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Article December 2015

Mergers and Acquisitions in the U.S. Sector By Edward Best, Lawrence Hamilton and Magnus Karlberg1

Introduction • a highly specialized, capital-intensive, and seasoned with high barriers to entry; and This practice note discusses recent trends in private merger and acquisition (M&A) • an industry that has developed over many transactions in the U.S. insurance sector and centuries with its own terminology and explores some central aspects of successfully particularities, which can be difficult for structuring, negotiating, and documenting an outsiders to penetrate. insurance M&A transaction. It also addresses While this article will discuss various ways in considerations that are specific to, or assume which insurance M&A transactions can be more importance in, M&A transactions in the structured, it will focus on the and insurance industry. Such considerations affect negotiation issues in a “classic” insurance M&A nearly every stage of the M&A process, transaction—namely, the acquisition by an including: acquirer from a seller of all of the common • structuring the deal; of a stock insurance . • due diligence; The Insurance • negotiating the terms of the purchase and sale agreement; and Generally speaking, insurance is a mechanism for contractually shifting the burden of a number • addressing post-closing matters. of pure risks by pooling those risks. A pure risk Although the structure and terms of insurance involves the chance of a loss or no loss (but no M&A transactions vary, the following factors chance of a gain). The purchaser of an insurance affect all insurance M&A deals: must be subject to a pure risk of • the insurance , which is based incurring an economic loss (i.e., must have an on the of potentially large and “insurable interest”). This concept is central for unpredictable liabilities and correlated determining whether the product in question is requiring prudent in fact an insurance product rather than, for strategies; example, an option or a gambling product. • state regulatory regimes, in which active There are two key aspects of an insurance regulators play a central role; company’s business model: and • an industry standard financial reporting management. An insurer’s underwriting system that is focused on a company’s business consists of issuing policies to liquidation value rather than the “going policyholders, collecting premiums on the concern” value of the company; policies and paying claims to policyholders who suffer losses covered by the policies. The

Materials reproduced with the permission of LexisNexis. www.lexisnexis.com/practice-advisor. Published on 12/03/2015 underwriting business will be profitable if the property and casualty manage insurer collects more in premiums than it pays instant and catastrophic risk through various out in claims. Simply looking at the success or risk management strategies, like spreading the failure of an insurer’s underwriting business, risk across many actors, such as reinsurers, who however, does not tell the whole story of an essentially insure the insurer, or diversifying the insurer’s profitability. The insurer’s ability to risk profile. generate investment income on the premiums Many property and casualty insurers and held by the insurer (i.e., its reinsurers are domiciled in Bermuda, thanks to business) is also of importance. For example, an its favorable regime, less onerous regulatory insurer that collects all of its premiums on rules, and growing pool of insurance experts. January 1, and returns every penny of those Bermuda-domiciled property and casualty premiums to policyholders on December 31, may insurers and reinsurers are often considered still be very profitable if it earns investment part of the U.S. market, due to Bermuda’s income on those premiums. This is why some geographic proximity to the U.S. and its ability commentators suggest that issuing insurance is to efficiently serve and support the U.S. merely a pretext for gathering assets under insurance and reinsurance market. management and that insurers are, more than anything, asset managers. Regardless of how one The Regulatory Regime views the essence of the insurance business, it is clear that both underwriting and asset With the McCarran–Ferguson Act of 1945, the management are crucial elements. This dual U.S. Congress ensured that the primary nature of the insurance business model responsibility for insurance regulation would permeates an insurer’s and remain with the states. Each state has adopted activities. its own insurance legislation and established an insurance regulatory body tasked with The insurance industry is divided into two main promulgating state-specific regulations and segments: guidelines, monitoring insurers and their • life, annuity, and health; and operations, and intervening in their operations • property and casualty when necessary. As a result, the legal framework for an insurance company will depend primarily The insurance products written in the life on where it is organized or domiciled and segment are typically of duration, with secondarily on where it is operating. State potential payment obligations lasting many insurance laws regulate insurance companies years. companies must carefully that are domiciled in that state more extensively balance asset yields with these long durations of than those merely conducting business in the liability to ensure payments can be made when state. The policy rationale for this is that insurer required. To do this, successful estimation of the stakeholders (such as policyholders, employees, length and peak of long-term liabilities is and business partners) who are located in the critical. domiciliary state are more likely to be affected Property and casualty insurers usually write by the insurer’s insolvency as well as its market insurance of considerably shorter duration. conduct and other activities. Some states Other than for certain types of casualty (California, Florida, and Texas are notable insurance, such as environmental and asbestos examples) will deem an out-of-state insurer to insurance, property and casualty insurance is be “commercially domiciled” in the state if the typically written yearly. Rather than calculating insurer meets certain thresholds for business the potential duration of the insurance liability, activity in the state (typically based on a

2 Mayer Brown | in the U.S. Insurance Sector percentage of business written in that state over for of securities. All of these tools are the course of the most recent three years). used throughout the U.S. insurance industry.

Another important aspect of the state-based The insurance industry is also subject to various system of insurance regulation is that federal federal laws with both indirect and direct bankruptcy laws generally do not apply to application, including: insurers. In the event of an insurance company’s • the Gramm–Leach–Bliley Act of 1999, which actual or threatened insolvency, the insurance impelled the states to establish a more regulator of the domiciliary state has far- uniform, reciprocal system for producer reaching powers to intervene in the insurer’s licensing; operations, including the power to seize • the National Association of Registered Agents of the insurer. Drafting and negotiating contract provisions addressing an insurance company’s and Brokers Reform Act of 2015, which provided for the establishment of a national insolvency, or proximity to insolvency, should be clearinghouse to streamline market access for viewed in that light. For example, contract provisions dealing with actions to be taken by an nonresident insurance producers; insurer may not be enforceable if the insurer is • the Dodd–Frank Wall Street Reform and deemed to have financial difficulties and the Consumer Protection Act of 2010 (Dodd– regulator has determined it is necessary to Frank), which established a federal insurance intervene. office to serve as an information resource for the U.S. Congress and the industry, and which Although the main features of the legal gave the U.S. Department of the Treasury the framework for the insurance industry are state- power to designate insurance companies as specific, there have been efforts to harmonize systemically important financial institutions, insurance laws across state borders. The most resulting in a framework for heightened prominent forum for these efforts is the National regulatory oversight (to date, such designation Association of Insurance Commissioners has been given to AIG, Prudential Financial, (NAIC). The NAIC is a standard-setting and and MetLife); and regulatory support organization created and • the Nonadmitted and Reinsurance Reform Act governed by the head insurance regulators of the of 2010 (enacted as part of Dodd–Frank), 50 states, the District of Columbia, and the five U.S. territories. The NAIC’s objective is to which streamlined access to the nonadmitted insurance market for large commercial represent the collective views of U.S. state purchasers of insurance and limited the insurance regulators. Through the NAIC, regulators establish standards and determine authority of non-domiciliary states to regulate reinsurance transactions. best practices, conduct peer review, and collaborate on regulatory oversight. The NAIC also creates model laws, which are typically Insurance System adopted into the states’ legal frameworks in Model Act and Regulation some form. The NAIC has effectively The NAIC recognized early on that there was a harmonized many state insurance laws across need to supervise the and operations the United States. This is particularly true in the of insurance companies not only in isolation but area of financial reporting, where the NAIC has also in relation to their affiliated companies. An adopted forms for insurers’ annual and quarterly insurance company that is ultimately owned by financial statements (known as statutory legal or natural persons with low statements), statutory principles, a creditworthiness or with a history of fraudulent financial examiners’ handbook, and procedures or otherwise questionable transactions may put

3 Mayer Brown | Mergers and Acquisitions in the U.S. Insurance Sector the insurer at risk. Likewise, a transaction proposed to become directors and officers of the between an insurance company and a non- target will be required as part of the Form A insurer affiliate that favors the non-insurer to filing. The regulator will sometimes request that the detriment of the insurance company may put a public hearing be held prior to approving or the insurance company and its policyholders at rejecting the Form A. In some states, public risk. To address some of these issues, NAIC hearings are mandatory. adopted in 1961 a model act and accompanying The main criterion for regulatory approval of a regulations known as the Insurance Holding Form A application is whether the proposed Company System Regulatory Act and Insurance acquisition would be consistent with the best Holding Company System Model Regulation interests of the target insurer’s policyholders. with Reporting Forms and Instructions. Some relatively new guidance (adopted March Although changes have been made to the model 2015) requires examiners who review Form A act and related regulations since 1961, the applications to consider the following: approach to group supervision has been • all aspects of the financial condition of the cemented at both the NAIC and state levels. acquiring entity, including the acquiring Thus, the model act and regulations, as adopted group’s business model, general business in a state, give the state regulator a say over strategy, and specific strategy with respect to relationships and transactions involving an the acquired insurer; insurance group that could be harmful to the • the risks of the acquiring entity and its group, insurance companies within the group. The model act and regulations are based on a filing including , market, pricing, underwriting, reserving, liquidity, operational, system wherein the insurance company discloses legal, strategic, and reputational risk and, in pending or completed business activities to the state regulator. The following filings are required particular, risks associated with the acquirer’s investment strategies; under most state insurance holding company system regimes: • whether specific additional requirements should be imposed on the acquirer as a Form A. A person who desires to acquire condition for approval, such as: (i) control of a U.S. insurer is required to file a maintaining a risk-based capital (RBC) ratio change of control statement, known as a Form A, for the target insurance company at a higher with the domiciliary regulator. “Control” is level than normally required (for a discussion presumed to be acquired when, as a result of an of RBC, see Risk-Based Capital); (ii) acquisition, a person holds, directly or indirectly, submitting RBC reports quarterly, rather than 10% or more of the voting securities of the annually; (iii) obtaining regulatory approval insurer. This presumption can be rebutted if the for dividends during a certain period of time; acquirer files a disclaimer of control explaining, (iv) establishing a capital maintenance essentially, why the acquirer should be viewed as agreement or prefunded account to a passive . The domiciliary regulator secure policy claim payment obligations; (v) must approve the Form A filing before the disclosing direct and indirect controlling transaction is allowed to be consummated. The equityholders of the acquirer; or (vi) requiring regulator will review the terms of the personal financial statements from all transaction, the appropriateness of the acquirer, controlling persons of the insurer; and and the acquirer’s (including • whether certain post-closing measures should financial projections). Biographical affidavits be imposed, such as an annual stress test of (and, in some states, fingerprints) of directors and officers of the acquirer and persons the target insurance company or targeted

4 Mayer Brown | Mergers and Acquisitions in the U.S. Insurance Sector examinations to ensure that the proposed reported to the domiciliary insurance investment strategy is followed and continues department within a stipulated period after to be sound. declaration and before payment of the dividend.

