2012 year end review and forecast - dla...

1www.dlapiper.com DLA Piper LLP (US)

2012 YEAR END REVIEW AND FORECAST


2012 was a year of significant regulatory, political and commercial developments for the insurance industry. The advancement of the NAIC’s Solvency Modernization Initiative, the twists and turns of Solvency II, the development of ComFrame, systemic significance debates, the implementation of the Dodd-Frank Act, the emergence and early efforts of the Federal Insurance Office (FIO), the evolution of capital markets solutions to insurance risk exposures and many more initiatives and issues made this a dynamic year of challenges and opportunities for the insurance industry. Our readers will be familiar with most, if not all, of the major developments that occurred in 2012 and the issues that are looming in 2013. This 2012 Year End Review and Forecast will catalogue what we view as some of the most significant developments during this past year and will offer our thoughts on what they mean for the insurance industry over the coming months. We hope that this review will provide some food for thought as you plan for 2013.

2012 YEAR END REVIEW AND FORECAST


NAIC DEVELOPMENTS 4

FEDERAL DEVELOPMENTS 7

IAIS DEVELOPMENTS 11

EUROPEAN DEVELOPMENTS 14

ASIAN DEVELOPMENTS 17

COMPLIANCE ISSUES 19

COMMERCIAL AND TRANSACTIONAL DEVELOPMENTS 21

CONCLUSION 24

ABOUT US 25

OUR GLOBAL PRESENCE 26

TABLE OF CONTENTS


NAIC DEVELOPMENTS

2012 was an active year for the NAIC. The organization continued to advance its Solvency Modernization Initiative (discussed further below), among other significant activities. Perhaps most importantly, however, the NAIC continued to work to define its role within an evolving and increasingly complex cast of domestic and international insurance regulators. This included working on the parameters of its relationship with the newly created FIO, significant engagement with the International Association of Insurance Supervisors (IAIS), participating in detailed regulatory discussions within the EU-US regulatory dialogue group and, with respect to the implementation of the Affordable Care Act, coordinating state insurance regulation with an increasingly active US Department of Health and Human Services.

November 2012 also saw the retirement of Terri Vaughn, the Chief Executive Officer of the NAIC. Terri was a forceful advocate in international circles for the role of state regulation. She was a member of the Executive Committee of the IAIS and also served as Chair of the Joint Forum. Regardless of one’s views, her departure significantly changes the dynamics of the debates over US and international insurance regulation. There is, of course, much speculation regarding who will replace Terri as NAIC CEO – a selection process which itself will help set the trajectory of state regulation.

The NAIC also elected a new slate of officers for 2013, including Jim Donelon (Louisiana) as President, Adam Hamm (North Dakota) as President-elect, Monica Lindeen (Montana) as Vice-President and Michael Consedine (Pennsylvania) as Secretary-Treasurer. Kevin McCarty will step down as NAIC President, but he remains the Vice Chair of the IAIS Executive Committee and is likely to continue as an important voice for state regulatory interests. Solvency modernization at the NAIC

The NAIC’s Solvency Modernization Initiative, or “SMI,” began in June 2008. It was, in part, the state regulators’ response to Solvency II developments in Europe and the growing debate about possible federal regulation in the US. As described in the NAIC’s Solvency Modernization Roadmap, SMI is “a critical self-examination to update the United States insurance solvency regulation framework.” It focuses on five key

areas, including capital requirements, international accounting, insurance valuation, reinsurance and group supervision.

A number of major accomplishments related to SMI were achieved by the NAIC during 2012, setting the stage for a busy agenda related to this issue in 2013. These include: Own Risk and Solvency Assessment

As part of the NAIC’s increased interest in developing an effective means of group supervision, amendments to the NAIC’s model insurance holding company systems act and regulation (that are currently in the process of being adopted by the States) require, among other things, that insurers conduct and report a group-wide risk and solvency assessment. In 2011, the NAIC adopted the Own Risk and Solvency Assessment (ORSA) Guidance Manual (the Manual) to provide guidance to insurance companies as to how to conduct an ORSA.

ORSA has emerged as one of the NAIC’s key tools for conducting group supervision. In contrast to the European model of express capital standards, the US ORSA is designed for flexibility and to allow an insurer to conduct an ORSA “in a manner that is consistent with the way in which its business is managed,” according to the Manual. It is not surprising, therefore, that during 2012, the NAIC took a number of steps to move closer to implementing the requirement that insurers conduct an ORSA.

Most importantly, the NAIC has adopted the Risk Management and Own Risk and Solvency Assessment Model Act, that would establish many of the components of the Manual as a matter of state law. At its 2012 Winter National Meeting, the working group with jurisdiction over ORSA issues, the Group Solvency Working Group, began the process of making adoption of the ORSA model act an NAIC accreditation standard. This is generally viewed positively by insurers, because both the Manual and the ORSA model act reflect a great deal of cooperation among insurers and regulators.

A second very important development that occurred in 2012 regarding ORSA was a pilot project the NAIC conducted with several insurers which volunteered to conduct ORSAs and share their results confidentially with the NAIC. Regulators said they learned much from


the pilot project and made revisions to the Manual as a result. A second pilot project is planned for 2013.

ORSA appears to be off to an impressive start, but 2013 may be a key year as states start to consider adopting the model act and the need to conduct an ORSA comes closer to becoming a legal requirement for insurers. Principles-Based Reserving

For many life insurers, the single most important aspect of SMI is the effort by the NAIC to adopt a principles based approach to setting reserves for term life insurance and other common life insurance products. The project has been under way since 2005.

The NAIC adopted amendments to the Model Standard Valuation Law in 2009 that opened the door to Principles-Based Reserving (PBR). Implementation of those amendments has been on hold, however, pending the adoption by the NAIC of a manual to be used by life insurers in order to conduct PBR. That major milestone in the development of PBR was achieved in 2012, because the NAIC’s plenary voted at the NAIC’s Winter Meeting to adopt a Valuation Manual which contains the detailed terms and conditions that are designed to govern how an insurer is to conduct PBR. The significance of this development is that now state legislatures can begin to consider whether to amend the standard valuation law and replace the NAIC’s current formulaic based system of setting life insurance reserves with PBR.

The decision to approve the Valuation Manual was somewhat controversial: 42 votes were required to vote to adopt the Valuation Manual and just 43 votes were cast in favor of it. Moreover, California Commissioner Jones and New York Superintendent Lawsky made relatively impassioned speeches to their fellow regulators urging that the Valuation Manual not be adopted, at least not at this time. Furthermore, several other regulators who ultimately voted in favor of adoption noted that much more needs to be done to ensure that PBR is implemented smoothly. This view is widely held, and a “PBR Implementation Plan” has been drafted by NAIC staff and released for comment.

The Implementation Plan addresses the practical elements of implementing PBR, including the resources needed to effectively implement PBR and to assure consistency in application and regulatory review of PBR. The Implementation Plan, as drafted, calls for the formation of an NAIC Actuarial Resource within the

NAIC, as well as an Actuarial Analysis Working Group at the NAIC; defining the statistical data for collection and how that collection will be funded; standardizing financial reporting and analysis tools across filings and forms and generally addressing the coordination of the impact of PBR on accounting, solvency and other areas, such as staff and resource training and making PBR an Accreditation Standard. Significantly, the NAIC members voted to make the PBR Working Group an executive joint working group of the Life Insurance and Annuities (A) Committee and the Financial Condition (E) Committee. The elevation of the Committee signals the NAIC’s commitment to address implementation concerns and issues at an executive level and provide greater opportunity to address certain of the concerns raised by the states that did not support the adoption of the Valuation Manual.

Therefore, notwithstanding the importance of the adoption of the Valuation Manual, much work needs to be done before PBR can be used. By its own terms, the Valuation Manual does not become operative until the new standard valuation law has been adopted by forty-two states and states that account for 75 percent of life insurance premium. It also remains to be seen how the new standard valuation law is received in state legislatures, given that the National Council of Insurance Legislators has not endorsed PBR.

