Friday, March 25, 2016

No. 152: Captive Reinsurers—A Brief Released by the Office of Financial Research in the U.S. Department of the Treasury

In No. 135 (posted December 28, 2015), I discussed the first Financial Stability Report issued by the Office of Financial Research (OFR), an independent bureau within the U.S. Department of the Treasury. The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 established the OFR, which issues periodic reports. The OFR also issues "briefs" on various topics.

Brief No. 16-02
On March 17, 2016, the OFR issued Brief No. 16-02 entitled "Mind the Gaps: What Do New Disclosures Tell Us About Life Insurers' Use of Off-Balance-Sheet Captives?" The authors of the brief are four members of the OFR staff: Jill Cetina, Arthur Fliegelman, Jonathan Glicoes, and Ruth Leung. Here is the abstract of the ten-page brief:
Some U.S. life insurance companies use wholly owned captive reinsurers to transfer risk and reduce regulatory requirements. Since 2002, such transfers have increased rapidly, and they now exceed $200 billion in reserve credit. This brief discusses recent policy measures and the data that insurers began reporting in 2015 about their captive transactions. Publicly available data are insufficient to analyze fully the risks from captives and the impact on insurers' financial condition. Regulators have revised reporting standards to improve the public data, but gaps remain. Because life insurers are a material part of the financial system, these gaps may mask financial stability vulnerabilities.
The authors of the brief explain that the ceding of reserve liabilities to captive reinsurers to reduce the liabilities of the parent ceding companies began about 15 years ago, after state insurance regulators had increased reserve requirements for term life policies and for universal life policies with secondary guarantees (ULSG). The problem is that the captive reinsurers are permitted by some state insurance regulators to treat as admitted assets what the authors of the brief refer to as "nontraditional" items such as letters of credit and parental guarantees, despite the fact that accounting rules adopted by the National Association of Insurance Commissioners do not permit such items to be treated as admitted assets.

Some of the Data
The brief contains a considerable amount of information based on year-end 2014 data. (Year-end 2015 data were not available when the brief was being prepared.) The 2014 data show that the use of captives by U.S. life insurers totaled $213.4 billion in reserve credit. The authors of the brief point out that, because of exemptions, ceding insurers disclosed the quality of the assets for only 55 percent of the assets of term life and ULSG captives. The authors of the brief also point out that, for the 2014 data, there were no requirements for disclosure of the impact of the use of captives on the risk-based capital ratios of the ceding insurers.

General Observations
This is not the first time OFR has expressed concern about captive reinsurers. Earlier expressions of concern were in OFR's 2014 Annual Report and 2015 Financial Stability Report. I think the recent OFR brief should be studied carefully by persons interested in the welfare of life insurance companies and policyholders.

Perhaps the most detailed official expression of concern about captive reinsurers was a 24-page report entitled "Shining a Light on Shadow Insurance." The report was issued in June 2013 by the New York Department of Financial Services (NYDFS) during the tenure of Benjamin M. Lawsky, the former NYDFS superintendent.

Today, almost three years after issuance of the NYDFS report, we still have very little disclosure of the details of captive reinsurance transactions. In my view, the central problem is the secrecy surrounding what the authors of the OFR brief refer to as "nontraditional" admitted assets carried on the balance sheets of captive reinsurers. I think of those assets as "toxic," and I have referred to their use as a "shell game" that would collapse if the details of those assets were clearly disclosed.

Available Material
I am making available two complimentary PDFs. One is the recent ten-page OFR brief. The other is the 24-page NYDFS report released in 2013. Email and ask for the March 2016 OFR brief and/or the June 2013 NYDFS report on shadow insurance.