Forms B and C. All domestic insurers that are Form E. Form E filings are required in many members of a holding company system must states to allow the state insurance regulator to register with the applicable state regulator. Any determine whether an acquisition of an insurer insurer required to register must do so within 15 may have anti-competitive effects on the days after it becomes subject to registration and, insurance market in the state. In states that annually thereafter, must submit an amended require Form E filings, subject to certain registration statement for the previous calendar exemptions for acquisitions that will affect the year. The annual holding company registration market in a state only minimally, a Form E pre- statements, commonly referred to as Forms B notification filing will need to be made if any of and C, must be filed on forms provided by the the insurers involved in the transaction are relevant state regulator. licensed (not just domiciled) in the state. Regardless of whether any Form E filing is Form D. Form D filings may be applicable in required, a federal Hart–Scott–Rodino filing the M&A context, but are conceptually unrelated and waiting period may still apply to the to change of control transactions. Form D is transaction. used to disclose transactions between an insurance company and one or more of its Form F. Form F filings are a relatively new affiliates. Because insurance regulators are wary creation that principally came about as a of contractual terms that appear to favor a non- reaction to AIG’s woes during the global insurer affiliate to the detriment of an insurer financial crises. To date, thirty-six states require affiliate (e.g., an excessive investment Form F filings to be made with the domiciliary payable by the insurer to an regulator to identify systemic enterprise risk affiliated investment management arm of the within the holding company structure. The Form group), regulators want to review the terms of F procedure requires the ultimate controlling affiliate transactions before such arrangements person of the group to submit an annual are implemented. The insurer must file a Form enterprise risk report, in which the enterprise D with its domiciliary regulator and include the risks are identified. Enterprise risk is defined as proposed affiliate agreement at least 30 days “any activity, circumstance, event or series of prior to the expected execution date. If the events involving one or more affiliates of an regulator does not object to the terms of the insurer that, if not remedied properly, is likely to agreement within the 30-day period, the have a material adverse effect upon the financial agreement is deemed approved. condition or liquidity of the insurer or its insurance holding company as a whole . . . ” (see In connection with the acquisition of an Insurance Holding Company System Regulatory insurance company, it is not uncommon for the Act §1H (1st Quarter 2015)). parties to agree to distribute the target company’s surplus capital to the seller As noted above, several of these filings (and immediately prior to closing. Dividends or related approvals) may be required in distributions that exceed a specified threshold connection with an M&A insurance transaction. when added to dividends paid over a rolling 12- Note also that if an insurer is deemed to be month period (i.e., “extraordinary dividends”) commercially domiciled in a state that applies are subject to the Form D or similar non- holding company regulation to commercially disapproval filing process. Ordinary dividends domiciled insurers (see The Regulatory are typically not subject to approval, but must be

5 Mayer Brown | Mergers and Acquisitions in the U.S. Insurance Sector Regime), the insurer and the acquirer may also are generally excluded as “non-admitted assets” be required to make filings in that state. under SAP). The main purpose of the conservative approach adopted by NAIC and Government Ownership Statutes state regulators through SAP is to ensure that Statutes in more than half of the U.S. states each insurance company can meet its obligations to policyholders at any given moment. impose restrictions on government ownership or control of insurance companies licensed to do business in the state. If an acquirer is owned or Risk-Based Capital controlled, directly or indirectly, in whole or in Insurance regulators use RBC to measure the part, by a U.S. or foreign government or minimum amount of capital appropriate for an government agency, the impact of those statutes insurer to support its overall business will need to be considered. Among other things, operations, taking into account its size and risk such statutes may restrict the ability of the profile. The RBC calculation focuses on the insurer to claim sovereign immunity based on its amount of risk an insurer can take on, and governmental ownership or to receive subsidies requires an insurer with a higher risk profile to from a governmental parent. hold a higher amount of high-quality capital. Risk factors used to determine the RBC formula GAAP Versus SAP are separated into three main categories: asset Most U.S. companies use generally accepted risk, underwriting risk, and other risks (e.g., credit and counterparty risk). The emphasis accounting principles (GAAP) to report their placed on these risks will differ from one type of financial information. While GAAP is officially recognized as authoritative by the Securities and insurance company to another. For example, holding investments is less risky for a life Exchange Commission (the SEC) and the insurance company with longer-term liabilities American Institute of Certified Public , in the U.S. insurance industry, than it is for a casualty and property company with more immediate payment obligations. GAAP accounting is secondary. State regulations require insurance companies to report financial The regulatory utility of RBC is addressed by the information using Statutory Accounting NAIC on its website as follows: “RBC is intended Principles (SAP). SAP is a uniform framework to be a minimum regulatory capital standard developed by the NAIC, principally to ensure and not necessarily the full amount of capital that state regulators have the right tools to that an insurer would want to hold to meet its assess the condition and performance of the safety and competitive objectives. In addition, insurance companies they monitor and to RBC is not designed to be used as a stand-alone evaluate their solvency. Unlike GAAP tool in determining financial solvency of an accounting, which assumes an entity will insurance company; rather it is one of the tools continue to operate following the date of that give regulators legal authority to take determination, SAP aims to determine what control of an insurance company” (see assets would be available to discharge the http://www.naic.org/cipr_topics/topic_risk_b entity’s liabilities if the entity were liquidated ased_capital.htm). Accordingly, the RBC metric “today.” For example, SAP does not allow an is one of many tools, albeit probably the most insurer to include certain non-liquid and important, used by regulators to determine intangible assets on the (e.g., whether regulatory intervention is warranted. , supplies, furniture, and certain tax For instance, an RBC ratio below 200% indicates can be included as assets on a balance that the insurer has financial difficulties. Under sheet prepared in accordance with GAAP, but such circumstances, the regulator may request

6 Mayer Brown | Mergers and Acquisitions in the U.S. Insurance Sector that the insurer submit a plan for improvement scrutiny by insurance regulators, particularly by of its capital . If the RBC ratio drops the Department of below 100%, the regulator may take control of (NY DFS). ’s the insurer. acquisition, through Athene Holding, of the life and annuity assets of Aviva US, and Guggenheim Recent Industry Trends Partners’ acquisition, through Delaware Life Holdings, of Sun Life of New York, involved New Life Sector. In the life sector, the number of announced deals was down for the third straight York domiciled insurers and were therefore subject to approval by the NY DFS and its year in 2014. The value of announced deals, superintendent, Benjamin M. Lawsky. however, climbed in the wake of the $5.7 billion purchase of Protective Life by Dai-ichi Life. Statements made by Mr. Lawsky in the press indicated that he was concerned about the Although Japanese non-life insurers have been possible -term investment view held by venturing into the U.S. market through large acquisitions in recent years (e.g., Tokio Marine firms and their appetite for riskier investments. In the end, it took a set of tailor- Group’s acquisitions of Delphi Financial for made “heightened policyholder protections” $2.66 billion in 2012 and HCC Insurance Holdings for $7.5 billion in 2015), Dai-ichi Life’s imposed by the NY DFS on the new owners for both transactions to be approved by the acquisition of Protective Life marked the first regulator. Among other things, Delaware Life significant acquisition of a U.S. life insurer by a Japanese group. The Protective Life / Dai-ichi Holdings agreed to: increased required RBC levels of at least 450%; the establishment of a transaction created the thirteenth largest global separate backstop trust account of $200 million; insurer, with more than $420 billion in assets. This acquisition can be seen as Dai-ichi Life’s more extensive scrutiny of the insurance company’s operations, investments, dividend attempt to branch out into more favorable policies, and reinsurance arrangements; and markets, given a mature Japanese domestic market that is characterized by a shrinking enhanced disclosure obligations. Mr. Lawsky made clear that the special arrangement was population and a stagnant economy. Strategic targeted at the private equity community by across borders may be the next natural driver of M&A activity in the life stating that “other non-traditional insurance industry asking us to approve similar segment in the United States, particularly by transactions are going to have to step up and strong foreign insurers facing domestic headwinds and seeking higher returns in clear a high bar for protecting policyholders” (see The Wall Street Journal, July 31, 2013). continued robust or growing markets. Athene Holding agreed to similar conditions in Two trends that had recently fueled M&A order to secure its approval. activity in the life space petered out in 2014. In NY DFS’s approach and the discussions it the years prior to 2014, private equity–backed spurred in the insurance industry resulted in the firms like Apollo Global Management, Guggenheim Partners, Harbinger Capital NAIC forming a new working group to study ways to address the risks associated with private Partners, and Resolution Group were active equity / fund ownership or control of acquirers of U.S. life and annuity companies and assets. For private equity firms with investment insurance company assets. The result was additional guidance to examiners in connection management arms, there is an obvious allure to with the Form A approval process discussed in spread-based annuity businesses and increasing . These Insurance Holding Company System Model Act and Regulation. It should be noted, however, transactions, however, resulted in heightened

