Insurance Requirements in Commercial Contracts (Part 4)

Welcome to Part 4 of the Insurance Requirements in Commercial Contracts series.
 
In Part 1, we touched on the importance of insurance provisions in commercial contracts, the use of outdated terms, and additional insured status.  In Part 2, we reviewed the difference between a deductible policy and a self insured retention.  In Part 3, we explained the difference in Loss Payee versus Lender Loss Payee status.  Today's blog post is about theft and commercial crime coverage.

A secured lender may wish to require the borrower to obtain coverage for “theft” of the property (equipment, inventory, etc.) which secures the loan. Otherwise, the personal property could be stolen and the secured lender would be left without any collateral securing the financing.  

Ordinary property coverage will typically cover many types of theft, subject to exclusions and any special terms of the policy. At the same time, the insurer may require the insured (i.e., the borrower) to have certain physical security measures in place before writing the insurance, such as fences, locked gates, security cameras, or a monitored burglar alarm. The underwriter of the insurer will typically, either prior to writing the policy or shortly after inception, verify the existence of these physical security measures. These physical security measures not only assist the insurer in helping to prevent a claim, but ultimately also inure to the benefit of the lender who will be protected when the borrower maintains physical possession and custody of the items securing the loan. However, in many cases these policies will contain an exclusion for employee theft. This is significant because, by some estimates and depending on industry, up to 80% of workplace crime is the sort of insider theft/white-collar fraud conducted by a company’s own employees. 

A commercial crime policy, often described as a fidelity bond or fidelity insurance, is designed to insure against criminal acts of a company’s own employees, as well as certain other criminal acts by non-employees. This policy is directly squarely at the theft of money, marketable securities, embezzlement, certain computer crimes, forgery, and other crimes which businesses are sometimes targets of and victims of. Dedicated crime coverage will also often cover other situations where a business is the victim, such as the receipt of counterfeit money or a financial loss which is the result of a forgery or facsimile signature. 

Like many types of insurance, a crime policy also serves as a type of credit enhancement to a lender. If a borrower already has a crime policy (or is required to obtain one) the borrower will be better able to weather an unpredicted criminal event and thus be better able to have the cash flows to service its debt obligations. 

While a crime policy will cost additional premium, it will provide much broader coverage in the event of criminal acts, particularly by “insiders” of the company such as employees, management, and often officers of the company. When drafting or insisting on contract terms which require the provision of “theft” insurance, the parties need to clarify whether the financing documents only require ordinary property coverage, or also require a commercial crime policy or fidelity bond.

Later this week we will probably post Part 5, the final installment of our series on insurance provisions in commercial contracts.

North Carolina Studying Drug Formularies in Workers’ Comp Claims

Gemma Saluta and I recently had an article published in Insurance Journal regarding new legislation in North Carolina which directs the Industrial Commission to conduct a study regarding the adoption of drug formularies for state-employee worker's comp claims.

Five Important Lessons on North Carolina Insurance Law from Recent Federal District Court Decision

A recent decision by United States District Court Judge Richard L. Voorhees in Charlotte, North Carolina, serves as a reminder of five rules followed by the North Carolina courts when determining an insurance company’s duty to defend. See New NGC, Inc. v. ACE American Insurance Co., et. al, 3:10-CV-00022-RLV-DSC, 2015 WL 2259172 (W.D.N.C. May 13, 2015) (“Memorandum and Order”).

In New NGC, the policyholder was one of the largest drywall manufacturers in the country. It became a defendant in a number of individual actions and class actions around the country, which all generally claimed that New NGC’s products were defective, causing both property damage within buildings where the drywall was installed, as well as bodily injury to individuals complaining of respiratory illness and allergy-like symptoms.

The first major takeaway from this opinion is, not only is the North Carolina Court of Appeals’ 1991 decision in West American Insurance Co., v. Tufco Flooring East, Inc., 409 S.E.2d 692 (N.C. App. 1991) of questionable precedential value, but the attempt by the policyholder to argue that the pollution does not apply when the pollution arises out of the policyholders’ central business activity only applies, if at all, if the court determines that the pollution exclusion is ambiguous. [Tufco] was unusual in that the court found that the exclusion was ambiguous because of the “interrelationship between the completed operations coverage and the pollution exclusion clause.” Id at 697.

