COLUMN: Picture set to clarify for captive reinsurance regulatory muddle

November 24, 2015

By Lawrence Hsieh, Practical Law

NEW YORK, (Thomson Reuters) – The regulatory environment for captive reinsurance, the technique used by life insurance companies to leverage statutory reserves seen as redundant and free up capital for other purposes, may soon come to a head after being in flux since 2013 .

This is when the New York State Department of Financial Services (New York DFS) began a quest to protect policyholders and taxpayers and stamp out the practice, which it dubbed “financial alchemy.”

The National Association of Insurance Commissioners (NAIC), the private organization that provides regulatory support to state insurance regulators, rejected the New York DFS’ call for a national moratorium on the practice, and has responded with its own initiatives. The federal government also has weighed in and invoked the specter of “systemic risk” to prod state regulators. The coming year promises to be eventful as many of the issues raised by these and other stakeholders over the past couple of years start to play out.

A captive is a wholly-owned subsidiary formed to provide insurance exclusively to its parent company. Captives historically have been used by non-insurance companies such as manufacturers to self-insure risk that they deemed too expensive to insure otherwise. But captives and the regulatory environment for them have evolved over time to become part of the growing menu of financial innovations used by insurance companies to meet their alternative risk-management needs, including redundant reserve financing.

Many commentators use the term “alternative risk transfer.” However, the economic terms of many redundant reserve financing transactions require the ceding insurer (or its parent holding company) to remain on the hook (for example, via a conditional letter of credit backed by the parent rather than a third party) to pay policyholder claims if the captive’s lower reserves have been exhausted. In other words, the parent remains obligated even as the captive transaction diminishes the ceding insurer’s ability to absorb losses.

An insurer, like a bank, must meet capital adequacy standards and abide by statutory or regulatory reserve requirements. These reserves (“XXX reserves” for term life, and “AXXX reserves”, for universal life insurance policies) help to ensure that the premiums collected by the insurer will be available to pay policyholder claims. But insurers, also like banks, have the incentive to reserve as little as possible because they can harness the surplus to generate new business — by, for example, writing new policies or making new loans — pay dividends, invest in acquisitions or engage in other activities that quickly drive shareholder value.

A key difference between banks and insurers, however, is the nature of the regulatory environment. Bank capital adequacy is governed in the U.S. mainly by federal law such as the federal regulations that implement BASEL III and the Collins Amendment to Dodd-Frank. But insurance capital adequacy is governed by a patchwork of state law containing wide disparity in captive reserve requirements.

Another key difference? Bank regulators around the world have given at least lip service to regulatory harmonization. Insurance regulators vie for captive business by openly engaging in regulatory competition to manufacture regulatory divergence and catalyze regulatory (and financial accounting) arbitrage.

Regulators know that many insurers perceive the regulatory reserve requirements to be “excessive”. Whether this perception is reasonable is beside the point. The insurance sector has not (yet) faced an existential threat like the one that nearly took down the banks, even though the orthodox view is that the crisis was triggered by an behemoth insurer (AIG) that wrote credit default swaps for “naked” counterparties who had no insurable interest in (and in an notional amount vastly exceeding the value of) the underlying subprime loans.

Nor has there been widespread public indignation about reinsurance captives, despite the continuing efforts of the New York DFS to raise awareness. Contrast that with the moral outrage almost always generated by tax arbitrage techniques – such as carried interest, corporate inversions, master limited partnerships, REITs, and the only one on this list that is actually illegal – offshore tax evasion.

Regulators know that they can exploit insurer sentiment and public complacency by crafting off-balance-sheet, captive-enabling legislation that features some combination of low tax rates on captive reinsurance premiums, low barriers to entry, exemplified by low establishment fees for captives and especially, low reserve requirements compared to commercial insurers. They know that they can supercharge the impact of the reserve requirements by ring-fencing the domiciled captive — operating-company domiciles do not require the consolidated capital assessment of the entire enterprise.

Today, according to the NAIC, more than 70 jurisdictions around the world have enacted some variation of captive-enabling legislation. Popular offshore captive havens include some familiar names: Bermuda, the Cayman Islands, Guernsey, Ireland and Luxemburg.

In the United States, as expected, corporate law leader Delaware has captive legislation on the books. But Delaware is not alone. Nor is it the U.S. leader in attracting captives. That distinction belongs to Vermont, with Hawaii, Kentucky, Nevada and Utah in close pursuit.

According to 2013 figures, insurers and their affiliates based in New York, which has relatively strict capital requirements, have engaged in at least $48 billion of reserve financing transactions. The New York DFS calls them “shadow insurance” transactions. According to the Federal Reserve Bank of Minneapolis, shadow insurance business now exceeds traditional third-party reinsurance business by a comfortable margin.

Here are some of the captive reinsurance issues on the 2016 radar screen (there are important tax issues as well, and I will discuss them in a future post).

Federal regulation of the insurance industry

Percolating beneath the surface is the continuing tension about who gets to regulate the “business of insurance”. McCarran-Ferguson is the 1945 federal law that defends state laws from evisceration by federal laws that do not specifically relate to insurance. It remains the law of the land. As a result, the states remain the primary regulators of most kinds of insurance, including life insurance, with health care insurance being a notable exception. The Insurance Capital Standards Clarification Act of 2014 amends the Collins Act by confirming that capital adequacy standards for banks and insurance companies will continue to be bifurcated.