Although 2012 was a very important year in the development of PBR, 2013 may turn out to be more decisive for this element of SMI. Corporate governance

A third important aspect of SMI has been the increased focus on insurers’ corporate governance. Although regulators have been careful to avoid any suggestion that they intend to actively regulate how insurance groups govern themselves, it is widely felt that group supervision, in general, cannot be done effectively unless insurers provide more detailed information about their internal corporate governance structures and procedures. Regulators claim that currently the only opportunity they have to consider issues related to an insurer’s corporate governance is in connection with a financial examination and that is viewed as inadequate by most regulators.

To address these concerns, the NAIC spent much of 2012 working on a format for the reporting of corporate


governance information. Three initiatives are being considered: submission of a narrative discussion of an insurer’s corporate governance practices similar to the ORSA Summary Report or Management’s Discussion and Analysis filing requirements; increased disclosure of compensation paid to senior executives; and enhanced tools to be used in conducting financial analysis and examinations of insurers’ corporate governance. As 2012 ended, revised materials to implement these initiatives had been released for exposure.

Reinsurance regulation

The NAIC, and individual states, continue work to implement changes in the rules governing reinsurance collateral requirements. As most will know, the NAIC has adopted amendments to the NAIC Model Credit for Reinsurance Law and Credit for Reinsurance Model Regulation, which establishes procedures for rating non-US reinsurers and calibrating their collateral requirements based on six security ratings. Implementation of these new rules has been slow, but steady. As of the end of 2012, 11 states had adopted the new rules, but only two states (New York and Florida) have actually approved any reinsurers to operate with reduced collateral.

One of the key issues regarding the implementation of these new rules is the process by which states will review and approve non-US jurisdictions as “approved jurisdictions” under the model law changes. Just prior to the NAIC’S winter meeting, the NAIC’s Reinsurance Task Force issued an exposure paper which outlined a proposed methodology by which the NAIC would review relevant jurisdictions. The 20-page paper provides a framework for a deep dive by US regulators into the solvency regulation of any candidate jurisdiction. This paper has been released for public comment and we anticipate that it will stimulate substantial discussion about the appropriate levels of regulator-to-regulator reviews. Consideration of this issue will also echo in the ongoing discussions concerning regulatory equivalence under Solvency II and the ongoing discussions on regulatory compatibility, which are underway within the EU-US regulatory dialogue group (discussed below). All in all, this could provide for a heady mixture of regulatory policy debates and the opportunity to demonstrate regulatory cooperation and accommodation (or the opposite).

Captive insurer regulation

Since many of the life insurers that will be impacted by PBR use captives to manage their reserve requirements under the current rules for establishing statutory reserves, most market participants who have been following PBR have also been following the Captive and Special Purpose Vehicle Use Subgroup of the NAIC E Committee (the Captive Task Force). A draft NAIC white paper by the Captive Task Force was a topic of discussion at both the Summer and Winter NAIC Meetings.

Following a regulatory survey of certain captive transactions, particularly those used to finance reserves for term life insurance and universal life insurance policies with secondary guarantees required under NAIC Valuation of Life Insurance Policies Model Regulation 830 and Actuarial Guidance XXXVIII, commonly known as Reg. XXX and AG38, the draft white paper concludes that there is a need to improve the regulation and transparency of certain captive transactions. The Captive Task Force further expressed a consensus view that the E Committee should form a separate subgroup to develop possible solutions for addressing perceived redundancies in the reserves required by Reg. XXX and AG38, as well as establishing that captives and SPVs should not be used by commercial insurers to avoid statutory accounting prescribed by the states. In the Captive Task Force meetings, however, regulators expressed some disagreement (indeed some heated exchanges occurred) over the extent to which captives and SPVs were used to avoid statutory accounting, if at all, especially given that captive transactions are typically subject to prior regulatory approval.

Numerous comments were received by the Captives Task Force on the draft white paper prior to the Winter Meeting from various regulators and trade groups as well as New York Life. The white paper will be finalized in early 2013. However, more important than what the white paper says will be what regulators decide to do next about this issue, although no concrete action is currently proposed. Market participants will continue to watch with interest as deliberations continue at the E Committee level on this issue.


FEDERAL DEVELOPMENTS

The federal government has had a dramatic impact on the insurance industry in the last several years. Some of the key developments in 2012 were: The Federal Insurance Office

2012 was the first full year of operation for the Federal Insurance Office. The FIO’s first Director, Michael McRaith, the former Director of Insurance in Illinois, was appointed in March 2011. In looking at 2012, it is worth noting what FIO has done and what it has not yet done.

2012 saw FIO begin to establish its position within the IAIS, engage in bi-lateral and multi-lateral discussions with international regulators and begin to calibrate its working relationship with the NAIC and state regulators. Director McRaith also became a member of the IAIS Executive Committee (occupying one of three seats held by the US on that important committee) and became Chair of the powerful Technical Committee of the IAIS. This position provides the US with a new voice within an association that is becoming increasingly important in the development of insurance regulation (see, discussion of IAIS developments, infra).

FIO has also been closely involved in advancing the work of the EU-US regulatory dialogue group, including supporting and helping to lead a significant project (the EU-US Dialogue Project) by which US and EU regulators have reviewed and discussed their respective regulatory systems. This project, which began in January 2012, involved an in-depth review of the following areas of insurance regulation in both markets: (1) professional secrecy/confidentiality, (2) group supervision, (3) solvency and capital requirements, (4) reinsurance and collateral requirements, (5) supervisory reporting, data collection and analyses, (6) regulatory peer review and (7) independent third-party review and on-site examination. This review was marked by a refreshing level of cooperation among the US state regulators, FIO, the NAIC and EU regulators and has been very well received by industry commenters. On December 21, 2012, the EU-US Dialogue Project issued the final reports of its Technical Committees addressing the seven areas identified above. It also published The Way Forward, a document articulating the objectives and future workstreams of the Dialogue Project. The self-described “high-level common objectives” are to:

Promote the free flow of information between EU and US supervisors under conditions of professional secrecy

Establish a robust regime for group supervision, which would include a clear allocation of tasks, responsibilities and authority amongst supervisors, a holistic approach to the determination of the solvency and financial condition of the group, greater cooperation and coordination of supervisors within colleges and efficient enforcement measures

Further develop an approach to valuation which more accurately reflects the risk profile of companies and capital requirements that are fully risk-based

Work to achieve a consistent approach within each jurisdiction and examine the further reduction and possible removal of collateral requirements in both jurisdictions; pursue greater coordination in relation to the monitoring of the solvency and financial


condition of solo entities and groups through the analysis of supervisory reporting and

Ensure the consistent application of prudential requirements and commitment to supervisory best practices through different peer review processes that ensure an independent view of the jurisdiction being examined; and ensure consistency and effectiveness in the supervision of solo entities and groups

The Way Forward contains an ambitious agenda which will engage regulators on some very hot topics. It will be interesting to see if this project continues to advance at the impressive speed at which it moved in 2012 and, more importantly, what specific decisions/changes flow from this work.

In 2012, FIO also formed a Federal Advisory Committee on Insurance to help it understand and address a variety of commercial and regulatory issues facing the industry. This committee met several times in 2012, but it has yet to produce any significant results.

Although FIO took some significant steps last year, it did not issue two key reports which were mandated by Congress. The first report, How to Modernize and Improve the System of Insurance Regulation in the United States, was due in January 2012 (the Modernization Report). The second report is to focus on the global reinsurance industry and the role it plays in supporting the US insurance industry (the Reinsurance Report). The Reinsurance Report was due on September 30, 2012. Although it is understood that at least the Modernization Report was substantially, if not completely, done earlier in the year, it has not been published. FIO did request public comment on what the Reinsurance Report should address, but there has been no further public disclosures regarding this report. These delays certainly raise questions about the ability of FIO to fulfill its statutory mandates and the level of political support for FIO, even within the federal government. We believe that FIO can play an important role – in cooperation with state regulators – in advancing insurance regulation and in protecting the interests of the US insurance industry and those who support it. For these reasons, we will watch with great interest to see what FIO does in 2013.