Second, this case is important because it explains that an insurance company may not focus exclusively on the allegations of the putative class representative in evaluating its duty to defend. Focusing solely on the named Plaintiff would “completely ignore the general notice pleadings standard of the Federal Rules of Civil Procedure as well as the underlying purposes of class action.” Memorandum and Order at 23.

In our next post, we will address three additional points of insurance law, as explained by Judge Voorhees.

Cyber insurance tips, courtesy of Lloyd's of London

On November 9th, Lloyd's of London issued a market bulletin to its syndicates on managing catastrophe-risk and exposures.  While the memo is directed at the syndicates which make up the Lloyd's insurance market and in assisting those syndicates in managing their cyber exposure (and the accumulated cyber exposure risk to the entire Lloyd's market), it also provides some insight into how this insurance market leader believes its constituents should be approaching cyber insurance. 

The memo's guidance can be applied to business owners and purchasers of cyber insurance as well.

The memo suggests that the syndicates "create and develop their own lists of 'plausible but extreme' types of cyber-attack scenarios, with associated lines of business that may be affected."  This is good advice for anyone purchasing cyber insurance.  It is important for policyholders to understand what types of cyber attacks would most effect their business, what is the possible scope and scale of the attack, and what is the possible expense.  With that information, a business can plan for what types and how much insurance to purchase.

For example, the memo also notes that "there are different types of cyber-attack, which could cause different types of harm: denial of service, data-theft, data-damage, reputational harm, physical damage etc.  The economic damage for each type may differ, with consequences including direct financial loss, bodily injury or property damage."  These are just some of the questions that businesses should be asking themselves when considering the purchase of cyber insurance.   

Art insurance rates in Manhattan drop (plus tips on art insurance!)

It is widely known that Hurricane Sandy, in 2012, caused large losses in the insurance industry, in part because of the high property values in the storm's path, as well as the population density. This included flooding in the Chelsea neighborhood of Manhattan, which damaged nearly three dozen art galleries, and property damage at storage units and warehouses across the region.

After the storm, it was estimated that there was $300 million Because so much art is only temporarily in Manhattan - either on loan or consignment - the ramifications and insurance claims were worldwide. 

After the storm, it was predicted that the art insurance industry would react with higher premiums, which would then taper back to normal.  As Robert Salmon of Willis was quoted: “It’s mainly knee-jerk: restrictions, huge deductibles, and rate increases. As we get further from the events, insurers are going to have to tone down that kind of reaction or lose too much business.”

Mr. Salmon's predictions have been borne out.  The Art Newspaper is reporting that insurance premiums are now lower than before Hurricane Sandy, in part because of the fierce price competition in the industry and because, as LeConte Moore of DeWitt Stern, a specialist art insurance broker says, "People handle art with care: they put on white gloves, they package it specifically.  They take good care of art whether it's a Tiffany lamp or a Picasso."  However, underwriting standards are typically stricter and the policies contain greater restrictions and conditions. 

If you collect fine art (whether for a personal collection or to display at your business), here are a few tips to remember:

First, understand what coverage you already have.  Obtain a copy of your existing homeowner's/renter's insurance or business personal property insurance policy.  Read the policy and speak with your insurance broker to find out whether your existing property insurance policies cover fine art.  It is likely that fine art is either (1) wholly excluded or (2) subject to a sublimit.  Many insurers then offer additional coverage options (usually called a “rider” or “floater”) to add specified fine arts coverage.  This may be a blanket floater for all of your fine art, or it may be separate and individual floaters for each work of art (or, obviously, a combination of a blanket with individual floaters on certain works).

