Regulatory Update: NAIC Summer 2019 National Meeting

Under Regulation Best Interest (Regulation BI), as adopted by the U.S. Securities and Exchange Commission on June 5, 2019, broker-dealers and associated persons are required to act in the best interest of a retail customer when recommending a securities transaction or investment strategy involving securities to a retail customer. While Regulation BI does not expressly define “best interest,” the obligations under Regulation BI will be satisfied if the broker-dealer complies with certain disclosure obligations, care obligations and conflict of interest obligations as prescribed by Regulation BI. 

Similarly, the ASWG is considering whether, in the context of the SAT, “best interest” should be defined by reference to the following obligations: a disclosure obligation, a care obligation, a conflict of interest obligation, a documentation obligation and a supervision system/compliance obligation. Once the ASWG determines the meaning of “best interest,” the ASWG will then consider whether it supports including a “best interest” standard in the proposed amendments to the SAT. 

The New York State Department of Financial Services recently amended its annuity suitability regulation to apply a “best interest” standard in connection with both life insurance and annuity transactions with consumers. The amended regulation took effect on August 1, 2019, for annuity products and will become effective on February 1, 2020, for life insurance products. 

The ASWG is forming a technical drafting group to develop a revised draft of the proposed amendments to the SAT, which the ASWG will expose for public comment. The ASWG intends to present a draft of the proposed amendments to the Life Insurance and Annuities (A) Committee for its consideration prior to or at the NAIC’s Fall 2019 National Meeting. The last draft of the proposed amendments to the SAT that was exposed for comment was dated November 19, 2018, and it did not include a standard that expressly referenced the “best interest” of the consumer. 

On June 25, 2019, the NAIC adopted the Revised CFR Model Laws to incorporate the collateral reduction requirements set forth in the Covered Agreements. The revisions to the CFR Model Laws permit a ceding insurer to take credit for reinsurance ceded to a qualifying unauthorized reinsurer without collateral if the reinsurer satisfies certain criteria, including being domiciled in a “reciprocal jurisdiction.” Under the Revised CFR Model Laws, a “reciprocal jurisdiction” includes (a) a non-U.S. jurisdiction (such as the EU and the UK) that has entered into a covered agreement with the U.S., (b) a “qualified jurisdiction” (generally expected to consist of Bermuda, Japan and Switzerland) that meets certain additional requirements consistent with the terms and conditions of the Covered Agreements and (c) any NAIC-accredited U.S. state.

The Covered Agreements require states to take action with respect to the reinsurance collateral provisions within 60 months (or five years) of signing or face potential federal preemption by the Federal Insurance Office (FIO) under the federal Dodd-Frank Wall Street Reform and Consumer Protection Act. FIO may begin its federal preemption analysis on April 1, 2021, which is the first day of the 42nd month after the date of signature of the Covered Agreement. Any changes or modifications by states to the language as adopted in the Revised CFR Model Laws could potentially lead to a federal preemption analysis by the FIO.

At the Summer Meeting, the Financial Regulation Standards and Accreditation (F) Committee ((F) Committee) discussed the process for amending the current reinsurance ceded accreditation standard (Accreditation Standard) while encouraging states to begin immediate and uniform adoption of the Revised CFR Model Laws. As a result of the changes in the Revised CFR Model Laws, the Accreditation Standard under the NAIC Financial Regulation Standards and Accreditation Program (Accreditation Program) must be revised; otherwise states adopting the revisions to CFR Model Laws will be out of compliance with the current Accreditation Standard, which presently permits reduction, but not complete elimination, of reinsurance collateral for “certified” reinsurers. The normal process for review under the Accreditation Program provides time for public discussion and exposure and can take a total of at least four years to complete. The Accreditation Program also includes a mechanism for expedited review, which may take up to two full years to complete.

In light of the risk of federal preemption, the (F) Committee adopted the following three recommendations with respect to the Accreditation Standard:

• Recognize that states may begin the adoption of provisions that are substantially similar to the Revised CFR Model Laws and remain in compliance with the Accreditation Standard.
• Modify the Accreditation Standard in accordance with the normal processes and procedures outlined in the Accreditation Program, with the goal of review by the (F) Committee at the Spring 2020 National Meeting.
• Encourage states to adopt the Revised CFR Model Laws in the form adopted by the NAIC within the 60-month timeframe set forth in the Covered Agreements to avoid federal preemption.

