October 2011

Greetings!

The October edition of Insurance Perspectives discusses some of the regulatory issues that can arise regarding competition in markets when insurers merge with or acquire others, guidance on deferred tax assets and the notion of "living wills," or resolution plans, for large financial companies including "nonbanks" such as insurers. In addition, we highlight a managing director's appointment by the U.S. Treasury to the NAFTA Dispute Settlement Panel as well as upcoming Invotex speaking engagements at industry conferences.

As always, we welcome your feedback and invite you to share Insurance Perspectives with your colleagues and business acquaintances. If you do not currently receive our newsletter via e-mail, please subscribe at the left.

Tom Finnell, Les Schott and Jim Stangroom
Managing Directors, Insurance Services

In this Issue

1. Insurance Mergers & Acquisitions - Economic Issues to be Evaluated
2. Deferred Tax Asset Guidance Moves Towards Final Adoption
3. Feds Take Action to Adopt Rules Requiring Large Nonbank Financial Companies to Have “Living Wills”
4. Managing Director Tom Finnell Named by U.S. Treasury to Dispute Settlement Panel
5. Upcoming Invotex Speaking Engagements

Insurance Mergers & Acquisitions – Economic Issues to be Evaluated
by Edward A. Gold, Ph.D., ASA

There has been an uptick in interest in mergers and acquisitions by insurers, in many cases by small and mid-sized companies that lack sufficient scale to be cost competitive and that have run out of options to squeeze out meaningful investment returns in the current investment and interest rate environment. Larger insurers can take advantage and add to their own scale, and broaden their distribution channels and product offerings in the process.

However, a successful marriage will hinge not only on a mutually acceptable deal between the parties but also on the blessings of the proper regulatory authorities – in the case of insurers, that means state insurance regulators as well as federal agencies. While the regulatory Form A (Statement Regarding the Acquisition of Control of or Merger with a Domestic Insurer) approval process is known to many, what may be less familiar are some of the broader economic issues that insurance regulators sometimes face as they contemplate the fate of proposed transactions. Only a hint of these issues can be gleaned from the accompanying Form E, Pre-Acquisition Notification Form Regarding the Potential Competitive Impact of a Proposed Merger or Acquisition. But there is much more that lies beneath the surface.

Broadly, a review of a merger or acquisition from an economic or market-based perspective evaluates the risk that prices to policyholders might increase and / or that fees paid to providers or other suppliers might decrease as a result of an acquisition or merger. In the U.S., the Federal Trade Commission and the Department of Justice have the responsibility for approving mergers at the national level. For example, the FTC’s website states, in part, that its Bureau of Competition “reviews mergers and acquisitions, and challenges those that would likely lead to higher prices, fewer choices, or less innovation.”

But the federal authorities don’t have a monopoly on the review process. A state’s insurance commissioner may have the authority to perform its own review focused on the market and competition implications at the state level. In addition to the two broad pricing issues posed above – risk of price increases to policyholders or fees to providers decreasing – other potential questions that might be raised in a state’s review of a potential merger or acquisition can include, among others, the following:

• How competitive is the marketplace and how price-sensitive are policyholders?
• How should the product market be defined?
• What are the pre- and post-transaction market shares of the merging companies within the state for a specific product market definition?
• Is the state as a whole the market to be considered? Or do relevant markets exist at more narrow geographic delineations?
• How will certain policyholder segments, such as high risk policyholders or small businesses, be affected?
• Is one of the parties bringing innovative business processes, technology or ideas into the industry or market segment? Would the loss of that innovation, or its absorption into another market participant, be detrimental to competition in the market and add to the risk of rising prices?
• Do the parties to the transaction compete very strongly head to head or do they serve different targeted policyholder bases? Do the post-transaction plans indicate a likely change in the market-facing role that each party would play?
• Are there vertical agreements regarding referrals or exclusive provider relationships that would create problematic restrictions on trade once an acquisition is completed?

Although there is no one-size-fits-all road map for an antitrust review of potential merging companies by a state, there are a few basic steps that are likely to be performed for most reviews. These include developing an understanding of the rationale for the merger or acquisition as publicly disclosed by the parties and as confidentially disclosed to federal agencies and/or the state in applicable filings; examining filed and public information for a range of viewpoints on the impact of the transaction as well as data that will allow the testing of hypotheses regarding the potential impact of the transaction on prices; and presenting document requests to the parties to focus the efforts on targeted areas of concern.

