D e b e v o i s e & P l i m p t o n F i n a n c i a l I n s t i t u t i o n s R e p o r t
November 2010 Volume 4 Number 10
Regulation of Securities Lending What’s InsIde by U.S. Insurers The “Own Risk and 2 Solvency Assessment” by John Dembeck and its Potential Implications for Securities lending has long been an enacted laws, promulgated regulations or U.S. Insurers important component of insurance company issued published regulatory guidance on investment strategies. The New York securities lending activities by U.S. insurers. Insurance Department (the “Department”) Most of these jurisdictions (20) have enacted 4 The New York Court recently issued guidance on “prudent laws based on or similar to the provisions of Appeals Considers practices” for all authorized insurers that of the Investments of Insurer Model Act Stranger-Originated engage in securities lending. In addition, (Defined Limits Version) (the “Model Act”) Life Insurance securities lending by U.S. insurers has been first adopted by the National Association of subject to recent changes in statutory Insurance Commissioners (“NAIC”) in 1996. that are fully guaranteed as to principal and financial statement disclosure and related A few states (3) have provisions that are not interest by, the government of the U.S. or statutory accounting rules. Given all of this necessarily based on the Model Act, and two any agency of the U.S., or by the Federal recent activity relating to the regulatory states, California and New York, have issued National Mortgage Association or the framework for securities lending transactions guidance by Bulletin (1982) and Circular Federal Home Loan Mortgage Corporation, entered into by U.S. insurers, and our work Letter (2010), respectively. and as to lending foreign securities, in the securities lending industry, this seems The Model Act sovereign debt rated NAIC 1. like a good time to review the new New York “prudent practices” guidance on securities The Model Act, if enacted in a state, regulate s Securities Lending Program Size. lending as well as other existing state securities lending by insurers domiciled in An insurer may not enter into a securities insurance laws, statutory financial statement that state in the following manner: lending transaction if, as a result of and disclosure and related statutory accounting Authorization. The insurer’s board must after giving effect to the transaction, the practices and insurer risk-based capital rules adopt a written plan that specifies securities aggregate amount of all securities then as they relate to securities lending by U.S. lending guidelines and objectives, including: loaned, sold to or purchased from all insurers. Of course, because a securities (i) a description of how cash received will business entity counterparties under lending program is a component of an be invested or used for general corporate permitted securities lending, repurchase, insurance company’s broader investment purposes; (ii) operational procedures to reserve repurchase or dollar roll transactions program, the regulatory guidance described manage interest rate risk, counterparty combined would exceed 40% of the insurer’s in this article should be viewed in the context default risk and the use of “acceptable admitted assets. of, and subject to, the prudence of the collateral” in a manner that reflects the Borrower Concentration and overall investment program. liquidity needs of the transaction; and (iii) the Creditworthiness. An insurer may not extent to which the insurer may engage in Laws, Regulations and Bulletins enter into a securities lending transaction securities lending transactions. For securities if, as a result of and after giving effect to General Survey lending transactions, “acceptable collateral” the transaction, the aggregate amount of Only one-half of the states in the U.S., and means cash, cash equivalents, letters of securities then loaned, sold to or purchased the Commonwealth of Puerto Rico, have credit, direct obligations of, or securities from any one business entity counterparty
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New York l Washington, D.C. l London l Paris l Frankfurt l Moscow l Hong Kong l Shanghai The “Own Risk and Solvency Assessment” and its Potential Implications for U.S. Insurers
by Michael K. McDonnell and Sean P. Neenan
As part of its ongoing “solvency modernization initiative,” the National it will create a regulatory mandate for the enterprise risk management Association of Insurance Commissioners is considering the adoption techniques and processes that have become increasingly important of a new regulatory reporting requirement inspired by the Own Risk within insurance organizations in recent years . and Solvency Assessment, or ORSA, that is part of the Solvency II The International Association of Insurance Supervisors (“IAIS”), which Framework currently being implemented by the European Union. As is a multinational non-governmental organization that represents the envisioned by Solvency II, the ORSA is a self assessment by insurance principal insurance regulators of some 190 jurisdictions across the company groups, undertaken annually, to analyze the group’s financial world, recently endorsed the ORSA, and enterprise risk management strength in the face of the risks that the group encounters in its more generally, as part of a set of “core principles” promulgated business. Among other things, the ORSA will require that a group to communicate best practices to insurance regulators around the review and report on changes in its risk profile and assess whether world. In particular, according to the IAIS, a “core principle” of regulatory capital requirements can be met on a continual basis. The effective insurance regulation is the establishment by a supervisory ORSA is intended to shed light on the quality and scope of internal regime of “enterprise risk management requirements for solvency risk management and reporting procedures within insurance company purposes that require insurers to address all relevant and material groups. In a sense, if an ORSA-style requirement is adopted in the U.S., risks.” In the view of the IAIS, a key component of these requirements
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FINANCIAL INSTITUTIONS PARTNERS AND COUNSEL
