WASHINGTON — A fresh lawsuit in Iowa has renewed the battle over whether the use of captives by insurers as part of their regulatory capital allows them to mask potential financial inadequacies.
Federal regulators and insurance industry officials also are sounding the alarm.
A staff paper by researchers at the Federal Reserve Bank of Minneapolis in May raised concerns about whether use of captives by insurers masks their actual financial adequacy.
The Office of Financial Research (OFR) at the Treasury Department raised similar concerns through a March paper that argued the “publicly available data are insufficient to analyze fully the risks from captives and the impact on insurers’ financial condition.”
The paper said that many states do not hold captives to the same standards as traditional insurers because captive insurance laws were initially developed to address self-insurance by corporations. Some states have allowed captives to fund their reserves with nontraditional assets, such as bank letters of credit and parental guarantees.
“Regulators have revised reporting standards to improve the public data, but gaps remain,” the paper said. The OFR, created through the Dodd-Frank Act, said the issue is important “because life insurers are a material part of the financial system, these gaps may mask financial stability vulnerabilities.”
Thomas Gober, a former regulatory insurance examiner who is in private practice as a fraud examiner, also has voiced strong concerns about a recent late change to the discussion draft of the National Association of Insurance Commissioner’s Credit for Reinsurance model law.
Gober made his comments in a paper he submitted to the NAIC in preparation for its summer meeting this week in San Diego. A hearing on the proposed model law was held at the meeting.
Gober argued that the proposed provision, if adopted, would codify the use of “captive reinsurance.” He adds that the language would allow insurance commissioners to authorize insurers to use as assets any “other securities” deemed to be credit-worthy. In sum, Gober fears use of these “other securities” would possibly be a “race to the bottom,” that would place policyholders, guaranty funds and other insurers at risk of loss.
The Iowa suit was by Joseph M. Belth, professor emeritus of insurance at Indiana University. It seeks access to documents that can be withheld through an Iowa law that Belth fears sanctioned “risky new life insurance industry practices.”
Belth said in his lawsuit that he believes the Iowa law allows insurers to provide “insufficient transparency” of their financial health, “thereby adversely affecting the interests of shareholders, policyholders, and taxpayers.”
The suit was filed Aug. 26 in Des Moines.
He wants access to documents that would allow him, as a member of the public, to have access to information and documents related to certain kinds of “now-secret financial instruments used in the life insurance industry.”
These policies, as interpreted by Nick Gerhart, Iowa insurance commissioner, allow insurers to hide “critical information from policyholders, shareholders, and the public of the life insurance companies’ “potential risks and also to lower the amount of capital that state regulators require life insurance companies to maintain,” Belth alleges in his lawsuit.
Belth characterizes captives — or any company created by another company to insure its own risks — so-called “shadow insurance.” In his suit, Belth said once issued by parent life insurance companies domiciled in Iowa to their “captive” or “shadow” wholly owned subsidiaries, also domiciled in
Iowa, “illusions of ‘excess’ capital are shown on balance sheets.
“Instead, parental life insurance companies can use the ‘excess’ capital to pay executive salaries and bonuses, to distribute shareholder dividends, to make acquisitions and to invest in other projects.”
Belth said in his lawsuit that “such schemes pose real risks to the public,” noting that existing and prospective life insurance policyholders and their beneficiaries rely on sufficient capital to pay benefits, and use of captives leaves shareholders unable to determine the true financial strength of life insurance companies. Moreover, the suit said, “taxpayers are left holding the bag when large life insurance companies fail.”
Belth also says in the lawsuit that the risks posed by shadow insurance are growing nationally, in large part due to practices allowed in Iowa and certain other states.
“Nationally, competing states have blocked the implementation of uniform insurance laws aimed to regulate the use of wholly owned subsidiaries to create phantom assets and to dissipate capital,” leaving open the “possibility that shadow insurance reduces risk-based capital and increases expected loss for the industry.”
Chance McElhaney, communications director and legislative liaison for the Ohio Insurance Division, said Wednesday that the department would have no comment “due to the pending litigation.”
This OFR report said that U.S. life insurers’ use of captives totaled $213.4 billion in “reserve credit” in 2014, the latest year for which data is available.
Reserve credit is the dollar amount of credit a “ceding insurer” receives by using reinsurance, the paper said, which decreases the ceding company’s required reserves by the same amount.
A little more than a third of the reserve credit backs higher-risk product lines, such as variable annuities and long-term care, the March report said.
The analysis revealed that U.S. life insurers’ use of captives totaled $213.4 billion in reserve credit. Reserve credit is the dollar amount of credit a “ceding insurer” receives by using reinsurance. Reserve credit decreases the ceding company’s required reserves by the same amount. A little more than a third of the reserve credit backs higher-risk product lines, such as variable annuities and long-term care.
The analysis also revealed that insurers disclosed the quality of assets for only 5 percent of term life and universal life policies with secondary guarantees (ULSG) captives, as measured by reserve credit, largely because of exemptions.
The paper also notes that for 2014, insurers were not required to report the impact of captives on their risk-based capital ratios. The risk-based capital ratio is one of the most important metrics for evaluating an insurer’s financial health, the report noted.
The report said that four states — Vermont, Delaware, Arizona, and South Carolina — host the majority of captive insurers.
Some captives hold mostly high-quality investments, but others hold “other assets,” the report said.
The report also raised alarms about asset quality, as noted by Gober, noting that “asset quality can vary even among captives of the same life insurer.”
The data also revealed that some captives report letters of credit from banks as assets, the report said.
The OFR paper noted that a letter of credit (LOC) may help a captive reinsurer meet its liabilities to a ceding insurer, but that LOCs can also result in maturity mismatches because the term of the letter of credit may be shorter than the term of the insurer’s liabilities to policyholders.
“If banks are unable or unwilling to roll over the letters of credit, the captives, ceding insurers, and policyholders may face risks,” the OFR report said.
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