On Tuesday, June 11, 2013, the New York State Department of Financial Services (NY DFS) issued a report highlighting captives. Some media have used this report as basis for a discussion characterizing captives as complex tools companies use as a means to present a more robust financial portrait than may be the case. In the wake of the NY DFS report and related media coverage, Pinnacle, in partnership with M Financial, has compiled this white paper to provide background information on the uses and mechanics of captives, and detailed perspective from other interested parties.
What is a Captive?
Captive insurance companies, as the name implies, insure or reinsure the risk exposure of their parent companies and affiliates. Captives are formed under specific laws that prohibit them from issuing policies directly to consumers.
Why Captives Are Used and How Captives Work
Captive insurance companies provide for the efficient aggregation and management of certain insurance risks by insurance companies when third party commercial reinsurance may not be reasonably available. Captive structures can be especially helpful in managing term life insurance and no-lapse guarantee UL risks. These products are subject to statutory reserve requirements that are widely regarded within the insurance industry as conservative, resulting in reserves that are commonly referred to as redundant; “XXX” reserves for term life insurance products and “AXXX” for no-lapse guarantee UL products.
Captive reinsurance transactions work very much like other commercial reinsurance transactions in that they must meet the same regulatory requirements for the insurance company to receive credit for reinsurance. Unlike commercial reinsurance transactions, each captive transaction is reviewed by regulators—both the insurance company’s state of domicile and the captive’s state of domicile review and analyze these transactions to ensure they meet regulatory requirements.
The life insurance company cedes risks and reserves to the captive entity. For the insurance company to receive credit for the reinsurance, the captive must either be an authorized reinsurer in the insurance company’s state of domicile or post collateral that meets the regulatory requirements of the insurance company’s state of domicile. Collateral can take the form of assets held in trust, a letter of credit (LOC), funds withheld, or, in some states, a parental guarantee. In the context of “XXX” and “AXXX” captive transactions, the insurance company will determine the economic reserves (or actual expected losses) associated with the obligations through actuarial analysis. The formula used to determine the economic reserves is reviewed by an independent third party actuary at inception and may be subject to an annual independent third party actuarial review.
The difference between the statutory reserves and economic reserves is the redundant reserves. In a captive reinsurance transaction, the ceding company will generally create a funds withheld account to hold assets backing the economic reserves or require the captive to establish a trust account to hold assets in that amount. The redundant reserve will often be backed by an LOC, issued by a bank for the benefit of the ceding company, and held by the captive. In states where the law allows, and subject to certain requirements, guarantees from the ceding company’s parent may also serve to back the redundant reserve.
Captives are beneficial in that they allow for efficient use of capital. By segregating the risk in a captive, companies are able to obtain third-party financing at a lower cost, which results in more consumer friendly pricing (i.e., more affordable insurance coverage). In addition, risk is spread as third-party financing partners are liable for the risks represented by the redundant reserve.
Potential Captive Abuses
The NY DFS report focused primarily on transactions where an appropriate third-party LOC is not secured. In these transactions:
The LOC is contingent and may not provide the funds when needed by the insurance company, or
The LOC is a wrap-around arrangement where the LOC cedes the risk back to the original ceding company — there are reduced reserves but no risk transfer.
Industry Response to NY DFS Report
M Financial requested and received commentary regarding captive transactions from the following M Carriers: ING, John Hancock, Lincoln Financial, Pacific Life, Prudential, and TIAA-CREF Life Insurance Company. According to their responses, all M Carrier captive transactions provide full risk transfer supported by high-quality assets or financing arrangements (such as banking institution LOCs), which provide reimbursement when needed.
Moreover, a number of interested parties have responded to the NY DFS report to bring context and balance to the issue. Their responses follow:
State Regulator Responses
While the NY DFS report has called for a national moratorium on captive reinsurance transactions, the National Association of Insurance Commissioners (NAIC)—the U.S. standard-setting and regulatory support organization created and governed by the chief insurance regulators from the 50 states, the District of Columbia, and five U.S. territories—has been studying the use of captive reinsurers for more than a year and is taking a more balanced approach by advocating enhanced disclosure of the transactions.
NAIC President Jim Donelon stated that there appears to be no need to call for a moratorium on captives as requested by the NY DFS. In addition, Donelon commented that state insurance regulators are continuing to monitor the risks posed by captives and special purpose vehicles while working to implement principles-based reserving (PBR) for life insurers. The overwhelming majority of state insurance regulators believe the successful implementation of PBR will address the perceived reserving redundancies that have precipitated the use of captives for reserving purposes.
The NAIC’s Captive and Special Purpose Vehicle (SPV) Use Subgroup met after the release of the NY DFS report and agreed to submit a white paper—Captives and Special Purpose Vehicles—to the Financial Condition (E) Committee for their consideration. The white paper lists the following regulatory recommendations:
Disclosure and Transparency—enhanced disclosure in ceding company statements regarding the impact of the transactions on the financial position of the ceding insurers.
Uniform Standards—development of guidance in the Financial Analysis Handbook for the states’ review and ongoing analysis of transactions involving captives and SPVs, including specific considerations of such transactions when performing holding company analysis.
On July 1, 2013, North Carolina joined 31 other states and the District of Columbia as a captive domicile.
