NEW YORK: An Introduction to Insurance: Transactional & Regulatory
Insurance transactions have changed radically over the past few years. An industry that used to be characterized by occasional transactions involving dislocated businesses, mergers between strategic competitors in a highly fragmented industry, run-off sales and sales of troubled companies is now one of the most dynamic centers of deal activity across the entire financial services market.
As the industry has changed, largely driven by transactional activity and by macro factors (like climate change, the emergence of new risks like cyber risks, and the evolution of new technologies, most importantly the now-omnipresent specter of AI) so too has the regulation of the industry changed. Insurance regulators are often required to apply statutes and regulations drafted possibly only a decade or so ago that feel as if they were contemporaries of the Code of Hammurabi, so fast has been the evolution of the insurance industry over the last few years. The regulatory community deserves a tip of the collective hat for the manner in which regulators strike an ongoing balance between encouraging innovation and the flow of capital into the insurance sector, while at the same time constantly looking out for the interests of its most important constituents, the policyholders.
What Changed?
The first thing that happened was the global financial crisis (GFC) of 2007–2008. That period gave rise to three distinct phenomena: first, a recognition of the interrelatedness of insurance businesses with the rest of the financial economy; second a period of prolonged dampened interest rates as central banks leaned in to Keynesian principles to stimulate growth; and third an understanding that insurance companies, due to their specific regulatory, accounting and reporting characteristics, actually served as a good home for long-dated, higher-yielding (and thus interest-rate exposed) assets.
Next, AIG’s restructuring after the GFC gave rise to an entirely new era of insurance M&A. The transactions that AIG signed and executed coming out of the GFC were of an entirely different caliber from the transactions that had marked the insurance M&A landscape up to that point. These deals were global, complex and enormous in terms of the enterprise value of the businesses being moved out of AIG’s group control in order to repay the holding company’s debt to the US Treasury.
The next occurrence was the emergence of private equity sponsors as owners of insurance businesses. This move started as a search for “permanent capital” – ie, a source of capital that did not need to be, indeed should not be, returned to investors at the end of every investment cycle. PE firms had up to that point largely steered clear of insurance companies, focusing instead on businesses that could be leveraged up in a traditional LBO style. Those businesses included insurance services, insurance brokers and producers, and businesses focused on driving value by improving the technological abilities of insurance companies – ie, “insurtech” businesses.
Leverage had always been an issue for insurance M&A since too much financial debt was frowned on by rating agencies and by regulators. Regulatory requirements for insurance M&A require disclosure of any and all debt being incurred in order to acquire the shares of an insurance business. It has always been an article of faith that insurance regulators will not support the use of policyholder assets to help an acquiror buy an insurance company, and there is a distinct feeling that in highly leveraged structures there would indeed be pressure placed on insurance businesses to dedicate those assets to the repayment of debt through dividends or internal leverage.
Moreover, financial leverage greater than 15–25% of total capital (depending on the nature of the business in question) typically attracts negative attention from rating agencies. As insurance businesses are essentially selling a promise to policyholders (ie, the promise to pay claims when a death or retirement occurs, or a catastrophic event takes place), ratings often play a critical role in the marketing of an insurance company’s products, and thus its vibrancy as a going concern.
So without the traditional LBO financing model available to them, PE sponsors tended to look elsewhere for investment opportunities and leave insurance underwriting businesses for another day.
That other day arrived on the heels of the GFC, when it became apparent that the low interest rate environment was driving a need for insurance companies, particularly those engaged in life insurance and retirement businesses, to identify higher yielding assets without moving their balance sheets into more risky territory. At the same time, PE sponsors were building out private credit businesses that were designed to acquire assets that would pay out healthy returns in a steady stream over extended durations. In simplest terms, those durations (ten years or more) match up well with the liabilities of fixed annuity companies, where the product being sold is essentially a promise to help fund the policyholder’s retirement with a steady stream of cash outflows beginning with the holder’s decision to annuitize. The spread between income on the assets and pay-outs to annuitants drops directly to the bottom line, net of fees. Properly matched assets and liabilities thus create a sort of virtuous circle, in which policyholder interests are protected, the insurance balance sheet is strengthened and positioned to grow profitably, asset managers earn reasonable fees on growing amounts of assets under management, and the equity owners of the business benefit from its increasing equity value.
What Are the Key Regulatory Topics?
At one level, the core regulatory principle that underlies all insurance M&A transactions is agonizingly simple: any person that seeks to acquire “control” of an insurance company must first obtain regulatory approval. The approval must be granted by the state where the relevant insurance company is “domiciled” (meaning incorporated), or in some more unusual cases “commercially domiciled” (meaning brought in scope by virtue of the volume of business written in the state).
But what is “control” and how is approval obtained?
On the first point, the NAIC model, and all the states, provide a presumption that control exists if a shareholder owns or controls 10% or more of the voting shares of a company. This test applies at each level of ownership in a holding company system, such that if a buyer acquires 10% of a holding company that itself owns only 10% of an insurance company, the buyer still must file for approval (ie, the ownership calculus leads to a 10%, not 1%, solution in that case).
While it used to be the case that practitioners took comfort in the 10% voting threshold as the test for control, more recently New York’s Department of Financial Services (DFS) has made clear that the threshold should not be read as a safe harbor. In other words, ownership of less than 10%, when coupled with other indicia of control, may in the view of the DFS amount to a controlling influence that requires prior approval.
Conversely, it is also possible to cross the 10% voting threshold and yet not be required to file for approval as a control person. This does require the exercise of regulatory discretion, embodied in the form of a “disclaimer” of control which indicates a commitment to remain a passive investor. Index funds and other passive investors are often able to take advantage of the disclaimer filing.
Disclosure of Control Persons
New York focuses on two main factors when deciding whether or not to approve an acquisition of control: the identity and background of the proposed acquiring person, and the plans that person has for the insurance company following its acquisition.
On the former point, NY Reg. 52 lays out detailed disclosure requirements for all “applicants”, including biographical and financial information. The requirements of Reg. 52 are, in a word, onerous, and New York has been historically somewhat strict in its adherence to those requirements. For example, personal financial statements are required of control individuals.
On the business plans of the person acquiring control, New York (like most states) is happiest if the answer is “business as usual”. But most of the time an acquisition does lead to changes in the business plan, including any number of inter-affiliate arrangements that could be put in place in an effort to improve the operations of the acquired insurance company. Investment management agreements (IMAs) are commonly implemented in PE-backed M&A deals, but New York has taken a strict view of those agreements, allowing services to be provided only at cost when provided by an affiliated asset manager.
What’s Next?
Insurance regulators will need to keep up with the fast pace of change in the insurance sector, constantly evaluating whether their rules adequately address the risks that may be entering the system. While all this sounds daunting, the good news is that New York’s insurance regulatory system has proven itself surprisingly resilient in the face of rapid change in the past and there is every reason to expect it will continue to do so in the future.