Second and related, consider specialty insurance.  You may find that your property insurer’s limits are insufficient, or that its policy terms are inadequate.  If that is the case, consider working with a specialist art insurer and possibly a specialist art insurance broker.  Some specialist insurers will also have employees who can assist you in upgrading your facilities to make it safer to store or display fine art. 

Third, know that premiums will likely vary on a number of factors.  These include the type of art (some types being more fragile than others), the geographic location (risk of flood, hurricane, or wildfire), the specific location (public display or private collection), whether the art is stored in a vacant facility or not, and how frequently the art will be moved. 

Fourth, keep good records.  This goes for any insurable collection and, indeed, many other types of insured personal property.  In the event of a loss, it will be helpful to have the original bill of sale or receipt, photographs of the item, any appraisals that have ever been done (even if they are “informal” appraisals such as print-outs of similar items sold at auction), and a copy of the item’s provenance (if applicable).  Further, in today’s world, it is easy to copy this information electronically and store it remotely where it is safe from natural disasters or fire damage, and can be easily retrieved after a catastrophe.

Fifth, get an appraisal.  Depending on the insurance policy, have the art appraised on a semi-regular basis.  An appraisal serves two purposes: (1) by knowing the market value of the item, you can adjust your insurance coverage up or down so that you purchase enough insurance (but not too much) and (2) an appraisal will assist in substantiating the value of the item in the event of a loss. Certain insurers will permit you to "self-appraise" and, for some individuals and collectors, this is an easy process because they already have the background knowledge in the field. For the more casual collector, a professional appraisal will be more helpful.        

Insurance Requirements in Commercial Contracts (Part 3)

In Part 1 of this series we touched on the importance of insurance provisions in commercial contracts, the use of outdated terms, and additional insured status.  In Part 2, we reviewed the difference between a deductible policy and a self insured retention. 

Today we hope to provide some clarity to the distcintion between being named as a Loss Payee compared to a Lender Loss Payee.

In a financing agreement, a lender might request to be named as a Loss Payee. The first reaction should be “why aren’t you requesting to become a Lender Loss Payee”? Without an understanding of insurance law principles, this distinction is commonly ignored or misunderstood.

Secured lenders seek to protect themselves from a debtor’s default by perfecting a security interest in certain of the debtor’s assets (commonly land, buildings, equipment, or inventory). As a means of further protection or simply as a credit enhancement, the lender may also require that the collateral be insured. If the collateral is insured by a legitimate, rated, commercial insurance carrier, the lender will be more likely to lend money because in the event of a catastrophic loss, the debtor will receive insurance proceeds with which the loan can be paid off and the lender made whole. The lender sometimes goes one step further and requires the borrower to name the lender as a Loss Payee on the policy.

However, in certain instances, an insurer has no obligation to pay because of a policyholder’s misconduct or failure to comply with certain policy provisions. For example, the insurer can often avoid any indemnity obligation because of the policyholder’s fraud, failure to give timely notice, failure to sit for an Examination Under Oath, or intentional acts. In those instances, the lender would be exposed to an uncovered loss; the contract term which bargained for insurance would be ineffective because of the policyholder’s misconduct.

The practical implication is that if a borrower commits arson – burning the building, equipment, and inventory in an attempt to collect insurance proceeds – the insurer may have zero liability to a Loss Payee. On the other hand, had the lender bargained to be named a Lender’s Loss Payee (the simple addition of one single word), then the insurer would be obligated to indemnify the lender, regardless of the acts or misconduct of the policyholder.

NC Insurance Commissioner Expresses Frustration about Medical Insurance Rate Increases

The Raleigh News and Observer ran an interesting piece regarding the Medical Insurance options in North Carolina. In particular, it comments that the Legislature's decision not to expand Medicaid, set up its own ACA exchange, or partner with the federal government in running an exchange has made premiums higher.  

The Commissioner's reported comments are strong, and not what we typically see from an elected official. It is worth a read, and is located here. 

If you are unfamiliar with the expansion of Medicaid topic, a primer on the subject (albeit comedic) can be located here.