While the (F) Committee initially seemed to be in favor of following the normal timeline set forth in the Accreditation Program for revisions to the Accreditation Standard, during the Reinsurance (E) Task Force meeting, regulators and interested parties raised concerns that the delay caused by following the normal process may send a message that timing is not of the essence and therefore states may wait to adopt the Revised CFR Model Laws. Many interested parties noted that state legislatures often are not motivated to adopt model law revisions without such revisions being required as part of the Accreditation Program. In response to these concerns, members of the (F) Committee noted that they intend to send a clear message that states should begin the immediate adoption of the CFR Model Laws and agreed to consider whether to use the expedited process for review of the Accreditation Standard.

The following material changes were made in the July Draft (as compared to the March Draft), and during a July 29, 2019 teleconference the ADWG voted on several of the key outstanding issues, as further described below.

• Whereas the March Draft would prohibit the illustration of indexed returns for an index that has been in existence for less than 20 calendar years unless certain criteria are met, the July Draft decreases the index history requirement to 15 years (unless 20 years of history is otherwise available for illustration). During the July 29 teleconference, the ADWG voted in favor of including this requirement in the final version of the proposed revisions to Model 245.
• Whereas the March Draft would require an index less than 20 years old to be constructed entirely of a “combination of indices, each of which has been in existence for at least 20 years,” the July Draft would, in addition to reducing the age requirement to 15 years, also allow such constructed indices to include “financial instruments” that have been in existence for at least 15 years. During the July 29 teleconference, the ADWG rejected the requirement that an index less than 15 years old be constructed entirely of a “combination of indices, each of which has been in existence for at least 15 years.” However, the ADWG did not vote in favor of allowing constructed indices to include “financial instruments” that have been in existence for at least 15 years, as the July Draft had proposed. Instead, the consensus of the ADWG was to allow “financial instruments” as a general conceptual matter but to draft language that defines such term (which in the July Draft remained undefined).
• The July Draft would require “backcast” history to be visually delineated from “actual” history for the consumer. During the July 29 teleconference, the ADWG voted in favor of including this requirement in the final version of the proposed revisions to Model 245.
• Whereas the March Draft would require any constructed indices that use algorithms to have such algorithms be fixed from the creation of the index, the July Draft would allow changes to an algorithm pursuant to “an index provider’s established governance rules and procedures.” During the July 29 teleconference, the ADWG rejected the newly added language and voted to require any constructed indices that use algorithms to have such algorithms be fixed from the creation of the index.
• Whereas the March Draft would require “any algorithm or other method that is supporting such an index and is included in the illustration” to be available for inspection at the request of the commissioner or the consumer, the July Draft deleted the consumer’s inspection right. The ADWG did not have an opportunity to vote on this issue during the July 29 teleconference.

The ADWG is expected to continue to meet by teleconference to finalize the proposed revisions to Model 245 in order to present them for consideration by the Life Insurance and Annuities (A) Committee prior to or at the NAIC’s Fall 2019 National Meeting. 

Consultation on the Holistic Framework was initiated in November 2018, and in early 2019 the IAIS published a summary of the feedback it received and the policy decisions taken in response to these comments. During the Summer Meeting, a panel of industry members provided input on the Holistic Framework and, in particular, the IAIS’ response to the comments received during the consultation period. In general, panel members were supportive of the Holistic Framework but continued to reiterate concerns regarding (a) the evaluation of systemic risk in activities versus products, (b) cross-sector evaluation of risk among industries and (c) the process for implementation among supervisors and global regulatory bodies. On June 14, 2019, the IAIS announced the launch of an additional consultation period (which ended August 15) to seek feedback on revisions to certain Insurance Core Principles (ICPs) and Common Framework for the Supervision of Internationally Active Insurance Groups (ComFrame) material related to the Holistic Framework. With the close of this public consultation period, the IAIS will start its internal process to review and resolve comments received and perform a final editorial check for consistency. The IAIS plans the adoption of the Holistic Framework, revised ICPs and ComFrame in November 2019.

