal excise tax regime for reinsurance ceded to foreign reinsurers that do not pay U.S. income tax.

12 If former shareholders of the acquired U.S. company own less than 80% of the combined company, the foreign holding company continues to be treated as a non-U.S. corporation for tax purposes, in contrast to certain transactions described in Section VI.B below.

Finally, U.S. insurers may see significant accounting effects of fundamental tax reform to the extent they carry deferred tax assets on their regulatory or financial balance sheets. A lower income tax rate would reduce the balance sheet value of net operating loss (“NOL”) carryovers. On the other hand, part of the House Republican plan involves extending the NOL carryover period to become an indefinite carryover without expiration, which in some cases would increase the value of NOL carryovers on balance sheets. The House Republican plan calls for repealing the corporate AMT but is completely silent on the future treatment of existing AMT credits, which is a significant deferred tax asset on the balance sheets of many U.S. insurers. Repeal or limitation of those existing credits would have a significant adverse accounting impact on some insurers.

2. Inversion Guidance

The IRS delivered the formal guidance this past year that it had promised in 2014 and 2015 governing the ability of foreign insurance companies to acquire U.S. targets using stock consideration. These regulations (the “2016 Regulations”) implement the guidance previewed, but also go farther in important ways, imposing new restrictions on debt-financed acquisitions and other transactions entered into in connection with an inversion. Although the new provisions of the 2016 Regulations are of general interest to any potential foreign acquirer, the insurance-specific provisions in the 2016 Regulations generally follow quite closely the guidance previewed in the Notices published in 2014 and 2015.

The Code significantly limits transactions in which a domestic corporation is acquired by a foreign company in a transaction in which the former shareholders of the domestic corporation come to own 80% or more of the combined entity. In such a circumstance, the acquiring foreign corporation will be treated as a domestic corporation subject to U.S. income tax—such transactions are termed “inversions.”

In Notices 2014-52 and 2015-79, the IRS announced its intention to issue regulations to expand the universe of transactions that will be treated as “inversions” by providing more onerous rules for calculating the 80% ratio in the case of so-called “cash box” acquirers (i.e., acquirers that hold significant amounts of passive investment-type assets). These rules generally exclude such passive assets from the calculation of the denominator of the 80% fraction, making an inversion much more likely. Recognizing that these rules would be burdensome on financial services companies, which are required to hold large amounts of passive financial assets in the ordinary course of their business, the IRS announced in these Notices that special rules would apply to banking and finance companies and insurance companies. In April 2016, the IRS released temporary regulations formalizing the guidance promised in the Notices.

The 2016 Regulations formalized the cash-box rules, and provided exceptions for banking and finance companies and insurance companies as the Notices had suggested. Specifically, the 2016 Regulations provided exceptions from the cash-box rules for foreign insurance companies that would otherwise satisfy certain conditions in the CFC and passive forein investment company (“PFIC”) regimes. With respect to the CFC regime, assets held for the production of “qualified insurance income” derived in the conduct of an active

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insurance business are excepted from the cash-box rules. With respect to the PFIC regime, there is an exception for income derived in the active conduct of an insurance business by a corporation predominately engaged in an insurance business and which would be subject to tax under subchapter L (relating to the taxation of U.S. insurance companies) as an insurance company if the non-U.S. corporation were a U.S. corporation (known as the PFIC Insurance Exception). The 2016 Regulations note that any guidance in the PFIC area regarding what constitutes the active conduct of an insurance business would apply in the inversion context as well. As discussed in greater detail below (see the discussion below the proposed PFIC regulations) the continued vitality of the general PFIC regulatory project is in some doubt, and it remains to be seen whether guidance is forthcoming. The passive asset rules are generally applicable to acquisitions completed on or after September 22, 2014. The modified rules described above are generally applicable to acquisitions completed on or after April 4, 2016, but taxpayers may elect to apply them to prior transactions. Some of the relief rules described above (such as the insurance related exceptions) apply to acquisitions completed on or after November 19, 2015, but taxpayers may elect to apply these exceptions to prior transactions.

