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A Captive Audience

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On the front page of today’s New York Times, in the pole position, is an interesting story about captive insurance. It begins by telling readers what anybody with even the tiniest experience with captive insurance already knows about it. But it then moves on to detail how heavy hitters in the life industry, especially Aetna and MetLife have used captives to reduce their own capital requirements and in so doing, free up operating capital for other purposes, such as paying out bigger dividends.

You can read the story here, but basically it starts by describing for the readers what captive insurance companies are, and then it quickly moves into how companies such as Aetna have been using them to reduce their capital requirements. This, in turn, shows how utterly fragmented the state-based regulatory system, championed by the NAIC, really is. According to the Times, the captives industry and the state insurance regulators allow for insurers to pick and choose where they want to be regulated, slipping out of whatever insurers feel are pernicious regulations, and pitting states against each other as companies go forum shopping. The end result is a system of loopholes that allow insurance companies to dodge the very capital requirements that are supposed to keep them in check. It is eerily reminiscient, the Times suggests, of the kinds of procedures – and the regulatory failure to prevent it – that allowed AIG to implode in the way that it did. And that is the real concern. Where might the next AIG be? And might it be found somewhere in the life insurance industry?

Before we get into that last question, let’s take a look not just at what the Times story said, but at how it said it. First things first, they placed the story in the Monday morning edition’s pole position: front page, top of the fold. Why is this important? Consider, for a moment, the newspaper maxim of “if it bleeds, it leads.” Then consider that this story about life insurance and captives displaced to a second spot on the front page a longer, deeper and frankly, more compelling story about how New York social services failed to prevent a four-year-old girl from being neglected to death by her drug-addled family. The death of an innocent girl was trumped by supposed financial shenanigans by the life insurance industry. If that does not show a sign of intent on the part of the media to chase what it thinks is a spectacular villain story in the making, then nothing will. Likewise, if that doesn’t send a chill up your spine, then you are a far cooler cucumber than I am.

Along these lines, the headline for the story is “Seeking Business, States Loosen Insurance Rules.” But on the front page of the Times’ website, wthe header reads, “As States Battle for Cash, Insurance Concerns Grow.” Virtually the same number of characters, yet the second headline immediately tells a more suspicious story on the part of the industry. Hmm.

The guts of the story is really nothing new. Aside from National Underwriter covering Aetna’s tricky financial move (which was reported elsewhere too; the details of the financing were made plain in Aetna’s earnings report), the business of captvie insurance itself is decades old, and is a staple of how much insurance business is done today. Granted, it is less common for insurers to use captives for their own purposes, but what Aetna and every other company listed in this story has done is entirely legal. And that is the point, but on two different fronts.

The first, and a point the story makes is that there is no consistency in insurance regulations in this country. The NAIC and state insurance commissioners like it that way, as it gives them sovereignty and autonomy. Not to mention that every state is utterly addicted to the premium taxes it levies upon its insurers, so none are eager to see into being system that might take that source of funding away from them. This, more than anything, is what I suspect the NAIC and the states are all about. It is not that they are hellbent to protect consumers, or to drive efficiency within the industry. It is because the present arrangement drives a lot of money into the coffers of the NAIC and a lot of power into the hands of those who see a post as insurance commissioner as a stepping stone to bigger and better things. Only a system as hopelessly fragmented as ours could enable such a mess. Small wonder, then, that the NAIC is so dead-set against federal regulation and has been very active in trying to prevent the Federal Insurance Office from wielding any real regulatory power. To this end, the story is a de facto call for federal insurance regulation, and I must agree with this. I said back in November, and I’ll say it again that the golden era of state-based insurance regulation ended in September 2008 when the states’ collective inability to notice or warn that AIG was about to join the ranks of the dodo bird helped to plunge the entire planet into financial chaos.

But the other point made here about the state of rules for the industry is that the companies themselves are somehow getting away with something by taking advantage of current captives law. The Times story notes how companies are trying to use captives legislation to reduce their own capital on hand, seemingly in contrast to how they ought to be maintaining their finances for the sake of policyholders. What the Times does not mention, however, is that certainly within the life and health industry, capital requirements are widely felt to be excessive, put into place by a reactionary hand in the wake of the disastrous Executive Life failure some years ago. As one contact put it to me, the industry’s capital levels need to be at one level. The rules demand they be well above what is really necessary, and so the industry strives to actually have on hand reserves that split the difference somewhere. You would like to think that the financial experts of the life insurance world have more acumen on what their companies need on hand to ensure their own survivability. But then again, you would have thought the same thing of AIG, too, and we all remember what happened there. Ultimately, a sales-driven culture matched with a horrifying single point of failure – a small financial markets outfit in London – turned one of the world’s seemingly invincible financial juggernauts into a balance sheet vortex that could have swallowed everyone and everything.

Whare is the next AIG? Who is it? Where is is lurking? What is it up to? These are all questions being asked of the financial journalism world right now. These are questions that have been asked since late 2008. And now, eyes are upon the life insurance world to determine if it has any answers to cough up.

Well, does it? The industry is already the subject of what can onyl be described as a 35+ state treasure hunting expedition, courtesy of numerous state regulators acting on behalf of depleted state treasuries, spurred on by the likes of Verus Financial. Even if that particular effort yields nothing major, the damage to the industry has already begun, with a skeptical public further informed that the life insurance industry is most likely hiding money from its policyholders, and has done so going back to about World War II. That industry that implores you to put your safekeeping in its care? Yeah, forget about that. That is the message the life claims fiasco has to say at the moment. And now, this bit about captives, which at best shows the industry as taking advantage (excessively so?) of a hopelessly porous regulatory system. At worst? It is the industry knowingly using its financial skills to dodge paying taxes, which is something the average American is already fed up hearing about.

So far, the industry’s lobbying efforts have done an impressive job of limiting the damage wrought by health care reform and financial services reform, but the reality is that even the most powerful political engine cannot protect the industry forever. Insurers have often protested that even if they are doing nothing wrong, people assume that they are. People in juries, people looking to get elected. And if the industry really is doing something wrong? Well, better not to talk about it.

It cannot go on like this. Later this week, I’ll be detailing a pretty interesting social good program that Aviva is up to, and I think that while Aviva clearly has its own interests to serve with such an initiative, it is also hoping that other companies will catch on to what it is doing and thereby raise the collective image of the industry. It is a bold plan, and fraught with as much difficulty as building a space elevator between the Earth and the Moon. But given the environment this industry currently occupies, it doesn’t seem like such a long shot, given what’s at stake. Stay tuned.