It is not often that an industry development excites the collective imaginations of state insurance regulators, high-rolling investment bankers and Wall Street lawyers. But that is what has been happening in recent years as more life insurers establish special insurance subsidiaries, or captive reinsurers, and engage in complex financing transactions.
The purposes of these machinations is to meet state-mandated statutory reserves required to fulfill policy obligations and, thereby, free up capital the insurers can use to help gain a competitive edge in the marketplace. For the state regulators and Wall Street deal-makers, the maneuverings add up to big dollar signs, much-needed tax revenue for state coffers; and fees for the professionals who execute the transactions.
But sources interviewed by National Underwriter are divided over whether the growth of captives is ultimately good for policyholders, investors, the companies and the financial health of the industry.
Origins of an Industry
A captive insurance company is a special kind of risk financing wherein a company creates an insurance subsidiary with a single policyholder: the parent. The premiums paid to the captive are written off as expenses, which helps the parent company’s overall tax profile, in addition to serving as a true insurance vehicle. Companies typically form captives when they are either so large that they have more resources than the insurers who would be covering their risk, or when it is simply less expensive to start and run one’s own insurance company than it is to pay the market value for certain kinds of insurance. Captives are formed to cover all kinds of risk, but heavy industrial risk and high liability risks are prevalent.
The use of captives is fairly widespread, but where insurers double down on them is when they use captives to build their own reinsurance companies, which even for the insurance industry carries with it a high level of inscrutable financial complexity.
“My experience is that captives are a very useful, adaptable and flexible risk management tool for any industry, and will remain so for the insurance industry,” says David Provost, deputy commissioner of captive insurance, for the Vermont Department of Banking, Insurance Securities and Health Care Administration, Montpelier, Vt.
Provost’s sentiment comes as little surprise, since Vermont is the single largest captive insurance domicile in the United States, and the third largest in the world, after Bermuda and the Cayman Islands. As of 2010, more than 900 captive insurers were domiciled within Vermont, earning the state millions each year in licensing fees and other charges.
Because of the peculiar tax implications of captive insurance, it can only be carried out in places where it is specifically permitted. For decades, that meant Bermuda and other, mainly Caribbean, locations. But in 1981, the Vermont legislature sensed it was missing out on a big financial opportunity, and it passed the Special Insurer Act, allowing captives to operate within the state. Since then, more than half of all U.S. states have followed suit, becoming rival domiciles themselves. Some of the most prominent include Utah, Hawaii, South Carolina, the District of Columbia, Kentucky, Nevada, Arizona and Delaware.
Of the states that do not allow captives, their numbers dwindle as one by one, they eventually get into the captives market. In early 2011, New Jersey became one of the country’s newest domiciles, aiming to present itself as a niche market for the healthcare, pharmaceutical and financial services industries. By July 15, Prudential had established NJCAP, the state’s first captive. The captive is intended to manage risk in a portion of Prudential’s life insurance and annuity policies, according to the New Jersey Department of Insurance.
Douglas Murray, an analyst and group managing director at Fitch Ratings, Chicago, strikes a cautious note about captives. “Some people refer to these captives as the black hole of insurance company analysis,” he says. “From our standpoint, the important thing is to understand the insurers’ activities and to factor these into our assessment of the companies’ capital adequacy, which is key to the assignment of company credit ratings.”
Market watchers say the use of captive reinsurance subsidiaries and insurance securitizations executed by special purpose vehicles (SPVs) set up by the captives have been on the rise since February of 2001, when the first of some 37 states began implementing Regulation XXX.
Developed by the National Association of Insurance Commissioners (NAIC), XXX imposes on insurers conservative assumptions and valuation methodologies by which to determine statutory “excess reserves” required to fulfill long-term premium rate guarantees on term life insurance policies. The NAIC thereafter established reserve requirements under Guideline AXXX for issuers of universal life insurance policies with secondary guarantees.
Because of the new rules, insurers now are obliged to hold “excess reserves,” or funds in excess of amounts required to assure payment on policy claims. Because of this redundancy, critics argue, life insurers are restricted in their ability to leverage capital that otherwise could be deployed to diverse products, develop distribution channels, enhance productivity and promote other business objectives.