Through information already available to the state through prior filings and the subject Form A and Form E, publicly available information about the market, and documents and data obtained directly from the parties, an economic assessment can be made of the competitive environment and the ability of policyholders and suppliers to find comparable alternatives in the face of a completed transaction. Supporting reports, presentations, and/or testimony can be delivered as needed to assist the state insurance regulator in his/her decision making.

No matter which side of the fence one is on – the buyer, the seller or the regulator – anticipating the issues to be overcome is critical. Invotex has been involved in the regulatory approval process from an economic and analytical perspective. We will be monitoring market conditions for mergers and acquisitions and will explore trends in future issues of Insurance Perspectives.

For more information, contact Edward A. Gold.

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Deferred Tax Asset Guidance Moves Towards Final Adoption
by Les Schott

After nearly three years of debate over a topic that was initially conceived to stem the drain of insurers’ surplus at the height of the recent financial crisis, the sensitive issue of admissibility of deferred tax assets (DTAs) has finally – well, almost – been put to rest. In a recent meeting, the NAIC’s Financial Condition (E) Committee adopted Statement of Statutory Accounting Principles (SSAP) 101 – Income Taxes, A Replacement of SSAP No. 10R and SSAP No. 10. It will now move forward to the NAIC’s Executive Committee and Plenary, to be considered for final adoption during the November NAIC National Meeting.

DTAs represent the effect of timing differences between an insurer’s statutory and tax accounting values that will reverse and create lower statutory tax expense for the insurer in the future. During the Statutory Accounting Principles (SAP) Codification Project in the late 1990s, an initial determination was that SAP should continue to nonadmit DTAs consistent with traditional SAP practices, reflecting regulators’ concerns that DTAs were not liquid or otherwise readily available to fulfill policyholder obligations. However, in an effort to keep other changes brought about by Codification “surplus neutral” to the industry overall, the NAIC’s Codification Working Group agreed to permit DTAs as assets – but limited the amount that could be reported as an admitted asset to the amount that would reverse within one year from the balance sheet date and 10% of the insurer’s surplus.

As a result of the economic downturn and credit crisis in late 2008, the DTA issue was resurrected by industry trade groups requesting that the NAIC approve a number of changes to provide surplus relief, including an increase in the level of DTAs that could be admitted. Although the proposal did not pass at that time, some states, nonetheless, approved DTA increases as a permitted practice for some of their domestic insurers on a case-by-case basis. That was an ominous outcome, given that one of the primary reasons behind the codification effort was to put an end to the proliferation of permitted practices. The NAIC, therefore, further studied the DTA issue in 2009 and ultimately adopted SSAP No. 10R – Revised Income Taxes—A Temporary Replacement of SSAP No. 10. The result was an increase in the amount of admissible DTAs, from the prior 1-year realization test and 10% of surplus limitation to a more generous 3-year /15% rule if specific criteria were met. SSAP 10R was initially intended to be effective only for 2009 annual financial statements and 2010 interim and annual financial statements, but was ultimately extended through 2011, which provided the NAIC Statutory Accounting Principles Working Group more time to study the issue before the expiration of the sunset provision.

The impact of the increased admissibility of DTAs provided has been dramatic. From year end 2007 to year end 2010, admitted DTAs increased more than 80% industry-wide to more than $64 billion, representing nearly 7% of industry-wide surplus as of December 31, 2010. The following chart shows the percentage of insurers’ surplus, by segment and in total, that DTAs represent:

Admitted Deferred Tax Assets to Surplus Ratio
(click on chart for larger image)

SSAP 101 provides that adjusted DTAs can be admitted based upon a three-component admission calculation equal to the sum of the following:

