Richard J. Fidei Insurance Law Blog on Lawyers.com

During September, 2008, the Florida Cabinet adopted a potentially far-reaching Rule providing for an alternative ratings-based approach to the State’s reinsurance collateral requirement enabling ceding insurers to take credit for reinsurance. In essence, the new Rule provides for lower collateral requirements for certain reinsurers that are determined to be "eligible" by the Florida Insurance Commissioner after an application process. These requirements will be based upon insurer credit ratings.

Reinsurance Credit in Florida

Under Florida’s current system and throughout the United States, insurers are permitted to take credit on their financial statements for ceded reinsurance based upon certain conditions being met. In Florida, credit for reinsurance has been available if a reinsurer is authorized or accredited by the State. Otherwise, credit is available only if the reinsurer posts appropriate collateral under a reinsurance agreement in order to secure its obligations, which would normally include losses and loss adjustment expenses, as well as unearned premium. Typically, the assuming reinsurer, if not licensed or accredited in Florida, would be required to post money or assets into a trust fund, or arrange for the issuance of a bank letter of credit--both for the benefit of the ceding insurer. This law still remains in place and provides an appropriate mechanism for the insurer to obtain credit for reinsurance.

Adopted pursuant to 2007 legislation, Florida’s new ratings-based Rule enables the State’s Insurance Commissioner to establish lower collateral requirements for unauthorized and unaccredited foreign and alien reinsurers that meet the Rule eligibility standards, as well as those that have certain financially secure ratings from at least two nationally recognized rating organizations.

Eligibility status requisites

Part of the eligibility determination process to secure reinsurance credit includes demonstrating satisfactory evidence that the ceding insurer meets and maintains solvency standards of its domestic regulator. A reinsurance contract also must contain certain required provisions relating to solvency, including service of process and the reinsurer’s submission to Florida jurisdiction.

Among the requirements for a determination of reinsurer eligibility include possession of surplus over $100 million, authorization in a domiciliary jurisdiction for the types of insurance to be ceded, and determination of eligible domiciliary jurisdiction by the Insurance Commissioner.

After review of all appropriate information, the Insurance Commissioner must decide upon the amount of credit that may be taken without posting collateral, taking into account the best interests of market stability and the solvency of ceding insurers.

What are the benefits of eligibility?

Under the new Rule, a reinsurer would still be required to post 100 percent collateral for its obligations unless it has and maintains certain minimum ratings from at least two nationally recognized credit rating agencies, such as A.M. Best Company, Standard and Poor’s, Moody’s Investors Service or Fitch Ratings. Simply, the higher a reinsurer’s credit ratings, the less collateral that must be posted. A schedule of required collateral percentages based on credit ratings is contained in the Rule.

What should an eligibility application include?

Reinsurers are required to submit the following in an eligibility application to Florida’s Insurance Commissioner:

¿ Audited financial statements

¿ An agreement to submit to U.S. jurisdiction and to post 100 percent collateral if the reinsurer resists a final judgment or fails to provide any information required by the Florida Office of Insurance Regulation ("OIR")

¿ An report pertaining to its ceding and ceded reinsurance

¿ A list of disputed or overdue recoverables claimed by ceding insurers

¿ Certification of good standing from its domiciliary regulator and that the regulator will provide any OIR-required financial and operational information

Domiciliary regulator eligibility requisites

For reinsurers to be eligible under Florida’s new Rule, the Insurance Commissioner must determine from the following criteria that the reinsurer’s domiciliary jurisdiction has eligibility status:

¿ The jurisdiction has satisfactory structure and authority regarding solvency regulation: acceptable financial and operating standards; acceptable, transparent financial reports; and verifiable evidence of adequate and prompt enforcement of U.S. judgments and arbitration awards

¿ The jurisdiction has a history of performance by its reinsurers such that the public would be served by an eligibility finding by OIR

¿ For non-U.S. jurisdictions, the particular jurisdiction involved provides U.S. reinsurers with the same favorable market access as those provided by Florida to its reinsurers

¿ There is no information to support a determination that a finding of eligibility would not serve the public best interests.

