XXX financing market braced for increased captive scrutiny

A no-holds-barred fight is raging between US insurers and regulators over the future of reserve financing. The furore centres on redundant reserves – the additional statutory reserves for certain life products that go above and beyond what insurers’ internal economic models deem prudent – and the methods that US firms are deploying to fund them.

Yet, in this conflict, the battle lines are far from clear, with some state regulators taking the insurance industry’s side, while others are taking a stand against them. And to add to the ruckus, the National Association of Insurance Commissioners (NAIC), the US standard-setting body, has been consulting on insurers’ use of captives and special-purpose vehicles (SPVs) amid concerns over their role in the financing of redundant reserves.

The NAIC’s consultation, which closed on April 29, 2013, comes at a pivotal moment for US insurers. New structures for financing redundant reserves are being developed by insurers and reinsurers, as the reserve financing market continues to grow, reaching $15 billion (£8 billion) in 2012. The outcome of the NAIC’s work could have far-reaching consequences for the insurance industry in the way in which redundant reserves are financed.

Redundant reserves have been an issue for US life insurers for more than a decade (see below). The NAIC’s Model Regulation XXX requires insurers to establish heightened statutory reserves for term life insurance policies with long-term premium guarantees. Similarly, Actuarial Guideline XXXVIII (more commonly known as Regulation AXXX or AG 38) requires insurers to establish heightened statutory reserves for certain universal life insurance policies with secondary guarantees.

Initially, bank-issued letters of credit (LOCs) were the most popular solution for financing these reserves. From 2003, securitisations offered an alternative funding solution to US insurance companies. However, since the 2007–08 financial crisis, LOCs have resumed their position as being the favoured funding option.

Market participants say financing structures are evolving and that interest in securitisations is once again growing. Many banks, which were quite happy to finance highly-rated insurers without hedging the counterparty risk in previous years, are now looking to repackage and sell on their exposures to others.

“The typical structure over the last few years has been banks providing insurers with LOCs to finance the redundant reserves,” says Nardeep Sangha, London-based global head of life and health risk transformation at Swiss Re. “Now, the trend we are seeing are banks turning to the reinsurance market to hedge their risks, and synthetic or contingent structures are being developed directly between insurers and reinsurers to dis-intermediate the banks,” he adds.

Some reinsurers are now providing credit-linked notes via a subsidiary (usually offshore) or affiliate backed by a parental guarantee, which an insurer can then bank as regulatory capital. Reinsurers are also working in partnership with banks, offering insurance wrappers to LOC transactions to protect the bank from the mortality risk.

Jorge Fries, managing director in the securitisation group at Crédit Agricole CIB in New York, comments: “From 2008 through 2011, XXX and AXXX financing was a bank-dominated market. Since then we have seen the bank market continuing to be active, but with increasing competition from the reinsurance market.

“In addition, some of the capital markets solutions that are evolving are seeing banks repackaging letters of credit into notes that are sold to ILS [insurance-linked securities] investors who are increasingly keen to invest in life insurance-related risks as well.”

The extreme mortality-risk exposure inherent in A/XXX securities is attractive to ILS investors as it diversifies the large amount of property and casualty catastrophe risk they hold.  

“Seventy per cent of the ILS market is US wind and earthquake risk. The risk profile for an XXX security is different. While a cat bond tends to be BB-rated providing relatively high risk and reward to ILS investors, a XXX repackaged deal is typically rated AA – so the risk and return is commensurately lower for the investor. Any risk that diversifies that exposure is a good thing for them,” says Fries.

Yet there are several factors that suggest it would be premature to say securitisations are back in vogue. The first is that ILS investors need to become better acquainted with the risk profile of the policies wrapped up in these securitisations. While life investors will be familiar with the mortality risk embedded in an XXX portfolio, they need to be careful when it comes to those policies with secondary guarantees. “When you move into the AXXX space there are some more risks involved in terms of potentially having lapse or prudential market risk embedded in the structure as well,” says Sangha at Swiss Re.

A second and greater problem is the NAIC’s white paper on captives and SPVs. The association is gunning for the domestic industry over its employment of captives to fund XXX/AXXX reserves amid concerns that insurers are using these structures effectively to evade statutory requirements.