Read more here: http://www.newsobserver.com/opinion/opn-columns-blogs/ned-barnett/article43619169.html#storylink=cpy

North Carolina's modern Incorporated Cell Captive statute should allay Fitch's fears

Recently, Fitch announced its new views regarding credit risks it believes may be inherent in protected cell captive insurance companies ("PCCs").  This questioning of the structure of PCCs is in light of Pac Re 5-AT v. AmTrust North America, 2015 WL 2383406 (D. Montana, May 13, 2015 ).

A protected cell company is a captive insurance company composed of (1) a “core” and (2) a number of “cells” which are established around the core.&nbs;Unless limited by statute or regulatory rule, there can be an unlimited number of cells.&nbs;The assets and liabilities of each cell are segregated from the assets and liabilities of every other cell, as well as from the core.&nbs;The PCC structure was designed so that the assets of each cell are only available to creditors of that cell.&nbs;  Once a PCC is established by a sponsor, the sponsor can then operate each cell as an independent insurance company.&nbs;Or, more commonly, the sponsor can operate the core and other, non-related companies can operate each cell as independent insurance companies.&nbs;The cell structure – and its shared overhead – permits smaller companies who do have the capability or desire to operate a single parent captive insurance company to obtain some of the benefits of captive insurance.&nbs;

In Pac Re 5-AT v. AmTrust, a contract dispute regarding a captive reinsurance agreement between a cell and its reinsurer (which was subject to arbitration) broadened into an issue of first impression regarding protected cell companies.   Originally, the dispute was between the reinsurer and the one single protected cell (Pac Re 5-AT a/k/a Cell 5) under the terms of the captive reinsurance agreement.  However, the reinsurer named both the cell and the core (Pacific Re, Inc., a Montana captive insurance company) as a party as well.  Pacific Re then sought a declaratory and injunction in federal court that it was not a party to the arbitration. 

On cross motions for summary judgment, the court applied Montana’s corporate law to its captive insurance enabling statutes (which established protective cell captive insurance companies).&nbs;

Stating that this was an issue of first impression under Montana law (and indeed, an issue of first impression under all domestic United States law), the court stated in pertinent part:

The statutory construction issue arises here because a cell is not a separate de jure legal entity, but has many de facto aspects of a legal identity.&nbs;It is clear that the liabilities and assets of a protected cell are segregated from the other cells and from the PCC, but it is also clear that a protected cell does not have a separate legal identity.  Each cell, in essence, operates as its own separate entity, but remains part of the larger PCC.&nbs;Though the statute does not contemplate that the assets of a protected cell will be used to satisfy the liabilities of any other cell, the cells are not entirely independent from the PCC.

The court went on to rule that:

 “A protected cell is not a separate legal person.&nbs;Without a separate legal identity, and absent a statutory grant to the contrary, a protected cell does not have the capacity to sue and be sued independent of the larger PCC.&nbs;The statutory language is clear, and the court may not look beyond the plain meaning.&nbs;Although a protected cell has many attributes of independence from the PCC, it remains a part of the PCC, which has the capacity to act on behalf of the protected cell as in this instance Pacific Re acted on behalf of Cell 5 in agreements at issue.”&nbs;

In summary, “Pacific Re, as the PCC, entered into contracts at issue, both on its own and on behalf of the protected cell.&nbs;It is properly before the arbitration tribunal and will appropriately be bound by the results of the arbitration.”

As Fitch points out, the Pac Re 5-AT opinion raises significant concerns regarding how well "ring-fenced" each cell in a PCC is, and what would happen to a cell if another unrelated cell caused the core of a PCC to become insolvent. 

North Carolina recently revised its captive insurance statute with a number of technical corrections.  Under N.C.G.S. § 58-10-510, “a protected cell captive insurance company licensed under this Part may establish and maintain one or more incorporated or unincorporated cells, to insure risks of one or more participants. . . [ subject to certain conditions].”