1. Federal income taxes paid in prior years that can be recovered through loss carrybacks for existing temporary differences that reverse during a timeframe corresponding with IRS tax loss carryback provisions, not to exceed three years, including any amounts established in accordance with the provision of SSAP No. 5R “Liabilities, Contingencies and Impairments of Assets” related to those periods as follows:
   1. The term “probable” as used in SSAP No. 5R shall be replaced by the term “more likely than not (a likelihood of more than 50 percent)” for federal and foreign income tax loss contingencies only.
   2. For purposes of the determination of a federal and foreign income tax loss contingency, it shall be presumed that the reporting entity will be examined by the relevant taxing authority that has full knowledge of all relevant information.
   3. If the estimated tax loss contingency is greater than 50% of the tax benefit originally recognized, the tax loss contingency recorded shall be equal to 100% of the original tax benefit recognized.
2. The major change SSAP 101 makes from SSAP 10R is an additional test which determines admissibility based on a company’s Authorized Control Level Risk Based Capital (ACL RBC). Insurers will be required to compute their December 31 ACL RBC based on ACL RBC as filed with their respective state of domicile and computed without net deferred tax assets (“ExDTA ACL RBC”). The threshold limitations are contingent upon the ExDTA ACL RBC as follows:
   
   

Realization Threshold Limitation Table - RBC Reporting Entities

ExDTA ACL RBC (%)	11.b.i[1]	11.b.ii.[2]
Greater than 300%	3 years	15%
200% to 300%	1 year	10%
Less than 200%	0 years	0%

3. An additional amount of adjusted gross DTAs can be admitted after the application of the two preceding paragraphs, to the extent that they can be offset against existing gross deferred tax liabilities (DTLs). The reporting entity is required to consider the character (i.e., ordinary versus capital) of the DTAs and DTLs such that offsetting would be permitted in the tax return under existing tax law.

In reaching its decision on the issue of DTAs the Statutory Accounting Principles Working Group held seven conference calls/meetings in 2011 alone, during which both the regulators and interested parties were able to explain their views, ask and answer each other’s questions, introduce proposed changes, and reach a better understanding of the issues and complexities of statutory income tax accounting. As a result, SSAP 101 represents a compromise between regulators and industry and other interested parties. However, the final product, in addition to making a complex standard even more complex, creates the potential for a “vanishing asset.” As a result of the ExDTA limitations, the DTA that can be admitted will ultimately vanish as an insurer’s RBC drops closer to action levels, exactly when the insurer needs the admitted asset the most.

For more information, contact Les Schott.
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^[1]The amount of adjusted gross DTAs, after the application of SSAP 101 paragraph 11.a., expected to be realized within the applicable period (refer to the 11.b.i. column of the applicable Realization Threshold Limitation Table above) following the balance sheet date limited to the amount determined in paragraph 11.b.ii.
^[2]An amount that is no greater than the applicable percentage (refer to the 11.b.ii column of the Realization Threshold Table above) of statutory capital and surplus as required to be shown on the statutory balance sheet of the reporting entity for the current reporting period’s statement filed with the domiciliary state commissioner adjusted to exclude any net DTAs, EDP equipment and operating system software and any net positive goodwill.

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Feds Take Action to Adopt Rules Requiring Large Nonbank Financial Companies to Have “Living Wills”
by Tom Finnell

The Federal Deposit Insurance Corporation (FDIC) recently adopted a new rule requiring that certain large nonbank financial firms develop and maintain resolution plans, or “living wills,” to aid management and regulators alike should the time come when it may be necessary to take action to reduce the size of the firm or its risks in order to mitigate the likelihood of serious adverse effects on the nation’s financial stability. The new rule is to be jointly issued by the FDIC and the Federal Reserve Board (FRB; collectively, the Agencies); adoption by the FRB is currently pending. In addition, the FDIC issued a related interim final rule that applies to large banks, specifically, those insured depository institutions with over $50 billion in assets. In this article, Invotex explores the key aspects of the newly adopted rule and its potential implications specifically to insurers. It is not our intent to detail a point-by-point summary of the rule, and readers are encouraged to read the rule in its entirety.

The notion of a resolution plan is fundamentally simple – instead of waiting until an emergency arises and then trying to find a solution to the problem, anticipate the worst and plan ahead. That includes anticipating adverse stress levels, not just on the company but also on other players in the financial markets. As the recent crisis made painfully clear, when it rains, it pours, and there are fewer options each with a less favorable outcome when the chips are down.

The target of the rule is to achieve a rapid and orderly resolution, defined as “a reorganization or liquidation of the covered company (or, in the case of a covered company that is incorporated or organized in a jurisdiction other than the United States, the subsidiaries and operations of such foreign company that are domiciled in the United States) under the Bankruptcy Code that can be accomplished within a reasonable period of time and in a manner that substantially mitigates the risk that the failure of the covered company would have serious adverse effects on financial stability in the United States.”