In addition to the Holistic Framework, as part of ComFrame, the IAIS is developing an insurance capital standard (ICS), which is expected to apply to internationally active insurance groups (IAIGs). The ICS is intended to act as a risk-based global groupwide prescribed capital requirement and is expected to be approved by the IAIS by year’s end. Prior to full implementation, the ICS will undergo a five-year monitoring period, during which the ICS will be used for confidential reporting to the groupwide supervisor and discussion in supervisory colleges.

The U.S. continues to work on the development of its own group capital standard (GCC), and efforts continue to ensure that the GCC’s aggregation method will be deemed outcome-equivalent to the ICS to avoid the application of multiple capital standards to U.S. groups. Panel members continued to express concern regarding transparency on how the GCC will be evaluated for its outcome equivalence. In particular, industry representatives expressed concern that the measures for determining outcome equivalence need to be addressed at the beginning of the monitoring period rather than at the end as concerns still linger that the monitoring period will not be viewed as a period of continuing development. IAIS representatives noted that the issue of comparability will be the subject of upcoming meetings at the IAIS and that prior to moving onto the monitoring period, the IAIS intends to have in place a framework for the process, noting that the IAIS has an ongoing commitment to the evaluation of the aggregation method.

Field testing for the GCC began in mid-May 2019 and will continue into the fall. As the field testing process enters the regulator review stage, conversations centered on the confidentiality protections that will be provided for the data submitted to lead state regulators in connection with the GCC. The Group Capital Calculation (E) Working Group is considering amendments to the NAIC Insurance Holding Company System Regulatory Act to specifically provide for confidential treatment of the information reported in connection with the GCC and reviewed a draft referral letter to the Group Solvency Issues (E) Working Group. However, industry participants expressed concern regarding whether such revisions would go far enough to address permitted voluntarily disclosure of a group’s GCC, which could lead to the possible unintended use of the GCC as a comparison tool among groups. The GCC Working Group intends to continue to discuss this issue, as regulators and industry members agree that robust confidentiality protections will need to be in place prior to the GCC going into effect.

The issue of the application of SSAP No. 43R to CFOs and related instruments was brought to the attention of NAIC staff by an unidentified rating provider who contacted the NAIC to request information regarding the treatment of CFOs for statutory accounting purposes. After reviewing the matter, NAIC staff proposed revisions to SSAP No. 43R to clarify that the intent of SSAP No. 43R is to capture investments that have bondlike cash flows and to explicitly exclude (a) any structures with underlying equity exposures and (b) securitization of assets that were previously reported as standalone assets by the insurer (i.e., existing assets that are “repackaged” via securitization).

Specifically, the proposed revisions include the following statements:

“Pursuant to the intent of to capture investments with bond-like cash flows, the scope of SSAP No. 43R does not include equity instruments, investments with underlying assets that include equity instruments or any structures representing an equity interest (e.g., joint ventures, limited liability companies, partnerships) in which the cash flow payments (return of principle or interest) are partially or fully contingent on the equity performance of an underlying asset. For example, Collateralized Fund Obligations (CFO) are not captured in scope of SSAP No. 43R. In these structures, investors gain exposure to a collection of funds (or equity interests) with the established interest and principle payments based on the issuer’s expected performance of the underlying funds. These are equity investments and shall not be captured as debt instruments in scope of SSAP No. 43R. [typos as per original]

“The scope of SSAP No. 43R shall not include any securitization of assets that were previously reported as standalone assets by the insurance reporting entity. In other words, an insurance reporting entity is not permitted to repackage existing assets as ‘securitizations’ to move the reporting of the existing assets within scope of SSAP No. 43R. For example, investments in joint ventures held by a reporting entity and reported on Schedule BA shall not be repackaged as a securitization (with the joint ventures as the underlying assets) for reporting on Schedule D-1: Long-Term Bonds. This guidance is applicable regardless if the reporting entity retains less than 100% of the securitized assets. In these situations, the reporting entity shall continue to report the underlying assets (with any reduction of ownership) as if they had not been repackaged into a securitization.”

NAIC staff indicated that despite the fact that the proposed revisions were not yet exposed for comment, a number of comment letters from interested parties had already been received but noted that many of the letters received to date related to suggested clarifications on the treatment of lease-backed securities and equipment trust certificates.

