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Fed bank fearful of insurance risks

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The growing use of captives is among “the rising and poorly-understood risks to the financial system” posed by the U.S. life industry, according to a new study commissioned by the Federal Reserve Bank of Minneapolis.

The report also singled out deep concern for the trend toward guaranty riders in variable annuities because of the shift from defined-benefit to defined-contribution plans.

Ironically, the study by Ralph Koijen, a London Business School professor, and Motohiro Yogo, a monetary advisor to the Minneapolis Fed, was released the same week as Benjamin Lawsky, superintendent of the New York Department of Financial Services, sent a letter to the National Association of Insurance Commissioners (NAIC) in advance of its spring meeting in Orlando that criticizes a plan proposed by the NAIC to strengthen oversight of captives.

Similar concerns voiced recently by Michael McRaith, director of the Federal Office of Insurance, prompted Ben Nelson, NAIC CEO, to tell McRaith to “stay in lane,” and butt out of life insurance industry solvency issues.

And, the Federal Reserve in Washington recently came under fire at a Senate hearing for seeking to use “bank-centric” rules to oversee insurers it now oversees through provisions of the Dodd-Frank financial services law.

The reason insurers pose a growing risk is that, “Although these risks have been growing rapidly over the past 15 years, they have received relatively little attention from academics and regulators,” the Minneapolis Fed report said.

“If unaddressed, these risks could cause severe problems,” the report said, because insurance is “a large share of the financial sector.” For example, U.S. life insurance liabilities amounted to $4.1 trillion in 2012, compared to $7 trillion in U.S. savings deposits, the report said. “Moreover, as the largest institutional investors in the corporate bond market, insurance companies serve an important role in real investment and economic activity,’ the report said.

The authors said that U.S. life insurance liabilities totaled $4.1 trillion in 2012, compared with total savings deposits of $7 trillion.

The report said that captives pose a particular danger. “By moving liabilities from operating companies that sell policies to captives, a holding company as a whole can reduce its required capital and increase leverage,” the authors say.

As for VAs with guarantees, the report said that in 2012, assets under management in U.S. variable annuity accounts amounted to $1.6 trillion.

“The long-term nature of these guarantees presents significant challenges for both valuation and risk management,” Koijen and Yogo said. The combination of a low-interest-rate environment and poor risk management, they said, generated large losses during the financial crisis. Some companies responded by closing existing accounts to new investment and reducing the generosity of newly offered guarantees, they said, adding that other companies, such as Hartford and John Hancock, exited from the market entirely. “Since insurance liabilities are not ‘marked to market’ (i.e., regularly reevaluated at fair market value), worse losses could yet occur, especially if the low-interest-rate environment continues,” the report said.

Captives have drawn the concern of Lawsky and the FIO because these instruments do not have to comply with the stricter funding requirements that apply to other insurers. Lawsky refers to the use of captives as “shadow insurance” because the details of their funding are often confidential and disclosed to only some regulators and the ratings firms that evaluate the financial strength of insurers.

In this case, Lawsky was commenting on a proposal that will be taken up next week by the NAIC that is aimed at strengthening capitalization of captives. The NAIC proposal is based on a February report by Rector & Associates Inc., which offers for consideration a new framework for the uniform treatment of captives.

Lawsky said he “harbors serious reservations” about the proposal because it “enshrines VM-20,” the relaxed reserving methodology that serves as the underpinning for the NAIC’s principles-based reserving (PBR) initiative as the basis around which its recommendations revolve.

In essence, Lawsky said, the Rector Report would “create a beachhead” for a deregulatory principles-based reserving approach that puts policyholders and taxpayers at greater risk.

Lawsky said New York believes that the NAIC should fundamentally rethink the interconnection between PBR and captives. “PBR is often offered by its proponents as a solution to eradicating the need for risky and opaque shadow insurance transactions,” Lawsky said. However, investigations conducted by New York, as well as statements made by the life insurance industry itself, “clearly demonstrate that such an argument is a fiction,” Lawsky said. “Rather, PBR and shadow insurance are both symptoms of the same disease: a desire to divert policyholder reserves, juice financial results, and make company balance sheets look artificially rosy,” Lawsky said.

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