A telling line from the draft white paper, released for public consultation on March 14, reads as a shot across the industry’s bows: “The practice of using a different entity or different structure outside of the commercial insurer to engage in a particular activity because of a perception that the regulatory framework does not accurately account for such activity should be discouraged.”

The paper goes on to recommend the NAIC explore the accounting and reserving issues within companies to eliminate the need for “separate transactions outside of the commercial insurer”.

The captives question has already had some impact on US reserve financing, causing the XXX market to begin to slow, explains Dan Knipe, London-based life portfolio manager at Leadenhall Capital Partners, an ILS specialist with $1 billion assets under management.

“Insurers are waiting to see what the NAIC says on the use of captives, because the last thing you want to do when there’s all this regulatory talk is invest money in setting up a captive and work with a bank to capitalise it, only for the NAIC to say we don’t like these anymore.”

The NAIC consultation on the white paper closed on April 29 and the future of captives and SPVs hangs in the balance. If the association introduces a model law that bans their use, there could be significant ramifications for the XXX financing market. Investors are attracted to these structures for the very reason that the risks are ring-fenced within the captive and are not exposed to other risks inherent in the insurance company. Take away the captives, and regulators take away the market, critics say.

Steve Schreiber, principal and consulting actuary at Milliman, based in New York, says any ban on the use of captives and SPVs is unlikely and that moves to increase disclosure are more likely to be introduced. “There are all kinds of discussions going on out there. Some have suggested banning the use of captives, although I’d be surprised if that happens. I expect it’s more likely that we’ll see more disclosure and more transparency over their use,” he says.

State regulators, and even members of the NAIC subgroup working on the proposals, are at loggerheads over the issue. Different state commissioners hold wildly divergent views on the practicalities – and even ethics – of captive or SPV use.

Connecticut insurance commissioner Thomas Leonardi is one who falls into the pro-captives camp. “The utilisation of SPV/captive transactions needs to be placed in proper context. These transactions are ‘tools’ for capital management, and not techniques to avoid statutory accounting rules. We believe the majority of these vehicles are designed to provide additional capital that is needed to back the products offered by insurance companies – and demanded by consumers,” he says.

Florida’s commissoner Kevin McCarty also recognises their value, pointing out the use of captives and SPVs in Florida’s catastrophe insurance market.

Yet other state regulators are downright hostile towards them. New York superintendent of financial services, Benjamin Lawsky, has referred to captives as “shadow insurance”, which places the stability of the broader financial system in jeopardy. “Insurance companies use these captives to shift blocks of insurance policy claims to special entities – often in states outside where the companies are based, or else offshore (for example, the Cayman Islands) – in order to take advantage of looser reserve and oversight requirements,” he said at a conference in New York City on April 18.

Under Lawsky, New York is already clamping down on captive use. In July last year, the Department of Financial Services mandated all life insurers in the state to disclose information on their use of captives, including the amount of statutory reserves transferred to a captive reinsurer and the change in the parent’s risk-based capital as a result of such transactions.

Perhaps this might be a model rolled out across the country once the white paper is finalised. A number of industry bodies are keeping close tabs on its development. Scott Harrison, executive director of the Affordable Life Insurance Association (Alia) in Washington, DC, says: “Companies need to have the ability to obtain balance sheet relief with respect to the excessively redundant reserves associated with these products. But we also understand that regulators need to understand these transactions. We think the discussion ought to be around giving regulators more comfort in dealing with these transactions.”

The future of US captives hinges on three points, according to Alia. These are: transparency, confidentiality and uniformity. “The transparency issue for the regulators is that under current law the only states that have access to information about the transactions are those directly involved in reviewing and approving the captive. We would support enhanced transparency and information-sharing on a confidential basis among the states,” says Harrison.

Uniformity of captive regulation is also something both industry and supervisors seem to support. At present, 25 states do not recognise SPVs in state law, making a coherent, nationwide approach to regulating them difficult. In addition, while 27 states indicated in a request for information from the NAIC that they allow insurance risks to be transferred from a domestic insurer to a captive or SPV in their respective states, only 12 placed limitations on the types of products that can be transferred.

In a letter of recommendations sent to the chairman of the NAIC’s captives and SPV use subgroup by Bruce Ferguson, senior vice-president, state relations, at the American Council of Life Insurers, it was suggested that regulators develop a uniform analytical framework to provide consistency in regulatory reviews of captive transactions. The council also recommends such a framework be incorporated in the Financial Analysis Handbook, a supervisory resource published by the NAIC.