7 Mayer Brown | Mergers and Acquisitions in the U.S. Insurance Sector that prior to NAIC’s release of additional A recent source of M&A activity was a sell-side guidance, the NY DFS had already promulgated trend in 2012 and 2013, which saw non-U.S. its own rules through revisions to New York financial institutions retreating from the U.S. life Insurance Regulation 52, which now imposes and annuity market. Amid looming changes in additional requirements on private equity firms regulatory capital rules (e.g., the Solvency II seeking to acquire insurance companies Directive) and depressed interest rates, domiciled in New York. Those new requirements European and Canadian financial institutions include the following: divested U.S. life and annuity assets. In 2012, Financial ceded a multi-billion dollar • submission of a comprehensive five-year block of U.S. fixed deferred annuities to business plan for the insurance company, Reinsurance Group of America in a 90% co- from which the insurance company cannot insurance arrangement. Also in 2012, Swiss Re deviate without approval from the NY DFS agreed to divest its Admin Re U.S. life insurance superintendent; business to Jackson National Life, and, as • submission of five-year financial projections, previously discussed, Aviva announced the sale and—if the company seeks to enter into of its U.S. life and annuity business to Athene certain new transactions and if requested by Holding, an entity sponsored by Apollo Global the superintendent—resubmission of new Management. In 2013, Sun Life, another five-year projections; Canadian life insurance group, sold Sun Life of • provision of additional capital to the insurer, New York, its U.S. annuity business, to up to an amount as required by the Guggenheim-sponsored Delaware Life Holdings. superintendent, if the superintendent Further in 2013, the Italian reinsurance group determines that new five-year financial Generali sold its U.S. life reinsurance business to projections show the insurer will not have SCOR. This type of sell-side activity was adequate capital; noticeably absent in 2014 and is perhaps a sign • for life insurers, establishment of a backstop of the U.S. market beginning to look more trust account in an amount and for a duration appealing to non-U.S. financial institutions with to be determined by the superintendent if the a strong balance sheet. As private equity superintendent determines that the acquirers show hesitancy in jumping into the acquisition is likely to be hazardous or acquisition pool due to regulatory uncertainty, it prejudicial to the insurer’s policyholders or appears that the market has opened up for shareholders; and domestic and foreign strategic acquirers to find • submission of additional information about attractive deals. Dai-ichi Life’s $5.7 billion the identity and structure of the relevant acquisition of Protective Life is an example of controlling persons and the materials used to such a strategic combination. The Protective Life solicit investors. transaction could mark the beginning of an era of strategic consolidation in the U.S. life and The NY DFS’s treatment of private equity– annuity market, as interest rates start to climb sponsored acquirers of life and annuity insurers back up and new opportunities abound in a has had a chilling effect on M&A activity. It population that is not only growing in numbers, remains to be seen how other states’ regulators but also in wealth and age. will treat private equity–sponsored acquirers and what effects NAIC’s additional guidance will Meanwhile, in the health insurance sector, two have; in the meanwhile, such buy-side actors are transformative deals were announced during the currently standing on the sidelines. summer of 2015. In early July, Aetna, a Connecticut-based health insurer, announced

8 Mayer Brown | Mergers and Acquisitions in the U.S. Insurance Sector that it would acquire Humana, a health insurer RenaissanceRe agreed to acquire Platinum based in Kentucky, in a transaction valued at Underwriters, ACP Re announced it would buy more than $37 billion. The deal is expected to Tower Group, and Fosun International nearly triple Aetna’s Medicare Advantage announced its acquisition of Meadowbrook business and create a health insurer with more Insurance. The latter acquisition by Fosun than 33 million members. In what was viewed as International, a Shanghai-based insurance a reaction to the Aetna/Humana merger, an group, marked the entry of yet another Asian even larger combination was announced just a insurance into the U.S. insurance few weeks later. Anthem, a health insurer market (see the discussion above regarding Dai- headquartered in Indiana, signed a merger ichi Life’s acquisition of Protective Life and agreement with Cigna, a Connecticut-based Tokio Marine’s acquisitions of Delphi Financial health services provider, in a transaction valued and HCC Insurance Holdings). In the first at approximately $54 billion. This transaction quarter of 2015, Fosun International completed would create the largest health insurer in the its acquisition of 20% of Bermuda-based country with more than 53 million members. Ironshore, which led to Ironshore’s These two extraordinary transactions, however, postponement of its planned U.S. initial public caused anti-trust authorities to take a closer look offering. Ironshore used the proceeds to at the anti-competitive effects of the repurchase shares from existing shareholders, combinations. While it is not clear if the two thereby making Fosun International its largest transactions will be consummated in their shareholder. In May 2015, Fosun announced a current form, commentators point to the plan to acquire the remaining interest in Affordable Care Act as driving consolidation Ironshore. After giving effect to the transaction, momentum in the health insurance industry. Ironshore will be an indirect wholly owned The U.S. Supreme Court’s affirmation of the of Fosun International. ACP Re’s constitutionality of the Affordable Care Act, and acquisition of Tower Group came in the wake of the growth prospects from new forms of a number of significant loss reserve increases payment encouraged by the law, have driven recorded in 2013 by Tower Group and health insurers to the deal negotiation table. subsequent downgrades of Tower Group’s Health insurers are keen on both cutting costs financial strength rating. Tower Group had been and building scale to help them face off against one of the fastest-growing insurers in the market health care providers that are bulking up. (largely through acquisitions), from net written premium of $98 million in 2004 to $1.2 billion Property and Casualty Sector. The in 2014. The future will tell if Tower Group can combined deal value of property and casualty continue its impressive growth under the transactions in the U.S./Bermuda market stewardship of ACP Re. increased in 2014 compared to 2013, offsetting a decline in the number of deals in absolute terms. Other notable transactions announced in 2014 Considered alongside the announcement of and 2015 include XL Group’s agreement to buy several large property and casualty transactions Bermuda-based Catlin Group for $4.2 billion in early 2015, a trend of increased deal activity is and the beginning of a battle for rapidly emerging. PartnerRe, a Bermuda based reinsurer, between AXIS Capital, another Bermuda-based Although 2014 was largely characterized by insurer/reinsurer, and Exor, an Italian small- and medium-sized transactions, with investment company controlled by the Agnelli more than two-thirds of the announced deals family. The takeover contest ended with Exor valued at or below $200 million, three large, agreeing to buy PartnerRe for $6.9 billion. Other public M&A deals were announced.

9 Mayer Brown | Mergers and Acquisitions in the U.S. Insurance Sector deals that made the headlines in the first half of as different types of entities bring different deal 2015 include: (i) Tokio Marine’s continued considerations. interest in U.S. insurance assets, demonstrated Stock Insurance Companies. Most by the execution of an agreement to acquire HCC insurance companies are stock companies Insurance Holdings, a specialty insurer, for $7.5 owned by the holders of the insurance billion and (ii) Bermuda-based Endurance companies’ capital stock. In contrast to a mutual Specialty Holdings’ announcement of its $1.8 insurance company, the profits of a stock billion acquisition of Montpelier Re Holdings, insurance company accrue for the benefit of the another Bermuda-based reinsurer. In July 2015, shareholders rather than the policyholders. ACE Limited announced one of the largest deals However, the distribution of any profits ever made between two property and casualty generated is subject to regulatory restrictions insurers, a $28.3 billion stock and merger and, in some cases, approval by the domiciliary with competitor Chubb . The regulator. Regulators are tasked with protecting combined entity will have assets under the interests of policyholders and ensuring that management of approximately $150 billion. the insurance company maintains sufficient Many commentators see the string of late 2014 capital and surplus to cover current and future and early 2015 deal activity as a sign of things to claims. As such, regulators view restrictions on come, and expect various structural and dividends and distributions as an important tool competitive factors to act as catalysts for to protect the long-term viability of the increased property and casualty M&A deal insurance company and its ability to pay future activity in the coming years. Such factors policyholder claims. include: Counsel should be aware that regulatory • historic levels of excess capital (and pressure restrictions on dividends may prevent a seller to make use of such capital in ways other than from causing the target company to distribute share buy-back programs); excess cash before, or even after, consummating • challenging organic growth opportunities; and an M&A transaction. For example, New York generally requires an insurer to agree not to pay • strengthening of macroeconomic conditions any dividends without regulatory approval for a (including the possibility of period of three years after a change of control. increases). Depending on how the purchase price for the Deal Structure Considerations target company is determined, this may mean that the acquirer will have to “pay” for restricted M&A transactions in the insurance sector can capital held by the target company. As such, the take many forms. The structure is dictated by the acquirer’s financial models should account for parties’ motivations for the transaction and the fact that what the parties perceive to be factors such as timing, certainty of excess capital may not be distributable at the consummation, and the regulatory framework in time the acquisition is consummated. However, which the transaction occurs. The following are it will often be possible to assess through private some of the most common structures for discussions with the regulator what capital and insurance M&A transactions. surplus levels will be required upon consummation of the transaction. In any event, ACQUISITION OF INSURANCE ENTITY the acquirer and seller are wise to address, in the Counsel to the acquirer needs to understand purchase agreement, how restricted capital is to what kind of insurance entity is being acquired, be treated in the transaction.

10 Mayer Brown | Mergers and Acquisitions in the U.S. Insurance Sector Mutual Insurance Companies. Mutual liquidated and dissolved once it becomes non- insurance companies, or “mutuals,” are operative. In the insurance industry, a dormant collectives of insureds pooling their risk for the shell company could have an intrinsic value common good of the collective. Mutuals do not because of the licenses it holds. have stockholders. Instead, they are controlled Each state has its own requirements for granting by their members (i.e., the policyholders of the out-of-state insurance companies a license to insurance company). Membership interests in a transact business in its state. Subject to certain mutual are not transferable separate and apart exceptions, most states require an out-of-state from the underlying policy, and a membership insurer to have been organized and actively interest ends when the policy ends. In contrast engaged in insurance business in its domiciliary to a stock insurance company, the profits of a state for a certain period of time prior to being mutual insurance company accrue for the granted a license in the other state. For example, benefit of the policyholders (since there are no New York, California, and Florida require prior stockholders). There are many large mutuals in operation of at least three years. Considering the the insurance industry, such as State Farm, process required to incorporate and license a Nationwide, and Guardian Life. new insurance company in its domiciliary state, Since a mutual insurance company has no which can range from a couple of months to stockholders, it cannot be acquired in the usual more than a year, acquiring a licensed shell sense of the word. Therefore, prior to the company can be an attractive option for an acquisition of a mutual insurer, it must be acquirer looking to start new operations or converted into a stock company in a process expand current operations. Because the acquirer known as demutualization. Demutualization can of a shell company expects to acquire a company extend for months or even years, involving without net liabilities, it is common for the discussions with state insurance regulators, one acquirer to request that the seller assume all pre- or more public hearings, and an affirmative vote closing liabilities of the shell company. This by the policyholders. Depending on the mutual’s approach is similar to an asset sale, where the domiciliary state, the required affirmative vote seller retains certain pre-closing liabilities can range from a simple majority to a related to the assets. Limitations on supermajority of the policyholders. The indemnification in shell company transactions insurance laws of some states restrict acquisition can sometimes be a contentious negotiating of more than a certain percentage of the voting point for the parties. The seller will not want to rights in the company for a period of time prior be responsible for more than the (usually) to and following demutualization. However, modest purchase price it has received. The such restrictions can typically be waived by the acquirer will view any problem associated with domiciliary regulator. In a demutualization the shell company as antithetical to the very occurring for the purpose of a later sale, also purpose of acquiring a “clean” shell and known as a sponsored demutualization, it is therefore will want to remove all limitations on important for the acquirer and the board to vet indemnification. the proposed acquisition with regulators, key Reciprocal. A reciprocal, otherwise known as policyholder groups, and other stakeholders to an insurance exchange, has no corporate avoid unforeseen and costly hurdles. existence, but is rather a network of Licensed Shell Company. A licensed shell policyholders who insure, and are insured by, company is a dormant insurance company that each other. The actual administration of the holds one or more insurance licenses. In other network (e.g., policy issuance and claims industries, a dormant entity would likely be handling) is managed by an attorney-in-fact—