Section 58-10-512 goes on to outline in more detail the formation, operation, and obligations under an incorporated cell captive program.  This passage deals squarely with the issue raised by Pac Re 5-AT .  The statute specifically states that:

"In the case of a contract or obligation to which the protected cell captive insurance company is not a party, either in its own name and for its own account or on behalf of a protected cell, the counterparty to the contract or obligation shall have no right or recourse against the protected cell captive insurance company and its assets other than against assets properly attributable to the incorporated protected cell that is a party to the contract or obligation."

As Pac Re 5-AT shows, understanding the applicable corporate law and captive insurance law of any domicile is important not just to those operating PCCs, but to anyone dealing with them as well.

The Economics of the ALI's Principles of Liability Insurance project

Yale Law Professor George L. Priest, who teaches in the fields of insurance law and law & economics, has written the first paper that I am aware of which applies a law & economics analysis to the ALI's Insurance Principles project.  This paper gives a very good explanation of the basic law & economic explanation of liability insurance and the social benefit of liability insurance (although that explanation takes nearly 25 pages of a 43 page paper). 

As readers of this blog may know, the American Law Institute has undertaken a project to publish a "Principles of Liability Insurance," similar to the Restatements of the Law which the ALI is well-known in legal circles for publishing.  The Principles of Liability Insurance project has shifted from being little-known outside of academic circles and is now widely discussed at meetings of coverage lawyers.  Note that this is no Restatement of the law; which, by its name, would imply it simply restates the law as it exists. 

The project is currently being managed by Tom Baker of the University of Pennsylvania and Kyle Logue of the University of Michigan, along with input from a number of stakeholders, and seeks to produce a book (perhaps, a multi-volume set) to set forth the law (as the authors believe it should be) on important issues of liability insurance coverage. In states with a paucity of insurance case law, the publication by the ALI of the Principles of Liability Insurance Law will likely have a major impact; in those states, judges will be more likely to rely on the ALI's Principles project as akin to a national treatise on insurance law. 

In states which already have a well-developed body of state common law (i.e., New York, New Jersey), the impact of the Principles project will likely be less.  North Carolina would probably fall somewhere in the middle; our state's insurance law has several large areas which are underdeveloped or completely undeveloped, however we are far ahead of many states which have less reported opinions, lack an intermediate appellate court, have fewer cases decided on summary judgment (and thus fewer appeals of legal issues), and which lack courts for complex commercial disputes such as the North Carolina Business Court.    

Professor Priest clearly explains his view that the greatest aggregate social utility of liability insurance is when it is easy to obtain and thus widely distributed.  He believes, in short, that although Professor Baker and Professor Logue intend to re-write various rules to be pro-policyholder in the short term (i.e., in an individual case), that these revisions may end up harming policyholders more broadly in the long run by making liability insurance harder to obtain, thus having a net negative effect. 

XXX/AXXX captive life insurance class actions dismissed for lack of standing

Two putative class actions arising from captive life insurance transactions have both been dismissed.  In both cases, the Court found that the plaintiff had failed to adequately allege any injury personal to himself, and thus lacked standing to bring a lawsuit. 

 It is well-known in the captive insurance industry that New York state’s regulators have, for several years, been critical of captive insurance.  This includes the New York State Department of Financial Services publication in June 2013 of a 24 page report regarding captive reinsurance transactions in the life insurance industry which was ominously titled Shining a Light on Shadow Insurance.  In that report, the New York regulators assert that captive reinsurance arrangements undertaken by large life insurance companies masks financial weakness (and hints that the entire economy is at risk of a financial collapse if a large, interconnected life insurer were to collapse as AIG Financial Products did in 2008).

These transactions are motivated by an effort to manage the gap between economic reserves and statutory reserves (often called XXX/AXXX reserves) approved by the National Association of Insurance Commissions and adopted by a number of states during the 1990s. Academics have divided views on the propriety of these life insurer captive reinsurance transactions.  Some (notably Ralph Koijen of the London Business School and Motohiro Yogo of Princeton) essentially agree with the New York State Department of Financial Services, concluding that the potential cost of life insurer insolvencies is underpriced or under-recognized by current models and ratings.  Others have concluded that use of the captive reinsurance transaction permits the life insurer to become more economically efficient (thus lowering prices for consumers in a market which is cost-shopped and heavily-driven by premium price) without additional risk of insolvency. 