Harrison at Alia believes this would be a sensible solution. “One of the concerns raised by some regulators is the lack of uniform standards concerning these special-purpose captives. I’ve had some commissioners express this to me – we would be more comfortable if we knew that what other states are doing is consistent with our approach and vice versa,” he says.

Transparency and confidentiality, however, are more toxic issues. There are mixed messages within the NAIC itself on the matter, particularly on the extent to which captive transactions should be brought out in the light of public scrutiny.

The draft white paper makes no attempt to hide dissension in the ranks. One section reads: “Some subgroup members indicated that confidentiality is needed, and that state laws often require it… [but] some subgroup members expressed questions about the need for confidentiality and were supportive of public disclosure of at least some level of information.”

Even on regulator-to-regulator confidentiality there are signs that the road to agreement will not be smooth. “Right now the captive domiciliary states are taking the position that we cannot share, even with other regulators, information about these transactions. We support changes to existing captive laws that would allow discretionary regulator-to-regulator information-sharing about these transactions and about these structures,” says Harrison.

This is likely to be one of the key issues that will be thrashed out in the next round of negotiations over the white paper.

There are fears, however, that the longer the debate drags on the less willing insurers will be to wait to explore new ways of dealing with their A/XXX reserves. Leadenhall’s Knipe remarks that the NAIC has been vacillating on the issue for around a year already, and that many firms are running out of patience.

“It is getting to the state where the insurers feel they just have to do something. The NAIC gives the model guidance, but the individual state regulators choose how to adopt and implement it. Sooner or later someone is going to say ‘I can’t sit around waiting for the NAIC’, and at that point they’ll just go to a state regulator and say ‘can we do this deal?’ The state regulator may approve it, and then others, encouraged by this example, will follow.”

In a competitive marketplace, faced with a low-yield investment environment, holding liquid capital against redundant reserves is a luxury most insurers cannot afford. The life ILS market may be on the rise again, and the NAIC will have to work fast to adapt to the challenge before individual regulators take matters into their own hands.

XXX boost to life ILS

Since Regulation XXX and Actuarial Guidance XXXVIII (AXXX) were issued by the NAIC over a decade ago, life insurers have been required to hold large reserves to cover exposures on universal life policies with secondary guarantees and term universal life products, reserves that insurers believe go beyond the true economic cost of honouring the policy liabilities.

Each level premium term insurance product has a premium fixed for a certain period, which could be 10, 20 or 30 years. Because mortality risk increases over time, US insurers need to build reserves to cover the difference between the fixed premium and escalating life exposure.

However, the Regulation XXX rules mandate reserves that are far in excess of what insurers’ own actuarial models suggest is prudent.

Steve Schreiber, principal and consulting actuary for Milliman, based in New York, explains: “Because the regulatory assumptions used in setting these reserves are viewed as very conservative, insurers define an economic reserve, which might be based on best-estimate assumptions, and compare that against the statutory reserve, and the difference is what companies are trying to get financing for.”

In the years before the crisis, insurers sought smart ways to fund this difference without incurring the opportunity cost associated with holding liquid capital. Using securitisation techniques, insurance companies ceded the liabilities to a captive or special-purpose vehicle (SPV) and issued securities to the capital markets to finance them, often going through a monoline insurer for a credit wrap to boost the securities’ ratings. These investors would be paid for the risk through the reinsurance premium and investment income from assets purchased by the SPV.

The XXX/AXXX regulations had unwittingly started off a boom in life insurance-linked securities (ILSs). These securitisations were gathering pace in the years preceding Lehman Brothers’ collapse, but when the market imploded in 2008, so did interest in securitisations. Insurers returned to using letters of credit to finance these reserves.

“When the monolines went away these securities could not be placed with the same investor base anymore, so insurers went to the bank financing market instead,” explains Dan Knipe, London-based life portfolio manager at Leadenhall Capital Partners, an ILS specialist with $1 billion in assets under management.

XXX/AXX has proved to be a significant market for banks, says Jorge Fries, managing director in the securitisation group at Crédit Agricole CIB in New York. “The typical transaction size is $500 million for the top 20 life insurers in the market. It is not uncommon for transactions to exceed $1 billion,” he adds.