The Debevoise & Plimpton Wolcott B. Dunham, Jr. E. Raman Bet-Mansour - Paris Dmitri V. Nikiforov - Moscow Darius Tencza Financial Institutions Report Editor-in-Chief Paul S. Bird Steven Ostner My Chi To is a publication of Michael W. Blair Andrew M. Ostrognai - Hong Kong John Dembeck Litigation Craig A. Bowman Alan H. Paley Debevoise & Plimpton LLP Frederick T. Davis - Paris David A. Luigs Thomas M. Britt III - Hong Kong Nicholas F. Potter Donald Francis Donovan 919 Third Avenue Managing Editors Séverine Canarelli - Paris Robert F. Quaintance, Jr. Martin Frederic Evans New York, New York 10022 Marc Castagnède - Paris William D. Regner Michael K. McDonnell Mark W. Friedman +1 212 909 6000 Pierre Clermontel - Paris Paul M. Rodel Deputy Managing Editor Lord Goldsmith QC - London John Dembeck Jeffrey E. Ross www.debevoise.com Mark P. Goodman Wolcott B. Dunham, Jr. Michael D. Devins Thomas Schürrle - Frankfurt Robert D. Goodman Washington, D.C. Michael K. McDonnell Wolcott B. Dunham, Jr. James C. Scoville - London Donald W. Hawthorne +1 202 383 8000 Issue Editors Edward Drew Dutton - Hong Kong Keith J. Slattery Mary Beth Hogan Sarah A.W. Fitts Steven J. Slutzky London The articles appearing in this John S. Kiernan Gregory V. Gooding Andrew L. Sommer +44 20 7786 9000 publication provide summary Gary W. Kubek Christopher Henley - London John M. Vasily information only and are not Carl Micarelli Paris Stephen R. Hertz Peter Wand - Frankfurt intended as legal advice. Readers John B. Missing - Washington, D.C. +33 1 40 73 12 12 should seek specific legal advice Jeremy G. Hill - London Employee Compensation & Benefits Joseph P. Moodhe Frankfurt before taking any action with Matthew E. Kaplan Lawrence K. Cagney Michael B. Mukasey +49 69 2097 5000 respect to the matters discussed Alan Kartashkin - Moscow Jonathan F. Lewis David W. Rivkin herein. Any discussion of U.S. Thomas M. Kelly Elizabeth Pagel Serebransky Moscow Edwin G. Schallert Federal tax law contained in these James A. Kiernan III - London Charles E. Wachsstock Lorna G. Schofield +7 495 956 3858 articles was not intended or Satish M. Kini - Washington, D.C. Investments and Workouts Colby A. Smith - Washington, D.C. Hong Kong written to be used, and it cannot Antoine Kirry - Paris Steven M. Alden Mary Jo White +852 2160 9800 be used by any taxpayer, for the Patrick Laporte - Paris Bruce E. Yannett purpose of avoiding penalties that Paul L. Lee Katherine Ashton - London Shanghai may be imposed on the taxpayer Linda Lerner William B. Beekman Tax +86 21 5047 1800 under U.S. Federal tax law. Guy Lewin-Smith - London Hans Bertram-Nothnagel - Frankfurt Pierre-Pascal Bruneau - Paris Li Li - Shanghai Colin Bogie - London Peter A. Furci All contents © 2010 Debevoise & All lawyers based in New York, Byungkwon Lim Alan J. Davies - London Friedrich E.F. Hey - Frankfurt Plimpton LLP. All rights reserved. except where noted. Peter J. Loughran Robert J. Gibbons Seth L. Rosen Corporate and Capital Markets David A. Luigs - Washington, D.C. Steven R. Gross Hugh Rowland, Jr. Marwan Al-Turki - London Gregory J. Lyons Richard F. Hahn Peter F.G. Schuur Kenneth J. Berman - Washington, D.C. Peter Hockless - London Marcia L. MacHarg - Frankfurt Richard Ward - London George E.B. Maguire Ivan E. Mattei
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( CONTINUED FROM PREVIOUS PAGE ) is the ORSA, defined by the IAIS as “an what should be included in an ORSA, triggered an action based on their risk assessment the insurer makes about the breaking the possible components into based capital level or control level and adequacy of the insurer’s risk management two categories, “Risk Management” and how that is considered in the group’s and current and likely future solvency “Solvency Assessment.” Set out below risk management. position ... encompass[ing] all reasonably are some of the significant potential Possible “Solvency Assessment” foreseeable and relevant material risks.” components of an ORSA requirement that Component of a U.S. ORSA the NAIC has highlighted for consideration. The endorsement by the IAIS of the ORSA • A discussion of the insurance group’s provides impetus to the NAIC as it seeks, Possible “Qualitative Risk view of the short- and long-term through its solvency modernization initiative, Management” Components of significant risks and the amount of funds to ensure the continued effectiveness of a U.S. ORSA necessary to cover them. the U.S. system of insurance regulation. • Description by the insurance group of Regulatory deliberations over a potential • A discussion of the insurance group’s risk management and the process used ORSA requirement in the U.S. featured view as to whether its risk-based capital to assess, monitor and communicate risk. prominently at the recent fall national is too low. • Identification by the insurance group of meeting of the NAIC, and it appears • A prospective solvency assessment by significant risks faced by the group and a likely that the NAIC will adopt an ORSA the insurance group to attest to the discussion of its risk appetite, tolerances requirement or a very similar concept in ability to maintain a going concern. and limits. the coming years. Among other things, U.S. • Disclosure by the insurance group of its insurance regulators seem keen to pursue • Identification by the insurance group of target capital level. an ORSA requirement because it is likely emerging risks and new actions that will that the ORSA would focus on insurance impact the group’s risk profile. • An explanation of the internal models groups as a whole, and would not limit itself • Identification by the insurance group of used by the insurance group, including to an analysis of individual regulated legal recent changes to the group’s risk profile. the extent of reliance on outside models. entities within a group. The absence in the • Description by the insurance group In addition to the very basic question U.S. of adequate tools to monitor group- of risk-mitigation measures, such as: of what should be analyzed through wide risks has been noted as a regulatory reinsurance, securitization and pooling. an ORSA, the discussion paper raised shortcoming during the recent financial additional questions about how often the • Description by the insurance group of crisis. For example, in its recent Financial insurer would be required to perform the contingency plans that the group would Sector Assessment Program (FSAP) Report assessment, how forward-looking expect to take under certain relating to the U.S. system of insurance information provided by insurers would be circumstances. regulation, the International Monetary Fund kept confidential, whether an ORSA would urged U.S. insurance regulators to improve Possible “Quantitative Risk be performed on an entity-specific or their ability to analyze financial strength on Management” Components of group-wide basis (potentially including a group-wide basis . a U.S. ORSA non-insurance entities) and how the As the ORSA concept is in the early stages • Quantification and assessment by the requirements would be adjusted based on of development in the U.S., it still is not insurance group of each significant risk the size of an insurer, if at all. To help answer entirely clear what an ORSA would require and the assumptions used for such these questions, the NAIC is engaged in insurers to monitor and report (or even assessment (and related explanation). a detailed analysis of similar requirements in other jurisdictions. In addition to whether the U.S. version will be referred • Description and results of forward- summarizing the ORSA requirement to as an “ORSA” or will take some other looking stress and scenario testing. name). The NAIC released a discussion included within the Solvency II framework, paper in August, which put forward such • Description of any trends observed. the discussion paper considers similar questions to insurers and regulators alike. • Identification by the insurance group of enterprise risk management requirements In the discussion paper, the NAIC queried any insurers in the group that have in Bermuda, Canada and Switzerland .