3. New Debt/Equity Regulations

As part of its attack on inversions, the IRS released final and temporary regulations concerning the classification of purported related party debt instruments as equity for U.S. federal income tax purposes. The regulations are intended to prevent taxpayers from using debt in certain related party contexts to erode the U.S. tax base. The classic example is a foreign parent corporation that funds its wholly owned U.S. subsidiary with a mix of interest-bearing debt and equity to minimize the U.S. corporate tax of the U.S. subsidiary through interest deductions. In many cases, the interest payments are not subject to U.S. interest withholding tax under an applicable income tax treaty. Because of the parent’s control over the subsidiary, and because the parent is both the sole equity holder and the sole lender, the IRS is of the view that the economic significance of this shareholder debt (when compared with equity) is minimal or non-existent compared with the significant tax benefit of the annual interest deduction. Therefore, the regulations, under certain circumstances, recharacterize such debt as equity. The regulations can be broadly divided into (i) the documentation rule and (ii) the recharacterization rule. The regulations significantly relax proposed regulations released earlier in the year.

a. The Documentation Rule

The IRS imposed a documentation rule on certain related party instruments referred to as “expanded group instruments.” If these instruments do not satisfy the documentation rule, the debt will be recast as equity of the issuer and the holder of the debt instrument will be treated as an equity holder in the issuer. A debt instrument is an “expanded group instrument” if the stock of any member of an “expanded group” of entities (generally using an 80% by vote or value test) (i) is publicly traded, (ii) all or any portion of the expanded group’s financial results are reported on financial statements with total assets exceeded US$100 million or (iii) the expanded group’s financial results are reported on financial statements that reflect annual total revenue of more than US$50 million.

To avoid being recast as equity, an instrument must demonstrate an unconditional obligation to pay a sum certain, creditor’s rights, reasonable expectation of repayment and an ongoing debtor-creditor relationship. The documentation requirements generally must be met prior to the time the issuer’s federal income tax return is filed.

Debt instruments issued or deemed issued prior to January 1, 2018 are not subject to the documentation rule.

b. The Recharacterization Rule

The recharacterization rule generally deals with certain debt issued or deemed issued by a domestic corporation to its affiliates where there is no new investment in the operations of the issuer or its controlled subsidiaries (e.g., a domestic corporation that distributes a note to its foreign parent). Under the Regulations, such debt may be recharacterized as equity. The recharacterization rule applies only to debt issued on or after April 5, 2016 and such debt may be recharacterized only after January 19, 2017. Neither part applies to debt between members of a consolidated group.

Generally, under the new regulations the IRS may treat a related party debt instrumented issued by a member of an expanded group (but not between members of a consolidated group) as stock if the debt is issued in one of three transactions: (i) in a distribution, (ii) in exchange for the stock of a member of the expanded group, other than pursuant to certain identified exempt exchanges and (iii) in exchange for property in an internal asset reorganization if, pursuant to the plan of reorganization, an expanded group member receives the debt instrument with respect to its stock in the transferor corporation. A sub-rule referred to as the “funding rule” treats a debt instrument issued by an expanded group member as stock if the instrument is exchanged for property treated as funding one of the three transactions described above.

c. Observations

The regulations include important exceptions and clarifications for the insurance industry. Debt issued by a regulated insurance company in the form of a surplus note is considered to meet the documentation requirements if it requires the consent of a regulator to pay interest or principal and, at the time of issuance, is expected to be repaid (although documentation must be maintained that these two requirements are satisfied). The Preamble also clarifies that the new documentation requirements generally do not apply to reinsurance (including funds-withheld reinsurance) because such contractual agreements are not debt in form. Additionally, the debt distribution recharacterization rules do not apply to debt issued by regulated insurance companies domiciled in the U.S. (other than certain captive insurance companies) that are subject to risk-based capital requirements under state law. As noted, the rules generally do not apply to debt issued between members of the same consolidated group; the industry sought a clarification that this exception would also apply to debt issued between affiliated groups that did not consolidate due to the special rules for life insurance companies, but the IRS and Treasury explicitly declined to provide for such an exclusion.