 

In the first case to be dismissed, the plaintiffs alleged that AXA Equitable Life Insurance Company violated New York statutory insurance law and regulations which prohibited misrepresentation of a life insurer’s financial condition when it used captive reinsurance transactions. Jonathan Ross v. AXA Equitable Life Insurance Co., 2015 WL 4461654 (S.D.N.Y. July 21, 2015).  The Plaintiffs further argued that, by misrepresenting its financial condition, AXA was able to obtain higher ratings from the ratings agencies with less capital.  The opinion also gives a good summary of the background of current life insurance reserve scenarios, XXX and AXXX statutory reserves, and the captive reinsurance transaction. 

However, the Plaintiffs could not articulate any concrete and discrete harm personally suffered.  They did not allege that their monthly premiums were higher.  They did not alleged that AXA had defaulted in any way.  Plaintiffs also did not have any misrepresentation-based allegations; they did not alleged that they relied on the financial statements of AXA in selecting an insurance product or that, had a disclosure of captive reinsurance transactions been made, that they would not have purchased the AXA policies.  Because they had suffered no identifiable, immediate, articulable and concrete harm, the Court dismissed the putative class action for lack of standing.

More recently, another judge in the Southern District of New York came to the same conclusion in Robainas v. Metropolitan Life Insurance Co., 2015 WL 5918200 (S.D.N.Y. Oct. 30, 2015).  In Robainas, plaintiffs alleged that they had purchased MetLife policies, unaware that MetLife had engaged in captive reinsurance transactions totaling over $1.1 billion.  Citing to Ross, the Court rejected similar arguments on the same grounds: the plaintiffs lacked standing under Article III of the United States Constitution to bring this claim because they failed to have any cognizable injury.  Indeed, the plaintiffs in Robainas had included an article by Koijen and Yogo as an exhibit to the Complaint which showed that captive reinsurance transactions actually lowered premiums for consumers.  Even taking the allegations in a light most favorable to the plaintiffs, the Court was unpersuaded that the plaintiffs had suffered any injury when these transactions made the consumers premiums less expensive.  Any risk of future insolvency was deemed too remote or tenuous (note that the Court did not go as far as to say such claims were not “ripe” for adjudication). 

Further, although the Robainas plaintiffs specifically alleged violations of state insurance statutes, the Court held that mere violation of a state statute did not create a federal cause of action absent an injury under Article III.  Although beyond the scope of this blog post, this is the right result.  Similar arguments were presented to the United States Supreme Court in Spokeo v. Robins regarding whether Congress could create standing under Article III when the plaintiff suffered no concrete harm.  All too often in insurance litigation, plaintiffs complain of theoretical "injuries" which have not yet occurred.  Under Article III of the Constitution, these plaintiffs do not have standing to bring a claim until after they have a concrete, demonstrable, and cognizable injury in fact. 

Quiet October for Hurricanes in the Atlantic States

The National Hurricane Center released its Monthly Atlantic Tropical Weather Summary yesterday.  In October, no new storms developed in the Atlantic.  Hurricane Joaquin had formed in September 2015.  Typically, there are two storms formed in October, with one developing into a hurricane. 

The National Oceanic and Atmospheric Association had predicted in May 2015 that this would be below-normal season this year.

Hopefully, this record and prediction will continue through November 30, when hurricane season officially ends. 

Will North Carolina follow Tennessee's memo on captive reinsurance transactions?

On October 22, the Tennessee Department of Commerce and Insurance adopted a memo which provides guidance to captive insurance companies domiciled in Tennessee regarding the credit obtained for reinsurance from unauthorized reinsurers. This is significant, not only because Tennessee and North Carolina are adjacent states (which to some degree compete against each other for captive insurance domestications and formations), but also because the statutory language of the North Carolina General Statutes and the Tennessee Insurance Code are identical.

