SIDLEY GLOBAL INSURANCE REVIEW

March 2014

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SIDLEY GLOBAL INSURANCE REVIEWMarch 2014

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 from every corner of the earth and serve as an enormous investor base. 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, hedge funds, or capital market investors. This constantly evolving industry requires regulatory regimes to adapt on a frequent basis. Regulatory issues arising in one market may influence the way in which similar regulatory concerns are addressed elsewhere. To operate competently within the insurance industry, one must have a solid understanding of global developments.

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 developments in this global 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 approximately 1,800 lawyers and 19 offices in North America, Europe, Asia and Australia. Sidley is one of only a few internationally recognized law firms to have a substantial, multi-disciplinary practice devoted to the insurance industry. We have more than 100 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, M&A, private equity, insurance-linked securities, derivatives, tax, reinsurance dispute, class action defense, insolvency and other transactional and litigation services.

We hope you enjoy the Sidley Global Insurance Review.

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Table of Contents

I. The Global Mergers & Acquisitions Market ..................................................................................1

U.S. Market ....................................................................................................................................1

Life and Annuity ................................................................................................................................1

Regulators React to Acquisitions by Financial Buyers ................................................................1

Outlook for Financial Buyers .....................................................................................................2

Disposition of Non-Core Assets by European Insurers ..............................................................3

Interest in Variable Annuity Business ..........................................................................................3

U.S. Insurers Look Overseas .......................................................................................................3

No Significant Pension De-Risking Transactions in 2013 ...........................................................4

Property & Casualty ..........................................................................................................................4

Acquisitions of Bermuda Reinsurance Companies .....................................................................4

Distressed Company Activity .....................................................................................................5

Excess and Surplus Lines Activity ...............................................................................................5

Canadian Activity ........................................................................................................................6

Health ...............................................................................................................................................7

Continued Consolidation in the Medicaid and Medicare Managed Care Segments ................7

Formation of Integrated Healthcare Systems and Other Alternative Partnership Arrangements .....................................................................7

Blue Cross Blue Shield Conversions ...........................................................................................8

C.V. Starr’s Acquisition of MultiPlan ...........................................................................................8

Insurance Intermediaries ..................................................................................................................8

Outlook for 2014 ..............................................................................................................................9

European and Asian Market ..........................................................................................................9

Europe ..............................................................................................................................................9

Asia Pacific ......................................................................................................................................10

II. The Global Alternative Risk Transfer Market ..............................................................................10

Life Insurance Market ..................................................................................................................10

NAIC ..............................................................................................................................................11

Captive White Paper ................................................................................................................11

Rector Reports..........................................................................................................................11

RBC Activity ..............................................................................................................................12

FAWG .......................................................................................................................................12

Accreditation ............................................................................................................................12

State Regulatory Developments ....................................................................................................13

Federal Regulatory Developments.................................................................................................13

Outlook for 2014 ............................................................................................................................13

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Property & Casualty Insurance Market ........................................................................................14

Catastrophe Bonds .........................................................................................................................14

Traditional Reinsurers in the Insurance-Linked Securities (“ILS”) Market ......................................15

Hedge Fund Activity .......................................................................................................................16

Outlook Ahead ...............................................................................................................................16

III. The Global Longevity Market .....................................................................................................16

Transaction Structures .................................................................................................................16

Buy-Outs .........................................................................................................................................17

Buy-Ins ............................................................................................................................................17

Longevity Swaps ............................................................................................................................17

Index-Based Trades ........................................................................................................................17

Market Overview .........................................................................................................................18

Increased Regulatory Scrutiny .....................................................................................................18

IV. The Global Capital Markets .........................................................................................................19

United States Markets .................................................................................................................19

United States Legal and Other Developments ............................................................................20

Impact of European Market Infrastructure Regulation on European Insurance Companies .........22

Reporting ........................................................................................................................................22

Record Keeping ..............................................................................................................................22

Clearing ...........................................................................................................................................22

Risk Mitigation Techniques .............................................................................................................23

V. Global Regulatory and Litigation Developments ........................................................................25

Introduction .................................................................................................................................25

United States – Federal Regulatory Developments .....................................................................25

Treasury/FSOC Activities ................................................................................................................25

Federal Insurance Office ................................................................................................................26

Other Federal Initiatives .................................................................................................................28

Volcker Rule ..............................................................................................................................28

TRIA ..........................................................................................................................................28

NARAB II...................................................................................................................................28

Derivative Transactions ...................................................................................................................29

United States – State and NAIC Developments ...........................................................................30

Health Insurance Regulation ..........................................................................................................30

Principles-Based Reserving .............................................................................................................31

PBR Implementation ................................................................................................................31

Use of Reinsurance Captives to Finance Reserves Required Under Regulation XXX and Regulation AXXX ...................................................................33

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Captives and Captive Reinsurance Transactions ............................................................................34

Reinsurance .....................................................................................................................................35

Solvency and Corporate Governance Initiatives ............................................................................35

Corporate Governance Working Group Activities ..................................................................36

Holding Company Act and Related Changes in Law ...............................................................36

Enterprise Risk Management ...................................................................................................37

Own Risk and Solvency Assessment ........................................................................................37

Capital Adequacy .....................................................................................................................37

Private Equity Issues ......................................................................................................................38

Force-Placed Insurance ...................................................................................................................39

Unclaimed Property ........................................................................................................................40

State Bills based on NCOIL Unclaimed Life Insurance Benefits Model Act .............................40

NCOIL Forms Task Force to review Unclaimed Property Matters in Life and Annuity Industries and NAIC (A) Committee Will Study the Issues .....................40

Litigation ...................................................................................................................................40

Settlements with Insurance Regulators and Unclaimed Property Agencies ............................41

DMF Restrictions in Federal Budget for 2014 ..........................................................................42

Invested Assets ...............................................................................................................................42

Working Capital Finance Programs ..........................................................................................42

Capital Efficient Solutions ........................................................................................................43

Mortgage Guaranty Insurance .......................................................................................................44

Federal Home Loan Bank Loans and Advances to Insurance Companies .....................................45

Contingent Deferred Annuities ......................................................................................................46

International (Non-U.S.) Insurance Issues .....................................................................................46

IAIS .................................................................................................................................................46

IAIS Transparency .....................................................................................................................47

Global Capital Standards .........................................................................................................47

ComFrame ......................................................................................................................................47

Solvency II ......................................................................................................................................47

Implementation Set for 2016 ...................................................................................................47

Non-EU Country Solvency II Equivalence.................................................................................48

IAIS Global Insurance Capital Standard - Complementary or Conflicting to Solvency II? .......48

FSA Reorganization Update ...........................................................................................................49

Evolution of UK Regulation .....................................................................................................49

Finding their Footing ................................................................................................................50

Lloyd’s Developments ....................................................................................................................51

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Cyber Risk/Data Protection Update ...............................................................................................51

EU Data Protection Reform and Cyber Security Developments ..............................................52

Insurance is the Answer? ..........................................................................................................53

Brokers’ Duties and the Insurance Mediation Directive ................................................................53

The FCA’s Thematic Review .....................................................................................................54

Revision of the Insurance Mediation Directive – New Remuneration Disclosure Provisions ...54

EU/UK Competition Law Enforcement Activity .............................................................................55

DG Comp .................................................................................................................................55

Court of Justice judgment in Allianz Hungaria Case Confounds Experts ................................56

National Level Enforcement in the UK ....................................................................................56

Car Insurance Market Investigation Progresses and Involves Price-Comparison Websites .....56

Workplace Pensions Market Study Closed .............................................................................56

FCA Review of Annuities and General Insurance Add-On Products ......................................57

Asia Regulatory Developments ......................................................................................................57

China: Progress on New Solvency Capital Regime ..................................................................57

CIRC Continues its Financial Liberalization of the Insurance Sector ........................................57

Relaxation of Rules on Equity Investment into the Chinese Insurance Sector ........................57

CIRC Raises Limits on Investments by Chinese Insurers into the Equity and Real Estate Markets Following Expansion of Permitted Overseas Investment in 2012 ....58

Launch of the Shanghai Pilot Free Trade Zone ........................................................................58

Bancassurance in China: Regulators Tighten Requirements ....................................................59

VI. Select Tax Issues Affecting Insurance Companies and Products .................................................59

Prospects for Tax Reform ............................................................................................................59

FATCA ..........................................................................................................................................60

Cascading Federal Excise Tax ......................................................................................................61

Alternative Reinsurance ...............................................................................................................61

Property and Casualty Tax Controversies – Loss Reserves ...........................................................61

Insurance Tax Controversies – Timing of Dividends .....................................................................62

Limitations on What Constitutes Insurance for Tax Purposes ......................................................62

Extension of the UK Investment Manager Exemption .................................................................62

Financial Transaction Tax .............................................................................................................63

UK Taxation of Corporate Debt ...................................................................................................63

VAT and Cross-Border Supplies of Services .................................................................................63

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I. The Global Mergers & Acquisitions Market

A. U.S. Market

1. Life and Annuity

Relatively few major life insurance acquisition transactions were announced in 2013, and despite a few notable transactions, none could reasonably be characterized as a blockbuster. Of greatest note were (i) SCOR’s acquisition of Generali’s U.S. life reinsurance operation (US$910 million), (ii) Resolution Life Holdings’ acquisition of Lincoln Benefit Life Company from the Allstate Corporation (US$600 million), (iii) Protective Life’s acquisition of MONY Life Insurance Company from AXA Financial (US$1.1 billion), and (iv) Global Atlantic’s acquisition of Aviva USA’s life insurance operations (purchase price not disclosed). Wilton Re also recently entered into agreements to acquire CNA Financial Corp.’s life and group insurance business (US$615 million) and Conseco Life Insurance Company, a subsidiary of CNO Financial Group, Inc. As part of the latter agreement, Wilton Re agreed to acquire US$3.4 billion of closed-block interest-sensitive and traditional life and annuity statutory reserves and transfer all operations of the business to its administrative services platform.

On the annuity side, buyers backed by private equity and other non-traditional financial buyers (“financial buyers”) largely had the field to themselves, as traditional life insurers continued to evince very limited enthusiasm for the acquisition of variable, fixed and indexed annuity businesses. The most significant annuity transactions announced or completed in 2013 all featured financial buyers with roots in the private equity or investment management world. These transactions included (i) the acquisition by Athene Holdings, Ltd. of Aviva plc’s U.S. life and annuity business (and the related resale of Aviva’s U.S. life business to Global Atlantic) (US$2.6 billion), (ii) Guggenheim’s acquisition of Sun Life Financial Inc.’s U.S. annuity business (US$1.1 billion), and (iii) Global Atlantic’s acquisition of Forethought Financial Group, Inc. (purchase price not disclosed). In addition, Berkshire Hathaway (in many respects akin to a financial buyer) acquired variable annuities issued by CIGNA through an assumption reinsurance transaction (US$4.0 billion) and Hartford’s UK variable annuity business (US$285 million).

Notwithstanding the relatively modest numbers posted on M&A league tables in the life and annuity sector for the year, 2013 was notable for a number of significant developments and potential trends that bear watching in 2014.

a. Regulators React to Acquisitions by Financial Buyers

As in 2012, financial buyers continued to drive mergers and acquisitions activity in the life insurance and annuity sector in 2013. The inhospitable interest rate environment of recent years has prompted insurers to put underperforming blocks of business such as fixed annuity lines up for sale, and few traditional insurers have aggressively pursued these businesses. Those that have expressed interest have generally been at a competitive disadvantage to financial buyers, which by and large have assigned higher valuations to the target businesses. One factor perceived to attract financial buyers to these transactions is the potential to realize efficiencies and higher investment returns through the application of such buyers’ sophisticated investment management expertise and hedging capabilities to the substantial investment portfolios backing the annuity reserves of the acquired businesses.

The increasing participation of financial buyers in life and annuity acquisitions has not gone unnoticed by insurance regulators, and in that regard, 2013 was in some respects a watershed year. For some time, insurance regulators have voiced concern about the possibility that financial buyers may take a more aggressive approach to the management of insurers’ investment portfolios and the concomitant risk to policyholders. These concerns were voiced in May 2013, when the New York State Department of Financial Services (“NYSDFS”) announced its issuance of subpoenas to a number of leading private equity and other financial firms soliciting financial and other information relating to their involvement in the New York life insurance industry. These firms included Guggenheim Partners LLC, Apollo Global Management LLC, Athene Holding Ltd., Goldman Sachs Group Inc., Global Atlantic Financial Group and Harbinger Group Inc. The NYSDFS expressed concern that these firms may undertake excessive risk and focus on short-term investment gains at the expense of the long-term interests of policyholders of their affiliated insurance companies.

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Later in the year, the scrutiny of the NYSDFS found more concrete expression in the context of the two most prominent acquisitions involving financial buyers completed in 2013: Guggenheim’s acquisition of Sun Life Financial Inc.’s U.S. annuity business, closed on August 2, 2013, and the acquisition by Athene Holding Ltd. (an affiliate of Apollo Global Management LLC) of Aviva plc’s U.S. life and annuity business, closed on October 2, 2013. NYSDFS approval of each transaction was conditioned on the buyers’ agreement to certain “heightened policyholder protections” proposed by the NYSDFS. In each transaction, the acquirer agreed to the following conditions:

• the acquirer would maintain the Risk-Based Capital (“RBC”) levels of the acquired company’s New York insurer at an amount not less than 450%;

• the acquirer would establish a “backstop” trust account (to be maintained for seven years) containing a specified amount of cash (US$200 million in the case of Guggenheim, and approximately US$35 million in the case of Athene) to replenish the RBC levels of the acquired company’s New York insurer should they fall below 450%;

• any material changes in the acquirer’s plan of operations for the acquired company’s New York insurer would require the prior approval of the NYSDFS; and

• the acquired company’s New York insurer would file quarterly RBC reports (in addition to the annual reports required under the New York Insurance Law), and would disclose necessary information concerning corporate structure, control persons and “other information regarding the operations of the company.”

Additionally, the Iowa Insurance Division (the “IID”) conditioned its approval of the Aviva transaction upon Aviva’s not paying dividends or distributions for five years, changing its plan of operations, or making investments, payments or agreements with an affiliate without commissioner approval. Further, the IID required Aviva to reserve for all non-variable deferred annuities containing guaranteed minimum death benefits or withdrawal benefits using the more conservative accounting

guidelines (AG 33 rather than AG 43). Athene also voluntarily agreed to increase policy reserves by an additional US$150 million and to enter into a capital management agreement with respect to its RBC requirements in Iowa. (It is notable, however, that none of these regulatory requirements placed any heightened restrictions on the investment management activity of these buyers despite the investment management-related concerns initially voiced by the regulators.)

The NYSDFS recently announced that it intends to promulgate regulations to formalize these conditions in the context of life insurer acquisitions by financial buyers. On the national level, a working group of the National Association of Insurance Commissioners (the “NAIC”) has also been established to consider these issues, as to which NAIC members have thus far expressed varying views. (Please see Section C.6 of “Global Regulatory and Litigation Developments” below.)

b. Outlook for Financial Buyers

If, as many observers expect, the “heightened policyholder protections” that are ultimately promulgated by the NAIC, the NYSDFS or other states are broadly in line with those imposed in the Aviva and Sun Life transactions, we would not expect them to drive financial buyers from the market or materially diminish such buyers’ interest in life and annuity M&A. We expect financial buyers to continue to play a significant role in overall transactional activity in the life and annuity sector, especially in view of their evident willingness to tackle the regulatory and capital challenges that such transactions present. It remains to be seen, however, how evolving market conditions (especially with respect to the expected rise in interest rates) will alter the calculus, particularly in the context of fixed annuities. Financial buyers will also be paying close attention to recent regulatory developments that could affect the economics and the structure of acquisitions, including regulatory developments as to the use of reinsurance captives, reinsurance to unauthorized reinsurers and principles-based reserving, all of which are discussed in detail in Section A of “The Global Alternative Risk Transfer Market” and Sections B.2 and B.3 of “Global Regulatory and Litigation Developments.”

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While financial buyers have come under unprecedented regulatory scrutiny in recent years, they have in fact proven thus far to be a source of stable and committed capital. Indeed, as the participation of financial or non-traditional buyers in the life and annuity sector has expanded in recent years, some of the distinctions between such buyers and more traditional “strategic” players have become harder to divine, and it is clear that the more seasoned financial buyers possess substantial industry expertise and a long term perspective that belies some of the stereotypes about private equity. If that distinction continues to blur and financial buyers continue to demonstrate that they are long-term, committed fixtures in the life and annuity community, the concerns that have heretofore driven regulators to single out financial buyers for enhanced scrutiny could begin to subside.

c. Disposition of Non-Core Assets by European Insurers

Two significant transactions continued a recent trend of European insurers exiting from, or reducing their exposure to, the U.S. market. In October 2013, as we have noted, Aviva plc completed the sale of its U.S. life and annuity business to Athene, and Generali completed the sale of Generali U.S. Holdings, Inc., the holding company of Generali’s U.S. life reinsurance operations, to SCOR. It will be interesting to see whether the factors that have lately driven European insurers to shed U.S. businesses remain relevant in 2014.

d. Interest in Variable Annuity Business

Two notable transactions announced by Berkshire Hathaway in 2013 signaled a potential increase in activity involving variable annuities. In a US$2.2 billion reinsurance transaction, Berkshire Hathaway agreed to assume up to US$4.0 billion of future claims with respect to guaranteed minimum death benefit and guaranteed minimum income benefit exposures under annuities issued by CIGNA. In a separate transaction, Berkshire acquired Hartford’s UK variable annuity business for approximately US$285 million. The acquired subsidiary reportedly had approximately US$1.7 billion of assets under management at the time of the transaction. Perceived volatility has traditionally deterred potential buyers of variable annuity businesses. However, among buyers such as Berkshire Hathaway

with substantial balance sheets that are better able to handle financial statement volatility, there is the potential for future mergers and acquisitions activity in this space. Recent transactions involving buyers with more modest balance sheets (including Kansas City Life Insurance Company’s assumption of American Family Insurance Company’s variable life insurance policies and variable annuities) suggest that activity in this space may not be confined to the financial buyers and Berkshire Hathaways of the marketplace. As interest rates trend upwards and the securities markets improve, it will be interesting to see if the mergers and acquisitions market for issuers of variable annuities develops and if strategic buyers return to the fray.

Going forward, with improved investment portfolio performance as well as the expectation of rising interest rates, issuers of annuities may opt to hold blocks of business that were previously considered for the auction block. In addition, many insurers have reformed product features, such as guaranteed benefits and surrender charges, which contributed to the development of distressed books in previous years, and may accordingly be emboldened to write additional business rather than explore exit strategies from the annuity space. These developments could limit the movement of large blocks of annuity business that bolstered activity in recent years.

e. U.S. Insurers Look Overseas

Subject to a few exceptions, the slow pace of consolidation of U.S. life insurance assets has continued in 2013. To the extent that U.S. strategic buyers looked for growth through acquisitions, their focus continued to be on emerging markets. For example, Prudential recently completed its acquisition (announced in 2013) of the Malaysian life insurer Uni.Asia Life Assurance Berhad’s through a 70/30 joint venture with Bank Simpanan Nasional, a Malaysian bank that will distribute Uni.Asia’s products through its bank branches. In a similar vein, in December 2013, MetLife reached an agreement with Malaysia-based AMMB Holdings to acquire fifty-one percent of its stake in AmLife Insurance Berhad and forty-nine percent of AmFamily Takaful Berhad. AMMB would continue to hold forty-nine percent and fifty-one percent of the companies, respectively, in a continuing strategic

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partnership. As a part of the partnership, AmLife and AmTakaful will also enter into “exclusive” 20-year bancassurance and “bancatakaful” agreements for the distribution of life insurance and family “takaful” products through the distribution network of certain of AMMB’s banking subsidiaries. These transactions demonstrate the continuing attractiveness of the Southeast Asian market and the importance of bank channels for product distribution in such markets.

In Latin America, emerging markets expansion by one life insurer took different form, as MetLife, which already boasts a substantial presence in the region, completed its acquisition of Chilean pension manager AFP Provida SA for approximately US$2 billion.

We anticipate that well-capitalized U.S. life carriers will continue to focus more on emerging markets and less on domestic consolidation in order to stimulate top-line growth in 2014. Asia and Latin America are expected to remain the most popular targets, as buyers seek to expand their distribution channels through acquisitions as well as strategic partnerships.

f. No Significant Pension De-Risking Transactions in 2013

In 2012, Verizon and General Motors each transferred significant pension liabilities to Prudential Financial following an M&A-style auction process. At the time of these transactions, the view was expressed from some quarters that these transactions heralded a wave of similar activity in the U.S. However, since then, in contrast to the activity in the UK market, no similar deals of comparable scale have been announced in the U.S. It remains to be seen whether economic conditions in 2014 will be conducive to an expansion of the U.S. market for such transactions. See “The Global Longevity Market” in Section III of this Report for a detailed discussion of developments in the pension de-risking and longevity risk transfer market.

2. Property & Casualty

As was the case in 2012, activity in the property and casualty sector was sluggish in 2013. Although there were few blockbuster transactions in 2013, several areas of the property and casualty market saw steady activity throughout 2013. For example, several transactions involving Bermuda-based

reinsurance companies, excess and surplus lines providers and Canadian businesses were announced in 2013. In addition, reserve deficiency issues and ratings-agency pressures gave rise to acquisition opportunities for certain property and casualty insurers. Finally, transaction flow involving the acquisition of insurance intermediaries continued to be strong in 2013.

a. Acquisitions of Bermuda Reinsurance Companies

With the exception of a few noteworthy acquisitions, despite improved price-to-book ratios for many Bermuda-based reinsurers, overall activity in the historically competitive Bermuda marketplace was relatively quiet in 2013. Amidst the generally low level of deal-making activity involving Bermuda property and casualty companies, one high point was the announced acquisition of SAC Re Ltd. by a group led by hedge fund Two Sigma Investments, LLC. Additionally, in a continuation of the 2012 trend of transactions involving buyers specializing in the management of run-off blocks of business, runoff consolidators Enstar Group Limited and Catalina Holdings (Bermuda) Ltd each closed multiple acquisitions involving Bermuda targets in 2013.

In December 2013, SAC Capital Advisors announced that it had agreed to sell SAC Re for US$625 million to Hamilton Insurance Group, Ltd., a Bermuda holding company founded in 2013 by Two Sigma and other investors with private equity and hedge fund ties. The sale of SAC Re was required as part of a plea agreement relating to insider trading allegations in which SAC Capital Advisors agreed to stop managing outside capital. Following the close of the acquisition in December 2013, Two Sigma became sole investment manager of the investible assets of Hamilton Re, Hamilton Insurance Group’s operating subsidiary. Two Sigma’s expansion into the property and casualty insurance sector through the acquisition of SAC Re appears to have been motivated in part by its desire to increase its assets under management at lower costs relative to traditional fundraising efforts by hedge funds.

One of the more active players in the property and casualty sector in recent years, runoff specialist Enstar completed a pair of acquisitions in 2013 involving active underwriting companies with ties to Bermuda and the Lloyd’s of London market. In

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June 2013, Enstar signed an agreement with Arden Holdings Limited to acquire its subsidiaries Atrium Underwriting Group Limited and Arden Reinsurance Company Limited for a reported US$262.6 million. Approximately US$183 million of the purchase price was paid for Atrium, a Lloyd’s managing agency and syndicate specializing in a wide range of property and casualty lines. The remaining US$79.6 million was paid for Arden Reinsurance, a Bermuda-based company that provides reinsurance to Atrium and certain other runoff blocks of business.

A month later, Enstar, in a 60/40 partnership with private equity firm Stone Point Capital LLC, reached an agreement to acquire specialty insurer Torus Holdings Limited for approximately US$646 million. In connection with the transaction, Enstar and Stone Point acquired Torus Holdings’ six operating subsidiaries, which include Bermuda, U.S. and UK insurers and a Lloyd’s managing agency and syndicate. In announcing the acquisition, Enstar revealed Stone Point had also committed to provide financing for the Atrium/Arden acquisition, leaving Enstar with a 60% stake in those companies and Stone Point with a 40% stake. Public reports regarding Enstar’s acquisition of live underwriting platforms indicate that such acquisitions will bolster its ability to offer competitive bids for future runoff acquisitions, which appear to remain the core focus of Enstar’s business. The Torus acquisition also appears to have been motivated in part by a desire to gain entrance to the Lloyd’s market without undertaking the formation of a start-up syndicate.

Another runoff specialist, Catalina Holdings was also active in the Bermuda property and casualty sector in 2013. In August 2013, Catalina Holdings announced an agreement to acquire Bermuda-based American Safety Reinsurance, Ltd. for an undisclosed amount from Fairfax Financial Holdings Limited, in connection with Fairfax’s acquisition of parent company American Safety Holdings Ltd. For additional information regarding the acquisition of American Safety Holdings Ltd. by Fairfax, see the “Excess and Surplus Lines Activity” discussion in Section A.2.c below. Then, in September 2013, Catalina Holdings announced it had agreed to acquire runoff reinsurer Alea Group Holdings (Bermuda) Ltd. from buyout firm

Fortress Investment Group LLC. Catalina Holdings had previously acquired Alea’s UK business from Fortress in 2009.

b. Distressed Company Activity

In 2013, reserve deficiencies at several property and casualty insurance companies resulted in ratings downgrades and downward pressure on the share prices of the affected companies, creating deal-making opportunities that were typified in the January 2014 announcement of the indirect acquisition of Tower Group by AmTrust Financial Services Inc.

While ratings downgrades and the threat of downgrades can make it difficult for distressed companies to compete for business, declining share prices may create attractive valuations for potential buyers. Following a series of announcements in the fall and winter of 2013, Tower disclosed reserve shortfalls totaling nearly US$500 million as a result of loss development primarily associated with its workers’ compensation line. In January 2014, AmTrust Financial Services announced that it had reached an agreement to indirectly acquire Tower in a transaction also involving its affiliates ACP Re Ltd. and National General Holdings Corp. ACP Re, which is owned by a trust established by the founder of AmTrust Financial and National General, paid approximately US$172.1 million for Tower. Concurrently, in a series of reinsurance transactions, AmTrust Financial reached an agreement to acquire the renewal rights and assets of Tower’s commercial lines for an additional US$125 million, while National General acquired the renewal rights and assets of Tower’s personal lines for an undisclosed amount.

In addition to Tower, property and casualty insurance companies confronting serious reserving issues in 2013 included Australian-based QBE Insurance Group Ltd. Beginning with a February profit warning, over the course of 2013, QBE announced an aggregate of more than US$1 billion in reserve deficiencies tied to its North American operations, which ultimately led to the resignation of the company’s chair.

c. Excess and Surplus Lines Activity

Another bright spot of property and casualty mergers and acquisitions activity in 2013 was the excess and surplus lines market. Non-admitted

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specialty lines, such as excess and surplus insurance products, have emerged as an attractive segment, due in part to the fact that they are less encumbered by government regulation and have more flexibility to effectively address the growing demand for coverage of unique business risks. The flexible regulatory environment and profit potential in the excess and surplus lines segment has attracted new players to the sector and has prompted existing players to expand their presence.

