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.

Also withheld in many jurisdictions are the names of the companies. This is true, for example, of Delaware. Kinion says the state’s captives are protected by a confidentiality law that forbids disclosure unless authorized by the companies.

Gober acknowledges that “true captives”—those that reinsure risks, such as the loss of plants and equipment that are incurred only by the parent company—are entitled to less public scrutiny. Nondisclosure is particularly applicable, he adds, in respect to proprietary information that could put the companies at a competitive disadvantage if publicly available. But Gober insists that sound regulatory policy dictates full disclosure of captives’ operational results in cases where they are reinsuring “unaffiliated assets,” i.e., the life insurance policies underwritten by the company or of third-party insurers.

“Special purpose captives like those I see domiciled in Vermont, South Carolina, Missouri, Hawaii and other jurisdictions are not captives at all,” says Gober. “These states have bastardized the definition of captive by seemingly allowing unaffiliated risks—policy liabilities incurred by insurers across the 50 states—to be dumped in a captive, and thereby hide the liabilities. This flies in the face of what captive reinsurance is all about.”

Of notable concern to Gober is nondisclosure of “loss development,” the difference between the amount of losses initially estimated by the insurer and the amount reported in an evaluation at a later date. If, say, Company X sets aside $500,000 to cover expected policy liabilities, but ultimately has to pay $5 million in claims, then the result is $4.5 million in “bad loss development” that investors, policyholders and other stakeholders ought to know about.

Gober also takes issue with how ceding insurers manage the capital surplus they secure by establishing a captive. If  they spend this surplus—say, by paying shareholders dividends to boost investor interest in company stock—then, says Gober, they put at risk their ability to pay on future claims.

“By establishing these special purpose captives, insurers are gutting their future,” says Gober. “When you use this tactic—moving policy liability risks off the balance sheet where no one can see them, then spending the resulting surplus—you gut any chance of a positive future.”

Particularly dangerous, Gober adds, are insurance securitizations undertaken by captives’ SPVs. Such arrangements, he says—citing as an example a $3.8 billion securitization, purportedly the largest on record, which MetLife concluded in 2008 through a captive reinsurer, MetLife Re of Charleston—“should be absolutely outlawed.”

MetLife, among other life insurers, declined an National Underwriter interview request regarding the company’s use of captive reinsurers and its positions in respect to NAIC model laws covering captives. But the company issued the following prepared statement: “MetLife, like many insurers, utilizes captives in order to finance certain current reserve requirements and to help ensure we can provide competitive universal life and term life insurance products.

“Since there have not been any announced changes regarding the regulation of captives,” MetLife adds, “it would be premature for us to comment on the work of the [NAIC’s] Financial Condition Committee Subgroup at this time. As always, we remain open to having ongoing dialogue with all of our regulators and will of course fully comply with any new rules or requirements.”

The captives’ proponents say the concerns of Gober and other critics are overblown. Outdated, even. “This sort of thinking is 20 years old,” Mead says. “Captives do all kinds of things today—not just self-insuring plants and equipment. A captive is truly a balance sheet item today that savvy CFOs understand and use to their full potential.”

In respect the financial disclosure issue, Vermont’s Provost observes that information that may be material to investors and policyholders, such as amounts ceded to captive reinsurers, and their state of domicile, are listed in the ceding insurers’ audited financial statements, including footnotes of the companies’ annual statements.

He notes, too, that the books and records of both parent and captive insurers are thoroughly scrutinized by regulators in states where the companies are domiciled. The due diligence in most jurisdictions also includes a review of proposals for establishing a captive by an independent actuary recruited by the captive domicile.

That close scrutiny, adds Mead, is reflected in the captive companies’ track records. He notes there are “far fewer failures of captives” than there are insurers. He adds the NAIC has, through requirements established in its Model Captive Reinsurance Act, eliminated a practice that might have led to such failures: insurers setting up, but not funding, reinsurance shell companies.

Critics remain unconvinced by these arguments. W.O. Myrick, a now retired state insurance examiner, sides with Gober in insisting that captives have no business assuming policy liability risks. These, he adds, should remain with the company that had underwritten the policies.

“In my experience, where there is an opportunity to throw liabilities into a vehicle that is shielded [from the public], then there is a very high likelihood that the insurer chose to do this so as to falsify reserves,” says Myrick. “What I fear is that the captives are being used to hide more and more risk. And when risk bounces from one entity to another, it often vanishes.”