Dodd-Frank Act implementation issues

The rule-making process with respect to the Dodd-Frank Wall Street Reform and Consumer Protection Act has continued in a somewhat iterative way in 2012. Outside of issues relating to the possible designation of some insurers as “systemically important financial institutions” (discussed below), many insurers have been pre-occupied with what the Dodd-Frank Act means to their derivatives books and hedging programs, especially with respect to such issues as “Major Swap Participant” status, margining and clearing requirements, and what the secondary effects of the Dodd-Frank Act mean to their derivative counterparties. State insurance law amendments regarding derivatives have also impacted insurers, such as the August 2012 amendment of Section 1410 of the New York Insurance Law with respect to “qualified counterparties” for certain derivatives transactions, as well as the amendments to insurance investment statutes in a number of states to permit “netting” with respect to certain derivatives. These “netting” amendments allow the bank counterparties to derivatives with insurers to obtain favorable capital treatment under the Basel III rules (and offer insurers more favorable pricing). They also resolved some nettlesome insurer receivership set-off issues.

For the segment of the insurance industry that issues insurance-linked securities, the Dodd-Frank Act has also created a number of new issues. Notably, the SEC and CFTC in their joint final rule release with respect to the definition of a “swap” and a “security based swap” and certain other product rules (the Product Rules) expressly declined to comment whether industry loss warranties constituted “swaps” for purposes of the Dodd-Frank Act in the context of a general definitional rulemaking. More broadly, the Product Rules created a non-exclusive safe harbor for certain insurance products effectively carving them out of the definition of “swaps.” This creates certain interesting questions as to the new dividing line between “swaps” and “insurance.” For example, New York Insurance Law Section 1101(b)(7) now provides that the making of a “swap,” as defined under the Dodd-Frank Act, does not constitute doing an insurance business in the State of New York. However, the definition of a “swap” under the Product Rules then carves out certain insurance products from constituting “swaps” under a non-exclusive safe harbor. Insurers and others who utilize insurance-linked derivatives and other synthetic products will have to exercise additional care


in complying with the new and changing regulatory regime.

In addition, catastrophe bond issuers will have to grapple with issues related to the new inclusion of swaps within the definition of “commodity interests” for purposes of the Commodity Exchange Act (the CEA). Certain operators or sponsors of catastrophe bonds therefore have had to consider whether their special purpose vehicles may be commodity pools if they have issued swaps rather than reinsurance contracts to offer insurance-linked protection. The use of a commodity pool creates compliance issues under the CEA as well as potential Volcker Rule issues with respect to “covered funds,” which may include commodity pools, and can complicate the involvement of banks in certain cat bonds. While the staff of the CFTC has issued a number of letters that provide some relief to certain securitization vehicles as regards commodity pool status, as yet the scope of these letters does not include most insurance-linked securities. Catastrophe bond issuers and underwriters therefore must carefully consider the new complications and regulatory uncertainty presented by the Dodd-Frank Act. Implementation of the Affordable Care Act

After the United States Supreme Court upheld the constitutionality of the Patient Protection and Affordable Care Act (the ACA), the re-election of President Barack Obama removed any remaining doubt that the ACA is the law of the land. With that doubt removed, the federal government and the states will now focus on several major implementation challenges presented by the ACA. Many of these need to be resolved in 2013, because, effective January 1, 2014, the requirement that all residents of the United States must have minimum essential health insurance goes into effect.

Six of the most critical implementation matters that must be addressed are as follows:

1. Affordable Insurance Exchanges

Each state must have a health insurance exchange in place and operating by January 1, 2014, which means, practically speaking, that it must be in place by October 1, 2013, to beginning taking applications for insurance to be effective on January 1, 2014. With the exception of Massachusetts, which has had an exchange for several years, no state is currently ready to start operating an exchange. Moreover,

many states, either for political or practical reasons, have advised HHS that they do not intend to establish exchanges. As of January 3, 2103, HHS reported that only 24 states had said they intend to run their own and that HHS had named only 18 states as conditionally approved to operate their own exchanges. A federal exchange is supposed to exist in states that will not have their own exchanges and federal officials insist that this federal exchange will be operating in time to be used by residents of those states. Some skeptics doubt that this will occur.

2. Qualified health plans

In addition to the questions regarding the formation of exchanges, there are many unresolved issues about what insurers need to do to become qualified health plans, which is a pre-condition to offering coverage on an exchange.

3. Essential health benefits

Effective January 1, 2014, all comprehensive health insurance policies must provide essential health benefits, which are to be determined in each state based roughly on a benchmark plan selected for that state that reflects the package of benefits provided by a typical employer plan. Within those broad parameters, however, insurers and self-insured plans are supposed to have flexibility, subject to providing an actuarially equivalent level of benefits to the benchmark plan. The details of how that flexibility will be measured are still not completely clear. Proposed regulations to clarify these issues were issued within days after the 2012 election, but it is likely that questions will linger into 2014 over whether a particular insurance policy or self-insured plan provides essential health benefits.

4. Rate reviews

The ACA gave the federal government substantial new powers to require insurers to disclose rate increases and for the federal government to review rate filings in states that HHS determines do not have effective rate review systems. During 2012, HHS concluded a number of rate filings were excessive. HHS is likely to be even more active regarding rate reviews during 2013 and shortly after the election it issued proposed new regulations which would allow it to do exactly that by standardizing various rating factors and establishing


a mandatory format for rate filings, among other measures.

5. Insurer taxes

Providing universal access to insurance, as called for by the ACA, will not be inexpensive, and to meet some of those costs the ACA imposes three new taxes on insurers.

Section 1341 of the ACA requires that all health insurance issuers and self-insured plans make payments to fund the reinsurance programs for individual markets that each state is required to establish pursuant to this section (discussed further below). The amount to be collected in the aggregate is to equal US$12 billion in 2014, US$8 billion in 2015 and US$5 billion in 2016. HHS has proposed that in 2014 insurers and self-insureds be assessed US$5.25 per insured person per month to collect the first installment of these fees.

Beginning in 2014, and continuing every year after that, pursuant to Section 9010 of the ACA, all health insurers (but not self-insured plans) must pay an excise tax. The total revenue to be generated by this tax is as follows: US$8 billion in 2014, US$11.3 billion in 2015, US$11.3 billion in 2016, US$13.9 billion in 2017, US$14.3 billion in 2018 and an amount that reflects the annual rate of health care cost inflation in subsequent years. Each health insurer is required to pay an amount that reflects the insurer’s pro-rata share of the total health insurance premium revenue collected in the prior calendar year to the year in which the tax is owed.

Section 6301 of the ACA establishes the Patient Centered Outcomes Research Institute, as a quasi-public agency. The Institute is to be partly funded by a “Patient Centered Outcomes Research Trust Fund” (which is codified in a new Section 9511 of the Internal Revenue Code). This trust fund is to be funded partly by appropriations and partly by a fee that is imposed on “each specified health insurance policy for each policy year ending after September 30, 2012.” The fee is US$1 for each policy ending during federal FY 2013 and US$2 for each policy ending during FY 2014 – 2019.

HHS and the IRS have published some guidance regarding how these taxes will be imposed on individual insurers, but interpretive questions

remain regarding the impact of them on market conditions and on the cost of insurance to businesses and individuals.

6. The “3Rs”

In recognition of the fact that the requirement that all insurers “guarantee issue” policies beginning in 2014 will result in adverse selection, the ACA calls for three programs to mitigate the impact of this adverse section. Referred to as the “3Rs”, these programs are as follows:

1. Reinsurance

Each state is required to set up a transitional reinsurance entity (for 2014 – 2016) to provide reinsurance of coverage provided to high risk insureds in the individual insurance market. Insurers will have to pay a premium for this reinsurance, but (as noted above), all insurers will be assessed to fund the program. The federal government will operate the program in states that do not do so.

2. Risk adjustment

Insurers in the individual market will be measured against one another and those that have comparatively less costly books of business will be assessed for funds to be transferred to insurers whose books of business are comparatively more costly. The CBO estimates that as much as US$27 billion will be transferred within the industry during the first three years of this program.

3. Risk corridors

The risk corridors program is intended to protect against inaccurate rate setting in the early years of the exchanges by limiting the extent of issuer losses and gains. Qualified health plans with costs below expectations will be required to subsidize to some extent QHP issuers with costs that exceed expectations. Only QHP issuers will make payments into or receive payments from the risk corridors program.

HHS published proposed regulations for these three programs on December 7, 2012 with comments due on December 31. These are very highly technical initiatives, but given the amount of money that will be subject to these


regulations, they may be the most carefully analyzed measures of all related to the implementation of the ACA for insurers.