11 Mayer Brown | Mergers and Acquisitions in the U.S. Insurance Sector either a legal entity or an individual. In the case more; although in some negotiated reinsurance of a reciprocal, what is acquired is not the arrangements, the reinsurer may also cover ex network itself, but the attorney-in-fact gratia payments, “bad faith” penalties, and administrator (if a legal entity) and the stream of other extra-contractual liabilities that the cedent fees received by the attorney-in-fact for did not expressly assume pursuant to the terms managing the reciprocal. of the policy with the insured, but that it may nevertheless have to pay as a consequence of, for ACQUISITION OF A BLOCK OF BUSINESS example, deficient adjustment practices of If the presumptive acquirer is not interested in policyholder claims. using the target insurance entity as a vehicle to Through a reinsurance agreement under which write new business—or is solely interested in all premiums and liabilities associated with a part of the target entity’s written business and is cedent’s block of business are transferred to the not seeking to assume employee, operational, reinsurer (known as a 100% quota share and other liabilities not related to insurance—it indemnity reinsurance agreement), the reinsurer may seek to “acquire” a specified block or will in effect acquire all of the streams portfolio of insurance policies. Block and and liabilities associated with that block of portfolio acquisitions can take various forms. business. A reinsurance transaction could also Indemnity Reinsurance. A common way to involve one or more subsequent acquisitions of acquire a portfolio or block of business is to the same block of business by a second-in-line reinsure the insurance policies written by an reinsurer (a retrocessionaire), who would insurer. This is often called “bulk reinsurance.” reinsure all or part of the risk assumed by the Reinsurance is a contract by which the reinsurer original reinsurer (the retrocedent). assumes the risks of another insurer (the Assumption Reinsurance. If the intended cedent), who transfers or cedes the risk to the reinsurer wants to step into the shoes of the reinsurer. The cedent passes to the reinsurer all insurer for a particular block of business, rather or part of the premiums it receives from the than reinsuring the block, the parties can effect relevant policyholders, subject to a ceding an assumption reinsurance transaction. The commission payable by the reinsurer to the term is in fact a misnomer, since the cedent, which is intended to cover the arrangement is not really a reinsurance cedent incurs in finding and writing the transaction but rather a novation arrangement. business. If the profitability of the block of In an assumption reinsurance transaction, the business is questionable, the commission could acquirer substitutes itself in place of the original go in the opposite direction, from the cedent to insurer as the contracting party under the the reinsurer. The typical reinsurance contract is insurance with the policyholder by not a liability contract but an indemnity novating the contracts, thereby entering into a contract. This means that the cedent is still the direct contractual relationship with the contractual party to the underlying insurance policyholders. It is typically required that the policy issued to the policyholder and therefore policyholders consent to the novation, either by remains the contractual party liable to the signing a written consent or by paying future policyholder. The role of the reinsurer is to premiums to the acquirer. From the perspective indemnify the cedent after the cedent has paid a of the original insurer, the objective of express or loss on the underlying policy to the policyholder. tacit consent from the policyholder is to Typically, the reinsurance contract will stipulate establish evidence of a clean break from the that the cedent will cover only the risk associated liabilities associated with the policies being with the reinsured block of business and not novated. Assumption reinsurance transactions

12 Mayer Brown | Mergers and Acquisitions in the U.S. Insurance Sector are relatively uncommon because of the by the life insurance company under the group difficulty in obtaining consent from a large annuity contract for the payments that would number of policyholders. otherwise be due from the pension plan. The group annuity contract is purchased by the Renewal Rights Transaction. In a renewal corporation using the plan assets and, in some rights transaction, the acquirer purchases from cases, additional cash (e.g., if the plan is deemed the seller the exclusive right to use the existing underfunded). Following the purchase of the business relationships with policyholders to seek group annuity contract, the corporation is to write any renewals of policies on the relieved of all responsibility for future payments acquirer’s paper. A renewal rights transaction to participants covered by the group annuity may serve as a useful complement to an contract. These transactions are sometimes acquisition of a block of business through combined with a buy-out feature. In those cases, reinsurance, as those two elements would both participants that are currently receiving secure the economics of the existing business payments under the pension plan may be offered and allow the reinsurer to directly acquire any an opportunity to receive a lump-sum payment future insurance written from such block of instead of continued payments under the group business. Renewal rights transactions present annuity contract. Several large with some unique challenges. Depending on the large pension liabilities have undergone these overall nature of the transaction, the seller may types of de-risking transactions in the last few be prevented by consumer privacy and data years, including General Motors (transaction protection rules from sharing information about value of $26 billion), ($7.5 billion), the policyholders. This is particularly likely Motorola ($3.1 billion), and Bristol-Myers before the transaction closes and during due Squibb ($1.4 billion). diligence. Moreover, agents and producers who brokered the original sale of the insurance A defined benefit plan may be viewed as a contracts to the policyholders may have rights to “quasi” life insurer that provides lifetime policyholder information that may limit the annuities to plan participants. In this light, a ability of the insurer to pass that information on pension de-risking transaction involving the to the acquirer. Finally, any transaction transfer of liabilities to a “real” life insurer involving direct action by policyholders to (through the purchase of a group annuity consent to a novation or a renewal of policy with contract) resembles an M&A transaction a new insurer is likely to result in some attrition. involving the sale of an annuity book from one One way to address this potential predicament is insurer to another. Consequently, the large de- to make all or part of the consideration for the risking transactions to date have generally renewal rights contingent on the number of followed a process similar to a privately policies that are actually renewed. negotiated M&A deal.

Pension Liability De-risking So far, these transactions have held up to legal Transactions. One type of transaction that has scrutiny by the courts. In April 2014, a federal recently gained popularity involves the “de- court in Texas dismissed for the third time a risking” of pension liabilities of large class action suit challenging Verizon’s de-risking corporations. In these transactions, corporations transaction on the grounds of various ERISA with large defined benefit pension plans enter violations, including deficient disclosure and into a group annuity contract with a life breaches of fiduciary and anti-discrimination insurance company. The group annuity contract obligations. Among other things, the court noted is designed to cover all future payments to be that ERISA permits an employer to make made under the plan by substituting payments business decisions in its “settlor capacity.” The

13 Mayer Brown | Mergers and Acquisitions in the U.S. Insurance Sector court held that the decision to pursue a • individuals should be provided with clear particular de-risking settlement strategy, information about the key elements of their including the right to transfer assets and group annuity arrangement; and liabilities to an insurance company, is a business • states should adopt laws to protect annuity decision that a plan sponsor is permitted to transfers to insurance companies that do not make under ERISA. In August 2015, the district have sufficient financial strength to guarantee court’s decision was affirmed by the U.S. Court that payment obligations will be met. of Appeals for the Fifth Circuit. The de-risking transactions that have taken Certain attempts at legislative action have been place so far appear to be beneficial to made. In New York and Connecticut, for corporations that desire to manage their long- example, state legislators have explored the term pension obligations predictably and for life possibility of legislation addressing de-risking insurance companies that manage long-term transactions. Some commentators argue, risk. Importantly, there appears so far to be no however, that legislative changes in state compelling evidence to support the notion that assemblies that conflict with ERISA would be payments received under a group annuity fruitless because of federal law pre-emption. A contract from a creditworthy life insurer pose group of state insurance legislators called the more risk to plan participants than pension National Conference of Insurance Legislators payments received under a corporation’s defined (NCOIL) prepared a model act for de-risking benefit pension plan. transactions. NCOIL’s proposal received lukewarm reception from the industry and did Due Diligence in Insurance M&A not move forward in any tangible way. NCOIL Transactions then turned to developing best practices for the industry in collaboration with market As with any M&A transaction, careful due diligence is an important element of a successful participants. In November 2014, NCOIL adopted acquisition of a target insurance company. the following best practices: Naturally, many of the matters covered during • the state guaranty associations should provide due diligence of an insurance company are the a minimum guaranteed level of coverage of no same as those covered in other types of M&A less than $250,000. Guaranty associations transactions, such as pending and threatened require mandatory insurance company litigation, owned and leased real property, tax membership and are designed to protect matters, labor and benefits matters, and policyholders from an insurance company environmental liabilities. Nevertheless, there are that has become insolvent and is no longer several aspects of the due diligence process that able to meet its policy obligations; are unique to or particularly important in the • payments to individuals should be protected acquisition of an insurance company. These from creditors, comparable to the protection include: granted to pension payments under ERISA • calculation and adequacy of reserves; (note that in October 2015, legislation went into effect in Connecticut that affords the • underwriting and claims administration; same protection from creditors that pension • market conduct and producers; payments enjoy under ERISA to payments • regulatory matters, including licensing issues, under a group annuity that replace pension permitted practices, regulatory filings, and payments); interactions with government agencies; • collectability of reinsurance;

