Insurance Industry Developments for Winter 2008

Court Decision May Impact Patent-Eligibility of Insurance-Related Innovations
By David G. Luettgen

In a decision that will impact insurance-related patents and patent applications, on October 30, 2008, the United States Court of Appeals for the Federal Circuit (Court) issued its en banc decision in In re Bilski, No. 2007-1130 (Fed. Cir. Oct. 30, 2008). The Court focused on U.S. Supreme Court precedent and stated that the proper test for patent-eligibility of processes is a machine-or-transformation test. Under the machine-or-transformation test, “[a] claimed process is surely patent-eligible under § 101 if: (1) it is tied to a particular machine or apparatus, or (2) it transforms a particular article into a different state or thing.” Bilski, slip op. at 10.

The en banc Court sought to stay true to Supreme Court precedent in outlining the test for patent-eligible subject matter for processes. The Court carefully evaluated the Supreme Court precedent and adopted what it believed to be a test centered around the core principle of whether granting protection to a particular application would completely preempt use of a fundamental principle or just foreclose a particular application of that fundamental principle. The Court made clear that it was declining to adopt broad exclusions against business methods and software. Rather, the Court stated that business methods and software can be patent-eligible if they meet the machine-or-transformation test. See Bilski, slip op. at 21. Significantly, the Court left open whether a process is “tied” to a machine by merely reciting a general purpose computer.

Turning to Mr. Bilski’s patent, the Court found that the subject matter of the claims was not patent-eligible. Bilski, slip op. at 28. The Court noted that the first claim involved purely mental processes coupled with a post-solution step of consummating the transaction. Bilski, slip op. at 28. The claim was not tied to any sort of machine such as a computer. According to the Court, “a claimed process wherein all of the process steps may be performed entirely in the human mind is obviously not tied to any machine and does not transform any article into a different state or thing. As a result, it would not be patent-eligible under § 101.” Bilski, slip op. at 23.

The machine-or-transformation test announced in Bilski will likely impact the insurance industry. In the insurance industry, companies have typically sought patents for insurance products, underwriting systems, customer and business-business Web site features, and other innovations. With regard to insurance products, the Court indicated that transformations involving only manipulations of legal obligations do not constitute patent-eligible subject matter. Bilski, slip op. at 28. Hence, insurance products in the abstract are likely not patent-eligible under the machine-or-transformation test.

Less clear, however, is the fate of other innovations that insurance companies typically seek to patent. For example, rather than trying to patent insurance products in the abstract, insurance companies often seek to patent the computer systems that perform required processing associated with insurance products that have been sold to customers (e.g., to determine benefit payments due to policy holders). The strategy in this regard has been to attempt to place their patent applications on more solid § 101 footing by tying their inventions to a computer. Likewise, patent protection for other innovations such as underwriting systems and Web site features are typically sought in the context of a computer system irrespective of patent eligibility concerns. Because the Court left the door open to software and business method patents, it is likely that patent practitioners will devise ways to comply with the machine-or-transformation test and obtain patent protection for at least some categories of insurance-related innovations.

In the coming months, it is likely that the Court and district courts will further clarify and interpret the machine-or-transformation test. In the meantime, insurance companies should continue to consider patenting their innovations, especially in situations where the innovations can be tied to a computer.

Florida Life Insurance Agent Continuing Education Requirements Take Effect January 1, 2009
By Wes Strickland

Effective January 1, 2009, Florida-licensed life insurance agents are required to fulfill new continuing education requirements by completing at least three hours on the subject of suitability in annuity and life insurance transactions. This new continuing education requirement was added to Section 626.2815, Florida Statutes, as part of legislation enacted in 2008 aimed at strengthening the regulation of annuity sales to seniors.¹

The Florida Department of Financial Services (Department) issued an information notice on November 20, 2008, informing Florida-licensed life insurance agents of the new continuing education requirements. The Department’s notice provided that, beginning in January 2009, life insurance agents must complete three hours of senior suitability education before the end of their continuing education compliance periods. Agents whose continuing education compliance periods end in January or February 2009 should act quickly to satisfy the requirement. The three hours will count toward the continuing education in ethics requirement. An agent who has already completed hours in ethics will not lose credit for those hours, which will be applied to the general continuing education requirement or carried over to the next compliance period.

The Department’s informational notice also provided instructions for locating a Department-approved continuing education course in compliance with the new law. A new course authority, “CE 9911 – Senior Suitability,” has been created. Only courses approved with this new course authority number will fulfill the new requirement. The Department’s notice instructs life insurance agents to go to the Department’s Web site at www.myfloridacfo.com/agents to find approved courses. and log in to “MyProfile.” Select “Locate” in the upper left-hand corner, then “Future Course Offerings,” and select a course with the CE 9911 course authority number. A self-study course is also available by selecting one of the “self-study” options under “Study Method.”