In summary, while there may be little doubt that the ACA is the law of the land, there are still many questions regarding how it will be implemented and what its consequences will be.

IAIS DEVELOPMENTS

The IAIS continues to emerge as an increasingly dominant voice concerning international insurance regulatory matters. The IAIS has also come a long ways towards establishing itself as a peer of the Basel Committee on Banking Supervision and the International Organization of Securities Commissioners (IOSCO).

The major work streams of the IAIS during 2012 included:

The development of ComFrame

Almost two and a half years ago, the IAIS began working on the development of the Common Framework for the Supervision of Internationally Active Insurance Groups, or “ComFrame.”

ComFrame’s original goals were to:

1. Enhance group-wide supervision of internationally active insurance groups (IAIGs)

2. Establish a framework for supervisors to address group-wide activities and risks and improve supervisory cooperation and

3. Foster global convergence of regulatory requirements and supervisory approaches

The development of ComFrame was driven, as so many regulatory initiatives have been, by the global financial crisis and perceived weaknesses in the insurance regulatory response to the financial troubles faced by some IAIGs (AIG, of course, included). Accordingly, ComFrame began with great momentum, if not complete unity of purpose and goals.

After two drafts of the ComFrame paper, several hearings and public comment periods, ComFrame has begun to take shape. It has also become the focal point of discussions – and some strong disagreements –

regarding how IAIGs should be regulated and the extent to which there should be specific global regulatory requirements applicable to these insurers. Imbedded in these debates are questions of level playing fields, both among IAIGs and among IAIGs and non-IAIGs, and thorny issues of sovereign rights and regulatory comity.

The current version of ComFrame contains four key sections or “modules.” Module 1 addresses the scope of ComFrame, i.e., what insurers will be deemed IAIGs. Module 2 (which is probably the most contentious part of the proposal) sets forth specific regulatory requirements addressing such things as group governance, group enterprise risk management, group structure, group financial condition (including controversial group capital adequacy assessment standards) and group reporting requirements. Module 3 is focused on regulatory cooperation, including the identification and role of group wide regulators, use of supervisory colleges and how regulators will handle crises management and resolution issues. Module 4 is focused on implementation.


As noted above, Module 2 in the real flash point. In particular, the proposed use of capital adequacy standards has morphed into a debate about the relative value of Solvency II’s capital standard versus US risk-based capital requirements.

Given the debates over some of the fundamental goals of ComFrame, its progress slowed during 2012. Indeed, some commentators have suggested that ComFrame is adrift or is faced with an identity crisis. In an effort to advance the development of ComFrame, and to address some of the complaints that ComFrame’s requirements are too prescriptive and onerous, the IAIS has sought a group of IAIGs to undergo a “field test,” i.e., to have the current ComFrame requirements applied to them to see what are the results.

In addition to field testing and other procedural steps, the fate and direction of ComFrame will be influenced by some key personnel changes. Most importantly, as noted above, Michael McRaith, the FIO Director, now chairs the Technical Committee of the IAIS, which has jurisdiction over ComFrame. The IAIS will hold another ComFrame hearing in mid-January and this should shed some light on the likely progress of ComFrame in 2013. Systemic significance of insurers

Perhaps no subject has generated as much debate throughout the insurance industry as whether any insurers should by designated as “systemically important financial institutions” (also called SIFIs or Global Systemically Important Insurers, or G-SIIs). This debate and regulatory analysis is playing out in both the United States (through the deliberations of the Financial Stability Oversight Council (FSOC) and through the work of the IAIS and the Financial Stability Board (FSB).

The fundamental issue is simply this, are there certain insurers which are too big (or too interconnected) to fail? If so, what additional regulatory measures should be applied to these insurers/reinsurers?

The industry has argued, with some success, that insurers are fundamentally different institutions than banks and do not, at least in terms of their traditional insurance activities, pose systemic risks to the global financial markets. US and international regulators have by and large agreed. The challenge for insurers is proving the negative, i.e., that they do not transact anything other than traditional insurance activities. The

difficulty in proving this negative, the necessary rescue of AIG during the 2007-2009 financial crisis due to a largely unknown business unit that was engaged in non-traditional insurance business activities, combined with a seemingly pervasive feeling among regulators that at least some insurers will have to be designated as systemically significant, leads most observers to believe that it is inevitable that both the FSB and FSOC will designate a certain number of insurers as systemically significant.

The implications of such a designation are not clear. The IAIS has issued a draft paper, Global Systemically Important Insurers: Proposed Policy Measures. Comments on the paper were due by December 16, 2012. Similar guidance has been published by the Fed for use in connection with entities that have been determined to be systemically significant by FSOC.

Under the IAIS proposals, (which are based upon the requirements to be imposed on Global Systemically Important Banks or G-SIBs), such insurers would be faced with:

1. Enhanced supervision

2. “Increased resolvability,” i.e., need to prepare a plan of recovery or resolution if its business should become impaired

3. “Higher loss assumption (HLA) capacity” – that is, higher capital requirements

Although the measures seem, on their face, to be alarmingly similar to the requirements imposed on banks, there is a general recognition that they should be focused on the systemically significant aspects of the insurer’s operations and that these operations would be fundamentally non-traditional insurance and non-insurance activities (NTNI activities).

Adding to the complexity and importance of these discussions is the interplay of the G-SII debate and the development of ComFrame (discussed above) which is focused on a new generation of regulation for IAIGs. Regulators have been quick to point out that not all IAIGs will be systemically important and that there is a possibility that an insurer could be systemically important, even if it is not an IAIG. Consequently, there is a lot of discussion that is yet to occur regarding the regulatory requirements applicable to a G-SII versus an IAIG.


It is likely that both FSOC and the FSB/IAIS will produce their initial list of systemically important insurers within the first three to six months of 2013. Accordingly, this will be an area to watch as the New Year unfolds.

The debate over whether insurers are systemically significant has also highlighted an overarching issue for the insurance industry – i.e., that governments and non-insurance financial regulators, in particular, have a very limited knowledge of how the insurance industry operates. Many policy makers have learned a great deal during the past few years, but there is still a profound knowledge gap concerning the role of the insurance industry in the global economy and the performance of insurance industry through the financial crisis. The industry needs to redouble its efforts to educate decision makers regarding its role and impact on financial markets and the larger economy.

Paper on cross-border operations through branches

One of the lesser known, but potentially significant, activities carried out by the IAIS during 2012 has been the development of an issues paper on the supervision of cross-border operations through branches. An initial draft of the paper was released in September 2012 and a revised draft was released in November 2012. The paper declares that it has two objectives: to identify how foreign branches are supervised and to “analyze (possible) challenges in the supervision of foreign branches that supervisors have been facing.”

The paper generally is an objectively reported summary of survey responses the IAIS received from 33 of its members regarding the regulation of branches. The survey and the paper address the following topics: licensing, financial commitment to host jurisdictions, market conduct regulation, governance, solvency regulation, on and off-site examinations and monitoring, reporting and public disclosure, ORSA, supervisory intervention, cross-border cooperation and resolution of branches.

The paper states it has the somewhat modest objective of “neither establishing any supervisory principles nor recommending best practices.” Nevertheless, the paper discloses that “either could be considered as the next step, taking into account the findings of this paper.”

Scattered throughout the current draft are statements which suggest that at least some regulators already intend to take that next step. For example, the paper states that “that some supervisors feel that there are difficulties in supervising foreign branches” and that “there are issues that could threaten to some extent the effectiveness of the supervision of foreign branches.” The paper also asserts that host regulators “should be provided with authority to direct a foreign branch to, within a certain time frame, increase the margin of its assets over its liabilities that it is required to maintain,” with no mention of coordinating the exercise of this authority with the branch’s home regulator. Such statements have led some industry commenters to criticize the draft paper on the grounds that there is nothing in the survey responses as reported in the text of the paper to support these kinds of conclusions.

The IAIS is expected to complete the issues paper during the first few months of 2013. Insurers that do business using branches should monitor this matter carefully, in light of the possibility that some regulators intend to use the paper to propose substantive reforms regarding the regulation of branches.


