Insurance: Transactional and Regulatory
U.S. insurers are heavily regulated and present unique challenges when involved in M&A, capital raising and other transactions. As a general rule, U.S. insurance regulation is handled on a state-by-state (and not a federal) basis, with the state of the insurer's incorporation being the primary regulator; however, some states exert regulatory authority over insurers that transact significant business in the state. The key emphasis of the insurance regulator is to protect the policyholders.
INSURANCE M&A TRANSACTIONS
Most insurance M&A transactions require the consent of an insurer's regulator whenever a significant amount of stock of the insurer or its parent is being sold (generally triggered at 10% or more of the voting stock). The process of obtaining consent typically takes a few months during which time the regulator reviews the bona fides of the acquiror and the transaction and the likely impact on the target company’s policyholders. Accordingly, speed of execution is less critical in insurance M&A transactions than in M&A transactions in unregulated industries. The gap between signing and closing also presents unique structuring challenges.
Public Insurance M&A Transactions
In a public insurance M&A transaction, the need for regulatory approval eliminates the advantage of speed that a first-step tender offer would otherwise afford. It may be possible to obtain the approval of the target company's shareholders before regulatory approval is obtained. For these and other reasons, acquisitions of publicly traded insurance groups are almost always structured as single-step mergers. Regulatory impediments also make hostile acquisitions of public insurers difficult (but not impossible).
Private Insurance M&A Transactions
In structuring a private insurance M&A transaction, the parties have more freedom than exists in a public acquisition, or for that matter in most non-insurer transactions, to allow their respective commercial objectives to dictate the form of the transaction. However, the potential requirement to obtain regulatory approval will be an important factor for the parties to consider and may influence their choice of structure. Among other things, obtaining regulatory approval typically takes time (requiring negotiations over allocation of risk between signing and closing), a buyer is not guaranteed to be approved (thereby raising execution risk to a seller) and the regulator could place conditions on its approval (raising questions regarding what conditions a buyer may be required to accept). Typical private insurance M&A transaction structures are:
Acquisition of Entire Business. This approach is common where the insurer’s in-force business is not core to the seller’s future plans and has associated employees, contractual relationships, etc., which are not used in any other aspect of the seller’s business. Such a disposal will commonly take the form of a sale and purchase of the stock of the insurer. As in most share sales, with the stock of the insurer comes all its assets and liabilities, both contractual and extra-contractual, thereby requiring industry-specific and general due diligence as well as warranties and indemnities from the seller that survive closing. For acquisition of property/casualty insurers, aggregate excess of loss reinsurance may also be used to provide an acquiror with protection against policy-related liabilities.
Acquisition of Partial Business. An acquiror may wish to acquire only part of an insurer’s business. For example, if the target insurer writes auto insurance, homeowners insurance and commercial fire and liability insurance, then the acquiror may want to keep some or all of one line of business and exclude some or all of another. Eliminating business from the target insurer’s operations, so that its stock may be acquired, may be complicated: in some U.S. states, for example, laws may obligate the insurer to renew certain types of policies or impose regulatory requirements (such as lengthy notice periods) to protect consumers against abrupt withdrawals from writing new business and arbitrary non-renewal of policies.
Acquisition of a Block of Insurance Business. An acquiror may want to acquire a group of individual insurance policies (referred to as a “block” or “portfolio” of business) without acquiring the insurer in which the block of business resides. For example, if an acquiror is interested only in purchasing a particular product or line of insurance from an insurer that has a diverse mix of business, or that sells the particular product or line using multiple legal entities, this transaction structure may be the most practical option. The transaction often takes the form of indemnity reinsurance by the acquiror of a specific block of insurance policies. This simplified transaction structure permits a strategic reallocation of a specific block of insurance liabilities from the target insurer to the acquiror without the complications and risks inherent in a stock purchase. These transactions include arrangements for the administration of the reinsured block of policies.
Acquisition of Renewal Rights. As an alternative to (or in combination with) a block of business acquisition, the parties may opt for a “renewal rights” transaction. This type of transaction requires the seller to provide the acquiror with an exclusive right to seek renewal of policies originally issued by the target insurer or one of its affiliates. In jurisdictions where the transfer of liabilities under an in-force block of business would be subject to a lengthy consultation and/or regulatory approvals process, a “pure” renewal rights transaction may provide a useful and speedier alternative, as the existing in-force block of business is retained by the seller. It may be combined with 100% reinsurance (usually provided by the acquiror or an affiliate) of the in-force business, so as to pass the economic interests to the acquiror. The target insurer may also agree to “front” the renewal of new policies for the acquiror for some period of time where the acquiror is not yet authorized to conduct the acquired block of business, or does not have approved policy forms in place.
CAPITAL RAISING TRANSACTIONS
Insurance Holding Company Capital Raising
Most major U.S. insurance holding companies are SEC-reporting companies that have filed shelf registration statements to facilitate access to the capital markets. These shelf registration statements are similar to those filed by companies in other industries.