In June 2013, Berkshire Hathaway Inc. announced that its newly formed subsidiary Berkshire Hathaway Specialty Insurance had commenced operations and would focus on providing tailored excess and surplus lines products to commercial customers. Several months later, in January 2014, Berkshire Specialty announced it had reached an agreement to acquire MyAssist Inc., a live-agent concierge and telematics service provider to a variety of travel and insurance companies, and Insure America LLC, a provider of niche insurance products to the travel industry, from privately-held Noel Group, which enhanced Berkshire Specialty’s operations and distribution platforms. In addition to its planned organic expansion in the excess and surplus lines market, given the opportunities presented by market fragmentation, Berkshire Hathaway may look to continue to acquisitively build out its specialty business unit in the years ahead.

As noted in the discussion of Catalina Holdings’ purchase of American Safety Reinsurance, in June 2013, Fairfax announced an agreement to acquire American Safety Insurance Holdings in a merger valued at approximately US$306 million (the transaction was approved by the target’s shareholders in August 2013). Previously, in June 2013, American Safety had announced an agreement to sell its Bermuda-based reinsurance subsidiary to Tower for approximately US$59 million. However, shortly after that announcement, American Safety terminated the proposed transaction with Tower in favor of an acquisition by Fairfax. In addition to paying the contractually required break-up fee to Tower, Fairfax also agreed, immediately upon the close of the acquisition, to sell American Safety Reinsurance to Catalina Holdings. For Fairfax,

the acquisition of niche insurer American Safety Insurance Holdings signals its interest in expanding its existing specialty insurance platform.

Also indicative of an interest in acquisitive excess and surplus lines growth was Enstar’s aforementioned acquisition of Torus Insurance Holdings, which included subsidiary Torus Specialty Insurance, a company that devotes a substantial portion of its business to excess and surplus lines products.

Given that excess and surplus lines have historically outperformed other lines in harder markets, in 2014, similar mergers and acquisitions activity may take place as economic conditions improve and pricing in the property and casualty sector continues to harden, particularly if other niche players decide the benefits of merging with conglomerates like Berkshire Hathaway outweigh the risks of being crowded out of the marketplace.

d. Canadian Activity

As was the case in 2012, consolidation in the Canadian property and casualty market continued in 2013 and early 2014 with the announcement of large acquisitions by the Travelers Companies, Inc. and Desjardins Group.

In November 2013, Travelers announced the completion of its approximately US$1.1 billion acquisition of the Dominion of Canada General from E-L Financial Corporation Limited (the transaction was announced in June 2013). The transaction signaled Travelers’ commitment to acquisitive growth of its international commercial lines operations with the purchase of a personal and commercial lines carrier that will be rebranded as Toronto-based Travelers Canada.

In another deal indicative of ongoing consolidation in Canada’s property and casualty market, in January 2014, State Farm announced the US$1.46 billion sale of its Canadian assets to leading Canadian financial services provider Desjardins Group. Desjardins will operate the business under the State Farm banner for an unspecified period of time. The transferred assets include State Farm’s Canadian property and casualty and life insurance businesses as well as its Canadian mutual fund, loan and living benefits companies. Upon the completion

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of the transaction, expected in January 2015, Desjardins will become Canada’s second largest property and casualty underwriter and its fourth largest life and health insurer.

In the near term, Canadian consolidation activity is likely to continue, as Intact Financial Corporation, the country’s largest property and casualty underwriter, has announced that it intends to continue seeking large-scale acquisition opportunities (Intact’s last acquisition occurred in 2011 with the purchase of AXA SA’s Canadian division). In addition, if, as expected, the Canadian government publishes regulations establishing a framework for the demutualization of Canadian property and casualty insurers, transactions involving Canada-based mutual companies may be an additional driver of Canadian consolidation activity.

3. Health

Coming off a strong 2012, mergers and acquisitions activity in the health insurance sector was slow in comparison in 2013, in large measure because of the uncertainty surrounding the rollout of healthcare reform under the Patient Protection and Affordable Care Act and its companion, the Health Care and Education Reconciliation Act of 2010 (together, the “ACA”) and the implementation of state insurance exchanges. Such uncertainty was likely a contributing factor for a number of insurers deciding to exit the individual health insurance market. Opportunities for large-scale consolidation were also limited following the consolidation and related integration that resulted from a number of large health insurer acquisitions completed in 2012. Rather than searching out potential blockbuster deals, large managed care companies focused their efforts on integrating recently acquired businesses or effecting small-scale state-specific transactions. Isolated bright spots of activity in the health insurance sector involved the continued consolidation of Medicaid and Medicare managed care providers, the pursuit of integrated healthcare systems providers and a pair of Blue Cross Blue Shield conversions. However, despite a slow 2013, the February 2014 announcement of C.V. Starr & Co. Inc.’s US$4.4 billion acquisition of MultiPlan Inc., the country’s largest healthcare cost management

solutions provider, may signal the start of another upsurge in activity relating to the health insurance industry in 2014.

a. Continued Consolidation in the Medicaid and Medicare Managed Care Segments

In February 2013, Florida-based managed care provider WellCare Health Plans, Inc. completed its acquisition of UnitedHealthcare’s South Carolina Medicaid business, a transaction that was announced in October 2012. Then, in April 2013, WellCare consummated its acquisition of Aetna Inc’s Missouri Medicaid management business, Missouri Care Inc. Finally, in January 2014, WellCare completed its acquisition of Windsor Health Group Inc. from Munich Re. After a very acquisitive 2013, WellCare has announced that it intends to continue to pursue aggressive growth in 2014, despite the twin headwinds of ACA implementation and lower Medicare Advantage reimbursement rates.

b. Formation of Integrated Healthcare Systems and Other Alternative Partnership Arrangements

To combat increased costs associated with the ACA and distinguish their products in a highly competitive marketplace, some health insurers are seeking to form integrated healthcare systems or other alternative partnership arrangements with community healthcare providers. For example, in April 2013, Highmark Inc. completed its US$1.1 billion acquisition of West Penn Allegheny Health System, a transaction first announced in June 2011 and subsequently renegotiated in January 2013 following regulatory approval delays and the settlement of antitrust claims brought by both sides. The transaction resulted in the creation of the Allegheny Health Network, an integrated healthcare delivery network serving Western Pennsylvania. Pennsylvania regulators approved the transaction subject to a series of safeguards aimed at fostering regional competition, transparency and the protection of Highmark policyholders. Highmark’s regional consolidation push continued with its February 2014 announcement of an agreement to merge with Blue Cross of Northeastern Pennsylvania, pending public hearings on, and regulatory approval of, the proposed merger. For further discussion of recent Blue Cross Blue Shield activity, see “Blue Cross Blue Shield Conversions” in Section A.3.c below. Similar regional consolidation

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activity is likely to occur in 2014 and beyond as managed care insurers and healthcare providers continue to seek opportunities to manage the rising costs associated with the U.S. healthcare system.

c. Blue Cross Blue Shield Conversions

In March 2013, Michigan legislation was signed into law transforming Blue Cross Blue Shield of Michigan from a tax-exempt nonprofit to a taxable nonprofit mutual insurance company. In response to concerns that the implementation of the ACA would undermine Blue Cross Blue Shield of Michigan’s financial stability, as it would no longer be the state’s health insurer of last resort, the statutory conversion resulted in the relaxation of certain regulatory constraints applicable to the insurer and will allow for substantial product expansion.

In August 2013, Health Care Service Corp. completed its merger with Blue Cross Blue Shield of Montana. Health Care Service Corp., which also owns Blues insurers in Illinois, New Mexico, Oklahoma and Texas, paid US$40 million for the acquisition, which will serve as an endowment for a new state-owned public interest foundation. The conversion of Blue Cross Blue Shield of Montana to a for-profit entity received regulatory approval subject to certain conditions, which included a freeze on administrative fees on policies for three years and public disclosure of salaries for certain Montana-based executives.

Also in August 2013, the proposed statutory conversion of Blue Cross Blue Shield of Florida was approved by state regulators. As part of the conversion, which was approved by policyholders in September 2013, the Florida Blue was transformed into a stock insurance company with a newly-created nonprofit mutual holding company as its parent. While the policyholders of Blue Cross Blue Shield of Florida will continue to own 100% of the statutorily-created mutual holding company, the transformation’s regulatory impact on the insurer will allow for increased flexibility in terms of the range of healthcare services and solutions that it may offer to customers.

d. C.V. Starr’s Acquisition of MultiPlan

After a slow 2013, February 2014 saw the announcement of C.V. Starr’s agreement to acquire healthcare cost management solutions provider MultiPlan from private equity firms Silver

Lake Partners and BC Partners for a reported US$4.4 billion. Heading an investor group that included Swiss investment firm Partners Group, the transaction is reportedly part of C.V. Starr’s effort to expand its presence in private equity investment. The blockbuster deal represents the largest acquisition to date for the insurance and investment conglomerate, which is led by Hank Greenberg, former chair and CEO of American International Group Inc.

4. Insurance Intermediaries

Mergers and acquisitions activity involving insurance brokers and insurance services providers remained strong in 2013. In addition to numerous small to mid-size strategic transactions that were announced and/or consummated, private equity-backed acquirers continued to demonstrate substantial interest in the brokerage and insurance services sector in 2013.

The continued influx of private equity investment in the insurance brokerage sector has been driven by the opportunity for high internal rates of return associated with such investments in the current low cost of capital environment. In July 2013, Chicago-based private equity firm Madison Dearborn Partners, LLC completed its purchase of National Financial Partners, a benefits, wealth management and insurance services provider, in a transaction valued at a reported US$1.3 billion. In August 2013, investment adviser Hellman and Friedman announced it had agreed to acquire Hub International Limited, a global insurance broker, for US$4.4 billion from Apax Partners and a private equity affiliate of Morgan Stanley. The deal, which ranks as the largest takeover of a U.S. insurance broker on record, represents a substantial return for Apax and Morgan Stanley, which took Hub private in a 2007 transaction valued at approximately US$1.8 billion. Finally, in January 2014, privately-held USI Insurance Services, which was acquired by private equity firm Onex Corporation in 2012, announced it had agreed to purchase 42 regional insurance brokerage and consulting firms from Wells Fargo Insurance for an undisclosed sum.

There were also several large strategic transactions in the brokerage and insurance services sector in 2013. Brown and Brown, Inc. was involved in two such acquisitions in the latter half of 2013.

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In July 2013, Brown and Brown completed its US$360 million acquisition of rival Bleecher Carlson Holdings, Inc. from an investor group led by Texas-based private equity firm Austin Ventures, in a transaction that enhanced the large accounts platform of Brown and Brown, which has historically been associated with the retail market. This acquisition was followed by the January 2014 announcement that Brown & Brown had reached an agreement to acquire Wright Insurance Group for a reported US$640 million from an investor group led by Aquiline Capital Partners LLC. In addition, in its largest acquisition to date, Arthur J. Gallagher & Co. announced an agreement in August 2013 to acquire New Jersey-based Bollinger Inc. for US$276.5 million in net consideration. Structured as a tax-free reorganization, the transaction will expand Arthur Gallagher’s Northeastern operating platform through the absorption of Bollinger’s retail property and casualty placement, wholesale brokerage, employee benefits brokerage, program management and consultancy businesses.

5. Outlook for 2014

We expect financial buyers to continue to play a leading role in the annuity M&A market, and that new financial buyers will emerge to follow the path mapped out by Athene, Guggenheim and other major players. One unknown is how economic conditions will affect this marketplace, including the availability of targets. In the context of stabilized equity markets and a rising interest rate environment, insurers may feel less immediate pressure to sell, or at any rate to sell at the valuations seen in recent years, and aside from changing transaction economics, this could limit the supply of blocks of business coming to market. Another perspective is that higher valuations, far from limiting supply, may in fact prompt insurers to pursue sales of blocks they had been unwilling to sell at depressed valuations. It will also be interesting to see whether improved market conditions inspire traditional insurers to become more active bidders for annuity blocks than they have been in recent years. On the life insurance front, we expect U.S. insurers to continue to focus more on emerging markets than on domestic consolidation opportunities. Non-U.S. insurers, particularly Asian

insurers, may prove to have a greater appetite than their U.S. counterparts for U.S. life insurance acquisitions in 2014.

Mirroring developments in the life insurance and annuity sectors, we expect that involvement of financial buyers in the property and casualty M&A market will continue to increase in 2014 as financial buyers seek growth opportunities in the property and casualty reinsurance business. In addition to demand driven by financial buyers, 2014 may also see an increase in strategic acquisitions, which are the traditional drivers of deal volume. Many potential strategic buyers have accumulated significant amounts of cash during the past few years. Given that share buybacks, the primary alternative to putting cash to work in the mergers and acquisitions market, have become less effective as stock valuations continue to rise, such stockpiles could fuel an uptick in strategic acquisition activity, especially if the trend of reserve strengthening announcements based on loss development in prior accident years continues to create downward pressure on the share prices of certain property and casualty insurers in 2014.

In the health sector, although activity in 2013 was muted, deal volume in 2014 could trend upwards once the impact of the ACA becomes clear and is absorbed by market participants. Activity involving insurers, hospital networks and other healthcare providers may increase as other insurers seek to achieve the operational efficiencies that an integrated health system provides, which include streamlining the delivery of wellness and individual healthcare services and combining information technology systems.

B. European and Asian Market

1. Europe

Multiple factors combine to suggest increasing activity, as compared with 2013, in the insurance M&A sector in the European region and, specifically, the UK. In particular, London will continue to attract attention, where Lloyd’s vehicles remain sought after, due to the diversification of risk they provide, being generally uncorrelated with other risks. The attractiveness of a Lloyd’s platform is further enhanced by the fact that, in 2013, all but two of the Lloyds syndicates generated a profit for their capital providers. The returns generated,

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often double-digits, suggest that the Lloyd’s vehicles remain highly sought after, and, when available, tend to be transferred at a premium, driven in many circumstances by an auction process. Recent years have seen a large-scale investment, in particular, in Lloyd’s Syndicates by private equity, and that trend is expected to continue given the attractive returns generated by the Lloyd’s syndicates in 2013.

A continuing soft market on the P&C side of the industry also promotes consolidation, which is more likely to occur when compared to 2013, because of the growing certainty around the new regulatory regimes, including Solvency II. Given increased familiarity by the market with the proposed regulations, and indications from those leading the reforms that the current proposals will be adopted and implemented in substantially the forms currently circulating, there is a corresponding growth in confidence among market participants regarding capital requirements. Knowledge of capital requirements in turn allows for decisions to be made about how much capital can be deployed in the acquisition context. Because of the soft market and the pressure on companies to grow the bottom line, consolidation leading to cost efficiencies is an attractive solution. The soft market delivers consolidation in another way, too: with premium rates stagnant or declining and competition for business increasing, there can be a slackening of discipline, resulting in depressed returns. To the extent this occurs, companies looking to bolster their results may consider doing so through the tack-on of additional business, acquired either as a discreet book or through the acquisition of an entity.

Additionally, with global interest rates remaining low for an almost unprecedented five years, the pressure on investment portfolios remains acute. Taken with a general industry-wide improvement in stock valuations, there is currently a coming together of sellers and buyers; with the spread narrowing between what sellers expect to receive and buyers are willing to pay; sellers eager to dispose of assets are finding a way to dispose of such assets to buyers seeking economies of scale, or greater diversification.

Globalization of the insurance industry is another continuing trend further driving M&A activity across Europe and, in particular, in the UK. For all but the most regional industry participants,

remaining competitive in 2014 (and beyond) requires a presence in all markets, including emerging markets in Africa and South America. The recovering European economy has allowed insurance companies as well as investors to consider acquisitions that will, in the case of companies, expand their global reach and, in the case of investors, allow for increased geographic diversification. Both objectives are continuing to drive M&A activity in the sector.

2. Asia Pacific

The trend of increased M&A activity in China and the pan-Asia market should also continue throughout 2014. With a burgeoning middle class, the Asian market—China alone representing 600 million consumers—is booming in terms of potential policyholders, and traditional European insurers and reinsurers, joined by Bermudian companies, seek a greater footprint in the region. Acquisitions of regional Asian firms present a means of recognizing growth materially more quickly than organic growth allows. Given the attractiveness of the market, Asia is likely to continue to be a focal point for acquisitive European and Bermudian entities.

Unevenness country-to-country within the Asian market, in terms of regulatory structures and the health of local economies, will make certain jurisdictions more attractive than others. Political stability is another factor distinguishing one jurisdiction from another, with M&A activity within countries with a sustained history of political calm predictably leading the jurisdictions targeted for M&A transactions. The presence of a Lloyd’s platform in China further promotes M&A activity in the region, providing as it does a benchmark for the growth of business generally in Asia.

II. The Global Alternative Risk Transfer Market

A. Life Insurance Market

In 2013, the pace of reserve financing transactions continued, despite a flurry of regulatory developments. The bulk of these transactions involved the financing of life insurance companies’ perceived excess reserves associated with blocks of level premium term insurance subject to Regulation XXX (“Regulation XXX”) or universal life products with secondary guarantees subject to Actuarial Guideline XXXVIII (AXXX) (“Regulation AXXX”

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or “AG 38”) through the use of captive reinsurers (each, a “Captive”). These transactions typically involve a third party stand-by capital provider who funds reinsurance payments after exhaustion of all other available funds. Stand-by capital may take the form of bank letters of credit, surplus notes or other capital funding solutions. Recently, most new money transactions have been structured as surplus note issuances. There have also been letter of credit transactions completed.

A number of regulatory developments at the state and federal level have affected the way in which market participants view reserve financing transactions. These developments have been met with varying levels of support and dissent throughout the regulatory community, and universal acceptance of any one proposal seems improbable. The following summarizes these regulatory developments and the potential impact they might have on the alternative risk transfer market for life and annuity companies.

1. NAIC

a. Captive White Paper

In 2011, the NAIC established a working group to study the use of Captives by affiliated insurance companies. The working group, known as the Captives and SPV Use (E) Subgroup of the Financial Condition (E) Committee (the “(E) Committee”), focused on the reserve financing of level premium term and universal life products with secondary guarantees. The (E) Committee prepared and exposed for public comment in March 2013 a white paper (the “White Paper”) discussing issues associated with the use of these types of Captives. On June 6, 2013, the (E) Committee voted unanimously to adopt the White Paper (which was subsequently adopted by the (E) Committee on July 17, 2013 and the Executive & Plenary Committee of the NAIC on July 26, 2013).

The White Paper included recommendations regarding (1) accounting considerations, (2) confidentiality, (3) access to alternative markets, (4) the International Association of Insurance Supervisors, (5) credit for reinsurance model enhancements, (6) disclosure transparency and (7) financial analysis handbook guidance. For a

more detailed discussion of the recommendations proposed in the White Paper, please see the Sidley Global Insurance Review (March 2013).

The first, second, sixth, and seventh White Paper recommendations were assigned to the Principle-Based Reserving (PBR) Implementation (EX) Task Force the (the “PBR Task Force”) for analysis within the context of the proposed adoption of principal-based reserving (“PBR”). The third, fourth, and fifth White Paper recommendations were referred to the Reinsurance Task Force for review. The PBR Task Force charged Rector & Associates, Inc. (“Rector”) with the responsibility of reporting on the use of financing techniques relating to Regulation XXX and Regulation AXXX, and in response, Rector has issued two reports discussed below.

b. Rector Reports

The first report, issued on September 13, 2013 (the “2013 Rector Report”), addressed the ability of an insurer to use reinsurance as well as self-funded solutions to finance Regulation XXX and Regulation AXXX reserves (collectively “Regulation A/XXX Reserves”). Regardless of the technique, the 2013 Rector Report focused on the type of assets used to back the Regulation A/XXX Reserves. Under the proposal, the insurance company could use a previously approved actuarial method to determine the level of assets expected to be needed to support reserves. These assets, known as “Primary Assets”, would consist of certain types of admitted assets. To support reserves in excess of the level of required Primary Assets (the “Primary Asset Level”), the insurer would be able to use assets that were admitted assets, as well as assets that would not qualify as admitted assets (known as “Other Assets”).

On February 17, 2014, Rector issued a second report (the “2014 Rector Report,” and together with the 2013 Rector Report, the “Rector Reports”). This 2014 Rector Report concluded that the Primary Asset Level should be set at the level dictated by PBR (which is reflected in NAIC Valuation Manual 20, Requirements for Principle-Based Reserves for Life Products). The 2014 Rector Report suggested that reserve financing transactions should not be necessary following the adoption of PBR. This assertion will likely be challenged by the

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industry and some regulators given that many industry participants believe significant reserve redundancies would still exist despite the adoption of PBR. Other interesting suggestions found in the 2014 Rector Report include limiting the type of Primary Assets to cash, securities that are listed (and filing-exempt) by the Securities Valuation Office (the “SVO”) and, after the first year of a financing, letters of credit (so long as such letters of credit in the aggregate comprise no more than 10% of the insurer’s total Primary Asset Level). In other words, admitted assets outside of cash and SVO-listed securities would be ineligible to back Regulation A/XXX Reserves.

The 2014 Rector Report also recommends that RBC should be calculated by the cedent or the reinsurer and disclosed in an enhanced Schedule S filing. Finally, the 2014 Rector Report introduced a draft Regulation XXX/AXXX Reinsurance Model Regulation which encompasses all of these proposals. Under the proposed regulation, the NAIC Financial Analysis Working Group (the “FAWG”) would be required to review any non-compliant transaction which, given its non-compliant nature, would be deemed to be financially hazardous. The 2014 Rector Report recommends that the requirements contained therein be used (i) in concept, with as much detail as possible based on available requirements and regulator judgment, with respect to any new financing structures that are created on or after July 1, 2014, and (ii) in greater detail, with respect to any Regulation A/XXX business written on or after January 1, 2015, regardless of when the financing structure or vehicle was created. The 2014 Rector Report will be addressed at the NAIC Spring meeting. We anticipate significant debate and measured deliberation before any of these proposals are codified.

c. RBC Activity

In addition to the Rector Reports, there has been additional NAIC activity relating to RBC and unauthorized reinsurers. On its January 31, 2014 conference call, the Life RBC Working Group discussed a NYSDFS proposal to require life companies to collateralize the amount of RBC that would be released when ceded to unauthorized reinsurers. This proposal would reduce RBC released for business ceded to any unauthorized

reinsurer. The Working Group decided to refer the issue to its parent Capital Adequacy Task Force (“CATF”), so that the CATF can consider how to coordinate with other NAIC Task Forces and whether such requirement should be considered also for health and P&C insurers.

d. FAWG

In addition to various NAIC proposals, the FAWG has been activated. The FAWG is an established, ongoing committee charged with analyzing and monitoring nationally significant insurers and groups that exhibit characteristics of trending toward or being financially troubled. Arising out of the White Paper adoption, the FAWG received a new charge. The FAWG was required to (i) review Regulation A/XXX transactions occurring on or after July 26, 2013, by nationally significant U.S. life insurers to preserve the effectiveness and uniformity of the solvency regulatory system, and (ii) for transactions entered into and approved prior to July 26, 2013, and still in place, collect specified data in order to analyze the prevalence and significance of those transactions throughout the industry. At the recommendation of the (E) Committee, State regulators are encouraged to present Captive transactions to the FAWG for its review and comment on a confidential basis. It remains unclear how this confidentiality will be maintained. At the time of publication, we are not aware of any specific transaction that has been reviewed by the FAWG.

e. Accreditation

Rhode Island Superintendent Torti stated in December 2013 that Captives used in Regulation A/XXX transactions should be designated as “multi-state insurers” for purposes of accreditation; specifically, whether life insurer-owned Captives should be considered multi-state insurers and therefore subject to Regulations XXX and AXXX, as compared to traditional Captive insurers owned by non-insurance entities for purposes of managing their own risk. On December 15, 2013, the Financial Regulation Standards and Accreditation (F) Committee (the “(F) Committee”) discussed the definition of “multi-state insurer” and the potential impact on the States’ financial regulation of Captives and Captives themselves if such a designation were given. The (F) Committee noted some inconsistencies in existing guidance and asked

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the NAIC staff to draft proposed clarifying language regarding the definition and treatment of multi-state insurers for the (F) Committee’s review at the 2014 Spring National Meeting.

2. State Regulatory Developments

At the State level, some State insurance departments have also recently weighed in on the use of Captives in certain reserve financing transactions, with the NYSDFS taking an aggressive stance against the use of Captives. In June 2013, the NYSDFS released a white paper titled “Shining a Light on Shadow Insurance,” in which it labeled captive reinsurance transactions as “shadow insurance” transactions. The NYSDFS suggested that no actual risk transfer exists because the insurer is ultimately liable for paying claims. Additionally, the NYSDFS posited that these transactions could put the stability of the broader financial system at risk as they could leave insurance companies on the hook for the Captive’s losses.

The NYSDFS provided recommendations to address these concerns, including:

• detailed disclosure of these transactions by New York-insurers and their affiliates;

• enhanced general disclosure requirements (to be developed by the NAIC);

• other states and governing bodies to conduct similar investigations; and

• consideration of an immediate national moratorium on approving these transactions.

On June 13, 2013, the NAIC, through then-president Jim Donelan, commented that a moratorium was not necessary and was premature. Presently, no other State has followed New York’s recommendation for a moratorium.

On the other side of the debate, in January 2014, the Vermont Department of Financial Regulation (the “Vermont Department”) released a bulletin titled “Captive Insurance Division Bulletin No. C-2014-01”. The Vermont Department reaffirmed its belief that such Captives should be regulated more like traditional companies in order to preserve the confidence of policyholders in the traditional insurers and in the state-based regulatory regime. The bulletin listed the types of collateral that would be considered best practice for treatment as permitted assets or as a reduction in liabilities

to support underlying reserves (i.e., prioritized letters of credit in favor of the ceding company, securitizations, surplus notes issued in accordance with SSAP 41 and reinsurance agreements with traditional insurance or reinsurance companies with acceptable financial strength ratings). The bulletin increased transparency requirements with respect to company group codes given by the NAIC and periodic financial statements to be filed with the Vermont Department and the NAIC. Although the increased transparency requirements are only effective for Captives licensed after January 1, 2014, the bulletin stated that the Vermont Department will encourage voluntary compliance for Captives licensed prior to that date.

3. Federal Regulatory Developments

In addition to State regulatory developments, the use of Captives has also received attention at the Federal level. On December 12, 2013, the Federal Insurance Office (the “FIO”) issued a report to Congress on how to modernize and improve the system of insurance regulation in the United States (the “Modernization Report”). With respect to Captives, the Modernization Report recommended that States develop a uniform and transparent solvency oversight regime for the transfer of risk to Captives. The Modernization Report did not endorse the moratorium recommendation of the NYSDFS discussed above.

The U.S. Securities and Exchange Commission (the “SEC”) has asked various life insurers to disclose more detail regarding the use of Captives and any potential solvency concerns that would arise if they were forced to refrain from using Captives. Certain life insurers have responded to the SEC noting potential problems that could arise from a Captive moratorium, and also these insurers have made more detailed disclosures in their management discussion and analysis (MD&A) sections describing the types of financings.

4. Outlook for 2014

During the past few years, the NAIC has studied the use of Captives and A/XXX Reserve transactions. 2014 may be the year of NAIC action. The 2014 Rector Report is the first concrete proposal to address these types of transactions. Even if the Rector framework is not fully adopted, we anticipate

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that the proposals will influence the approach state regulators take when approving these types of transactions.

B. Property & Casualty Insurance Market

The importance of alternative risk transfer (“ART”) products in the property and casualty market proved to be on the rise in 2013, taking the trends of 2012 to new heights. In the catastrophe bond market, it was a groundbreaking year for deal activity, market size and innovation. Building on the prior year’s themes of broadened investor demand and structural flexibility, 2013 also brought continued growth of third-party capital, sidecar capacity and hedge fund reinsurer activity. According to market sources, increasingly favorable pricing within the ART market was partially responsible for falling rates on line among traditional reinsurers. The following provides an overview of the global property and casualty ART market’s highlights and trends of 2013.