14 Mayer Brown | Mergers and Acquisitions in the U.S. Insurance Sector • composition of the investment portfolio; UNDERWRITING AND CLAIMS • dependency on intercompany agreements; ADMINISTRATION • data and compliance with privacy An important measure of an insurer’s financial laws; and performance is its loss ratio. The loss ratio is the ratio of incurred losses plus loss adjustment • other financial arrangements, including expenses to earned premium, without regard to reserve financing. the performance of the insurer’s investment Once the acquirer’s counsel has a full assets. The higher the insurer’s loss ratio, the understanding of these matters, it will be less money it is making on its underwriting possible to advise the acquirer on the legal issues business. If the loss ratio is more than 100%, the raised by the transaction and assist in creating a insurer is losing money on its underwriting suitable structure. In addition, once the initial business (which can be partially offset by due diligence is completed, acquirer’s counsel positive returns on its investment portfolio). will be better equipped to stress-test the due Deficient or lax underwriting practices can easily diligence findings through a carefully drafted lead to a high loss ratio. Therefore, it is catalog of seller representations and warranties. important for the acquirer to assess the insurer’s As noted in the Introduction, the following underwriting practices (e.g., quality of discussion assumes the outright acquisition of a procedures, level of discipline in following those stock insurance company. procedures, and quality of the technological tools available) to make sure that the risks CALCULATION AND ADEQUACY OF RESERVES assumed are appropriate. It will also be If an insurer’s products are priced correctly, the important for the acquirer to understand how average loss on a portfolio of policies should be claims are handled. Claims administration and covered by the premiums received. Being correct loss adjustment practices that are prolonged or about the average, however, does not protect the flawed can result in higher costs and claim insurer from temporary and extraordinary payouts as well as policyholder lawsuits and payment obligations outside the average, or regulatory scrutiny. If the target has been payment obligations that arise earlier than the adjudged to have paid less than provided for by a receipt of sufficient premiums to honor such policy (without good reason), the target could be obligations. It is also quite possible for insurers held liable for “bad faith” penalties or extra- to price products incorrectly. For all of these contractual obligations in excess of the stated reasons, insurance companies maintain reserves insurance coverage. If these issues are severe, to cover their current and future liabilities. the target’s licenses and right to operate could be Inadequate reserving can have a devastating put in jeopardy. impact on an insurer, which is why due diligence efforts by the acquirer should focus on the MARKET CONDUCT AND PRODUCERS manner in which reserves have been calculated Another aspect of the target’s operations that the and the assumptions underlying the calculation. acquirer will want to investigate is the manner in The acquirer may also retain outside actuaries to which the target conducts its business in the conduct an independent review of the reserve marketplace. Is the target in compliance with assumptions and calculations. At the very least, insurance marketing rules in the manner in the acquirer will want to review any internal or which it advertises and discloses information third-party actuarial studies performed on the about its products? Has the target filed all its target insurer’s reserves and reserve practices. policy forms and rates with applicable regulators, and have such forms and rates been approved (or non-disapproved within the period

15 Mayer Brown | Mergers and Acquisitions in the U.S. Insurance Sector mandated for regulatory response) by the restrictions or capital maintenance relevant authority? Most insurance companies obligations. A review of the certificates in also engage agents, brokers, and other producers conjunction with the statutory statements will to sell their insurance products. The acquirer also confirm that there is a certificate of will want to know whether such producers have authority for each jurisdiction in which the authority to contractually bind the target. insurer reported premiums. Although delegating such authority to third- • Commercial domicile. The due diligence party producers could provide for a more examination should determine whether the efficient sales procedure, the target gives up target is commercially domiciled in any some of its control and ability to ensure jurisdiction. See The Regulatory Regime for a adherence to its underwriting policies and sales discussion of commercial domicile. If a large procedures. The acquirer will also want to assess portion of the target’s current or past whether unlicensed persons are being premiums have been written in a state other compensated for referring business to the target. than the target’s jurisdictional domicile, For instance, a party without a producer license counsel will have to analyze such state’s referring business to the target and being commercial domicile rules to determine if any compensated for such referrals through a activity thresholds have been exceeded. commission structure could be in violation of • Permitted practices. The acquirer’s state licensing rules. Large insurance companies counsel should understand if there are any generally use third-party producers to market “permitted practices” that regulators have and sell their insurance products, and it can be approved for the target. Permitted practices difficult to monitor such producers’ behavior are case-by-case exemptions to insurance and their compliance with laws and regulations. rules that regulators may grant at their Reviewing the target’s standard terms of discretion. For example, a shell insurance agreement with producers and receiving a list of company without meaningful operations may the producers generating the largest be exempted from filing audited annual can be a good place to start during the diligence statutory statements. Additional diligence process. Insurers are also subject to routine may be warranted to cover any gaps in market conduct examinations by state oversight that such regulatory relief may have regulators, and the findings from these created. examinations will provide useful information to • Regulatory filings. Another aspect of the the acquirer. regulatory due diligence is review of REGULATORY MATTERS regulatory filings made by the target and correspondence received from regulators in The acquirer’s counsel is particularly involved in regulatory due diligence. As part of the connection with those filings. The insurer’s insurance holding company system filings will regulatory due diligence, counsel will want to be of particular interest (see the discussion of review and consider the following: these filings in Insurance Holding Company • Certificates of authority. Counsel should System Model Act and Regulation). Counsel determine whether all of the target’s should also review the target’s quarterly and certificates of authority (i.e., insurance annual statutory statements, which will reveal licenses) and the specific lines of business more than financial information. These listed on such certificates are current and in statements contain valuable information effect. Counsel should also consider if the about affiliate agreements, material certificates are conditioned upon operational reinsurance contracts, paid dividends and

16 Mayer Brown | Mergers and Acquisitions in the U.S. Insurance Sector distributions, and other key matters. The the need for good regulatory relationships and management discussion and analysis filed in are wary of pushing the envelope in these connection with the annual statutory dealings. Counsel should be mindful that clients statements and the auditor’s report on the may have spent considerable time and effort annual statutory statements may also contain building a strong relationship with a regulator crucial information about the condition of the and should not jeopardize that relationship. company. • Orders and undertakings. If the regulator COLLECTABILITY OF REINSURANCE has deemed it necessary to intervene in the A common form of counterparty risk to which target’s operations, such intervention often insurers are subjected is the risk that its takes the form of an order or, if the target is reinsurers are unable or unwilling to pay claims cooperating, a consent order or agreement to made by the insurer under reinsurance undertake certain action. If any such orders or agreements. Regardless of whether the reinsurer undertakings exist, counsel will want to is able to pay a reinsurance claim to the insurer, review them. the insurer will be liable under the policy issued to the policyholder. In other words, the non- • Examinations. Regulators conduct periodic performance of the reinsurer is not an excuse for financial and market conduct examinations of non-performance by the insurer. Accordingly, an the insurers in their domiciliary state. The insurer that has paid reinsurance premiums to a reports from such examinations can be very reinsurer that is or becomes insolvent, or for any informative with respect to the target’s other reason fails to pay under a reinsurance and its market activities. agreement, would be subject to a dual financial Another aspect of regulatory due diligence, setback: the loss of the reinsurance premium which can sometimes be hard to assess, is the and the loss of reinsurance coverage. In strength of the relationship between the target addition, loss of reinsurance for which the and its domiciliary regulator. Considering that insurer had previously taken credit on its the regulator plays a central role in monitoring balance sheet for regulatory reserving purposes the target’s operations, and is in a position to could result in the insurer being forced to raise approve many aspects of the target’s activities additional capital or secure alternative (e.g., the payment of extraordinary dividends, reinsurance arrangements to address the loss of affiliate contracts, new product development, the reinsurance credit. For the acquirer it will rate and form filings), the acquirer will need to therefore be important to scrutinize the target’s understand what kind of relationship the target reinsurers, including assessing their ratings, has developed with the regulator. Such analysis payment history, and any disputes with the could give the acquirer helpful leads about the insurer and others, along with other factors severity of the target’s regulatory shortcomings, bearing on the reinsurers’ creditworthiness if any. It could also be useful to understand if and solidity. certain officers and staff were responsible for creating a cordial and trustworthy relationship COMPOSITION OF THE INVESTMENT with the regulator, in order to consider if such PORTFOLIO officers and staff should be retained. Contacts As part of its financial due diligence review of with insurance regulators are in many ways the target, the acquirer will want to review the more complex than those with regulators in composition and nature of the target’s other industries and, unlike a difficult third investment portfolio to ensure that the asset party, a regulator cannot be replaced by the classes, level of concentration, and liquidity of insurer. Most insurance companies understand the investment portfolio are consistent with the

17 Mayer Brown | Mergers and Acquisitions in the U.S. Insurance Sector target’s investment guidelines and appropriate discounts to maintain customers, fines, litigation for an insurer of its kind. The acquirer must also costs, and damages; (ii) indirect costs, such as ensure that the target matches investment asset decline in sales and stock price; and (iii) yields with policy payout obligations. This task is intangible losses, such as reputational damage particularly important for life and annuity and loss of business opportunities. Insurance insurers that have written policies with companies are particularly attractive targets minimum guaranteed benefits. If the amount because of their information-rich databases promised under a guaranteed minimum benefit and networks. policy is higher than the asset yields, the The due diligence review of a target’s data insurance company is at risk of incurring steady security standards should therefore focus not losses on such policies. only on its preparedness and response to cyber attacks, but also on its maintenance and DEPENDENCY ON INTERCOMPANY implementation of policies and procedures for ARRANGEMENTS preventing and mitigating the effects of lost Many smaller insurance companies are legal and devices and employee breaches—whether financial vehicles without operational personnel, intentional or unintentional. For legal counsel, assets, or facilities of their own. In those cases, it the due diligence review could consider a whole is common to source services (e.g., financial, spectrum of issues, such as: reporting, accounting, and legal services), staff, information technology, and physical space from • whether the target has a written information an affiliated company. If the target will be security policy and whether the policy is on separated from its larger group, the acquirer par with industry practice; must understand to what extent those services • whether the target has a chief information need to be replaced after closing. In addition, security officer or similar function; affiliates of the target may be providing financial • whether the target carries cyber security support through intercompany guarantees or insurance; capital maintenance agreements. Such affiliate • whether sensitive data is shared outside of the financial backing could underpin financial target with third parties and what such third strength ratings, letters of credit issued by parties do to protect such data; to support excess reserve financing, and comfort to regulators. The acquirer should expect that it • what procedures the target has in place for will be required to meet these commitments or determining whether a data breach has taken arrange for them to be met by the seller and its place; affiliates during a transition period. • whether there have been any known security breaches; and DATA SECURITY AND PRIVACY LAWS • how the target is responding to or has In recent years, there have been an increasing responded to any breaches. number of instances in which customers’ In addition to data security breaches, other personal data have been compromised. privacy matters pose significant concerns for Prominent examples include Target (70 million insurance companies. In its due diligence individuals’ personal information stolen), Sony review, the acquirer should examine how the (data from 100 million user accounts stolen), target uses personal information and to what and Anthem (between 60 and 80 million extent such information is disclosed to the customers’ data compromised). Losses from public and third parties. The acquirer should data breaches can include (i) direct costs, such also determine in what jurisdictions such as costs of investigation and remediation,