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4. New Partnership Audit Rules

Although insurance and reinsurance entities are treated as corporations and not partnerships as a matter of tax law, many such entities own investments in partnership interests of various kinds, including hedge funds and private equity funds. The developments described in this section may cause insurance entities to consider additional diligence or other steps relating to potential partnership-level tax audit liabilities of partnerships in which an insurer is an investor.

As a part of the Bipartisan Budget Act of 2015, Congress repealed the 1982 Tax Equity and Fiscal Responsibility Act (“TEFRA”) partnership audit rules and created a new regime (the “New Partnership Audit Rules”) for auditing partnerships beginning in tax years starting after December 31, 2017.

Under TEFRA, an audit of a partnership would result in adjustments to the allocation of items to partners, who would then have a corresponding adjustment to their own tax liability. Under the New Partnership Audit Rules, by contrast, an audit of a partnership will require the partnership to determine and pay an imputed underpayment of tax (plus interest and penalties) resulting from an adjustment of the partnership’s return at the partnership level without the benefit of partner-level tax items that could otherwise reduce tax liability and, where the adjustment reallocates any such item from one partner to another, without the benefit of any corresponding decrease in any item of income or gain of another partner (or increase in any item of deduction, loss or credit). The partnership’s liability can be reduced, however, for partners’ tax exemption. This liability will fall to the partnership in the year in which the assessment is made, not the tax year to which it refers.

There are exceptions available from the New Partnership Audit Rules for partnerships with fewer than 100 partners and for partnerships that elect to “push out” the entity-level tax liability to their partners. However, because the former is not available to “tiered” partnerships in which the partners are, themselves, partnerships, it is unlikely to be available to investment partnerships. Furthermore, because the “push-out” election may only be made, according to the statute, “at such time and in such manner as the Secretary may provide,” it will be available only after regulations have been implemented; regulations were proposed in January, but promptly withdrawn after President Trump issued a moratorium on new regulatory action. Treasury officials have indicated to a tax trade publication that no regulatory action on tax issues is anticipated in the near future. As a result, it remains to be seen whether the push-out election will be available when the New Partnership Audit Rules become effective.

Because the New Partnership Audit Rules impose entity-level liability on partnerships for prior-year adjustments, and do not take into account the reduction in liability resulting from a reallocation of an item of income from one partner to another, investors in partnerships bear the risk that their return on investment will be materially impaired by an audit of a prior-year return.

Investors in partnerships should be aware of the potential for reduced return. They should also consider entering into side letters with managers that will limit, to the extent possible, their exposure to

prior-period liability, including through obtaining commitments from managers to make push-out elections, when possible, and to obtain information from all partners to reduce aggregate liability.

5. PFIC Guidance

On April 23, 2015, the Department of the Treasury issued proposed regulations that address the status of non-U.S. insurance and reinsurance companies as PFICs. The proposed regulations are intended to curtail certain abuses believed to arise when an asset manager forms an offshore reinsurance company that invests in the funds it manages, with the intent of deferring U.S. tax on the income of the reinsurer. As we discussed in the 2016 Sidley Global Insurance Review, the proposed regulations were a mixed bag; they offered some helpful guidance, imposed some unhelpful and unrealistic requirements, and left open certain fundamental questions on their application for further guidance. The IRS received numerous comments on the proposed regulations, including from industry associations. A public hearing was held on September 18, 2015.

The status of the regulatory project is now in doubt. The Trump administration, as is common, imposed a moratorium on the issuance of new regulations pending a full review. As noted above, both the House of Representatives and the Trump administration appear interested in pursuing fundamental tax reform. Against this background, it appears unlikely that further guidance on the application of the PFIC exception for foreign insurance companies will be forthcoming in the near future. Indeed, fundamental tax reform may fundamentally change the PFIC regime, or do away with it entirely. For now, the uncertainty in this area will continue.