1. Catastrophe Bonds

The issuance of catastrophe bonds soared in 2013, reaching a total of over US$7.5 billion, up more than US$1.25 billion from 2012.1 Market sources reported 34 catastrophe bond transactions having been completed in 2013, with an average issuance size of US$216.1 million per transaction, sponsored by 30 different sponsors, 11 of which were first-time sponsors. Non-traditional sponsors, including various governmental entities and non-insurance companies, contributed to the exceptional number of issuances, and three long-time sponsors (AIG, Nationwide and USAA) each went to market twice over the course of the year.

With a record number of transactions brought to the global market, not only was 2013 a remarkable year in terms of deal activity, 2013 also saw the total catastrophe bond limit reach the highest level in market history with more than US$20.5 billion in catastrophe bonds outstanding at year-end. According to Swiss Re, the catastrophe bond market has now grown by nearly 50% from its post financial crisis low set in 2011.2 In addition, 2013 catastrophe bond returns were notable. The Aon Benfield All

Bond ILS index posted returns of 10.87% (compared to 9.75% in 2012), outperforming comparable fixed income indices for 2013.3

The majority of catastrophe bond issuances in 2013 included coverage for U.S. hurricane risk. In addition, indemnity coverage continued to dominate the market. Market sources reported other catastrophe bond features becoming more prominent in 2013, including optional resets, annual aggregate bonds and tranches of longer duration (four-year maturities in particular). Expanding on the non-standard transaction structures and elements emerging over the last several years, 2013 also saw new types of underlying risk brought to market. With the increased demand for catastrophe bonds and ever-increasing sophistication among the investor base, first-of-their-kind transactions once again made headlines in 2013. Four of the more distinctive deals of the year are highlighted below.

• Residential Reinsurance 2013 Limited (Series 2013-2).The Residential Reinsurance transaction (sponsored by USAA) offered investors a tranche of U.S. multi-peril notes that was one of the riskiest layers ever offered in the catastrophe bond market, with an expected loss of 13.06%. These notes priced at the lowest end of marketing guidance and resulted in the year’s highest yielding transaction, paying a 20% coupon. The transaction was reported to be oversubscribed even after the size of the issuance was increased. The overwhelming demand for these notes pushed the interest spread below the modeled sensitivity case attachment probability, another first for the market.

• Tradewynd Re Ltd. (Series 2013-2).The Tradewynd Re transaction (sponsored by AIG) introduced a novel approach with respect to modeling. In addition to detailed exposure data having been provided to Risk Management Solutions, Inc., the modeler retained to perform the risk analysis provided in the transaction’s offering documentation, EQECAT, Inc. and Air Worldwide Corporation

1 See Aon Benfield Securities, Inc. Insurance-Linked Securities, Fourth Quarter 2013 Update.

2 See Swiss Re Insurance-Linked Securities Market Update, January 2014.

3 See Aon Benfield Securities, Inc. Insurance-Linked Securities, Fourth Quarter 2013 Update.

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also had the opportunity to receive underlying portfolio data and provide an independent analysis. The market appeared to respond positively to this innovation, with the final spread closing at the lower end of initial guidance on all three tranches issued.

• Loma Reinsurance (Bermuda) Ltd. (Series 2013-1).Argo’s third catastrophe bond transaction was yet another deal that grew in size during marketing and ultimately priced at the lower end of guidance on all three of its tranches. More importantly, it was the first transaction in the market to utilize an annual aggregate loss calculation, combining both an indemnity trigger for its insurance businesses and an industry loss index trigger for its reinsurance business. In a single issuance, the sponsor benefited from both reinsurance and retrocessional reinsurance protection.

• MetroCat Re Ltd. (Series 2013-1).The MetroCat Re transaction (sponsored by first-time sponsor First Mutual Transportation Assurance Co.) was the first catastrophe bond transaction to cover storm surge risk as the sole peril and the first catastrophe bond designed specifically to protect public transportation infrastructure. The cedant, a captive insurer of the New York Mass Transit Authority (“MTA”), suffered approximately US$5 billion in losses from 2012’s Superstorm Sandy. MetroCat Re Ltd. was established to overcome the MTA’s shortage of traditional reinsurance as a result of Superstorm Sandy. Market reports suggested significant investor interest in the deal. Pricing for the catastrophe bond settled at below the bottom of initial guidance.

2. Traditional Reinsurers in the Insurance-Linked Securities (“ILS”) Market

2013 also saw the highest amount of new third-party capital enter the property and casualty ART sector with an influx of an estimated US$10 billion.4 The growing popularity of insurance-linked risk as an alternative asset class led many traditional reinsurers to consider how to define their roles in this market. Although third-party capital is often

framed as a threat to traditional reinsurers, there were no significant consolidations of traditional reinsurers to report. Rather, in line with the recent trend, traditional reinsurers continued to adapt their business models to the changing marketplace and pursue strategies to develop their own alternative capital programs.

Traditional reinsurers in the United States and Europe participated in the catastrophe bond market (e.g., Munich Re, Hannover Re and Swiss Re). In addition, new capital markets divisions were established by Aspen, AXIS, Lancashire, Montpelier, Sirius and XL. Validus, Hannover Re and Renaissance Re opened existing internal funds to third parties. Others, including Allied World (Aeolus) and Hiscox (Third Point Re), entered into strategic partnerships with existing ILS fund managers.

Due to the growing investor demand for insurance-linked risk, 2013 was also characterized by an abundance of sidecar capacity, with more traditional reinsurers establishing facilities for alternative reinsurance capacity. Again, innovation and adaptability proved critical for fundraising. Longtime sidecar sponsors and new sponsors alike deviated from traditional practices, developing vehicles with more catastrophe bond features than seen before. For example, some sidecar transactions were structured as 144A eligible to facilitate liquidity. In addition, the typical investor pool expanded with new and renewed facilities targeting the institutional investor base of ILS funds. Some sidecars offered enhanced reporting of investment value. Sector Re drew attention among market sources for its offer of weekly pricing reports. Sidecar securities in 2013 also offered investors access to different levels of risk and return within the same vehicle (e.g., Lorenz Re (sponsored by PartnerRe) and Kinesis Re (sponsored by Lancashire)).

For traditional reinsurers outside the ILS market, 2013 was marked with softening prices, because of competition from rival reinsurers, substantial sidecar activity and the robust catastrophe bond market. 2013’s ILS market offered reinsurance at a 25%-40% reduction from 2012 rates, making it a particularly attractive option for sponsors. In response to this rate competition, traditional reinsurers sought to underwrite contractual features

4 See Guy Carpenter & Company, LLC, “January 1, 2014 Renewals Bring Downward Pressure on Pricing” December 29, 2013.

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that are difficult to replicate in the ILS market and offered more favorable reinstatement terms and other enhanced terms and conditions. Market sources reported that many traditional reinsurers embraced the need to innovate to meet clients needs in the competitive market with offerings of more tailored coverage (using options such as aggregate and quota share cover, multi-year arrangements and early signings at reduced prices) and the development of new product offerings for terror and cyber risks.

3. Hedge Fund Activity

Hedge fund-backed reinsurance structures gained further traction in 2013. Third Point Reinsurance Company Ltd. raised US$276 million (US$252.2 million net of costs) in an initial public offering. Greenlight Capital Re Ltd. achieved its highest earnings per share since before 2009. S.A.C. Re, Ltd. was acquired by Hamilton Insurance Group, Ltd., a company owned by Brian Duperreault, former CEO of Marsh & McLennan Companies and ACE Limited, and other investors, including two private equity firms, affiliates of a hedge fund and various institutional investors. The reinsurer was renamed Hamilton Re, Ltd. and has since announced a new leadership team including Sandy Weill, the former head of Citigroup, and Conan Ward, the former Validus Re CEO. A number of other investment managers have expressed interest in this strategy, and we expect significant continuing activity.

4. Outlook Ahead

On track for additional expansion, we anticipate that the ILS market will experience another busy year in 2014. An estimated US$4.2 billion in catastrophe bonds—many of which were originally issued during times of significantly higher premium rates—are scheduled to mature, and market conditions are ripe for their reissuances as well as for new entrants.5 This segment of the market should continue to grow in prominence so long as reinsurance funded through catastrophe bonds and other ILS remains cost effective. While traditional reinsurers are likely to see rate pressures persist, many may be better positioned in 2014 to ward off the competition. As in 2013, we expect that ART mechanisms in the property and casualty market will become more

prevalent in the year ahead, and the alternative asset class, as a whole, will continue to attract new participants and new capital.

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 an increased level of transaction activity in relation to the latter, with some European-based life insurance groups looking to hedge longevity exposure in light of the additional regulatory capital that may have to be held under Solvency II in respect of annuity business. However, it is the demand from defined benefit pension schemes that has been the principal driver for the development of an active secondary market for longevity risk, in which reinsurers have been the principal participants.

According to figures published by the International Monetary Fund in 2012, on a global basis the aggregate value of private defined benefit pension liabilities totals US$23 trillion. 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 such schemes in deficit. This in turn has adversely affected the balance sheets of corporate sponsors who are liable to fund 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. A further alternative first became available to the market in 2009, with the emergence of longevity swaps.

A. Transaction Structures

To put into context our review of recent longevity transactions, we first set out below a brief overview of the principal longevity risk transfer methods.

5 See Munich Re Insurance-Linked Securities, Market Review 2013 and Outlook 2014.

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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 effected 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 being 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 over 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 intended to be derivatives and not contracts of insurance. 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) in reference 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 off-shore) 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 typically offer a much 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 usually means that the investment, interest rate and inflation risk remains with the trustees. Accordingly, longevity swaps are often a less expensive alternative to buy-ins and buy-outs, albeit much 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.

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, index-based trades are perhaps more likely in the short term to be of greater interest to insurers and ILS investors than to pension schemes. Deutsche Bank launched a template for trading longevity options in late 2013. This is based on certain population data for England and Wales and the Netherlands and is available in population cohorts split by gender and five year age brackets. It has been reported that at least one transaction has been completed on the basis of a so-called “longevity experience option,” involving an acquisition (the selling of ) of longevity protection by an ILS fund.

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B. Market Overview

As we predicted in last year’s report, 2013 turned out to be a record year for UK pension de-risking transactions. Highlights included Deutsche Bank’s longevity swap with the AstraZeneca pension scheme covering £2.5 billion of liabilities and around 10,000 pensioners. This risk was in turn hedged with the reinsurance market. Deutsche Bank also completed a longevity swap covering approximately £1 billion of Carillion’s pension fund liabilities. In the more traditional bulk annuity market, significant transactions included Prudential’s £120 million buy-in policy in respect of JLT’s UK pension scheme.

The total value of UK longevity risk transferred in 2013 is assessed as being in the region of £12 billion, beating the previous UK annual record of £7.7 billion in 2011.

This intense level of activity has continued into 2014, with the largest ever pension scheme longevity swap being announced in March 2014. This involved an innovative structure whereby £5 billion of liabilities of the Aviva Staff Pension Scheme (covering 19,000 lives) were insured by Aviva Life & Pensions UK Limited and simultaneously reinsured by Munich Re, Scor and Swiss Re.

Factors fuelling the continuing growth of this market include the healthy levels of capacity within the reinsurance market. Aon Hewitt reports that the number of reinsurers willing to assume longevity risk has increased in recent years from approximately 5 or 6 a few years ago to closer to 20, with around 10 reinsurers actively bidding to participate in longevity risk transfer transactions. The demand from reinsurers has been driven by a number of factors, but perhaps the most significant for life reinsurers with excess mortality books is that longevity risk acts as a natural hedge against mortality exposure and can create diversification benefits for regulatory capital purposes.

This healthy competition is in turn driving more attractive pricing and encouraging more pension schemes to evaluate their de-risking options. Hymans Robertson predict that by 2017, half of the FTSE 100 companies will have transferred risk from their defined benefit pension schemes through either a traditional bulk annuity deal or a longevity swap. To date, approximately 20 FTSE 100

companies have taken this action, suggesting that there will be a continuing sharp increase in activity in this sector in the coming years.

As we discussed in last year’s report, in 2012, a few significant transactions were completed in the United States in the longevity market, including the purchase of separate account group annuity contracts by certain General Motors and Verizon Communications Inc. pension plans from The Prudential Insurance Company of America. Since these transactions, we are not aware of the completion of any other significant longevity transactions in the United States market.

C. Increased Regulatory Scrutiny

The growth in the global longevity risk transfer market has prompted a detailed review by the Joint Forum (representing the Basel Committee on Banking Supervision, the International Organization of Securities Commissions and the International Association of Insurance Supervisors). In a report published in December 2013, entitled “Longevity risk transfer markets: market structure, growth drivers and impediments, and potential risks,” the Joint Forum undertook an analysis of the longevity risk transfer market. This was preceded by a consultation paper earlier in 2013 in which the Joint Forum explained that their mandate was to assist in setting appropriate policies and to help ensure effective supervision of related activities and risks on a global basis. The key conclusion in the final report was that while the longevity risk transfer markets are not large enough to present systemic concerns yet, “their massive potential size and the growing interest from investment banks in mobilizing this risk makes it important to ensure that these markets are safe, both on a prudential and systemic level.”

The Joint Forum made several recommendations, including that:

• supervisors should communicate and co-operate on longevity risk transfer internationally and cross-sectorally in order to reduce the potential for regulatory arbitrage;

• policymakers should review rules and regulations pertaining to the measurement, management and disclosure of longevity risks;

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• supervisors should take into account that longevity swaps may expose the banking sector to longevity tail risk, possibly leading to a risk transfer chain breakdown; and

• policymakers should closely monitor the longevity risk transfer taking place between corporates, banks, (re)insurers and the financial markets, including the amount and nature of the longevity risk transferred and the resulting interconnectedness.

The increased level of pension scheme de-risking activity in the UK, coupled with continuing demand from life insurers looking to hedge the longevity risk in annuity books, has fueled an active secondary market for longevity risk. To date, the vast majority of that business has been written by reinsurers, and such has been the available capacity within the life reinsurance market that the pricing has been competitive and there have been relatively few opportunities for the capital markets, ILS funds and others attracted by an asset class that is largely uncorrelated to the financial markets. However, with the strong growth in demand for longevity hedging, some are predicting that within the short-to-medium term, traditional reinsurance capacity may well become fully utilized, creating opportunities for new entrants to this market.

IV. The Global Capital Markets

A. United States Markets

In 2013, the volume of capital markets transactions has continued to build. These transactions primarily involved initial public offerings and spin-offs, hybrid offerings, debt offerings and funding agreement-backed note issuances. Offering sizes ranged generally from US$25 million to US$1.3 billion.

A number of IPOs and spin-offs closed in 2013, with ING’s spin-off of its U.S. insurance investment management business through a US$1.3 billion IPO of ING U.S. being the largest. ING has publicly announced additional future plans to spin off its European insurance business and fully divest its remaining Asian businesses. Additionally, The Goldman Sachs Group, Inc. spun off its global financial services holding company, Global Atlantic Financial Group, through a private placement to

more than 1,000 investors, but has retained a 25% interest in the entity. Other notable transactions in 2013 included a US$125 million IPO of Blue Capital Reinsurance Holdings Ltd., a Bermuda reinsurance holding company affiliated with Montpelier Re Holdings Ltd., offering collateralized reinsurance in the property catastrophe market. In addition, there were two mortgage insurer IPOs: (i) a US$335 million IPO of Essent Group Ltd., a Bermuda-based mortgage insurer, backed by investors including The Goldman Sachs Group Inc. and George Soros, that was the first IPO of a U.S. home-loan mortgage guarantor in almost 20 years; and (ii) a US$27.3 million IPO of NMI Holdings Inc., a mortgage insurer backed by funds tied to Carlyle Group LP and Kyle Bass.

A hybrid offering refers to an offering of a security that combines elements of debt and equity securities. Hybrid debt, for example, is subordinated to senior debt but senior to equity, and the issuer generally has the freedom to suspend coupon payments and defer repayment of principal in certain circumstances. Several hybrid offerings closed in 2013 and the first quarter of 2014, including SCOR SE’s arrangement for a new €200 million contingent capital equity line with UBS AG; W.R. Berkley’s issuance of US$350 million of subordinated debentures due in 2053; and Prudential Financial, Inc.’s issuance of US$650 million 5.7% fixed rate junior subordinate notes, due March 15, 2053.

A limited number of traditional debt offerings occurred in 2013, with the Sammons Financial Group, Inc.’s 144A issuance of US$200 million aggregate principal amount of 7% 30-year senior unsecured notes being the main example.

Life insurance companies continue to use funding agreement-backed note programs to fund a portion of their institutional spread business through private placement securitization vehicles, such as global medium term note (“GMTN”) programs. The total issuance in 2013 of approximately US$12.3 billion has dropped from US$15.2 billion in 2012, according to Standard & Poor’s.6 GMTN programs provide a life insurance company with flexibility in that it can issue GMTNs both to investors outside the United States pursuant to Regulation S and to

6 See Standard & Poor’s report, dated January 16, 2014, entitled “Rated Funding Agreement-Backed Note Issuance Totals $12.3 Billion in 2013”.

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qualified institutional buyers within the United States pursuant to Rule 144A. Issuances over the past 5 years have been limited to a small group of life insurers including MetLife, New York Life, Massachusetts Mutual and Principal Life. In 2013, however, Prudential Insurance Company of America and Jackson National Life Insurance Company issued notes after several years of inactivity. As interest rates increase and the yield curve widens, we expect more activity and new issuers in the funding agreement-backed note market.

B. United States Legal and Other Developments

Various legal developments over the past year have had an impact on capital markets transactions in the United States. For example, the Staff (the “Staff”) of the SEC has provided comment letters to insurance holding company registrants, focusing on the following areas:

• Transactions with Captive Subsidiaries. The Staff has requested expanded disclosure regarding the nature, purpose and number of captive transactions, as well as the impact of captive subsidiaries on the insurer’s financial statements and uncertainties associated with captive subsidiaries.

• Investments and Financial Instruments. The Staff has focused on the use of third-party credit ratings, drivers of net derivative results and effective interest rates.

• Reinsurance Receivables. The Staff has requested enhanced disclosure relating to the credit quality of reinsurance receivables and allowances for credit losses associated with reinsurance receivables.

• Statutory Disclosures and Dividend Restrictions. The Staff has focused on compliance with existing disclosure requirements regarding capital and surplus, specifically, minimum capital and surplus requirements for domestic and foreign subsidiaries. The Staff has also asked about compliance with Regulation S-X, which mandates the format and content of financial reports, including dividend limitations, and certain rules thereunder regarding dividend restrictions.

• Reserve and Loss Adjustment Expense. The Staff has continued its focus on enhanced disclosure concerning the key methods and assumptions used to derive loss adjustment expense and related reserves, and a discussion of the reasons behind any changes therein.

• Deferred Acquisition Costs. The Staff has asked for disclosure concerning an insurer’s adoption of ASU 2010-26, which requires insurance entities to defer and amortize certain new or renewal insurance contract acquisition costs.

There have also been developments during 2013 with respect to executive compensation advisers. As required by Section 952 of the Dodd-Frank Act (“Dodd-Frank”), the SEC adopted Rule 10C-1 under the Securities Exchange Act of 1934, as amended, directing all national securities exchanges, including the New York Stock Exchange (the “NYSE”) and The NASDAQ Stock Market LLC (“Nasdaq”) to adopt (and, effective as of July 1, 2013, the NYSE and the Nasdaq did in fact adopt) rules providing that the compensation committee of a listed company may select a compensation adviser only after considering the following six independence factors: (i) the provision of other services to the issuer by the person that employs the compensation adviser; (ii) the amount of fees received from the issuer by the person that employs the compensation adviser (as a percentage of the total revenue of such employer); (iii) the policies and procedures of the person that employs the compensation adviser that are designed to prevent conflicts of interest; (iv) any business or personal relationship of the compensation adviser with a compensation committee member; (v) any stock of the issuer owned by the compensation adviser; and (vi) any business or personal relationship of the compensation adviser or the person employing the adviser with an executive officer of the issuer. These rules apply to any compensation adviser who provides advice to a compensation committee, regardless of whether such adviser is retained by the compensation committee itself (excluding in-house legal advisers and certain other limited engagements).

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In December 2013, the five agencies principally responsible for banking and financial markets regulation in the United States adopted implementing rules under Section 13 of the Bank Holding Company Act of 1956, which was added to the statute by Section 619 of Dodd-Frank (collectively, the “Volcker Rule”). The Volcker Rule restricts the ability of banking entities to engage in proprietary trading or to sponsor, or to acquire or retain ownership interests in, covered funds. The Volcker Rule defines banking entity very broadly to include subsidiaries and affiliates of federally insured depository institutions and of most large international non-U.S. banks; thus the definition covers insurance companies that are affiliated with U.S. depository institutions (including savings banks) and many foreign banks. Insurance companies that qualify as banking entities must therefore consider their proprietary trading and covered fund activities in light of the Volcker Rule; however, the rule includes specific exemptions for many typical insurance company activities, though these exemptions are subject to certain specified limitations and conditions.

Proprietary trading is generally defined as the purchase or sale of any financial instrument as principal for the trading account of the banking entity, and it covers a broad range of short-term trading. However, an insurance company acting for its general or separate account is exempt from the proprietary trading restriction, provided that the following criteria are met: (i) the purchase or sale is solely for the general account or separate account of the insurance company, as applicable, (ii) the purchase or sale is conducted in compliance with, and subject to, the insurance company investment laws, regulations and written guidance of the state or jurisdiction in which the insurance company is domiciled, and (iii) the appropriate Federal agencies have not determined that a particular law, regulation or written guidance described in clause (ii) is insufficient to protect the safety and soundness of the banking entity or the financial stability of the United States.

The portion of the Volcker Rule addressing covered funds generally prevents a banking entity from acquiring or retaining an ownership interest in, or sponsoring, in either case, as principal, directly or indirectly, a covered fund. The rule defines

“covered fund” broadly to include many private issuing entities (i.e., those that would be investment companies under the Investment Company Act of 1940, as amended (the “Investment Company Act”), but for Section 3(c)(1) or 3(c)(7) thereunder—the so-called “100 holder” and “qualified purchaser” exemptions), certain commodity pools and, solely with respect to U.S. banking entities, certain entities that are organized and owned solely outside the United States that raise money from investors primarily for investing in securities for resale and that have a U.S. banking entity as their sponsor or an owner of their ownership interests (a term that is also very broadly defined and covers more than traditional equity, partnership and similar interests). For example, an issuer of catastrophe bonds that relies solely on Section 3(c)(7) under the Investment Company Act would be a covered fund (and its catastrophe bonds, because of their loss absorbing features, would likely be ownership interests). As with the restrictions on proprietary trading, the covered fund restrictions include certain exemptions for insurance companies. An insurance company separate account is excluded from the definition of covered fund so long as no banking entity other than the insurance company participates in the separate account’s profits and losses. In addition, an insurance company and its affiliates are not subject to the restrictions on sponsoring, or acquiring or retaining ownership interests in, covered funds, provided that the following criteria are met: (i) the acquisition or retention is solely for the general or one or more separate accounts of the insurance company, (ii) the acquisition and retention of the ownership interest is conducted in compliance with, and subject to, the insurance company investment laws, regulations, and written guidance of the state or jurisdiction in which such insurance company is domiciled, and (iii) the appropriate Federal agencies have not jointly determined that a particular law, regulation or written guidance described in clause (ii) is insufficient to protect the safety and soundness of the banking entity or the financial stability of the United States.

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C. Impact of European Market Infrastructure Regulation on European Insurance Companies

The European Market Infrastructure Regulation (“EMIR”) came into force on August 16, 2012. EMIR represents part of the European Union’s (the “EU”) response to the G20 summit in September 2009, which resolved to reduce risk in the financial system and in particular to minimize the risk of contagion from OTC derivative markets.

As such, EMIR imposes certain obligations on counterparties to derivative contracts. For the purposes of EMIR, the definition of a derivative contract is that set out in the Markets in Financial Instruments Directive (“MiFID”).

Certain of the obligations under EMIR apply to all types of derivative contract, for example reporting and record-keeping, whereas risk mitigation techniques only apply to uncleared OTC derivative contracts (i.e. derivative contracts the execution of which does not take place on a regulated market within the meaning of MiFID or on a third country market which has been designated as an equivalent market). Although, at the time of publication, there have not been any non-EU exchanges declared as equivalent.

The obligations applicable to a particular counterparty will depend on its classification under EMIR. The following types of entity within the European insurance industry will be properly classified as financial counterparties (“FCs”) under EMIR:

• insurance undertakings as authorized in accordance with First Council Directive 73/239/EEC of July 24, 1973 on the coordination of laws, Regulations and administrative provisions relating to the taking-up and pursuit of the business of direct insurance other than life insurance;

• assurance undertakings as authorized in accordance with Directive 2002/83/EC of the European Parliament and of the Council of November 5, 2002 concerning life assurance; and

• reinsurance undertakings as authorized in accordance with Directive 2005/68/EC of the European Parliament and of the Council of November 16, 2005 on reinsurance.

These entities (“Insurance Company FCs”), as FCs, are subject to the most stringent obligations under EMIR.

What follows is a brief summary of the obligations applying to Insurance Company FCs and a timeline of when each of the obligations begins to apply.

1. Reporting

Details of all derivative contracts (whether OTC or exchange traded) which have been concluded, modified or terminated on or after August 16, 2012, transacted between Insurance Company FCs and any of their counterparties (i.e. regardless of how the relevant counterparty is classified under EMIR and regardless of whether or not the counterparty is established within the EU) must be reported to an authorized trade repository. Insurance Company FCs must also report data relating to valuation and collateral.

Special provisions apply with respect to back reporting, which are as follows:

• contracts entered into on or after August 16, 2012, and not outstanding on February 12, 2014 (the “Reporting Start Date”), must be reported to a trade repository within three years of the Reporting Start Date;

• contracts entered into on or before August 16, 2012, and outstanding on the Reporting Start Date must be reported within 90 days of the Reporting Start Date; and

• contracts entered into after August 16, 2012, and outstanding on the Reporting Start Date are required to have been reported on the Reporting Start Date.

In addition, there is an extension of the Reporting Start Date by 180 days for the reporting of data on valuation and collateral.

2. Record Keeping

Insurance Company FCs must maintain records of all derivative contracts (again, whether OTC or exchange traded) for at least five years following the termination of the contract.

3. Clearing

The clearing obligation will apply to OTC derivative contracts transacted by Insurance Company FCs which are of a type which the European Securities and Markets Authority (“ESMA”) has

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determined are to be cleared, except where the relevant counterparty is either (i) a non-financial counterparty below each of the clearing thresholds for the various asset classes (an “NFC”) or (ii) a third country entity which would fall within the definition of an NFC if it had been established in the EU, in each case determined according to the gross notional value of certain OTC derivative contracts transacted.

The obligation requires Insurance Company FCs to clear OTC derivative contracts subject to the clearing obligation with a central counterparty which is either established in the EU or recognized by ESMA if established outside the EU.

4. Risk Mitigation Techniques

Where an OTC derivative contract is not required to be cleared, EMIR imposes certain other obligations on these contracts as an alternative means of reducing operational and counterparty risk. These obligations will apply to all uncleared OTC derivative contracts transacted by Insurance Company FCs, regardless of the classification of their counterparty under EMIR.

