Last month, the Federal Housing Finance Agency (FHFA) released a Final Rule amending its regulations on Federal Home Loan Bank (FHL Bank) membership. The previous regulation, which implements the provisions of the Federal Home Loan Bank Act governing eligibility for membership and establishing requirements for a financial institution to become and remain a member of the FHL Bank, allowed a captive insurer to constitute a “financial institution,” to enable the member to access low interest financing. The Final Rule materially undercuts the ability of a captive to access such financing.
The Final Rule does adopt the provision in the 2014 proposed rule that defines “insurance company, to exclude so-called “captive insurers.” The Final Rule, thus, will prevent non-eligible entities from gaining de facto FHL 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 FHL Bank members by establishing and using captives as conduits to circumvent the membership eligibility requirements and gain access to low-cost FHL Bank funding and other benefits of the FHL Bank membership.
To minimize disruption of current members and the FHL Bank system, the rule allows FHL Bank captive insurers’ members that joined prior to FHFA’s proposed rule up to five years to terminate their membership, and those that joined after issuance of the proposed rule up to one year to terminate. However, advances to captives are rumored to have been halted. The Final Rule also requires FHL Banks to obtain and review audited financial statements for insurance company applicants when considering them for membership and clarifies the standards for determining the location of an institution’s “principal place of business” for purposes of identifying the appropriate FHL Bank district for membership. A link to the final Federal Home Loan Bank membership rule FAQs can be found here.
As of the end of the third calendar quarter for 2015, there were 40 captive insurers in the FHL Bank system, and the total dollar volume of outstanding advances to captive insurers was just over $35 billion. See Final Rule of Federal Home Loan Bank membership Frequently Asked Questions. Thus, transition will have a significant impact on the marketplace.
The Final Rule will not exclude all captive insurers from membership as the FHFA has defined “insurance company,” so that captives having the characteristics that give rise to the Agency’s concerns (i.e., pure captive insurers that underwrite insurance primarily for the parent company or for other affiliates, rather than for the public at large), will be excluded while those financial institutions that do not give rise to such concerns (i.e., those whose primary business purpose is to insure third party risk), and that would be regarded as carrying out the business of insurance in the traditional sense arguably will continue to be considered “insurance companies” for purposes of determining eligibility for FHL Bank membership. Further regulatory guidance on how much unaffiliated risk an insurer must write and what is actually intended by “primary business purpose” will be necessary.
FHL Bank members which are captive insurers and their sponsoring organizations will have to fully evaluate how to proceed in face of the Final Rules. These members have several options (depending upon the jurisdiction in which they are created) including, risk pooling, retaining the captive and allowing the captive to accept substantial third party risk (subject to precise regulatory guidance), dissolving the captive and creating a traditional insurance company which, depending on whether its primary business is non-affiliated risk, could be considered a “financial institution” within the confines of the Final Rules. Further legislative and regulatory action as well as possible litigation challenging the FHFA Final Rules may be on the horizon.