6. Treatment of Ceding Commission

The IRS released a Chief Counsel Advice memorandum in 2016 that partially withdrew a controversial conclusion offered in a 2015 Chief Counsel Memorandum on the treatment of ceding commissions paid in indemnity reinsurance. In the 2015 edition of the Sidley Global Insurance Review, we reported on a 2015 Chief Counsel Advice memorandum (CCA 201501011) which concluded that, in certain circumstances, portions of a ceding commission paid under an indemnity reinsurance transaction are required to be capitalized and amortized over fifteen years, rather than immediately deducted, as had generally been believed. The 2015 CCA offered two lines of reasoning for this conclusion, neither of which was altogether satisfying. In October 2016, the IRS issued a Chief Counsel Memorandum addressing very similar facts (CCA 201642032). Although the ultimate conclusion reached in the two rulings was the same (and continues to be controversial), the 2016 CCA announced that the IRS had reconsidered one of the grounds offered in the 2015 CCA.

The 2015 CCA describes a taxpayer that purchased a block of reinsurance business through indemnity reinsurance. The taxpayer also acquired transferred workforce, fixed assets, software and other assets, and the memorandum indicated the transaction constituted the transfer of a business. Crucially, the agreement obligated the parties to use commercially reasonable efforts to novate the underlying reinsurance agreements to the taxpayer after closing. The memorandum indicates that the contracts were in fact novated to the taxpayer. The 2015 CCA concluded that the ceding commission was

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required to be capitalized and deducted over time on two grounds. First, although the reinsurance was done on an indemnity basis as a matter of form, the reinsurance was in substance assumption reinsurance because of the obligation to use efforts to novate the agreements, and the fact that these efforts were successful. Second, the IRS argued that, even if the transaction was treated as indemnity reinsurance, a ceding commission paid in the context of the acquisition of a trade or business is required to be capitalized under the regulations under Section 1060 of the Code.

In the 2016 CCA, the IRS announced that it had reconsidered the position it adopted in the 2015 CCA and had now concluded that the 1060 regulations govern only the allocation of basis, and do not treat indemnity reinsurance as assumption reinsurance transactions for federal income tax purposes. Importantly, the 2016 CCA reinforced the conclusion of the 2015 CCA that efforts by the parties to novate the agreements after the closing, and the fact that a portion of the novations actually occurred, are sufficient to characterize the transaction as assumption reinsurance for federal income tax purposes. Accordingly, the portion of the ceding commission deemed paid for those novated contracts (above amounts already required to be capitalized under Section 848 of the Code) was required to be capitalized and amortized over 15 years.

It therefore appears that the uncertainty in treatment and pricing of reinsurance transactions created by the 2015 CCA will persist. Any transaction in which the parties enter into a covenant or agreement to novate business should be carefully scrutinized as to whether they could create a “creeping” assumption reinsurance transaction.

7. The Advent of Principle-Based Reserving

In 2009, the NAIC introduced PBR as a new method for calculating life insurance reserves. The NAIC announced in 2016 that the conditions for adoption of PBR had been met. Accordingly, PBR became effective on January 1, 2017, although there are several facets that will reduce the initial impact. First, PBR applies only to contracts issued on or after January 1, 2017. Second, there is a three-year transition period, during which PBR will be optional (January 1, 2017 through January 1, 2020). Finally, there is an exemption from PBR for small companies. The current rules for the treatment of life insurance reserves for federal income tax purposes are an uneasy fit with the requirements of PBR, and a number of issues need to be resolved in their application.

Under PBR, the reserve for a life insurance product is the greatest of (a) net premium reserve, (b) deterministic reserve, and (c) stochastic reserve. The net premium reserve is very similar to the reserve method in effect prior to PBR: the present value of future benefits less the present value of future premiums. The deterministic reserve is based on the present value of projected cash flows from benefits and expenses, less the present value of future gross premiums, using prudent best estimate assumptions over a single investment scenario. The overarching purpose of the deterministic reserve is to model cash flows based on a set of assumptions that represent the best estimate of the future, with margins to provide a level of conservatism. Finally, the stochastic reserve is calculated in a similar manner to the determinist reserve, except that instead of using a single economic scenario, the stochastic model uses multiple economic scenarios. By

using multiple economic scenarios, the stochastic reserve attempts to assess risk that materialized in so-called “tail scenarios”: low probability events that can have a large impact on reserves.