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¹ See Committee Substitute for Committee Substitute for Senate Bill 2082, ch. 2008-237, Laws of Fla.

Global Credit Crisis Threatens Florida Catastrophe Fund
By Leonard E. Schulte

For more than a decade, the Florida Hurricane Catastrophe Fund (FHCF) has provided a working layer of hurricane reinsurance for all admitted insurers writing residential property insurance in Florida. The FHCF’s ability to pay claims, especially after a major hurricane, depends on its ability to sell bonds that are backed by assessments on most property and casualty premiums. In today’s credit environment, where the FHCF’s ability to incur significant amounts of debt is in doubt, insurers that depend on the FHCF are facing new issues relating to solvency, reinsurance, and rates.

FHCF coverage layers. The FHCF provides four types of hurricane reinsurance for Florida residential property insurers: a basic layer, for which participation is mandatory, two optional layers available to all residential property insurers, and a limited amount of low-level coverage for certain small companies.

The basic layer¹  pays 90 percent of the insurer’s losses in excess of its share of the industry retention, up to its share of an industry cap; an insurer also has the option of selecting coverage at the 45-percent level or the 75-percent level, but very few insurers select these options. The retention and potential FHCF coverage applicable to a particular insurer are calculated by applying the insurer’s percentage of the total FHCF premium to the industry aggregate retention and capacity.

For the contract year beginning June 1, 2008, the aggregate attachment point for the basic layer was $6.9 billion in losses (reflecting a 7.5-year return period), and aggregate coverage capped out at $16.5 billion (reflecting a 33-year return period). The rate-on-line for the basic layer was 6.46 percent.

The fund also provides an optional layer of coverage known as Temporary Increase in Coverage Limits (TICL).² For the 2008 – 2009 contract year, TICL provided a layer of coverage that attached at the top of the basic layer and capped out at an aggregate amount of $11.1 billion (reflecting a 59-year return period). As the name implies, TICL was intended to be temporary. In the absence of legislative changes, the last year that the TICL option will be available is the contract year that begins on June 1, 2009.

Almost all insurers have taken advantage of the TICL option, which was priced at a rate-on-line of 2.15 percent.

The fund provides a low layer of coverage, known as Temporary Emergency Additional Coverage Option (TEACO).³ TEACO enables the insurer to lower its attachment point below the attachment point of the basic layer. Few insurers take advantage of TEACO, which is statutorily priced at rates-on-line of 75 percent, 80 percent, and 85 percent, depending on the attachment point chosen by the insurer. As with TICL, in the absence of a legislative decision to the contrary, the last year that the TEACO option will be available is the contract year that begins on June 1, 2009.

In addition to these layers of coverage, the fund also has provided an optional layer of coverage of up to $10 million to certain small insurers.⁴ The attachment point for this layer was an amount equal to 30 percent of the insurer’s 2007 surplus. The rate-on-line was 50 percent. In the absence of a legislative decision to the contrary, this option will not be available for the 2009 or subsequent contract years.

Limitation on FHCF obligations and determination of borrowing capacity. The FHCF statute requires that the fund’s reimbursement contracts provide that the obligation of the fund is limited to its “actual claims-paying capacity.”⁵ The fund’s ability to meet its obligations — its claims-paying capacity — depends on its ability to borrow. Twice each year, the fund calculates its claims-paying capacity based on its cash resources and its ability to borrow.

Historically, the fund had always determined its borrowing capacity based solely on the question of what level of bonding the fund’s revenue stream (that is, the proceeds of fund assessments on property and casualty insurance premiums) would support. The calculation did not consider the capacity of credit markets to absorb the fund’s debt offerings.

In October 2008, responding to the worldwide credit crisis, the fund’s staff and financial advisors calculated both a “theoretical loss-reimbursement capacity,” which assumed that the fund’s revenue stream was the only restriction on its ability to bond and an “estimated loss-reimbursement capacity,” which takes into account actual credit market conditions. The State Board of Administration (SBA), which manages the fund, has adopted the estimate that takes actual credit market conditions into account as a statement of the fund’s “actual claims-paying capacity” for 2008.⁶

The fund calculated a borrowing capacity of between $1.5 billion and $3 billion, which would create a potential shortfall in the basic layer of the fund in the amount of $6.7 billion to $8.2 billion. The capacity to support the TICL layer would be limited to $4 billion in proceeds from a put-option arrangement that applies only to 2008 losses. The total potential shortfall for 2008, had there been hurricane losses that triggered the fund, would have been between $14.5 billion and $16 billion.

