HBA-JRA, GUM, ATS C.S.H.B. 3042 76(R)BILL ANALYSIS Office of House Bill AnalysisC.S.H.B. 3042 By: Averitt Insurance 4/23/1999 Committee Report (Substituted) BACKGROUND AND PURPOSE In 1997, the 75th Texas Legislature gave broader authority to life insurance companies to diversify their investment portfolios to increase their returns. No similar provision was made for property and casualty insurers. Currently, property and casualty insurers are authorized to buy put options or sell call options and terminate them, buy or sell interest rate futures contracts and options on interest rate futures contracts, or utilize such other instruments or devices as are consistent with this article and are traded on an established exchange regulated by the Securities and Exchange Commission or the Commodities Futures Trading Commission only for purposes of protecting such assets against the risk of changing asset values or interest rates and for risk reduction. C.S.H.B. 3042 includes income generation in addition to risk reduction as a valid purpose for which an insurer is authorized to engage, for purposes of protecting its assets, in certain risk control transactions. This bill also authorizes an insurer to engage in securities lending, repurchase, reverse repurchase and dollar roll transactions. RULEMAKING AUTHORITY It is the opinion of the Office of House Bill Analysis that rulemaking authority is expressly delegated to the commissioner of insurance in SECTIONS 2 and 3 (Articles 2.10-3 and 2.10-4, Insurance Code, respectively) of this bill. SECTION BY SECTION ANALYSIS SECTION 1. Amends Article 2.10, Texas Insurance Code, as follows: Art. 2.10. INVESTMENT OF FUNDS IN EXCESS OF MINIMUM CAPITAL AND MINIMUM SURPLUS. (a) Requires the board of directors of each insurer, or the corresponding authority designated by the charter, bylaws, or plan of operations of an insurer that does not have a board of directors, to adopt a written investment plan consistent with the requirements of this article and other certain specified and applicable statutes governing investments by the insurer. Provides that the investment plan must specify the diversification of the insurer's investments designed to reduce the risk of large losses, by certain specified types of investments, balance the safety of principal with yield and growth, seek a reasonable relationship of assets and liabilities as to term and nature, and be appropriate considering the capital and surplus and the business conducted by the insurer. (b) Requires the board of directors or other authority to review the adequacy of the investment plan and implementation of the plan at least annually. (c) Requires the insurer to maintain the investment plan in its principal office and to provide the plan to the commissioner or the commissioner's designee on request. Requires the commissioner or the commissioner's designee to maintain the investment plan as a privileged and confidential document. Provides that the plan is not subject to public disclosure. (d) Requires the insurer to maintain investment records covering each transaction. Provides that at all times, the insurer must be able to demonstrate to the Texas Department of Insurance (department) that its investments are within the limitations prescribed by the statutes described by Subsection (a) of this article. (e)(1)-(4) Makes nonsubstantive changes. (5) Provides that a life, health, and accident insurer is authorized to invest its funds over and above its minimum capital and its minimum surplus in any type or form of savings deposits, time deposits, certificates of deposit, NOW accounts, and money market accounts in solvent banks, savings and loan associations, and credit unions, organized under U.S. or state laws. Provides an exception to the investment in these types of investments by providing that the amount of the deposits in any one bank, savings and loan association, or credit union may not exceed the greater of 20 percent of the insurer's capital and surplus, the amount of federal or state deposit insurance coverage relating to that deposit, or 10 percent of the amount of capital, surplus, and undivided profits of the entity receiving the deposits. (6) Provides that a life, health, and accident insurer is authorized to invest its funds over and above its minimum capital and its minimum surplus in the stocks, bonds, debentures, bills of exchange, evidence of indebtedness, or other commercial notes or bills and securities of any solvent partnership or solvent dividend paying corporation at time of purchase. Previously such an insurer was only authorized to invest such funds in the stocks, bonds, debentures, bills of exchange, or other commercial notes or bills and securities of any solvent dividend paying corporation at time of purchase. Makes nonsubstantive changes. (7) Deletes the prohibition that the aggregate of all investments made under other subdivisions of this subsection are not to exceed 25 percent of the insurer's assets. Makes nonsubstantive and conforming changes. (8)-(13) Makes nonsubstantive and conforming changes. (f) Provides that the percentage authorizations and limitations set forth in any or all of the provisions of this article apply only at the time of the original acquisition of an investment or at the time a transaction is entered into, and do not thereafter apply to the insurer or such investment or transaction except as provided in this subsection. Provides that any investment, once qualified under any subsection of this section, is to remain qualified notwithstanding any refinancing, restructuring or modification of such