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Debevoise & Plimpton Financial Institutions Report | November 2010 | page 3 Own Risk and Solvency Assessment
( CONTINUED FROM PREVIOUS PAGE ) The NAIC has received a large volume of remedial actions by regulators? If an sensitive data embedded in an ORSA will comments in response to its discussion ORSA reveals that an insurance group remain confidential. In any event, although paper. The insurance industry’s comments, has particularly strong risk management the details are not yet clear at this early on the whole, reflect a skeptical view. practices, will that group be the subject stage, the development of an ORSA Among other things, there is a concern that of a lesser degree of scrutiny during requirement in the U.S. bears close an ORSA requirement, while imposing new periodic regulatory examinations? When a attention by industry participants and other and expensive administrative burdens on U.S. insurer is owned by a non-U.S. parent, interested parties. < insurance groups, may duplicate extensive what is the insurance group to be regulatory reporting and examination reviewed? If companies were to be Michael K. McDonnell and Sean P. Neenan are requirements that have long been in place compared, how would groups that only associates in Debevoise & Plimpton LLP’s New in the U.S. Others are understandably keen report on a statutory accounting principles York office . to flesh out the details of the requirement basis be compared with those that report and its implications. Many important on a GAAP basis? In addition, if an ORSA [email protected] questions remain. For example, will the requirement comes into being, care will be [email protected] results of an ORSA form the basis for needed to ensure that competitively
The New York Court of Appeals Considers Stranger-Originated Life Insurance by Michael K. McDonnell and Donald H. Guthrie
In New York, Section 3205(b) of the New York disablement or injury of the insured.” The A difficult question arises under Sections Insurance Law codifies the ancient doctrine New York Insurance Law, therefore, reflects a 3205(a) and (b) when a person purchases life of “insurable interest” in the law of life longstanding policy, inherent in the common insurance on his or her own life in order to insurance, providing that “no person shall law, in opposition to wagers on human life. participate in a stranger-originated life procure or cause to be procured, directly or insurance scheme, sometimes referred to as In contrast, Section 3205(a) of the New York by assignment or otherwise any contract of a “STOLI” transaction. In such a transaction, Insurance Law provides that “any person of insurance upon the person of another unless an individual might purchase a life insurance lawful age may on his own initiative procure the benefits under such contract are payable policy, naming him- or herself as the insured, or effect a contract of insurance upon his to the person insured or his personal and then immediately sell the policy, for a own person for the benefit of any person, representatives, or to a person having, at the lump sum, to investors. The investors pay the firm, association or corporation. Nothing time when such contract is made, an premium on the policy for the life of the herein shall be deemed to prohibit the insurable interest in the person insured.” insured and, when the insured dies, the immediate transfer or assignment of a According to the New York Insurance Law, an investors collect the policy benefits. contract so procured or effectuated.” In “insurable interest” is either (1) “in the case other words, although a purchaser of life In a recent decision that has been of great of persons closely related by blood or by law, insurance may be prohibited from interest to industry participants and other a substantial interest engendered by love purchasing coverage on the lives of interested parties, the New York Court of and affection;” or (2) “in the case of other unrelated individuals in whom the Appeals ruled that Sections 3205(a) and (b) persons, a lawful and substantial economic purchaser has no insurable interest, that do not prohibit STOLI transactions of this interest in the continued life, health or bodily purchaser has an unrestricted right to type. 1 Specifically, the court held that “New safety of the person insured, as distinguished purchase life insurance on his or her own York law permits a person to procure an from an interest which would arise only by, or life, and in doing so may name any other insurance policy on his or her own life and would be enhanced in value by, the death, person as the beneficiary . immediately transfer it to one without an
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( CONTINUED FROM PREVIOUS PAGE ) insurable interest in that life, even where the court declined to reach this conclusion. arrangements. In particular, Section 7815(c) policy was obtained for just such a purpose.” Instead, on the basis of a detailed analysis of of the New York Insurance Law provides the statutory language and related legislative that “[n]o person shall directly or indirectly In this particular case, prior to his death in history, the court found that “the Legislature engage in any act, practice or arrangement 2008, the insured obtained several policies, intended to allow the immediate assignment that constitutes stranger-originated life with benefits totaling approximately $56 of a policy by an insured to one lacking an insurance.” The term “stranger-originated million, and sold them in short order to insurable interest.” life insurance,” in turn, is broadly defined to investors. After his death, the insured’s include the type of transaction considered widow claimed the benefits on behalf of his Although this decision is clearly favorable in the court’s recent decision. < estate. The investors counterclaimed for the to those interested in pursuing STOLI benefits, and the relevant insurance transactions, its effect in New York will be companies, in turn, argued that no proceeds limited by new legislation that became Michael K. McDonnell and Donald H. Guthrie should be paid out because the policies effective earlier this year. The court noted in are associates in Debevoise & Plimpton LLP’s New were invalid from inception. According to the its decision that it was not taking these York office. court, both the insurance companies and the recent legislative changes into account, as insured’s widow urged a finding that a they did not come into effect until after [email protected] person who purchases a life insurance the completion of the transactions under [email protected] policy on his own life, with the intent of consideration. Among other things, the immediately transferring the policy to New York Insurance Law now includes 1. Kramer v. Phoenix Life Insurance Co. et al., Slip another person without an insurable strict limitations on policy transfers during Op. No. 176 (N.Y. Nov. 17 2010). 2 interest, would violate the insurable interest the first two years after issuance, and 2. New York Insurance Law § 7813. requirement codified in Section 3205(b). The an explicit prohibition against STOLI