If, at any point, a list of eligible jurisdictions is promulgated by the National Association of Insurance Commissioners ("NAIC"), the Insurance Commissioner in Florida can utilize that list if it is judged in the best interests of the public and the solvency of ceding reinsurers to do so.

Conversely, the Insurance Commissioner may withdraw any eligibility determination for any jurisdiction if it is determined that such action is in the best interests of market stability and the solvency of ceding insurers.

Eligibility rules and criteria

Florida’s Insurance Commissioner, who has broad discretion under the new Rule, must act in the best interests of market stability and the solvency of ceding insurers. Using this standard, the Insurance Commissioner has authority to decide the following:

¿ reinsurer eligibility

¿ withdrawal of eligibility determination or the determination of the amount of collateral required

¿ whether a determination that any particular jurisdiction is "eligible" should be withdrawn

¿ whether to disallow the ceding insurer’s credit for reinsurance or any portion thereof

Once eligibility is determined, the reinsurer is required to file annual certifications regarding its domiciliary state license, applicable credit ratings and financial statements, updates on any changes in its officers and directors, a list of disputed or overdue reinsurance claims, and other information as may be required by the OIR.

Upon an order of rehabilitation, liquidation or conservation of a ceding insurer, the eligible reinsurer shall be required to post 100 percent collateral within 30 days for the entire amount the cedant has taken as an asset or deduction from reserves for reinsurance recoverables.

Clearly, cedants will need to have a provision in the reinsurance contract for the posting of appropriate collateral in this situation.

If the rating of the eligible reinsurer improves, that reinsurer may petition the Florida Insurance Commissioner to redetermine the amount of collateral that will be required for ceded reinsurance.

Ceding insurer requirements under the new Rule

The ceding insurer is required to notify OIR if its experience in collecting recoverables would indicate that the credit provided should be lower.

In addition, the ceding insurer is required to give immediate notice to OIR and increase its reserves for reinsurance recoverables if any of the reinsurer’s obligations that are not in dispute are more than 90 days past due, or there is any evidence that the reinsurer fails to substantially comply with its domiciliary state’s solvency requirements.

What precipitated Florida’s rule change?

In Florida, reinsurance capacity and pricing became significant issues after the 2004 and 2005 hurricane seasons. In the wake of these storms, the Florida Legislature created a Task Force on Long-Term Solutions for Florida’s Hurricane Insurance. After multiple hearings, the Task Force found that matters pertaining to the capacity, availability and pricing of reinsurance in Florida needed to be addressed, and any artificial barriers to competition in the reinsurance market should be restricted so long as insurer solvency would not be jeopardized. At the same time, the NAIC was pursuing its reinsurance collateral rule modernization initiative.

For years, alien reinsurers have challenged the need for 100 percent collateralization, which has existed regardless of the financial stability of the reinsurers and the level of regulatory scrutiny imposed by domiciliary states. In addition, there has been strong sentiment that U.S. standards are more stringent than those of other nations, and that the increasing globalization of the reinsurance industry calls for standardized regulation of reinsurance. It also has been argued that freeing a reinsurer’s capital, which may be tied up in traditional reinsurance arrangements, would increase the capacity of the reinsurance market.

Rule impact on reinsurers, insurers and consumers

The impact of this Rule for reinsurers and insurers will be significant by readjusting how reinsurance collateral is handled in the future. Many in Florida argue that increased capacity of foreign capital will be available to be reinvested in the State and other states that adopt a ratings-based rule. This increased capacity ultimately is expected to benefit consumers.

At the September 16 reinsurance collateral Rule adoption, Florida Insurance Commissioner Kevin McCarty commented that he felt although lower premiums would be marginal based upon the Rule’s adoption, the action sends a positive message to the international reinsurance community that Florida is actively promoting reinsurance market competition.

Some have argued this change potentially would jeopardize the integrity and solvency of ceding insurers impacted by the Rule. This could be particularly true for smaller, single state insurers that may not have enough negotiating leverage to require collateral when not required by regulation, or that will have to pay a premium for that benefit. The current collateral requirements provide assurance that reinsurance collectables will be paid. If 100 percent collateral is not required, ceding insurers may be required to pursue reinsurance claims to recover the sums due and may be required to proceed in non-U.S. jurisdictions to collect on those claims.