Thus, it is reasonable that the rule would apply to those companies that are of such size, scale and interconnectedness that they could pose a risk to financial stability. In retrospect, many would say that AIG was the poster child for such a rule. But to what other insurers should the rule apply? As written, the rule applies to bank holding companies as well as to “any nonbank financial company supervised by the Board.” That would include any company – including an insurance holding company – deemed to be a systemically important financial institution (SIFI). However, and until yesterday, the Financial Stability Oversight Council (FSOC) had not acted on a rule that had been initially exposed in January that would define criteria to determine SIFIs. At its October 11, 2011 meeting, FSOC approved a second notice of proposed rulemaking (NPR) and proposed interpretive guidance on FSOC's authority to require supervision and regulation of certain nonbank financial companies.

An issue that one insurer trade group raised is that while the objective of the rule is to have a plan in place that could effectuate a rapid and orderly resolution, “the resolution system for property/casualty insurers, while orderly, is intentionally not rapid. Policyholders and other claimants do not have demand rights and are paid only over time as their claims come due.”^[1]

A related issue to insurers is that they are not subject to the U.S. Bankruptcy Code; rather, they are subject to comprehensive legislation at the state level that applies increasingly more stringent degrees of regulatory oversight and intervention as an insurer becomes financially hazardous, then in need of rehabilitation, and then, if necessary, liquidation including the triggering of state guaranty fund protection for certain personal lines. Some insurer trade groups had therefore commented that insurers should not be required to submit to the FRB and the FDIC a resolution plan inasmuch as they are subject to a state-based regulatory regime the requirements of which are not comparable to the resolution plan requirement put forth by the FDIC.

As finally adopted, the rule does not provide carte blanche exemption for insurers from the resolution plan requirement but it does raise the company size threshold and other criteria to trigger compliance. Specifically, it states that each resolution plan of a covered company shall include an executive summary describing, among other matters, the following:

“Covered company’s strategy in the event of a failure or discontinuation of a material entity, core business line or critical operation, and the actions that will be taken by the covered company to prevent or mitigate any adverse affects of such failure or discontinuation on the financial stability of the United States; provided, however, if any such material entity is subject to an insolvency regime other than the Bankruptcy Code, a covered company may exclude that entity from its strategic analysis unless that entity either has $50 billion or more in total assets or conducts a critical operation…”

Other requirements for a covered company’s resolution plan include the following:

• Key elements of its strategic plan for rapid and orderly resolution in the event of material financial distress or failure of the company
• Material changes from the company’s prior filed resolution plan
• Actions taken by the company since the last filing to improve the plan or remediate material weaknesses or impediments to effective and timely execution of the plan, as well as a description of potential material weaknesses or impediments that remain and actions proposed to address them
• A strategic analysis describing the company’s resolution plan; assumptions made; a range of possible actions that can be taken; the related funding, liquidity and capital needs for each; strategy for maintaining operations and funding; and time periods for each aspect of the plan
• A detailed description of the processes used by the company to determine the market values and marketability of the core business lines, critical operations and material asset holdings of the company; the feasibility of the company’s plans and timeframes for executing any sales, divestitures, restructurings, recapitalizations or other similar actions contemplated in the plan; and assessing the impact of such actions on the value, funding, and operations of the company, its material entities, critical operations and core business lines
• A description of how the company’s governance structure applies to resolution plan development, maintenance and implementation; who is responsible; the chain of reporting and oversight by senior management and the board; and the relevant risk measures used by the covered company to report credit risk exposures both internally to its senior management and to its board as well as those risk measures reported externally to investors or to the covered company’s appropriate Federal regulator
• A description of the covered company’s organizational structure – material entities; direct holder and percentage voting shares of each; location and legal domicile; licensing; key management by material legal entity and foreign office; a mapping of critical operations and core business lines to material entities; processes used to determine to whom the company has pledged collateral, who holds it and where it is located; material off-balance sheet exposures; trading and derivatives activities; hedge activities and mapping to legal entities; process to establish exposure limits; major counterparties and impact if they defaulted; and trading payment, clearing or settlement systems used
• An unconsolidated balance sheet for the covered company and a consolidating schedule for all material entities that are subject to consolidation
• A description of company’s information systems and its capabilities to collect, maintain, and report information and other data underlying the resolution plan to the Board in a timely manner, including any weaknesses, deficiencies or gaps and the actions being taken or proposed to address them; and identification of the scope, content and frequency of the key internal reports used to monitor financial health, risks and operations
• A description of the “interconnections and interdependencies among the covered company and its material entities and affiliates, and among the critical components and core business lines of the covered company that, if disrupted, would materially affect the funding or operations of the covered company, its material entities, or its critical operations or core business lines”

