NAIC studies ‘shadow’ as AIG, MetLife lead insurers in ceding reinsurance

Investigations launched in tandem with NY Department of Financial Services

By Sean P. Carr and Wayne Dalton
Reprinted with permission from SNL Financial


Five of the nation’s largest life insurance companies have ceded more than half of their reinsurance loads to affiliates, stoking fears that a potential “shadow insurance industry” is emerging.
Life insurers are assigning increasing shares of their reinsurance load to their own captives, special purpose vehicles and other affiliates, according to SNL data. Industrywide, the share of reinsurance ceded to affiliates increased to 49.61% in 2011 from 35.57% in 2006 — up nearly 40%. The total amount of life insurance reinsured increased to 55.96% from 45.07% over the same period.
Several of the largest life insurers in the U.S. saw substantial increases in affiliate-ceded reinsurance over those five years. MetLife Inc.’s percentage of reinsurance ceded to affiliates leapt from 26.72% to 71.88%. Protective Life Corp. roughly doubled its portion, from 15.17% to 32.30%. Pacific Mutual Holding Co. went from having none of its reinsurance load with an affiliate in 2006 to 32.79% in 2011. The share of American International Group Inc.’s life business, which already stood well above rivals at 67.85% in 2006, climbed to nearly 80% in 2011.
The NAIC and the New York Department of Financial Services have launched investigations into the practice of ceding reinsurance to affiliated captives. The NAIC is soliciting comments through Nov. 16 on a draft white paperfrom the Captives and Special Purpose Vehicle Use Subgroup. New York officials declined to comment on the status of their inquiry.
The NAIC subgroup used unusually energetic language to establish its reasons for studying the issue. Right at the top of the draft, it referenced the role of a “shadow banking system” in fomenting the financial crisis. The paper describes an increased use of captives and “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.”
As expressed in the paper, one concern of regulators is uncertainty over how this shift affects the financial health of the industry. Each of the captive domicile states has some form of confidentiality requirement embedded in state law. Six states and Washington, D.C., do not require that filings be made with the NAIC.

Shadow of doubt

The “shadow” phrasing may have been an overstatement, Rhode Island Insurance Superintendent Joseph Torti III told SNL. “This wasn’t done behind the backs of regulators,” said Torti, who chairs the NAIC’s Financial Condition Committee, to which the subgroup reports. “The increase in activity is something that should be looked at, and we are looking at it.”
The subgroup is seriously considering what steps it can take to address the reasons insurers are looking to captives and other affiliates for their reinsurance, Torti said. One proposal is to focus on accounting and reserving issues at the ceding company level, addressing perceived reserve redundancies. A stepped-up commitment to principles-based reserving would also phase out this issue, Torti said, though the draft paper cautions that such captives and SPVs could remain in place for years or decades.
“Perhaps we don’t need that complexity and the added cost to solve this problem,” Torti said.
Regulators are looking to prescribed or permitted practices or to the new approach for Actuarial Guideline 38 as possible models, according to the draft. An AG38-like approach would still leave questions. A Principal Financial Group Inc. representative cited uncertainty over implementation of AG38 as a reason for a lack of clarity on what the impact of regulators’ captive inquiry could be.
Fair concerns exist and caution is warranted, but any risk is overstated, said Albert Pinzon, a partner with the law firm Edwards Wildman Palmer LLP. “The language tried to make comparisons to what happened in the banking industry, which are not necessarily proper comparisons,” he told SNL.
Pinzon, who represents life companies and others that make use of special purpose vehicles, said an important question is whether these captives represent a true transfer of risk and accordingly deserve surplus relief — and, generally speaking, they do, he said.
The subgroup received 35 responses from state regulators to a request for information about commercial insurers in their jurisdictions that transfer risk to captives or special purpose vehicles domiciled both within and outside the U.S. According to the paper, nine of those 35 states reported that their laws do not define what makes a captive. More than 30 states and jurisdictions currently allow the establishment of captives.
While captives were originally created as a means for noninsurance companies to insure their own risk, their use by life insurers in particular includes stark differences, according to the draft paper. As insurers expanded the use of special purpose captives for reinsurance, life companies used these vehicles to gain the benefits of securitization and access alternative capital sources.
Commercial insurers are not permitted to use letters of credit as admitted assets. However, letters of credit can be considered admitted assets for captives, when used to support statutory reserves in excess of economic reserves, according to the paper. There is, broadly speaking, a growing concern about long-range risks for the industry, particularly given economic uncertainty in Europe and the U.S., said Mike Nelson, chairman of the law firm Nelson Levine de Luca & Hamilton LLC, which represents domestic and global insurers.
The system of state guaranty funds has served well, but Nelson said he understands regulators’ concerns. “No one company wants to pay the bill of some other company,” he told SNL.

Fundamentally different captives

The NAIC subgroup used unusually energetic language to establish its reasons for studying the issue. Right at the top of the draft, it referenced the role of a "shadow banking system" in fomenting the financial crisis. The paper describes an increased use of captives and "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

Captives and SPVs owned by commercial insurers are fundamentally different from captives used by non-insurance companies and should be subject to public disclosure, some subgroup members argued. Insurers compete with one another in part on the basis of their financial strength, they noted, and this information is needed to provide a broader picture.
Members did not reach consensus, however, on what steps should be taken. Those arguing in favor of confidentiality maintained that many insurers’ captives are used for a single transaction. Greater reporting of these would make for easy access for competitors seeking data on the economics of these transactions.
One question raised by the paper is whether accounting and reporting rules for the affiliated entities should be different from those of the commercial insurers if the business transacted by the captive is the assumption of commercial risk from the commercial insurer. “This question is posed since the concern is that such transactions may be consummated, in part, to provide relief from statutory accounting,” according to the draft.
MetLife, which led all U.S. life insurers with $22.89 billion in direct premiums in 2011, saw a 169% increase in the percentage of reinsurance ceded to its affiliates over five years, according to SNL data. The company engages in captive reinsurance arrangements to reduce the impact of “redundant or non-economic reserve requirements for certain universal life and term life insurance business,” spokesman John Calagna told SNL. The consequences of financing the reserve requirements with equity would be stark, he said.
“Such an outcome would result in significantly higher cost to both policyholders and shareholders, or could result in limiting the ability of MetLife to continue to offer universal life and term life insurance coverage at all,” Calagna said. Perhaps regulators should consider changes to model acts to help ensure that insurers are practicing a true transfer of risk, Pinzon said. “The life industry has done pretty well in meeting its obligations to policyholders,” he said.
The American Council of Life Insurers is reviewing the white paper, a spokesman told SNL.
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