In addition, the assets that would have otherwise been posted as collateral for reinsurance recoverables may be utilized for other purposes, which could potentially jeopardize the solvency of the reinsurers. By the time solvency issues are discovered, it may be too late for Florida regulators or the ceding insurer to take protective action that would assure that the ceding insurer will be made whole.

Potentially, this could jeopardize reinsurance collectibles and force cedants to negotiate settlements they would not have agreed to if they had secured 100 percent collateral. These types of issues could jeopardize the solvency of certain ceding insurers and lead to liquidations and guarantee fund payments, resulting in assessments by the Guaranty Fund on all Florida insurance consumers. It is argued all of this will occur even though it is unlikely that reinsurance rates will drop as a result of this Rule.

Rule impact On Florida’s "Cat" Fund

The Florida Hurricane Catastrophe Fund ("FHCF") functions as a state-backed reinsurer for Florida residential property carriers. Because the FHCF is not required to post collateral, it will not be directly affected by the changes in the collateral rule. Under Florida law, the FHCF provides certain layers of mandatory reinsurance coverage that must be purchased by Florida residential property carriers. It also currently offers other layers of voluntary coverage that may be purchased. Generally, the pricing for some of these coverages is viewed to be less expensive than the open voluntary market.

The FHCF has the authority to assess Florida policyholders if it has insufficient funds and bonding capacity available in order to pay its reinsurance obligations. In essence, the Florida insurance public is at risk for any losses sustained by the FHCF. Pricing discounts available from the FHCF increase this risk.

If sufficient additional private reinsurance capacity becomes available within the market at pricing deemed appropriate by Florida policymakers, it is possible the Legislature could eventually reduce the reinsurance capacity available from the FHCF. Private market capacity could eventually be available to replace some of the coverage now provided by the FHCF. Of course, this will be dependent upon the pricing and availability of the reinsurance from the private market.

A number of bills have been proposed in Congress that would provide for a federal backstop for catastrophes such as hurricanes, tornadoes, and earthquakes. Typically, these bills provide for federal or state-consortium reinsurance or federal, low interest loans and are based upon the premise that sufficient, well-priced voluntary market reinsurance capacity is not available to cover the most significant of catastrophic risks. Any efforts to increase the voluntary market capacity for reinsurance could impact any proposed federal legislation.

The NAIC and reinsurance collateral

The NAIC Reinsurance Task Force has been holding meetings and considering comments on a proposed rule that would provide for a reduction in collateral requirements applicable to eligible reinsurers. The updated NAIC Reinsurance Regulatory Modernization Proposal was approved by the Task Force during the September 2008 NAIC Fall National Meeting. The Proposal also was approved by the NAIC Financial Condition Committee at the same meeting and now proceeds to NAIC Plenary for consideration during the next scheduled NAIC meeting in December, 2008. In many respects, this Rule is very similar to that of Florida’s.

Impact of Florida’s Rule on other states

Florida’s rule, which, in scope, is limited specifically to the state, provides that it does not affect the laws of any other states, and that all insurers must comply with the laws in any other states in which they do business.

New York and Texas are proceeding with rule development on comparable ratings-based reinsurance collateral rules. Other states will be watching the results in Florida and

New York closely, as well as NAIC model law developments.

The ratings-based reinsurance collateralization approach appears to be gaining momentum. Insurance industry members should familiarize themselves with it and be ready to address the resultant changes.

Richard J. Fidei, Esq., a partner at Colodny, Fass, Talenfeld, Karlinsky & Abate, represents insurance and reinsurance companies, brokers and other related entities in transactional and corporate matters, as well as in claim and dispute resolution proceedings. His practice includes start-up activities, structuring and financing, vendor relationships, regulatory issues, and court proceedings, including supervision, liquidation and insolvency. A member of both the Florida and Pennsylvania Bars, he also is Vice President of the Association of Insurance Compliance Professionals Gulf States Chapter, among other insurance industry leadership positions.