A draft white paper by an NAIC subgroup on the use of captives and special purpose vehicles increasingly used by insurers to transfer risk raises questions on the safety and soundness of these reserve offloading activities and suggests modifications to model laws or even a new NAIC model law to address an issue of great concern to some state regulators.
One suggestion is to deal with the accounting for certain transactions within the ceding company, thereby eliminating the need for the captive in certain instances.
The industry doesn’t agree with that tack, as it made clear in letters to regulators. Life companies use captives to loosen their balance sheets and free up capital some insurers see as otherwise hampered or weighed down by excess reserves.
Required reserves are like a leash for capital at many public life insurance companies, especially when judged to be excessive or more than desired.
Concerned about the increased use of captives and the potential concern that “a shadow insurance industry is emerging, with less regulation and more potential exposure than policyholders may be aware of as compared to commercial insurers,” the Captive and Special Purpose Vehicle (SPV) Use Subgroup was formed under the Financial Condition Committee in early 2012.
Some state regulators are raising the specter of the “shadow banking system” which was believed to have contributed to the recent financial crisis, in addressing the captives issue. Captives and SPVs have often been a means of dealing with perceived reserve redundancies.
However, the subgroup concluded that that captives and SPVs should not be used by commercial insurers to avoid statutory accounting prescribed by states, suggesting that is what has been happening.
The majority of the transactions studied by the subgroup involved the NAIC’s Valuation of Life Insurance Policies Model Regulation (#830), Regulation XXX, and actuarial reserves required to be held under Actuarial Guidance 38—the Valuation of Life Insurance Policies Model Regulation (AG 38), or AXXX. Thus, the subgroup concluded, it appears the use of captives may be more common among life insurers than other lines of business, the group of regulators concluded. These captives are often referred to as SPVs.
A special purpose vehicle, where defined under state law, is a captive licensed and designated as a special purpose captive insurance company by the commissioner. Special purpose vehicles can take several forms. Special purpose financial captives are limited to issue only special purpose financial captive insurer contracts to provide reinsurance protection to the counter-party.
Captives were originally created to allow non-insurance companies to set up subsidiaries to insure their company’s own risk. Currently more than 30 states, the District of Columbia, and the U.S. Virgin Islands allow captives to domicile and form in the state. The number of captive domiciles has continued to grow over the past few years, with state governors’ offices touting in press releases their new or growing captives industry. Others warned that captive use was going too far and needed to be watched.
The NAIC research by the subgroup revealed that a significant portion of this industry increase is due to the use of captives as a means of dealing with perceived redundancies in actuarial reserves required to be held under XXX and AG 38. Actuarial guidelines for reserving designed to keep companies safe are driving them, especially life insurers, to offload some of their reserves into these vehicles to try to free up more capital so they can engage more facilely in the open market.
The subgroup, in its discussion draft of the white paper, concluded that a more appropriate treatment of such transactions should be to deal with the accounting and reserving issues within the ceding company, thereby eliminating the need for the separate transaction outside of the commercial insurer, not a popular view with the life insurance industry as its comment letters made clear.
The subgroup, for instance, held a consensus view that the Financial Condition Committee should form a separate subgroup to develop possible solutions for addressing the remaining reserving redundancies.
Possible solutions could include changes similar to the AG 38 solution, or disclosed, prescribed or permitted accounting practices, the group said. The NAIC, the subgroup said, should also consider modifications to the statutory accounting framework to recognize, in strictly limited situations, alternative assets, such as “tier 2” type assets” to support specific situations thereby eliminating the need for the separate transaction.
The subgroup also recommended that additional guidance should be developed by the NAIC to assist states in a uniform review of transactions, including recommendations for minimum regulatory analysis to be performed, as well as ongoing monitoring of the ceding insurer, the captive and the holding company for any uses insurers might think up in the future.
Life insurers said in letters to the NAIC that the industry is already well monitored.
“In reality these transactions are subject to substantial regulation by both the life insurer’s and the captive’s states of domicile, and in all cases these states are accredited by the NAIC,” one life insurance industry letter argued.
The subgroup went so far as to recommend that once developed, the guidance should be considered to be added to the accreditation standards to ensure consistency and uniformity among states.
Virtually all the state regulators that have been involved in these types of transactions have indicated that they review such proposed transactions in detail to ascertain at a minimum that the transaction does in fact match its intent, which is to transfer the redundant/non-economic reserves to the captive/SPV, the subgroup acknowledged.
In these transactions, the assuming captive or SPV assumes the full statutory reserve liability and secures those reserves in various manners. The economic reserves are typically the expected losses plus a small margin for adverse development and are secured by assets held by the ceding company. The redundant reserves are secured by a letter of credit that is to the benefit of the ceding company.
So, for these types of transactions, the belief is that the regulatory review of the transaction ultimately matches the risk posed by the transaction.