Much ado about captive life reinsurance
In June 2013 the New York Department of Financial Services (DFS) presented an alarmist report, Shining a Light on Shadow Insurance: A Little-known Loophole That Puts Insurance Policyholders and Taxpayers at Greater Risk, which condemned many in the life insurance industry.
Specifically, the DFS challenged the use of captive reinsurance to manage capital and reserves. Dubbing this practice “shadow insurance”, DFS asserted that these arrangements amount to financial “alchemy” designed to hide financial weakness and inflate capital ratios—despite specifically approving many of the structures at issue. DFS ultimately concluded that these arrangements place the broader financial system at risk.
DFS did not conclude that captive reinsurance is unlawful, nor did it seek to unwind or penalise any carrier who engaged in these transactions. Rather, it recognised that regulators, including those in New York, regularly approve these types of transactions. DFS also implicitly agreed that no disclosure rules had been violated by these transactions.
After publication of the report, DFS did not pursue more aggressive rules governing reserves to clamp down on what it declared to be a dangerous practice. Instead, New York has actually reduced its reserve requirements, including significant reductions for universal life policies with secondary guarantees.
Nonetheless, the report’s inflammatory analogies to the “subprime mortgage fiasco” and attendant financial crisis ignited a vigorous debate between and among insurance regulators and, predictably, class action litigation against many insurers employing these structures.
The insurance industry has responded. In The Use of Captive Reinsurance in Life Insurance, an American Council of Life Insurers (ACLI)-funded study and analysis of captive reinsurance arrangements in life insurance from May 2014, Professor Scott E. Harrington of the University of Pennsylvania states that “captive reinsurance arrangements are an important tool for efficiently managing capital and the gap between statutory and economic reserves for certain products.”
Each transaction is closely monitored and approved “by regulators and rating agencies.” These transactions facilitate lower prices for life insurance, and in fact more insurance protection for more people, without excessive financial risk.
"Evidence suggests that captive reinsurance arrangements generally provide a method of satisfying formulaic reserve requirements at lower cost to insurers and policyholders than would be achievable without such arrangements." Professor Scott Harrington
Captive reinsurance is not new, is not unique to life insurers, and is not “in the shadows”.
According to the National Association of Insurance Commissioners (NAIC), captive reinsurers underwrite more than 25 percent of reinsurance policies for the US life industry. Regulators have known about these transactions for many years. New York and other states have been approving these transactions after a thorough review process—designed to ensure the transactions are safe to the insureds and to the system.
Capital management and captives
It should go without saying that, as Harrington writes: “Other things being equal, insurers that hold more capital in relation to their liabilities have lower insolvency risk and receive higher financial strength ratings than insurers with less capital.”
In addition to simply providing an insurer with another tool to manage its surplus, the use of captive structures improves reserving flexibility. Reserves clearly affect the amount of assets an insurer must hold. Because reserves increase the amount of liabilities an insurer is holding on its books, they increase the assets an insurer must hold. As such, reserves have a direct impact on the cushion of assets available to pay policyholder claims.
Harrington states that higher reserves, on average, require “higher premiums to cover the increased [capital] costs.” Managing capital through the use of captive reinsurance helps insurers maintain appropriate surplus levels while providing consumers with more affordable policies. Lowering the cost of providing insurance also increases the supply of insurance in the market, as even detractors of captive reinsurance would recognise.
In the early 2000s, new regulations significantly increased reserve requirements. Regulations XXX and AXXX required higher reserves. The assumptions used in calculating these reserve requirements are extremely conservative. They are infrequently updated and fail to take into account improvements in mortality and underwriting standards. Ultimately, these reserves far exceed the actual economic reserves necessary to pay claims.
Recognising the burden imposed by XXX and AXXX, regulations were developed to specifically permit captive reinsurance. Using these rules, an insurer can cede risks to a captive and obtain statement credit for the cession. In so doing, the insurer reduces the assets it must hold. The risks have been transferred, so the ceding insurer can now redeploy capital that had previously been tied up.