The various risk mitigation techniques are as follows:

• Timely ConfirmationOTC derivative contracts must be confirmed, where available, by electronic means, as soon as possible and in any event by the deadline specified for the particular type of product.

• Reporting unconfirmed OTC derivative contractsInsurance Company FCs must have procedures in place to make monthly reports to their national competent authority detailing the number of unconfirmed OTC derivative contracts subject to the timely confirmation obligation which have been outstanding for more than five business days after expiry of the relevant deadline for confirmation. Insurance Company FCs need only provide this report to their national competent authority if requested to do so by such authority.

• Portfolio ReconciliationInsurance Company FCs must agree with each of their counterparties a process by which their portfolios of OTC derivative

contracts will be reconciled. The reconciliation covers key trade terms (for example, the effective date, the scheduled maturity date and the notional value of the contract) as well as the valuation attributed to each contract in accordance with the mark-to-market requirement. The frequency of such reconciliation will depend upon that specified by EMIR, determined according to the number of outstanding contracts between the relevant counterparties and could be anything from daily to quarterly for Insurance Company FCs.

• Portfolio CompressionInsurance Company FCs with more than 500 OTC derivative contracts outstanding with any counterparty are required to have procedures in place to regularly analyze the possibility of conducting a portfolio compression exercise.

• Dispute ResolutionInsurance Company FCs must have detailed procedures in place to identify, record, monitor and resolve disputes relating to recognition or valuation of OTC derivative contracts and the valuation of collateral in a timely manner. A specific process is required for disputes that are not resolved within five business days. Counterparties may agree where the amount disputed is below an agreed threshold it will not count as a dispute for these purposes.

• Reporting Outstanding DisputesInsurance Company FCs are required to report on a monthly basis to their national competent authority any dispute relating to an OTC derivative contract, its valuation or the exchange of collateral for an amount or value higher than €15 million and outstanding for at least 15 business days.

• Marking-to-marketInsurance Company FCs are required to mark-to-market the value of outstanding contracts on a daily basis. Where market conditions mean that marking-to-market is impossible, reliable and prudent “marking-to-model” is required. The board of directors of the Insurance Company FC are responsible for the

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regular approval of the model intended to be used for these purposes so as to be ready if the relevant market conditions arise.

• Exchange of collateralOnce the applicable regulatory technical standards have been approved by the EU, Insurance Company FCs may be required to have risk management procedures in place for the timely, accurate and appropriately segregated exchange of collateral with respect to uncleared OTC derivative contracts.

• Holding capitalInsurance Company FCs may also be required to hold an appropriate and proportionate amount of capital to manage the risk not covered by an appropriate exchange of collateral. Draft regulatory technical standards are yet to be prepared on this requirement.

The various obligations under EMIR applicable to Insurance Company FCs apply in accordance with the timeline below (though please note that some of the deadlines are still subject to change):

Obligation Date

Clearing obligation Summer 2014 – Spring 2015* (likely to be certain Interest Rate Swaps then certain Credit Default Swaps)

Record-keeping obligation August 16, 2012

Reporting February 12, 2014

Risk mitigation for uncleared derivatives

• Timely confirmation March 15, 2013

• Mark-to-market/mark-to-model March 15, 2013

• Reporting unconfirmed OTC derivative contracts to national competent authority

March 15, 2013

• Portfolio reconciliation

• Portfolio compression

• Dispute resolution

September 15, 2013

• Reporting outstanding disputes to national competent authority

September 15, 2013

• Margin for uncleared derivatives December 1, 2015*

• Additional capital requirements No estimate available

* Estimated dates

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V. Global Regulatory and Litigation Developments

A. Introduction

In 2013, participants in the global insurance industry contributed to the continuing discussion of difficult questions regarding the interpretation and intersection of U.S. federal, state and non-U.S. insurance regulations. In the U.S., the publication of the report of the Federal Insurance Office on how to modernize and improve U.S. insurance regulation establishes a framework for state-based insurance regulation partnered with Federal regulation and enforcement where “warranted.” Therefore, in 2014, state and Federal regulators will continue to tackle ongoing initiatives, including healthcare reform implementation and the effect thereof on the U.S. health insurance marketplace, implementation of principle-based reserving, life insurers’ use of affiliated captive reinsurers to finance reserves, standards that should apply to insurance company acquisitions by private equity firms, establishing corporate governance standards for insurance companies, regulation of insurer investments and financial solvency and achieving consistency with international regulatory standards. In the UK, key developments include IAIS transparency, Solvency II implementation and FSA reorganization. In China, key developments include the establishment of a new solvency capital regime and the launch of the Shanghai Pilot Free Trade Zone. These and other important insurance regulatory topics are discussed in more detail below.

B. United States – Federal Regulatory Developments

1. Treasury/FSOC Activities

In 2013, the Financial Stability Oversight Council (“FSOC”) began issuing determinations on which non-bank financial companies (defined in the Dodd-Frank Act) to include insurers, should be designated as “systemically important” (“SIFIs”). FSOC was established under Dodd-Frank to provide recommendations to the Board of Governors of the Federal Reserve System (the “Federal Reserve Board”) concerning risks to U.S. financial stability caused by the activities of large bank holding companies and nonbank financial companies. A company designated as a SIFI becomes subject to supervision by the Federal Reserve Board and to the enhanced “prudential standards” approved by the

Federal Reserve Board in December 2011. It must also create a recovery/resolution plan (living will) addressing strategy for handling material financial distress or company failure.

In July 2013, FSOC designated American International Group Inc. and GE Capital Corporation as SIFIs—decisions that were not contested. In the same month, FSOC voted to advance MetLife Inc. to the final stage of a three-step process used for SIFI designations but, as of the date of this publication, a final determination has not been made. In September 2013, FSOC designated Prudential Financial, Inc. as a SIFI, following a hearing held in July at which Prudential contested the FSOC’s proposed SIFI designation. Three FSOC members (two voting members and one non-voting member) objected to the decision, including the two members of FSOC with insurance expertise. Further, there were strong dissenting opinions written by the two voting member objectors. Nevertheless, Prudential ultimately decided not to appeal the decision. As of the date of this publication, FSOC is said to be considering Berkshire Hathaway for a SIFI designation.

Prudential’s SIFI designation has renewed debate over the FSOC process in general. One of the dissenters in the Prudential decision, Roy Woodall (independent FSOC member with insurance expertise) remains active as a speaker at the NAIC and other forums, emphasizing the following views expressed in his dissenting opinion:

• FSOC should focus more on activities and less on material distress during the designation process;

• The impact and potential unintended consequences resulting from the higher capital requirements under Section 171 of Dodd-Frank (popularly known as the Collins Amendment) need to be considered; and

• The U.S. may not have the most effective participants in international regulatory efforts, particularly those of the International Association of Insurance Supervisors (“IAIS”) and the Financial Stability Board.

The timing of FSOC’s designations have also raised questions. Before FSOC finalized its decisions, the Financial Stability Board published its own list

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designating nine entities as globally systemically important insurers (“G-SIIs”), including AIG, Prudential Financial, Prudential plc and MetLife Inc.

To date, there has been no final determination on the capital standards that will apply to insurers designated as SIFIs. In October 2013, the Federal Reserve Board issued a proposed regulation concerning bank liquidity standards, which expressly exempts insurers from its scope (comments on the regulation were received until January 31, 2014, and a final regulation has not yet been issued as of this writing). U.S. Treasury representatives have publicly stated that bank capital rules should not apply to insurers. In addition, in her first Congressional testimony, Federal Reserve Chairperson Yellen emphasized that insurers are distinct from banks and that new rules will be tailored to them so that SIFIs will not be forced to adhere to the same standards. At this writing, there has been no formal standard proposed for insurer SIFIs. However, a number of members of the insurance industry testified on March 11, 2014, before two subcommittees of the Senate Banking Committee (the Financial Institutions and Consumer Protection and the Securities, Insurance and Investment Subcommittees) regarding the ongoing state regulation of insurance companies’ capital levels and the Federal Reserve’s potential application of bank-centric standards to non-Bank SIFIS and to Federal Reserve-regulated banking groups that include insurance companies. In addition, Senator Collins testified as to the intent of the Collins Amendment and introduced in the Senate an amendment to Dodd-Frank that would clarify the application of the Federal Reserve Board’s oversight of insurance companies that are engaged in activities already regulated as insurance at the state level.

2. Federal Insurance Office

The FIO issued its long-awaited Modernization Report, titled How to Modernize and Improve the System of Insurance Regulation in the United States on December 12, 2013, nearly two years after the statutory deadline for issuing the Modernization Report had passed. The Modernization Report was prepared pursuant to a requirement under Title V, Subtitle A of the Dodd-Frank Act, also known as the Federal Insurance Office Act of 2010 (the “FIO Act”), that the FIO conduct a study and submit a report to Congress on how to

modernize and improve U.S. insurance regulation. In the Modernization Report, the FIO makes 27 recommendations for insurance regulatory reform. The recommendations are generally categorized as relating to prudential oversight of the financial condition of insurance companies or marketplace oversight of insurance operations. The majority of recommendations are directives for states to continue work on existing reform initiatives. Only nine of the recommendations are for direct Federal involvement in insurance regulation. In the Modernization Report, the FIO implicitly recognizes the following three primary principles that should guide U.S. insurance regulatory reform (and Federal involvement therein):

• Principle #1: The need for Federal monitoring to achieve uniformity in certain areas of insurance regulation.Multistate activities of insurers make state-based insurance regulation complicated. Since its inaugural meeting in 1871, one of the main objectives of the NAIC has been to promote coordination among the states in regulating multistate activity of insurance companies. In fact, it is the NAIC that historically has shouldered the burden of achieving consistency and uniformity in U.S. insurance regulation—primarily through the NAIC’s Financial Regulation Standards and Accreditation Program. However, the Modernization Report reopens the dialogue regarding how much commonality and uniformity is optimal in regulating the activities of insurers across the United States and whether state-based or Federal regulation of the insurance industry is the best path forward to achieve those results. Several of the recommendations set forth in the Modernization Report, including, among others, those related to regulation of captives, implementation of principle-based reserving and solvency oversight, suggest that the FIO believes that greater uniformity is required in regulating certain areas of insurer solvency and marketplace conduct.

Although it is hard to argue with the FIO’s observations that greater uniformity could be achieved in certain areas of U.S. insurance regulation, it is worth remembering that

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often state insurance regulators and state legislators deliberately choose not to follow a certain uniform practice. In a system of state-based insurance regulation, public policy at the state level will certainly influence the outcome in any given state of any debate on important insurance regulatory topics that may be ongoing at a national level. If the new priority in insurance regulation is achieving uniformity irrespective of state public policy, then one of the recognized benefits of the long-standing state-based approach to insurance regulation could be lost. Indeed, the tone of the Modernization Report suggests that if state activity does not respond to the FIO’s mandate to achieve uniformity in certain areas of insurance regulation in the “near term,” then direct Federal involvement in those areas may be warranted.

• Principle #2: The need for direct Federal involvement in certain areas of insurance regulation affecting national and international interests. Another factor that makes state-based insurance regulation more complicated in the 21st century than it has been historically, is the increasingly global financial services marketplace in which U.S. insurance companies are operating internationally. In fact, one-third of the FIO’s recommendations for direct Federal involvement in insurance regulation (e.g. such as the recommendations that “federal standards for mortgage insurers should be developed and implemented;” that the FIO assist the U.S. Department of the Treasury and the United States Trade Representative in negotiating covered agreements with foreign jurisdictions in connection with reinsurance collateral requirements; and that the FIO play an active role in supervisory colleges to address group supervision issues) imply that the FIO views states as ineffective regulators of matters affecting national interests and ineffective representatives of the United States before international insurance regulatory supervisors.

• Principle #3: The need for Federal oversight in connection with implementing public policy in support of principles of equity and fairness in certain areas of insurance regulation. In addition to prudential oversight of the financial condition of insurance companies, a long-standing purpose of insurance regulation has been to ensure that insurers operate equitably and do not unfairly take advantage of consumers in a marketplace filled with complex insurance and financial instruments. However, the Modernization Report points out that the state-based insurance regulation system sometimes results in the inconsistent application of principles of equity and fairness that are not necessarily explained by differences in the public policy underlying the laws and regulations of different states. Several of the FIO’s recommendations, such as those related to consumer protections offered by the NAIC Suitability in Annuity Transactions Model Regulation, variability in recoveries available from state guaranty funds and pricing and underwriting personal lines products, suggest that additional Federal oversight may be warranted to ensure that the public policy implemented through state insurance laws and regulations reflects a national consensus on what is fair with respect to particular insurance issues.

The objective of state insurance regulators has always been consumer and policyholder protection. Therefore, the idea that principles of equity and fairness should strongly influence the direction of insurance regulatory reform is neither new nor surprising. However, the FIO’s recommendations in this regard seem to suggest a shift from states enacting and enforcing insurance laws and regulations that reflect state public policy to increasing Federal influence on the public policy that should be implemented pursuant to state insurance laws and regulations.

The precise roles that the FIO, specifically, and the Federal government, generally, may play in insurance regulation in the future largely remain undefined following the publication of the Modernization Report. Indeed, the Modernization Report leaves dissatisfied those

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who expected the FIO to decide once and for all the binary debate regarding whether the business of insurance must be subject to either state or Federal authority. Director McRaith testified during the recent hearing before the House Housing and Insurance Subcommittee (the “Subcommittee”) that the “report determines that the U.S. should build on the existing hybrid model of insurance regulation, incorporating both Federal and state oversight,” calling the binary debate on the topic a “relic of a bygone era.” Following the Modernization Report, the evolution of additional Federal involvement in U.S. insurance regulation remains to be seen. The FIO perceives certain areas as especially ripe for further Federal involvement—namely, and to use Director McRaith’s own words before the Subcommittee, to “improve uniformity of regulation, address the realities of globally active, diversified insurance firms, and better serve national interests.”

3. Other Federal Initiatives

a. Volcker Rule

In late 2013, the so-called “Volcker Rule” (Section 619 of Dodd-Frank) was finalized and adopted by the following five agencies: the Federal Reserve Board; the Office of the Comptroller of the Currency (the “OCC”); the Federal Deposit Insurance Corporation (the “FDIC”); the SEC; and the Commodity Futures Trading Commission (the “CFTC”). The final rule clarifies when insurers that are considered “banking entities” under the Volker Rule can engage in proprietary trading. Under the final Volcker Rule, insurers that are banking entities are generally prohibited from engaging in proprietary trading or investing in or sponsoring hedge funds and private equity funds (“covered funds”), except for certain enumerated exceptions. The final Volcker Rule allows a banking entity to purchase or sell a financial instrument if the banking entity is a regulated insurance company acting for its general or separate account. In addition, the rule permits an affiliate of an insurance company to purchase or sell a financial instrument for the insurance company’s general account or for a separate account maintained at the insurance company.

The final version of the Volcker Rule defines “general account” as all of the assets of an insurance company except those allocated to a separate account. The final rule also provides clarity on the meaning of “regulated insurance company.” Unlike the proposed rule, the final rule defines the terms “state insurance regulator” and “foreign insurance regulator.” A “state insurance regulator” is defined as the insurance commissioner, or similar official or agency, of a state that is engaged in the supervision of insurance companies under state insurance law. Additionally, the final rule defines a “foreign insurance regulator” as the insurance commissioner, or similar official or agency, of any country other than the U.S. that is engaged in the supervision of insurance companies under foreign insurance law.

b. TRIA

The Terrorism Risk Insurance Act of 2002 (“TRIA”), which was extended for seven years in 2007, will again expire on December 31, 2014. The TRIA program, administered by the Secretary of the Treasury, requires that qualifying insurers offer property-casualty insurance coverage for losses resulting from acts of terrorism, with partial reimbursement from the Federal government, subject to deductibles and other terms. As of the date of this publication, it is unclear how the TRIA program will be extended and whether an extension will involve restructuring the current program to change participation levels, deductibles and other terms. In the past year, more vocal efforts have been made to reauthorize TRIA on a permanent basis.

c. NARAB II

In September 2013, the U.S. House of Representatives passed the National Association of Registered Agents and Brokers Reform Act of 2013 (“NARAB II”). However, the NARAB II bill was later pulled from the U.S. Senate calendar and future prospects for NARAB II are unclear. NARAB II reflects a long-standing effort by legislators, industry and trade groups to ensure uniformity among states for insurance producer licensing. The effort began with the original NARAB provisions in the Gramm-Leach Bliley Act of 1999 (“GLBA”), which threatened Federal regulation of producer licensing if states did not increase uniformity. Although the requisite number of states eventually adopted key provisions of the NAIC Producer Licensing Model Act, critics

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argued that true uniformity was not fully realized. NARAB II would authorize creation of a board to issue multi-state licenses to producers in accordance with standards established by state regulators, thus creating a centralized licensing process—one that could not be avoided by additional state efforts at achieving uniformity.

It is not clear whether the current U.S. Congress is motivated to pass NARAB II (or any new Federal insurance initiative with respect to insurance intermediaries). However, in the Modernization Report (discussed above), the FIO recommended that the U.S. Congress adopt NARAB II and that the FIO monitor its implementation. Further, in his February 2014 testimony before the House Financial Services Subcommittee on Housing and Insurance, FIO Director McRaith stated that NARAB II is one of the two most important initiatives for Congress’ immediate future (along with a Federal regulator for mortgage guaranty insurance).

4. Derivative Transactions

The regulation of the derivatives markets continued to develop throughout 2013, with the implementation and effectiveness of a number of the Dodd-Frank Title VII provisions by the CFTC with respect to its regulation of “swaps.” Insurance companies that engage in derivatives trading in the U.S., whether for hedging or replication purposes, are now required to obtain legal entity identifiers (a/k/a CICI Utility numbers), adhere to the ISDA Dodd-Frank August 2012 and March 2013 Protocols (or enter into other bilateral arrangements addressing similar issues), certify their status as U.S. Persons (under the CFTC’s cross-border interpretive guidance), commence reporting of all new trades (and certain legacy trades) to the CFTC designated central data repository the (“DTCC”), and mandatorily utilize central clearinghouses for certain types of interest rate and index credit default swaps. Additionally, for insurance companies that are trading derivatives with dealers that are organized in EU countries, 2013 included an introduction to EMIR, which started off with portfolio reconciliation and dispute resolution requirements.

In addition to the issues implicated by direct derivatives trading activities by insurance companies, Dodd-Frank Title VII presented

some challenges for insurance-linked securities (“ILS”) and other types of structured transactions relating to the insurance industry. Because of the broad definition of what constitutes a “swap” for Dodd-Frank Title VII purposes, and the narrow insurance safe-harbor jointly adopted by the CFTC and the SEC, there continues to be uncertainty over whether certain contingent products will be viewed as “swaps” for Title VII purposes where the product is either: (x) issued by a non-U.S. domiciled insurer; (y) does not have traditional insurable interest and indemnity provisions; or (z) is not regulated as an insurance product by an insurance regulator located in the U.S. In situations where a product may be a “swap” for Dodd-Frank Title VII purposes, additional consideration is required with respect to a host of issues raised under the Commodity Exchange Act (“CEA”). Under the CEA, there could be enforceability issues if each of the parties to the “swap” agreement are not “Eligible Contract Participants,” and the parties to the “swap” will need to obtain legal entity identifiers and make arrangements for reporting to DTCC, as the designated swap data repository. Additionally, if insurance (or other similar) brokers are involved in the placement of the “swap” there may also be introducing broker (“IB”) or futures commission merchant (“FCM”) issues raised under the CEA. Finally, if one of the parties to the “swap” is a collective investment vehicle, then commodity pool and commodity pool operator (“CPO”) issues may also be implicated under the CEA.

In 2014, insurance companies can look forward to the continued evolution of derivatives regulation in the U.S., with the effectiveness of the Swap Execution Facility (“SEF”) made available to trade determinations (which affect certain trades subject to the central clearing mandate), mandatory minimum margin for uncleared swap trades, as well as the SEC’s implementation of regulations with respect to “security-based swaps”—some of which may be different from the CFTC’s requirements with respect to “swaps.”

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C. United States – State and NAIC Developments

1. Health Insurance Regulation

Highly anticipated changes to the U.S. healthcare system took effect on January 1, 2014, the effective date for many of the operative provisions of the ACA. Throughout 2013, the priority of the health insurance industry and its regulators was preparing for healthcare reform implementation, including, but not limited to, the following specific issues:

• Health Insurance ExchangesOn October 1, 2013, health insurance exchanges launched the 2014 open enrollment period, with 17 states (California, Colorado, Connecticut, District of Columbia, Hawaii, Idaho, Kentucky, Maryland, Massachusetts, Minnesota, Nevada, New Mexico, New York, Oregon, Rhode Island, Vermont and Washington) operating a state-based exchange, seven states (Arkansas, Delaware, Illinois, Iowa, Michigan, New Hampshire and West Virginia) operating a partnership exchange and the remaining 27 states defaulting to the Federally facilitated exchange. According to the Henry J. Kaiser Family Foundation, based on data published by the Office of the Assistant Secretary for Planning and Evaluation, Department of Health and Human Services, 14.8% of the total number of individuals determined eligible to enroll in a plan through the health insurance exchanges had so enrolled as of March 1, 2014. Well-publicized difficulties affected enrollment on the exchanges during the early weeks of the open enrollment period. With open enrollment for the 2014 benefit year ending on March 31, 2014, final enrollment numbers remain to be determined.

• Updating the State Regulatory FrameworkIn many jurisdictions, state laws and regulations governing health insurance have yet to incorporate changes mandated by the Federal government via the ACA. Throughout 2013, the NAIC’s Regulatory Framework (B) Task Force has been working on initiatives to update state law to incorporate such changes, primarily through (i) developing an Individual Market Health Insurance Model

Regulation and Small Group Market Health Insurance Coverage Model regulation, in each case, to accompany the related model acts that were adopted at the Fall 2012 NAIC National Meeting and (ii) developing model review recommendations with respect to 31 model laws and regulations affected by the ACA. If the Centers for Medicare & Medicaid Services (“CMS”) determines that a state is not substantially enforcing the ACA’s requirements, then CMS may assume enforcement authority. Thus, until the new model laws and regulations or other enabling legislation is passed in each state, a question remains as to whether state regulators will “substantially enforce” the ACA’s requirements or whether the Federal government will assume the primary role in enforcing the ACA’s reforms in such state.

• NavigatorsThe ACA authorizes several types of licensed and non-licensed categories of personnel (e.g., navigators, producers and non-navigators, such as assistors) to assist consumers as they shop for coverage and apply for subsidies through the exchanges. Throughout 2013, the industry and regulators have been considering how to respond to concerns related to the lack of requirements related to licensing and training of navigator and non-navigator personnel and the potential for fraud because the personnel assisting consumers may ask for or passively receive protected personal information and/or credit card numbers. Several NAIC technical groups are currently collaborating to draft an NAIC white paper that analyzes the following issues related to navigator and non-navigator personnel: outreach functions of such persons, certification and training standards applicable to such persons and protecting against fraudulent activity perpetrated by such persons.

• Fees Under Section 9010 of the ACAIn 2013, there was substantial and protracted debate to determine the proper method of accounting for fees to be assessed under Section 9010 of the ACA (the “ACA 9010 Fees”). Health insurers are required to pay the

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ACA 9010 Fees, which are not tax deductible, to the Federal government, beginning in 2014, based on data for premiums written in 2013. In subsequent years, the fees will be due each year (the “fee year”) based on premiums written in the prior year (the “data year”). The Statutory Accounting Principles Working Group (the “SAP Working Group”) initially adopted guidance prescribing the recognition of a liability and expense for ACA 9010 Fees payable on January 1 of the fee year, beginning in 2014, with a classification in special surplus in the data year. At the Fall 2013 NAIC National Meeting, the Accounting Practices and Procedures Task Force (the “APP Task Force”) voted to re-draft that guidance to require a liability at year-end in the data year with a non-admitted deferred asset; the ACA 9010 Fees would then be expensed on January 1 of the fee year. However, the APP Task Force’s actions were reversed during a subsequent meeting of the (E) Committee in December 2013. Due to the degree of debate, on February 19, 2014, the Executive and Plenary Committees voted to adopt the guidance developed by the SAP Working Group. Thus, such accounting treatment will apply in connection with affected insurers’ year-end 2013 financial statements.

With healthcare reform implementation initiatives winding down upon effectiveness of many healthcare reform provisions as of January 1, 2014, industry participants and regulators likely will be evaluating the impact of the ACA’s reforms on the health insurance marketplace throughout 2014. It remains to be seen whether additional states will elect to operate state-based exchanges for the 2015 annual enrollment period. Upon release of final health insurance exchange enrollment tallies and related claims for benefits throughout 2014, insurers will assess whether pricing for exchange plans accurately reflects the demographics of the newly insured population. Facing consumer complaints, regulators may decide to restrict insurers’ ability to manage costs by offering limited provider networks for qualified health plans purchased on health insurance exchanges. True to the President’s earlier promise to Americans that people who like their health insurance plans could keep their

health insurance plans, the Obama Administration has granted a three-year extension for the sale of individual health insurance policies that are not compliant with the ACA, which merely defers the timing for insurers and state regulators to determine whether to permit the continued sale of such policies. Additional key provisions of healthcare reform also remain to be implemented (namely, the employer mandate applicable to employers with more than 100 full-time employees, which the Obama Administration has delayed until January 1, 2015, and the employer mandate applicable to employers with 50 to 99 full-time workers, which the Obama Administration has delayed until January 1, 2016). These are just a few examples of the issues that will likely garner significant attention in 2014 in the wake of healthcare reform implementation.

2. Principles-Based Reserving

The NAIC continues its work on implementing PBR, which it approved in December 2012 through its adoption of the NAIC’s Standard Valuation Manual (the “Valuation Manual”). PBR will become operative only after adoption by 42 states representing 75% of total U.S. premium as of 2008. As of early March 2014, seven states had adopted and a number of additional states had introduced such legislation. Thus, while full PBR implementation could take a number of years for states to accomplish, in the meantime, regulators and industry participants are busy considering important issues related to how to implement PBR and the appropriate use of reinsurance captives to finance reserve requirements associated with blocks of level premium term insurance subject to Regulation XXX or universal life products with secondary guarantees subject to Regulation AXXX.

a. PBR Implementation

The Principle-Based Reserving Implementation (EX) Task Force (the “PBR Task Force”) is the NAIC group charged with serving as the coordinating body with all NAIC technical groups involved with PBR implementation. Within the past year, the PBR Task Force has considered the following key initiatives to advance PBR implementation:

• PBR Implementation PlanThe PBR Implementation Plan, as adopted by the Executive (EX) Committee in 2013, establishes a framework for, among other

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things, (i) surveying states regarding financial and personnel resources required to support PBR, (ii) developing NAIC actuarial resources and related technical groups to further develop PBR reserving requirements, (iii) collecting and reporting statistical data related to PBR and (iv) training state insurance department staff charged with overseeing PBR. According to the PBR Implementation Plan, during the early stages of PBR implementation, companies will be subject to a PBR implementation review process, which is intended to be independent from ordinary course financial examinations; “nationally significant insurers” will be given “priority” in such reviews.

