Wednesday, October 14, 2015

No. 120: The Federal Insurance Office Expresses Concern about Principles-Based Reserving and Captive Reinsurance Transactions

In September 2015, the Federal Insurance Office (FIO) of the U.S. Department of the Treasury issued its Annual Report on the Insurance Industry. The FIO expresses concern about principles-based reserving (PBR) and the related subject of captive reinsurance (sometimes called "shadow insurance"). Here are three excerpts from the Report:
  • Wholesale adoption of PBR continues to raise concerns, including potential overreliance on an insurer's internal modeling and a shortage of resources and expertise on state insurance regulatory staffs.
  • State insurance regulators are developing a framework for consistent standards for reinsurance captives that would allow lower-quality assets to support the so-called "redundant reserves" relating to term life and universal life with secondary guarantee products. The Report outlines FIO's concerns about the scope and yet-to-be-determined specific details of the framework, including that reinsurance captives will continue to be established in states competing to serve in that capacity.
  • While disclosure requirements of life insurers pertaining to cessions of reinsurance captives of reserves related to term and universal life with secondary guarantee products has improved, state insurance regulators do not require public disclosure of the financial statements of reinsurance captives.
The Report is in the form of a 105-page PDF. The first two excerpts above are on page 15 of the PDF, and the third is on page 67. The full discussions of PBR and captive reinsurance are on pages 65-68.

Presumably the discussions of PBR and captive reinsurance are of great interest to members of the American Council of Life Insurers and members of the National Association of Insurance Commissioners. However, I am not aware of any comments on those topics, or about the Report generally, from either of those organizations.

General Observations
I agree with the first excerpt above. I believe that adequate staffing in state insurance departments to handle PBR is not possible.

I also agree with the second excerpt above. The way it is worded in the Report is a polite way of describing what has become a race to the bottom in terms of the rigor of state regulation of insurance companies.

I agree with the third excerpt as far as it goes. However, it is not merely the lack of a requirement for public disclosure of the financial statements of reinsurance captives that concerns me. Rather, I am concerned about the lack of a requirement for public disclosure of the details of the phony assets carried by reinsurance captives. Among those assets are parental guarantees, contingent notes, credit linked notes, variable funding notes, note guarantees, and letters of credit.

If there were rigorous disclosure of the details of those assets, I think regulators would be so embarrassed that they would not approve such assets. Indeed, I think promoters would not even try to get such assets approved. As I have said previously, captive reinsurance is a shell game, and no shell game can survive disclosure.

Available Material
I am offering a complimentary 105-page PDF containing the 2015 Report of the FIO. E-mail and ask for the FIO Report issued in September 2015.