“The NAIC is now reviewing the XXX and AXXX requirements, having recognized that reserves established by actuarial guidelines are too high,” says Vermont’s Provost. “From what I’ve seen, the excess reserves are nearly double what the actuaries calculate are needed.”
Enter Captives and SPVs
The new reserve requirements, say experts, have fueled a significant expansion over the last decade in captive reinsurers and, through affiliated SPVs such as insurance securitizations. The trend has been especially widespread among large life insurers—AIG, Genworth Financial, Hartford Financial, MetLife, Swiss Re, among others—that can justify the transaction costs associated with a reserve funding securitization program; and that are looking for a cost-effective alternative to traditional, third-party reinsurance supported through bank-issued letters of credit.
“By forming a captive reinsurer, and thereby eliminating the middleman, life insurance companies can eliminate the significant expenses associated with third-party reinsurers,” says Jay Adkisson, an attorney/partner at Riser Adkisson LLP, New Beach, Calif., and chair of the American Bar Association’s Captive Insurance Committee. “All insurance is simply a bet. If you’re willing to bet on a captive, believing it to be a good gamble, then why not do so if you can keep the profit for yourself?”
How large is the insurance securitization space? Research organizations contacted by National Underwriter, including Captive Insurance Companies Association (CICA), Captive.com, LIMRA and SNL Insurance, don’t keep statistics on the market. But according to a 2007 article appearing in the Journal of Taxation and Regulation of Financial Institutions, captive reinsurers and affiliated special purpose vehicles have floated more than $20 billion of securities since Regulation XXX was promulgated. The authors’ pegged the additional reserves required to meet XXX/AXXX guidelines at more than $150 billion by 2017.
The transactions involve multiple players. In a typical scenario, the parent company (“ceding insurer”) transfers the risk associated with policy liabilities subject to XXX/AXXX guidelines to the captive reinsurer, the parent paying a reinsurance premium as compensation for the assumed risk. Separately, a special purpose vehicle, usually an affiliate or subsidiary of the insurer, sells securities on the capital markets to finance “non-economic reserves”—the amount by which the XXX/AXXX requirements exceed the policies’ economic value.
These insurance securitizations often involve other moving parts. Among them: (1) a AAA-rated financial guaranty insurance (or “wrap”) used to ensure the SPV’s payments to security holders; (2) a reinsurance trust that secures the obligations of the captive to the insurer; and (3) a financial institution, such as a state-chartered bank or trust company, to act as trustee of the reinsurance trust.
The insurance securitizations, say experts, are money-makers for Wall Street investment bankers and attorneys who put together the deals. They are also a revenue machine for the states that are aggressively courting the captives. Chief among them: Vermont, which has generated $25 million annually in taxes and fees for the state plus 1,400 jobs, over the past 30 years.
“Domestic domiciles love the captive companies,” says Michael Mead, president of M.R. Mead & Co., Chicago, and chairman of the Fronting Survey Committee for the Captive Insurance Companies Association, Minneapolis. “On the day a captive is licensed, the state in which it’s domiciled receives a check. So the state regulators are very happy to accommodate these companies.”
Other states that have fully functioning captive insurance programs, including Hawaii, Delaware and South Carolina, are endeavoring to close Vermont’s three-decade-long lead in attracting the companies. Delaware now has 118 captives domiciled in the state, up from fewer than 40 when Insurance Commissioner Karen Stewart took office in 2009.
“One of the commissioner’s campaign platforms was to build a captive insurance industry in the state,” says Steve Kinion, director of the Bureau of Captive and Financial Products for the Delaware Insurance Department, Wilmington. “Since taking the helm, she’s followed through on that platform, which makes my job a lot easier.”
Critics Who Cry Foul
The revenue-generating potential the captives hold for state coffers, and the often close, long-standing ties between the companies and their regulators—an 18-year industry veteran, Provost himself has worked at Johnson & Higgins Services, Sedgwick Management Services and AIG Insurance Management Services—raises alarm bells among critics who question whether the captives and SPVs are receiving the financial scrutiny they merit.
Among the naysayers is Tom Gober, an expert on insurance and reinsurance corporate accounting fraud and president of San Diego-based Gober Forensic Accounting Services. Gober’s chief complaint is about the lack of transparency in the companies’ financial statements. Though the regulators themselves can view captive reinsurers’ balance sheets, cash flow and income statements and other pertinent financial data, this information is withheld from the public.