Shell games aside, critics are asking whether captive reinsurers are being properly regulated. Memories still linger of how AIG, in 1987, off-loaded some $1 billion in losses to its captive Coral Re, and then moved those liabilities to another captive, Richmond Re, when state regulators objected. Ultimately, the losses returned to AIG’s main balance sheet after regulators deemed that the captive transaction was little more than an effort to purge liabilities from AIG’s books by making them appear to be third-party reinsurance recoverables.

Prompted in part by an article on the industry in a May edition of the New York Times—which was written after Aetna chief financial officer Joseph M. Zubretsky noted how the company had successfully refinanced a book of health insurance through a Vermont captive, saving some $150 million in the process—the NAIC’s Executive Committee authorized its Financial Condition Committee to “study insurers’ use of captives and special purpose vehicles to transfer third-party insurance risk in relation to existing state laws and regulations.” Depending on the study’s findings, an NAIC statement adds, the committee may recommend “modifications to existing NAIC model laws and/or generation of a new model law.”

(The NAIC did not respond to an National Underwriter request for additional comment on the study, the XXX and AXXX reserve requirements and questions raised about oversight of captive reinsurers.)

 

Eyeing the State Regulators

One potential area of concern for the NAIC committee, some observers suggest, is an uneven ability among the 50 states to properly police the captives. The issue is likely to grow, they note, as more insurers seek to domicile captives in the minority of states that are garnering much of the business due to successful captive programs, but may not be appropriately staffed to oversee the companies. Or as critics would put more bluntly: what kind of regulatory shortcomings are likely to develop when the states themselves, with no strong federal oversight, are competing with each other to provide the most insurance-friendly captive domiciles? What captive proponents consider a competitive marketplace for risk, critics see a kind of forum-shopping for insurers looking to enjoy the benefits of lower reserving requirements, thereby skirting the most primary reason for insurance regulation at all—to protect policyholders by enforcing insurers’ ability to pay claims.

Kinion insists that Delaware’s insurance department is up to the task, noting that company’s staff has accrued extensive experience regulating the 135 commercial insurers domiciled in the state; and that the staff applies many of the “lessons learned” regarding these companies to captives also. He adds that he hasn’t “seen anything to substantiate critics’ concerns on this issue” in other states.

Adkisson, for his part, questions whether the captive business ought to be more evenly shared among the states so as: (1) not to overtax those that are attracting a disproportionate number of the companies; and (2) enable better due diligence by limiting oversight of both the ceding and captive insurers to a single insurance department.

“As of now, you have about a dozen states that are intensively courting captive business because of the revenue potential,” says Adkisson. “But insurance departments that are poorly funded or understaffed may not be able to do a good job policing all of the new captive companies.

“The best solution therefore is for every state where an insurer is domiciled to develop its own captive industry and thereby keep the business at home. That will allow for a more evenly distributed oversight of the companies.”

Some observers say the best way to address critics’ unease about captive reinsurers to is to lessen, if not entirely eliminate, the need for their existence. This proposition brings us full circle to the excess reserves mandated by NAIC’s XXX and AXXX reserve requirements—and whether there is a more sensible alternative.

The NAIC thinks so, and it is now actively promoting a new system, principal-based reserving, for life insurance and annuity products. If adopted by at least 75% (42) of the NAIC’s insurance commissioners or of the state legislatures, say experts, PBR would allow for more customized actuarial assumptions and reserving based on life insurers’ claims experience. This enhanced flexibility could, in turn, free insurers from having to rely on captives and complex securitization transactions to meet reserve requirements.

How soon can we expect PBR to be implemented by the states? “I thought we would be moving to principal-based reserving by 2014,” says Kinion. “But given the hurdles remaining—finalizing the valuation methodologies and new model law, then adoption of PBR by 42 of the states—this isn’t going to happen for some time. It’s a slow-moving process.”

In the meantime another way to address concerns is transparency. Ostensibly, rating agencies get full access to captive transactions when meeting with management. Why not, then, allow the public the same level of access? The notion is that it would help the public determine for itself whether insurers are actually achieving their financial goals through the use of captive reinsurance…or are merely appearing to.