Four current regulatory risks facing US insurers

March 2021  |  SPECIAL REPORT: MANAGING RISK

Financier Worldwide Magazine

March 2021 Issue

This article will examine four possible evolving sources of regulatory risk affecting US insurance companies: one affecting carriers across all lines of business, one affecting life, one affecting property-casualty, and one affecting health.

All lines of insurance – group capital

Historically, insurance company surplus (the amount of capital needed to support the carrier’s risks) in the US has been regulated at the legal-entity level. A tool known as ‘risk-based capital’ (RBC), developed by the National Association of Insurance Commissioners (NAIC) in the 1990s measures each statutory insurance company’s risks and assigns a level of optimal regulatory capital to that entity based on such risks. The state regulator can enforce that level of capital with remedial measures that grow more severe as the carrier falls below successively lower multiples of the benchmark.

Affiliates and holding companies of insurers could be subject to less-quantitative regulatory scrutiny, such as oversight of individual transactions with the affiliated insurer or subjective assessments of ‘enterprise risks’. However, traditionally state insurance regulators did not have the authority to oversee capital levels at insurance company affiliates.

This is changing in light of the NAIC’s adoption, in December 2020, of a ‘group capital calculation’ (GCC) tool applicable to insurance groups. In enacting the GCC, the NAIC is in part accommodating ICS 2.0, the capital standard announced in late 2019 by the International Association of Insurance Supervisors (IAIS) for internationally active insurance groups, or IAIGs (insurance groups whose entities and operations straddle national borders). Under the GCC model provisions, US insurers will be required to report to their home state regulators on the capital adequacy of their groups, including non-insurance affiliates. This could mean less flexibility in deploying existing assets or using leverage to pursue corporate strategies. Although there are no specific regulatory remedies provided for lacking sufficient group capital (as there are for RBC deficiencies), insurance companies will have to be alert to the risks of regulatory scrutiny of transactions, leverage and capital levels even where these take place outside the statutory insurer.

Health insurers – loss of certain antitrust exemptions

Historically in the US, insurance has been governed at the state level, a system codified by a 1945 federal law known as McCarran-Ferguson. That law was motivated by a decision of the US Supreme Court in 1944 (South-Eastern Underwriters Association (SEUA)) that had held that insurance was a kind of “interstate commerce” within the meaning of the American Constitution and thus subject to federal regulation. Insurance had been regulated by the states since the 19th century, and SEUA held, in effect, that the states could be preempted by the federal government in insurance regulation going forward.

The SEUA decision was perceived by the insurance industry as a threat not only to state regulation but also to certain customary practices of insurance companies related to data sharing. It was thought that such routine sharing of historical loss data among insurers, which is used to set rates, would now be vulnerable to US antitrust laws proscribing collusion in pricing.

In response, Congress adopted McCarran-Ferguson in an effort to blunt the effect of SEUA. McCarran-Ferguson, in essence, protected such data sharing by specifying that federal law applies to insurers only in the case of “boycott, coercion or intimidation”. State, not federal, law would continue to be the primary source of insurance regulation. This would leave ordinary-course data-sharing immune from federal antitrust enforcement.

In late 2020, Congress adopted H.R. 1418, which president Trump signed just prior to leaving office in January 2021. H.R. 1418 amends McCarran-Ferguson by applying the federal antitrust laws to health insurance, including the business of dental insurance and limited-scope dental benefits. In other words, H.R. 1418 permits some application of federal antitrust law even in a case where boycott, coercion and intimidation are not present. However, under H.R. 1418, this extension of antitrust law does not apply to “making a contract, or engaging in a combination or conspiracy” to “collect, compile or disseminate historical loss data; to determine a loss development factor”, or “to perform actuarial services if such contract, combination or conspiracy does not involve a restraint of trade”. Also immune from federal antitrust law is the making of a contract, combination or conspiracy to “to develop or disseminate a standard insurance policy form… if such contract, combination, or conspiracy is not to adhere” to such form.

