Captive Insurers: The Wrong and Right Way to Reign them in

Sometimes, when I see an insurance article that could be big, relevant, and tough to explain, I say to myself, “Dave, you’re going to have to write about that.”  But now, I get requests via email to write about it. So tonight I write about the New York Department of Insurance’s attempt to rein in captive insurers.  [Long report here.]  My first question to the department would be: “What took you so long?  These issues have been known for years.”

Captive Insurers: The Wrong and Right Way to Reign them in

I write this as one that in general admires the New York Department of Insurance.  They are the toughest regulator of insurance in the US.  If I could have my way, I would replace the Federal Insurance Office (“FIO”) with the New York Department of Insurance, and let New York regulate the country.  But that can’t happen.  Insurance is regulated by the states.  As a result, if some states are liberal with respect to reserving practices, companies can set up reinsurers there, and shed reserves to a state that allow the reserves to be lower.

Now, why does this happen with respect to life insurance, and not other insurance?  There are complexities in the regulatory [“statutory”] reserving where the statutory reserving does its estimates such that every advantage a policyholder has versus an insurer gets used against the insurer.  That makes the reserve high.  But on average, policyholders aren’t that smart; the reserves should be lower.  Should they be as low as the GAAP reserve, which is supposed to be conservative and realistic?  That seems to be the goal of many insurers.

Life insurance is long in duration, which means small differences in assumptions can make relatively large differences in the reserves.  That’s why you only see it in life insurance.  This happens with long-dated term insurance, universal life, and any product that guarantees that are not core to the product, and are hard to calculate reserves as a result.

But what about mutual versus stock companies?  First, let’s take a step back.  Why does statutory accounting matter?  It matters because it affects the ability of regulated insurance companies to dividend money to their holding companies.  The lower statutory reserves are, and the lower risk-based capital requirements are, the more that can be dividended, and the greater the flexibility of the enterprise.

Mutual life companies typically have more capital than they need, and they do not have a claimant on the excess (unless it is management, and that is quiet, slow, through the pension plan, the hidden plans, etc. Shh.)

Stock Life companies have to optimize their capital to compete against everyone else.  Sorry, but that is the way it is.  Let’s move to the recommendations of the NY Insurance Department:

Given the troubling findings uncovered during its investigation, DFS [Department of Financial Services] is taking immediate action and making several recommendations to address the potential risks and lack of transparency surrounding shadow insurance:

  1. Through its authority under New York Insurance Law, DFS will require detailed disclosure of shadow insurance transactions by New York-based insurers and their affiliates.

  2. In the interest of national uniformity, the National Association of Insurance Commissioners (“NAIC”) should develop enhanced disclosure requirements for shadow insurance across the country.

  3. The Federal Insurance Office (“FIO”), Office of Financial Research (“OFR”), the NAIC, and other state insurance commissioners should conduct similar investigations to document a more complete picture of the full extent of shadow insurance written nationwide.

  4. State insurance commissioners should consider an immediate national moratorium on approving additional shadow insurance transactions until those investigations are complete and a fuller picture emerges.

Number 1 is a given.  New York can do that on its own.  New York could unilaterally refuse to give reserve credit to any reinsurance agreement they think is not creditworthy.  But that comes with a cost: native New York insurers might leave, and leave behind a small New York only “pup” insurer.  (Imagine Metlife decamping to New Jersey, and AXA’s American subsidiary also.)  That’s what most insurers do, because New York is a tough state for insurance.  If the size of the New York insurance industry shrinks, so will the New York Insurance Department.

Number 2 is not a given.  There are a number of states that benefit from looser regulation.  The NAIC only advises & proposes; it does not create law.

Number 3 could be done, but will they do it?  There are many other issues that press.  The states that benefit from captive insurers will not want to cooperate.

And for the same reasons as 2 & 3, 4 will not likely succeed.  Not everyone has the same incentives here.  New York is engaging in bluster.

What Would I Do?

  1. I would take the risk, and disallow reserve credits from companies in locales that don’t regulate insurance well.
  2. I would disallow the use of surplus notes for stock companies.  With stock companies, it is just a hidden form of leverage.
  3. I would eliminate all surplus relief from reinsurance treaties that do not rely on “diversifiable risks.”  If it is merely shifting a nondiversifiable risk, offer no reserve credit.  The company should bear that itself.

Insurance CEOs can be glad I am not their regulator; they would have a tough time under me.  There is nothing that they know that I don’t.  That said, the New York Department of Insurance will have a a hard time making their ideas work, unless all the states agree with them, and that is not likely.

By David Merkel, CFA of Aleph Blog