18 Mayer Brown | Mergers and Acquisitions in the U.S. Insurance Sector personal data is collected, stored, and used, and Regulations XXX and AXXX are currently should analyze legal compliance issues in reserve standards in all states. connection with such practices. Part of that The perception of the life insurance industry was analysis should consider if data transfers will that the reserves mandated by Regulations XXX occur as result of the acquisition of the target, and AXXX were significantly in excess of the particularly if such transfer will occur over state “economic” reserves considered necessary by the and national borders. For example, the industry to satisfy insurers’ obligations to European Union’s Directive 95/46/EC provides policyholders. For life insurers, posting certain limitations on personal data transfers “redundant reserves” in highly conservative outside of the European Economic Area. investments reduced their rate of return on It is also important to consider what information capital and was seen as a waste of capital. is shared by the seller and the target with the Against this backdrop, life insurers started to acquirer during the due diligence phase. The develop ways to up capital from these seller is well advised to avoid sharing any redundant reserve requirements through sensitive personal information about customers techniques. In a typical Regulation and employees with the acquirer prior to the XXX or AXXX securitization, the insurer forms a closing. Depending on the context and wholly owned special purpose reinsurer, applicable jurisdiction, information such as licensed as a captive reinsurer, and cedes the Social Security numbers, driver’s license policies to which the redundant reserve numbers, credit card numbers, medical requirements apply to the captive reinsurer. The information, addresses, and names could be reinsurer is financed partly by the insurer, but deemed protected information. Sharing such mostly through a third party. In the early stages information with the acquirer could breach the of Regulation XXX and AXXX , target’s customer and employee privacy securities that were guaranteed (“wrapped”) by a guidelines and policies, could trigger notification insurer like Ambac or MBIA were issued to and consent requirements to customers and the capital markets to fund the reinsurance employees, and could be an outright violation of captives. However, after the global financial privacy laws. If certain information is deemed to crisis, which caused many bond insurers to cease be appropriate to disclose to the acquirer, the writing new business, funding for seller should ensure that any such information is this financing became harder to come by. subject to a non-disclosure agreement signed by Insurers turned to financial institutions instead. the parties prior to the due diligence phase and Today, a captive reinsurer’s obligations under a that secure means of transmission are used. reinsurance agreement are typically supported by a from a third-party in RESERVE FINANCING exchange for a fee paid to the bank. Regulation In the early , to address what it considered XXX and AXXX transactions must be approved inadequate reserve practices for certain life by both the insurer’s and the captive reinsurer’s insurers, the NAIC adopted new and more domiciliary states in order for the insurer to stringent reserve requirements for level receive credit for reinsurance on its balance premium policies. These sheet. Credit for reinsurance mitigates the requirements are known as Regulation XXX. capital strain on the insurer from the redundant Similar requirements for certain universal life reserves, thus accomplishing the primary policies with secondary guarantees were also purpose of the transaction. adopted, known as Regulation AXXX. In May 2011, a New York Times article shined a spotlight on life insurers’ use of captive

19 Mayer Brown | Mergers and Acquisitions in the U.S. Insurance Sector reinsurers to relieve capital strains caused by over approximately three years and only for new Regulations XXX and AXXX. While the NAIC business. created a special subgroup to study the issue, the In light of the regulatory uncertainty NY DFS undertook its own investigation. In surrounding the use of captive reinsurers, the June 2013, the NY DFS issued a report, calling acquirer needs to understand the following in for a national moratorium on the use of captive any M&A transaction: reinsurers in the life insurance industry. In particular, the report highlighted the use of • to what extent the life insurer uses captive letters of credit as the supporting collateral in reinsurers to relieve capital strains; two particular instances: (i) where the letter of • whether the captive reinsurer will follow along credit is contingent and may not provide the with the insurer in the transaction; funds when needed by the captive reinsurer • to what extent the seller is willing to continue (and, in turn, the insurer) and (ii) where a providing the supporting structure (e.g., parental guarantee from the insurer to the issuer parental guarantee, if applicable) to give the of the letter of credit creates a “wrap around” in acquirer time to replace the structure, and which all or part of the risk has not actually been what replacement funding alternatives are transferred away from the insurer, but the available; supporting reserves nevertheless are decreased, • the terms of the captive arrangement (e.g., potentially putting the insurer at risk for not with respect to change of control provisions satisfying its obligations to policyholders. and reporting and capital maintenance Ultimately, the NAIC opted for a less draconian covenants to a third-party issuer of a approach than that called for by the NY DFS. In supporting letter of credit); and December 2014, the NAIC adopted a new Actuarial Guideline XLVIII (“AG 48”), which • regulatory implications of a change of control established rules for new life reserve financing of the captive structure. transactions entered into after January 1, 2015. AG 48 is intended to: (i) permit life insurers to The Purchase Agreement continue to pursue capital relief opportunities The purchase agreement in an insurance M&A through third-party financings; (ii) establish transaction must address both the unique nature some uniformity among jurisdictions and of the insurance business and the regulatory regulators for the review and approval of such framework in which the industry operates. The financings; (iii) facilitate transparency regarding following discussion highlights common issues such financings; and (iv) add enhanced that arise in the drafting and negotiation of policyholder protections to such financings by insurance M&A purchase agreements. As noted way of increased liquidity and solvency margins. in the Introduction, the following discussion The NAIC has also been trying to tackle the core assumes an outright acquisition of a stock issue of reserve requirements, In 2012, the insurance company. NAIC adopted revisions to its Standard Valuation Law that move away from formulaic COMMON PURCHASE PRICE MECHANICS AND reserve requirements to “principle-based FEATURES reserving,” which is in some ways less As discussed in Insurance Holding Company conservative. Once at least 42 states System Model Act and Regulation, an acquirer representing 75% of total U.S. premium adopt is required to file a Form A application with the the revisions to the Standard Valuation Law, target’s domiciliary regulator after signing the principle-based reserving will be implemented purchase agreement, and must obtain the regulator’s approval prior to closing. Therefore,

20 Mayer Brown | Mergers and Acquisitions in the U.S. Insurance Sector insurance company acquisitions will have including special liabilities like reinsurance from separate signing and closing dates. Form A unauthorized reinsurers, and adding or approval can take months or in some cases even subtracting reserve redundancy or reserve years. Consequently, the acquirer will want to inadequacy). Because the calculation of reserves ensure that any diminution in the target’s value is rather subjective, the parties may have very between signing and closing is reflected in the different views on whether the target’s current purchase price. Conversely, the seller will want reserves are adequate or not. This may be to make sure that any increase in the target’s particularly true for long-tail liabilities, such as value during such period is also reflected in the asbestos and environmental liabilities, or for purchase price. On rare occasions, the seller and long-term liabilities such as life and annuity the acquirer will agree on a “locked box” liabilities. structure, where the value of the target is Risk-Based Capital Ratio. Because the RBC determined at signing (usually based on recently ratio is a determinative element for regulatory audited financial statements), sometimes with intervention and is perceived as a reliable the addition of an interest rate component. measurement of an insurance company’s Because insurance regulations require insurance financial health, an insurer’s RBC ratio is companies to prepare financial statements based sometimes used as a benchmark in setting and on SAP, these financial statements usually form adjusting the purchase price. Since the the basis for the acquirer’s determination of the calculation of the RBC ratio requires a rather target’s value. Some insurance company targets, complex analysis of the insurer’s capital particularly if they are listed on a adequacy and risk profile, counsel’s close or if non-insurance companies are included collaboration with the parties’ financial experts among the companies being acquired, will also is strongly advised when formulating a purchase have financial statements prepared in price adjustment based on a target’s RBC ratio. accordance with GAAP. In those instances, the acquirer may base the valuation of the target on KEY REPRESENTATIONS AND WARRANTIES GAAP. If that is the case, more traditional The representations and warranties given by the purchase price methodologies could be seller in the purchase agreement typically focus appropriate and provide for post-closing on the target’s nature and operations, issues adjustments based on the target’s working arising in due diligence, and matters related to capital or GAAP net worth. The following the target which the seller would be in the best discussion addresses purchase price position to know. The items below are common adjustment benchmarks that are more specific points for negotiating the representations and to insurance M&A. warranties in an insurance M&A purchase agreement. Statutory Book Value. A common method of purchase price adjustment in an insurance Qualification of the Target. Most M&A transaction is to gauge the difference in the agreements include a seller representation target’s book value between a benchmark regarding the organization or incorporation, number and the value at closing. The book value qualification, and authority of the target of a company is meant to reflect the value of company. Such representations often state that assets that its shareholders would theoretically the target is duly qualified as a foreign receive if the company were liquidated the next corporation to do business in each jurisdiction day. In the insurance M&A context, the book where the nature of its activities makes such value of the insurer is often adjusted based on qualification necessary. However, in the case of SAP (e.g., by excluding non-admitted assets and an insurance company target, the wording of

21 Mayer Brown | Mergers and Acquisitions in the U.S. Insurance Sector that representation could be read to encompass state, or if the transaction could have anti- more than just corporate or organizational competitive effects in another state, filing a authority. With a few exceptions (e.g., insurance Form A or Form E would be required in that written on an “excess line” or “surplus line” state. It should also be noted that regardless of basis), an insurance company that seeks to whether Form E filings are required, a federal conduct insurance operations in a particular Hart–Scott–Rodino filing and waiting period state must be licensed in that state for the lines may still apply. of insurance the company is offering. It is quite Regulatory Compliance. Naturally, the possible that a court would view the wording of acquirer will want the seller to represent that the the representation set out above to also apply to target has been and is in compliance with laws. insurance licenses. As such, a deficiency, More specifically, the acquirer will want the suspension, or withdrawal of an insurance seller to represent that the target has complied license could cause this seemingly innocuous with a host of regulatory matters, such as having representation to be breached. Considering also made all required regulatory filings, received that the qualification representation is regulatory approvals to such filings where commonly given status as a “fundamental needed, complied with regulatory requests and representation,” where recourse for its breach orders, and resolved any requests or orders could give the acquirer the right to walk away issued. The acquirer will also want the seller from the transaction or be indemnified without to confirm that there are no consent agreements threshold and cap limitations, narrowing the or other agreed undertakings in effect with scope of the representation to exclude insurance any regulator. license deficiencies is essential for the seller. Counsel to the seller should also be mindful of Another central aspect of regulatory compliance any intended or unintended backdoor has to do with the target’s certificates of representation coverage of insurance licenses. authority (i.e., insurance licenses) required to Note that the representation catalog typically operate in the jurisdictions and insurance includes a representation regarding “permits,” segments where the target is doing business. The where license representation is primarily acquirer will want the seller to represent that the intended to be covered. certificates of authority are valid and in full force and that there are no current circumstances that Governmental Consents and Approvals. are reasonably likely to lead to any of those As previously discussed, the insurance industry certificates being withdrawn or suspended (e.g., is more regulated than most other industries. written notice of violation from a regulator or Therefore, the representation covering failure by the target to satisfy express conditions governmental approvals included in an of any certificate of authority). In addition, the insurance M&A agreement should take into acquirer will want to obtain a list of all account all necessary filings to be made and certificates of authority of the target (and any consents to be received in connection with the other insurance companies being acquired in the transaction. This representation will typically transaction) and confirm that the list’s focus on the filings and consents required in and completeness are backed by a connection with the domiciliary state’s representation from the seller. regulations (see the discussion in The Insurance Holding Company System Model Act and The acquirer may desire more specific and Regulation). Note also that filings and approvals thorough representations such as the following: in other states may be necessary. For example, if • that the target’s marketing and sale of the target is commercially domiciled in another insurance products is in compliance with