• Coordination with Other NAIC Technical GroupsPursuant to the PBR Implementation Plan, the PBR Task Force has referred many charges related to PBR implementation to other NAIC technical groups, including (i) the Life Actuarial (A) Task Force (“LATF”), to develop a procedure to update the Valuation Manual and specifically consider industry concerns regarding the confidentiality of data collected in connection with PBR, (ii) the (E) Committee, to consider the PBR review process and the role of the domestic (or lead) regulator in connection with such review of insurance companies doing business in more than one state and (iii) the Capital Adequacy (E) Task Force, to evaluate the need to revise RBC requirements as a result of PBR implementation.

• Company Outreach PlanUnder the PBR Implementation Plan, the PBR Task Force is charged with the task of company outreach related to PBR implementation. Under the proposed Company Outreach Plan, the PBR Task Force, together with the Society of Actuaries (“SOA”), is drafting a joint survey to be sent to each life company to assess such company’s readiness for PBR and its need for related resources, training, and regulatory guidance. The survey would also identify companies likely to be affected by PBR (and the extent of the impact on such

company). The PBR Task Force seeks to issue the survey in May or June 2014 and to have the results tabulated for the Fall 2014 NAIC National Meeting. It is excepted that a second, more detailed survey also will be prepared, to be completed in 2015. Under the Company Outreach Plan, the PBR Task Force will also consider a pilot project to flesh out issues in advance of full implementation of the new initiative, similar to the Own Risk and Solvency Assessment pilot project, which is widely recognized to have been helpful to industry and regulators. It is anticipated that the joint survey and the draft Company Outreach Plan, neither of which have been adopted by the NAIC to date, will be discussed during future meetings, including the PBR Task Force’s meeting at the Spring 2014 NAIC National Meeting.

• Impact on Small CompaniesIt is clear from the PBR provisions in the Valuation Manual (such as the 3-year transition period contemplated therein) that a significant amount of work is necessary for a company to implement PBR. The Valuation Manual exempts certain products from the application of PBR. However, a number of smaller life insurance companies have advocated for a “small company” exemption from the application of PBR. Such companies have asserted that the analysis required to determine qualification for a small company exemption would be much less burdensome than the analysis required to qualify for the product exemption under the Valuation Manual. To this end, the American Council of Life Insurers (the “ACLI”) is developing a proposal for a new PBR exemption for “small companies” (i) that are within a certain bottom percentile range of life insurance companies, based on volume of ordinary life insurance premium, (ii) with (a) an RBC ratio above a threshold level to demonstrate sufficient capital and (b) an unqualified actuarial opinion from the appointed actuary regarding sufficiency of reserves, and (iii) without a material amount of universal life insurance with secondary guarantees written after

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PBR is implemented. The actual quantitative limitations applicable to the three parts of this test would be determined by LATF or by the PBR Task Force following a recommendation from LATF. The PBR Task Force and LATF have agreed to review the ACLI’s proposal, once completed.

b. Use of Reinsurance Captives to Finance Reserves Required Under Regulation XXX and Regulation AXXX

The PBR Task Force is also charged with assessing “the solvency implications of life insurer-owned captive insurers and alternative mechanisms.” Related to this charge, in 2013, the PBR Task Force devoted substantial time to considering the proper use of captive reinsurance transactions pending implementation of PBR. This focus results, in part, from certain recommendations in the NAIC’s White Paper, which were referred to the PBR Task Force for discussion within the context of the proposed PBR overhaul. (Please see Section A.1.a of “The Global Alternative Risk Transfer Market” above for a discussion regarding the White Paper.) It is possible that the PBR Task Force will create a subgroup to focus exclusively on affiliated captive transactions. In the meantime, the specific activities of the PBR Task Force within the past year related to evaluating the use of reinsurance captives include the following:

• PBR Implementation PlanThe PBR Implementation Plan includes the following charge: “Address any remaining XXX and AXXX problems without encouraging formation of significant legal structures utilizing captives to cede business.” This charge adopts as NAIC policy a position that is contrary to the policy of many states that are popular captive domiciles, which encourages the development of the state’s captive insurance industry. Thus, this charge has been contentious between regulators from “captive friendly” states, such as Delaware, the District of Columbia and Vermont, and regulators from other states that support a moratorium on reinsurance captive transactions, such as New York, which imposed a moratorium on such transactions in 2013. Unless and until the NAIC finalizes a uniform framework for captive reinsurance transactions pending PBR

implementation, regulators must reconcile the potential conflict between NAIC policy and state policy on this issue.

• Rector ReportsThe PBR Task Force engaged Rector & Associates, Inc. (“Rector”) to assist the PBR Task Force with its charge to consider the recommendations in the White Paper. Rector has since prepared two reports, dated September 13, 2013, and February 17, 2014, respectively, that analyze captive reinsurance transactions in order to assist regulators in determining whether such transactions should be permitted for reserve relief under Regulation XXX and Regulation AXXX.

The 2013 Rector Report provides background for the relevant issues and presents as the “threshold decision” whether regulators will allow financing transactions to continue until PBR implementation is accomplished. To assist regulators in making that decision, the 2013 Rector Report suggests two alternatives for addressing reserves. The first alternative would allow the use of reinsurance (including the use of captives). With respect to this alternative, the 2013 Rector Report suggests applying a “primary asset requirement” concept, under which a specified level of reserves on business ceded to a captive would be backed by traditional admitted assets in order for the ceding insurer to receive credit for reinsurance (and the balance of assets could be non-admitted other assets). An “actuarial standard” would be developed to designate the required level of admitted assets, perhaps using AG 38 or the Valuation Manual (e.g., VM-20—Requirements for Principle-Based Reserves for Life Products) as a guide. The second alternative involves keeping assets and liabilities on the balance sheet of the direct insurer, an approach that would require legislative and/or statutory accounting changes.

The 2014 Rector Report expands upon the concepts introduced in the 2013 Rector Report. (Please see Section A.1.b of The Global Alternative Risk Transfer Market above for a detailed discussion of the Rector Reports.)

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Specifically, the 2014 Rector Report includes (i) recommendations related to key terms identified in the 2013 Rector Report, such as “actuarial method” and “primary assets,” (ii) comments regarding the viability and whether there is actual industry interest related to the second alternative (the direct insurer alternative), (iii) additional analysis of issues to be addressed in connection with establishing a uniform framework for regulating reinsurance captive transactions and (iv) an evaluation of the conclusions and recommendations in the White Paper. Importantly, Rector explains that its recommendations would impact the types of assets permitted to support reserves, rather than the actual level of insurer reserves, with a focus on regulating the direct/ceding insurer, rather than the assuming insurer. Further, while the recommendations borrow certain concepts developed in connection with PBR, the recommendations could stand irrespective of whether or not PBR actually becomes effective. The PBR Task Force held an interim call on March 12, 2013, at which Rector outlined such Report’s findings and responded to questions from regulators and the ACLI. Written comments were due by March 21, 2014. The recommendations in the Second Rector Report (and comments received thereon) will likely be the subject of much discussion and debate during the PBR Task Force’s meeting at the Spring 2014 NAIC National Meeting.

3. Captives and Captive Reinsurance Transactions

During 2013 and continuing into 2014, there has been increasing regulatory scrutiny involving life insurance companies’ transactions with affiliated Captives. In addition to the ongoing work at the PBR Task Force, there was other regulatory focus, not directly related to transactions, but to the financial statement and disclosure to regulators and others regarding the extent of life insurance companies’ use of Captives. As noted above, the FIO and the SEC joined state regulators in looking at the effects of life insurers’ uses of Captives in transactions and the transparency of such activity, while the New York Department of Financial Services issued critical

comments on life insurers’ affiliated Captives and called for a moratorium on their use. See Sections A.2 and A.3 of “The Global Alternative Risk Transfer Market” above for details. In addition, the NYSDFS implemented a Captives Reinsurance Schedule that will be included in the New York Supplement to the Annual Statement for 2013 reporting.

In December 2013, the (F) Committee and interested parties spent a considerable amount of time discussing the definition of “multi-state insurer” for purposes of accreditation; specifically, whether life insurer-owned Captives should be considered multi-state insurers and therefore subject to Regulations XXX and AXXX, as compared to traditional captive insurers owned by non-insurance entities for purposes of managing their own risk. Noting some inconsistencies in existing guidance, the (F) Committee asked NAIC staff to draft proposed clarifying language regarding the definition and treatment of multi-state insurers for the committee’s review, following which such language would be exposed for one year. See Section A.1.d of “The Global Alternative Risk Transfer Market” above.

Despite the regulatory questions being considered, a few states’ legislatures enacted new or updated older Captive laws that became effective during 2013, with a number updating their Captive laws to provide for sponsored, protected cell, or special purpose Captives. In recent years, a limited number of states (Indiana, Iowa, Nebraska, Georgia, and Texas) enacted authority for life insurance companies to organize Limited Purpose Subsidiary Life Insurance Companies, which would be wholly-owned subsidiaries organized in the same state as the insurance company and would only be authorized to reinsure the risks of the parent or affiliated companies. Unlike the other three states, the Texas statute specifies that it will only be in effect until principle-based reserving goes into effect in accordance with NAIC processes. This appears to reflect the commonly heard, but as yet unverified, perception that principle-based reserving will eliminate life insurance companies’ need for affiliated Captive transactions.

In a quite different context, the Vermont Legislature recently enacted a law authorizing the organization of Vermont-domiciled companies with the express purpose of purchasing from insurance companies, and running off, closed blocks of commercial

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property/casualty insurance. The new entities would not be Captives, but would build on Vermont’s success with being a captive domicile in order to reach another segment of the industry. The Vermont Governor signed House Bill 198, the Legacy Insurance Management Act, into law on February 19, 2014. The new law would permit a Vermont company to be formed as a “non-admitted insurance and reinsurance management” company to purchase property/casualty or surplus lines insurance or reinsurance of expired, non-premium-paying commercial policies through a legacy insurance management plan approved by the Commissioner of Insurance. The law expressly excludes life, health, personal lines, and workers compensation insurance.

4. Reinsurance

States continue implementing changes to their credit for reinsurance laws to allow for a reduction in posted collateral from unauthorized reinsurers that have been approved by states as “Certified Reinsurers.” Such changes have been effected by states passing key provisions of the NAIC’s amended Credit for Reinsurance Model Act and Regulation (“CFR Model Laws”), adopted by the NAIC in 2011. At the time the NAIC adopted the CFR Model Laws, two states had already effected changes to collateral requirements—New York and Florida (the latter, for property-casualty reinsurance only). As of the date of this publication, the following additional states have adopted some form of the CFR Model Laws and have accepted (or will begin accepting) applications from reinsurers seeking Certified Reinsurer status: Alabama; California; Connecticut; Delaware; Georgia; Indiana; Iowa; Louisiana; Maine; Maryland; Missouri; New Hampshire; New Jersey; Pennsylvania; Rhode Island; and Virginia.

Although it has been more than two years since the NAIC amended its CFR Model Laws, the NAIC remains active in assisting state insurance regulators with procedural aspects of the new laws. In deciding whether to certify a reinsurer, state insurance regulators must evaluate a number of factors, including whether a reinsurer is domiciled in a jurisdiction the state considers to be a “Qualified Jurisdiction” (i.e., one that “effectively” regulates reinsurers domiciled in the jurisdiction). Through its Reinsurance (E) Task Force, the NAIC has been providing a forum for multiple-state review of

Certified Reinsurers applications and has also created a process to help states determine what constitutes a “Qualified Jurisdiction.”

The Reinsurance Task Force has adopted the NAIC’s “Qualified Jurisdiction Process” to assist states in determining which countries should be considered “Qualifying Jurisdictions.” The NAIC has granted Conditional Qualified Jurisdiction status for a 1-year period after an expedited review process to the following countries: Bermuda, Germany, Switzerland and the UK. The Reinsurance Task Force is now reviewing the regulatory supervisory systems of other countries, such as Ireland and France, which have requested approval as Qualifying Jurisdictions. The Reinsurance Task Force also created a Reinsurance Financial Analysis Working Group (“RFAWG”) to address specific applications by reinsurers that have already been approved as Certified Reinsurers in Florida, Connecticut, New York and New Jersey. RFAWG provides a forum for multi-state review of Certified Reinsurer applications and for “peer review” by state insurance regulators of decisions made by other states on applications. Peer reviews allow states to access diligence already conducted by other states during the approval process. At its meeting on December 18, 2013, RFAWG reported that, of the twenty one reinsurer applications that had been peer reviewed, 18 were approved and two are still pending. One application was denied (so that the reinsurer, certified in one state, must now seek individual approval in all other states).

Beyond credit for reinsurance initiatives, there has been an increased focus on regulating other aspects of reinsurance transactions. Such initiatives include the proper use of Captives for reinsurance transactions, and the New York effort to require a new RBC collateral requirement applicable to insurance ceded to unauthorized reinsurers. (Both discussed in Section A.2 of “The Global Alternative Risk Transfer Market”).

5. Solvency and Corporate Governance Initiatives

Five years after its organization in 2008, the Solvency Modernization Initiative Task Force (the “SMI Task Force”) held its last meeting on December 16, 2013, where it adopted the reports of its working groups, including the Corporate

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Governance Working Group (the activities of which are discussed in further detail below). Additionally, the SMI Task Force received a report from the SMI RBC Subgroup regarding plans to modify the RBC formula to cover operational risk in 2014, as further described in Section C.5.e of “Global Regulatory and Litigation Developments” below. In light of the disbanding of the SMI Task Force, its current subgroups will report directly to the (E) Committee (or another subgroup of the (E) Committee).

a. Corporate Governance Working Group Activities

At its December 16, 2013, meeting, the Corporate Governance Working Group continued its work on proposed revisions to the Annual Financial Reporting Model Regulation (#205) (commonly referred to as the Model Audit Rule) that would require large insurers to maintain an internal audit function. After a thorough discussion of comments received from interested parties, the working group agreed to integrate the comments received and to re-expose the draft for 45 days (until the end of January 2014), with the goal of adopting the revised regulation at the NAIC’s 2014 Spring National Meeting.

The Corporate Governance Working Group also continued its efforts to adopt a Corporate Governance Annual Filing Model Act and related Guidance Manual on an expedited basis. The inclusion of a Guidance Manual permitting modifications through a less fulsome process than an amendment to the model act was the subject of considerable objection by interested parties. After discussion, the working group voted to expose the current drafts for a 45-day period ending on January 31, 2014. Comments were submitted by several parties, including jointly-submitted industry comments. The industry comments included a draft of a new Corporate Governance Annual Filing Model Regulation in lieu of a Guidance Manual; specific wording to avoid duplicative filings; the addition of a threshold in order for an insurer or insurance group to be required to make a Corporate Governance Annual Filing (which is the same level as the filing threshold in the ORSA Model Act (#505) for insurers that are not part of an insurance group and the threshold in the current draft Model Audit Rule (#205) for an insurer that is not part of an insurance group to maintain an internal audit function); and a

change to have the Corporate Governance Annual filing be for information only. Industry and others made comments relating to confidentiality and information-sharing, a topic of continuing concern, even though the Corporate Governance Annual Filing Model Act was based on the ORSA Model Act (#505), which addressed confidentiality after lengthy negotiation by regulators and the industry.

During a conference call on March 6, 2014, there was an extended discussion among the Working Group members and members of the industry regarding whether the detailed requirements of the Corporate Governance Annual Filing will be outlined within a Guidance Manual versus a Model Regulation. The Corporate Governance Working Group circulated a draft of its own version of a Model Regulation, which was based on the industry’s proposed Annual Filing Model Regulation, but which included an extensive list governance topics to be disclosed in such Filing. Some industry members read the list of concepts as prescriptive, while the Corporate Governance Working Group members viewed them as topics to be disclosed, if applicable. The Corporate Governance Working Group’s Model Regulation was exposed for a 45-day comment period, ending April 21, 2014, after which the discussions will continue, with a goal of adoption of a Corporate Governance Model Act and accompanying Regulation during 2014.

Discussions on the substance of the two Model Acts (#205 and the Corporate Governance Annual Filing Model) will continue at the NAIC’s Spring National Meeting. The current draft of the Corporate Governance Model Act anticipates that the first Corporate Governance Annual Filings would be made during 2016. However, it is clear that there are significant issues yet to be agreed prior to adoption.

b. Holding Company Act and Related Changes in Law

As of early 2014, approximately 25 states had adopted the 2010 updates to the Insurance Holding Company System Regulatory Model Act (#440) and/or the Holding Company System Regulatory Model Regulation (#450), which Models include authority for states to participate in supervisory colleges and requiring annual enterprise risk reporting. Updated Model #440 also amends laws governing insurance company registration, annual

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reports and notice to the insurance regulators of an insurer’s transactions with its affiliates. A number of additional states have introduced legislation, or expect to do so, that would implement increased holding company act supervision, including requirements with respect to enterprise risk management (“ERM”), during 2014. At its December 17, 2013, meeting, the (E) Committee adopted an additional charge to “Review the Model Insurance Holding Company Act (#440) and Regulation (#450) and consider amendments to address issues that have arisen subsequent to the adoption of the Act and Regulation by the NAIC in 2010.” While the charge is worded in a slightly cryptic fashion, it is intended to address amendments that may be needed in light of international group supervision efforts, in particular, the group supervision aspects of the IAIS’s Common Framework (“ComFrame”) for the Supervision of Internationally Active Insurance Groups (“IAIGs”). See Section D.2 of “Global Regulatory and Litigation Developments” below. The work is expected to be performed primarily by the NAIC Group Solvency Issues Working Group.

c. Enterprise Risk Management

For domestic insurers in states that adopted the updated NAIC Insurance Holding Company System Regulatory Model Act and Regulation with an effective date on or prior to January 1, 2014, the first ERM reports generally will be provided to regulators in 2014. Note that states may not be entirely aligned on the filing dates. Under NAIC Model #440, an Enterprise Risk Report must be filed annually but not on a specified date. For example, the NYSDFS proposed regulations in January 2014 that would require ERM Reports to be filed by April 30 of each year; in California, the first annual enterprise risk report must be filed with the insurer’s registration statement after July 1, 2013, unless the commissioner establishes a later date either by bulletin or notice; in Illinois, the first ERM filing will be due by May 1, 2015, after implementing regulations are adopted; while the Connecticut Holding Company Act requires annual ERM filings by June 1 of each year commencing in 2013. The filing is to be made by the ultimate controlling person of each insurance company subject to registration and must identify the material risks within such holding company system that “could

pose enterprise risk to the [insurance] company.” The Enterprise Risk Report represents a key augmentation of U.S. insurance regulators’ ability to directly receive information from insurance companies about risks that may be posed by the insurers’ affiliates.

d. Own Risk and Solvency Assessment

As of the date of this publication, eight states (California, Iowa, Maine, New Hampshire, New York, Ohio, Pennsylvania, Rhode Island, and Vermont) had adopted laws based on the NAIC Risk Management and Own Risk and Solvency Assessment (“ORSA”) Model Act (#505) and a number of states had pending bills to adopt ORSA. For domestic insurers in states that adopt the ORSA requirements with an effective date on or before January 1, 2015, generally, the first ORSAs must be completed during 2015 and the summary reports filed during 2015. An expanded third phase of the ORSA pilot project will be conducted during 2014; the second phase was conducted during 2013, following the 2012 initial pilot. During the pilot’s first two phases, insurers voluntarily completed an internal ORSA process and submitted an ORSA summary report. The NAIC ORSA (E) Subgroup provided combined written feedback on the 2012 and 2013 phases of the pilot in November 2013. The feedback consists of observations and recommendations for insurers to improve their ORSA summary reports, but neither the feedback nor the ORSA Guidance Manual are prescriptive, consistent with the overall structure of the ORSA to be each insurer’s “own” risk and solvency assessment. The feedback was discussed on a well-attended conference call on January 30, 2014. As a result of the 2013 pilot, a few changes to the ORSA Guidance Manual were proposed during the January 30th call and exposed for 45 days for public comment.

e. Capital Adequacy

During 2013, the NAIC Capital Adequacy Task Force adopted the ACLI Commercial Mortgage Loan Proposal (specifying RBC treatment for commercial mortgage loans to replace the previously-employed Mortgage Experience Adjustment Factor) and developed RBC factors for working capital finance investments (“WCFIs”) and mandatory convertible securities. In addition, the task force has been investigating whether changes to RBC calculations

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would be useful in capturing risks that were not contemplated, or may not have been quantifiable, when the RBC formulae were first created. During the meeting of the Capital Adequacy Task Force on December 16, 2013, a lively discussion occurred concerning a December 5, 2013, letter to the Capital Adequacy Task Force from the Connecticut Insurance Department’s chief actuary broadly questioning whether RBC is useful or effective. The letter suggested that if RBC thresholds were capturing too many companies (through Company Action Level or more severe events), regulators should question if they are using an overly conservative system. The letter characterized as a “Type 1” error the identification of an otherwise strong company as “weakly capitalized” and suggested that regulators also consider “Type 2” errors, characterized as involving troubled companies where RBC was not effective as a leading indicator. A representative from the Pennsylvania Insurance Department strongly objected to the Connecticut letter and argued that RBC has “saved the industry” and RBC triggers are a good way to “wake up management.” After considerable discussion, Capital Adequacy Task Force members agreed that RBC initiatives should focus on important issues and the Capital Adequacy Task Force should not spend as much time considering small, piecemeal proposals.

In 2013, the Capital Adequacy Task Force also exposed an Operational Risk RBC Proposal developed by the Solvency Modernization Initiative RBC Subgroup (the “SMI RBC Subgroup”). The Capital Adequacy Task Force has been charged with examining whether and how an operational risk charge can be incorporated into RBC formulas. In developing its proposal, the SMI RBC Subgroup examined how regulators in other jurisdictions, such as Bermuda and Canada, incorporate operational risk into their regulatory capital formulas. Operational risk is currently addressed through other NAIC-led initiatives, such as the requirement that insurers conduct an ORSA (see C.5.a. of this Section above) and prepare ORSA summary reports and enhanced corporate governance standards, which require analysis of risks that include underwriting, credit, market, liquidity as well as operational risk. As the mechanics of the proposal are discussed, some industry groups such as the

ACLI object to the proposal overall, believing it does not provide a good measure of operational risk and that such risk is better addressed in ORSA summary reports, which provide a qualitative measure of operational risk, rather than quantitative.

The Capital Adequacy Task Force met by conference call on March 10, 2014, where the focus of the call was on the controversial RBC collateral proposal submitted by the New York Insurance Department of Financial Services. The proposal is meant to address risks associated with unauthorized reinsurers from the perspective of RBC, rather than reserve credit. Critics of the proposal point out regulators have already addressed risks associated with unauthorized reinsurers when they adopted, after almost a decade of discussion, amendments to the CFR Model Laws (allowing reduced collateral from unauthorized reinsurers that have good ratings and qualify as Certified Reinsurers). The argument during the amendment process was that highly-rated unauthorized reinsurers should not be viewed as “riskier” than C-rated reinsurers that are licensed in the U.S. Similarly, some groups are questioning why the RBC proposal should apply to highly-rated Certified Reinsurers but not C-rated licensed insurers. At this juncture, it is anticipated that the Task Force will be consulting with NAIC leadership, because the proposal has become a highly political issue.

6. Private Equity Issues

In 2013, both the NYSDFS and the NAIC focused attention on private equity firm involvement with insurance companies, particularly life and annuity companies. New York Superintendent Benjamin Lawsky drew attention to this trend in a speech in April 2013. This was quickly followed by a referral from the NAIC’s Financial Analysis Working Group to the (E) Committee to consider ways to mitigate or monitor related risks, ultimately resulting in the creation of a new Private Equity Issues Working Group (the “PE Working Group”).

In connection with obtaining NYSDFS approval for acquisitions of New York domestic life insurers, each of Guggenheim Partners LLC and Apollo Global Management, LLC agreed to enhanced policyholder protections with respect to acquired insurers, including heightened RBC standards, establishment of a backstop capital account, enhanced regulatory

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scrutiny of operations, dividends, investments and reinsurance, and stronger disclosure and transparency requirements. Fidelity & Guaranty Life Insurance Company of New York also agreed to such enhanced policyholder protections. (Please see Section A.1 of The Global Mergers & Acquisitions Market above for a detailed discussion of this topic.)

The PE Working Group is chaired by Virginia, and its members also include Iowa, Delaware, Indiana, Kansas, New Jersey, New York, Ohio and Oklahoma. The PE Working Group held its first public meeting on December 16, 2013. After discussing its charge, the working group heard a presentation by Apollo Global Management, LLC and Athene Holding Ltd. regarding the history and rationale for its and other alternative asset managers’ interest in annuity writers, as well as feedback on the potential best practices identified by the Financial Analysis Working Group. Following discussion, the PE Working Group voted to re-expose the May 2013 referral memo from the Financial Analysis Working Group for public comment.

7. Force-Placed Insurance

As predicted in last year’s publication, there has been significant regulatory and litigation activity involving force-placed insurance. In addition to regulatory activity, many lenders, servicers, and insurers transacting business in this space have been the subject of lawsuits by the class action plaintiffs’ bar, and there has been quite a lot of activity in these actions as of late, as lenders, servicers, and insurers try to narrow the claims against them or extract themselves from the litigation entirely.

On the regulatory front, the Federal Housing Finance Agency (the “FHFA”), which oversees Fannie Mae and Freddie Mac, directed the mortgage lenders to stop reimbursing costs incurred by mortgage servicers for lender-placed business. In doing so, the FHFA stated: “FHFA remains concerned about the cost of lender-placed insurance for Fannie Mae, Freddie Mac and consumers. One of our primary responsibilities as conservator of Fannie Mae and Freddie Mac is to preserve and conserve their assets on behalf of taxpayers.”

In January 2014, a federal court overseeing a suit against Bank of America and QBE, among others, narrowed the case by dismissing claims under

California’s Unfair Competition Law. The court did so because it determined that the law of the state where the property is located (New Mexico) governs the mortgage contracts, which contained the force-placed insurance clauses. The action remains pending, however, to address other common law claims. The case is Vitek v. Bank of America N.A., No. 13-CV-00816.

In February 2014, Citibank and Assurant agreed to pay more than US$110 million to settle actions against them arising out of lender-placed flood and hazard insurance contracts. The settlement covers flood insurance that was lender-placed since 2006 while it covers hazard insurance that was lender-placed since 2007. The case is Casey v. Citigroup Inc., Nos. 5:12-CV-820 and 1:13-CV-353 (N.D.N.Y.).

Also in February 2014, a federal court approved the settlement of a nationwide class action against JP Morgan Chase and Assurant arising out of the lender’s standard mortgage contract, which “required borrowers to maintain hazard and wind insurance on the property that secured their mortgage loans.” The settlement covered more than 750,000 borrowers who had lender-placed hazard coverage between January 1, 2008, and October 4, 2013. According to the court’s order approving the settlement, borrowers will receive more than US$300 million in monetary compensation. The case is Saccoccio v. JP Morgan Chase Bank, N.A., No. 13-CV-21107 (S.D. Fla.).

Finally, in March 2014, Wells Fargo, Assurant, and QBE announced that they had settled with a nationwide class, which had alleged they were excessively charged for “hazard, flood, flood gap or wind-only” lender-placed insurance for residential property. Although the monetary amount of the settlement has not yet been made public, the proposed settlement indicates that payment to class members will be equal to 11% of the amount the premium payments made before March 24, 2012, and 7% for payments made after that date. The monetary amount will presumably be disclosed when the parties seek court approval of their settlement. The case is Fladell v. Wells Fargo Bank, N.A., No. 13-CV-60721 (S.D.N.Y.).