Chair Dale Bruggeman (Ohio) highlighted that these changes are categorized as nonsubstantive for purposes of review by the SAP Working Group, which means, for purposes of the process for review and development of the proposed changes by the SAP Working Group, that the SAP Working Group does not deem the proposed changes as modifying the conclusion or original intent of the existing SSAP. Conversely, revisions that the SAP Working Group does deem to be “substantive” follow a more formal process through which a new issue paper and SSAP would need to be developed. As such, the Chair noted that even though the proposed revisions are categorized as nonsubstantive, given the complex nature of determining what may be in or out of the scope of SSAP No. 43R, an issue paper may still be warranted to properly document the discussions and determinations made in connection with evaluating the proposed revisions. 

The motion to expose the proposed revisions was passed without additional comment or discussion from members of the SAP Working Group or interested parties. The deadline to submit comments to the exposed revisions is October 11, 2019.

In response to regulator inquiries, NAIC staff recommended revisions to SSAP No. 71 with regard to the use of levelized commission arrangements and when the liability for commission based on annual persistency is required to be recorded as a liability in accordance with SSAP No. 5R — Liabilities, Contingencies and Impairments of Assets.

In a levelized commission arrangement, a third party pays agents nonlevelized commissions and the reporting entity pays a third party levelized payments. It is intended, but not necessarily guaranteed, that the amounts paid to the agents by the third party would ultimately be repaid to the third party from the reporting entity. SSAP No. 71 identifies such arrangements as funding agreements between the reporting entity and the third party and identifies that the use of a commission arrangement where commission payments are not linked to traditional elements (such as premium payments and policy persistency) requires the establishment of a liability for the full amount of the unpaid principal and accrued interest that is payable to a third party related to levelized commissions. 

While the revisions were not formally exposed for comment, industry representatives commented that despite the “non-substantive” listing of these revisions, the effect of the proposed changes to SSAP No. 71 will be substantive to the industry, as they will result in the need to reserve for the payment of all unpaid commissions. The motion to expose the proposed revisions was passed without additional comment or discussion from members of the SAP Working Group or interested parties. The deadline to submit comments to the exposed revisions is October 11, 2019.

The proposed revisions were initially exposed at the Spring 2019 National Meeting and are intended to prevent situations in which affiliated debt is knowingly captured and repackaged to be recorded as “non-affiliated” because of the involvement of a non-related party. In response to the exposed revisions, interested parties commented that the proposed wording used the terms “affiliated” and “related party” interchangeably and the NAIC staff made further revisions to the Proposed Changes to address those comments and clarify the use of the terms. 

In addition, NAIC staff added clarifying footnotes with regard to the determination of whether a transaction should be treated as a related party transaction. A new footnote to the revisions to SSAP No. 32 — Preferred Stock states that “[a]s identified in SSAP No. 25, it is erroneous to conclude that the inclusion of a non-related intermediary, or the presence of non-related assets in a structure predominantly comprised of related party investments, eliminates the requirement to identify and assess the investment transaction as a related party/affiliated arrangement.” [emphasis added] A separate footnote to the revisions to SSAP No. 43R states that “[w]ith the identification of whether the reporting entity has a minor ownership interest, reporting entities must also identify whether the investment is an affiliate transaction. Pursuant to the concepts reflected in SSAP No. 25, consideration shall be given to the substance of the transaction, and the parties whose action or performance materially impacts the insurance reporting entity holding the security.” [emphasis added]

While these footnotes are intended to clarify that the test for determining what makes an investment related or nonrelated is one of facts and circumstances, it remains to be seen how regulators will interpret whether an investment is “predominately” comprised of related-party investments or whether a reporting entity has a “minor ownership interest,” leaving uncertainty regarding how these revisions will be applied. 