Both Tennessee Insurance Code § 56-13-112 and North Carolina General Statute § 58-10-445 explain that: 

Any captive insurance company may take credit for the reinsurance of risks or portions of risks ceded to reinsurers complying with this Chapter. If the reinsurer is licensed as a risk retention group, then the ceding risk retention group or its members must qualify for membership with the reinsurer. The Commissioner shall have the discretion to allow a captive insurance company to take credit for the reinsurance of risks or portions of risks ceded to an unauthorized reinsurer, after review, on a case-by-case basis. The Commissioner may require any documents, financial information, or other evidence that will allow an unauthorized reinsurer to demonstrate adequate security for its financial obligations.

In addition to reinsurers authorized by this Chapter, a captive insurance company may take credit for the reinsurance of risks or portions of risks ceded to a pool, exchange, or association to the extent authorized by the Commissioner. The Commissioner may require any documents, financial information, or other evidence that such a pool, exchange, or association will be able to provide adequate security for its financial obligations. The Commissioner may deny authorization or impose any limitations on the activities of a reinsurance pool, exchange, or association that in the Commissioner's judgment are necessary and proper to provide adequate security for the ceding captive insurance company and for the protection and benefit of the public at large.

 

 The memo from the Tennessee Department of Commerce and Insurance provides a regulatory gloss on the statute. It goes on to state that “Tennessee captives seeking to enter into a reinsurance contract with the same unauthorized reinsurer should likewise include the details of the proposed reinsurance agreement and its proposed business plan or submit a change of business plan.” This obviously has large implications for the risk pools operated by many captive managers.

The Tennessee memo then lays out five factors which it claims will be used in deciding whether to grant credit for reinsurance purchased from unauthorized reinsurers. These factors are:

• “The policy issued to the original named insured is issued by a traditional admitted domestic insurance carrier acting as a front.
• The reinsurance agreement is made upon secured collateral. This includes reinsurance agreements made on a funds withheld basis, via a domestic U.S. trust, or via a letter of credit issued by a reputable U.S. based financial institution.
• The reinsurance agreements are obtained from an accredited reinsurer as defined by Tenn. Code Ann. §56-2-208.
• Reinsurance is obtained from a reinsurer that is highly rated by a reputable rating agency.  
• The reinsurer has a paid in unencumbered capital and surplus of at least $20,000,000 and agrees to submit to Tennessee copies of its audited annual financial statements as well as copies of any examination report conducted by its home domicile.”

Two additional factors are also explained: Tennessee will provide additional weight to a reinsurer if it is “domiciled in a jurisdiction with a solid reputation for providing accountability and oversight to its insurers” and the Department will give weight to the “experience and reputation of the captive manager and other service providers selected by the captive owner.”  These factors, of course, beg the question as to what qualifies as a domicile with a "solid reputation."  Does this exclude all off-shore domiciles?  Will Tennessee consider any on-shore domiciles other than itself to be qualified?

This memo continues that “some captives choose to participate in reinsurance exchange pooling arrangements structured in any number of ways. When such pooling arrangements include scenarios where a Tennessee captive insurance company cedes risk to an unauthorized reinsurer, the Department will give the greatest weight to arrangements where the ceded premium is held in a domestic U.S. trust, or where all pool participants are managed by the same captive manager. Any type of proposed pooling arrangement should include information sufficient to satisfy the Department that adequate controls are present and that the pooling arrangement, and its participants, possesses sufficient liquidity and accountability.” 

The memo concludes by stating that the Department of Commerce and Insurance retains its discretion to grant credit for reinsurance on a case by case basis.

This memo is important because it applies a regulatory interpretation to statutory language that is identical to North Carolina’s captive insurance law.  It will be interesting to see whether North Carolina's Department of Insurance reacts in any way to this memo.  Even if North Carolina's regulators do not adopt the Tennessee memo outright, would they consider compliance with it as a "plus factor"?  Conversely, depending on whether Tennessee construes its policy memo narrowly or broadly could have implications for North Carolina's captive insurance industry.