FHFA cuts off FHLB access to captives
After considering input received in more than 1,300 comment letters submitted in response to a proposed rule issued in 2014, the Federal Housing Finance Agency (FHFA) issued its final rule on Federal Home Loan Bank (Bank) membership that effectively excludes captive insurers from Federal Home Loan Bank membership. The final rule defines the term "insurance company" to exclude captive insurers, and requires that an insurance company have as its primary business the underwriting of insurance for nonaffiliated persons. This continues to include traditional insurance companies but not captive insurers. Existing membership of captive insurers must “sunset” over five years and advances during that time period are limited. Additionally, the final rule requires a Bank to obtain and review an insurance company's audited financial statements when considering its application for membership; clarifies the standards by which a Bank is to determine the "principal place of business" for its members, including specific standards for insurance companies and community development financial institutions; and removes obsolete provisions and makes numerous non-substantive textual revisions so as to provide greater clarity. The final rule does not implement the proposed rule's provisions with respect to continuing eligibility requirements.
The Federal Home Loan Bank system (FHLB System) was established in 1932 by Congress to be a steady source of funding in the housing market through good and bad economies. It is a cooperative system made up of eleven regional lending institutions that are owned by their members—more than 7,500 financial institutions in the United States—and is regulated by the federal government. The Banks have been regulated by the FHFA since 2008 when that agency was created through the Housing and Economic Recovery Act of 2008. The eleven Banks are conservatively managed with a long-term view of financial investments. Because they are cooperatives, they reinvest any profits, keeping costs low. Small financial institutions and community banks rely on loans from Banks to help maintain liquidity. The FHLB System is worth over $800 billion and, after the US Treasury, is the biggest US bond borrower.
According to a speech made by FHFA director Mel Watt in May 2014, loans made by Banks to insurance company members increased from one percent in 2000 to 14 percent in 2013. Insurance companies have always been allowed membership in the FHLB System, but have accounted for a larger portion of the loans awarded. The growth in member insurance companies receiving loans is reflected in the growth of the insurance sector in the overall financial marketplace.
In 2012 through 2014, several real estate investment trusts (REIT), which are not eligible for Bank membership, began establishing captive insurer subsidiaries that then applied for Bank membership. As the Banks can generally offer better terms than traditional banks and bond markets for dependable funding, it can be an important source of liquidity for the alternative risk transfer market. The new memberships drew scrutiny from the FHFA. In May 2014, the FHFA director, Mel Watt, warned in a speech at the FHLB's Directors Conference that captive insurance membership raised a number of red flags “related to the safety and soundness and access to the system.” According to the FHFA, these captives obtained advances that were disproportionately large in comparison with the investments and operations of the captives themselves. Additionally, many of the parents were guaranteeing repayment of the advances made to their captives and providing the collateral for those advances. This led the FHFA to conclude that the real purpose of the arrangement was to provide the non-member REIT with access to Bank funding to which they were not legally entitled.
In June 2014, the Banks jointly agreed to a three-month moratorium on admitting captive insurers to the FHLB System. On September 12, 2014, during the moratorium, the FHFA proposed substantial changes to the rules governing membership in the FHLB System. On January 11, 2016, the FHFA issued the final rule. The final rule will become effective 30 days from publication in the Federal Register.
The final rule prevents non-eligible entities from gaining Bank membership through a captive insurer. In defining "insurance company" to exclude captives, the FHFA seeks to prevent entities that do not otherwise meet the statutory requirements from becoming Bank members by establishing and using captives as conduits to circumvent the membership eligibility requirements and gain access to low-cost Bank funding and other benefits of Bank membership.
Captive insurer members that became members prior to publication of the proposed rule must terminate their membership within five years of the effective date. During that time, outstanding advances are limited to 40 percent of their assets and new advances or renewals must mature within the five-year transition period.
Captive insurers admitted to membership on or after the date of publication of the proposed rule have up to one year following the effective date of the final rule within which to terminate the membership of those captives. These captives have until the end of that year to repay their existing advances; they may not take new advances or renew existing advances.
REITs that have already used captive insurers to get Bank access will lose that access within five years. Thus, they will have to consider available options, including the following:
- Maintain the captive insurer—the many benefits of a captive insurer remain. Moreover, a change in administration could bring in new views and changes to, or elimination of, the final rule.
- Lobby for legislation clarifying that captive insurers are included in the statutory definition of "insurance company."
- Pursue an administrative action challenging the final rule and the FHFA's interpretation of "insurance company."
- Acquire or start a fully-licensed commercial insurance company, one that meets the criteria of the final rule—such insurance company must meet the membership requirements (including meeting the requirement that your business is primarily the underwriting of unaffiliated risk) and access limitations. A fully-licensed commercial insurance company, however, faces more regulatory requirements and a higher level of regulatory scrutiny than a captive insurer.
- Wind down the captive after access to the Bank is terminated.
Each of these options contain pros and cons, which must be evaluated on an case-by-case basis.
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