22 Mayer Brown | Mergers and Acquisitions in the U.S. Insurance Sector applicable laws, in particular with respect to representation cover both these sets of (i) advertising and sales practices and (ii) financials, particularly if the valuation of the approval of required policy form and rate target is based on GAAP accounting. filings by applicable insurance regulatory Reserves and Actuarial Studies. A hotly bodies; contested area in insurance M&A agreements is • that no third-party producer has authority to to what extent the seller will make bind the target to issue insurance products to representations regarding the reserves set aside policyholders without the target’s approval; by the target to pay for incurred or future • that all third-party producers are adequately insurance liability. The seller will try to resist licensed, in compliance with market conduct making any representations regarding such rules, and acting within the scope of the reserves, contending that (i) assessing the authority granted by the target; adequacy of reserves is inherently subjective and • that no compensation is being paid to (ii) many elements of reserve assessment are unlicensed persons for selling insurance outside the control of the seller and the target. products for the target; The acquirer, on the other hand, will want to make sure that the reserves have been computed • that the target has made payment for, or is in in accordance with generally accepted actuarial the process of handling in the ordinary course, principles and in compliance with applicable all valid policy claims; and regulations and that the actuaries calculating the • that there has been no intentional withholding reserves had access to correct and complete of amounts from policyholders, and no information. If the seller or the target hired objections to payment by the target without a outside actuaries to assess the adequacy of the reasonable basis to contest such payments. target’s reserves, the acquirer should also seek a The acquirer may also want the seller to list a representation from the seller that any reports certain number of its largest revenue generators regarding reserves generated by those actuaries and make representations as to the accuracy of are accurate and complete. such list in order to backstop due diligence Reinsurance Arrangements. One of the findings on the target’s most important principal risk management tools of an insurer is producers. to spread its insurance risk to other parties Financial Information. An insurer must through reinsurance arrangements. By ceding prepare financial statements in accordance with underwritten policy liabilities to reinsurers, the SAP for submission to the regulator on a insurer limits its exposure to the portion of the quarterly and annual basis. These are known as written policies retained, subject to the credit statutory statements. Unless the insurer has risk of the reinsurer. The target may also have applied for and received an exemption, the assumed, as a reinsurer, business from other annual statutory statements must also be insurers. If the underlying business is audited. A representation on financial underwritten and managed well, reinsuring the information would therefore typically cover at underlying business can be very lucrative. least the last annual audited and interim The insurance M&A agreement often contains quarterly statutory statements, and whether any separate representations regarding reinsurance. permitted practices apply to such statements. The acquirer should ensure that both ceded Insurers that are part of a holding company (outgoing) and assumed (incoming) reinsurance system commonly have two accounting regimes, contracts are covered. The acquirer will want to SAP and GAAP, serving different purposes. The include assurances regarding the validity and acquirer would be wise to have the effectiveness of the reinsurance agreements,

23 Mayer Brown | Mergers and Acquisitions in the U.S. Insurance Sector similar to the representation the seller will be The acquirer will also ask for robust providing with respect to material contracts. The representations on the target’s policies and acquirer will also ask the seller to represent that procedures to safeguard policyholder and no reinsurer is impaired or has other financial consumer privacy information. For some difficulties. The seller, on the other hand, will insurers, there is an additional layer of view such risks as common business risks regulatory obligation. For example, health inherent to the ownership of an insurance insurers’ use and disclosure of customer operation and will try to reject such information are subject to the Health Insurance representations. Portability and Accountability Act of 1996 (HIPAA). The acquirer will want to ensure Finally, the acquirer may request a seller compliance with any such regulations. representation that the target is entitled to take credit on its statutory statements for its Separate Accounts. The term “separate reinsurance agreements. The point here is that if account” refers to assets held by a life insurer credit cannot be taken on the target’s statutory that are maintained separately from the statements for such reinsurance agreements, the insurer’s general assets. Separate accounts were acquirer may have to post other assets to satisfy originally established in response to federal the target’s capital and surplus requirements securities laws for investment-linked variable under state insurance laws. Consequently, if the annuities, but their application has grown target or its reinsurers are not in compliance beyond these products. Assets in a separate with the credit for reinsurance rules, it can be account are earmarked to satisfy the insurance costly to make up an unexpected shortfall in company’s liabilities under variable life capital and surplus of the target. insurance policies and variable annuities. The holders of such policies select specific Data Security and Privacy Laws. As investment strategies for the separate account discussed in Due Diligence in Insurance M&A assets and bear the associated investment risks. Transactions, data security and privacy issues Separate accounts can be subject to filings with have gained attention in the insurance industry the SEC. The representation will typically cover during the last few years. The seller’s the separate accounts’ compliance with federal representations in the purchase agreement will securities laws. typically reflect this. The acquirer will want to ensure that the representations cover the KEY COVENANTS integrity of the target’s hardware and software Pursuant to the covenants in the purchase for data security and the target’s adoption and agreement, the parties commit to perform (or implementation of robust security policies and refrain from performing) certain actions after procedures. The acquirer will also want the seller signing and up to closing. A primary purpose of to represent that no data security breaches are this practice is to ensure that the closing known to have occurred and that there is no conditions will be satisfied and the acquisition reason to believe that such breaches have will close. In most M&A transactions, the occurred. Considering that most data breaches heaviest burden of the covenants is on the seller. are not discovered upon occurrence, and that it For example, the seller may be required to could take months or years for a breach to be restructure the target, notify third parties of the detected, the acquirer may want to extend the transaction and obtain necessary third-party survival period for such data security consents, and terminate or discharge representations. The acquirer may also request intercompany agreements and balances between representations regarding adequate insurance the seller or its affiliates and the target. In for data security and cyber attacks.

24 Mayer Brown | Mergers and Acquisitions in the U.S. Insurance Sector addition, the acquirer will want to ensure that any agreed-upon terms related to regulator the target is not operating in a manner outside of conditions will be known to the regulator. The the ordinary course of business and that regulator may use that information to shore up extraordinary actions—such as stock issuances policyholder safeguards or impose other or reclassifications, changes in accounting conditions. However, such considerations practices, or the sale of significant assets—are should not be overstated, since the regulator will not undertaken prior to closing. The following make its own assessment of the capital needs of are some issues specific to covenants in the target going forward, often hiring its own insurance M&A transactions. actuaries to conduct an independent review of reserve adequacy. Efforts to Obtain Governmental Approvals. Unlike most other pre-closing Investment Assets. The acquirer will have an covenants, the provisions addressing the parties’ interest in reducing the risk associated with the efforts to obtain governmental approvals is a target’s investment portfolio and in having covenant that places obligations mainly on the flexibility with respect to the investments. acquirer, rather than the seller. The acquirer is Therefore, the acquirer will sometimes ask that required to file the Form A application and be the seller liquidate the target’s investment approved as the target’s new owner. However, portfolio into cash or cash equivalents between the seller is typically obligated to co-operate with signing and closing. At the very least, the the acquirer in preparing and gathering acquirer will want to make sure that the seller necessary information about the target for the ensures, during the pre-closing period, that the Form A application. target does not engage in investment practices that have not been agreed upon by the seller and A question that often arises in connection with the acquirer in a separate investment policy Form A approval is the extent to which the document, or that the target’s investment acquirer and seller will be obligated to satisfy policies are consistent with past practice. In requirements or conditions imposed by the short, the acquirer does not want any domiciliary regulator in connection with unexpected negative swings in the investment approval of the Form A filing. Regulators portfolio, especially if the performance of the (sometimes under pressure from policyholder investment portfolio is not subject to purchase groups and other stakeholders) may view an price adjustment. The seller, on the other hand, acquirer as less financially stable than the seller, may not want to liquidate the target’s portfolio if for reasons ranging from the acquirer having an doing so would realize losses, or may want to inexperienced management team to poor credit refrain from liquidating the portfolio until the ratings and a less robust balance sheet. Under seller is certain that the transaction will close. In such circumstances, the regulator may impose larger transactions, liquidating a large requirements or conditions. For example, it may investment portfolio may also be costly and require that additional capital be contributed to inefficient. The seller may view the nature and the target as a condition for approving the allocation of the investment portfolio as fully transaction. The parties should address in the adequate and may argue that the acquirer will be purchase agreement how to resolve such in a position to make any changes it sees fit once requests or “burdensome conditions,” and to the acquirer has assumed control of the target. what extent they will be contractually obligated to satisfy such conditions. From a drafting Seller Guarantees. Insurers and their perspective, this can be problematic, since the insurance and reinsurance often purchase agreement will be submitted to the rely on guarantees from the insurer’s parent regulator with the Form A application, and thus company or the parent’s affiliates to support

