June 20, 2014

NAIC Private Equity Issues Working Group Exposes Proposed Changes to Holding Company System Analysis Section of Financial Analysis Handbook

By Thomas Dawson, Daniel Krane, Joseph Seiler and Parimah Hassouri

Last Wednesday, June 11,  the NAIC’s Private Equity Issues (E) Working Group (the “Working Group”) held a short meeting to consider some preliminary data with respect to invested asset profiles of hedge or private equity fund-controlled insurers in the life, P&C and health sectors.  The Working Group also considered the New York Department of Financial Services’ proposal to strengthen filing and disclosure requirements in connection with Form A transactions (see our May 27 Client Alert titled New York Department of Financial Services Proposes New Requirements for Acquirers of Domestic Insurers). 

At the conclusion of the Working Group’s short meeting, regulators exposed for a 45-day comment period proposed changes to the NAIC Financial Analysis Handbook – essentially the reference work that guides financial examiners that conduct (i) reviews of Form A transactions and (ii) “field” financial examinations of U.S. insurers every three to five years. 

The proposed changes consist of 3 1/2 pages of “qualitative factors” that examiners may be asked to consider in connection with all Form A transactions – not just acquisitions involving hedge or private equity funds.  For Form A purposes, the focus is on the “broader risks associated with the proposed transaction.”  In addition, certain conditions to the approval of such transactions are suggested in the new proposal.


The proposals released for comment last week should attract a heavy volume of responses from interested parties.  Taken together, the proposals represent arguably an unprecedented intrusion into insurer management, with standards and guidance so imprecise as to leave both regulators and insurer management in the dark as to what the rules are at a given moment. 


The NAIC’s Model Insurance Holding Company System Act requires hearing officers and chief regulatory officers to consider several tests in connection with Form A applications; according to the proposal, these tests are that:

  • The target insurer’s financial stability will not be jeopardized;
  • Policyholders of the target will not be prejudiced;
  • The acquiring party’s future plans are not unfair or unreasonable to policyholders of the target; and
  • The transaction is not likely to be hazardous or prejudicial to the insurance-buying public.

Note: There are in fact several additional tests in the Model Act – satisfaction of licensing standards post-closing, whether competition will be lessened substantially and “competence, experience and integrity” of insurer management.

The Proposal

The first suggestion for examiners is to ignore all of the tests set forth above and to ask instead whether the proposed acquirer has demonstrated “that the policyholder [of the target company] is fundamentally more secure.”   The commentary admits that this is “not necessarily the standard” – perhaps the understatement of the year – but goes on to assert that regulators ought to “consider all aspects of the financial condition of the acquiring entity.”  Without apparent limitation this consideration would include the proposed acquirer’s “business model … strategy in general . . . specific strategy in purchasing the insurer and their implicit requirements [sic] that must be reached [sic] in order for the transaction to be successful by the acquiring entity.” (emphasis added).  Perhaps it is enough to say that these are not very precise notions.  Readers are also entitled to ask whether holding company laws and regulations support this kind of approach.  As far as we know, regulators – in any industry not just insurance – are rarely if ever asked to decide whether particular “business models” are appropriate or whether company “strategy” is viable or to determine what “implicit requirements” for “success” (whatever these are) are present in a particular model or strategy.  And, more importantly, any standard that requires policyholders of the target be somehow better off – more secure in the above articulation – on account of the acquisition will prove difficult, if not impossible, to meet in typical sale of stock transactions because the target’s balance often remains unchanged.

But the commentary does not end here.  It suggests that “it may be appropriate” to consider a laundry list of risks presented by the proposed acquirer and “the entire group of affiliate insurers and non-insurers under its control” [1] including the following:

  • Credit.
  • Market – apparently examiners are now supposed to look at whether the acquiring entity has a handle on interest rates, foreign exchange rates, the direction of equity prices and other factors that could “adversely affect the reported and/or market value of investments.”
  • Pricing/underwriting – examiners will apparently examine whether an insurer’s pricing and underwriting are “inadequate to provide for risks assumed”—second guessing pricing actuaries, underwriters and management.
  • Reserving – examiners will second-guess actuaries again.
  • Liquidity – examiners are to inquire into the insurer’s “inability to liquidate assets or to obtain adequate funding without incurring unacceptable losses.”
  • Operational – examiners should make judgments about “inadequate information systems, breaches in internal controls, fraud or unseen catastrophes [sic] resulting in unexpected losses.”
  • Legal – examiners should decide whether the insurer has failed to conform its operations to “laws, rules, regulations, prescribed practices or ethical standards in any jurisdiction in which the entity operates” that could disrupt the insurer’s business or cause financial loss.
  • Strategic – examiners are going to inquire into the insurer’s ability to “implement appropriate business plans … make decisions . . . allocate resources or . . . adapt to changes in the business environment.”
  • Reputational – examiners are also in the future going to be urged to consider whether there has been “negative publicity, whether true or not [that could] cause a decline in the customer base, costly litigation and/or revenue reductions.”

