Relates to derivative transactions and derivative instruments

These amendments are intended to strengthen the rules applied to insurer derivative transactions with "qualified counterparties" in order to ensure that they are fully collateralized pursuant to a master netting agreement. These amendments will allow insurers to continue entering into responsible derivatives arrangements to hedge their investment strategies. These arrangements assist insurers in supporting their ability to continue to offer certain variable insurance products to consumers, to keep product pricing affordable and ensure that they can continue to meet their policyholder obligations.

Summary of provisions

This bill would amend subsection (a) of section 1401 of the insurance law to add new paragraphs (19) - (21) which establish new definitions of "over the counter derivative instrument", "clearinghouse" and "master agreement" to Article 14 of the insurance law which addresses investment by insurers. This bill would also amend subsection (t) of section 1410 of the insurance law to redefine the terms "qualified counterparty" and "aggregate counterparty exposure" and to refine the rules which insurers must follow in order to enter into derivative transactions with "qualified counterparties" and other than qualified counterparties. The new standard provided for in this bill will require that, in order for a counterparty to be a "qualified counterparty" it would need to have entered into a netting and collateral agreement with the insurer and would also need to be rated (or have a parent or guarantor or other credit enhancer rated) investment grade or better.

Existing law

Section 1401 of the insurance law currently does not define the terms over the counter derivative instrument", "clearinghouse" and "master agreement." Section 1410 of the insurance law currently contains an alternative definition for "qualified counterparty" and "aggregate counterparty exposure." The current definitions of these terms are meant to establish that, in order to be qualified to enter into a derivative transaction with an insurer, an entity must have a credit rating of AA or better by a nationally-recognized statistical rating organization. The current restrictions contained in section 1410 of the insurance law and placed on insurers entering into derivative transactions remain intact.

Justification

Section 1410 of the insurance law was adopted in 1998 to establish the rules which domestic insurers must follow in order to enter into derivative transactions in New York. The law strictly limits the amount of derivative transactions that insurers may enter into and provides that they should be used primarily for hedging purposes. It also requires that insurer derivative use must be overseen by the company Board of Directors and requires that insurers must have a derivative use plan approved by the Superintendent and audited by an independent, outside auditing firm. This law has proven to be successful in ensuring that insurers in New York are limited to entering only into appropriate derivative transactions which are suitable for their level of assets. By requiring that these transactions are used primarily for the purposes of hedging, this law has allowed insurers to have the ability to adjust to the changing markets during the recent economic downturn.

Most importantly, the ability to enter into responsible and well-regulated derivative transactions, primarily for the purposes of hedging insurer investment strategies, has enabled insurers to continue to offer certain variable life insurance products that are currently very popular with consumers and also allowed them to offer their products at more affordable rates, since the 2008 economic downturn.

Chapter 650 of the Laws of 1998 allowed for certain, expanded insurer derivative use authority with restrictions and significant oversight by insurer Boards, the Superintendent of the Department of Financial Services and outside auditors. Under the current law, insurer derivative transactions with counterparties which are not "qualified counterparties" are subject to strict quantitative limits. The term "qualified counterparty" is defined as a counterparty rated AA or higher by at least one nationally recognized statistical rating organization and meeting certain other qualifications. These standards were carried over from earlier law governing insurance derivative transactions and, even in 1998, did not reflect the actual counterparty universe. Current derivatives markets and participants are considerably different from that which were in place in 1998 and, following the restructuring of this market due to certain provisions of the Federal Dodd-Frank Wall Street Reform and Consumer Protection Act, additional changes are occurring.

The primary counterparties with which insurers enter into derivatives transactions are banks. Bank ratings have deteriorated markedly since 1998 and are expected to continue to decline. On February 15, 2012, Moody's announced a review for downgrade of the long-term debt ratings of 17 banks and securities firms with global capital markets operations. This action will likely result in additional downgrades in this sector. The downgrading of insurer banking counterparties will reduce the number of qualified counterparties available, perhaps even to the point where there will no longer be any "qualified counterparties" under New York law.

The current law is also outdated in its enumeration of types of qualified counterparties. It includes registered broker dealers, which no longer engage in this business, and does not include either foreign banks or non-rated derivatives dealers guaranteed by a parent

or affiliate, both of which are major participant categories in this market. Also, the Federal Dodd-Frank Act will begin to require that banks must spin off certain of their derivatives activities into affiliate entities and many of these newly-created entities will not meet the current AA standard necessary in order to be determined a "qualified counterparty".

The utility of using rating categories to define a "qualified counterparty" has been called into question since the 2008 economic downturn when several very highly rated banking organizations were downgraded to junk status overnight. Recognizing this, many, if not most, insurers have moved to the use of standard netting and collateral agreements, under which the counterparty's obligations to the insurer are collateralized, subject to normal credit thresholds and minimum transfer amounts. This has greatly reduced the risk to insurers of these trading relationships.

This bill would codify the responsible practice of collateralizing these types of transactions by requiring that a "qualified counterparty" will need to have entered into a netting and collateral agreement with the insurer and would also need to be rated (or have a parent or guarantor or other credit enhancer rated) investment grade or better.

Enactment of this bill will result in simplification of the current "qualified counterparty" standard to more flexibly reflect current and future market conditions, will permit lower rated counterparties to be qualified, so long as collateral arrangements are entered into to protect insurers and their policyholders, and will update the law for the new Dodd-Frank era derivatives marketplace.

By making these refinements to the Current law, insurers will be enabled to continue entering into responsible derivative transactions in the limited manner provided for in the current law, with the continuing oversight by their Board of Directors and the NYS Department of Financial Services. It will also enable insurers to continue offering certain variable life insurance products that are currently very popular with consumers and to offer these and other products at more affordable rates.

Legislative history

New bill.

Fiscal implications

None.

Effective date

Immediately.