Regulation of Securities Lending
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under permitted securities lending, additional acceptable collateral, the collateral, for so long as the securities repurchase, reverse repurchase (for which market value of which, together with the lending transaction remains outstanding, the netting provisions under a master market value of all acceptable collateral the insurer, its agent or custodian must written agreement are to be given effect) then held in connection with the maintain, as to acceptable collateral or dollar roll transactions combined would transaction, at least equals 102% of the received in a transaction, either physically exceed 5% of the insurer’s admitted assets. market value of the loaned securities. (See or through the book-entry systems of The Model Act imposes no limitations on Statutory Financial Statement Disclosure, the Federal Reserve, Depository Trust borrower creditworthiness. below, regarding collateral rules for Company, Participants Trust Company or lending certain foreign securities.) other securities depositories approved by Amount of Collateral. The insurer must the state insurance regulator: (i) possession receive acceptable collateral having a Investment of Cash Collateral. Cash of the acceptable collateral; (ii) a perfected market value as of the transaction date at collateral received in a securities lending security interest in the acceptable collateral; least equal to 102% of the market value transaction must be: (i) invested in or (iii) in the case of a jurisdiction outside of the securities loaned by the insurer in accordance with the permitted investments of the U.S., title to, or rights of a secured the transaction as of that date. If at any otherwise allowed under the Model Act creditor to, the acceptable collateral. time the market value of the acceptable and in a manner that recognizes the collateral is less than the market value of liquidity needs of the transaction; or Written Agreements. The insurer must the loaned securities, the business entity (ii) used by the insurer for its general enter into a written agreement for all counterparty must be obligated to deliver corporate purposes. For non-cash securities lending transactions. The written
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Debevoise & Plimpton Financial Institutions Report | November 2010 | page 5 Regulation of Securities Lending
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agreement must: (i) be with a business Model Act. Among the possible changes experienced significant losses in the prior entity counterparty; and (ii) require that the mentioned with respect to securities year. Losses resulted from the fact that transaction terminate no more than one lending are reducing the aggregate cash collateral was reinvested into securities year from its inception or upon the earlier limitations on these transactions, imposing whose value had significantly declined. demand of the insurer. However, the written a limit on securities lending for life insurer The Department expressed concern agreement may be with an agent acting separate accounts, limitations on collateral that, with increased volumes in securities on behalf of the insurer, if: (i) the agent is reinvestment and a liquidity requirement. lending activity, some insurers may not a “qualified business entity;” (ii) the written When the NAIC Investment of Insurers be maintaining adequate collateral and agreement requires the agent to enter Model Act Revision Working Group polled prudently managing the risks associated into separate agreements with each state insurance regulators on possible with the securities lending. The Department counterparty that are consistent with the changes to the Model Act, 100% of advised that insurers that engaged in Model Act securities lending requirements; respondents agreed that the NAIC should securities lending should be sure that and (iii) the written agreement prohibits review the 40% admitted asset aggregate they have identified all the risks and have securities lending transactions under the limit for securities lending transactions . controls in place to manage those risks. agreement with the agent or its affiliates. In addition, the Department stated that it New York Circular Letter (2010) A “qualified business entity” is defined would place more emphasis on securities as a business entity that is: (i) an issuer of Although securities lending by insurers is lending by insurers by evaluating how well obligations or preferred stock that are rated not expressly authorized under or subject they managed these risks through both NAIC 1 or 2 or an issuer of obligations, to any express limitations or restrictions the examination of insurers and special preferred stock or derivative instruments under the New York Insurance Law or requests made on insurers. that are rated the equivalent of NAIC 1 Department regulations, securities lending From 2008 to 2010, the Department closely or 2 or by a nationally recognized statistical is a permitted practice in New York as part examined insurers’ securities lending rating organization recognized by the of a prudently operated investment activities. This included the following: Securities Valuation Office of the NAIC; portfolio and has been the subject of or (ii) a primary dealer in U.S. government a number of Department opinions and 1. The Department served a request, on or securities, recognized by the Federal pronouncements since 1975. about September 22, 2008, for a special report pursuant to New York Insurance Reserve Bank of New York. In 1975, the Department first opined that Law § 308(a) on various insurers that “Admitted Assets” for Measuring Other securities lending was a permitted practice requested information on the insurer’s Investment Limitations. Securities lending by