The financial services industry continues to experience substantial growth and innovation as companies develop new ways to address evolving consumer expectations and risks. “Insurtech” refers to a relatively new and rapidly growing area of innovation that focuses on using technology-driven solutions to improve the highly regulated insurance industry. This includes the use of AI and machine learning to enhance risk assessment and underwriting, the use of data analytics to better understand customer behavior, the creation of novel products and services that cater to specific groups, and new distribution models (e.g., embedded insurance) that make it easier for customers to buy insurance when and where they need it.
As these innovative technologies continue to transform the industry, new classes of investors and buyers — including fintechs, software-as-a-service (SaaS) providers, private equity firms, venture capital funds, and many others — are looking for business opportunities involving promising insurtech startups and other licensed insurance entities. However, insurtech companies are often subject to complicated regulations that require thoughtful time and consideration. This alert discusses a few of these key considerations and highlights four regulatory issues.
Issue 1: Change of Control Notices and Filings
Depending on whether the target is an insurance company or insurance producer (e.g., broker or agent), any investment or acquisition may trigger change of control notices and filings.
For insurance companies, if an investor acquires 10% or more of the voting securities of an insurance company, either directly or indirectly, it will generally be considered a change of “control.” This means that the investment or purchase will be subject to stringent regulatory review and approval in the insurance company’s “home” state. Further, while many investors have treated the 10% threshold as determinative as to whether a particular transaction requires regulatory approval, regulators have recently cautioned, in light of the rise of alternative capital and structured investments, that any determination of control depends on all facts and circumstances, and investments below the 10% threshold may still result in a control determination. However, potential investors typically have the option of attempting to rebut a presumption of control by submitting what is called a “disclaimer of control” filing.
By contrast, the process of acquiring an insurance agency is typically subject to much less regulatory scrutiny than acquiring an insurance company. However, to the extent an agency holds an insurance agency or producer license, any change in control of such a licensed entity may still require regulatory approval or notification. While most jurisdictions do not require formal notification of changes in control involving licensed agencies, many jurisdictions ask to be notified through informal positions or guidance posted online, including as to changes in an agency’s directors or officers. Further, at least one state — Texas — requires pre-closing notification and exercises approval authority over the deal, and thus special consideration should be given prior to purchasing any insurance agency that holds a Texas license. That said, absent any unusual circumstances (e.g., if the target company has failed to keep its records updated or has been the subject of disciplinary action by another state regulator), this is typically a quick process and very rarely an obstacle to closing if done correctly.
Issue 2: Licensing Requirements and DRLP
In most transactions, any potential buyer or investor will need to confirm the target’s licensing requirements and verify that the target company has complied with these requirements, whether on its own or by working with a reputable licensing vendor.
For example, an insurance agency generally must hold an insurance agency or producer license where the agency sells, solicits, and/or negotiates insurance (a few states do not have entity licensing requirements). The statutory definitions of “sell,” “solicit,” and “negotiate” are typically broad and open to interpretation by state regulators in terms of the specific activities triggering licensing requirements. That said, in order to determine whether an agency is selling, soliciting, or negotiating insurance, it is important to verify (1) whether the products the agency is offering actually constitute insurance; and (2) whether the agency’s contracts with respect to such products require it to hold any specific licenses.
In terms of products, potential buyers and investors should confirm the target’s product offering in order to consider whether each product would be classified as insurance, a warranty, a service contract, or something else under state laws. It is common for these types of offerings to straddle the boundary between insurance and other risk-sharing arrangements, and state insurance laws on these issues are not always defined or clear. Thus, further research may be necessary.
In terms of contracts, potential buyers and investors should review the target’s contracts with its insurance company partners. Many times, these types of contracts will require an agency to hold certain licenses, including insurance agency licenses, which is a factor that would weigh in favor of conducting further diligence on these issues.