EUROPEAN DEVELOPMENTS

Developments have been as significant in Europe, as they have been in the US. Some of the notable ones include: Solvency II delays

With the ongoing discussions relating to the adoption of the Omnibus II Directive, most in the global insurance environment find it hard to imagine that the Solvency II Directive will ever be implemented in the form that many in the EU institutions would have wished for a year ago.

EIOPA has been working on a proposed partial implementation of several areas of the Solvency II Directive – a so-called Solvency 1.5 approach. EIOPA issued its first legal opinion on this new approach on December 20, 2012. This partial, phased-in approach would see an implementation by January 2014 of the Pillar II provisions relating to the risk management model and the own-risk assessment provisions. The partial implementation will also seek to advance the work concerning the approval of an internal model application process for insurers and reinsurers operating in Europe, as well as some Pillar III provisions, including supervisory reporting. This work will be subject to public comment in the Spring 2013.

With regard to the overall implementation of Solvency II, the key remaining issue is the calculation method of the premium for long-term guarantees. On this issue, EIOPA has been tasked to deliver a report concerning the impact of using different methodologies, but this is not expected until April or May 2013. As EIOPA works through this issue, 2016 is seen as the earliest full implementation date for Solvency II.

Many countries remain skeptical concerning a harmonized approach for long-term guarantees and question whether a matching premium would be an appropriate methodology in certain jurisdictions while it remains largely untested in various product categories. Several companies have stressed to their national regulators the wider implication of using a different methodology upon their business models and capital provisioning – some highlighting the impact on their solvency margins and economic profitability. A non-harmonized approach, however, raises the threat of forum shopping by multinationals, which would simply

choose the regime which best fits their business models, and makes some EU member states less attractive than others for establishment.

In addition to the outstanding issue on the use of the matching premium, many European insurers have struggled with determining how they could get an approval for their internal model. In the past year, there has been a distinct trend away from the internal model approach towards the use of the standard formula, as many companies have found the national regulatory approval process for internal models too challenging in view of any benefits which could be attained.

The introduction of Solvency II has also been bedeviled by the lack of progress in relation to the determination of equivalence of third countries with the EU regime. There is added confusion now from the lack of a determined EU regime for countries to benchmark against. With respect to the US, the EU has sought some form of resolution within the EU/US Dialogue Project by trying to attain common areas of agreement in the insurance


and reinsurance fields with the goal of achieving mutual understanding and cooperation concerning insurance supervision.

Other countries have, however, continued with the Solvency II equivalence process despite recent setbacks at the EU political level. Bermuda, Switzerland and Japan (originally for reinsurance supervision only, but this may be expanded to include group solvency and group supervision) did apply for and underwent equivalence assessments. In October 2011, EIOPA reported to the European Commission positive findings regarding its assessment of these three countries. The EC has directed EIOPA to revisit its reports “once the final level 2 implementing measures have been agreed to” at which time the EC will make its determination concerning the equivalence of these three countries. In late 2011, the EC indicated it expected to do so in the first half of 2013; however, it is unclear at the moment whether that time frame will be met. Several other countries, including Australia, Hong Kong, Mexico and South Africa, have expressed an interest in being part of a “transitional regime” for third-country equivalence under Solvency II, although the details of a transitional regime have not yet been agreed upon.

The delay in Solvency II implementation and now the prospect that Solvency II might now be implemented in a fragmented manner has created great uncertainty inside the insurance industry and within regulatory circles, both in the EU and elsewhere. It is unclear how this will all play out in 2013 and beyond, but it will be an area to watch closely as the year unfolds. New Insurance Mediation Directive 2

In July 2012, the European Commission published its proposal to recast the Insurance Mediation Directive (IMD1), in the form of a draft directive (IMD2). IMD2 seeks to enhance consumer protection and to harmonize the regulatory requirements applicable to insurance mediation (a/k/a “distribution”) across Europe. It is anticipated that IMD2 will be adopted at EU level in 2013. The level 2 implementing measures are expected to be finalized during 2013 and 2014, with a view to national regimes coming into force in 2015.

IMD2 has several key provisions which could raise significant issues for insurers and intermediaries. These can be summarized as follows:

Scope: IMD2 extends the scope of IMD1 to cover (i) direct sales by insurers; (ii) claims management activities by or for insurers; (iii) loss adjusting and expert appraisal of claims; and (iv) policies sold ancillary to the sale of services (e.g., travel insurance sold with travel services and sales through insurance comparison websites).

Remuneration disclosure: Insurance intermediaries will be required to disclose to their customers the nature and amount of remuneration they receive, including any contingent commissions. If the full amount cannot be calculated, the basis of calculation must be provided. In relation to life insurance products, this disclosure obligation will be mandatory from the date on which IMD2 is implemented by member states. In relation to general insurance products, there will be a transitional period of five years during which time disclosure of remuneration will only be required if requested by a customer. Upon the expiry of the five-year transitional period, mandatory full disclosure obligations will apply.

Dispute resolution: IMD1 encourages insurance intermediaries to participate in out-of-court complaint and redress procedures. However, IMD2 compels (rather than encourages) insurers and intermediaries to participate in such processes in relation to any of the rights and obligations established under IMD2.

Conflicts of interest: IMD2 requires intermediaries to act “in accordance with the best interest of customers.” Intermediaries will also be required to disclose whether they are representing the customer or the insurer and, in relation to insurance investment products, the intermediary must take “all appropriate steps” to identify conflicts of interest.

General good rules: IMD2 is a minimum harmonization directive, meaning that member states can “gold plate” the requirements. However, member states will have a duty to publish “general good” rules that regulate insurance mediation in their jurisdiction.

The extension of the scope of IMD2 to cover claims management activities by and for insurers, loss adjusting and expert appraisal of claims is a significant revision to IMD1. Although regulation may improve these services, the additional cost of regulatory compliance is likely to be passed onto the insurer and subsequently the consumer.


Key changes in UK insurance supervisory administrative structure

A number of important changes in the organization of insurance regulation in the United Kingdom were announced in 2012. These changes are to go into effect in April 2013 and include the following:

Establishment of the Prudential Regulation Authority (PRA): The PRA will be part of the Bank of England (BOE). This agency will authorize and prudentially supervise banks/insurers/significant investment firms

The Financial Conduct Authority (FCA): This organization will authorize and prudentially supervise all other firms (such as intermediaries) and will lead in regulating business conduct issues, subject to PRA power of veto, as may be necessary to protect financial stability. Unlike its predecessor, the FSA, the FCA has the additional objective of promoting effective competition in interests of consumers

BOE and Financial Policy Committee (FPC): BOE will be lead regulator to ensure financial stability, whereas previously BOE only “contributed” to this objective. FPC will monitor systemic risk and provide directions to PRA and FCA, such as requiring firms to increase capital in respect of particular risks

Practical impact

FSA currently regulates approximately 29,000 firms. FSA estimates that approximately 26,000 firms will have dual regulators (PRA and FCA). Therefore, in some circumstances, there will be dual regulatory applications/notifications/processes and handbooks/compliance issues. There is an appreciable risk of disjointed regulation, repetition of efforts (both by regulators and by firms) and potential issues falling through the cracks. Many firms will no longer have a nominated supervisor, meaning no dedicated contact point at the regulator

BOE, PRA and FCA are intended to be more forward looking, assertive and willing to intervene earlier to protect consumers and ensure stability, with less tolerance for consumer detriment. Insurers and intermediaries will be concerned about how the FCA will exercise its powers to promote effective

competition in the interests of consumers, and whether this will overlap with existing competition, regulators and bodies. In particular, the FCA has said that it does not accept that there are some categories of relationships which should be exempt from the FCA's concern due to the sophistication of the parties – rather, all relationships impact on the integrity of the market and are of concern to the FCA

New assessment and enforcement powers – FCA will take more interest in the design of products (FCA's comments open up the possibility of pre-approving products in certain situations), have the power to ban promotions/products or limit sales to certain groups (or require refunds) and be more likely to use Section 166 (Skilled Person Reports) when conducting assessments of an insurer (costs of which would be passed on). In particular, the FCA need not wait until it has taken formal action against a firm before publishing details of a disciplinary investigation (which is said to bring the transparency of the FCA's enforcement powers in line with the criminal system, where details of arrests are published prior to judgments being issued)

Some insurance industry observers also believe there is a risk of a new approach being tailored for the banking sector, rather than other sectors such as insurance, resulting in insurers being required to adopt practices designed for the banking sector. In addition, the potential exists for smaller firms to be overwhelmed by (and incur a disproportionate cost to comply with) these changes.