The implementation of PBR raises significant federal tax issues because of the difficulty in fitting the flexible, principle-based method of PBR within the rigid structure of Part I of Subchapter L of the Code. In Notices 2008-18 and 2010-29, the IRS raised several issues that must still be resolved:

• Whether stochastic reserves are included in the federally prescribed reserve (and are therefore deductible for tax purposes), given the stark difference in methodology in effect when Section 807 of the Code was adopted in 1984 and the fact they do not use a single prevailing Commissioner’s standard table.

• Whether certain reserves determined under PBR constitute “life insurance reserves” under Section 816(b), which is relevant for determining the status of a company as a “life insurance company.”

A number of other issues have been raised by the IRS outside the Notices, and by practitioners:

• Concern that the amount of discretion PBR affords to insurance companies may render the stochastic reserve amount difficult or impossible for examiners to audit.

• Uncertainty on whether updated assumptions under PBR from year to year would trigger a 10-year spread of the resulting change under Section 807(f) of the Code.

• Uncertainty as to whether the deterministic model should be included in the federally prescribed reserve. Some of the same arguments made for excluding the stochastic method from the federally prescribed reserves—e.g., use of best estimate assumptions about mortality as opposed to industry-wide prescribed tables—can also be applied to the deterministic model.

• Uncertainty as to the treatment of companies that do not implement PBR, either because their state has not adopted it or they meet one of the exclusions. It is possible that the IRS could require these companies to produce tax reserves based on PBR, even if the companies are not required to undertake that calculation for regulatory purposes.

• Uncertainty as to the pricing of insurance products. Because pricing relies on profit projections, including tax considerations, there is uncertainty around the pricing of insurance products going forward. Although this issue is correlated with all of the issues discussed above, it is a pressing, practical consideration for insurance companies.

Resolution of these open questions is a pressing question for the industry.

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8. International Tax Issues: The OECD BEPS Project

In 2013, responding to concerns by some policymakers that multinational enterprises (“MNEs”) were able to unfairly reduce their net worldwide income tax through legal tax planning techniques that shift the recognition of income from high-tax jurisdictions to low-tax ones (such practice, “base erosion and profit shifting,” or “BEPS”), the Organisation for Economic Co-operation and Development (the “OECD”) commenced a study of mechanisms that would combat BEPS. That year, it released a report, Addressing Base Erosion and Profit Shifting, and an “action plan” identifying 15 actions items on which the OECD would make recommendations.

In 2015, the OECD released its final recommendations for action on the 15 areas it had identified.13 It describes the recommendations as “soft law,” i.e., they are not self-enforcing, and only become effective as countries enact them, either by changing their domestic laws, modifying their existing bilateral income tax treaties, or joining new multilateral treaties.

During 2016, many countries have taken steps to enact recommendations in the action reports. Those of particular interest to insurance companies are summarized here.

a. Country-by-Country Reporting

Arguably the recommendation most widely adopted to date has been country-by-country reporting (“CbC reporting”), a system by which MNEs will file reports on their worldwide activities with a country (generally, with the jurisdiction in which MNE is headquartered) that will share the report with other countries pursuant to bilateral or multilateral information sharing agreements. It is expected that, as a result of sharing CbC reports among participating countries, taxing authorities will have a global view of the operations of taxpayers over whom they can exert jurisdiction, which would provide such taxing authorities with more information with which to analyze—and potentially challenge—the reporting positions taken by taxpayers. The OECD recommends that CbC requirements apply to MNEs with annual revenues of €750 million or more.

Many countries, including the U.S. and Bermuda, have adopted CbC rules. In particular, the Multilateral Competent Authority Agreement on the Exchange of Country-by-Country Reports (“CbC MCAA”) provides a multinational regime for CbC reporting. The CbC MCAA was first signed in January 2016; to date, 57 countries have joined, including Bermuda, Canada, Germany, Guernsey, Ireland, the Isle of Man, Jersey, Luxembourg, Mauritius, Switzerland and the UK. The OECD released a template CbC report in March 2016. Some jurisdictions have implemented CbC reporting requirements for fiscal years starting as early as 2016.