These estimates apply only to the contract year beginning June 1, 2008. The fund is not scheduled to adopt its first estimate of claims-paying capacity for the 2009 – 2010 contract year until May 2009. It is expected that insurers’ reinsurance decisions for the 2009 hurricane season will be guided by their own estimates of the fund’s 2009 claims-paying capacity, their expectations regarding future legislative action, and the rating and ratemaking issues discussed below.

Reaction of rating agencies. Rating agencies responded quickly to the fund’s determination of its potential shortfalls. The day after FHCF staff and financial advisors released their shortfall estimates, the A.M. Best Company issued a press release, stating in part:

A.M. Best continues to view catastrophe risk as a primary threat to solvency due to the rapid and unexpected deterioration that can occur. Accordingly, A.M. Best has begun to assess the impact on rated entities’ risk-adjusted capitalization based on the reduction in the potential coverage available from the FHCF. … Those companies with significant potential gaps in reinsurance coverage and correspondingly inadequate risk-adjusted capitalization will be placed under review with negative implications pending discussions with company management regarding improving this key metric.⁷

On October 29, 2008, A.M. Best issued a statement listing seven companies that were under review with negative implications.⁸ The companies under review include the Allstate Floridian Group, which had a combined market share of 7.7 percent in 2006, and two Tower Hill Insurance Group LLC companies, which had a combined market share of 3.3 percent in 2006. Best has not indicated whether it intends to place additional insurers under review.

In November 2008, Demotech, Inc. issued a statement in response to the potential FHCF shortfalls.⁹ Most of the startup companies that have become a major component of the Florida property insurance market rely on Demotech for their ratings. The statement notes that Demotech’s willingness to assign ratings to these relatively small and heavily reinsured companies has depended on two factors: the regulator’s commitment to rate adequacy and the ability of the FHCF to meet its obligations. The statement notes that there is an ongoing debate regarding rate adequacy and that the ability of the FHCF to pay claims has now been called into question.

Demotech states that the potential inability of the FHCF to honor meritorious claims related to a significant event adversely affects the ratings of each carrier that is heavily dependent on the FHCF. Demotech further states that it will not support ratings for Florida property insurers after May 15, 2009 in the absence of definitive information regarding a company’s participation in the FHCF, financing arrangements to cover losses while the FHCF is raising capital, and other financial and reinsurance arrangements.

Impact on reinsurance and rates. The rating law allows insurers to recoup, in their rates, any premiums paid for FHCF coverage, but specifically provides that an insurer “may not recoup reinsurance costs that duplicate coverage” provided by the FHCF.¹⁰ The law that created the TICL layer and required rate rollbacks to reflect the cost savings attributable to the new, low-cost reinsurance similarly provided that “[a]ny additional cost for private reinsurance or loss exposure that duplicates such coverage options may not be factored in the rate, whether or not such coverage options are purchased.”¹¹ Thus, an insurer that rejects the optional TICL coverage and instead procures private reinsurance can include the TICL premium in its rates as a reinsurance expense, but cannot include the (presumably) higher cost of the private reinsurance.

Now that the SBA has acknowledged that the FHCF would not have been able to honor its obligations fully in 2008, the key issue going forward is what the word “duplicate” means in the context of reinsurance and rate filings.

Insurers will need to consider whether they will be able to procure reinsurance in lieu of the TICL layer and include its full cost as an appropriate factor in their rates if, in effect, there is no TICL coverage. Insurers also will need to consider whether they will be able to recoup additional reinsurance costs in their rates if they procure reinsurance to cover the possibility that the FHCF will not be able to fund fully the basic FHCF layer.

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No “Reverse Pre-Emption” by Louisiana Law Prohibiting Insurance Arbitration
By Paul R. Monsees

A federal appeals court recently resolved a conflict among a state statute that prohibits enforcing arbitration clauses in insurance matters, a treaty providing for international arbitrations, and a federal statute that dictates that the states, not Congress, shall regulate the business of insurance. A fairly straightforward reinsurance dispute evolved into a complicated procedural morass, a detailed discussion of “reverse pre-emption,” and how federal and state law could impact arbitration clauses in reinsurance contracts. In the end, the United States Court of Appeals for the Fifth Circuit held that the treaty favoring arbitration prevailed over the contradictory state law and that reverse pre-emption, favoring state over federal law, did not apply.

