As part of its new role under Dodd-Frank, the Federal Reserve is responsible for regulating life insurance companies that have been designated as systemically important financial institutions (SIFIs), but according to Chicago-based Fitch Ratings the Fed might be taking a look at how life insurance companies of all sizes use captive insurance for risk management.

Federal Reserve Fed FOMC

RBC Capital Markets analysts Eric N. Berg and Bulent Ozcan organized a series of meeting between investors and experts at Fitch, including Doug Meyer, the head of life insurance analysis at Fitch, who mentioned a recent Fed white paper that was critical of life insurance companies’ use of captives (wholly-owned insurance companies that have other subsidiaries as clients).

“That, Mr. Meyer said, indicates to him that the Fed has interests in the life business extending beyond just managing the Goliaths of the business,” write Berg and Ozcan in an April 7 report. “The Fitch executives didn’t provide any details, including critically answering the question under what power the Fed would regulate insurers that aren’t SIFI’s.”

Captive insurance companies may have to disclose more about collateral

As the RBC analysts point out, it’s not clear that the Fed has the authority to directly regulate life insurance companies that haven’t been designated as SIFIs, but it could still use its considerable influence get other regulatory bodies involved. Captive insurance companies have also drawn fire from Benjamin Lawsky, New York State’s head of the Department of Financial Services, among others. If the Fed argues that captive insurance companies as they currently exist makes it difficult to judge and manage systemic risk, and other state regulators support its argument, it could act as a catalyst even if it can’t act directly.

Meyer told investors that the most likely outcome is that captive insurance companies will be requires to disclose more information about their balance sheet health and financial results, possibly causing captives to become more conservative in the collateral used to back liabilities.

Captives make capital positions ‘incomparable’: Fitch

While the Fed might be overstepping what it’s supposed to be doing under Dodd-Frank, it also sounds like captive insurance companies do make it difficult to judge a life insurance company’s credit worthiness.

“Mr. Meyer told the group in Chicago, that Fitch increasingly is not using risk-based-capital as a measure of financial strength, citing the presence or absence of captives at one company as making its capital position incomparable to that of rivals,” write Berg and Ozcan.

Even when two companies both have captives, not knowing how the quality of their collateral compares to the other competitors makes it difficult to give accurate side-by-side comparisons of their credit worthiness. If one of the big three ratings companies doesn’t know what to make of life insurance companies that use captives, it’s not surprising that the Fed is becoming critical.