Nevertheless, DLA Piper’s recent survey of executives in the UK financial services industry shows that a majority of executives believe the changes to the regulatory system will result in improved effectiveness, contributing to promoting the UK as a global hub for the financial sector. The survey does show, however, that given the FCA is more likely to intervene, compared to the FSA, insurers are most concerned about the FCA's new product intervention powers and its focus on competition and culture within firms. Interestingly, the survey also shows that an element of “regulatory fatigue” has perhaps set in, with many firms expecting no increase to their compliance headcounts in the next 12 to 24 months, indicating many firms are unaware of the additional compliance pressures brought by the new


regulatory regime. On a positive note, our survey highlights that many firms are now spreading the burden of managing the regulatory regime, with the workload shifting away from the compliance staff and towards finance, risk and legal functions. This will result in a shift in the manner in which regulatory compliance is managed, from a tick-box type approach to a more integrated, business-led risk management role.

ASIAN DEVELOPMENTS

Reflecting developments in Europe and the United States, we have seen the evolution of regulatory standards and, indeed, changes in the regulatory structure in Asia. New independent insurance regulatory body in Hong Kong

On October 26, 2012, the Financial Services and the Treasury Bureau (FSTB) of the Government of the Hong Kong Special Administrative Region (HKSAR)

published legislative proposals concerning the establishment in 2015 of the Independent Insurance Authority (IIA).

Under these proposals:

The IIA will be established as a body corporate independent of the Government of HKSAR, with a governing board comprised of members from a cross-section of the local insurance community (but there will be no representatives from the Government in order to ensure independence of the IIA). The IIA will replace the existing government department (Office of the Commissioner of Insurance) that currently serves as lead regulator

A new statutory licensing regime will be set up for insurance intermediaries to replace the current self-regulatory scheme; transitional arrangements will be in place whereby existing registered insurance intermediaries and their responsible officers will be deemed as licensees and responsible officers under the new licensing regime during the first three years

The existing functions of the Insurance Authority will be expanded so that the IIA will assume additional functions of regulating conduct of intermediaries, promoting insurance literacy of the public, formulating regulatory strategies, facilitating the development of the insurance industry, conducting thematic studies on the insurance industry and assisting the Financial Secretary of the Government of HKSAR in maintaining financial stability of Hong Kong

The IIA will be the primary and lead regulator for insurers and intermediaries that carry out insurance-related “regulated activities” with new investigative and disciplinary powers. The scope of insurance activities that would trigger a licensing requirement under the new legislative proposal is arguably wider than that under the existing rules which only govern activities involving “advising on” matters related to insurance and “arranging contracts of insurance”

Operation of the IIA will be funded through the imposition of license fees and users fees payable by insurers and intermediaries as well as a levy of 0.1 percent on insurance premiums for all insurance policies (subject to applicable caps)

Under the new statutory regime, each corporate licensee will be required to appoint a responsible


officer (the responsible officer should be a senior management officer with responsibility to ensure that internal control and procedures are in place and observed by all intermediaries engaged by the corporate licensee). It is also proposed that each authorized insurer should appoint a responsible officer to ensure systems are in place for securing compliance by its appointed insurance agents with the conduct requirements

The IIA shall have powers to undertake inspection and investigation into the conduct of insurers and intermediaries, to impose disciplinary sanctions against licensed insurance intermediaries and the responsible officers of intermediaries and insurers for misconduct and breach of the “fit and proper” requirements and to prosecute offences summarily. The IIA shall be empowered to revoke or suspend the license of a regulated intermediary or revoke or suspend the approval of a person as a responsible officer. In the case of an insurer, the IIA may revoke or suspend its authorization and issue a public or private reprimand and order a defaulting regulated intermediary, responsible officer of a defaulting regulated intermediary or a defaulting insurer to either pay a pecuniary penalty of up to three times the amount of the profit gained or loss avoided by the regulated intermediary, responsible officer or insurer as a result of the misconduct, or to pay a maximum of HK$10 million, whichever is greater

The establishment of an independent watchdog in the insurance industry will bring Hong Kong more in line with the regulatory frameworks adopted by developed insurance markets. This should in turn result in better protection of insurance policyholders and enhance the public's confidence in the industry. However, with the IIA being armed with extensive inspection, investigative and disciplinary powers, the conduct of the insurers and intermediaries will come under increased scrutiny going forward. Insurers and intermediaries should take this as a timely opportunity to review and revamp their internal distribution compliance systems to ensure the risks of carrying out insurance business are effectively managed. China releases new regulation on overseas investment with insurance funds

As part of the effort to liberalize insurance investment and improve return of insurers' investment, in October 2012 the China Insurance Regulatory Commission

(CIRC) promulgated the Implementation Rule of the Provisional Administration Measures on Overseas Insurance Investment. (Implementation Rule).

The Implementation Rule provides a clear framework that enables qualified insurers to obtain a license to invest in a permitted range of financial products and real estate projects in designated jurisdictions. Moreover, duly authorized insurers are no longer required to obtain prior approval for overseas investment and only need to file reports for such investment quarterly and annually (or on ad hoc basis for urgent and important matters).

According to the Implementation Rule, insurers are now authorized to invest in the following categories of assets: money market instruments, fixed income instruments, equity investment, real estate; and funds which include security funds, private equity and real estate investment trusts (REITs). The Implementation Rule also provides prudential requirements for each category of these portfolio assets.

In order for an insurer to qualify for such overseas investments, the insurer shall maintain its solvency margin at 120 percent or greater, which is lower than the minimum requirement (150 percent) of the draft regulation released in July 2012.

In addition to the conditions required for a general overseas investment license, an insurer must also satisfy qualification requirements for a particular investment (if any).

Insurance investments in overseas markets are limited to 15 percent of insurers' total assets. Separately, investments in 20 permitted developing countries will be capped at 10 percent of the total assets. It is worth noting that every portfolio asset has a limit cap which applies to both domestic and overseas investment and is calculated on a combined basis.

CIRC’s motivation for this change is no doubt related to that fact that according to public information, top insurers such as China Life, Ping An and China Pacific, all reported reduction of investment yields for 2011 (down by 1.6 percent, 0.9 percent and 1.6 percent on a yearly basis to 4 percent 3.7 percent and 3.8 percent respectively). In the context of a weak domestic capital market and immature investment environment, these giant insurers are motivated to look elsewhere for investable assets. The result is a Chinese insurance fund of hundreds of billions of RMB that has the potential to


bring enormous opportunities for the industries and countries listed in the Implementation Rule.

COMPLIANCE ISSUES

There is no doubt that compliance-related issues continue to be a dominant topic in regulatory quarters. Following are some key developments in the area of compliance. Data protection

A new EU data protection law is currently being finalized. It will significantly increase the compliance burden on all insurers and intermediaries providing services to EU citizens and will introduce fines of up to two percent of global annual turnover. There are an increasing number of similar laws being introduced in other regions including Asia Pacific and Latin America. Indeed, there are now over 80 jurisdictions with data protection laws in place, and this is forecast to rise to in excess of 100 over the next few years.

Asia Pacific is perhaps the fastest moving region. New data protection laws are imminent in Singapore and Malaysia and substantial reforms to the data protection laws have occurred in Australia and Hong Kong. India introduced a new law last year which caused consternation within the outsourcing community as it seemed to require additional consents to be obtained from individuals before transferring data to an Indian based service provider. This position was subsequently clarified by the Indian government, but is an example of the unintended consequences which can arise from the new laws being implemented outside the EU and the US.

South Korea has also issued a draft law which is more onerous than the EU model in many ways, requiring consent for international transfers of data and requiring individuals to be notified of each sub-contractor used to process the individuals' data.

Latin American countries such as Argentina, Colombia, Mexico, Peru and Uruguay have implemented laws based on the EU model with substantial sanctions, including prison sentences of four to eight years in Colombia.