25 Mayer Brown | Mergers and Acquisitions in the U.S. Insurance Sector their operations. Such guarantees could be in • make any changes to underwriting or claims place to support a credit rating or a letter of handling practices; and credit issued to support reserve financing, or • make any changes to its investment could be the result of an agreed undertaking guidelines or policies. with regulatory authorities. The seller will want to terminate any such arrangements at closing. Reserve Financing. In insurance M&A transactions involving a life insurer that is using The acquirer is typically sympathetic to the one or more captive reinsurers to relieve capital seller’s view, but may not want all terminations of seller guarantees to be closing conditions. strains caused by Regulations XXX and AXXX (see Due Diligence in Insurance M&A Instead, the acquirer may indemnify the seller Transactions – Reserve Financing), the parties for any parental guarantees that the parties have not been able to replace or terminate by closing, will want to address how the transfer or replacement of such arrangements will be and the acquirer may undertake to make efforts handled. Most of today’s captive reinsurer to replace or help terminate the guarantees as promptly as possible. transactions are backstopped by a letter of credit issued by a financial institution. The parties Insurance-Specific Interim Operating should consider whether the acquirer will be Limitations. Virtually all M&A agreements able to continue using that arrangement after dictate how the seller is allowed to operate the closing. If not, the parties will want to agree on target in the period between signing and closing. how the arrangement shall be replaced and the These covenants, sometimes referred to as timeline to complete replacement. If a “interim operating limitations,” usually require replacement structure is contemplated, the the seller to operate the target in the ordinary parties should consider who will be responsible course of business and refrain from taking for the initial funding of the new captive certain enumerated actions. Many of the interim reinsurer and the costs for issuance of the new operating limitations in an insurance M&A letter of credit. The parties should also transaction will be identical or similar to those explore what regulatory filings and approvals in other M&A transactions. In addition, are required for such replacement and the insurance M&A purchase agreements also obligations of the parties in include covenants requiring the target not to: connection therewith. • terminate, fail to renew, or let lapse any certificate of authority or other KEY CLOSING CONDITIONS insurance license; Purchase agreements in an insurance M&A transaction tend to include many of the same • change the terms for payment of commissions closing conditions that one would find in to any insurance agents, brokers, purchase agreements in other industries, such as or producers; confirmation that the representations and • modify its insurance policy forms in a manner warranties are accurate in all material respects, resulting in a material change in risk that pre-closing covenants have been satisfied in or coverage; all material respects, that anti-trust law • modify any reinsurance agreement or clearance has been received, that there is no treaty resulting in a material change in risk injunction or order preventing the transaction or coverage; from consummating, and that no material • reduce any insurance reserves other than as adverse effect has occurred. The acquirer in an required by SAP, or change the reserve insurance M&A transaction may also seek methodologies or practices; additional closing conditions to address

26 Mayer Brown | Mergers and Acquisitions in the U.S. Insurance Sector insurance-specific regulatory and business require that the termination of such guarantees concerns, such as the following. be added as a closing condition if, for example, such termination effectively requires prior Receipt of Governmental Approvals approval of a regulatory body. without Burdensome Conditions. As noted in Key Covenants – Efforts to Obtain Financial Metrics. Financial institutions, Governmental Approvals, the acquirer will seek including insurance companies, live and die by approval of the transaction from the target’s financial metrics. For example, if an insurer’s domiciliary regulator by filing a Form A RBC ratio falls below 200%, it will likely be application with the regulator upon signing the subject to intervention by the domiciliary purchase agreement. The acquirer’s receipt of regulator. From the acquirer’s perspective, a approval of the Form A filing should therefore be purchase price adjustment tied to the target’s included as a closing condition. Moreover, the RBC ratio (which would allow the acquirer to acquirer will typically be mindful of the nature pay a lower purchase price for the target if the and substance of such approval. A Form A RBC ratio dipped) may not be wholly approval can impose certain conditions on the satisfactory. Consequently, the acquirer may parties (typically on the acquirer as the new require that the RBC ratio be 300% or higher at presumptive owner of the target). For example, closing to avoid having to address an RBC the domiciliary regulator could condition the ratio problem at the outset of its ownership of approval on the acquirer’s establishment of a the target. separate trust with investment assets to be held Ratings. In situations where the target’s for the benefit of the target or on the acquirer’s financial strength ratings are critical to its contribution of additional capital to the target. operations, it is not uncommon for the parties to Therefore, the acquirer will often try to negotiate agree to include a closing condition that a closing condition that states that the Form A indicates the lowest allowable financial strength approval shall have been received and does not rating of the target. Such ratings conditions include any “burdensome conditions” or similar typically stipulate that the target has neither wording. The definition of “burdensome been placed on a rating agency watch list nor conditions” as it relates to the closing condition had its rating qualified with a negative outlook. section of the purchase agreement will often mirror the acquirer’s covenant regarding efforts POST-CLOSING RECOURSE to obtain governmental approvals. If the seller Indemnification and other post-closing recourse agrees to a “no burdensome conditions” concept, provisions included in an insurance M&A it will generally focus on limiting the parameters agreement are comparable to those seen in other of what constitutes a “burdensome condition.” industries. Provisions included to address Termination of Seller Guarantees. The insurance-specific concerns are described below. seller may have provided capital maintenance Specific Indemnities. An M&A transaction commitments or other parental guarantees for can include unlimited indemnity protection for the benefit of the target as support for credit specific events and circumstances, for which the ratings or letters of credit issued or due to acquirer requests that the seller take the risk. In regulatory mandates. The seller, who will no an insurance transaction, common areas for longer receive any benefits from the target’s specific indemnities are: operations after closing, will naturally want to ensure that such seller guarantees are • policyholder claims for extra-contractual terminated prior to closing. Depending on the obligations or claims in excess of insurance type of parental guarantee, the seller may policy limits; and

27 Mayer Brown | Mergers and Acquisitions in the U.S. Insurance Sector • certain types of litigation common in the not uncommon for the seller to require the insurance industry, such as litigation with acquirer to indemnify it and its affiliates for any insurers or reinsurers involving large losses incurred in connection with providing reinsurance claims and class action such fronting services. policyholder lawsuits, or regulatory actions initiated against the target for improper Post-closing Matters conduct of business such as false The following post-closing matters are advertisement and discriminatory sometimes made part of an insurance M&A underwriting. transaction, either through incorporating Certificates of Authority in Shell relevant provisions in the covenants section of Company Deals. If an acquirer is acquiring a the purchase agreement or through ancillary shell company without meaningful operations, it agreements that are executed at closing. will often try to strengthen the indemnification provisions backstopping the validity of the FRONTING ARRANGEMENTS target’s certificates of authority. The rationale As discussed in The Purchase Agreement – Post- for this is that the sole purpose of a shell closing Recourse, in cases where a reinsurance company acquisition is to acquire the target’s agreement transfers underwritten business from certificates of authority. The strengthening of an insurance company to another party that the indemnification provisions can be done in cannot write its own business in a particular numerous ways, including by extending the jurisdiction, the ceding insurer may agree to survival period for the seller’s representations write renewal policies, or “front” for the other regarding such certificates of authority to give entity until it is able to write its own renewal the acquirer additional time to evaluate their policies. Consequently, the fronting validity. This can be done by providing that arrangement is designed to avoid unnecessary defective certificates of authority will be covered interruption and loss of business during a by a specific indemnity (outside the limitations transitional period. If a fronting arrangement is imposed by baskets and caps), or by providing necessary, the seller and acquirer should include that any defective certificates of authority will post-closing covenants in the purchase result in a purchase price deduction. agreement to address the period of time during which the fronting services will be provided, Fronting Arrangements. Sometimes the under what circumstances the ceding insurer’s seller, or a seller-affiliated insurance company obligations to provide the fronting services will that is not included in the transaction, has been be excused, and what level of effort the assuming writing business out of a state where the target entity is required to make to ensure that the does not have a certificate or authority to do so. required licenses are eventually obtained. As the Nevertheless, the parties may have agreed that provider of the fronting services, it will be the business written by the seller or its affiliate important to the fronting company to assess how should pass to the acquirer in the transaction the fronting arrangement will affect the capital through a reinsurance arrangement. Since the requirements during the transitional period and target does not have a certificate of authority to how business risk related to the fronting write business in the state, and it would take arrangement is being shared between the time for the target to acquire such certificate, the parties. It should be noted that depending on the seller may agree to “front” renewals of existing transaction structure and the circumstances, business for the acquirer during a set period of both the seller and the acquirer could require time or until the target is able to write such fronting services from the other. renewals itself. Under such circumstances, it is

28 Mayer Brown | Mergers and Acquisitions in the U.S. Insurance Sector TRADEMARK ISSUES To backstop such initial determination, the If the target uses or has used trademarks or acquirer may attempt to include a seller names that belong to the seller and its representation regarding the “sufficiency of affiliates and that are not being transferred to assets” of the target. This can be used to the acquirer in the transaction, the seller will determine what the target lacks in terms of its want to ensure that the target does not use such ability to operate as a stand-alone entity. The trademarks and trade names after closing. The acquirer will also be guided by the seller’s acquirer, on the other hand, should make sure representations regarding intercompany that it will not be deemed to have infringed the agreements and material agreements that will rights of such trademarks require third-party consent in connection with and trade names during the period that such the transaction in order to assess what services trademarks and trade names are being phased and agreements may not be available to the out or being changed. A name change of an target and the acquirer following the closing. In insurance company often requires regulatory smaller insurance M&A transactions it is approval and multistate filings. In addition, common for the target to have been operated as material used by the target, such as policy forms, a pure financial entity without its own operating will likely also have to change. Such changes can assets (e.g., employees, facilities, accounting, also require governmental approval. Although legal, and finance functions). If that is the case, the seller will want to ensure that the target and the seller or an affiliate of the seller will likely the acquirer do not use the retained seller have provided such core services by way of one trademarks after closing, the acquirer wants to or more service agreements. If the acquirer will give itself sufficient time to phase out such be unable to provide such services to the target trademarks and receive any governmental upon closing, it may need to negotiate a approvals required for such changes. transition services arrangement with the seller so that the seller will continue to provide the POST-CLOSING FILINGS services on a temporary basis after closing. In Not all filings made in connection with an connection with negotiating and drafting a insurance M&A transaction are required to be transition services agreement, it will be filed prior to closing. For example, many states important for the acquirer to determine to what require an insurance company that is licensed extent the target has relied on such services from (but not domiciled) in the state to file a notice affiliates. Such transition services agreements with the state insurance department following a may be subject to Form D filings. merger or acquisition. Many states require or accept a standard NAIC form called the TAX ALLOCATION Corporate Amendments Application for The target is also commonly a party to a tax this purpose. allocation agreement with the seller and other affiliates to take advantage of joint group tax TRANSITION SERVICES ARRANGEMENTS filings. Any such tax allocation agreement will be A central aspect of any M&A transaction is to terminated in connection with the closing, and what extent the target is self-sufficient and able the acquirer will want to determine if a to operate on its own after the closing. The replacement tax allocation agreement with the acquirer will want to determine during the due acquirer and its affiliates should be entered into diligence phase what additional resources will be following closing. Such new tax allocation needed by the target after the closing. agreements may be subject to Form D filings

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30 Mayer Brown | Mergers and Acquisitions in the U.S. Insurance Sector