investment. Prohibits the insurer from engaging in any such refinancing, restructuring or modification of any investment for the purpose of circumventing the requirements or limitations of this article. (g) Prohibits investment in all or any types of securities, loans, obligations, or evidences of indebtedness of a single issuer or borrower, including the insurer's or borrower's majority-owned subsidiaries or parent or the majority-owned subsidiaries of that parent, other than those authorized investments that either are direct obligations of or are guaranteed by the full faith and credit of the United States of America, this state, or a political subdivision of this state, or are insured by any agency of the United States or this state from exceeding in the aggregate five percent of the insurer's total assets, other than investments described by Subsection (e)(5) or (e)(7) of this article notwithstanding Subsections (a) through (e) of this article. Authorizes the quantitative limitations regarding any investment authorized by this article to be waived by prior written approval of the commissioner if certain specified conditions are satisfied. SECTION 2. Amends Article 2.10-3, Texas Insurance Code, by adding Article 2.10-3A, as follows: Art. 2.10-3. SECURITIES LENDING; REPURCHASE, REVERSE REPURCHASE, AND DOLLAR ROLL TRANSACTIONS Sec. 1 DEFINITIONS. Defines "repurchase transaction," "reverse repurchase transaction," "securities lending transaction," and "dollar roll transaction" for purposes of this article. Makes nonsubstantive changes. Sec. 2. TRANSACTIONS AUTHORIZED. Authorizes an insurer to engage in securities lending, repurchase, reverse repurchase and dollar roll transactions as provided by this article. Requires the insurer to enter into a written agreement for each transaction, except a dollar roll transaction, that requires each transaction to terminate not later than the first anniversary of the inception of the transaction. Makes nonsubstantive changes. Sec. 3. TRANSACTION REQUIREMENTS. (a) Provides that cash received in a transaction under this article must be invested in accordance with this article and in a manner that recognizes the liquidity needs of the transaction or be used by the insurer for its general corporate purposes. (b) Requires, the insurer, its agent, or custodian, while the transaction is outstanding, to maintain, as to acceptable collateral received in a transaction under this subsection, either physically or through the book entry systems of the Federal Reserve, Depository Trust Company, Participants Trust Company, or other securities depositories approved by the commissioner on insurance (commissioner): possession of the acceptable collateral; a perfected security interest in the acceptable collateral; or in the case of a jurisdiction outside of the United States, title to, or rights of a secured creditor to, the acceptable collateral. Makes nonsubstantive changes. (c) Prohibits an insurer from entering into a transaction if, as a result of and after giving effect to the transaction, the aggregate amount of securities then loaned, sold to, or purchased from, any one business entity counterparty under this article would exceed five percent of its assets; or the aggregate amount of all securities then loaned, sold to, or purchased from all business entities under this article would exceed 40 percent of its assets. (d) Provides that in calculating the amount sold to or purchased from a business entity counterparty under repurchase or reverse repurchase transactions, effect may be given to netting provisions under a master written agreement (e) Provides that the amount of collateral required for securities lending, repurchase and reverse repurchase transactions is the amount required under the provisions of the Purposes and Procedures of the Securities Valuation Office or such successor publication. (f) Authorizes the commissioner to adopt reasonable rules and orders consistent with, and as necessary to implement, this article. SECTION 3. Amends Article 2.10-4, Texas Insurance Code, as follows: Sec. 1. DEFINITIONS. Defines "acceptable collateral," "business entity," "cap," "cash equivalents," "collar," "counterparty exposure amount," "derivative instrument," "derivative transaction," "floor," "forward," "future," "futures exchange," "hedging transaction," "income generation transaction," "market value," "option," "over-the-counter derivative instrument," "potential exposure," "qualified clearinghouse," "replication transaction," "securities exchange," "swap," "swaption," "underlying interest," and "warrant." Sec. 2. AUTHORIZED RISK CONTROL TRANSACTIONS; GENERAL REQUIREMENTS RELATING TO DERIVATIVE TRANSACTIONS. (a) Includes income generation in addition to risk reduction as a valid purpose in which an insurer is authorized to engage, for purposes of protecting its assets, in certain risk control transactions. Provides that this section applies except as provided by Section 8 of this article. Makes nonsubstantive changes. (b) Provides that before entering into any derivative transaction the board of directors of the insurer must approve a derivative use plan, as part of the insurer's investment plan otherwise required by law, that describes investment objectives and risk constraints, such as counterparty exposure amounts; defines permissible transactions identifying the risks to be hedged, the assets or liabilities being replicated; and requires compliance with internal control procedures. (c) Requires the insurer to establish written internal control procedures for a quarterly report to the board of directors relating to