A company’s initial resolution plan would be filed with the FRB and the FDIC in accordance with a staggered deadline schedule. Covered companies with $250 billion or more in total nonbank assets (total U.S. nonbank assets for foreign-based covered companies) would have to file by July 1, 2012; covered companies from $100 to $250 billion in assets by July 1, 2013; and those under $100 billion in assets by December 31, 2013. The Agencies have the authority to require a covered company to file earlier than these staggered dates as determined on a case by case basis. Each covered company would have to submit an updated resolution plan annually thereafter on or before the anniversary date of its initial submission date.

The “teeth” in the rule come into play upon review of a company’s resolution plan by the agencies. If the plan is found to lack credibility or would not facilitate an orderly resolution, the company would have the opportunity to correct those deficiencies and resubmit the plan. The time to cure such deficiencies can be extended by the Agencies, but at the end of the day the Agencies may subject a covered company or any of its subsidiaries to more stringent capital, leverage or liquidity requirements, or restrictions on growth. If such restrictions are in place for two years and the company has not submitted a resolution plan that rectifies the deficiencies, then the Agencies can order the covered company to divest such assets or operations as the Agencies jointly determine necessary to facilitate an orderly resolution of the covered company in the event it was to fail. That said, the Preamble to the rule indicates that the Agencies have no expectation that the initial plans to be filed will be found deficient, rather that they “will provide the foundation for developing more robust annual resolution plans” over the ensuing few years.

The rule provides that, prior to issuing any notice of deficiencies or imposing requirements or restrictions on a functionally regulated subsidiary of a covered company, that the FRB “shall consult with each [FSOC] member that primarily supervises any such subsidiary and may consult with any other Federal, state, or foreign supervisor as the [FRB] considers appropriate.” There are three FSOC members with insurance backgrounds, one of whom – Roy Woodall – is an independent voting member with insurance expertise that was appointed by President Obama and confirmed by the Senate for a six-year term. The other two individuals are non-voting members: John Huff, Director, Missouri Department of Insurance, Financial Institutions and Professional Registration; and Michael McRaith, Director, Federal Insurance Office, Department of the Treasury. Of those, only Mr. Huff is currently a functional regulator, but from the standpoint of financial regulation he likely would not be considered the “primary supervisor” of insurers that are domiciled in states other than Missouri.

In order to make their evaluation of a covered company’s resolution plan, the company must provide the Agencies with information and access to personnel to assess the credibility of the resolution plan and the ability of the covered company to implement the resolution plan. The Agencies “will rely to the fullest extent possible on examinations conducted by or on behalf of the appropriate Federal banking agency for the relevant company.” Of possible interest to insurers is that this excerpted phrase from the rule makes no reference to examinations performed by state insurance regulatory agencies.

Until the SIFI criteria rules are adopted, one can only speculate as to which insurer holding company groups will ultimately be subject to the new resolution plan requirements. We’ll keep our readers posted on further developments.

For more information, contact Tom Finnell.
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^[1]Letter dated June 10, 2011 by Stephen W. Broadie of the Property Casualty Insurers Association of America to Jennifer J. Johnson, Secretary, Board of Governors of the FRB, and to Robert E. Feldman, Executive Secretary, FDIC.

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Managing Director Tom Finnell Named by U.S. Treasury to Dispute Settlement Panel

Invotex Managing Director Tom Finnell’s appointment by the U.S. Department of the Treasury to the North American Free Trade Agreement (NAFTA) Financial Services Roster was approved at the NAFTA Free Trade Commission’s meeting in Mexico City earlier this year. NAFTA provides for expeditious and effective panel procedures to resolve disputes between the governments concerned when other means don’t work out. Special rules pertain to the resolution of disputes involving financial services, including that panelists be chosen from a special roster of experts in the field of financial services. Mr. Finnell will serve a three-year term as one of five U.S. members of the NAFTA Financial Services Roster.

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Upcoming Speaking Engagements

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