insurers subject to certain conditions. loaned securities, loan durations, cash collateral is deducted from the insurer’s Specifically, the Department determined collateral investments and security “admitted assets” as that amount is used that an agreement by a domestic insurer lending counterparties. for determining any other quantitative to loan securities to a securities broker was investment limitations under the Model Act, not per se violative of New York Insurance 2. The Department released financial such as single and aggregate limitations Law § 1411(b) (which required at the time examination reports as of December applicable to certain investment classes. that the disposition of an insurer’s property 31, 2007 for two New York domestic be under the control of the insurer’s board life insurer affiliates of the American Unlike the New York Circular Letter (2010) of directors). The Departmen t has affirmed International Group, Inc. – American discussed below, the Model Act imposes that securities lending is a permitted International Life Assurance Company no securities lending standards on: practice for domestic insurers in opinions of New York and First SunAmerica Life (i) the maturity of cash collateral investments; issued in 1988, 1989 and 2002. Insurance Company – dated January or (ii) indemnification by a securities 30, 2009. Each of these examination lending agent. In July 2008, the Department, in its Circular reports refers to the AIG U.S. securities Letter No. 16 (2008) (July 21, 2008), In 2009, the NAIC commenced a project to lending program and each mentions stated that some insurers had engaged review the investment limitations of the the large amount of losses each insurer in securities lending activity and had
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incurred related to securities lending that their securities lending program is an authorized insurer engaged in securities for 2008. prudent when viewed in the context of their lending should establish a management investment program as a whole. The or supervisory committee (the “Securities 3. As part of the Department’s “Liquidity prudent risk measures that an insurance Lending Risk Management Committee”) and Severe Mortality Inquiry” for all company imposes on its own program, as overseen by its board of directors, to licensed life insurers and accredited life well as how the program correlates with the establish guidelines setting forth criteria reinsurers, the 2009 version of the inquiry rest of its investment portfolio, would likely for evaluating the creditworthiness of a asks, among other things, whether be part of any such demonstration. securities borrower. An existing board the insurer engages in yield enhancing committee, such as an insurer’s audit activities such as securities lending. If so, Securities Lending Program Size. committee, may assume this role. the insurer must: (i) provide a detailed An authorized insurer should effectively overview of the activities; (ii) explain mitigate credit, market, and operational Amount of Collateral. An authorized how the insurer addresses any risk by limiting the size of its securities insurer must comply with NAIC Accounting incremental stress liquidity risk that lending program. If an insurer’s loan of Practices and Procedures Manual (the may be associated with the activities; a particular security, together with its “Accounting Manual”) Statement of (iii) disclose how much additional return outstanding loans of all other securities, Statutory Accounting Principles (“SSAP”) is generated by each of the activities in will exceed, when the loan is made, 5% No. 91R as it relates to collateral amount terms of portfolio yield; (iv) disclose of the insurer’s admitted assets as shown requirements. SSAP No. 91R requires how the activities are integrated into by its last sworn statement to the New insurers to hold cash collateral equal to the insurer’s overall risk management York Superintendent of Insurance, then 102% of the fair value of a loaned security practices; (v) identify the specific the insurer making such a loan may not for a domestic security, and 105% of the constraints on the activities; and (vi) be acting prudently. It is not clear what fair value of a loaned security for a foreign disclose what stress testing is performed the term “admitted assets” is intended security. If the fair value of the collateral by the insurer with respect to the to mean with respect to a life insurer – does not meet these standards, the insurer activities that might unwind dramatically whether the meaning in New York must require the borrower to “true-up” the faster than anticipated . Insurance Law § 107(a)(3) (which includes collateral by delivering additional collateral separate account assets) or the meaning so that the aggregate collateral levels In Circular Letter No. 2010-16 (Oct. 15, in New York Insurance Law § 1405(b)(1)(B) meet these requirements. The Accounting 2010), the Department published (which generally excludes separate Manual is updated annually each March “prudent practices” that it believes account assets). and the Department’s “prudent practices” all authorized insurers should follow in refers to SSAP No. 91R as of the March conducting a securities lending program. Borrower Concentration and 2009 Accounting Manual. Yet, SSAP No. The Department stated that it had Creditworthiness. An authorized insurer 91R has already been amended effective modeled these prudent practices on should include securities loans made to for statutory financial statements for 2010. pre-existing industry practices that it any single borrower, together with the Nevertheless, compliance with these considers prudent in light of the economic borrower’s subsidiaries and affiliates, amended securities lending collateral events following the U.S. financial crisis against the 10% of admitted assets single requirements for statutory financial of 2008. The Department requested that institution investment limitation set forth statements for 2010 is likely expected by any authorized insurer whose securities in New York Insurance Law § 1409(a). The the Department. lending practices materially deviate from term “admitted assets” as used in New the “prudent practices” set out by the York Insurance Law § 1409(a) has the Investment of Cash Collateral. If an Department and described below should meaning set forth in New York Insurance authorized insurer receives cash collateral communicate those material deviations to Law § 107(a)(3) (which means, in the case of in exchange for a loaned security and the Department . Insurers with such a life insurer, all admitted assets, including invests the cash collateral, then the deviations likely will need to demonstrate its separate account assets). In addition, insurer should mitigate against market