Because of the depressed price-to-book-value ratio of most insurance holding companies in recent years (i.e., generally less than 1.0, meaning that the market values the equity of these companies at less than book value), sales of common equity have been rare, with the notable exception of sales which facilitated the unwind of government support provided during the credit crisis. In fact, many insurance holding companies are currently actively buying back their own stock. A number of Bermuda-based companies listed in the U.S. also raised capital through the sale of preferred shares in 2011 and 2012.
Debt offerings by U.S. insurance holding companies have been somewhat limited in the last 18 months, as many insurers had already taken advantage of low rates to refinance existing debt. A significant portion of this activity focused on “hybrid” securities, which were issued to allow the interest coupon tax deduction of a debt security while providing the issuer with equity credit in rating agency capital models. The rating agencies changed their criteria for these securities in a way that reduced or eliminated that equity credit, prompting issuers to seek ways to redeem the securities in spite of impediments to such actions in the terms of the securities.
A significant minority of major U.S. insurance holding companies are mutuals, which means that their equity is owned by their policy holders. These companies tend not to be SEC-reporting companies, but they can and do undertake non-equity financing activities similar to those described above through private placements under Rule 144A.
Capital Raising by Insurers
In contrast with holding company capital raising transactions, capital raising at the operating insurer level tends to be highly peculiar to insurers. These transactions include:
Surplus Notes. These securities are creatures of the insurance law of the state of domicile of the insurer and require regulatory approval for issuance. Although they usually have stated coupons and payment schedules like debt, payments of both principal and interest also require regulatory approval, which makes them deeply subordinated. Capital markets offerings of these securities are conducted under Rule 144A.
Catastrophe Bonds. Special purpose reinsurers issue “cat” bonds to fund the acquisition of collateral to support the issuers’ reinsurance obligations to the sponsoring property/casualty insurers or reinsurers. These structures generally require minimal direct interaction with the sponsor’s regulator, but they do need to be structured to provide statutory credit for reinsurance to the sponsor. These securities are typically sold in private placements under Rule 144A.
Reserve Financings. Life insurers pursue these transactions to finance statutory reserves that are generally considered to be in excess of economic reserve requirements. Before the 2008 credit crisis these financings often came in the form of a Rule 144A capital markets transaction, typically with a financial guaranty insurer guaranteeing the securities and thereby taking on the “tail risk.” Since 2008 almost all of these financings have been done on a bilateral basis with banks and other capital providers.
Funding Agreement Asset-Backed Notes. Life insurers issue funding agreements to special purpose vehicles that issue debt securities intended to rank pari passu with policyholders in the event of the insolvency of the sponsoring insurer. These securities have been offered on an SEC-registered basis and under Rule 144A.
These examples provide only a broad overview of some of the most significant means of financing insurers, and they do not address many common alternatives, including, for example, traditional reinsurance.
OTHER REGULATORY CONSIDERATIONS
The Dodd-Frank Act
U.S. insurers have been and will continue to be impacted by the Dodd-Frank Wall Street Reform and Consumer Protection Act, major financial regulatory reform legislation enacted in response to the financial crisis. Although the Dodd-Frank Act generally preserves the existing state-based insurance regulatory framework, it alters the insurance regulatory paradigm in several key respects. The Dodd-Frank Act requires that federal regulatory agencies engage in significant rulemaking to implement its requirements; as of June 2012, much of this rulemaking is still ongoing, and thus the ultimate impact of Dodd-Frank on insurers is not yet clear. Aspects of Dodd-Frank relevant to insurers include:
Designation of Systemically Important Nonbank Financial Companies. The Dodd-Frank Act creates a new “systemic risk” regulator, the Financial Stability Oversight Council. The Council is tasked with designating nonbank financial companies as systemically important; designated companies will be subject to significantly enhanced regulation and oversight. Although the Council has yet to designate any nonbank financial companies as systemically important, one or more major U.S. insurance groups may be designated, and therefore made subject to enhanced regulation and oversight.
FRB Regulation and Oversight. The Dodd-Frank Act abolished the Office of Thrift Supervision and requires that thrifts and their affiliates be regulated and supervised by the Federal Reserve Board. Insurers that directly or indirectly own or control a thrift in the U.S. are therefore subject to Board oversight focusing on the group as a whole, with states remaining the principal regulators of insurers incorporated in their states. Consolidated supervision by the Board is likely to impact insurers with thrift affiliates in several respects, including through the eventual imposition of consolidated capital requirements by the Board at the holding company level. Several U.S. insurers have already divested or restructured their thrifts to avoid Board regulation and oversight.
Derivatives Regulation. The Dodd-Frank Act contemplates wholesale reform of derivatives regulation, and requires the SEC and the Commodity Futures Trading Commission to engage in significant rulemaking to implement these reforms. Depending on the ultimate outcome of this rulemaking process, insurers’ derivatives activities may be impacted, including inter alia through the imposition of capital, margin, and other prudential regulatory requirements and through requirements that “over the counter” derivatives be traded on regulated exchanges.