Insurance companies with operations in multiple jurisdictions should review their operations and finances to gain insight into how taxing authorities might view reports of their worldwide activities. Internal and external compliance procedures should be reviewed to ensure that companies are, and will be able to, prepare the data required for the reports.

13 For a lengthier discussion of those recommendations, see the 2016 Sidley Global Insurance Review, available at http://www.sidley.com/~/media/uploads/2016-sidley-global-insurance-review.pdf.

b. Transfer Pricing

BEPS action items 8, 9, and 10 address transfer pricing. Recommendations include specific guidance on interpreting the “arm’s length” standard, with a focus on risk transfer. These recommendations are expected to be implemented through modifications to the OECD’s Transfer Pricing Guidelines and by countries’ incorporating minimum standards into their domestic laws. In May, the OECD Council approved modifications to Transfer Pricing Guidelines. Additionally, some jurisdictions, such as the UK, have begun to revise their domestic laws in response to the OECD recommendations.

Insurance companies that expect to have significant transactions between related parties in different jurisdictions should be prepared to evaluate such transactions under evolving transfer pricing standards. Companies should plan future transactions, and engage in active monitoring of existing transactions, with an eye to compliance with these new rules as they are developed and adopted.

c. Multilateral Instrument

The 15th and final of the OECD’s BEPS action items is a “multilateral instrument” to facilitate countries’ modifications of their existing bilateral treaties. In principle, if two countries are both signatories to the multilateral convention, the multilateral instrument can provide a framework of pre-agreed options for modifying their existing bilateral treaties to incorporate the OECD’s recommended terms. The text of the convention was agreed in November, and an initial signing ceremony is scheduled for June 2017.

It remains to be seen how many treaties will be amended pursuant to the multilateral instrument, and the extent and impact of such amendments.

B. EU/UK

1. Tax Deductibility of Interest Expense

From April 1, 2017, new UK restrictions on the tax deductibility of net interest expense come into force. The proposals will implement recommendations in the OECD’s reports on BEPS.

The new rules will restrict the deductibility of a group’s net interest expense (and other similar financing costs) which are within the charge to UK corporation tax. Groups with less than £2 million of net interest expense will not need to apply the rules. Broadly, the new rules will operate to limit the amount of such net interest expense that a group can deduct against its taxable profits to:

• 30% of the tax-adjusted EBITDA of the UK group; or

• the ratio of the wider group’s net interest expense to EBITDA multiplied by the tax-adjusted EBITDA of the UK group.

No modifications to, or exclusions from, these new rules are proposed for insurance groups.

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2. Reform of Loss Relief

Currently, the UK has restrictive rules in relation to the ability to relieve carried-forward corporation tax losses. Losses that arise after April 1, 2017 will be subject to a new regime which will give greater flexibility in relation to how losses can be relieved. Broadly, such losses will be able to be set against the total taxable profits of a company and its group members, as opposed to being offset against specific types of income as is currently the case.

Increased flexibility will be accompanied by a restriction of the amount of taxable profits which can be relieved by carried forward losses. Only 50% of taxable profits in excess of £5 million will be available for relief by carried forward losses.

Concerns about the impact of the restriction were raised by the insurance sector at the consultation stage. However, the UK Government concluded that currently no modifications or exemptions will be made.

3. Changes to the Substantial Shareholding Exemption

Broadly, the substantial shareholding exemption currently allows an exemption from UK corporation tax on gains in relation to a “substantial shareholding” (generally at least a 10% shareholding) in a company where certain other conditions apply. For disposals of shares on or after April 1, 2017, the substantial shareholding exemption is being reformed. For such disposals it will no longer be a requirement that the investing company be a trading company or part of a trading group before or after the disposal. The current requirement that the shares must have been held for a continuous period of at least 12 months in the two years prior to their sale is being extended to a continuous holding period of 12 months in the six years leading up to their sale. There will also no longer be a requirement that the company in which shares are sold continues to be a trading company (or member of a trading group) immediately after the sale of the shares, unless such sale is to a connected party.

