Securitization, or the pooling of contractual debt (such as mortgages) into bonds, then reselling the bonds to investors (like big pension funds) has received intense scrutiny from regulators in recent years because of the central role the financing technique played in the near-catastrophic credit crisis of 2007-2009. Of as much concern were the credit rating agencies—A.M. Best, Moody’s, Fitch, and Standard & Poor’s—that federal authorities faulted for assigning to asset-back securities ratings they didn’t deserve.
As securitization deals become common within the life insurance industry, the question arises once more as to whether the rating agencies are failing to provide the rigorous financial analysis that stakeholders in the ratings process expect; and if so, whether investors are getting a less than accurate picture of life insurers’ financial strength.
As I note in this issue’s cover story (p.12) special purpose captives or reinsurance subsidiaries of major life insurers are engaging in securitizations to meet the excess reserves requirements for term life insurance policies (Regulation XXX) and universal life policies with secondary guarantees (Guideline AXXX) established by the NAIC in 2001. If a 2007 estimate cited in the article holds, the aggregate value of the securitizations will reach more than $150 billion by 2017.
This is a staggering number. And so policyholders, investors and life insurance professionals are justified in asking whether such a financing technique is appropriate for the insurers. Critics suggest that the complexity inherent in securitization can limit investors’ ability to monitor risk.
Industry stakeholders are right to question, too, how they can be confident about the financial health of the captive reinsurance subsidiaries that execute these complex transactions when states where the captives are domiciled shield their operational results from public scrutiny. Regulators assure me that they closely examine the books of proposed captives and their parents before approving those seeking to domicile in their states; and that information material to the public, such as policy liability risks ceded to the captives, can be readily obtained from financial statements of the parent companies.
But given the significant role the ratings agencies play in analyses of insurers’ financial standing, are they getting the information they need to do proper assessments? And if not, how might data that is missing impact the ratings they assign?
Steve Chirico, an assistant vice president of Oldwick, N.J.-based A.M. Best Company, says that A.M. Best subjects the books of thousands of insurers, including many small companies, to a proprietary financial analysis methodology that embraces “stress tests” of parent companies and captive subsidiaries, examining the companies’ results of operations both aggregately and separately.
When A.M. Best identifies weaknesses that could negatively impact the insurers’ ability to fulfill policy obligations, then the company accordingly downgrades the insurer’s credit rating. In the event an insurer fails to share information that is critical to an examination of the company then, says Chirico, A.M. Best “risk charges” the insurer for the information gap.
“In other words, we’ll shift the risk exposure from the captive to the parent insurer and not give the parent credit for capital that has been ceded to the captive,” says Chirico. “We’ll assume a worst case scenario, where the parent still bears the risk of paying the claims, but doesn’t have access to financial resources on the books of the captive to do so.”
In most cases, adds Chirico, life insurers are forthcoming with requests for financial data about the captives. This is the case despite non-disclosure laws that captives enjoy in many jurisdictions, and not just popular domestic domiciles like Vermont, South Carolina and Utah. Chirico observes that his main area of expertise—captives that seek offshore tax havens like Ireland, the Cayman Islands and Bermuda—also generally are obliging with information requests.
Chirico notes that insurers often employ captives to bear only a portion of policy liability risks they incur; when appropriate, they’ll transfer the balance of risk to traditional, third-party insurers. Captive expert Michael Mead of M.R. Mead & Co. echoed Chirico’s point. He says the captive companies of major insurers are generally so small compared to their parents as to make the captives’ balance sheets “inconsequential” by comparison.
All of these statements sound reassuring. And yet I have a nagging feeling that the rating agencies and state regulators are failing to account for certain variables—the “unknown unknowns” that former U.S. Defense Secretary Donald Rumsfeld famously referred to—that could potentially put the insurers at risk. One can only hope that all the right questions about the captives are being asked—and addressed.