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Debevoise & Plimpton Financial Institutions Report | November 2010 | page 7 Regulation of Securities Lending
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risk by having its Securities Lending Risk authorized insurer invest cash collateral liquidation proceeds of any investments Management Committee establish in: (i) securities designated as NAIC 1; and collateral are insufficient to purchase guidelines for the investment of the (ii) commercial paper rated A1/P1; or a security of the same issuer, issue, class cash collateral. These guidelines should (iii) the following asset classes as classified and quantity as the loaned security, the set forth prudent investment practices by the Securities Valuation Office of the agent will credit the insurer’s account in designed to reduce the likelihood of the NAIC: (x) class 1 mutual fund investments; an amount equal to the fair value of the insurer incurring losses when returning the (y) direct or full faith obligations of the U.S.; unreturned loaned security minus the cash collateral and include the following and (z) bond mutual funds. liquidation proceeds of any investments limits and requirements: limitations on the made with the cash collateral. In other Cash Flow Consideration. An authorized types of investments made, investment words, according to the Department, the insurer should aggregate its investment of diversification requirements and agent should indemnify the insurer to the cash collateral with all of its other investment investment credit quality limitations . extent that the liquidation proceeds of activities, i.e., consider investments of cash invested collateral fail to cover the cost Types of Investments. The Department collateral in determining the timing and of acquiring a security equivalent to the considers it prudent for an authorized amount of projected cash flows for any loaned security when the loaned security insurer to limit its investments of cash financial analyses . is not returned by the borrower. We note collateral received in securities lending Maturity of Cash Collateral Investments. that this requirement is significantly at odds transactions to the following: (i) obligations An authorized insurer should assure that with standard practice in the industry and issued, assumed, guaranteed or insured by the “maturity date” of an investment made believe that the risk profile of securities the U.S. or by any agency or instrumentality with cash collateral closely matches the lending programs would be adversely thereof, by any state of the U.S. and by date that the cash collateral must be affected if securities lending agents, with any territory or possession of the U.S. or returned to the borrower in exchange for their dedicated systems and processes any other governmental entity in the U.S.; the loaned securities as any mismatch may to mitigate risk, were not allowed to (ii) corporate debt securities; (iii) loan-backe d adversely affect an insurer’s balance sheet participate in such programs. and structured securities; (iv) commercial and negatively impact its surplus. In order paper; and (v) money market funds. In Written Agreements. All securities to mitigate the risk associated with a addition, an authorized insurer may use cash lending by an authorized insurer should mismatch, an authorized insurer should collateral to enter into reverse repurchase be memorialized in a written agreement limit the mismatch to no more than one agreements, subject to the following between the lender-insurer and the year in the aggregate. For this purpose, investment diversification requirements . borrower. If an authorized insurer authorizes “maturity date” means the earlier of the an agent to execute securities loans on Investment Diversification. The date on the face of the instrument on which its behalf, then the agreement with the Department considers it prudent that, the principal amount must be paid or, for borrower should be signed by the agent in connection with securities lending an instrument with an unconditional put on behalf of the lender-insurer. transactions, an authorized insurer not: or unconditional demand feature, the (i) invest more than 40% of cash collateral date on which the principal amount of the Other States in corporate debt securities, loan-backed instrument can be recovered by demand. Some key differences in the securities or structured securities; or (ii) enter into a For asset-backed securities, the maturity lending rules in the other non-Model Act reverse repurchase agreement in which the date is the expected maturity date. states are the following: authorized insurer agrees to pledge more Indemnification. Where an authorized than 25% of its available cash collateral to California. Under the California securities insurer appoints an agent to execute a single counterparty. lending rules, (i) the borrower in a securities securities loans on its behalf, the insurer lending transaction must be a registered Investment Quality. The Department should require in the securities loan securities broker, bank or trust company; considers it prudent that, in connection agreement that, in the event a borrower (ii) securities loans outstanding to any with securities lending transactions, an fails to return a loaned security and the single borrower may not, at any time,
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( CONTINUED FROM PREVIOUS PAGE ) exceed the greater of (w) 2% of the insurer’s amount of securities “loaned to others.” follows (new 2010 requirements are noted): admitted assets, or (x) 10% of the insurer’s This was in addition to disclosure of other 1. The reporting insurer must describe its surplus; and (iii) the amount of outstanding securities that were not under the exclusive policy for requiring collateral or other loans of securities to all borrowers may not, control of the insurer, such as those security for securities lending transaction s at any time, exceed in the aggregate the subject to repurchase agreements, reverse as required in SSAP No. 91R (new for 2010) . lesser of (y) 5% of the insurer's admitted repurchase agreements and those pledged assets, or (z) 50% of the insurer's surplus. as collateral. Interrogatory disclosure of 2. If the reporting insurer or its agent has securities lending programs was enhanced accepted collateral that it is permitted by Nebraska. The amount of loaned securities with the statutory financial statement contract or custom to sell or repledge, it may not exceed 10% of the insurer’s for 2008. The reporting insurer must now must be recorded on the reporting admitted assets. disclose the following (2009 Interrogatories insurer’s balance sheet (balance sheet New Hampshire. Total securities 22.3-22.6): (i) describe any securities recording is new for 2010 – see lending, repurchase agreement or reverse lending program for the reporting