In other words, H.R. 1418 appears to protect much the same kind of conduct that the insurance industry was concerned about in 1944-45 and that was protected by McCarran-Ferguson in the first place. However, H.R. 1418 does suggest that some informational or analytical activities of health insurers that were once protected now might not be. Exactly where the line is to be drawn, between health insurers’ data-pooling efforts that are permissible and those that are vulnerable to collusion accusations, is a possible risk frontier for this critical sector.

Life insurers – stricter credit-quality requirements for collateral

US life insurers writing term life and universal life with secondary guaranties (ULSG) have seen reserving requirements relaxed over the last several years, but with such reforms come new risks. Historically, term and ULSG were subject to the NAIC’s Regulation XXX, a formula-driven reserving regime that resulted in significant “redundant” (overly conservative) reserves for these products and, therefore, balance sheet strain. Many life carriers during the 2000s and early 2010s addressed this redundancy problem by reinsuring these risks to captives (often offshore) and, in some cases, persuading home-state regulators to permit such reinsurance to be secured with low-grade assets.

Principle-based reserving (PBR), which was phased in over the period 1 January 2017 through 1 January 2020, was intended in part to obviate the need for such reserve financing by providing for a more subjective, discretionary approach to setting reserves, rather than Reg. XXX’s formulaic approach. In addition, in 2016, the NAIC adopted a new model regulation on reinsurance for term and ULSG (Model 787, based on Actuarial Guideline XLVIII) intended to align reinsurance collateral requirements with the new PBR regime. Because of the likely effects of PBR, Model 787 generally required less security as a practical matter; however, as to the security that it did require, the home-state regulator would no longer have the discretion to deviate from strict credit quality requirements. The so-called “primary security” requirement that applies to the basic level of economic reserves would have to be satisfied by high-grade corporate and government obligations. The risk for life carriers is that, despite the relaxation of reserving requirements brought about by PBR, financing redundant reserves could result in more stringent reserving requirements because of this primary security requirement.

Property-casualty insurers – retroactive COVID-19 coverage

Finally, property-casualty carriers in the US are facing perhaps the direst risk of the four regulatory risks outlined – the risk of legislatively imposed retroactive coverage mandates for the COVID-19 outbreak. During 2020, legislatures in approximately 10 states considered bills that would invalidate exclusions in business interruption policies for viral outbreaks. The insurance industry, as well as numerous insurance regulators including the NAIC, vocally opposed these bills, arguing that they violate basic principles of contract law and due process. They also stated that, since insurers had not underwritten for viral outbreaks, imposing losses on them retroactively could exhaust surplus and essentially bankrupt the sector.

This issue of retroactive coverage is not the same as the issue of ‘physical damage’ being litigated in courts around the country – the question of whether business losses due to the COVID-19 pandemic or government-imposed lockdowns constitute physical loss as required by business interruption commercial insurance policies. In cases concerning ‘physical damage’, the policy at issue typically lacks an exclusion for viral outbreaks. The policies targeted by the state bills, by contrast, include those that do have specific exclusions, which the bills nullify.

It is possible that state legislatures have held off on advancing these bills because of an expectation that the federal government will respond to the pandemic with a financial backstop for business interruption coverage. Such a response could be patterned on the US Terrorism Risk Insurance Act (TRIA) legislation, adopted in 2002 in the wake of the 9/11 attacks. One bill in the last Congress, called the Pandemic Risk Insurance Act, would have implemented such an arrangement, requiring future coverage for pandemics but publicly subsidising a reinsurance programme that would support such writings. As of this writing, PRIA has not been reintroduced in the new Congress that convened in January 2021. But the industry is closely watching the political response to COVID-19 and the risk that states, in the absence of a federal backstop, will take the more drastic steps of requiring coverage in in-force policies even in the face of explicit exclusions for viral outbreaks.

 

Daniel A. Rabinowitz is a partner at Kramer Levin Naftalis & Frankel LLP. He can be contacted on +1 (212) 715 9378 or by email: drabinowitz@kramerlevin.com.

© Financier Worldwide

BY

Daniel A. Rabinowitz

Kramer Levin Naftalis & Frankel LLP

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