At their national meeting this past weekend, the full National Association of Insurance Commissioners formally adopted a long-awaited (and much needed) overhaul of the group’s model law and regulation governing credit for reinsurance. The move should help to set the stage for more states to follow the lead of Florida and New York and finally modernize their outdated and protectionist system of requiring foreign reinsurers to post 100% collateral for U.S. business.

But the new system advocated by state regulators – while a marked improvement from what came before – also raises the stakes surrounding the legislation introduced last month by Rep. Richard Neal, D-Mass., and Sen. Bob Menendez, D-N.J. to impose huge taxes on offshore affiliate reinsurance. Given the treatment that states now will give to cross-border reinsurance transactions, imposing new taxes on U.S. affiliates would likely cause some foreign-based reinsurers to rethink whether they want to maintain U.S. subsidiaries at all.

Under the NAIC’s old model, which has prevailed for generations, foreign reinsurers looking to take on U.S. risks had two choices: They could establish a domestic subsidiary that would be regulated by a state insurance department, or they could conduct business “cross-border.” Primary insurers who purchased reinsurance from these U.S. subsidiaries were granted credit for the full value of the reinsurance. But for those who opted to cede business cross-border, credit for reinsurance would only be granted if the reinsurer agreed to post collateral (often in the form of letters of credit) for 100% of obligations they agreed to take on.

That system long has been the subject of international scrutiny and trade complaints, and rightfully so. Nonetheless, it has remained in place largely because many domestic primary companies – fearing difficulties enforcing judgments to pay against offshore reinsurers and feeling they didn’t have the market power to demand reinsurers post collateral voluntarily— fought for years to perpetuate it.

Under the NAIC’s revised model, states will have the power to certify reinsurers from qualified non-U.S. jurisdictions (and in some cases, even approve jurisdictions not on the NAIC’s master list) to write business cross-border. Based on the financial strength rating assigned to the company, the certified reinsurer would be asked to post either 0%, 10%, 20%, 50%, 75% or 100% collateral. In practice, it is unlikely that reinsurers outside of the top three ratings groups would receive much business, so 20% is likely the maximum collateral required for most reinsurance transactions.

Formal adoption by the NAIC marks just the first step for the proposed changes. They still must be implemented across the states, where they could face opposition from some primary insurers who remain dead-set against the move. National Underwriter quoted a lobbyist for Cincinnati Insurance Cos. who said the company feels “now is not the time to exchange the security of collateral for an untested rating system.”

But after 12 years of debate, regulators moved the issue because they recognized that, without action, they faced the threat of preemption by the Federal Insurance Office. FIO is granted authority under the Dodd-Frank Act to preempt state laws that violate international insurance agreements.

What has gotten less attention is the impact the new model would presumably have should Neal and Menendez prove successful in getting their bill passed. Backed by a coalition of U.S. domestic insurers who claim they face unfair competition against firms headquartered in low-tax jurisdictions, the bill would defer tax deductions for any reinsurance premiums paid by a U.S. subsidiary to a foreign affiliate if the premium is not subject to U.S. tax. The sponsors claim enacting the law would raise $12 billion over 10 years.

For those revenue estimates to bear out, one would have to assume foreign-based companies would not change any of their business strategies in response to the tax. That is, of course, a ludicrous assumption. Insurance and reinsurance are global businesses and capital is fungible. To the extent new taxes make the U.S. market less attractive, international firms would be expected to change their mix of business to move capital where better returns are available.

And here’s where the new collateral rules become truly interesting, as they would appear to open another viable strategy for foreign reinsurers. Tax deferrals matter only where a U.S. subsidiary cedes business to an offshore affiliate. But the federal government has no claim to the earnings a foreign company makes in its own country. When a reinsurer does business cross-border, that’s exactly what’s happening. The transaction would be subject to a small excise tax, but any revenues a Swiss or Irish or Bermudan reinsurer makes from business it accepts from abroad is solely the jurisdiction of Swiss or Irish or Bermudan tax authorities.

Previously, the regulatory advantages granted to U.S.-domiciled reinsurers were sufficient to prompt many reinsurers to maintain U.S. subsidiaries. But for a well-capitalized reinsurer, who would no longer be required to post significant collateral on cross-border transactions but could be subject to U.S. tax on reinsurance it cedes to its parent or offshore affiliate, those advantages probably would disappear. The more cost-effective strategy would be to shut down the U.S. affiliate (in the process, destroying U.S. jobs) and simply transact all reinsurance business cross-border.

Back in 1992, Ross Perot predicted that passage of the NAFTA pact would be followed by a “giant sucking sound” of U.S. corporations redomesticating to Mexico. That particular prediction never came to pass; instead, the law was followed by waves of Mexican labor redomesticating to the United States.  But here is a case where the Giant Suck might actually transpire.

Collateral reform and taxation of offshore cessions are a pair of legislative and regulatory trains that have been moving for years, each seemingly unaware of the existence of the other. Should Congress pass the Neal-Menendez bill, just as the states are updating their collateral rules, it would have the effect of throwing a switch that puts them on the same track, heading for a collision course. The inevitable crash would not be pretty.

Featured Publications