insurer, discussion below). repurchase agreement transactions including the value for collateral and the 3. The following information must be outstanding with any one entity may not amount of loaned securities and whether provided for the reporting insurer’s exceed 10% of the insurer’s admitted collateral is carried on or off balance sheet; securities lending program: (i) the assets. In addition, total securities lending and (ii) indicate whether the reporting aggregate amount of contractually or repurchase or reverse repurchase insurer’s securities lending program obligated open collateral positions agreement transactions with all entities meets the requirements for a “conforming (aggregate amount of securities at may not to exceed 40% of the insurer’s program” under the NAIC risk-based current fair value or cash received for admitted assets . capital instructions (discussed below under which the borrower may request the Virginia. Virginia includes no single “Risk-Based Capital”). Whether or not return of on demand) and the aggregate institution or aggregate limit on securities the securities lending program meets the amount of contractually obligated lending . requirements for a “conforming program,” collateral positions under 30-day, 60-day, the aggregate amount of collateral must 90-day, and greater than 90-day terms; Statutory Financial be reported . (ii) the aggregate fair value of all securitie s Statement Disclosure Footnote Disclosure. For statutory acquired from the sale, trade or use As a result of the attention given securities financial statements for 2009 and prior, of the accepted collateral (reinvested lending by the AIG life insurers discussed each U.S. insurer had to disclose the collateral); and (iii) information about above, the NAIC has enhanced statutory following in respect of its securities the sources and uses of that collateral. financial statement disclosure of securities lending program in Footnote 17(B)(2): 4. The following information must be lending program activities together with (i) a description of any loaned securities, provided with respect to the reinvestment related statutory accounting practices. including the fair value, a description of the cash collateral and any securities Disclosure of securities lending programs of, and the reporting insurer’s policy for, which the reporting insurer or its agent in the statutory financial statement required collateral; (ii) whether or not the receives as collateral that can be sold or interrogatories was enhanced for statutory collateral is restricted ( e.g., cannot be repledged: (i) the aggregate amount of financial statements for 2008 and later and sold or repledged); and (iii) the amount the reinvested cash collateral (amortized balance sheet and footnote disclosure of collateral for transactions that extend cost and fair value) – reinvested cash will be enhanced for statutory financial beyond one year from the financial collateral must be broken down by the statements for 2010 and later. statement reporting date. This general maturity date of the invested asset – Interrogatory Disclosure. For statutory requirement will continue for statutory under 30-day, 60-day, 90-day, 120-day, financial statements for 2007 and prior, financial statements for 2010. However, with 180-day, less than 1 year, 1-2 years, 2-3 U.S. insurers merely had to report in their the statutory financial statement for 2010, years and greater than 3 years; and (ii) to interrogatories, in the aggregate, the dollar Footnote 5.E disclosure will be enhanced as the extent that the maturity dates of the
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liability (collateral to be returned) does liability for securities lending collateral proceeds consisting of the collateral not match the invested assets, the received by the reporting insurer that and a forward repurchase commitment; reporting insurer must explain the can be reinvested or repledged. This and (ii) by the transferee-borrower as a additional sources of liquidity to manage reporting requirement applies whether purchase of the “borrowed” securities in those mismatches (new for 2010). the reporting insurer administers the exchange for the collateral and a forward securities lending program itself or resale commitment. During the term Balance Sheet and 5-Year Historical Data engages an affiliated or unaffiliated of the agreement, the transferor has Disclosure. Consistent with the instructions agent to do so on its behalf. surrendered control over the securities for Footnote 5.E disclosure discussed above transferred and the transferee has (e.g., collateral that the reporting insurer is 3. The Five-Year Historical Data page will obtained control over those securities. permitted by contract or custom to sell or include a new line item (Line 41 – Life and repledge must be recorded on the balance Health and Line 39 – Property/Casualty) 3. The reporting insurer must receive sheet), the following new statutory financial titled “Securities lending reinvested collateral having a fair value as of the statement reporting enhancements will be collateral assets” to better allow state transaction date at least equal to 102% implemented for statutory financial insurance regulators to review the 5-year (105% where foreign securities are loaned statements for 2010 : trend for this newly reported asset. This and the denomination of the currency new line item need only be populated of the collateral is other than the 1. A new asset Line 10 (Life and Health and prospectively and not retrospectively. denomination of the currency of the Property/Casualty) will be added to the loaned foreign securities) of the fair statutory balance sheet titled “Securities The following other existing financial value of the loaned securities at that Lending Reinvested Collateral Assets.” statement reporting and accounting date. If at any time the fair value of the The amounts to be included in this new practices for securities lending remain collateral received from the counterparty asset line item will include reinvested unchanged: is less than 100% (102% for such foreign collateral assets from a securities 1. If the securities lending transaction is securities) of the fair value of the loaned lending program where the program is accompanied by an agreement that securities, the counterparty must be administered by the reporting insurer’s entitles and obligates the transferor- obligated to deliver additional collateral unaffiliated agent. If a reporting insurer insurer to repurchase or redeem the by the end of the next business day, administers its own securities lending transferred assets before their maturity the fair value of which, together with program with no agent, affiliated or under which the transferor-insurer the fair value of all collateral then unaffiliated, and the collateral it receives maintains effective