The United States, sometimes seen as having no data protection laws at the federal level, has many sector and state-specific laws concerning data protection and has

recently made proposals in the form of the White House Data Protection White Paper, which may result in a federal approach to data protection for the first time. A major on-line business was recently reported to have agreed to pay a US$22.5 million settlement to the FTC for misrepresenting to users how it used their personal data in cookie settings.

In Europe, the European Commission published a proposed new draft law earlier this year which is currently under review in the European Parliament. The new law, due to be finalized in 2013, would have a very significant impact on compliance requirements for insurers and intermediaries. The new law would require businesses to be able to “demonstrate” compliance with the new law including the new “privacy by design,” “privacy by default” and “data minimization” obligations. This would require introduction of procedures and policies and carrying out of impact assessments and verification audits to ensure, and to be able to demonstrate, compliance with the new law. The new user rights known as the “right to be forgotten” and


the “right to portability” have caused a great deal of concern among on-line businesses uncertain as to how they will be able to comply with these requirements in practice.

The new law would also extend the territorial reach of the EU data protection law to those providing goods or services to EU citizens – whether or not the provider had any presence or equipment in the EU. Significantly, the new law would introduce fines up to 2% of the global annual turnover of the “enterprise” which breaches the law. The new law would also require the appointment of a “data protection officer” to be responsible for overseeing compliance.

Insurance businesses would be well advised to review their data handling practices to ensure that they are prepared to meet the growing challenge of data protection compliance. DLA Piper has published a review of the data protection laws in 56 jurisdictions; please let us know if you require a copy. FATCA compliance

FATCA, colloquially known as the Foreign Account Tax Compliance Act, is unilateral US legislation whose purpose is to curb US tax evasion. It requires non-US financial institutions (FFIs), including certain insurance companies, to report offshore account information about their US customers to the US Internal Revenue Service (IRS). A 30 percent withholding tax is imposed on the US source income of any FFI that fails to comply. The objective of FATCA is to obtain US taxpayer offshore account information and not to collect the FATCA withholding tax. Although FATCA was scheduled to take effect January 2013, its implementation has been delayed until January 2014, with a phase-in of certain rules from that date through 2017.

An FFI generally becomes compliant by entering an agreement with the IRS that obligates the FFI to undertake certain obligations, to include performing due diligence with respect to its preexisting accounts and new accounts (those opened from January 2014) to ascertain whether its offshore financial account holders are Specified US Persons (to include US citizens and residents, privately held US corporations and US partnership and trusts), annually report offshore account information of its direct and indirect US account holders, and withhold on certain payments.

Compliance with FATCA by FFIs entails certain risks and costs. The primary risk relates to the consequence that if an FFI decides to comply with FATCA, its obligations to perform due diligence, to report and to withhold US tax (even if the FFI were to obtain client waivers for reporting) may cause the FFI to be in direct violation of local laws, such as data protection, consumer protection, anti-discrimination or withholding US tax, with the consequence that compliance likely would expose the FFI to regulatory sanctions, civil penalties or criminal sanctions. Compliance also will result in an FFI incurring significant administrative burdens and costs because an FFI will have to modify its current operating systems, AML and KYC terms and conditions, onboarding procedures and other policies and procedures.

In view of these concerns, the US Treasury Department consulted with foreign governments to develop bilateral approaches, called intergovernmental agreements (IGAs), to implement FATCA. This bilateral approach is intended to avoid the issues arising because the US has unilaterally imposed extraterritorial obligations on non-US entities, many of which may be wholly outside of US tax jurisdiction.

IGAs come in two models. The first provides for FFIs to report FATCA-required information to their home government, which, in turn, would transmit that information to the US. The second provides for FFIs to report the FATCA-required information directly to the IRS, supplemented by government-to-government exchange of information regarding non-consenting accounts (i.e., those account holders who do not provide requested information or waivers to the FFI). The bilateral IGA approach to the implementation of FATCA has shifted the emphasis of FATCA to IGAs. To date, the UK, Denmark, Mexico, Ireland and Spain have signed the model I IGA and Switzerland has initialed the model II IGA. The US Treasury Department has reported that there are more than 50 countries currently involved in IGA discussions.

FATCA compliance includes insurance companies whose business consists of issuing contracts that provide an investment component, namely cash value insurance contracts and annuity contracts. Insurance companies (or the holding company of an insurance company) are FFIs if their primary business relates to cash value insurance contracts or annuity contracts or the reinsuring of such contracts. An insurance company whose business


consists solely of issuing contracts without cash value is not an FFI. Thus, insurance companies that issue contracts that provide pure insurance protection, such as term life, disability, health and property and casualty contracts are not primarily targeted by FATCA, although such entities still will have to comply with the FATCA regime applicable to non-financial foreign entities (NFFEs), which requires less burdensome undertakings to comply with FATCA.

Generally, an insurance company will be required to report offshore cash value contracts, annuity contracts and amounts pursuant to a guaranteed investment contract or similar agreement to pay or credit interest held by Specified US Persons. However, certain contracts under a specified monetary amount are excluded, to include cash value insurance (but not annuity) contracts of US$50,000 or less and annuity contracts with a balance or value of US$250,000 or less as of December 31, 2013. In addition, various insurance products to include pension and savings plans, retirement funds, retirements accounts or products and other tax favored accounts or products are excluded. Further, regularly traded debt or equity interests of insurance companies that are FFIs are generally excluded.

Compliance with FATCA by insurance companies will be challenging. In effect, the compliance inquiry asks: (i) is the insurance company an FFI? and (ii) does it have policy or account holders who are Specified US Persons? Global insurance companies that operate in numerous countries will be required to comply with FATCA by reference to the bilateral IGA rules or the unilateral regulatory regime applicable to the country in which the branch or subsidiary of the insurance company is resident; this will prove burdensome because there will not be full conformance of the FATCA implementation rules, so it will not be possible to adopt a uniform software application or uniform terms and conditions and on-boarding procedures that will apply to all geographies, lines of business and products. Insurance companies that are more localized, however, may be subject to less onerous compliance burdens. With less than one year left to commence implementing FATCA, insurance companies must now determine how they will navigate these new rules.

COMMERCIAL AND TRANSACTIONAL

DEVELOPMENTS

As noted above, there are many developments that are influencing the trading environment for insurers. Many have been forced to reconsider their global strategy due to more stringent (and still evolving) capital requirements in Europe and other global regulatory pressures while conducting business in a very difficult operating environment. Insurance pricing remains soft due to weak demand and overcapacity of insurance providers (not withstanding record cat losses in 2011). Investment returns continue to be anemic and market valuations remain disappointing for most insurers.

Although a wave of large-scale insurance industry M&A is unlikely to result from the current market conditions, we expect to see strategic cross-border deals to continue and an increased interest in buying and selling medium- to small-sized insurance operations and blocks of business. Cross-border M&A

There are several drivers for cross-border M&A in the insurance sector. While some insurers have been forced to divest of their international operations to increase capital or comply with government bailout terms, others have found establishing or increasing their presence in international markets, especially in the faster growth emerging markets, as potentially attractive opportunities if the business can be acquired for the right price. As a continuation of ING’s disposal of its non-core international businesses (ING sold its Latin American insurance operations for US$3.9 billion in 2011), ING is now in the process of selling its Asia life insurance business. HSBC also recently agreed to sell its 15.57 percent stake in Ping An insurance for US$9.4 billion to a Thailand investor and may also be exploring a sale of its minority stake in one of Vietnam’s leading life insurers.

In addition to opportunities created by strategic or mandatory divestitures, insurers in slower growth markets have been making investments and acquisitions in insurance businesses in developing markets such as Asia and South America. Among the emerging market M&A deals in 2012, AXA closed its acquisition of HSBC P&C insurance business in Hong Kong, Singapore and Mexico for US$494 million and QBE


agreed to buy HSBC’s P&C insurance business in Argentina for US$420 million. In the international reinsurance markets, Validus closed its acquisition of Flagstone Re for US$623 million in December to grow its Bermuda-based reinsurance operations. Markel announced its US$3.1 billion acquisition of Alterra for a mixture of stock and cash to diversify its current book of specialty business via the purchase of the reinsurer.

