Emerging From COVID — Transaction Techniques in Insurance M&A and Bulk Annuity Deals

Transactional activity in the insurance sector, already robust during the past few years, has remained strong during the COVID-19 storm, including classic M&A, sales of in-force annuities and ILS issuances. Features of the current deal environment include: 

• Hesitancy last year about the impact of COVID has been replaced by recognition that the COVID crisis has not had an outsized effect on the insurance industry generally.

• The plethora of litigation on business interruption coverage, working its way through the courts, will form the backdrop of looming legislative debates on legislation in this area. 

• Health and worker-compensation insurers, which some feared would see heavy COVID-related losses, appear to have benefited from reductions in non-COVID treatments. 

• In the life/pension sector, there have been significant M&A deals, bulk sales and de-risking transactions, in some cases triggered by reassessment of strategies to adopt in the low-interest-rate environment. 

Recent trends suggest that the COVID-19 has not resulted in major changes in transaction techniques for insurance-related deals, which require taking careful account of the special legal and regulatory context in which insurers and reinsurers operate. We describe below some important terms of insurance/reinsurance deals generally in today’s market and then focus on key features of deals involving annuity bulk sales.

Deal Terms to Focus On

Across deal structures, buyers and sellers of insurance-related assets and liabilities are paying attention to developments such as the following:

In M&A deals: 

• Agreements may provide that events having a “material adverse effect” (MAE), when arising prior to closing, may give the buyer “walk rights,” i.e., the option not to close. Much attention has been given to whether and how such clauses take account of pandemics in general and COVID-19 in particular. However, typical MAE clauses may as a practical matter give few clear opportunities for the buyer to walk away, for reasons including the following:
  
  
  • Most adverse events extrinsic to the target, including changes in general economic conditions, markets, change in law, political conditions, war, natural disasters, epidemics/pandemics (such as COVID-19) and government measures taken in response to the foregoing, will be taken into account only to the extent that they impact the target disproportionately compared with peer companies — and the peer group used for comparison may be open for debate or may be defined very narrowly.
  • The criterion of what is “material” may be undefined, with no contractually agreed quantification (and the securities-law concept of “materiality” might not provide certainty). Further, materiality is usually evaluated in respect of the target “taken as a whole,” so that something material to a given line of business may not constitute a MAE.
    
    
• Representations and warranties (“reps”) will take account of the many features specific to insurance and reinsurance business, such as:
  
  
  • Insurance products – Beyond general reps as to compliance of the acquired business with applicable law, reference may be made to the specific rules applicable to insurance products (including, for example, compliance of life products with requirements for preferential tax treatment).
  • Producers and administrators – The rep may contain detailed assurances as to compliance by distributors and third-party administrators with regulatory requirements applicable to them.
  • Financial and accounting features of the acquired business – These may include investment holdings, claims and policy reserves.
  • Outward and inbound reinsurance and retrocessional coverage – Reps relating to reinsurance can take account of significant uncertainties that might surround such contracts — for example, whether the counterparty is financially impaired, whether full accounting credit can be taken for reinsurance coverage, whether the target is a party to any reinsurance that does not satisfy risk-transfer requirements (such as “finite” reinsurance) or whether it has been possible to obtain all required consents of contractual counterparties (cedents, reinsurers and retrocessionnaires).
    
    
• The expanded use generally of rep and warranty insurance (RWI, also known as W&I or warranty and indemnity insurance) has extended to major insurance M&A deals. Given some of the sector-specific content of representations in insurance M&A deals, it can be expected that the entry of RWI carriers will prompt discussions on new exclusions and limitations.
  
  
• Covenants will restrict changes to business practices during the interim between signing and closing, such as changes to underwriting, pricing or reserving methodologies.

In ILS including cat bonds:

• This healthy market is expanding, with minimum deal size decreasing over the past few years and expansion into non-cat property-casualty exposures.
  
  
• Loss calculation, loss reserving and dispute resolution provisions remain areas of particular attention.

In property-casualty reinsurance and loss portfolio transfers, subjects of particular attention include:

• Definitions of losses, loss events and related triggers of coverage.
  
  
• Scope of coverage for extra-contractual obligations (ECOs), losses in excess of policy limits (XPL) and ex gratia payments (particularly relevant to COVID-related claims, on which carriers may be tempted to act based on commercial and political considerations).

Key Features of Annuity Bulk Sales

The COVID phenomenon seems to have contributed to a perception, already held by some pre-pandemic, that mortality improvements are slowing. As a result, sellers of blocks of in-force annuities expect to find more favorable pricing from buyers than in prior years, during which increasing longevity, rather than mortality, was the more acute concern. In the remainder of this article, we identify some key points to consider in connection with a sale of such a block by means of indemnity reinsurance (as opposed to a stock purchase or an assumption and novation).

“Good faith”? The utmost. Unlike other kinds of deal structures, reinsurance (in most Anglo-American legal systems) imposes on the parties a duty of uberrima fides or “utmost good faith,” a duty that is said to go beyond ordinary good faith and fair dealing. This duty requires the cedent to disclose to the reinsurer all material facts about the risk being reinsured. In the view of many, the duty also requires disclosure of all material facts relating to handling the reinsured coverage including claims by insureds, and also applies to the reinsurer. Just as in a typical M&A context, the parties to a bulk annuity sale may seek in their agreement to structure and allocate risks on these subjects (after the buyer has conducted due diligence), but when the duty of utmost good faith applies, their conduct might be viewed through a more rigorous lens than in a classic M&A deal. It is not always evident what this duty requires in a given situation (or whether this includes issues known to the buyer as to which its rights might ordinarily be protected under pro-sandbagging case law). Duties of the parties in this respect can be varied by agreement — for example, by a disclaimer of any resort to the doctrine of utmost good faith on matters relating to the formation or negotiation of the agreement, while maintaining application of that doctrine for matters relating to performance thereof.

