The Real Deal on Captives

Superintendent Joe Torti, III (RI)

Systemic/Stability Concerns – Pt. 1

•Federal agencies and the media have expressed potential systemic/stability concerns with captive transactions▫FSOC, FIO, Federal Reserve, OFR

•Initial Response: Do not paint with a broad brush! The Differences Matter!▫“Pure” Captives vs. Captive Reinsurance▫XXX/AXXX vs. Variable Annuity vs. Long

Term Care vs. ?? Risks and concerns differ by type and even by

transaction

Consistent Solvency Framework•Insurance types and transactions differ

much more widely than banking transactions

•NAIC Solvency Framework establishes a consistent baseline of accounting to enhance comparability and efficiency, yet allows flexibility through Permitted/Prescribed Accounting Practices ▫Disclosure of impacts to Net Income and

Surplus to retain comparability

Regulatory Flexibility

• Regulation involves judgment▫More variety in insurance products requires

more flexibility for the regulator; Tailoring the regulation to the specifics of the

product/transaction to increase effectiveness▫NAIC Solvency Framework includes various

checks and balances to discourage outlier judgments Information sharing with licensure states, e.g.,

permitted accounting practice requests Transparency via significant disclosures Financial Analysis Working Group review NAIC Accreditation program

Flexibility vs. Arbitrage

•Such flexibility can turn into concerning regulatory arbitrage when two somewhat similar insurance risks, transactions, etc., are treated very differently▫Unlevel playing fields can occur▫Must assess if solvency protection is adequate▫If you add a lack of transparency on top of the

unlevel playing field, it makes it more difficult for regulators and other market participants to Compare transactions/insurers/groups Assess industry dynamics

How Did this Captive Situation Occur?

• NAIC Accreditation baseline for multi-state insurers▫ Baseline statutory accounting in NAIC Accounting

Practices & Procedures Manual – usually more conservative than GAAP Permitted/Prescribed differences are allowed but must

disclose impact on Net Income and Capital & Surplus in Note 1 of public financial statements

▫ Capital Requirements – fixed $ and RBC▫ Reinsurance Transactions Reviewed and/or Approved by

Regulator; Collateral Requirements; Material Transactions, etc.

• Captives were historically used by corporations & non-profit organizations to self-insurer risks (pure captive)

• Captives were excluded from NAIC Accreditation using the traditional “pure” captive concept▫ Developed outside of NAIC process since self-insurance

NAIC Priority • Life insurers more recently began to use captives

to reinsure third party risks—so called captive reinsurance transactions

• NAIC priority of reviewing captive reinsurance:▫XXX\AXXX Transactions (i.e., Term Life and

Universal Life)▫Variable Annuities▫Long Term Care▫Other Business Types?

• Risks differ based upon policy type; depends upon the nature of the potential regulatory arbitrage▫Regulatory response will need to differ as well

XXX/AXXX Captive Reinsurance

•Similar issue – redundant (excess) reserves•Similar structure in arbitrage solutions

▫Economic reserve level supported by normal, high quality assets (admitted assets)

▫Remainder of formulaic reserve supported by other security (e.g., LoCs, Parental Guarantees)

•Details differed by state with no correspond-ing differences in product designs, transaction structures = potential for concerning arbitrage

Regulatory Review•XXX/AXXX captive reinsurance transactions

reviewed/approved by state of domicile of the ceding insurer as well as the captive reinsurer▫Solvency assessment was performed▫If the regulatory actuary agreed the economic

reserve was an adequate reserve, including an appropriate level of conservatism, then no solvency concern

•NAIC established consistent analysis procedures for all XXX/AXXX captive transactions – Accreditation Requirement

Additional Point on Solvency with XXX/AXXX Captive Transactions

Ceding Insurer w/o

Captive

Ceding Insurer w/

Captive

∆ to Formulaic

Reserve for Ceding Insurer

Admitted Assets $ 100 $ 100 - $60= $40

$ 100

Non-admitted “Assets”

Formulaic Reserve $ 100 $100 - $100= $0

Conservative “Economic” Reserve

$ 60

Surplus $0 $40 $ 40

Consistency and Transparency

•Thus, NAIC response is to tackle the problems of concerning regulatory arbitrage▫Lack of consistency with similar products/ transactions

And▫Lack of transparency

1/1/2015 and Beyond

•AG 48 requires Qualified Actuarial Opinion if new transactions do not meet its provisions

•Prior transactions not covered▫But are covered by consistent analysis

procedures and transparency requirements for the ceding insurer

▫Not a solvency concern if actuarial and financial analysis do not identify concerns; just not consistent in the transaction structure

VARIABLE ANNUITY AND LTC CAPTIVE TRANSACTIONS• Financial Condition (E) Committee will consider any

appropriate modifications to solvency framework▫ After studying the reasons for and nature of the

transactions• Financial Regulation Standards and Accreditation (F)

Committee has adopted revisions to multi-state definition for XXX/AXXX, variable annuity and LTC captives▫ Captives assuming business that was written in more than

one state by the ceding insurer would be included in the Accreditation standards as multi-state Insurers XXX/AXXX captive cessions meeting the NAIC Framework result in the

captive being deemed in compliance with Accreditation requirements

▫ Regulators will need to decide on retroactivity for any regulatory change Variable annuities do not have the contractual language issues of older

life insurance policies, but it might be difficult to address without having bifurcated approaches to allow time to unwind existing hedges against statutory require-ments as opposed to the more preferred economic risk management hedges

Systemic/Stability Concerns – Pt. 2• SIFI designation was designed to identify non-

banks including insurers with potential to “threaten” US financial stability

• FSOC believes utilization of captive reinsurers can potentially increase concerns for a SIFI▫We say risks must be assessed for each

transaction; captive reinsurance is not always a stability issue

• Lack of consistency and transparency undermine confidence in the national system of state-based insurance regulation, causing these concerns