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8. Unclaimed Property

a. State Bills based on NCOIL Unclaimed Life Insurance Benefits Model Act

Nine state legislatures enacted laws in 2013 to expressly require insurance companies to make comparisons of their in-force business to the Social Security Administration’s Death Master File (the “DMF”). The purpose of the comparisons is to potentially identify deceased insureds whose beneficiaries have not filed a claim. An additional 10 states’ legislatures introduced bills in early 2014 (Georgia, Indiana, Iowa, Louisiana, Maryland, Mississippi, Oklahoma, Pennsylvania, Rhode Island, and Tennessee) that would adopt a version of the Unclaimed Life Insurance Benefits Model Act (the “NCOIL Model”) prepared by the National Conference of Insurance Legislators (“NCOIL”) in 2011 and amended in 2012 and 2013. The bills vary from the NCOIL Model due to comments from the ACLI and from various insurance industry parties. Some of the 2014 bills, like some of those passed during 2013, are prospective in application. Unlike some of the 2013 bills, the 2014 bills generally limit their scope to life insurance policies, annuity contract, or retained asset accounts issued or delivered into the particular state. The latter is a helpful change for life insurers attempting to perform comparisons across numerous states, because to the extent there is a state law requiring such comparisons, the laws may have conflicting requirements. Nonetheless, the 2014 bills are not entirely aligned in other respects, including the frequency of comparisons and the exempted types of business. This continues to be a challenging compliance area for multi-state life and annuity insurance companies.

b. NCOIL Forms Task Force to review Unclaimed Property Matters in Life and Annuity Industries and NAIC (A) Committee Will Study the Issues

During late 2013 and early 2014, the NCOIL President announced the formation of a task force to address key aspects of the ongoing unclaimed life insurance issues. An Advisory Council was also formed, consisting of insurance company, regulator, consumer, and legal representatives, as well as NCOIL member legislators. In February 2014, the Advisory Council members submitted lists of key issues for the task force to address. The suggestions

and issues were discussed at length at a March 7, 2013, meeting of the task force, at the conclusion of which interested persons were asked to submit written comments, issues, and any proposed revisions to the NCOIL Model within 30 days.

At its in-person meeting on December 16, 2013, the Life Insurance and Annuities (A) Committee (the “(A) Committee”) formed and requested volunteers for the new Unclaimed Property and Death Master File Working Group. The new working group will carry out the following 2014 charge of the (A) Committee: “undertake a study to determine if recommendations should be made to address unclaimed death benefits.” On December 18, 2013, the Executive (EX) Committee approved the (A) Committee’s 2014 proposed charges.

That charge was adopted by the (A) Committee during a December 4, 2013, conference call. Discussion during the conference call centered on whether the charge should include the phrase “the consistent handling of” such that the charge would have read, “undertake a study to determine if recommendations should be made to address the consistent handling of unclaimed death benefits” (emphasis added). The Chair of the (A) Committee emphasized that the key word in the charge is “study,” and the (A) Committee agreed to delete the phrase “the consistent handling of,” with only Florida objecting to adoption of the charge in its revised form. The new working group initially consists of the 13 states of Tennessee (chairing the new working group), California, Florida, Illinois, Iowa, Louisiana, Minnesota, Nebraska, New Hampshire, North Dakota, Pennsylvania, Rhode Island, and Wisconsin, although other states are welcome to join. The (A) Committee’s new working group’s first public meeting is scheduled during the Spring National Meeting, so it remains to be seen what actions this charge will produce.

c. Litigation

A number of lawsuits have been filed in connection with life insurance unclaimed property matters. For decades, life insurance policies traditionally have included contractual language that requires the person seeking benefits to furnish a claim and due proof of death to the life insurer. This contractual text requires the person seeking benefits to initiate the claim process, and provides the insurer the

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contractual right to require receipt of due proof of death as a condition precedent to its investigation and payment of any claim.

A series of recent judicial opinions interpreting the “standard” due-proof-of death requirement in life insurance policies have acknowledged the insurer’s “passive role in establishing an insured party’s proof of death.” Thus, “obligating [an insurer] to solicit or gather information pertaining to an insured’s death”—as the Act contemplates—is “contrary to the terms contained in the insurance policy.” See Andrews v. Nationwide Mut. Ins. Co., 2012 WL 5289946, at *4-5 (Oh. Ct. App. Oct. 25, 2012). See also Feingold v. John Hancock Life Ins. Co., 2013 WL 4495126, at *1-4 (D. Mass. Aug. 19, 2013) (holding that “established principles of insurance law” give insurers the contractual right to “require a beneficiary to furnish ‘due proof of loss’ . . . before paying policy proceeds,” and that an insurer’s “practice of holding policy proceeds until receiving proof of the insured’s death” comports with the terms of the “insurance policy” and state law (emphasis added)); Total Asset Recovery Servs., LLC v. MetLife, Inc., No. 2010-CA-3719, at 4 (Fla. Cir. Ct. Aug. 20, 2013) (on appeal) (holding that the proof-of-death requirement establishes that the insurer does not have a contractual obligation to “engage in elaborate data mining of external databases” such as the “Death Master File,” or to take affirmative steps to search for evidence of death “in connection with payment or escheatment of life insurance benefits”); West Virginia ex rel. Perdue v. Nationwide Life Ins. Co., No. 12-C-287, at 8-9 (W. Va. Cir. Ct. Dec. 27, 2013) (on appeal) (holding that this contractual language makes clear that life insurers have “no obligation…to proactively search the DMF” or to “surrender the life insurance proceeds . . . until the obligation to pay arises—either upon receipt of due proof of death or once the insured reaches the statutorily imposed limiting age”). To the contrary is United Life Ins. Co. of Am. v. Kentucky, No. 12-CI-1441 (Ky. Cir. Ct. Apr. 1, 2013) (on appeal) (holding that this language only grants insurers to right to require receipt of a death certificate as a condition precedent to claim payment, and is silent on whether the insurer may be required to search for evidence of death or locate beneficiaries before that time). In October 2013, in response to a petition by Thrivent for Lutherans,

the Florida Department of Financial Services issued a declaratory statement of the Department’s interpretation under the Florida Unclaimed Property Law that a life insurance policy becomes “due and payable” upon “the death of the insured,” regardless of whether the insurance company receives a claim or proof of death.

The same plaintiffs in the Kentucky decision filed declaratory judgment actions in multiple states’ courts raising, among other arguments, the issue of whether life insurance companies have a non-contractual obligation to use the DMF or to seek out deceased insureds. In California, the lawsuit was filed as a counterclaim to the California Controller’s action for an injunction seeking an order requiring the plaintiff life insurance companies to produce all of their in-force policy records to the state’s auditors to enable the firm to perform a comparison of such records against a Death Master File. These lawsuits are pending.

d. Settlements with Insurance Regulators and Unclaimed Property Agencies

As of mid-January 2014, 13 insurance companies (or affiliated groups) had settled with insurance regulators and 18 had settled with unclaimed property auditors, all with respect to unclaimed property and related life insurance claims handling issues. There are two distinct types of settlement agreements that have been entered into since early 2011. The first is an insurance regulatory settlement agreement (an “RSA”) entered into between (a) a life insurance company or a group of affiliated life insurance companies and (b) the insurance regulators. The second is a global resolution agreement or global settlement agreement (a “GSA”), generally entered into between (a) a life insurance company or a group of affiliated life insurance companies and (b) the state agencies with responsibility for unclaimed property and/or their outside auditors. The terms of the two types of settlements are somewhat consistent. The regulatory settlements involve an upfront payment, while the audit settlements do not. The upfront payments have ranged from US$1.9 million to US$40 million. Some of the settlement terms are tailored to an insurer’s book of business; such terms are primarily seen in settlements with companies having incomplete records or a lack

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of electronic records. The NAIC Investigations of Life Annuity Claim Settlement Practices Task Force (the “Investigations Task Force”), which is spearheading the RSA efforts through market conduct examinations, has repeatedly stated that it is looking at the top 40 life and annuity insurers. In press releases announcing the most recent RSA, Investigations Task Force member regulators stated that the task force has obtained settlements with 55% of the market.7 Notably, however, the market conduct examination of at least two life insurers have concluded with a determination that the insurers had been appropriately using the DMF; as such, no up-front payment was involved and there was no settlement agreement.

e. DMF Restrictions in Federal Budget for 2014

In an effort to combat fraud in the administration of Federal benefits, a provision in the Federal Bipartisan Budget Act of 2013, H.J.R. 59, limits access to information in the Social Security Administration’s Death Master File to “certified entities.” The U.S. Department of Commerce is charged with developing a fee-based certification process. The restricted access to information would apply for three years after an individual’s death and is scheduled to take effect 90 days from the date of enactment of the Budget Act in March 2014. The NAIC and the New York Superintendent each wrote to the Secretary of Commerce in January 2014 to advocate that life insurance companies be granted continuous and ongoing access to the DMF. The NAIC letter asked that the process not be “overly burdensome,” while the New York letter commented that all life insurers operating in New York should meet the statutory criteria for continued access.

The Department of Commerce has not yet proposed a certification regime, but announced that when it does, it will be proposed through the Federal administrative process, including publication in the Federal Register. The Department of Commerce, through its National Technical Information Service (“NTIS”) published a request on March 3, 2014, for public comments (due by March 18, 2014) regarding the establishment and implementation of a certification process. NTIS is the unit of the

Department of Commerce charged with the oversight of the DMF. NTIS held a public meeting on March 4, 2014, to hear comments from any interested persons regarding access to the DMF; all comments made at the hearing were posted to the NTIS site. Significantly to those who regularly access the full DMF or the DMF update files, there is an announcement posted on the NTIS website at https://dmf.ntis.gov/ indicating that access will be uninterrupted pending development of the certification process.

9. Invested Assets

a. Working Capital Finance Programs

The NAIC Valuation of Securities Task Force (“VOS”) adopted amendments to SSAP No. 105, which amend SSAP No. 20—Nonadmitted Assets (“SSAP No. 20”) to allow WCFIs as admitted assets to the extent they conform to the requirements of SSAP No. 105. In addition, the VOS adopted additional provisions to the Purposes & Procedures Manual of the SVO to address the reporting and approval of all Working Capital Finance Programs (each, a “WCFP”) that meet the requirements of SSAP No. 105. While we are not aware of any investment provisions in state insurance codes that specifically authorize WCFIs, WCFIs that meet the requirement of SSAP No. 105 likely would be considered an investment grade obligation, which are generally authorized investments.

Under SSAP No. 105, a WCFI represents “a confirmed short-term obligation to pay a specified amount owed by one party in connection with the purchase of goods or services (obligor) to another party (typically a supplier of goods)” as part of a program designated by the NAIC SVO as a WCFP. Under such a WCFP, the short-term obligation of the obligor is transferred by the supplier to a third-party investor, who then has the right to receive future payment. It is anticipated that a finance agent, as defined in SSAP No. 105, will facilitate the program and arrange the sale or assignment of the receivable to the investor for a fee. Subject to additional guidelines, SSAP No. 105 allows an insurer to invest in participation interests of WCFIs.

7 See http://insurance.illinois.gov/newsrls/2014/01/GenworthSettlement.pdf and http://www.portal.state.pa.us/portal/server.pt?open=512&objID=17319&PageID=502655&mode=2&contentid=http://pubcontent.state.pa.us/publishedcontent/publish/cop_hhs/insurance/news_and_media/news___media/articles/january_22__2014.html.

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To meet the WCFI requirements under SSAP No. 105, both the obligor and the program itself must be designated as NAIC “1” or “2” by the NAIC SVO after submission to the SVO of the Regulatory Treatment Analysis (“RTAS”) Application as discussed below. Further, the WCFI must represent a first priority perfected security interest or right to receive payment. Additionally, the obligor must commit that its obligations and payment to the investor will not be affected by the invalidity, unenforceability or nonperformance of the underlying transaction or contract, and otherwise waive any defenses against payment to the supplier or investors. Further, the documents establishing the program or the confirmation must state and confirm that the obligation to pay is independent of any other contracts or claims that the obligor might raise in defense of payment. In addition to the foregoing, the following arrangements are specifically excluded from qualification as a WCFI under SSAP No. 105: factoring, forfaiting and invoice discounting.

Pursuant to the Purposes & Procedures Manual of the SVO, in order for an insurance company to purchase a WCFI as part of a WCFP, the insurance company investor must file an RTAS Application with the SVO, available on the website of the NAIC, along with additional documents specified in the application, including (i) audited financial statements of the obligor (if the obligor is not rated by a Credit Rating Provider); (ii) the insurance company’s Investment Committee Memorandum for the proposed WCFP; (iii) the audited consolidated financial statements of the group of which the finance agent for the program is part, as well as an annual independent report relating to controls related to the administration of the investment or an annual audit of the internal controls of the consolidated group, noting no material weaknesses relating to servicing; (iv) a certification from the insurance company’s chief investment office stating that the insurance company is not affiliated with the obligor or with any supplier in the WCFP and that the WCFP does not include any insurance or insurance-related assets; (v) a certification from the insurance company’s legal counsel in case of a participation or a certificate representing a right to payment from a trust that such participation or certificate would qualify as first priority perfected security interests; and (vi) the agreements

establishing the WCFI and the WCFP. An insurance company investor will have ongoing reporting obligations to the SVO. The Purposes & Procedures Manual of the SVO does not set forth a specific standard for approval, but the program must be designated as NAIC “1” or “2” by the NAIC SVO after submission to the SVO of the RTAS Application.

To the extent WCFIs conform to the requirements of SSAP No. 105, they will be considered admitted assets under SSAP No. 20—Nonadmitted Assets (SSAP No. 20). WCFIs are not specifically addressed under state insurance laws, but because they are obligations rated NAIC “1” or “2” issued by a corporation, they would likely be authorized for investment as investment grade obligations. Nevertheless, an analysis of each state insurance code should be conducted to confirm such treatment. However, under the SSAP No. 105 guidance, the asset must be non-admitted if a WCFP’s rating or an obligor’s rating falls below NAIC “1” or “2”; therefore, a WCFI’s admissibility must be monitored and is subject to change.

b. Capital Efficient Solutions

As we are in a period of historically low interest rates and corresponding returns, many companies, including insurance companies, which have large debt portfolios, are exploring various structures to safely invest in higher yield investments. However, unlike general business corporations, insurance companies are subject to a risk-based capital regulatory regime which, in part, seeks to measure an insurance company’s financial health based on the risk associated with its investment portfolio. The calculation of an insurance company’s risk-based capital, in part, involves applying a capital change to each of its investments, based on the risk and volatility associated with such investments. Thus, RBC changes and other regulatory restrictions, typically limits an insurance company’s ability to invest in higher yield investments (e.g., hedge fund interests, common stock and other structured investments). In that regard, there has been increased interest in investment structures that allow an insurer to invest in assets that generate higher yields, but in a capital efficient manner. Such structures can involve taking a traditional investment grade instrument and structuring it such that part of its return is based on a traditionally

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higher yield investment. To obtain the lower risk-based capital charge, additional investment protection are typically incorporated to lower the risk profile of the investment. This can result in an investment that may have a slightly lower return than a traditional high yield investment, but will provide a capital charge that is more typical of a traditional investment grade instrument.

The structuring of these types of investments can involve various state insurance regulatory, rating, statutory financial treatment and regulatory capital issues. All of these issues must be considered in structuring an investment in order to ensure that the insurance company investor has the authority to make the investment and the investment is capital efficient. Generally, if any such structured investment can be structured as an investment grade instrument, an insurer would have the state regulatory authority to make such investment and, depending on the specifics of the structure, including various investor protections built into the investment, may obtain favorable risk-based capital treatment. However, the NAIC and the SVO do periodically examine the financial reporting and risk-based capital rules associated with structured investments. In fact, the NAIC and the SVO have previously examined and taken positions with respect to structured notes issued by special purpose vehicles, whereby part of the payment to the insurance company investor is based on the return of principal. Additionally, the NAIC Invested Asset Working Group the (“IA Working Group”) is currently examining the reporting of structured notes issued by insurance companies. The IA Working Group has reserved the right to address the further regulation of structured notes. Thus, while structured investments can provide insurance companies with enhanced yields in a capital efficient manner, care must be taken to navigate the various regulatory, statutory financial treatment and risk-based capital issues.

10. Mortgage Guaranty Insurance

Mortgage guaranty insurance was one of the relatively few topics on which the Modernization Report recommended Federal action, namely “[f ]ederal standards and oversight for mortgage insurers should be developed and implemented.” See Section B.2 of “Global Regulatory and Litigation Developments” above regarding the Modernization

Report. The Modernization Report specifically noted that during the housing crisis and the ensuing financial crisis, mortgage guaranty insurers had difficulties maintaining the existing capital standards, including (i) the state standards, in the approximately 16 states that had such standards, and (ii) the contractual capital standards imposed by the Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation. The Modernization Report recommended federal standards due to the fact that “the private mortgage guaranty insurance sector is interconnected with other aspects of federal housing finance system and, therefore, is an issue of significant national interest.” To date, there has not been any Federal action to develop direct Federal oversight of mortgage guaranty insurance companies (although the Consumer Financial Protection Bureau (“CFPB”) has been looking into other areas of the U.S. residential mortgage business and in particular, has been investigating some mortgage insurers’ alleged kickbacks in violation of the Federal Real Estate Settlement Procedures Act, including through the use of captives affiliated with mortgage originators).

The NAIC Mortgage Guaranty Insurance Working Group (the “MGI Working Group”) has a 2014 charge to pursue, and has been working since early 2013 to develop, rather extensive modifications to the Mortgage Guaranty Insurance Model Act (#630, originally adopted in 1976). The MGI Working Group’s proposed modifications are in six overarching categories: Capital Requirements, Underwriting Standards, Investment Limitations, Reinsurance and Use of Captives, Reserve Requirements, and Rescission Matters. The industry has been working with a consultant on a new capital model and has agreed to work with the MGI Working Group on the proposed model. At its meeting on August 23, 2013, the MGI Working Group asked the Wisconsin regulator to prepare a first draft of an updated Model #630, which was delivered to the MGI Working Group in October, 2013. The modifications included a proposal for a new Mortgage Guaranty Insurance Standards Manual in addition to the topics on the MGI Working Group’s concept list.

The MGI Working Group held extensive discussions at its December 15, 2013, meeting on the proposed modifications to Model #630. The proposed

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changes would prohibit captive reinsurance, make extensive changes to mortgage guaranty insurance underwriting standards, and add quality assurance standards intended to complement the new underwriting guidelines. The capital standards section develops a two-tiered capital adequacy measurement system using an RBC methodology similar to that applicable to property and casualty insurers and a loan-level capital model. The MGI Working Group received a nine-page comment letter from the industry on the exposure draft, and at the December 15, 2013, meeting, several regulators on the MGI Working Group expressed disappointment in the tone of the comment letter.

The industry group letter suggested that, in a number of respects, Model #630 should not be overly prescriptive and instead should be more flexible and principles-based. The industry also commented that the model should reflect the more risk-sensitive capital standards on which the industry, with its consultant, is currently at work. Further, the industry group suggested that any contingency reserves and/or premium deficiency reserves be deferred until the work on a new risk-based capital standard is finished. While a draft of the proposed Standards Manual had not been drafted, the industry was not generally in favor of such a manual if it were envisioned with prescriptive standards. The industry group also asserted that any Mortgage Guaranty Insurance Standards Manual authorized under Model #630 would need to be flexible. Industry representatives agreed to prepare a “workable” markup and requested an extension to the exposure period. Note that, unlike the debate taking place at the Corporate Governance Working Group regarding a Guidance Manual, the industry was not totally opposed to the use of a Standards Manual, but expressed a preference that a principles-based approach be given serious attention first.

The MGI Working Group extended the deadline for the exposure period from January 9, 2014, to February 15, 2014. The MGI Working Group held a public webinar on March 5, 2014, to hear a presentation by the industry’s consultant on the work to date on a proposed new capital plan for mortgage guaranty insurers. Comments on

the exposure draft will be the subject of the MGI Working Group’s meeting at the NAIC Spring National Meeting.

11. Federal Home Loan Bank Loans and Advances to Insurance Companies

During a December 6, 2013, conference call that preceded its in-person meeting at the Fall 2013 NAIC National Meeting, the Receivership and Insolvency Task Force (the “RITF”) adopted (a) without comment from regulators or interested parties, a memorandum to the (E) Committee and (b) without any changes, a report of the Federal Home Loan Bank Legislation Subgroup (the “FHLB Subgroup”), each regarding the FHLB Subgroup’s study of the Federal Home Loan Banks’ proposed receivership legislation. Such legislation was introduced to the NAIC in 2012 and had previously been adopted in a limited number of states. The draft proposes amendments to states’ insurance company receivership laws to provide the FHLB with blanket exemptions from (a) a stay in an insurance company insolvency proceeding, and (b) voidable preference provisions.

Through its 2013 study of the receivership issues, the FHLB Subgroup “observed that the Federal Home Loan Banks’ proposed legislation has no perceived benefit to the receivership process.” Although one of the stated goals of the FHLB Subgroup’s study was state uniformity in addressing the Federal Home Loan Banks’ legislative request, uniform legislation was not achieved. Instead, in its report, the FHLB Subgroup recommends that “each state make its own determination regarding the proposed exemption based on that state’s existing receivership law and any other factors the state feels appropriate.” (Other NAIC working groups, such as the Restricted Assets Subgroup of the Statutory Accounting Principles Working Group, addressed non-receivership issues, such as financial statement disclosure of FHLB loan data.)

In its memorandum to the (E) Committee regarding the FHLB Subgroup’s report, the RITF noted that each state insurance department should consider the following aspects of a broader review of Federal Home Loan Bank transactions within the state’s domestic insurance industry:

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• the need for, and impact of, amendments to the state’s receivership laws to create exemptions that apply exclusively to a Federal Home Loan Bank;

• engaging in discussions or adopting a memorandum of understanding with the state’s Federal Home Loan Bank to clarify expectations for a potential insurance receivership or troubled insurance company situation;

• where an exemption is adopted into law in a state, the state engaging in prospective solvency assessment, particularly in situations with high potential for future receivership; and

• in evaluating the impact of incorporating the proposed exemptions into the state’s receivership laws, considering the benefits of low-cost liquidity and increased operating leverage available to an insurer through Federal Home Loan Bank membership.

The FHLB Subgroup did not meet at the Fall 2013 NAIC National Meeting but expects to meet in 2014 to address its next charge, drafting updates to the Receivers Handbook for Insurance Company Insolvencies to include information for dealing with an insolvency where Federal Home Loan Bank agreements may be involved.

12. Contingent Deferred Annuities

A Contingent Deferred Annuity (“CDA”) is a type of annuity designed to offer protection from the risk of outliving one’s assets. Under a CDA, a life insurer is required to make periodic payments for the CDA contract holder’s lifetime. These payments are triggered once certain specified assets, which are owned by and in the custody of the contract holder (rather than the insurer), are reduced to a certain amount defined in the CDA due to permitted withdrawals, market results and other charges.

The (A) Committee charged the Contingent Deferred Annuity (A) Working Group (“CDA Working Group”) with evaluating (i) the adequacy of existing laws and regulations as applied to CDAs and (ii) whether additional solvency and consumer protection standards were required. At the NAIC 2013 Spring National Meeting, the CDA Working Group submitted its report and recommendations to the Life (A) Committee.

Among other matters, the CDA Working Group found that (i) a CDA does not easily fit into the category of a fixed or variable annuity, (ii) review of solvency and consumer protection standards are necessary and (iii) tools to assist states in reviewing CDA product filings and solvency oversight of CDAs should be established. The CDA Working Group also identified issues that should be addressed by other existing NAIC committees and working groups with specific subject-matter expertise.

The (A) Committee adopted the CDA Working Group’s recommendations and referred several CDA-related charges, which were adopted by the NAIC Executive Committee at the 2013 Fall National Meeting. The adopted proposed 2014 charges included, among other matters, the following:

• Review and consider revisions to various NAIC model laws and regulations in relation to CDAs including the (i) Producer Licensing Model Act, (ii) Annuity Disclosure Model Regulation, (iii) Suitability in Annuity Transactions Model Regulation, (iv) Advertisements of Life Insurance and Annuities Model Regulation, (v) Life Insurance and Annuities Replacement Model Regulation, (vi) Standard Nonforfeiture Law for Individual Deferred Annuities, (vii) Synthetic Guaranteed Investment Contracts Model Regulation and (viii) Life and Health Insurance Guaranty Association Model Act;

• Evaluate Actuarial Guideline 43 to determine whether the reserve guidance as applied to variable annuity guarantees would be deficient when applied to CDAs and recommend appropriate changes; and

• Develop guidance, for inclusion in the proposed NAIC CDA guidelines, as to how current regulations governing risk-based capital requirements, including C-3 Phase II, should be applied to CDAs and recommend a process for reviewing capital adequacy for insurers issuing CDAs.

D. International (non-U.S.) Insurance Issues

1. IAIS

The IAIS is an organization of insurance regulators with members from 140 countries representing over 95% of insurance premiums across the world.

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While the IAIS is not itself a regulator, it establishes standards which member countries can apply. The G-20’s Financial Stability Board had directed the IAIS to develop a work plan to develop a “comprehensive, group-wide supervisory and regulatory framework” for IAIGs, including a “quantitative capital standard.”

In 2013, the spotlight was on the transparency of IAIS activities, as well as its October 2013 announcement that it will develop a risk-based “global insurance capital standard” for IAIGs and certain basic capital and higher loss absorbency requirements for G-SIIs.

a. IAIS Transparency

The debate on transparency of IAIS activities continues among state regulators and the NAIC, international regulators and the global insurance industry. At the heart of the debate is the proper level of participation to be allowed by the IAIS to “observers,” which primarily consist of industry trade groups and insurers who have been granted “observer” status by the IAIS, but are not full members of the IAIS (the NAIC is a full member). State regulators and insurance industry groups have been advocating for more open meetings of the IAIS and its committees, particularly the IAIS Technical Committee. On the other hand, to improve “efficiency,” the IAIS has been restructuring its operations and in some cases limiting the point at which third parties may observe and comment on actions of the IAIS. Some regulators view the changes as a step in the wrong direction and believe that transparency is important especially if potential issues with IAIS work cannot be caught earlier due to late participation by observers. Industry representatives continue to push for enhanced transparency.

b. Global Capital Standards

IAIS’s development of a global capital standard for IAIGs has also been the subject of tense debate. The global risk-based capital standard will be developed by 2016, for implementation in 2019 and is to be included within the ComFrame. ComFrame is an international framework for integrated and multilateral group-wide supervision, which builds on the IAIS Insurance Core Principles that apply to all insurers and insurance groups, but contains requirements for supervisors that are intended to result in greater cooperation and coordination for

IAIGs. U.S. and EU regulators have been deadlocked over two key issues at the center of ComFrame negotiations: (i) whether to implement global capital standards; and (ii) who should act as lead regulator for large international insurers. Regulators in Europe have tended to support a common global approach, whereas U.S. regulators have argued in favor of the current system in which capital standards are set at the subsidiary level in the respective states or jurisdictions.

