In a new report, Moody’s Investors Service says the use of captives is influencing in a negative way the view of capital adequacy of stock insurers.
“Use of captives can lead to complex corporate structures and reduced financial transparency, both credit negatives,” Moody’s says in the new report.
The report said that life reinsurers are the most prominent users of captives. The report also made clear that mutual life insurance companies, “immune from shareholder pressures to improve returns on capital, are noticeably absent from the list of insurers using captives.”
The Moody’s report said captives help life insurers manage the regulatory volatility of reserve and capital requirements associated with variable annuity guarantees. Although U.S. statutory reporting has more of a focus on balance sheets than income statements, there are also some statutory income benefits, according to Scott Robinson, a senior vice president at Moody’s and author of the report.
“These practices undermine the conservatism U.S. regulators have embedded in their reserving and capital regimes,” Robinson said in the report.
He said life insurers use captives because it enables them to operate in jurisdictions with weaker regulatory standards, both inside and outside the U.S. “This facilitates their ability to operate more freely, with less scrutiny over activities such as investment risk, Robinson said.
In seeking to explain the reason for rating agencies’ concern, Moody’s analysts calculate that use of captives in the aggregate equates to approximately 85 percent of industry capital and surplus.
“In aggregate, a greater reliance on captives by the industry creates overall negative credit pressure, and these practices undermine the conservatism U.S. regulators have embedded in their reserving and capital regimes,” Robinson said.
Robinson explained his concerns about the overall impact by saying that as of the end of 2012, the life industry reported approximately $169 billion of general account reserve credit for business ceded to unauthorized affiliates. Additionally, life insurers had entered into about $155 billion of modified coinsurance (modco) treaties on general account business with unauthorized affiliates, the report said.
While modco transactions do not provide reserve relief, they provide some capital benefits to the ceding company, Robinson said. Hence, in total, the industry received more than $324 billion, or approximately 12 percent of total reserves, of “relief” in aggregate, he said.