Additionally, to the extent an agency must hold an insurance agency or producer license, it is common that certain individuals also must hold individual producer licenses. Further, an agency must typically designate an individual licensed agent as its designated responsible licensed producer (DRLP), meaning that this individual is ultimately responsible for the licensed entity’s compliance with applicable insurance laws. Each and every state has some form of DRLP requirement, the idea being that an agency has to designate a person who’s responsible from a compliance standpoint. Some states require that the DRLP be an officer or director of the agency. While many states have some wiggle room — multiple DRLPs to provide some overlapping responsibility coverage, a grace period for updating a DRLP, etc. — others don’t. In fact, some states will terminate the agency’s license if the DRLP license is terminated or if the DRLP is removed, and the agency can face fines and penalties for operating without the DRLP for any period.
It is important for potential buyers and investors to conduct the appropriate due diligence to determine whether the agency and such individuals should, and do, hold appropriate licensure depending on the scope of their activities.
Issue 3: Compensation and Commission-Sharing Issues
There are various insurance laws that govern the permissibility of giving an unlicensed person or entity a fee or something of monetary value in connection with the sale or solicitation of insurance products, including, among others, commission-sharing laws, anti-rebating laws, and compensation disclosure requirements.
For example, laws governing commission sharing typically provide, in relevant part, that a person or entity must be licensed as an insurance producer in order to receive any success-based compensation in connection with the sale of an insurance product (i.e., payment contingent on the sale of insurance). A number of other states allow licensed producers to pay referral fees to unlicensed persons, so long as the unlicensed person receiving referral fees does not sell, solicit, or negotiate insurance, and provided the referral fee is fixed and not contingent upon the sale of an insurance product. Finally, a handful of other states have laws on the subject that are unclear or that appear to generally prohibit both commission sharing and the payment of referral fees.
By contrast, unlicensed persons or entities may generally receive compensation that is not tied to the sale of insurance. For example, most states permit an insurance producer to share commissions or fees with such non-licensees (such as an advertising or marketing partner) so long as the unlicensed person does not sell, solicit, or negotiate insurance (i.e., plays only a passive role). However, state insurance regulators are increasingly sensitive to sales facilitated by non-licensees, and regulators are aware that the ability to earn commissions could lead a non-licensee to perform licensable activities to drive revenue. Thus, a marketing agreement can still be found to violate the above-referenced compensation laws.
While representations, warranties, and indemnification rights from the target may provide some comfort, it is still imperative that any potential buyer or investor review the target company’s compensation arrangements with both licensed and unlicensed business partners. It is also important to review the contracts applicable to such arrangements to confirm whether they distinguish between permissible activities and activities constituting the sale, solicitation, or negotiation of insurance.
Issue 4: Ownership of Customer Renewal Rights
In the insurance space, customer “expirations” or “renewal rights” generally refer to the right to own, continue to service, and renew the insurance policies subject to the applicable agreement. Generally, agents that have the direct customer relationship maintain ownership of the customer following termination of the agreement between the agency and its insurance company partner. Thus, the insurance company is typically barred from continuing to sell to the agent’s customer following termination of the parties’ relationship, unless required to do so by applicable law.
Any potential buyer or investor should therefore carefully scrutinize the target’s producer agreements to confirm who owns customer expirations and renewal rights. If the target agency does not own these rights vis-à-vis its material business partners, any buyer or investor should proceed with caution, as the agent’s continued relationship with such partners may be critical to the agency’s continued success.
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Given these common regulatory issues that can arise in insurance transactions, companies approaching an investment or acquisition in the insurance space should work with experienced counsel to assist with diligence, drafting, and regulatory matters.
Goodwin’s Insurtech and Insurance & Reinsurance Transactions team, part of its globally ranked Fintech Practice, advises startups, insurers, reinsurers, investors, and others on the legal and regulatory challenges associated with creating, marketing, distributing, and investing in innovative insurance products and companies. Goodwin provides clients with a full-stack insurtech offering, bringing together specialists from across the firm to provide forward-thinking counsel on strategic transactions, regulatory compliance, and litigation matters.