The draft Finance Bill 2017 provides a further extension of the substantial shareholding exemption for companies owned by “qualifying institutional investors”. In such cases, where at least 80% of a company’s shares are held (directly or indirectly but not through a listed company) by qualifying institutional investors, any gains and losses will be fully exempt, regardless of the trading status of the investing or investee companies. A proportionate exemption will apply for holdings between 25% and 80%. Further, in respect of this new exemption for qualifying institutional investors, the substantial shareholding condition can be met if the investing company’s shareholding is below 10% but the acquisition cost of the shares was more than £50 million.

A company carrying on life assurance business will be considered a “qualifying institutional investor.”

4. New Corporate Offenses of Failure to Prevent the Facilitation of Tax Evasion

The draft Criminal Finances Bill 2017 introduces two new strict liability corporate offenses of failure to prevent the facilitation of tax evasion, one in relation to UK tax (the “UK Offense”) and the other in relation to foreign tax (the “Foreign Offense”).

Broadly, the UK Offense is committed where a person engages in evasion of UK tax that was criminally facilitated by an “associated person” (which would include an employee or agent) of a “relevant body” (generally corporates and partnerships) and the relevant body failed to prevent the associated person facilitating that tax evasion.

The Foreign Offense is broadly similar in the way it operates in relation to evasion of foreign tax. For the Foreign Offense to apply, the “relevant body” must be established in, or carry on any part of their business in, the UK or any part of the criminal facilitation must take place in the UK.

The two offenses are subject to a defense where, at the time of the offense, the relevant body has reasonable prevention procedures in place. It is important to note that a conviction at the taxpayer level will not be a pre-requisite for bringing a prosecution against the relevant body under these offenses.

5. UK’s Insurance Linked Securities Initiative

We consider the proposed new tax regime for ILS vehicles operating in the UK in Section II.c.1.b above.

March 2017

SIDLEY GLOBALINSURANCE REVIEW

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39/F, Two Int’l Finance CentreCentral, Hong Kong +852 2509 7888

HOUSTON

1000 Louisiana Street Suite 6000 Houston, Texas 77002 +1 713 495 4500

LONDON

Woolgate Exchange 25 Basinghall Street London, EC2V 5HA, United Kingdom +44 20 7360 3600

LOS ANGELES

555 West Fifth Street Los Angeles, California 90013 +1 213 896 6000

MUNICH

Theresienstraße 1 80333 Munich +49 89 20 500 85060

NEW YORK

787 Seventh Avenue New York, New York 10019 +1 212 839 5300

PALO ALTO

1001 Page Mill Road Building 1 Palo Alto, California 94304 +1 650 565 7000

SAN FRANCISCO

555 California Street Suite 2000San Francisco, California 94104 +1 415 772 1200

SHANGHAI

Suite 20095 Corporate Avenue150 Hubin Road Shanghai 200021, China +86 21 2322 9322

SINGAPORE

Level 31Six Battery Road Singapore 049909 +65 6230 3900

SYDNEY

Level 10, 7 Macquarie Place Sydney NSW 2000, Australia +61 2 8214 2200

TOKYO

Sidley Austin Nishikawa Foreign Law Joint Enterprise

Marunouchi Building 23F 4-1, Marunouchi 2-chome Chiyoda-Ku, Tokyo 100-6323, Japan +81 3 3218 5900

WASHINGTON, D.C.

1501 K Street N.W. Washington, D.C. 20005 +1 202 736 8000

Attorney Advertising - Sidley Austin LLP, One South Dearborn, Chicago, IL 60603. +1 312 853 7000. Sidley and Sidley Austin refer to Sidley Austin LLP and affi liated partnerships as explained at www.sidley.com/disclaimer. Prior results do not guarantee a similar outcome. Some photos on this brochure may be of actors and not of clients or fi rm personnel.

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AMERICA • ASIA PACIFIC • EUROPE - Sidley Austin · This Global Insurance Review has been prepared by Sidley Austin LLP for informational purposes only and does not constitute