2. ComFrame

In October 2013, the IAIS released a third draft of ComFrame for public consultation, which is the last consultation before the document is ready for the field testing phase, where the practicality and feasibility of ComFrame’s procedures are examined before it is finalized in 2018. Additional comments added to ComFrame include the importance of distinguishing between IAIS work targeted toward IAIGs as opposed to G-SIIs, clarification on group actuarial opinions and reports, capital adequacy assessments in light of developing insurance capital standards and recognizing other supervisory measures in determining criteria for core vs. additional capital. The IAIS expects to finalize ComFrame by 2018; however, it is unclear how ComFrame will be adopted in and implemented by individual countries.

3. Solvency II

a. Implementation Set for 2016

Despite some gloomy forecasts last year for the fate of Solvency II, the European Parliament and the Council of the EU adopted the Solvency II “Quick Fix” Directive in December 2013 which now puts the implementation of Solvency II back on track. EU Member States must transpose the Solvency II Directive’s requirements into national law by March 31, 2015, with its provisions to apply to insurers from January 1, 2016.

In preparation for the January 1, 2016, implementation date, the European Insurance and Occupational Pensions Authority (“EIOPA”) has published guidelines on the interim measures national supervisors should be taking before Solvency II comes into force, with such measures to be implemented through phasing-in provisions as of January 1, 2014.

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Insurers operating in the EU should be able to re-engage with their Solvency II programs, with a view to transferring Solvency II compliance to business as usual by January 1, 2016, and keeping abreast of the oncoming avalanche of information to be published by the European Commission and EIOPA in the forthcoming months.

One up-coming battleground will be making sure that the delegated acts of the European Commission—the technical details of the Solvency II capital regime—will work as intended. Already Insurance Europe, a collective of trade bodies, has published a press release (March 12, 2014) expressing concern that the delegated acts, as presently drafted, fall short of expectations; with high risk charges for long-term investments and methods for setting credit risk adjustments or applying volatility adjustments, being among the items needing to be addressed.

b. Non-EU Country Solvency II Equivalence

The resurrection of Solvency II has largely been met with positive reaction coupled with heightened attention as to how Solvency II will be applied to insurers from non-EU countries.

Three jurisdictions (Bermuda, Switzerland and Japan (in Japan’s case for reinsurance only)) had actively engaged in a formal “full equivalence” assessment process, which is expected to result in a European Commission equivalence decision before 2016. In the meantime, these jurisdictions have been granted “temporary equivalence” status, which means their respective solvency regimes will be deemed equivalent to that of Solvency II for a maximum period of six years on the basis that they have committed to adopting a prudential regime which will be assessed equivalent to Solvency II by January 1, 2021. More recently, in January 2014, Brazil’s insurance supervisory authority, SUSEP, announced that it is also applying for equivalence recognition. Eight other countries (Australia, Chile, China, Hong Kong, Israel, Mexico, Singapore and South Africa) have expressed their interest in applying for temporary equivalence.

Notwithstanding the foregoing, the decision by some other non-EU countries—notably the U.S. and Canada—not to seek equivalent status became a “sticking point” for EU policymakers as they faced a real risk of driving large global insurers

from EU shores. As a result, the publication in November 2013 of the final compromise text of Omnibus II (scheduled for approval by the European Parliament in March 2014) introduced a new concept of “provisional equivalence.” For provisional equivalence, the European Commission and EIOPA must simply demonstrate that the non-EU country’s solvency regime would satisfy full equivalence criteria if such assessment were to be carried out or the non-EU country is likely to adopt an equivalent regime at an undefined future point. Provisional equivalence, if granted, will apply for an initial period of ten years with the possibility of renewal for an additional ten years provided that the criteria continue to be met. In essence, the EU’s solution for the damage to EU insurance operations (namely, increased capital requirements) of a “non-equivalent tag” is to allow the European Commission to grant provisional equivalence to important non-EU countries that refuse to engage with Solvency II’s full equivalence process.

The delegated acts of Solvency II have not yet been published (expected April 2014, with adoption anticipated around August/September 2014), so it would be premature to conclude whether the EU framework for equivalence is complete. Certainly, the innovative proposal on provisional equivalence—with its practical effect of diluting the benefits of an application for full equivalence—suggests a marked deviation from the EU’s initial ambition of Solvency II becoming the default global standard for calculating capital requirements.

c. IAIS Global Insurance Capital Standard - Complementary or Conflicting to Solvency II?

Unfortunately, regulatory pressure on insurers’ capital requirements in Europe does not stop with Solvency II. In a seemingly separate move, the IAIS, of which the UK’s Prudential Regulatory Authority is a member, is introducing new capital requirements and other measures. As of 2016, G-SIIs will be required to comply with basic capital requirements (“BCRs”). These, in turn, will form the basis of: (a) a global insurance capital standard (“ICS”), to apply to IAIGs; and (b) “higher loss absorbency” requirements (“HLAs”) to apply to G-SIIs, from 2019.

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The IAIS published a methodology for identifying G-SIIs and policy measures that will apply to G-SIIs, consistent with the policy framework published by the Financial Stability Board in 2011. Using this methodology, in July 2013, the Financial Stability Board designated nine companies G-SIIs: European insurers Allianz, Axa, Aviva, Generali and Prudential plc, U.S.-based AIG, MetLife and Prudential Financial, and China-based Ping An Insurance—with this initial list to be updated annually from November 2014 and expected to grow. An initial list of reinsurers classified as G-SIIs will be published in July 2014, and there is also talk of the designation of locally systemically important insurers. The G-SIIs designations sparked controversy, as they were made at the same time the FSOC was making determinations on SIFIs.

The recent publication, in February 2014, of the responses to the first IAIS consultation paper highlight industry concerns over what is seen by some as a rushed, potentially unrealistic, timetable set for the introduction of the BCR and also a potential clash between the BCR/ICS regime and Solvency II requirements. Moreover, local regulators in both Europe and the U.S. fear losing ultimate control over their solvency and capital regimes to an international regulatory body, which may mean that much of the preparatory work done at the domestic level (at great cost) will seem to have been wasted. In this respect, the industry should have great interest in continuing to actively engage in the consultation process (the next consultation currently scheduled to begin in March 2014) in order to ensure that the IAIS’s development of the ICS does not negate all of the work already completed, modeled and tested for Solvency II.

Moreover, this recent G20 initiative—which stemmed from an initial focus on banks as global systemically important financial institutions (“G-SIFIs”) in the wake of the 2008 economic crisis—raises the question of whether bank-centric rules are inappropriately creeping into the regulation of the global insurance sector.

4. FSA Reorganization Update

a. Evolution of UK Regulation

The 2008 economic crisis was regarded by the government and commentators as showing the need for a fundamental shake-up of the UK regulatory

regime, notably in relation to the banking sector. This resulted in the replacement of the Financial Services Authority (the “FSA”) by two new, separate, regulators. However, the transition has not been without its challenges. Lengthening approval times, staff retention issues and increased costs have been the subject of media comment since regulatory reform took effect.

On April 1, 2013, two new bodies—the Prudential Regulatory Authority (the “PRA”) and the Financial Conduct Authority (the “FCA”)—replaced and assumed the majority of functions of the FSA. Insurers are now subject to regulation by both the PRA and the FCA. The PRA and FCA work to achieve different objectives.

The PRA has two statutory objectives with respect to its supervision of insurers. First, it promotes the safety and soundness of the firms it supervises and, second, specifically for insurers, it promotes the protection of those who are or may become policyholders. The PRA is to take a forward-looking approach to assessing an insurer’s ability to meet its obligations, a key underlying principle being that it does not seek to operate a zero-failure regime, but does require a level of resilience to failure of all insurers. Another feature of the PRA’s supervisory approach is that it is judgment-based, taking into account a wide range of possible risks to its objective by using a risk-assessment framework. The framework is intended to capture three key elements: (i) the potential impact that an insurer could have on the financial stability and policyholders, both by the way it carries on its business and in the event of its own financial failure; (ii) the external context in which an insurer operates and the business risks it faces which might affect its viability; and (iii) any mitigating factors. From an international perspective, it is the PRA’s role to supervise overseas insurers operating in the UK, as well as UK groups operating abroad.

In contrast to the PRA, the FCA acts as a conduct regulator. Its objectives include securing an appropriate degree of protection for consumers and promoting efficiency and choice in the market for financial services. The FCA’s primary purpose is to ensure that consumers are treated fairly in their dealings with insurers and to promote effective competition.

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Since April 1, 2013, there has been a high level of FCA and PRA activity in the insurance sector. For example, in June 2013, the FCA published its findings on the mobile phone insurance market, in July 2013, the FCA launched a review into conflicts of interest in the insurance broking sector (please see section D.7.a of “Global Regulatory and Litigation Developments” below) and, in March 2014, the FCA published its provisional findings on add-on insurance sales (with a consultation on the FCA’s proposed remedies expected before the end of the year). The PRA, in September 2013, issued two separate consultation papers on schemes of arrangement and on capital extractions by run-off firms. The PRA has also been communicating to the insurance market its expectations for Solvency II preparation in the UK and, as a member of the International Association of Insurance Supervisors, is involved in the development of a global insurance capital standard for G-SIIs (please see section D.3 of “Global Regulatory and Litigation Developments” above). While some of these measures have created a stir in the market (notably the PRA’s September 2013 consultation papers and the G-SII initiative), they show that the dual regulators are engaging in their broad statutory objectives.

b. Finding their Footing

Approval times for new financial firms were reported to be, on average, 25.8 weeks in the second quarter of 2013 when the FCA took up the reins. However, there was an even higher a peak of 25.9 weeks in the same quarter of 2012 under the FSA. This compares to 13.9 weeks in the second quarter of 2008. These figures have led to some concern that the FCA’s consumer protection objective is preventing viable financial service operators from being able to get started. It has to be recognized, though, that insurers and regulators alike are now grappling with a new process. The FCA has been working with trade bodies to educate applicants on how to demonstrate they meet the new requirements, so that applications can be considered more quickly.

Early statistics also indicate that the duplex regulators may be struggling to retain their staff; with people leaving the FCA and PRA at an annualized rate of 12% and 11% respectively, compared to an average rate of 7.8% for the last

five years of the FSA. While these statistics are potentially troubling, it is important to remember that the annualized data for the FCA and PRA does not yet cover a full year, and turnover trends could be affected by one off and seasonal factors.

The two regulatory concerns that are often mentioned are first, that a significant number of experienced team members have left the regulators, meaning that insurers may find themselves dealing with supervisors who have limited knowledge and experience of the industry and, secondly, that even simple applications and procedures are becoming very delayed. On the positive side, regulatory reform provides the opportunity for these two new UK bodies to hire and retain skilled and motivated staff and allow them to learn their craft. The introduction by the FCA and PRA of a model whereby their key staff and the key staff from regulated firms (including insurers and reinsurers) spend a limited period of time in each other’s organizations looks like a step in the right direction and has received positive comment. This initiative is akin to that recently deployed in the U.S. by the SEC. The model aims to mitigate the risk of permanent FCA and PRA staff becoming “life-time” regulators and, therefore, also, the risk of regulatory rules being applied inflexibly in a way which is disconnected from the daily reality of reinsurance and insurance business. It has been acknowledged, though, that it may take some time before the benefits of such a model can be fully realized.

The new regime also represents a shift away from “light-touch” regulation, but in a context where this shift is seen as fundamental to the U.K. remaining an attractive market for insurance business. However, the announcement by the FCA and PRA in April 2013 that insurers were to shoulder a further 20% increase in regulatory costs (having already absorbed a 32.5% increase in the previous year) revived a fear of the U.K. becoming less competitive internationally because of alleged “gold plating” of Solvency II, excessive “red tape” and unnecessary duplication of regulatory requirements. The FCA and PRA have committed to reducing the regulatory costs for insurers in the future and stress that they are sensitive to these criticisms. This is a laudable aim, but will be challenging given impending regulatory changes at the domestic, European and international level.

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The overall sentiment appears to be that the FCA and PRA, are still finding their feet as they settle into new territory. Clearly insurers operating in the U.K. need to engage appropriately with the FCA and/or PRA at a time when the manner in which a number of key initiatives are implemented—namely, Solvency II rules in the U.K., the revision of the Insurance Mediation Directive and G-SII capital requirements—as these may have a profound long-term impact on their operations and the associated regulatory costs. Internally, boards are also having to work to instill a business culture that is more sensitive to key regulatory issues.

5. Lloyd’s Developments

Significant regulatory reform in the U.K. in 2013—namely, the introduction of dual regulation (please see section D.4 of “Global Regulatory and Litigation Developments” above)—, inevitably, affected the workings of the Lloyd’s market.

The cooperation agreements between Lloyd’s and the two new bodies—the FCA and the PRA—largely mirror the agreement that had been in place with the now defunct FSA. However, against the backdrop of a shift away from “light-touch” regulation, there has been greater regulatory focus on conduct issues in the Lloyd’s market.

Unsurprisingly, delegated underwriting authorities—through which, according to Lloyd’s itself, coverholders (in the U.S., managing general agents) generate business representing approximately 30% of premiums written in the Lloyd’s market annually—have attracted attention.

At the Coverholder Auditors Conference at the end of March 2013, the incoming FCA made clear its expectation that managing agents collect more data from their coverholders in order to improve reporting standards and increase transparency throughout the distribution chain. The FCA has since reiterated the need for insurers in the London market to tighten their due diligence processes and oversight of their delegated agents. Managing agents are, therefore, having to invest more time and resources in supervising their delegated authorities.

In 2013, the Lloyd’s Market Association concluded its extensive review of the Lloyd’s market standard model binding authority agreements, which have now been updated and reissued. Lloyd’s has also issued a number of key market bulletins to act as

guidance on the minimum standards expected of coverholders and managing agents. One such bulletin, issued on October 7, 2013, sets out Lloyd’s minimum expectations of managing agents regarding their coverholders’ compliance with sanctions and financial crime obligations. As well as consolidating previously communicated expectations; significantly, the bulletin highlights a number of financial crime and sanctions tools available to the market and invites managing agents to encourage their use by coverholders.

Moreover, as of October 2013, the Lloyd’s Code of Practice for Delegated Underwriting (the “Lloyd’s Code”) includes greater emphasis on the responsibility of coverholders themselves (in addition to managing agents) for their compliance with anti-money laundering legislation, international sanctions and the Bribery Act 2010. Coverholders are encouraged to demonstrate internal procedures which deal with these areas of compliance. A further amendment to the updated Lloyd’s Code now requires managing agents to notify Lloyd’s of any serious concern or issue that arises in their dealings with coverholders. It is anticipated that this increased expectation of diligence will ensure problems are discovered and dealt with at an early stage and at all levels.

While Lloyd’s market bulletins and the Lloyd’s Code are not strictly mandatory, they highlight the increasing trend recently towards tightening regulation of the distribution lines at Lloyd’s, with the intention that a culture develops where regulatory compliance becomes a greater focus of the operations of managing agents and those working with the Lloyd’s market.

6. Cyber Risk/Data Protection Update

Concern about cyber risk continues to escalate. Cyber risk was recognized by World Economic Forum in 2013 as one of the top five risks to the global economy and now ranks in 3rd place in Lloyd’s 2013 Risk Index (compared to 12th place in the previous two years).

Despite this, a “2014 Executive Perspectives on Top Risks” survey indicated complacency among smaller businesses, as only the boards of the largest organizations placed cyber threats and privacy

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management high up on their agendas. Both the UK and U.S. Governments are reiterating that cyber risk impacts all firms regardless of sector and size.

Recently, the UK Government identified cyber crime as a Tier 1 threat to national security—the same rating given to terrorism. Also, the UK Government’s 2013 “Cyber Governance Health Check” report found that, of the FTSE 350 respondents: 25% said their board of directors had a poor understanding of when data is stored with third parties; 63% thought their board of directors possessed only a marginal understanding of their company’s risk profile; and 39% were “very anxious” about their company’s approach to cyber risks. It is understood that the next iteration of the Health Check will allow an external “audit” of compliance, which could: (a) bring a degree of standardization to what are currently very disparate views on effective measures for protecting businesses; and (b) help underwriters to judge acceptable risks and pricing. In the U.S., in February 2014, President Obama issued an Executive Order and “Framework for Improving Critical Infrastructure Cybersecurity,” aimed at enhancing the resiliency of critical infrastructure and to help organizations, regardless of industry sector or size, to manage cyber risk.

Cyber risks take many forms, ranging from “home team” failures in software and protection of data, on the one hand, to externally induced disruption through denial of service attacks, extortion, hacktivism, and terrorist attacks against critical infrastructure, on the other.

Clearly, we are in an era where computer power presents consumers and businesses with unprecedented opportunities to increase efficiency. The wholesale interconnectedness of, and remote access to, our business and home environments have increased opportunities for nefariously minded outsiders and greatly increased the risks posed by cyber threats. For example, the increasing use of cloud systems—seen as a vital source of inexpensive storage and processing capacity—adds to the complexity and cost of managing fresh cyber risks, and creates new multi-jurisdictional compliance issues and hazards of telecommunications disruption.

Ultimately, more information to lose or abuse means regulators across the globe are focusing on this risk.

a. EU Data Protection Reform and Cyber Security Developments

The European Commission published a wide-ranging draft data protection regulation (“EU Data Protection Regulation”) in 2012. It is unclear when it will become effective, but it contains some important proposals:

a. Consent for processing personal data should be explicit with affirmative action required so the mere use of a service will not amount to consent.

b. In respect of profiling:

i. individuals will have a general right to object to profiling;

ii. individuals must be informed of their right to object to profiling in a highly visible manner;

iii. profiling which significantly affects the interests of an individual can only be carried out under limited circumstances, such as with the individual’s consent;

iv. profiling that has the effect of discriminating against individuals on the basis of race, ethnic origin, political opinions, religion, trade union membership, sexual orientation or gender will be prohibited; and

v. profiling that leads to measures with legal effect concerning the individual cannot be based solely or predominantly on automated processing and must include human assessment, with an explanation of the decision following such assessment.

c. A “Right of Erasure” (replacing the “right to be forgotten”), allowing individuals to require deletion of their personal data in certain circumstances (e.g. where they withdraw their consent or the data is no longer required), subject to certain exceptions (e.g. where it is necessary to retain the personal data for scientific research or for compliance with a legal obligation of EU law).

d. A requirement to notify security breaches without undue delay to the relevant data protection authority and also individuals if they are likely to have been affected by the breach.

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The draft EU Data Protection Regulation also envisages an ability to fine an organization up to 5% of its global turnover revenue. While this will likely be reserved for the most egregious breaches, it underlines that the principle of “privacy by design”—in essence, building in data protection safeguards into products, services and operations from the outset—is at the core of the EU’s modernized data protection regime. This would present a significant change to the approach of many businesses to date.

The European Commission’s involvement goes beyond data protection, as illustrated by its draft Network and Information Security Directive (“NIS Directive”) in 2013 (scheduled for adoption in 2014, to come into effect around 2016). Under the NIS Directive, certain businesses will be required to put in place appropriate measures for managing security risks and each EU Member State will have a designated National Competent Authority with investigatory and audit powers.

b. Insurance is the Answer?

For insurers, cyber risk represents a cloud with a potential silver lining. Insurers themselves will have greatly increased costs of compliance and will be operating their cyber risk management within their overall insurance regulatory framework, where it will be a focus of operational risk assessment. On the other hand, the high costs associated with the new notification requirements to individuals and “privacy by design” will undoubtedly increase the demand for cyber risk insurance (as has been the case in the U.S., where such notification requirements already exist).

Demand for cyber cover in the U.S. remains strong (cyber gross written premium jumping from US$75 million in 2003 to an estimated US$1.5 billion in 2014) and there are signs of increasing demand for cyber cover in the UK, with Lloyd’s insurer Beazley estimating premium growth of between 5% and 10% in 2014.

A key problem for insurers is how to effectively underwrite cyber risk, based in a relative lack of data for modeling purposes. Meaningful cyber insurance rests on a proper understanding of the nature and magnitude of a business’s risk exposure, and there is a growing demand for legal and consultancy advice, working with brokers, to enable the risks to be underwritten effectively. At present,

significant elements of cyber risk appear not to be commercially insurable, so it may be that the capital markets have a role to play, importing alternative risk transfer and other techniques to provide financial protection against these new risks.

Insurers themselves are not immune from cyber risks. On the contrary, as a treasure trove of sensitive and personal information, insurers would seem to be a prime target. While many other commercial sectors are lagging behind in their planning and risk awareness, insurers and banks at least have the benefit of being familiar with Operational Risk analysis from their increasingly demanding regulatory regimes.

7. Brokers’ Duties and the Insurance Mediation Directive

Under English law, the common law duties of a broker to act in good faith, put the client’s interests before its own and not make a secret profit are well-established. Overlaying these longstanding principles, UK regulatory rules require that any potential conflicts of interest be managed fairly (especially in the context of the soliciting or accepting of inducements) and that customers be informed of the basis upon which the broker’s service is provided (i.e. on a fair market analysis basis or on an exclusivity basis for one or more insurers) and compensated. In addition, criminal penalties now apply under the Bribery Act 2010 where bribes are either: (i) promised, offered or given; or (ii) requested, agreed to be received or accepted. The English legal framework makes it clear that the fair management of potential conflicts of interest for the protection of customers falls upon brokers and insurers alike.

Broker business models (including remuneration structures) have evolved considerably in recent years, as brokers have shifted away from simply acting as intermediaries to performing tasks that have traditionally been undertaken by insurers (for example, product design, underwriting and claims handling). As brokers increasingly look to both customers and insurers as sources of revenue, there has been increasing regulatory scrutiny of brokers’ management of conflicts of interest.

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a. The FCA’s Thematic Review

Most recently, this increased regulatory scrutiny became apparent when, on July 2, 2013, the FCA announced a thematic review into conflicts of interest in the insurance broking sector, with an initial focus on the small and medium-sized enterprises (“SME”) and micro-business markets. The publication of the FCA’s findings was scheduled for the last quarter of 2013, but this is now expected within the first quarter of 2014.

The FCA’s review focuses upon whether:

• payment flows between insurers and brokers compromise the broker’s duty to get the best outcome for the customer; and

• the broker’s performance of traditional “insurer” tasks gives rise to potential conflicts beyond the sales process and how any such potential conflicts are identified and mitigated in the broker’s business model.

The basis for including an analysis of the broker-SME customer relationship is that, while SMEs may be sophisticated in terms of the businesses they operate, they are not necessarily sophisticated buyers of insurance. The FCA has also indicated that the scope of the review may in the future be extended to capture contracts of large risks for commercial customers.

The FCA has assured the market that the starting hypothesis is not that there is a problem, but that the introduction of new broker business models demands a fresh check that customers’ interests are being sufficiently protected. For the market to work well for both brokers and customers, the FCA’s vision is that brokers focus on:

a. restoring confidence by making it clear to customers how brokers add value (this sitting in a context where brokers operate in an increasingly competitive environment and the reputation of the UK insurance sector has been damaged by widespread mis-selling of payment protection insurance);

b. re-evaluating their business model to ensure that firm culture, remuneration structures, incentive schemes and governance controls result in good outcomes for customers; and

c. enhancing customer experience by closing any gaps between customers’ expectations and the level of service delivered.

Recognizing that brokers play an important role in providing access to niche markets and placing complex risks, the FCA has signaled to the market that a ban on longstanding practices is unlikely unless there is clear evidence of customer detriment. Nevertheless, in anticipation of the publication of the FCA’s findings, brokers and insurers may benefit from undertaking a fresh check that their remuneration arrangements comply with existing rules and principles and are fair to customers. On a practical level, this will include being confident to point to: (a) a board focused on conduct issues, which communicates properly the firm’s risk appetite within its organization; and (b) effective use of systems and controls to identify, mitigate against and modify or correct any practices that may connote a lack of integrity.

b. Revision of the Insurance Mediation Directive – New Remuneration Disclosure Provisions

The industry must also adhere to regulatory developments at the European level, notably the ongoing revision of the Insurance Mediation Directive (“IMD”), which sets out minimum regulatory standards for insurance sales in the EU and was implemented in the UK through three statutory instruments made under the Financial Services and Markets Act 2000. On February 26, 2014, the European Parliament adopted amendments made by its Economic and Monetary Affairs Committee in January 2014 to the proposed text (published by the European Commission in July of 2012). An information note published by EU Council on March 5, 2014, indicates that the European Parliament will vote on the whole IMD text towards the end of 2014, with the revised IMD expected to come into force in 2016.

The proposed text requires intermediaries, prior to the conclusion of any insurance contract, to disclose the nature (fee or commission), basis and amount of their remuneration, and any variable remuneration received by individual sales employees, to their customers. A mandatory full disclosure regime will apply immediately upon the enactment of the revised IMD to the sale of life insurance products

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and after five years to the sale of non-life products. These new remuneration disclosure provisions will not apply to mediation of large risks, mediation by reinsurance intermediaries or reinsurance undertakings, or in relation to “professional customers.” The list of “professional customers” includes a catch-all provision that the customer possesses the experience, knowledge and expertise to make his/her own decisions and properly assess the risks that he/she incurs.

The new remuneration disclosure provisions will, therefore, impact brokers’ dealings with non-professional customers in the context of non-investment insurance contracts, where currently no such remuneration disclosure requirements under the Insurance Conduct of Business Sourcebook (“ICOBS”) apply. A point which remains open is how the concept of “professional customers” under the new IMD will fit into the existing regulatory framework in the UK for general insurance products.

The new remuneration disclosure provisions have been the subject of much discussion. There is broad industry support for firms involved in insurance distribution to make a meaningful cost disclosure. However, the extent to which the Markets in Financial Instruments Directive (“MiFID”)—which sets out sales and disclosure rules for investment products and is also being revised—has been used as the blueprint for the new IMD remuneration disclosure provisions has attracted criticism. The principal concern over the use of MiFID is that the proposed IMD remuneration disclosure provisions do not draw a distinction between general insurance and insurance investment products, where in the latter case disclosing the difference between the premium paid and the actual invested part of the premium will clearly assist the customer’s assessment of the value of cover. Previous surveys of the former UK regulatory body, the FSA, found that customers of general insurance products focus on quality of cover and level of premium, such that showing customers how much of the premium is paid as commission is unlikely to affect the purchasing decision. Moreover, it appears to be generally accepted in the market that importing such investment product disclosure requirements into the general insurance sector may result in

over-informing customers and diverting customers away from the issues of coverage, conditions and price.

In addition, the inapplicability of the new requirements to direct writers appears to undermine the European Commission’s concept of a “level-playing field.” If direct writers remain out of scope, we may see an increase in the number of intermediaries operating in intra-group risk structures; such intermediaries setting up underwriting agencies, so that they can wholesale products to sister companies for lower levels of commission. Furthermore, there is conflicting opinion on what should properly constitute “remuneration,” whether it is in fact sufficient to restrict disclosure to the nature and source of remuneration, and how the body to be appointed by the European Commission will determine how remuneration will be calculated and disclosed.

Ultimately, remuneration disclosure boils down to informing customers of what they are getting for their money. Whatever form the final revised IMD text takes, brokers will be forced to ensure their remuneration is competitive as against the services they provide. When presenting remuneration information to customers (whether to professional or non-professional customers), brokers should be confident that customers understand the context in which disclosures are made and can make use of the information.