All captive transactions already require approval from the ceding insurer regulator and the captive regulator.
Rating Agency Responses
The NY DFS report implies that rating agencies do not consider captives as part of their assessment of insurance company financial strength. In comments issued following the release of the NY DFS (excerpts of which are provided below), this implication was incorrect. Rating agencies are aware of—and assess—captive arrangements, including the ultimate collateral backing the redundant reserves, with such analysis impacting insurance company financial strength ratings.
A.M. Best views as positive the continued industry discussions related to increased regulatory scrutiny and transparency surrounding life captive reinsurers.
A.M. Best stated “it will continue to look through these transactions, and analyze groups on a consolidated basis using its capital model regardless of which affiliated entity assumes the risk.”
Furthermore, “A.M. Best will continue to monitor life insurers’ reinsurance programs with respect to potential decreasing LOC capacity and/or increasing LOC costs in the marketplace.”
Moreover, A.M. Best believes there are notable differences in the quality of collateral involved in these funding solutions (e.g., reinsurance trusts, long-term LOCs, short-term LOCs, and contingent LOCs). These differences are incorporated in A.M. Best’s overall evaluation of an organization’s balance sheet strength.
Moody’s believes a greater focus on captives by regulators is credit positive for the industry.
Life insurers use captives to manage regulatory capital strain associated with life and health insurance products subject to what they perceive to be conservative reserve and/or capital requirements. They also use captives to manage the volatility of reserve and capital requirements associated with variable annuity guarantees. Both practices undermine the conservatism regulators have embedded in the reserving and capital regimes.
Moody’s analysis of life insurance companies’ creditworthiness on an enterprise basis has determined that many companies’ captives are capitalized at levels lower than standard operating companies, which tends to weaken overall capital adequacy. Moreover, transactions such as those identified by the NY DFS can lead to complex corporate structures and reduced investor transparency, both credit negatives.
The attention placed on captives, not only by New York, but also by the NAIC, will likely be a positive development that will lead to more disclosure of transactions with captives.
The American Council of Life Insurers (ACLI), which represents the interest of life insurance companies, continues to examine captives and their impact on carriers, policyholders, and the life insurance industry as a whole. Following the release of the NY DFS report, the ACLI issued the following statement:
“For more than one year, the 56-members of the National Association of Insurance Commissioners (NAIC) have been reviewing the issue of captive reinsurance transactions discussed in the report issued by the New York Department of Financial Services.
Captive reinsurance transactions provide life insurers a means to spread the risks they assume. They also enable life insurers to deploy capital efficiently and, in turn, help them set prices as competitively as possible. Captive reinsurance transactions represent an important and positive element of a competitive life insurance marketplace and are, without exception, reviewed and approved by regulators.
To help improve transparency and regulation, ACLI is working with the NAIC to enhance disclosures that will provide regulators with more access to information about the captive reinsurer transactions. With greater transparency, concerns about this vital risk- management tool will be addressed.
ACLI fully supports national adoption of proposals to enhance disclosure involving these transactions.”
Because of our commitment to client advocacy, Pinnacle and M Financial are focused on the scrutiny of captives and the impact captives may have on policyholders. Based on our understanding, which is supported by conversations with carriers and analysis of statements from rating agencies and regulators, captives can provide an appropriate and efficient vehicle for segregating and spreading risk, lowering the cost of reserve financing, and ultimately providing better pricing for consumers. Captive transactions that support redundant reserves backed by high-quality assets or financing arrangements (e.g., bank LOCs that provide reimbursement when needed) — with full transparency and disclosure, as well as review and approval by state regulators — would reasonably appear to provide the consumer protection intended by state regulators and provide the benefits of lower cost insurance products to consumers.
The use of captives is a direct result of current reserving requirements. Are required statutory reserves backing guaranteed products truly redundant or overly conservative? The adoption of PBR by the NAIC may implicitly suggest reserves backing guarantees are indeed redundant. If they are truly redundant, and PBR is implemented (as anticipated in 2015), there may no longer be a need for captives (and the issue may become moot). However, if required reserves are not redundant, then the discussion may focus more specifically on the ultimate party or collateral backing the redundant reserve, not the use of captives themselves. It is important to remember that the economic portion of the total reserve is retained by the insurance company, or is fully collateralized with assets meeting regulatory requirements.
Pinnacle and M Financial support regulatory changes that provide more disclosure and transparency, uniform regulator review standards, and uniform standards for permitted assets and LOCs backing reserves. The NAIC is moving forward with regulatory changes via the Captives and SPV white paper.
With potential regulatory changes, it is possible that some insurance companies may be negatively impacted. However, based on the responses from M Carriers, it is anticipated there will be little or no impact to M Carriers.
Finally, alarmist tactics that seek to scare consumers are of little benefit. For example, to suggest that ratings agencies are not aware of the issues with captives, and are not reflected appropriately in their financial strength ratings, is irresponsible. As an alternative, we support an open dialogue, supported by disclosure and transparency that facilitates informed consumer decisions.
Additional information and analysis on this topic will be provided as relevant news and facts evolve over time. In the meantime, if you have any questions or comments, please contact us.
A link to the NY DFS report—“Shining a Light on Shadow Insurance: A Little-known Loophole That Puts Insurance Policyholders and Taxpayers at Greater Risk”— is below.