derivative transactions; a system for determining whether hedging or replication strategies utilized have been effective; a system of regular reports, at least as frequent as monthly, to management relating to each derivative transaction; written authorizations that identify the responsibilities and limitations of authority of persons authorized to effect and maintain derivative transactions; and documentation appropriate for each transaction. (d) Provides that an insurer must be able to demonstrate to the commissioner, upon request, the intended hedging characteristics and ongoing effectiveness of the derivative transaction or combination of transactions through cash flow testing, duration analysis, or other appropriate analysis. (e) Requires an insurer to include all counterparty exposure amounts in determining compliance with the limitations of this article. (f) Authorizes an insurer to purchase or sell one or more derivative instruments to offset, in whole or in part, any derivative instrument previously purchased or sold, as the case may be, without regard to the quantitative limitations of this article, provided that such offsetting transaction utilizes the same type of derivative instrument as the derivative instrument being offset. Sec. 3. REQUIREMENTS RELATING TO HEDGING TRANSACTIONS. (a) Requires the insurer, 10 days prior to entering into the initial hedging transaction, to notify the commissioner, in writing, that the insurer's board of directors has adopted an investment plan which authorizes hedging transactions, and that all hedging transactions will comply with this article. (b) Requires insurers engaged in hedging transactions to send to the commissioner a notice containing the statements required by Subsection (a) of this section not later than October 1, 1999. (c) Authorizes an insurer, after the notice under Subsection (a) or (b), to enter into hedging transactions under this article, if as a result of and after giving effect to each such transaction: _the aggregate statement value of all outstanding options, caps, floors, swaptions and warrants that are not attached to another financial instrument purchased by the insurer under this article, but not including collars, does not exceed seven and one-half percent of its assets; _the aggregate statement value of all outstanding options, swaptions, warrants, caps and floors written by the insurer pursuant to this article, but not including collars, does not exceed three percent of its assets; and _the aggregate potential exposure of all outstanding collars, swaps, forwards and futures entered into or acquired by the insurer pursuant to this article does not exceed six and one-half percent of its assets. (d) Authorizes the commissioner, whenever the derivative transactions entered into under this section, are not in compliance with this article or, if continued, may now or subsequently, create a hazardous financial condition to the insurer which affects its policyholders, creditors, or the general public, after notice and an opportunity for a hearing, to order the insurer to take such action as may be reasonably necessary to rectify a hazardous financial condition or to prevent an impending hazardous financial condition from occurring. Sec. 4. REQUIREMENTS RELATING TO INCOME GENERATION TRANSACTIONS. (a) Authorizes an insurer to enter into an income generation transaction only as provided by this section. (b) Authorizes an insurer to enter into an income generation transaction only if, as a result of and after giving effect to the transaction, the certain specified aggregate statement value of admitted assets, plus the certain specified statement value of admitted assets underlying derivative instruments, plus the purchase price of assets subject to puts then outstanding under this article, does not exceed 10 percent of the insurer's assets. (c) Provides that the transaction must be a sale of: _a call option on assets that meets the requirements of Subsection (d); _a put option on assets that meets the requirements of Subsection (e); _a cap or floor that meets the requirements of Subsection (g). (d) Provides that if the transaction is a sale of a call option on assets, the insurer must hold or have a currently exercisable right to acquire the underlying assets during the entire period that the option is outstanding. (e) Provides that if the transaction is a sale of a put option on assets, the insurer must hold sufficient cash, cash equivalents, or interests in a short-term investment pool to be able to purchase the underlying assets on exercise of the option during the entire period that the option is outstanding, and must be able to hold the underlying assets in the insurer's portfolio. Requires the insurer, if the total market value of all put options sold by the insurer exceeds two percent of the insurer's assets, to set aside, under a custodial or escrow agreement, cash or cash equivalents that have a market value equal to the excess amount. (f) Provides that if the transaction is a sale of a call option on a derivative instrument the insurer must hold or have a currently exercisable right to acquire assets generating the cash flow necessary to make payments for which the insurer is liable under the underlying derivative instrument during the entire period that the call option is outstanding, and must be able to enter into the underlying derivative transaction for the insurer's portfolio. (g) Provides that if the transaction is a sale of a cap or a floor, the insurer must hold or have a currently exercisable right to acquire assets generating the cash flow necessary to make