control over those held in connection with the transaction, can be sold or repledged, the collateral assets, the transaction is to be accounted at least equals 102% (105% for such must be reported with the invested assets for as a secured borrowing. The cash (or foreign securities) of the fair value of of the insurer. If a reporting insurer’s securities that the holder or its agent is the loaned securities. If the collateral securities lending program is administered permitted by contract or custom to sell received from the counterparty is less by the insurer’s affiliated agent, the insurer or repledge) received as collateral is than 100% at the statutory financial may chose either of the preceding two the amount borrowed and the securities statement reporting date, the difference reporting options for collateral – “one- loaned are pledged as collateral against between the actual collateral and 100% line” reporting or reporting the collateral the cash or securities borrowed. must be nonadmitted. with the insurer’s invested assets. 2. If the transferor-insurer surrenders control 4. Collateral value is measured and 2. A new liability line (Line 24.10 – Life and over the securities “loaned” (with the compared to the loaned securities Health and Line 22 – Property/Casualty) ability to sell or transfer them at will), in the aggregate by counterparty. will be added to the statutory balance then the securities lending transaction sheet titled “Payable for Securities 5. Reinvestment of collateral by the is to be accounted for: (i) by the Lending.” The amounts to be included reporting insurer or its agent must transferor-insurer as a sale of the in this new liability line item will include follow the same impairment guidance as “loaned” securities in exchange for the
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other similar invested assets reported on lending. Safeguards to be addressed not completely track the NAIC Model Act the insurer’s balance sheet, just as any in the procedures must, at a minimum, definition described above under “Laws, other invested asset held by the insurer. provide assurance of the following: Regulations and Bulletins, The Model Act, (i) documented investment guidelines Authorization.” NAIC 1-rated securities 6. Any fees received by the transferor-insurer between the lender and the investment are included under the “conforming for loaning the securities are recorded as manager, with established procedure program” standards but not the Model miscellaneous investment income . for review of compliance; (ii) investment Act standard, and letters of credit and These new statutory financial statement guidelines for cash collateral that clearly NAIC 1-rated sovereign debt, as to reporting items, coupled with the existing delineate liquidity, diversification, credit lending foreign securities, are included reporting items, should give state insurance quality and average life/duration in the Model Act standard but not the regulators better tools to evaluate returns requirements; (iii) approved borrower “conforming program” standards.) from reinvesting collateral received under a lists and limits to allow for adequate In addition, if the reporting insurer reports securities lending program . diversification; (iv) the reporting insurer the collateral received in a securities lending holding excess collateral with the Risk-Based Capital transaction with its other invested assets, following margin percentages – 102% U.S. insurers must annually calculate and each invested asset will be assigned the (or 105% for cross-currency loans); report their required risk-based capital and applicable asset risk factor accorded it (v) daily mark-to-market of lent securities compare that against their actual capital. under the insurer risk-based capital rules . and obtaining additional collateral The insurer risk-based capital rules attach needed to maintain margin of 102% of Conclusion a risk factor to the insurer’s assets and market; and (vi) the transaction not The changes in statutory financial liabilities and generate a risk-based being subject to any automatic stay in statement reporting and the related assessment of what capital the insurer bankruptcy and its ability to be closed statutory accounting practices for securities needs to support its assets and liabilities. out and terminated immediately upon lending by insurers coupled with New York’s Under the 2009 risk-based capital formula, the bankruptcy of any party. securities lending regulatory initiative seek the risk factor for collateral received under a to provide additional guidance as to the securities lending program will differ based 3. A binding securities lending agreement components of a prudent securities on whether the insurer’s program meets the (standard “Master Securities Lending lending program, including transparency requirements for a “conforming program.” Agreement” from Securities Industry of collateral held by insurers and the The risk factor for reported collateral for a and Financial Markets Association) in related collateral reinvestment risk and conforming program is 0.002 while the risk writing between the reporting insurer, specifically with overall limits on the size of factor for reported collateral for a non- or its agent on behalf of the insurer, an insurer’s securities lending program and conforming program is 0.013 for life insurers and the borrowers . limits on the types of collateral investments. and 0.010 for property/casualty insurers . 4. Acceptable collateral – defined as cash, Insurers should incorporate the latest cash equivalents, direct obligations of, or For a securities lending program to be a regulatory guidance into their evaluation securities that are fully guaranteed as to “conforming program,” all of the following of the prudence of their securities lenders principal and interest by the government elements must be present: and overall investment programs as they of the U.S. or any agency of the U.S., 1. The reporting insurer’s board must adopt continue to seek to include securities or by the Federal National Mortgage a written plan that outlines the extent lending as an important element of their Association or the Federal Home Loan to which the insurer can engage in investment returns. < Mortgage Corporation and NAIC 1-rated securities lending activities and how securities (excluding affiliate issued cash collateral received will be invested. collateral). In all cases, the collateral held John Dembeck is counsel in Debevoise & Plimpton 2. The reporting insurer must have written must be permitted investments in the LLP’s New York office. operational procedures to monitor and state of domicile for the insurer. (This control the risk associated with securities definition of “acceptable collateral” does [email protected]
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