On March 29, 2015, the National Association of Insurance Commissioners (the “NAIC”) Private Equity Issues Working Group (the “PEI Working Group”) adopted a new section to be added to the NAIC’s Financial Analysis Handbook that provides a narrative guidance to state insurance regulators considering an application seeking approval to acquire control of a domestic insurance company (the “Guidance”). The Guidance draws from many of the practices that have recently been used by states such as New York and Iowa in approving the acquisition of control of domestic insurers by private equity firms, and, in the case of New York, recently codified by regulation.[1] As is the case with the New York regulation, many of the issues identified in the Guidance also apply, on their face, to other acquiring parties that are not private equity firms. The Guidance encourages regulators to undertake a thorough review of all aspects of the financial condition of the acquiring entity and to consider a broad range of potential risks presented by the acquiring entity and the entire group of affiliate insurers and non-insurers under its control, with specific emphasis on credit, market, pricing/underwriting, reserving, liquidity, operational, legal, strategic and reputational risks. The Guidance also enumerates possible short- and long-term stipulations that regulators may request from the acquiror as a condition for approving its change of control filing, as well as post-acquisition procedures that regulators may wish to implement to ascertain whether the acquiror’s business plan is being executed as anticipated.
NAIC Private Equity Issues Working Group
Following concern from U.S. insurance regulators about the increased pace of acquisitions of insurance companies by private equity firms, in July 2013 the Financial Condition Committee of the NAIC formed the PEI Working Group and tasked it with developing procedures and guidance that regulators can use when considering ways to mitigate or monitor potential risks associated with the ownership or control of insurance company assets by a private equity or hedge fund. The PEI Working Group’s efforts culminated on March 29, 2015 at the NAIC Spring 2015 National Meeting in Phoenix, Arizona, where it voted to adopt the Guidance and refer it to the NAIC technical committee charged with updating the NAIC’s Financial Analysis Handbook[2] to add the Guidance as a new section in the 2015-2016 edition of the handbook.
The Guidance
As noted above, the Guidance is aimed at state insurance examiners reviewing an application of a party seeking approval to acquire control of a domestic insurance company (so-called “Form A” application) and focuses on issues regulators should consider in areas such as the acquiror’s overall financial condition, potential risks of the acquiror and affiliates, pre- and post-approval stipulations and monitoring procedures intended to ensure that the acquiror’s business plan is being implemented as approved. The Guidance is intended to be used in interpreting the general statutory standards that regulators must apply in consideration of every Form A application, i.e., that the financial stability of the insurer would not be jeopardized; policyholders will not be prejudiced; the acquiring party’s future plans are not unfair and unreasonable to policyholders; and the transaction is not likely to be hazardous or prejudicial to the insurance-buying public. The Chair of the PEI Working Group noted in previous meetings of the group that many of the issues described in the Guidance may be applicable to acquiring parties other than private equity firms, and thus the Guidance was worded generally to reference any acquiror of an insurance company.
Consideration of Acquiror’s Potential Risks
In considering whether the transaction meets the statutory grounds for approval of an acquisition of control, the Guidance encourages the examiner to analyze all aspects of the financial condition of the acquiror, including the acquiror’s group business model, its strategy both in general, and specifically in purchasing the insurer, as well as any assumptions used by the acquiror in its evaluation of the benefits of the proposed transaction. For example, while the Form A application process already contemplates obtaining proforma results for the insurer and the acquiring group, the Guidance contemplates that the examiner consider requesting additional information related to such proformas, such as how such results or key ratios (e.g., operating or leverage) may be affected under certain stress scenarios.
In particular, the Guidance suggests it may be appropriate for the examiner to consider the following risk categories with respect to the acquiring entity and the entire group of affiliate insurers and non-insurers under its control:
- Credit
- Market
- Pricing/Underwriting
- Reserving
- Liquidity
- Operational
- Legal
- Strategic
- Reputational
Certain of these risks, such as underwriting and reserving, are specific to insurance entities. In addition, the Guidance suggests a review of the investment portfolio of the entire group of affiliates of the acquiring entity in order to evaluate the most common risks that could exist within the non-insurer affiliates that are part of the acquiror’s holding company system, including credit, market and liquidity risk.