We can envision Form A hearings taking weeks if not months if any combination of the above suggestions are adopted by the Working Group, approved by the full NAIC in the form of recommended changes to the Model Insurance Holding Company System Act and then incorporated into state insurance laws. But there is more.

The proposal suggests that examiners ought to require applicants to stress test the pro forma financial statements and projections  typically required to be filed by applicants in a Form A proceeding.  In most states, three years’ worth are required (recall that New York recently proposed five years). The proposal talks about “certain feasible stress scenarios”—possibly including testing of product viability along with credit, market and liquidity risks. And the proposal links these inquiries into understanding an acquiring company’s (or group’s) “strategic risk”—noting immediately that regulators might need additional information beyond the pro formas to make a judgment about whether the acquirer can “execute its business plan.” Indeed, regulators may need to know “the demands of investors and plans of the group for obtaining such returns[sic]” to evaluate this.

Then the proposal swings over to discuss risks that non-insurance affiliates of the proposed acquirer may present – and in doing so reveals the regulators’ original impetus and focus on acquisitions of control by hedge and private equity funds.  The proposal suggests that “the analyst may need to request information regarding the investment portfolio of the entire group. In some cases, this may require more detailed information regarding investments such as LLCs, equity and other fund holdings and other invested assets (BA for insurers).”  For “complex portfolios” (undefined), the analyst is told to consider engaging an investment banker “to determine if the investment strategy and related affiliated agreements are appropriate for the backing of insurance contracts.” Analysts are also told to review “equity firm fees and fee structure as well as any arrangements with intercompany broker dealers” and ask whether they are “reasonable.”

The proposal next considers an even dozen “stipulations” that regulators may seek in an effort to ensure that the transaction meets either the general standards set forth in the holding company laws—or the new, optional, alternative, standard of “is the policyholder fundamentally more secure?” The conditions range from maintenance of  higher RBC levels to dividend payment prohibitions to establishment of trust accounts to multiple “enhanced supervision” requirements—more disclosure by the insurer/insurance group, more frequent disclosure, prior approval of all affiliate agreements/investments, prior approval of all reinsurance transactions to more financial disclosure by controllers, etc.

Finally, and this should not come as a total surprise given the foregoing, the proposal suggests that regulators ought to consider whether it would be “appropriate to use existing authority to perform either an annual or otherwise targeted examination of certain risks (i.e., borrowing the concept of “arrow” visits) or use of ongoing (e.g. quarterly) conference calls or meetings to ascertain the proposed transaction [sic] and the business plan are being executed as anticipated.” The proposal retreats a bit at this point, noting that this kind of ongoing scrutiny and analysis would be appropriate only when necessary to “give regulators the appropriate comfort level.” And, perhaps implicitly wondering whether there are enough insurance regulators  on the planet to take on the additional work required, the proposal recognizes that examiners/analysts may want to consider using presumably non-regulator “specialists” to assist with targeted financial examinations, stress testing, investment management reviews, etc.  The proposal ends with suggestions that (i) meetings with multiple regulators may need to be coordinated “to better understand the business plan and operations of the group” and (ii) examinations may need to be coordinated with regulators of “non-affiliated insurers where the direct writer has ceded a material portion of their risk to a separately controlled insurer.”  Again, compare these suggestions with ongoing NAIC efforts to broaden “group supervision,” using Supervisory Colleges among other tools, to include non-U.S. insurers and non-insurance subsidiaries.

This is an extraordinary set of suggestions to increase regulatory oversight of insurers and holding company systems. The suggestions assume levels of understanding of complex, intertwined regulatory, legal, financial, accounting, operational, actuarial, etc. concepts, as well as a knowledge of both insurance markets and capital/financial markets generally that very few regulators—indeed very few people period—possess. Whether the vast expansion of regulatory supervision contained in this proposal has solid support in existing law and regulations is another matter. Regardless, the proposal as drafted requires significant tightening and editing in order for industry AND regulators to understand what the new rules, practices and procedures really mean.

* * * * *

Comments are due to the NAIC by close of business on Monday, July 28, 2014. We anticipate that industry organizations and other interested parties will provide the NAIC with many comments. It will be interesting at least to see how this one plays out. Stay tuned.

[1] cf.  The NAIC’s Group Solvency Issues Working Group, which is headed in the same direction – extending regulatory review to non-insurance affiliates and to non-U.S. insurers.

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