Relates to treatment of qualified financial contracts in an insurance insolvency proceeding affecting a domestic, foreign or alien insurer

The only major category of financial and business institutions in the U.S. which lack such certainty are insurance companies. This lack of certainty threatens the ability of New York insurers to continue to use these investment tools to manage their risks and remain financially strong. Recent changes in the international capital rules for banks under the Basel II accords, events in the financial markets over the past year and the increasingly sophisticated risk control methods of financial institutions have placed a spotlight on the lack of protections for these contracts under the insurance laws of New York and most other states. While a framework for such protection was adopted by the NAIC in its Insurer Receivership Model Law (and a predecessor model), only 6 states have thus far taken action to adopt legislation validating these netting arrangements for insurers. This bill, if adopted, will reduce uncertainty and risk to NY insurance companies, as well as the banks, broker-dealers and other financial institutions with which they deal and will also reduce systemic risks to the financial markets. The bill will also redress the competitive disadvantage of New York insurers vis-a-vis their competitors in Connecticut and elsewhere where netting legislation has been adopted.

Summary of provisions

This Bill would add a new §7437 to Article 74 of the Insurance Law in regard to the following:

*Subsection (a) provides, for the purposes of Article 74 of the insurance law, definitions of specific types of financial contracts commonly used in the financial markets, including swap contracts, repurchase agreements, forward contracts, commodity contracts and security contracts as "qualified financial contracts" and the related "netting contracts". These definitions are intended to be consistent with those used under the Federal Deposit Insurance Act, applicable to bank insolvencies, and are similar to those contained in §619 of the New York banking law.

*Subsection (b) provides for the enforcement and recognition of the contractual rights of the insurer's counterparties, other than an insurer licensed to write financial guaranty insurance, under qualified financial contracts, netting agreements and related security arrangements to terminate, accelerate and close out such contracts, to offset and net off obligations owing under such contracts, and to enforce any security rights under such agreements, free of any stay or prohibition which might otherwise apply under Article 74.

*Subsection (c) provides for the transfer of any net or settlement amount owing under a qualified financial contract by the non-defaulting counter party to the insurer, other than an insurer licensed to write financial guaranty insurance, to the superintendent as liquidator, conservator or rehabilitator of the insurer. If netting results in an amount owing to the insurer, this provision confirms that the superintendent steps into the insurer's shoes with respect to that net amount.

*Subsections (d) and (e) provide for the transfer of all financial contracts between an insurer, other than an insurer licensed to write financial guaranty insurance, and a single counterparty and its affiliates together if a bulk transfer of insurer liabilities or contracts is made by the superintendent.

*Subsection (f) provides for validation of payments and transfers of money and property under netting agreements and qualified financial contracts made prior to the commencement of a rehabilitation, insolvency or conservation proceeding, unless such transfers were made with actual intent to hinder, delay or defraud the insurer, other than an insurer licensed to write financial guaranty insurance, the superintendent or other creditors. Parties to "qualified financial contracts" make payments and transfer collateral continually through the life of the agreements. Subsection (f) protects the creditor from the risk of "claw-back" of normal payment and collateral transfers under these agreements during the statutory preference period.

*Subsection (g) provides that, likewise, if the superintendent disaffirms or repudiates any qualified financial contracts or netting agreements with a counterparty, it must disaffirm or repudiate all such contracts. The Bill also establishes the amount of the counterparty's claim in the event of disaffirmance or repudiation. These provisions secure the integrity of the netting provisions under

qualified financial contracts by protecting the insurer's counterparties, other than an insurer licensed to write financial guaranty insurance, from "selective enforcement," the practice of keeping favorable contracts and rejecting unfavorable contracts.

This new section of the law would apply to contracts of both general and separate accounts of insurers, and would be effective immediately, except that it would not apply to any liquidation, receivership or conservatorship proceedings that have previously been commenced under Article 74.

Justification

Recent turmoil in the financial markets have heightened scrutiny, in the markets and among financial institutions about identifying, managing and limiting risk, the need for adequate capitalization and for understanding the interdependency of the different financial sectors. One source of risk to financial market participants has arisen due to the lack of certainty in the treatment of financial intermediaries in the event of the insolvency of state regulated insurers. Under the patchwork of state laws, only a handful attempt to address the issue of certainty. This bill attempts to correct this lack of clarity in New York insurance law by specifying the status of "qualified financial contracts" in an insurance insolvency proceeding. This amendment brings New York's insurance law into conformance with similar provisions of the state banking code, the Federal bankruptcy law and the NAIC Insurance Receivership Model Act (IRMA).

As defined in this Bill, "Qualified Financial Contracts" encompass a range of commonly traded financial market contracts, including over-the-counter and exchange traded derivatives, such as swaps, forwards and futures contracts, securities contracts, including securities lending arrangements and options, repurchase (repo) and reverse repurchase agreements. What these transactions have in common is that they are time sensitive, normally valued based on current market prices and traded repetitively and continuously between financial market participants. Trading in these contracts frequently involves chains of transactions, with intermediary institutions aggregating and transferring risk and providing liquidity to financial institutions and markets.