8. EU/UK Competition Law Enforcement Activity

The last 12 months have seen relatively little European Commission-led competition law enforcement in the insurance sector. However, competition authorities in the EU’s Member States have more than made up for the relative calm in Brussels, launching multiple new investigations and progressing plenty of old ones. The UK authorities have been particularly active, notwithstanding the fact that they are in the midst of a process of significant institutional reform.

a. DG Comp

When the European Commission’s Directorate General for Competition (“DG Comp”) published its Study on Pools and the Subscription Market in February 2013 (the “Pools and Subscription Study”) (see last year’s Sidley Global Insurance

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Review), it was widely anticipated that there might be some follow-up enforcement activity, especially in relation to a number of pool arrangements that DG Comp seemed to imply might be anti-competitive. But after hosting a workshop in March 2013 to discuss the contents of its Pools and Subscription Study (where there was further criticism of a number of pool arrangements), DG Comp seems to have gone quiet on the insurance sector; and has not even published a promised response to the Pools and Subscription Study. This relative inactivity may simply be a reflection of the fact that officials in DG Comp’s financial services unit have had their hands full with the high profile LIBOR and CDS investigations, but it may also be reflective of a wider tendency for insurance cases to be handled at a national level in the EU’s Member States.

b. Court of Justice judgment in Allianz Hungaria Case Confounds Experts

In March 2013, the EU’s highest court, the Court of Justice of the European Union (“CJEU”), handed down judgment in a Hungarian case involving agreements between Allianz and Generali and a number of car repair garages.8 The judgment appears inconsistent with previous CJEU judgments.9 Of concern to industry, the judgment may offer competition authorities in the EU greater scope to classify an agreement as being in breach of competition law without first having to prove that the agreement is actually restrictive of competition. The judgment is also somewhat novel in suggesting that where an agreement involves a breach of a law that is unrelated to competition law (e.g., a financial services mis-selling law), that fact alone may increase the likelihood of the agreement constituting a breach of competition law.

c. National Level Enforcement in the UK

Although DG Comp might not have been focused on the insurance sector at an EU level, there has been significant enforcement activity at a national level in the UK and there is every indication that such enforcement activity will be further stepped-up in the coming year. Effective April 1, 2014, the UK’s two main competition authorities (the Office of Fair Trading (“OFT”) and the Competition Commission

(“CC”)) will be merged into a single new authority, the Competition and Markets Authority (“CMA”). It is widely anticipated that once the CMA is up and running, a number of new cases will be opened. In addition, the UK’s new FCA will soon assume full “concurrent powers” to enforce EU and UK competition rules in the financial services sector. The reforms will likely leave the UK insurance industry facing simultaneous competition law enforcement by the CMA and the FCA.

d. Car Insurance Market Investigation Progresses and Involves Price-Comparison Websites

On December 17, 2013, the CC published initial findings in its investigation into the private motor insurance industry. The CC provisionally concluded that the conduct of the insurers of not-at-fault drivers served to increase costs for the insurers of at-fault drivers in such a way that premiums as a whole were inflated. The CC’s investigation also covered the use of “most-favored nation” clauses by price comparison websites (pursuant to which insurers were prevented from offering lower prices for the same cover on other price comparison websites). The CC recommended the following potential remedies (among others): (i) offering at-fault insurers greater control over managing claims; (ii) imposing caps on the cost of providing replacement vehicles and repairs; (iii) providing more information to consumers to allow more effective comparison of add-on products; and (iv) prohibiting certain types of most-favored nation clauses. The CMA (to whom the case will be passed on April 1, 2014) is set to publish its final report by September 27, 2014.

e. Workplace Pensions Market Study Closed

In September 2013, the OFT closed its market study into defined contribution workplace pensions (“DCWP”). The market study concluded that competition in the sector was failing to ensure value to plan participants. However, after coming to an agreement with the Association of British Insurers (“ABI”) and the Pensions Regulator (“PR”), the OFT opted against referring the sector to the CC for a more detailed investigation that could have led to the imposition of significant remedies. The

8 See Case C-32/11 - Allianz Hungária Biztosító Zrt., Generali-Providencia Biztosító Zrt. and others v. Gazdasági Versenyhivatal, judgment dated 14 March 2013 (not yet reported).

9 See, to this effect, the May 2013 article authored by Sidley’s Patrick Harrison and titled “The Court of Justice’s Judgment in Allianz Hungária is Wrong and Needs Correcting” (available at: www.competitionpolicyinternational.com/file/view/6928).

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OFT’s agreement with the ABI and the PR provided, among other things, that: (i) the ABI would conduct an independently-monitored audit of old and high-charging contracts and bundled trust arrangements; (ii) the PR would assess the efficiency of smaller trust-based arrangements; (iii) consideration would be given to whether the role of the PR should be extended to include new enforcement powers; and (iv) the ABI would establish independent governance committees to help strengthen the scrutiny of employer-controlled pension arrangements.

f. FCA Review of Annuities and General Insurance Add-On Products

On February 14, 2014, the FCA published the outcome to its thematic review of the UK annuities market. The review considered the benefits to consumers of purchasing annuities on the open market, rather than from their existing pension provider, and sought to assess the drivers of provider behavior. The FCA’s report found that in excess of 80% of consumers who purchased annuities from their existing pension provider could have found a more beneficial deal elsewhere. The FCA’s intention to use its competition powers is also evident from its ongoing review of general insurance add-on products. The FCA’s initial findings in relation to general insurance add-on products are due to be published for consultation in early 2014.

9. Asia Regulatory Developments

a. China: Progress on New Solvency Capital Regime

The China Insurance Regulatory Commission (“CIRC”) has continued to develop its framework for a “second generation” risk-based solvency regime, initially articulated in April 2012. Last year the CIRC invited market participants to engage in research groups relating to the three “pillars” of quantitative capital requirements, qualitative supervisory requirements and market discipline mechanisms.

In January, the CIRC Vice President, Chen Wenhui, summarized achievements so far and the work program for 2014. He stated that a significant amount had been achieved since the launch, with the work of 15 different project groups under way developing technical standards. The research groups had already conducted studies of domestic and international solvency regulation and embarked on several rounds of quantitative testing. Certain

preliminary proposals had been put forward for the property and casualty risk and asset risk elements. Chen Wenhui also pointed to successes in raising awareness of the project both domestically and internationally.

Preliminary technical standards for testing purposes are due to be finalized by the end of June 2014, with respect of the property and casualty sector, and by the end of September 2014, with respect of life insurance. The work groups would then move on to testing the standards in the industry and developing the method and timetable for transitioning from the current regime. Chen Wenhui encouraged industry participants to engage in the process.

The CIRC has always stressed that the regime would be developed to address the needs of the Chinese market, and that it would not be blindly following other regimes around the world. However, the new regime appears structurally similar to the EU’s much-delayed Solvency II project, and China has been in discussion with the EU with respect to equivalence status. In January 2014, the CIRC made a statement that significant progress had been made with the EU on this issue.

The CIRC has set a target of three to five years to implement the new regime.

b. CIRC Continues its Financial Liberalization of the Insurance Sector

The CIRC has continued its financial reform of the insurance sector, including easing of restrictions on equity ownership of mainland insurers, as well as the use of capital by insurers, and has announced plans to take advantage of the recently launched Shanghai Pilot Free Trade Zone (“SFTZ”).

c. Relaxation of Rules on Equity Investment into the Chinese Insurance Sector

New rules which became effective last year eased restrictions on acquiring shareholdings in domestic Chinese insurers (insurers with foreign ownership of less than 25%). Domestic investors may now acquire up to 51% of a domestic insurance company, where previously they were restricted to 20%, provided that they meet certain criteria, for example they must hold assets totaling at least RMB10 billion. The investor must then hold its shareholding for a minimum of three years.

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In addition, recently adopted rules now permit private equity investment into mainland insurers using limited partnership structures known as “limited partnership equity investment enterprises.” This applies to international as well as domestic private equity funds registered with the National Development and Reform Commission or provincial authorities. A number of conditions and limitations apply, including that any one limited partnership equity investment enterprise may only hold a maximum of 5% shareholding and that the aggregate holdings by limited partnership equity investment enterprises is subject to a maximum of 15%.

d. CIRC Raises Limits on Investments by Chinese Insurers into the Equity and Real Estate Markets Following Expansion of Permitted Overseas Investment in 2012

Following a consultation with the industry, on February 19, 2014, the CIRC increased the limit applying to the proportion of a Chinese insurer’s funds which may be invested in equities. The limit has now been set at 30%, up from 25%. The limit for real estate and infrastructure has also been increased to 30%, up from 20%.

It is thought unlikely that Chinese insurers will increase their holdings significantly in Chinese equities in the short term, due to the recent poor performance of the companies listed on the Chinese exchanges. Nevertheless, the CIRC Chairman, Xiang Junbo, has pointed to significant recent improvement in investment returns. According to data published by the CIRC, investment returns reached 5.04% in 2013, up by 1.65% in 2012.

Xiang Junbo has confirmed the CIRC’s commitment to continue liberalizing the capital investment rules beyond the reforms already implemented. Notably, in late 2012 the CIRC expanded the scope of permitted overseas investment by Chinese insurers, which are now able to invest in 45 countries and regions (including Hong Kong and Taiwan), comprising 25 developed markets and 20 emerging markets. Previously, Chinese insurers were not freely able to invest beyond the domestic and Hong Kong markets without engaging in often lengthy approval processes.

Insurance companies may invest overseas in the following categories:

• money markets, including short-term commercial paper, bank notes, negotiable certificates of deposit, reverse repos and short-term treasury bonds. Issuers must have a credit rating of A or above;

• fixed income products, including bank deposits, treasury bonds, corporate bonds and convertible bonds. Issuers must have a credit rating of BBB or above;

• equity, including listed shares and global or American depository receipts. Equities of unlisted companies are limited to certain industries (finance, pensions, pharmaceutical, energy, resources, automobiles and agriculture);

• real estate, limited to mature commercial real estate located in the central business districts of the major cities of the 25 developed markets;

• funds, including registered securities investment funds, private equity funds with at least US$1 billion in assets under management (and which meet certain other requirements) and listed real estate investment trusts; and

• derivatives (for risk hedging purposes only), including interest rate, currency and stock index products, within certain limits.

Investments in assets overseas are subject to a limit of 15% of an insurer’s total assets at the end of the previous year, with investment in emerging markets not exceeding 10%.

e. Launch of the Shanghai Pilot Free Trade Zone

In September 2013, the Chinese government launched the SFTZ, a pilot liberalisation initiative which shall apply initially to certain designated port and airport areas in Shanghai. The CIRC subsequently announced that it would be implementing a number measures so as to allow the insurance industry to benefit from the opportunity offered by the SFTZ. These include:

• permitting the establishment of foreign-funded health insurance providers (elsewhere, foreign investors are limited to a 50% stake);

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• allowing the conduct of cross-border reinsurance business in renminbi;

• expanding the scope for overseas investment;

• encouraging the establishment of internationally recognized intermediaries and other service providers; and

• encouraging the growth of marine/cargo insurance.

The CIRC intends to use the SFTZ to experiment with a more efficient and transparent regulatory system. In doing so, one of its goals is to encourage competition from China-based providers for the international insurance and reinsurance business which Chinese corporate and insurance companies are currently procuring overseas.

The SFTZ has been widely welcomed by the industry. So far, at least four domestic insurers have been authorised to operate in the SFTZ: Da Zhong Insurance and China Pacific Property (both property and casualty insurers), as well as China Life and China Pacific Life. In February of this year, Starr International received regulatory approval to increase its holdings in Da Zhong to 59% (up from 20%), resulting in the first foreign-owned insurance operation in Shanghai.

f. Bancassurance in China: Regulators Tighten Requirements

China’s banking regulator, the China Banking Regulatory Commission (“CBRC”) and the CIRC have jointly issued rules which will increase regulation of the conduct of bancassurance business. The new requirements, which come into force on April 1, 2014, are designed to reduce the likelihood of mis-selling, which has become a concern of the regulators in recent years. They include the following:

• Banks will be required to conduct customer suitability tests involving the assessment of the customer’s needs and ability to bear risk;

• In order to issue certain types of products with non-guaranteed benefit rates, the customer must have confirmed his or her understanding of the terms of the policy;

• Banks will be restricted to offering the products of a maximum of three insurance companies in any financial year;

• Banks will need to ensure that at least 20% of the premium generated by insurance sales relates to lower risk policies, such as long-term savings policies, accident/health policies and term or whole life policies. Banks will be required to report on a quarterly basis to local regulators to ensure adherence; and

• Various other rules designed to ensure appropriate treatment of customers, for example a prohibition on sales personnel from completing application forms on behalf of a customer without the customer’s recorded authorization.

Draft rules published in November 2013 suggested the regulators were considering allowing insurance companies to station sales staff in bank branches; however, this measure has not been adopted.

VI. Select Tax Issues Affecting Insurance Companies and Products

A. Prospects for Tax Reform

Tax reform continues to be a hotly contested subject, and Congressional leaders of both parties continue to endorse in broad outlines the concept of a 1986-style tax reform effort that would reduce the corporate tax rate and achieve revenue neutrality by broadening the corporate tax base. During the past year, former Senate Finance Committee Chairman Baucus and House Ways and Means Committee Chairman Camp have put forth detailed proposals for fundamental tax reform, each of which could have significant consequences for the taxation of insurance companies.

Former Chairman Baucus released a proposal to reform the international tax system. In broad outline, the Baucus draft aims to end deferral for new corporate earnings, moving to a system in which the income of foreign subsidiaries is taxed immediately when earned, or is exempt from U.S. tax, and offers two options for doing so. Under one option, the “active finance exception” from Subpart F income would be made permanent (with some changes), but U.S. owners would be taxed on a current basis on income earned by corporate subsidiaries in low-tax jurisdictions (whether or not such income otherwise qualified as exempt insurance income). Under a second option, 40% of exempt insurance income (along with other

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passive-type income) would be subject to tax, and the rest permanently exempted. The Baucus bill also incorporates a version of the so-called “Neal Bill” that has been discussed for many years. This proposal would disallow deductions for certain reinsurance premiums paid by a U.S. ceding company to a foreign affiliate.

Chairman Camp released proposals to reform the domestic and international tax systems. On the domestic side, the Camp business proposals contain several items of particular interest for insurance companies. With respect to the life industry, the Camp proposal would, among other things, impose new taxes on company-owned life insurance; repeal the small life insurance company deduction; change the interest rate used in computation of life insurance reserves to a rate based on the average federal mid-term rate over the prior five years, plus 3.5 percentage points; and simplify and increase the amount of DAC capitalization. With respect to the property and casualty industry, the Camp proposal would repeal the special status of Blue Cross Blue Shield organizations, and would modify the loss reserve discounting rules under section 846 of the Code. Like the Baucus bill, Chairman Camp’s proposal contains a provision similar to the Neal Bill.

The passage of the ACA has blunted in some respects the uncertainty over the continued exclusion from taxable income of employer-provided health coverage. As the political battles over the ACA continue, further developments in this area could arise. Finally, the tax-deferred “inside build up” of life and annuity products is often noted as a significant source of annual revenue loss to the Treasury and, therefore, could be the subject of continued Congressional debate.

B. FATCA

On July 12, 2013, the Treasury Department and the Internal Revenue Service (“IRS”) announced that the implementation of the U.S. withholding tax provisions, commonly known as the Foreign Account Tax Compliance Act (“FATCA”), would be extended again, this time to July 1, 2014. FATCA generally imposes a 30% withholding tax on any “withholdable payment” made to (i) a foreign financial institution (“FFI”) that does not register with the IRS and meets certain due diligence, reporting, withholding, and other requirements

with respect to its account holders under an “FFI agreement” or an applicable intergovernmental agreement (“IGA”) or (ii) a non-financial foreign entity (“NFFE”) that does not provide a certification to withholding agents regarding its substantial U.S. owners (if any) or meet an applicable exception. Withholdable payments include a wide variety of payments of U.S. source income (which are subject to FATCA withholding starting July 1, 2014), as well as the gross proceeds from the sale or redemption of stock, debt obligations, or other property of a type that could give rise to U.S. source interest or dividend income (which are subject to FATCA withholding starting January 1, 2017). Insurance and reinsurance premiums may be subject to withholding starting July 1, 2014.

Generally, a foreign insurance company will be an FFI only if it issues annuity contracts or other products having cash value. Otherwise, foreign insurance companies generally will be NFFEs under FATCA.

The IRS has continued to release guidance under FATCA and negotiate IGAs with various partner jurisdictions. The long-awaited “FFI agreement” was released on December 26, 2013, and the IRS FATCA registration system has gone live. Additional final, temporary, and proposed regulations were released on February 20, 2014, providing a number of substantive corrections and revisions to the existing FATCA regulations and coordinating other U.S. withholding, backup withholding, and information reporting requirements with the FATCA requirements.

The recently released regulations provide a number of potentially helpful revisions and clarifications to the FATCA rules. Under the regulations, NFFEs may report their substantial U.S. owners directly to the IRS, rather than disclose such owners to counterparties. The regulations also provide relief to certain “section 953(d)” insurance companies, which generally will now be treated as U.S. persons for purposes of FATCA unless they issue annuity contracts or other products having cash value and are not licensed to do business in any state of the United States. Further, a transitional rule that excludes from the definition of “withholdable payment” certain payments of U.S. source income made prior to January 1, 2017, with respect to an

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offshore obligation was expanded by the regulations, such that it now generally applies to insurance brokers with respect to such payments of premiums.

Details are still emerging, as the IRS works to finalize the forms that will be used to document FATCA compliance, and continues to negotiate IGAs with additional partner jurisdictions. Many U.S. and foreign insurance businesses have significant work ahead of them in 2014 to get ready for the July 1, 2014, effective date of FATCA.

C. Cascading Federal Excise Tax

On February 5, 2014, the U.S. District Court for the District of Columbia issued its opinion in Validus Reinsurance, Ltd. v. United States, which is the first case to involve a challenge to the IRS’ position on the “cascading” application of the federal excise tax (“FET”) to reinsurance agreements between foreign parties covering U.S. insurance risks. The court held that, although the statute authorizes the imposition of the FET on “reinsurance,” it does not do so with respect to “retrocessions,” and granted Validus’ motion for summary judgment. In so holding, the court reasoned that (i) “reinsurance” between an insurance company and a reinsurer is not the same as a “retrocession” in which a reinsurer purchases insurance from another reinsurer, and (ii) there is no mention of the taxation of retrocessions in the statute.

Validus also argued that, even if the FET statute applies to retrocessions, it cannot be applied on an extra-territorial basis to wholly foreign transactions without violating longstanding principles of territoriality, international law, and the U.S. Constitution. The District Court did not reach any of these alternative arguments in its decision.

The government has not yet indicated whether it will appeal, but an appeal is widely expected in the industry. Insurance companies that have been paying federal excise tax on foreign-to-foreign retrocessions should consider filing claims for a refund to preserve their ability to seek a refund of such taxes. Further proceedings on this case will certainly be an item of interest going forward.

D. Alternative Reinsurance

The market has seen continued, and increasing, interest in reinsurance companies that adopt investment strategies seeking yields greater than

those traditionally associated with insurance businesses, including strategies employed by hedge fund managers. Investments of such a venture may include a mix of more traditional and more aggressive investments. The reinsured liabilities that fit most naturally with such strategies are the most predictable and longest-term liabilities, including fixed annuities, although a number of ventures in the property/casualty reinsurance industry have been launched as well, attracting significant notice in the business press.

For some of these ventures, a key issue is whether U.S. investors may be subject to the federal income tax rules for shareholders of Passive Foreign Investment Companies (each, a “PFIC”). A U.S. taxpayer receiving either dividends or redemption/sale proceeds on stock of a corporation classified as a PFIC is not eligible for the benefit of any special lower federal income tax rates for dividend or long-term capital gain income, and such taxpayer must pay the IRS the equivalent of interest on any tax deferral enjoyed during the period when the U.S. investor held stock and the foreign corporation earned profits but did not distribute them.

Foreign corporations owning primarily financial assets are PFICs unless an exception applies, and the structures mentioned above are generally intended to come within an exception for corporations predominantly engaged in the active conduct of a reinsurance business. An IRS notice issued a decade ago signaled that the IRS would scrutinize such a venture and its U.S. shareholders, especially if the company was overcapitalized relative to the volume of its reinsurance business. This area remains active and may attract IRS scrutiny in the future.

E. Property and Casualty Tax Controversies – Loss Reserves

On September 4, 2013, the United States Tax Court issued its opinion in Acuity v. Commissioner, T.C. Memo. 2013-209. In brief, the court concluded that Acuity’s reserves for unpaid losses and loss adjustment expenses for 2006, as used by the company in computing “losses incurred” within the meaning of Internal Revenue Code Section 832(b)(5), were “fair and reasonable” estimates and represented “only actual unpaid losses” within the meaning of Treasury Regulation Section 1.832-4. The taxpayer presented detailed evidence of the analysis

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performed by its internal actuary and its outside actuary, and the Tax Court gave substantial weight to this analysis in reaching its decision that the estimate was fair and reasonable. During litigation, the IRS offered its own alternative estimate of loss reserves, but the Tax Court stated that Acuity did not bear the burden of “disproving” the IRS’ estimate. Rather, the applicable regulations required only that Acuity demonstrate that its loss reserves were fair and reasonable, which the court held it did.

F. Insurance Tax Controversies – Timing of Dividends

In New York Life Insurance Co. v. United States, No. 11-2394 (August 1, 2013), the Second Circuit Court of Appeals affirmed a district court’s decision that deductions for policyholder dividends in the year the dividend was “credited” to a policyholder account or accrued did not satisfy the “all-events” test under the principles of Section 461. The taxpayer, New York Life Insurance Company, deducted two types of policyholder dividends in a given year: (1) an annual dividend mandated by state law that was “credited” but not paid until the policy’s anniversary date (that in some cases would not occur until the next calendar year); and (2) a voluntary termination dividend that was calculated and “accrued” but not paid until death, maturity, or surrender. The court found that neither type of policyholder dividend deduction met the “all-events” test. In the case of the annual dividend, the court reasoned that a unilateral action by the policyholder could determine whether the dividend was actually required to be paid: the decision to maintain the policy until the anniversary date. In the case of the termination dividend, the court reasoned that, because payment of a termination dividend was not a requirement of law, the “all-events” test was not met until the dividend was actually paid.

A somewhat similar issue in the property and casualty context is pending in LUBA Mutual Holding Company v. Commissioner, Tax Ct. Dkt. No. 024675-15. In each of the years at issue, the taxpayer’s board of directors declared a dividend, and in the following taxable year, after audited financial statements were completed, passed another resolution setting the precise amount of the dividend. The IRS has taken the position that the nonlife insurance company policyholder dividend deduction is not available until the dividend is paid (unless some

other exception applies). The taxpayer has taken the position, with support in existing case law and regulatory authority, that the plain text of Internal Revenue Code Section 832(c)(11) allows the deduction in the year the dividend is “paid or declared” in accordance with its ordinary method of statutory accounting.

G. Limitations on What Constitutes Insurance for Tax Purposes

The Tax Court recently issued its decision in the closely watched case of Rent-A-Center Inc. et al. v. Commissioner, 142 T.C. 1 (2014). At issue in the case was whether the taxpayer was entitled to business expense deductions for insurance premiums paid by its subsidiaries to a wholly owned captive insurance company. The Tax Court found in favor of the taxpayers, holding that, on the facts of the case, the captive insurer was not a sham, and that the arrangement constituted insurance as commonly understood.

The case was decided on its facts, and did not firmly establish any new doctrinal ground. Nevertheless, the case is a leading example of the IRS’ continuing interest in captive insurance arrangements. In recent public comments, Sheryl Flum, Branch 4 Chief, IRS Office of Associate Chief Counsel (Financial Institutions and Products), has reiterated the IRS’ interest in these arrangements, but also noted that the IRS does not want to chill legitimate captive arrangements.

The pending case of R.V.I. Guaranty Co. Ltd. v. Commissioner, T.C. No. 27319-12, involving whether “residual value insurance” constitutes insurance for tax purposes, will be watched with interest in the industry. In this case, the IRS takes the position that the policyholder’s economic risk involved in this type of business is not an “insurance risk” and that any claims the insurer must pay do not arise from a casualty event.

H. Extension of the UK Investment Manager Exemption

The UK investment manager exemption (the “IME”) is a safe harbor which allows a UK-based investment manager to provide investment advice to, and to carry out transactions on behalf of, a non-UK fund without the fund acquiring a taxable presence in the UK.

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The IME, however, only applies to profits of a non-UK fund that are derived from “investment transactions” carried out by a UK-based investment manager on behalf of the non-UK fund. The UK government publishes a list (the “White List”) of the types of transaction that are considered to be “investment transactions” for the purposes of the IME.

The UK government has published draft legislation to extend the White List to cover transactions in rights under a life insurance policy. It is expected that the proposed extension will take effect from sometime in late summer 2014.

This is likely to be of interest to investment managers with UK operations which may be interested in trading such life insurance policies from within the UK.

I. Financial Transaction Tax

On February 14, 2013 the European Commission published a proposal for an EU directive concerning the implementation of the EU financial transaction tax (the “FTT”). Since the announcement, the FTT has been the subject of widespread discussion and debate and has led to many commentators questioning whether the FTT will ever come into force.

In the early part of 2014, however, a degree of momentum has apparently been restored to the FTT process, and it looks increasingly likely that a form of the FTT will, at some point, come into force.

It is important to note that the FTT could have consequences for the insurance sector. Indirect consequences could range from a reduction in the potential liquidity of financial markets, and a general impact on the worldwide economic recovery, through to an increase in the cost of policyholder protection (as the price of an insurance policy is dependent on the investment return).

Accordingly, international insurance groups should pay attention to further developments with respect to the FTT throughout 2014 and, when further details are made available, consider how any FTT may apply to their operations.

J. UK Taxation of Corporate Debt

Since June 2013, the UK tax authority (“HMRC”) has been considering ways of modernizing the taxation of corporate debt and derivative contracts in the UK. This review period is now drawing to a close. The

UK insurance industry has actively engaged with HMRC during the course of this process to highlight key issues that would likely affect international insurance groups, including: (i) the treatment of regulatory capital; (ii) the bond fund rules; (iii) the corporate streaming rules; (iv) the late paid interest rules; and (v) the application of the targeted anti-avoidance rule.

Although it is not expected that the proposed changes will be introduced at any time before 2016, it is important that insurance groups with UK operations continue to engage with HMRC, highlighting particular aspects of the proposed legislation which are inappropriate and/or may disproportionately affect their business.

K. VAT and Cross-Border Supplies of Services

Recently, the CJEU confirmed that the Skandia America Corporation case will be heard in March 2014. Broadly, the case concerns the value-added tax (“VAT”) treatment of intra-group cross-border supplies of services, which is likely to be of particular interest to international insurance groups with EU branches.

Currently, the EU VAT rules are interpreted so as to allow supplies as between: (i) different establishments of a single company (such as, for instance, between the headquarters and a branch (and vice versa)) (confirmed in 2006 by the CJEU in FCE Bank); and (ii) members of the same VAT group, to be disregarded for VAT purposes, subject to the application of certain anti-avoidance rules.

Specifically, in Skandia, the Swedish tax authority challenged supplies of software maintenance services as between a U.S. head office and its VAT-registered Swedish branch (such branch also being a member of a Swedish VAT group). In essence, the CJEU has been asked to decide whether: (i) such supplies should be disregarded for VAT purposes; and (ii) whether the Swedish VAT group should properly be regarded as a separate taxable person for these purposes. If the CJEU were to rule in favor of the Swedish tax authority, this would result in a VAT liability for the Swedish branch under the “reverse charge rules.”

Although the outcome will not be known until later in 2014, international insurance groups should be mindful of the potential impact the Skandia judgment could have on their businesses.

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