The dispute in Safety National Casualty Corp. v. Louisiana Safety Association of Timbermen–Self Insurers Fund v. Certain Underwriters at Lloyd’s London¹ started fairly simply. The Louisiana Safety Association of Timbermen (Louisiana Timbermen) provided workers’ compensation coverage for its members; the coverage was self-insured up to a retention and reinsured over that retention through Lloyd’s Syndicates (Lloyd’s). The Lloyd’s reinsurance agreements contained arbitration clauses. As a result of a later loss portfolio transfer, Safety National Casualty Corporation (Safety National) contended that Louisiana Timbermen had assigned its rights under the Lloyd’s reinsurance agreements to Safety National. When claims were presented for payment, Lloyd’s asserted that the reinsurance obligations were not assignable from the Louisiana Timbermen to Safety National. Lloyd’s failed to pay claims tendered by Safety National, and Safety National commenced litigation in a Louisiana federal court to enforce the agreements.

The dispute took several procedural twists and turns before ultimately reaching the federal appellate court for resolution. Lloyd’s filed an unopposed motion to stay the Safety National court proceedings and to compel arbitration, which the court granted. Lloyd’s and Safety National then failed to reach agreement about the selection of arbitrators for the arbitration proceeding and Lloyd’s went back to the federal court seeking to join Louisiana Timbermen as a party, consistent with Lloyd’s position that Louisiana Timbermen could not assign the reinsurance obligations to Safety National. Louisiana Timbermen intervened in the court matter and sought to dismiss the arbitration entirely, even though Safety National and Lloyd’s had already engaged in initial arbitration proceedings. Louisiana Timbermen took the position that the arbitration clauses in the reinsurance agreements with Lloyd’s were unenforceable pursuant to a Louisiana statute, which provided, in part, that “no insurance contract delivered or issued … in this state and covering subjects located, resident, or to be performed in this state … shall contain any agreement … depriving the courts of this state of jurisdiction of action against the insurer. … Any such condition … shall be void. … ”² Louisiana Timbermen’s position was consistent with other Louisiana court cases that had held that arbitration agreements governing insurance disputes were unenforceable. The federal district court agreed, reversed its earlier order compelling arbitration, and granted Louisiana Timbermen’s motion, effectively terminating the arbitration proceeding.

The appeals court had to decide whether the Louisiana statute or the Convention on the Recognition and Enforcement of Foreign Arbitral Awards (Convention)³ controlled the dispute. While the Louisiana statute prohibited arbitration provisions in insurance contracts, the Convention provided the opposite, requiring that courts “shall” compel arbitration when arbitration was requested by a party to an international arbitration agreement. The appellate court had to decide the issue based on its interpretation of the McCarran-Ferguson Act of 1945, which provides that “Congress hereby declares that the continued regulation and taxation by the several States of the business of insurance is in the public interest. … No Act of Congress shall be construed to invalidate, impair or supersede any law enacted by any State for the purpose of regulating the business of insurance. … ”⁴ The precise legal question presented was whether the Convention was an “Act of Congress” under McCarran-Ferguson. If so, as asserted by Louisiana Timbermen, that Act of Congress would arguably impair the Louisiana statute, McCarran-Ferguson would bar enforcement of the Convention, and the Louisiana statute prohibiting arbitration would control. This is referred to as reverse pre-emption. If the Convention was not deemed an Act of Congress, as Lloyd’s contended, there would be no conflict with McCarran-Ferguson, and the Convention and its policy in favor of arbitration of international disputes would control.

The appellate court was persuaded that Congress did not intend that treaties like the Convention be considered an Act of Congress as used in the McCarran-Ferguson Act. One distinction was that a treaty is an international agreement negotiated by the executive branch, which is ratified by the U.S. Senate, not by both houses of Congress. Thus, a treaty is not an Act of Congress per se. The court also noted that the Supreme Court stated that “the preemptive reach of the McCarran-Ferguson Act was not intended to extend to the conduct of foreign affairs.” This was announced in American Insurance Ass’n v. Garamendi,⁵ in which the court held that a California state law mandating certain insurance company Holocaust-era disclosures interfered with the federal government’s conduct of foreign relations because it conflicted with an executive agreement (not ratified by the Senate) between the president and the chancellor of Germany.

Ultimately, the appellate court thought it “unlikely” that Congress intended, in passing the McCarran-Ferguson Act, that future treaties would be abrogated if they conflicted with a state insurance law. The result was that the Fifth Circuit Court of Appeals reversed the federal district court’s denial of the motion to compel arbitration. Therefore, the Louisiana statute prohibiting arbitration of disputes over insurance contracts does not prohibit reinsurance arbitrations involving international parties.

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