Because of the key role played by these transactions in facilitating financial market functioning, the Federal Bankruptcy Code and other laws regulating market participants have been revised to provide special treatment for these transactions. For example, the legislative history of the Bankruptcy Code states that these obligations warranted a degree of finality at the outset of bankruptcy in order to prevent uncertainty in a marketplace where trading is continuous and often transactional. Other regulators have noted the important liquidity function in the financial markets played by these contracts and their providers and the financial systemic risks that a lack of certainty in these contracts could cause, including the potential for chain insolvencies.

The use of netting agreements for financial market contracts has evolved from common law setoff and recoupment law. Netting reduces the credit risk between two parties by offsetting of mutual

obligations and liabilities. Qualified transactions are typically entered into under master agreements, which allow the execution of multiple individual transactions and the close-out or termination of all of these transactions upon the occurrence of an event of default, including insolvency. Following the termination of the transactions, the close-out amount, representing the total lost value to one of the parties for terminating the transactions prior to their stated maturity is calculated for each individual transaction. Since a party may be "in the money" on some transactions and "out of the money" on others, such amounts are then netted against one another, creating a single net amount owing from one party to another.

The power of netting agreements to reduce credit exposure and risk from these financial market contracts can be illustrated with a simple example:

Under a single netting agreement, Party A and Party B have entered into 10 contracts. There are 5 contracts under which Party A owes money to Party B - worth $1000. There are 5 contracts under which Party B owes Party A money - worth $800. If this contract is terminated, a net amount owing is calculated: Party A owes Party B a net amount of $200.

Collateral arrangements normally included in the netting agreements further reduce exposure of market participants. Under these contracts, collateral is computed and collected, based on the "net" exposure. If enforceable these agreements potentially dramatically reduce the credit exposure of financial institutions to each other that are inherent to these financial market transactions and the risk that the default or insolvency of an institution could have on the financial system. Therefore, the importance of clarifying enforceability of these agreements is great.

Netting can also involve the setoff of securities, whether as a true setoff (as in the case of repurchase or securities lending agreements) or as foreclosure on collateral (as in the case of cash or securities held to secure derivative transactions.) The ability of an institution to set off or to sell securities to immediately satisfy a claim against an insolvent counterparty is critical not only to reduce the parties' credit risk but to maintain liquidity in the securities markets, since many of these transactions are part of a whole chain of interlocking trades. The imposition of a stay on the liquidation of these securities, as is normally the case in a New York insurer insolvency proceeding, could result in uncertainty, gridlock or a chain of insolvencies.

Finally, financial market transactions are usually valued, collateralized and traded based on current market prices, and credit exposures are calculated or managed on this basis. Any legal uncertainty which affects the ability to make exposure calculations, any delay or uncertainty around the time of payment or any subsequent legal determinations in an insolvency proceeding which might overturn the previously calculated credit exposures undermine the effectiveness of these contractual provisions and procedures and the certainty they provide in the market.

This bill would substitute the needed certainty and reliability to enforcement of these important contractual protections for the current state of doubt and unpredictability which currently prevails under the New York insolvency laws.

Qualified financial contracts are widely used by insurers, largely for hedging purposes. They have proven to be of great assistance to insurers during the recent market downturn. Derivative instruments are used for hedging risks, for asset/liability management and for creation of synthetic asset exposures in the insurer's investment operations. The Legislature recognized the importance of this activity in granting New York insurers' derivative authority in 1998 under § 1410 of the insurance law and making that law permanent. Pursuant to that law, insurers' use of these types of instruments are largely limited to hedging purposes and are strictly governed by derivative use plans that are filed with and approved by the New York State Insurance Department. These Plans must be re-filed with the Insurance Department when updated and are required to be audited annually by an independent auditing firm.

The New York insurance industry's continued access to these instruments, on favorable terms, is threatened by recent developments in the financial markets. In particular, implementation of the Basel II accords intensifies the pressure on insurers and their major counterparties. Basel II has currently been implemented in Europe and is in the process of implementation for major US banks through their regulation by the Federal Reserve and Office of Comptroller of the Currency, and for major investment banking organizations through consolidated regulation by the Securities Exchange Commission. Under Basel II, regulated institutions will be required to maintain significant additional capital for its derivatives transactions and other financial contracts with parties with which it does not have a legally enforceable netting agreement, including the ability to close out upon insolvency without being affected by any stay.

Without the certainty sought through the amendment of New York law proposed in the Bill it will become difficult for the counterparties of NY insurers to obtain the necessary legal comfort to transact business with New York insurers. The consequence for the domestic companies will be increasingly poor pricing for their transactions, and potentially, lack of equal access to these financial markets. An inability to continue to trade or a deterioration of the prices at which insurers can transact, potentially threatens the competitiveness and financial strength of New York companies.

By providing for the enforcement of netting and closeout rights for "qualified financial contracts" in an insurer insolvency, New York will be bringing its insurer insolvency law into harmony with federal law as well as the New York banking law and will give both insurers and their creditors the certainty and safety they need to continue to transact business.

Legislative history

S.4772 of 2009-10.

Fiscal implications

None to the state.

Effective date

This act will take effect immediately, except that section one will only apply to a liquidation, rehabilitation or conservation proceeding that commences under article 74 of the insurance law on or after the effective date.