Iowa lawsuit sounds the alarm about captive insurance

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.”

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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.”