There is, however, increasing oversight of the insurance industry by a federal government concerned about systemic risk, for example, by the Federal Reserve, which has supervisory authority over systemically important nonbanks such as Met Life and Prudential. The Federal Insurance Office (FIO) has used its bully pulpit to make a series of recommendations to state insurance regulators about a variety of issues, including captive reinsurance, in reports including September’s Annual Report on the Insurance Industry.

For example, FIO has called for consolidated capital assessment, rather than the capital assessment of individual legal entities within an insurance group. It will be interesting to monitor how the states respond, because we have seen in other fields, for example, international tax, how easily multinationals can tweak their ownership structures to “remove” a company from the group without forgoing any of the benefits.

If the federal government becomes more assertive, it won’t be the first time. The government certainly has a track record of encroaching on business law matters that have historically fallen under state jurisdiction. For example, until Sarbanes-Oxley, corporate governance fell within the exclusive purview of state corporate law. In the latest salvo, the SEC announced a change to its interpretation of Exchange Act Rule 14a-4(a)(3) designed to thwart corporate inversions by enabling a kind of line-item shareholder voting for each material corporate governance change wrought by the transaction. While the SEC couched its language to cover only corporate governance changes that would require shareholder approval under state law if presented on a standalone basis, the pronouncement represents a further blurring of the lines between federal and state authority.

International framework for capital standards

Further complicating matters is the nascent effort by the International Association of Insurance Supervisors (IAIS) to create global capital standards for the insurance industry. The IAIS represents insurance regulators and supervisors, including FIO, from almost 140 countries. The IAIS adopted the Basic Capital Requirement in 2014, and is working to finalize a Higher Loss Absorbency Requirement, for Global Systemically Important Insurers. It is also working towards adoption in 2017 of the Insurance Capital Standard, which will not only apply to the big insurers, but also to the larger subset of Internationally Active Insurance Groups (large, internationally active companies that include at least one significant insurer).

IAIS efforts to harmonize insurance sector capital standards are akin to the well-known Basel Committee efforts to harmonize bank sector capital standards. Neither body acts with the force of law. Member countries can implement part or all of an accord through national legislation, and in a way that is either stricter or looser than the accord. The task of harmonizing bank capital standards around the world has been challenging, to say the least. Disparate state insurance agendas in the U.S. (the world’s largest insurance market) will surely make the task of harmonizing global insurance capital standards even more formidable.

Principle-based versus formulaic reserves

The New York DFS and a handful of other state insurance regulators favour a formulaic approach to setting minimum reserves. Many other regulators and most insurers find this too rigid and inconsistent with the standard reserving techniques that insurers employ to capture perceived economic risk.

In the meantime, the NAIC is taking steps to move towards principle-based reserving (PBR), which allows accredited insurers to set their own standards based on internal risk modelling tailored to the insurer’s particular portfolio.

The NAIC plans to begin a three year “implementation period” for PBR when at least 42 states (representing 75 percent of aggregate U.S. premiums) adopt the methodology set out in the NAIC’s Valuation Manual, adopted in 2012. Thirty-six states representing about 60 percent of aggregate U.S. premiums have adopted PBR legislation as of August, 2015. The NAIC’s goal is to reach the 42-state threshold by the end of 2016. The NAIC plans to conduct a PBR pilot project in 2016, which will evaluate and recommend any changes to be made to the methodology before formal implementation.

The NAIC hopes that the principle-based reserving will eliminate the incentive to offload reserves, because insurers can unilaterally adjust the standards to eliminate any perceived redundancies. The question is whether state regulators have the ability to keep pace with the shifting actuarial nuances of complex risk modelling. The formulaic approach is rigid, but at least everybody can see the line in the sand. PBR, however, may give insurers an incentive to hide risk through obfuscation. It is easy to see how overwhelmed regulators might be star struck (and therefore “captured”) by insurance company executives who call on them with their “failsafe” algorithms. The resulting uneven supervision and selective enforcement of PBR could trigger even greater divergence (and arbitrage) than the formulaic approach.

Actuarial Guideline 48

As the the NAIC promotes the deregulation of reserve financing through PBR, it at the same time is implementing a captive framework that includes Actuarial Guideline 48 (AG 48). AG 48 aims to regulate reserve financing by dictating the types of assets that can be used to secure the economic reserve layer (high-quality) and the excess “redundant” layer (lower-quality) of the transaction without actually repealing the statutory reserve requirements. AG 48 applies to all XXX/AXXX reserve financing transactions entered into after January 1, 2015.

AG 48 has been billed as a preliminary step towards PBR, and its sunset is tied to the implementation of PBR. As PBR is a work-in-progress, it will be interesting to see in 2016 how the two approaches converge.

(Lawrence Hsieh is a senior legal editor for the Practical Law division of Thomson Reuters. The views expressed in this column for Thomson Reuters Regulatory Intelligence are his own. Lawrence is a graduate of the University of Chicago Law School and holds an engineering degree from Cornell University. Lawrence is the author of the Corporate Transactions Handbook.)

(This article was produced by Thomson Reuters Regulatory Intelligence and initially posted on Nov. 13. Regulatory Intelligence provides a single source for regulatory news, analysis, rules and developments, with global coverage of more than 400 regulators and exchanges. Follow Regulatory Intelligence compliance news on Twitter: @RiskMgment)

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