Speaking generally, a ceding insurer can receive credit where:
The captive is authorised;
The captive’s obligations are backed by a letter of credit (LOC);
The ceding insurer withholds funds on its balance sheet;
Assets are placed in a trust account; or
The ceding insurer’s parent guarantees the transaction.
The most popular way to receive credit is by using an LOC. In these transactions, the insurer cedes its redundant reserves to the captive, and the captive secures its obligations with an LOC. In other words, using an LOC, an insurer is able to transfer part of its risk, via its captive, to an unaffiliated bank. Again, this is heavily regulated. Captive reinsurance transactions must be approved by the ceding insurer’s regulator and, in many instances, by the captive’s regulator.
Additionally, insurance rating agencies monitor these transactions. They have extensively studied and analysed the details and risks of captive reinsurance transactions in the life insurance industry, and factor that knowledge into their ratings.
The policy debate
Following the publication of the 2013 DFS report, other regulators have publicly disagreed with the conclusions. Rather than impose a moratorium, the NAIC recently adopted new, far more lenient and practical actuarial guidelines for calculating reserves. This alternative encourages “principles-based” reserving. A NAIC study group white paper further recommends improved disclosure, greater uniformity of regulation, and areas for further study—all without a moratorium or significant new restrictions.
“The fundamental challenge of insurance solvency regulation,” as Professor Harrington has described it, “is to establish financial reporting rules, controls, and monitoring systems that help achieve the right balance between safety and soundness on the one hand, and the cost of coverage to consumers on the other.” In the end, the debate comes down to “how much is enough?”.
Harrington’s study effectively de-bunks the “shadow insurance” view. He describes “how captive arrangements are used to manage capital and reserves”, explains the regulatory environment and the scrutiny regulators have given to these arrangements, and describes “the extensive evaluation of the arrangements by insurance rating agencies”. All of this work and research demonstrates that captive reinsurance is hardly “in the shadows”.
A second part of Professor Harrington’s study, published in January 2015, is titled The Economics and Regulation of Captive Reinsurance in Life Insurance. This “explores the prevalence, economic benefits and risks, and regulation of captive reinsurance arrangements in life insurance to provide context and insight to help inform the policy debate over the role and regulation of the arrangements.”
It makes three points. First, it highlights “the development and oversight of captive reinsurance arrangements have received substantial attention over time” from regulators and rating agencies. Second, it illustrates “available qualitative and quantitative evidence suggests that captive reinsurance arrangements generally provide a method of satisfying formulaic reserve requirements at lower cost to insurers and policyholders than would be achievable without such arrangements, and without creating significant insolvency risk or systemic risk.” And finally, Harrington reviews the new regulatory framework adopted by the NAIC, concluding that it was not needed but probably prudent.
Even critics of captive reinsurance see a policy question and not an issue of legality. Two economists on this side of the debate, Ralph Koijen and Motohiro Yogo, who have been vocal critics of captive reinsurance, do not allege that it is illegal.
Here come the lawsuits
Litigation has naturally flowed from the DFS report. Plaintiffs have seized on the notion that insurers were deceiving the public about their financial strength, that the financial system might be in jeopardy, and that their policies may not be as ‘valuable’ as they thought. Class actions are now pending in several jurisdictions alleging various causes of action ranging from statutory violations to conspiracy to full-on offences under the Federal Racketeer Influenced and Corrupt Organizations (RICO) Act.
The insurers are vigorously defending themselves, and they will no doubt be buoyed by the fact that even the DFS report concedes that these practices are lawful. Nonetheless, the pressure exerted by these cases can be immense, and it will be interesting to see how they impact the greater policy debate, and whether insurers are comfortable standing firm behind practices that appear, from all reasonable standpoints, to be a net benefit to everyone involved in the industry—including policyholders.
Michael Kasdin, Sandra Hauser and Matthew Gaul are partners of Dentons. Carter White is an associate. He can be contacted at:
michael.kasdin@dentons.com.