payments for which the insurer is liable under the cap or floor during the entire period that the cap or floor is outstanding. Sec. 5. REQUIREMENTS RELATING TO REPLICATION TRANSACTIONS. (a) Authorizes an insurer to enter into replication transactions only with prior written approval from the commissioner. Sets forth the requirements for eligibility for approval by the commissioner. (b) Authorizes the commissioner to adopt such rules and regulations regarding replication transactions as may be fair and reasonable to implement this subsection. Sec. 6. TRADING REQUIREMENTS. Requires each derivative instrument to be traded on a securities exchange; entered into with, or guaranteed by, a business entity; issued or written by or entered into with the issuer of the underlying interest on which the derivative instrument is based; or in the case of futures, traded through a broker who is registered as a futures commission merchant under the Commodity Exchange Act (7 U.S.C. Section 1 et seq.), as amended, or who is exempt from that registration under Rule 30.10, adopted under the Commodity Exchange Act. Deletes existing text relating to the provisions by which an insurer may engage in the purchase of put options or sale of call options and terminate such option; buy or sell interest rate futures contracts and options on interest rate futures contracts or utilize such other instrument or devices; and engage in practices authorized by this article if a written policy with specified information is adopted. Sec. 7. RULES. Makes conforming and nonsubstantive changes. Sec. 8. NOTICE TO COMMISSIONER. (a) Requires an insurer that has a statutory net capital and surplus of less than $10 million, before engaging in a transaction authorized under this article, to file a written notice with the commissioner describing the need to engage in the transaction, the lack of acceptable alternatives, and the insurer's plan to engage in the transaction. Authorizes the insurer to engage in the transaction described in the notice if the commissioner does not issue an order prohibiting the insurer from engaging in the transaction within 90 days after the date of receipt of the insurer's notice. (b) Prohibits an insurer with a statutory net capital and surplus less than the minimum amount of capital and surplus required under Subsection (a) from engaging in the transactions authorized under this article. (c) Provides that net capital and surplus are determined by the most recent financial statement of the insurer required to be file with the department for purposes of this section. SECTION 4. Repealer: Article 2.10-3 (Repurchase Agreements), Insurance Code. SECTION 5. Effective date: September 1, 1999. SECTION 6. Emergency clause. COMPARISON OF ORIGINAL TO SUBSTITUTE The substitute modifies the original in the caption and throughout the bill to conform to Legislative Council format. The substitute modifies the original in SECTION 1 (Article 2.10, Insurance Code), by adding new Subsections (a)-(d) to require the board of directors of each insurer, or the corresponding authority, to adopt a written investment plan consistent with certain statutes governing investments by the insurer and to set forth the issues which the investment plan must address; to review the plan adequacy and implementation; to maintain the plan in its principal office and provide it to the commissioner of insurance (commissioner); and maintain appropriate investment records. The substitute creates Subsection (e) from existing text and creates Subsections (e)(1)-(13) from text of Sections 1-13 of the original bill, as amended. In Subsection (e)(6), the substitute includes the stocks, bonds, debentures, bills of exchange, evidence of investment, or other commercial notes or bills and securities of a solvent partnership among the investments in which a company writing life, health and accident insurance is authorized to invest funds over and above its minimum capital and its minimum surplus. In Subsection (e)(11)(B), the substitute requires the admitted assets of the company to be determined from its annual statements made as of the last preceding December 31 and filed with the Texas Department of Insurance, rather than the State Board of Insurance, as required by law. The substitute redesignates proposed Section 14 of the original to Subsection (f) and makes nonsubstantive changes. The substitute adds new Subsection (g) to prohibit certain investments from exceeding in the aggregate five percent of the insurer's total assets and to authorize the quantitative limitations regarding any investment authorized by this article to be waived by prior written approval of the commissioner if certain conditions are satisfied at a hearing. The substitute modifies the original in SECTION 2 by amending Article 2.10-3A, rather than 2.10-3, Insurance Code, and making changes to conform to Legislative Council format. The substitute adds a new Subsection (f) to authorize the commissioner to adopt rules and orders to implement this article. The substitute modifies the original in SECTION 3 by making changes to conform to Legislative Council format. The substitute also adds Section 8 (Notice to Commissioner) to set forth the requirements for notification to the commissioner of the need to engage in a transaction authorized under this article. The substitute modifies the original in SECTION 4 to repeal Article 2.10-3 (Repurchase Agreements), Insurance Code. Article 2.10-3 was deleted in SECTION 2 of the original. The substitute redesignates SECTIONS 4 (effective date) and 5 (emergency clause) of the original to SECTIONS 5 and 6.