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

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

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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.

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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

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David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.
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