Potential Short-term Stipulations
If the examiner, after considering all of the aforementioned risks of the proposed transaction, believes that the general statutory standards described above have not been met, the Guidance recommends imposing certain stipulations of a limited duration as a condition to the approval of the change of control transaction, including requiring:
- Risk Based Capital (“RBC”) to be maintained at a specified amount above company action level/trend test level as a buffer to absorb unexpected losses;
- quarterly RBC reports rather than the annual reports otherwise required by state law;
- the insurer to obtain prior regulatory approval before paying any ordinary or extraordinary dividends or other distributions to shareholders;
- a capital maintenance agreement from or the establishment of a prefunded trust account by the acquiring entity or appropriate holding company within the group;[3]
- material changes in plans of operation to be filed with the regulator (including revised projections), which, at a minimum, would include prior approval of affiliate/related party investments, dividends and reinsurance transactions; and
- the submission by the acquiring entity of a plan allowing all affiliated agreements and affiliated investments to be reviewed by the regulator regardless of any materiality thresholds otherwise applicable under state law.
Potential Long-term Stipulations and Monitoring Procedures
The Guidance also includes several long-term, continuing stipulations and monitoring procedures for regulators to consider, including requiring:
- prior approval for material arm’s-length, non-affiliated reinsurance treaties or risk-sharing agreements;
- 30-day notification following any changes in directors, officers or managers, including the submission of biographical affidavits;
- filing of additional information regarding corporate structure and controlling persons;
- filing of offering or private placement memoranda, investor disclosure statements or any other investment solicitation materials used in connection with the proposed acquisition;
- disclosure of equity holders (both economic and voting) in all intermediate holding companies up to the ultimate controlling person;
- filing of audit reports/financial statements of each equity holder of all intermediate holding companies;
- filing of personal financial statements for each controlling person or entity of the insurer and all intermediate holding companies up to the ultimate controlling person;
- periodic ongoing review of investment management and other affiliated agreements, including review of fees and fee structures to be charged to the insurer as well as arrangements with intercompany brokers;
- ongoing annual stress testing of the insurer and the group in accordance with existing laws and regulations, including stress testing of both investments and policyholder liabilities to ensure proper assets/liabilities matching; and
- meetings and examinations with other regulators of entities in the acquiror’s group as well as regulators of non-affiliated insurers to which the insurer has ceded a material portion of its risk.
The Guidance also emphasizes the need to analyze investment-related transactions, characterizing those as being particularly prone to excessive expense charges to the detriment of the insurer. In this regard the Guidance advises here again that the examiner also consider arrangements with parties not considered affiliates by definition, but which may be operating in a manner similar to affiliates (defined as “near-related” parties). The latter two recommendations emanate from a presentation by a representative of the SEC at a November 2014 PEI Working Group meeting regarding the SEC’s focus on private equity funds and their structure for the charging of management and performance fees as well as potential expense shifting.
ENDNOTES
[1] Our memo to clients on the New York regulations as proposed in May 2014, which are substantially similar to the final regulations as adopted, is available at http://www.sullcrom.com/new-york-state-department-of-financial-services-proposed-regulation-addressing-private-equity-investment-in-insurers.
[2] The Financial Analysis Handbook, which is not binding on states but is frequently consulted by insurance regulators, is designed to provide insurance regulators with a uniform risk-focused reference guide to more accurately identify insurers and/or holding company systems experiencing financial problems and to identify prospective risks that pose the greatest potential for developing financial problems.
[3] While not specifically mentioned in the Guidance, the requirements of a capital maintenance agreement and a trust fund, respectively, in the recent Iowa and New York approvals of insurance company acquisitions by private equity firms were tied to maintenance of certain RBC levels. Additionally, the newly adopted New York regulations require the trust account to “substantially conform[]” to the requirements of a New York credit for reinsurance trust account (commonly known as a “Regulation 114 trust”).
The full and original memorandum was published by Sullivan & Cromwell LLP on April 13, 2015 and is available here.