The Innovation and Technology (EX) Task Force (IT Task Force) initiated the model law amendment process to revise the NAIC’s Unfair Trade Practices Act to address anti-rebating laws that some perceive to be an obstacle to innovative insurance solutions. Before resources can be devoted to the development or drafting of an amendment to a model law, approval of the Executive (EX) Committee must be obtained. Pending such approval from the Executive (EX) Committee, the IT Task Force agreed to explore the option of developing a guideline on rebating based on the draft “North Dakota Guidance on Rebating” document (Draft Guideline Document) prepared by the North Dakota Insurance Department. The Draft Guideline Document is intended to facilitate discussion and serve as a starting point for developing guidance on rebating. It provides that insurers may offer value-added products, services or programs at no additional cost as long as they are (a) specified in the insurance policy, (b) aligned with the type of insurance offered and (c) either (i) mitigate loss or provide loss control that aligns with the risks of the policy or (ii) assess risk, identify sources of risk or develop strategies for eliminating or reducing those risks that aligns with the risks of the policy. The Draft Guidance Document further provides that value-added products, services or programs must comply with all other provisions of North Dakota law and that an application of North Dakota’s laws to each situation would require a fact-specific analysis. The IT Task Force requested that regulators and interested parties submit comments to the Draft Guideline Document by September 6, 2019.

The Casualty Actuarial and Statistical (C) Task Force exposed two new sections of its white paper on best practices for regulatory review of predictive analytics, including revisions to the Product Filing Review Handbook and Proposed State Guidance. The Task Force continues to consider previously submitted comments to the white paper for potential changes to the next draft.

In response to a referral from the Big Data (EX) Working Group, the Life Insurance and Annuities (A) Committee also voted to form a new working group, the Accelerated Underwriting (A) Working Group, which is expected to be led by Illinois and is charged with (a) studying the use of external data and data analytics in accelerated life underwriting (i.e., underwriting life products without the use of traditional medical examinations or blood and urine tests) and (b) considering the need for drafting state guidance. 

The VOS Task Force adopted a proposed amendment to the Purposes and Procedures Manual (P&P Manual) of the NAIC Investment Analysis Office to update the definition and instructions for structured notes that is intended to bring the P&P Manual in line with updates adopted by the Statutory Accounting Principles (E) Working Group to SSAP No. 26R — Bonds and SSAP No. 43R — Loan-Backed and Structured Securities. 

The VOS Task Force also exposed a proposed amendment to the P&P Manual related to principal-protected notes. As discussed by the VOS Task Force, there are concerns that principal-protected notes, which would otherwise be ineligible for reporting on Schedule D, are being reported on Schedule D through financial structuring. The amendment proposes to remove such assets from the filing exemption process. The amendment has been exposed for a 45-day comment period ending September 19, 2019. 

The VOS Task Force also heard an update on various projects, including an analysis of bespoke securities. While the VOS Task Force has not provided a specific definition that covers all possible bespoke securities, it has identified certain common characteristics of such securities. A bespoke security is one that, among other possible characteristics, is “(a) not broadly syndicated, (b) created by or for one or a few related insurance companies as an investment and (c) to be assigned a credit rating by only one NAIC credit rating provider.” Given the characteristics of bespoke securities and transparency concerns for the market and regulators, the NAIC currently lacks the ability to detect unusual risks or consider the financial solvency impact of such securities. The VOS Task Force intends to draft an issue paper that will include a proposed regulatory framework for how to address bespoke securities. 

The cannabis industry continues to grow with many states continuing to carve out exceptions for cannabis use. Currently 33 states, as well as Washington, D.C., allow cannabis use for medicinal purposes, while 11 states and Washington, D.C., have passed laws allowing recreational cannabis use. The 2018 Farm Bill removed certain products derived from hemp from the definition of “marijuana,” meaning such products are no longer controlled substances under federal law. 

The white paper identifies key areas of concern for insurers, particularly around the legal issues related to the interplay of state and federal law, as cannabis remains a Schedule I drug under the Controlled Substances Act, triggering potential legal issues with many federal statutes (Banking Secrecy Act, the money laundering statute and the unlicensed money transmitter statute). In 2019, however, Attorney General William Barr stated he does not intend to pursue enforcement of federal law against legal cannabis businesses operating intrastate. 

The white paper also highlights the need for several different types of insurance along the cannabis supply chain, which includes general liability, workers’ compensation, product liability and property insurance. States have started requiring insurance for cannabis businesses with some, such as California and Massachusetts, requiring insurance for licensure. Due to the relatively new nature of these businesses and rate at which some factors shift, the adequacy of insurance coverage is likely to change quickly. The white paper recommends that state regulators continue to educate insurance companies and monitor gaps.