February 3, 2011
Mr. B. Michael Verne
Premerger Notification Office
Federal Trade Commission
600 Pennsylvania Avenue, N.W.
Washington, D.C. 20580
Re: Treatment of ReinsuranceRecoverables under Rule 801.21 and Rule 802.4
I am writing this letter to confirm oraladvice you provided to the undersigned in a telephone conversation earliertoday regarding the applicability to the following transaction of thenotification requirements under the Hart-Scott-Rodino Antitrust Improvement Actof 1976 (the "Act") and the Federal Trade Commission's implementingregulations (the "Rules").
As we discussed, I believe that thetransaction is exempt from the reporting requirements under the Act based uponthe applicability of Rule 802.4. I have outlined the analysis we discussedbelow.Structure of ProposedTransaction
My firm represents an insurance group(the "Seller") which is selling all of the voting securities of aninsurer that in turn owns three other insurers (the "TargetCompanies"). All four of the Target Companies are property and casualtyinsurers domiciled in the US which are in "run-off' (i.e., not writing newpolicies but administering policies written in the past).
The purchase price for the votingsecurities of the target companies will be approximately $200 million (and theparties believe this to be the approximate fair market value of the votingsecurities of the target being sold). The size of the parties test issatisfied.Assets of the TargetCompanies
Since the Target Companies are in run-off,a large portion of their assets consist of cash and securities andindemnification rights under reinsurance contracts. The consolidated assets (ona GAAP basis) of the Target Companies total $2,117 million. Approximately $888million of the assets are investment assets (i.e., cash, securities, bonds andother obligations clearly exempt under Rule 801.21). Approximately $1,211million of the assets consist of reinsurers' obligations under reinsurancecontracts to indemnify the Target Companies for losses incurred under policieswritten by the Target Companies. Since these obligations represent amountspotentially payable by reinsurers under reinsurance contracts, they are oftenreferred to as "reinsurance recoverables" in the industry. Finally,approximately $18 million of the assets consist of other assets of the TargetCompanies (such as infrastructure and other assets used to administer therun-off).
The total liabilities of the TargetCompanies are $2,166 million, the bulk of which consist of loss reserves of$1,736 million. Essentially, the purchaser is buying the target companiesbecause it believes it can administer the run off of the Target Companies withactual net losses significantly lower than the amount currently reserved. Thereis no value ascribed to the Purchased Companies' goodwill or as a goingconcern, given that they are no longer writing any new business.
Based upon the foregoing, whether theproposed transaction is reportable under the Act will depend upon whether the"reinsurance recoverables" are exempt assets for purposes of Rule802.4. If the "reinsurance recoverables" are exempt, then the fairmarket value of the remaining (non-exempt) assets held by the target companiesis only $18 million, well below the threshold specified in Rule 802.4. If the"reinsurance recoverables" are not exempt, then the fair market valueof the non-exempt assets will exceed the threshold specified in Rule 802.4.Nature of ReinsuranceRecoverables
As you are aware, it is common forinsurance companies to reinsure the policies they write, thereby transferringthe economic risk associated with the losses that arise under the policies tothird parties. Reinsurance may be structured as indemnity reinsurance orassumption reinsurance. The reinsurance at issue for the Target Companies isall indemnity reinsurance.
In the case of indemnity reinsurance,the Target Companies continue to hold the policies they have written and bearthe economic risk of losses that are incurred under the policies. Under the reinsuranceagreement, the reinsurer is contractually obligated to indemnify the TargetCompany for all or a portion of the losses from claims arising under thereinsured policies. The holders of the original policies continue to asserttheir claims against the Target Company, and all claims are paid by the TargetCompanies. However, all or a portion of the economic burden of the lossesarising from the claims is bourn by the reinsurer, as it will reimburse theTarget Companies for all or a portion of the losses paid out on the policies.1
When the assets of the Target Companiesare reported to state insurance regulators (i.e., prepared on a"statutory" basis), their balance sheets show a loss reserve as aliability. This represents the estimate of the liabilities that will beincurred to settle reported but unpaid claims, as well as claims that have beenincurred but not yet reported, under the policies issued the Target Companies.On the Target Companies' balance sheets prepared on a statutory basis, the lossreserves reflected have been reduced for the estimated amount of reinsurancerecoverables (i.e., reinsurers' indemnity obligations to the Target Companiesunder indemnity reinsurance contracts). Thus, on the Target Companies'statutory balance sheet, the reinsurance recoverables for unpaid losses arenetted against the loss reserves rather than shown as an offsetting asset.
On the other hand, when the balancesheets of the Target Companies are prepared on a GAAP basis, the balance sheetsshow the full loss reserve as a liability, without any deduction or offset forthe estimated amount of reinsurance recoverables associated with the policies.Instead, the reinsurance recoverables for unpaid claims are treated on theTarget Companies' GAAP balance sheets as an asset because the Target Companieshave a contractual right to receive reimbursement from the reinsurers forspecified policy loss payments made by the Target Companies.2Analysisof Rule 804.2
The obligations of reinsurers underreinsurance contracts to indemnify the target companies for losses (whether forpotential contingent claims or for pending outstanding claims) would appear toqualify as "obligations which are not voting securities" underSection 7A(c)(2) of the Act. As noted above, "reinsurancerecoverables" can be viewed (i) on a statutory basis as an offset to theirloss reserves or (ii) on a GAAP basis as an asset because of the TargetCompanies' contractual right to recover from the reinsurer. Under either view,reinsurance recoverables do not appear to be voting securities.
Alternately, the "reinsurancerecoverables" can be viewed as a financial asset of the Target Companiesthat represent a transfers of risk akin to a "swap" financialinstrument, which we understand are viewed by the FTC staff as exempt assets(see e.g., Informal Staff Opinions 0511010, 0806008, 0705022 and 0412012).
Based upon our discussion, it is myunderstanding that you concur with the foregoing analysis. Please advise if myunderstanding is incorrect.
1 In the case of assumption reinsurance, the insurertransfer the policies they have written to the reinsurer in a novationarrangement. The policies are assumed by the reinsurer and become thereinsurer's direct contractual obligations. Under this arrangement, the holdersof the original policies are directed to assert their claims against thereinsurer, and the original insurer is no longer involved in the claimsprocess.
2 In contrast, when an insurer enters into anyassumption reinsurance arrangements, there is no reinsurance recoverablereflected on either the statutory or GAAP balance sheet. Instead, theunderlying loss reserve is simply removed from the balance sheet, since thereinsurer is now primarily responsible for payment of the claims and theoriginal insurer is no longer acting as a conduit for the payments.