In the more developed markets such as the United States, opportunistic insurers and private equity funds looked to the light at the end of the tunnel rather than lamenting on the current industry difficulties created by the global recession. These insurance industry players seemed to focus on strategic repositioning and investment opportunities to capture future asset and customer growth as the US market improves. Although there were no hostile M&A deals on the scale of last year’s transaction involving Transatlantic Holdings (which was ultimately acquired by Alleghany Corporation), there were still significant US insurance-related deals in 2012. For example, Nationwide acquired Harleysville for US$834 million in April, Tokio Marine completed its acquisition of Delphi for US$2.7 billion in May to enter into the US market and Prudential Financial agreed to acquire Hartford’s individual life insurance business for US$615 million in September. Private equity funds also concentrated on investing in insurance services rather than insurance companies which require more capital and regulatory oversight. Recent private equity deals include Onex Corporation agreeing to acquire USI Insurance for US$2.3 billion, CVC Capital Partners agreeing to buy Cunningham Lindsay Group for US$1 billion and KKR agreeing to buy Alliant Insurance Services for an undisclosed sum. Middle market deals

In the United States and Europe, where regulatory reform is under way and the insurance market is still relatively soft, we should expect more transactions that address inefficiencies in the market. In recent years, except for a few notable exceptions, most of these insurance-related transactions have been in the middle market category as various insurance industry players have reallocated assets rather than consolidating through mergers or large-scale acquisitions. One of the primary trends in insurance industry M&A we have seen, and believe will continue to see, includes deals involving financial buyers, such as private equity funds and hedge

funds, that have the capability of increasing the operating efficiencies of existing insurance businesses and/or investing insurance assets more effectively to achieve higher yields under current investment regulations. While valuations of insurance-related businesses have come down in the recent economic environment, many medium-sized insurance-related businesses have remained sufficiently stable throughout the global financial crisis for a financial buyer to make significant operational improvements, especially in transactions involving insurance services companies that have predictable cash flow. In addition, certain insurance sub-sectors, such as specialty insurance providers, brokers and claims administrators, are fragmented and offer opportunities for private equity firms and other financial buyers to potentially exit the investment at a substantial profit as industry conditions improve or through future industry consolidation. ILS developments

Not even Superstorm Sandy could stop another banner year in the cat bond market, which some estimate to top US$6 billion in issuance by year end. Even more interestingly, sidecar technology continued to develop, along with the use of segregated cell reinsurers in Bermuda and other jurisdictions to create “shelf” and other renewable programs with lower transaction costs. And for perhaps the first time, market chatter indicated that insurance-linked securities were having a quantifiable impact on pricing in catastrophe-exposed lines of business.

In addition, a number of hedge funds, private equity firms and money managers have entered or are rumored to be entering the collateralized reinsurance market through a variety of structures, including offshore reinsurers, sidecars and other structures designed to provide capital and capacity for a defined period of time. One factor behind this may be the increased liquidity and more defined tenor provided by these investment structures, as opposed to direct investment in startup or existing reinsurers, which may present greater difficulties in executing exit strategies. In addition, a new class of investors seems to be as or more interested in garnering assets under management than in earning premiums for taking “insurance” risk.

This desire to gain assets under management, subject to some level of insurance risk, has led to new market entrants in both the ILS and the M&A space, especially


in bulk life and in legacy run-off reinsurance. As these new entrants enter the insurance space, they should be aware of the insurance regulatory requirements imposed on insurance-linked transactions and hire counsel and other advisors accordingly. For existing insurers looking to expand their capital capacity through sidecars and ILS offerings, care must be paid not only to insurance regulatory concerns, of which many of them are aware, but also the new complications raised by the Dodd-Frank Act (some of which are discussed above) as well as the concerns and predilections of this new breed of investor. Longevity and annuity transactions

One of the drivers in bulk reinsurance M&A in 2012 has been potential buyers looking to grow assets under management by reinsuring annuity blocks. A number of hedge funds and private equity firms have either established their own reinsurers or otherwise looked to participate in the market. Most recently, Sun Life announced the sale of its US annuity and certain life insurance businesses to Delaware Life Holdings, a company owned by the shareholders of Guggenheim Partners, for US$1.35 billion in cash. While many of these entrants have hired their own management teams or looked to partner with existing (re)insurers, many of them may be relatively unfamiliar with the insurance regulatory constraints imposed on bulk reinsurance, including the credit for reinsurance rules that are imposed on US insurers. In addition, the successful negotiation, execution and administration of bulk reinsurance requires knowledge of the legal issues and business drivers involved in these somewhat esoteric M&A transactions.

Another interesting development in 2012 has been the annuitization of defined benefit pension plans. Both General Motors and Verizon announced transactions with Prudential Financial under which portions of their defined benefit pension plans would effectively be converted into annuities offered by Prudential. As defined benefit pension plans approach full funding, US plan sponsors are looking to transfer their obligations to annuity providers.

This follows on a number of longevity swaps and similar pension buy-in/buy-out transactions in Europe, as pension plan sponsors look to transfer the risks inherent in their retiree benefit schemes. While the longevity swap and other European transactions have typically

involved elements of either derivatives, insurance or both, US regulatory requirements under the Employee Retirement Income Security Act (ERISA) have generally led pension plans trustees and their sponsors to pursue the “safest possible annuity” under Department of Labor Interpretive Bulletin 95-1 or to offer lump sum distributions to pensioners.

The size, complexity and regulatory approvals required for recent US transactions have generally produced highly negotiated annuity purchase agreements which look very familiar to M&A practitioners. Insurers, plans, sponsors and independent fiduciaries must confront a number of knotty issues under ERISA, insurance regulation and basic contractual division of risk in these frequently multi-billion dollar transactions. This has been highlighted by the litigation arising out of one of the recently announced transactions. European market participants also face a panoply of benefits law and derivative and/or insurance regulatory issues in successfully transferring the risk of their pension obligations. Challenges

As can be seen throughout the other sections of this Year End Review and Forecast, there is a great deal of insurance regulatory reform underway. Regulatory reform in terms of capital requirements, risk management and reporting requirements needs to be monitored and addressed in deal documents. In addition, more specific deal issues such as reserve valuations, market conduct and accounting matters will also likely be impacted by new regulations and practices.


CONCLUSION

2012 was a year of significant changes and challenges. The commercial trading environments have been difficult and numerous regulatory developments mean the rules of the game are in flux – and in some critical areas not clear. Undoubtedly, issues such as group supervision, risk management and harmonization of regulatory standards will continue to dominate regulatory discussions. Insurers, meanwhile, will continue to look for top line growth, seek diversification of risks and grapple with the growing convergence of capital markets solutions and traditional insurance.

More specifically, in 2013 we will be watching, among many other important developments, the following:

Will Solvency II shrink to Solvency 1.5?

Will the EU and US reach a state of regulatory mutual acceptance – whether that is called equivalence, regulatory reciprocity, compatability or mutual admiration?

What insurers will be designated as systemically significant, and what will this mean for those insurers and the insurance industry at large?

What will the next phase in the evolution of insurance linked securities bring – both from a commercial and a regulatory standpoint?

Will FIO release its regulatory modernization report and what impact will it have on the development of insurance regulation in the US and internationally?

Will developments concerning the ACA crowd out all other issues from the US regulatory agenda?

What will US corporate tax reform mean for the insurance industry?

Will pressure be placed on closed markets – like India, China or Brazil – to open their markets further to international insurers?

Will ComFrame come to conclusion – and be focused on Module 3 only?

These, and other developments, await the industry in 2013. For our friends in the industry, we hope it is a successful year.


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For more information

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

William C. Marcoux New York [email protected]

Peter S. Rice Boston [email protected]

Paul Chen New York and Palo Alto [email protected]

Roy Chan Shanghai [email protected]

Joyce Chan Hong Kong [email protected]

Emma Greenow Brussels [email protected]

Melanie James London [email protected]

Roger Loo London [email protected]

David Luce New York [email protected]

Stephen Schwab Chicago [email protected]

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

www.dlapiper.com

DLA Piper is a global law firm operating through DLA Piper LLP (US) and affiliated entities. For further information please refer to www.dlapiper.com. Note past results are not guarantees of future results. Each matter is individual and will be decided on its own facts. Attorney Advertising. Copyright © 2013 DLA Piper LLP (US). All rights reserved. | JAN13 | 04641

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