Every year, I get calls seeking an opinion that a new product is not subject to any regulatory oversight.
The hope of the caller is that through some careful engineering the product can avoid being classified as “insurance” or a “security” or as anything else that might subject it or its provider to expensive regulatory burdens.
A classic example was credit default swaps, which were once the non-regulated product at the heart of the AIG meltdown.
The Dodd-Frank Act responded to swap issues by vastly expanding the authority of the Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC). Although insurance generally is exempt from the new swaps regime, the exemption is not 100%. Some new products may be subject to the new CFTC and SEC regulations. They include: margin and capital requirements; mandatory clearing and trade execution requirements; recordkeeping and real-time data reporting; and adherence to internal and external business conduct standards.
Brokers selling these swap-like products are subject to separate recordkeeping and reporting requirements. They likely need to register with the relevant commission and conduct activities on a Swap Execution Facility (SEF) to avoid fines for selling a product that is a swap without satisfying the regulatory requirements. These fines can be significant for intermediaries, and the sale of one creates a rescission risk.
The commissions have broadly defined a swap to include any contract that provides for any payment that depends on “a potential financial, economic, or commercial consequence.” This definition includes all insurance products.
Congress did not intend to sweep insurance under the new swaps regime. The SEC and CFTC, however, recognize some swaps "might be characterized as insurance products to evade the [Dodd-Frank swaps] regulatory regime..." As such, the commissions use a "facts and circumstances" test to determine whether an insurance product is sufficiently "insurance" to be exempt from the swaps regulations. This gives the regulatory agencies broad discretion to decide whether a product is insurance and qualifies for the exemption.
The regulations also create a safe-harbor that should ensure most, if not all, current insurance products are exempt from the swaps regime. To satisfy the safe harbor, a policy must be provided by a carrier that satisfies a “provider test” and must either be included on a list of products pre-approved by the two commissions or must satisfy a separate “products test.”
To satisfy the provider test, the provider must be subject to supervision by an insurance regulator, and the agreement or contract must be regulates as insurance. The provider test specifically allows non-admitted carriers that are approved to offer surplus lines or are included on the NAIC Alien Insurer White List. Foreign carriers that do not satisfy the test, and any products they offer may be considered swaps because they are beyond the purview of state regulators. If you have clients accessing these markets on a direct placement basis, they might inadvertently be subjecting themselves to the new regulations.
The provider test regulations do not really grapple over surplus lines insurance being essentially unregulated. The following types of policies, however, are pre-approved as insurance because they are subject to regulatory supervision:
- Surety bonds
- Fidelity bonds
- Life insurance
- Health insurance
- Long-term care insurance
- Title insurance
- Property and casualty insurance
- Disability insurance
- Insurance against default on individual residential mortgages (commonly known as private mortgage insurance, as distinguished from financial guaranty of mortgage pools)
- Reinsurance (including retrocession) of any of the foregoing.
The SEC and CFTC declined to extend the pre-approval status to mortgage insurance at the financial institution level; guaranteed investment contracts; funding agreements; structured settlements; deposit administration contracts; industry loss warrants; and catastrophe bonds.
Insurance contracts or agreements not included on the pre-approval list may still qualify for the insurance safe harbor if they meet the following product test:
- The contract beneficiary has an insurable interest that is the subject of the contract and the beneficiary carries that risk of loss continuously throughout the duration of the agreement;
- Payment is limited to the value of any such interest if there is a loss, and
- The insurance contract is not traded.
The regulations include a sweeping anti-evasion provision stating the form, label and written documentation of an insurance policy will not insulate it from regulation if the product was “willfully structured” to evade swaps regulations. The SEC and CFTC want to ensure swap-like instruments are regulated as swaps. At the same time, they recognize it may be difficult to discern the difference. So they encourage submitting requests for SEC and CFTC determinations.
As always, when in doubt, you can call us now…or can call us later and risk the consequences.