Captive SPVs: Shadow industry or necessary tool for life insurers?

November 21, 2012 at 05:34 AM

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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.

However, the question that has been raised is whether a more appropriate treatment of such transactions would be to deal with the accounting for this transaction within the ceding company, thereby eliminating the need for the separate transaction outside of the commercial insurer.

Members of the subgroup have been hotly debating the topic this year; subgroup members were originally unable to reach a consensus view on the transparency and confidentiality section of the white paper.

The subgroup agreed that confidentiality is warranted for pure captive transactions because there is generally no public interest in their business plan. However, for captives and SPVs owned by commercial insurers that cede insurance risk, the subgroup had disparate views on the level of confidentiality that was needed for such transactions, the white paper disclosed. Some regulators worried about state laws that might prevent disclosures or create competitive disadvantages should a company's proprietary finances or credit commitments and unusual circumstances could have a material impact on the economics of the credit facility. Others noted that consumers and other users need, in order to make good decisions on a company's financial strength, should have access to information about the insurer's reliance upon captives and SPVs to make informed decisions about it.

The subgroup has also made changes to the summary and conclusion of the white paper after discussion among regulators, most notably the recommendation that the parent committee, the Financial Condition Committee, form another NAIC subgroup to develop possible solutions for addressing the remaining perceived reserve redundancies between the XXX and AG 38, respectively.

In a regulatory discussion in mid-October hosted by the subgroup, Steve Kinion of the Delaware Captive Bureau expressed concern with a statement in the introduction suggesting that the captive insurance industry is a shadow industry and equating it to the shadow banking industry. Kinion, according to minute notes, stated that a shadow industry is unregulated and captive insurers are regulated. He said his concern was that an individual unfamiliar with the insurance industry would form a negative opinion of the captive insurance industry.

Subgroup Chair Doug Slape, chief financial analyst, Texas Department of Insurance, countered that regulators could not ignore the fact that there have been statements in the press that a shadow industry could emerge.

Some of the state regulators on the subgroup have been ones that previously expressed concern about AG 38 and principles-based reserving developments.

The Affordable Life Insurance Alliance (ALIA), established in 2005 to promote and modernize life insurance reserves through a principles-based reserving approach, stated it strongly supports the use of captives by life insurers.

Scott Harrison, executive director, said that "companies need to have the flexibility to adapt their risk management strategies to changes in the marketplace. In the current environment, companies need more options, not fewer, and U.S.-based captives that are subject to state regulation are a safe and effective risk management tool."

ALIA, which also was heavily involved in the AG 38 reserving issue that cut to the core of some life insurance companies' reserving methods, making necessary a regulatory fix for actuarial reserving, disagreed "with any suggestions that the current regulatory framework or oversight regarding the use of affiliated captives is somehow inadequate, or that companies have engaged in these transactions for reason other than effective risk management."

The American Council of Life Insurers (ACLI) took issue with the characterization of captives as a 'shadow insurance industry,' which it says is a term coined by the press.

"These characterizations are unfair to insurance regulators and to the regulated industry. They imply that captive transactions occur without regulatory scrutiny and approval," stated the letter by Bruce Ferguson, state relations, ACLI, and Carolyn Cobb, associate general counsel.

The ACLI also said that despite principles-based reserving, seen by the subgroup as a method, when adopted, to deal with reserve redundancies, captives will still be needed.

The ACLI also recommended—in much the same way that, at the industry's behest, the AG 38 issue was lifted from the task force level of actuaries to a joint working group reporting to the Executive Committee—that a multidisciplinary working group form and that the working group be led by commissioners under the auspices of the NAIC Executive Committee.

To wit, the prospect of contracts with inadequate reserves for universal life with secondary guarantee policies (USLG) led some regulators, as the NAIC wrote, to bring the issue to the Life Actuarial Task Force (LATF), which issued a statement on AG 38 in September 2011 to caution about the possibility of some insurers holding "reserves [that] do not properly reflect the full benefits of the secondary guarantee as required by the law, regulation and guideline."

During the NAIC 2011 Fall National Meeting, the Executive Committee, due to the interpretive differences on this issue, forwarded the statement to the newly established Joint Working Group of the Life Insurance and Annuities Committee and Financial Condition Committee to examine the adequacy of the reserve requirements for ULSG and term universal life (UL) products.

The NAIC adopted a motion to adopt a bifurcated approach to in-force and prospective business in concept; and exposed two proposed alternative revisions to AG 38 regarding the in-force business, one a Principles-Based Reserve Base, and the second a valuation Interest Rate Reserve Base where the reserving methodology historically used by the company is compared to a gross premium reserve that incorporates as the reinvestment return rate assumption the maximum valuation interest rate under the Standard Valuation Law for the year of issue of each policy (expected to be 4 percent for most policies). The industry was not displeased.

The formation of such a group for captives and SPV takes it out of the hands of regulators, like those in New York and Rhode Island, sounding the alarm on reserves.

The subgroup will meet to discuss the white paper and air comments at the Fall National Meeting on Thursday, Nov. 29 at the Gaylord Convention Center at Maryland's National Harbor.

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