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February 03, 2015 Article 4 min read

With their myriad parts and stakeholder interests, acquisition transactions present structuring complexities for both buyers and sellers. To address that concern, companies are turning to reinsurance as a tool that adds flexibility in the structuring of mergers and acquisitions transactions. Whether it’s excluding an unwanted class of business from a target company’s portfolio or, conversely, including a line of business that is not written on a target company’s paper, reinsurance is becoming increasingly prominent.

It is in this context that Sidley Austin Partner Jeremy Watson explained its key concepts and strategic applications.

Reinsurance basics

“Reinsurance involves the cession of insurance from the ceding company to a reinsurer,” Watson began, as he laid out the basics of a relationship that “is typically structured on an indemnity basis, whereby the reinsurer indemnifies the ceding company.” There are a number of types of reinsurance, including:

  • Indemnity reinsurance
    The reinsurer indemnifies the seller (ceding company) for its policyholder liabilities, with the seller (ceding company) remaining directly liable to policyholders.
  • Assumption reinsurance
    As contrasted with indemnity reinsurance, policyholder liabilities of the seller (ceding company) are assumed by the reinsurer, thus extinguishing the ceding company’s obligations to its policyholders. This requires policyholder (and, in certain cases, regulatory) consent.
  • Funds withheld transactions
    The ceding company transfers reserves associated with the reinsured business to the reinsurer, with the ceding company retaining on its books the assets supporting the reserves.
  • Modified coinsurance
    The ceding company retains on its books the reserves associated with the reinsured business as well as the assets supporting the reserves.

Reinsurance in acquisition transactions

Reinsurance can be used to provide tremendous flexibility in the structuring of stock acquisition by:

  • Removing a line or class of business from the target company that the parties want to exclude from the transaction. In this scenario, reinsurance is used to transfer a target company’s unwanted business before the stock acquisition is consummated.
  • Transferring a line or class of business into a target company that the parties want to include in a transaction. In this scenario, reinsurance is used to transfer the desired business to the target company prior to the stock acquisition.

Reinsurance can also be used as a primary acquisition vehicle when the transaction does not involve a stock sale or merger. “This is similar to an asset sale,” Watson explained, “and provides the parties flexibility to specifically define the insurance business that is to be transferred.”

Considerations in the structuring of transactions

To fully leverage the financial value of using reinsurance in an acquisition transaction, “the parties must ensure that the ceding company receives credit on its statutory financial statements for the reinsurance,” Watson said.

Even if a collateral mechanism is not required for credit for reinsurance purposes, the ceding company may insist on a collateral mechanism, such as a collateral trust, to protect against the credit risk associated with the reinsurer. While these collateral mechanisms are often undesirable from the buyer’s perspective, they can be structured so as to be minimally burdensome.

Other considerations that may be relevant in acquisitions transactions include:

  • Renewal rights
    The ceding company grants to the reinsurer a right to renew any expiring policies comprising the acquired business. These may be structured irrespective of whether a reinsurance arrangement is used.
  • Front arrangements
    The ceding company can grant the reinsurer the authority to quote, underwrite, and issue policies on the ceding company’s paper if the buyer lacks the authority to write the type of business being acquired or the seller cannot directly write the type of business that comprises the excluded business. In such an arrangement, the ceding company retains full liability to the policyholders if the reinsurer becomes insolvent.
  • Inuring reinsurance
    Whenever reinsurance is used in an acquisition transaction, due diligence is critical, Watson said. “For instance, retention provisions may require third-party consents.”
  • Extra-contractual obligations (ECO):
    “These are fairly heavily negotiated in reinsurance contracts,” Watson said, “with the reinsurer often being asked to accept responsibility for the ECO risk.”

Regulatory considerations

When using reinsurance in an acquisition transaction, there are a number of regulatory considerations that dictate structure and procedure:

Risk transfer

“Risk transfer is a key [consideration],” Watson said, introducing SSAP 62R requirements (which apply in connection with property and casualty reinsurance transactions). In order to receive reinsurance accounting treatment, a reinsurance agreement must transfer risk from the ceding company to the reinsurer. To satisfy the risk transfer requirements, agreements must, among other things, include an insolvency clause, require at least quarterly reporting, and transfer insurance risk (underwriting and timing).

Credit for reinsurance

Receiving proper accounting treatment is an integral consideration of a reinsurance transaction. Reinsurance credit is governed by the ceding company’s state of domicile. Each state has its own “credit for reinsurance” statute, which is often modeled after the NAIC Model Credit for Reinsurance Act. Typically, reinsurance credit is provided as a result of the reinsurer being licensed or accredited in the state of domicile of the ceding company or the reinsurer posting collateral to the ceding company. Some states now allow certified reinsurers to post less than 100 percent collateral.

Withdrawal requirements

Regulations also govern a ceding company’s withdrawal from a line of business. While these vary by state, many require the insurance regulator to receive prior notice of the withdrawal. A few states require the posting of collateral in a trust for a withdrawal from the state in its entirety, while others require prior approval of the insurance regulator and may require the withdrawal to take effect over time.

Looking ahead

Reinsurance transactions are gaining an increasing foothold in the structuring of acquisition transactions, “especially as private equity firms become more involved,” Watson concluded. “They’re constantly looking at ways of becoming more creative. And as they continue to look to these new structures, traditional buyers – insurance companies – are following.”

Jeremy Watson is a partner with Sidley Austin LLP. He presented at the fifth annual Plante Moran Insurance Conference, which brought together top executives from insurance organizations to explore a number of opportunities the insurance industry can leverage for continued growth and success.