Setting the liability boundaries. Defining with precision which liabilities are transferred from seller (cedent) to buyer (reinsurer) is at the heart of the reinsurance transaction. This may seem as straightforward as identifying the block being ceded, and the contract will usually define the ceded block by reference to specific contract numbers or other indices or by specifying a class of contracts issued by the seller over a certain period in a certain territory. However, parties should also bear in mind the nuances associated with annuity business. For example, do the reinsured liabilities include insurance contracts or death benefits that might be issuable upon an annuitization or other election? What about surrenders, withdrawals and other contractual features? And in respect of extra-contractual obligations or ex gratia payments (mentioned above), although they are typically (but not always) excluded from coverage, a seller may seek the flexibility to be covered in this respect up to stated maximum per contract or in the aggregate.

Who does what? The ongoing administration of the block is a fundamental deal term in annuity reinsurance. When the ceding company continues to provide the administrative support for the annuities, the reinsurer will generally impose checks on the cedent’s discretion. Where the reinsurer handles admin, often this will be memorialized in a separate administrative services agreement appended to the reinsurance agreement. Both parties will have a keen interest in carefully allocating administrative responsibilities so that annuity holders experience no disruption in service and that claims, elections and other interactions with holders are administered seamlessly. A related item is responsibility for non-guaranteed features of annuities subject to change from time to time, such as expense charges and crediting rates, which the cedent typically continues to administer, subject to recommendations and other input from the reinsurer.

Connecting the economic dots. Reserves supporting the annuity obligations can be treated in several ways, including: transferred to the reinsurer; not transferred (modified coinsurance or “modco”) but instead retained by the cedent in a segregated account; held by the ceding company as a deposit by the reinsurer (“funds withheld”); or posted by the reinsurer as collateral in favor of the ceding company (a credit-for-reinsurance or “Reg. 114” trust). Variations and combinations of these basic templates are also possible. The method employed in a given transaction is usually a function of not only regulatory requirements for balance sheet credit but also market circumstances and commercial preferences of the parties. It is important that the reinsurance agreement spell out these arrangements precisely, including which party (or third party, such as a trustee) holds contract reserves and also in what required amounts, in what capacity and what disbursement, release and true-up mechanisms apply. To satisfy regulatory requirements for obtaining credit for reinsurance, when the reserves are not held by the cedent itself these arrangements will provide (subject to regulatory approval) that in case of the cedent’s insolvency all amounts owed to the cedent will be paid into the receivership estate (for example, when a Reg. 114 trust is used, the reinsurance contract will include a traditional NAIC insolvency clause, providing for payments to the receiver in case of the cedent’s insolvency) or will include a “cut-through” provision, providing for direct liability of the reinsurer to annuity holders. 

Covering all the bases. The parties will want to specify what happens if and when certain unintended events occur — nonpayment by a party of some amount, insolvency, failure to fully fund a trust account or other account, a risk-based capital deficiency below some stated threshold, or a similar extraordinary event affecting a party. These might lead, for example, to an election by the ceding company to recapture reinsured business, an obligation for the reinsurer to post additional collateral or a termination by the reinsurer of reinsurance coverage. Reinsurance contracts can also include reps as well as indemnification for breaches of reps or covenants, which can serve a due diligence function and also frame remedies proportionate to problems as they arise, without requiring unwind of the reinsurance.

Permission granted? Parties will need to consider what notifications and prior regulatory approvals are necessary for the block annuity reinsurance transaction, including under “bulk reinsurance” laws of relevant states. The approval requirement might be based on the amount of in-force risk being ceded by the ceding company or the amount of reinsurance being assumed by the reinsurer. New York Insurance Law Section 1308(f) is an example of such a statute, requiring (among other things) prior approval by the superintendent of financial services where a domestic life insurer reinsures its “whole risk on any individual life or joint lives.” Where a state’s bulk reinsurance law purports to apply to an insurer not domiciled in that state, there is some likelihood that it has been preempted by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (which effectively prohibits a state from regulating credit for reinsurance where the ceding company is not domiciled in the state). California, for example, has issued regulatory guidance on Dodd-Frank’s preemptive effect on that state’s insurance statute (Section 1011(c)) governing bulk reinsurance and other transfers of “all or substantially all” of an insurer’s business), but not every state with an extraterritorial bulk reinsurance law has released such clarifications, so caution is warranted. In a deal involving variable annuities, it should be borne in mind that these products are regulated both as insurance products at the state level and as securities under federal law; one consequence is that applicable Securities and Exchange Commission and FINRA change-of-control requirements need to be considered.

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Although the COVID-19 pandemic itself does not seem to have influenced transaction techniques for insurance-related deals, market forces have pushed dealmakers to be increasingly careful about identifying the sometimes complex issues that can arise after a deal is signed, and addressing them appropriately in deal documents, including via the measures mentioned above.