On December 12, 2013, the Federal Insurance Office (the “FIO”) published its long-delayed report entitled “How to Modernize and Improve the System of Insurance Regulation in the United States” (the “Report”).  The FIO was required under Title V of the Dodd-Frank Wall Street Reform and Consumer Protection Act to issue the Report almost two years ago.  The Report covers an array of issues and in most instances offers recommendations to the states and Congress to address those concerns.  One particular topic that the Report addresses is one that we at Edwards Wildman have been following and have analyzed on a number of occasions: the use of affiliated reinsurance captives and special purpose vehicles (“SPVs”) within the life insurance industry.

The Report raises several questions regarding the ceding of risk by life insurers to affiliated reinsurance captives including (i) the quality and quantity of capital and assets used to support reserves held by the captive reinsurers and (ii) the lack of transparency of captive oversight from state-to-state.  The Report makes reference to the latest draft of the NAIC’s White Paper with respect to SPVs (which we have analyzed in detail here).  That White Paper attempted to steer a middle course between critics and proponents of affiliated reinsurance captives.  In addition, the Report summarizes certain conclusions of a New York Department of Financial Services’ report dated June 12, 2013 (the “NYDFS Report”) on the use of reinsurance captives, which criticized the state-based disclosure regulations that currently govern the transfer of risk to such captives and expressed concerns about “shadow insurance.”  We have analyzed the NYDFS Report here.

It is worth noting that the first draft of the NAIC’s White Paper explicitly discussed “shadow insurance.”  However, after criticism by insurance industry participants and some regulators, the term “shadow insurance” was removed from the White Paper.  The Report itself stops short of recommending abolishing the use of affiliated reinsurance captives altogether, but instead recommends uniform standards for transparency and capital requirements for reinsurance captives, with most details of such transactions being disclosed in the financial statements of the ceding insurer.

Another topic addressed in the Report is principles-based reserving (“PBR”) which has been a focus of committees and working groups within the NAIC for some time and has also been reported on by Edwards Wildman here.  The use of PBR would potentially, among other things, allow life insurers to factor in their own internal risk modeling when calculating their necessary reserves and thereby reduce the need for affiliated reinsurance captives and SPVs to alleviate redundant reserves.  The Report, however, warns of potential abuse by insurers and recommends that states “move forward cautiously” with PBR by establishing cross-state guidelines and training more actuaries and examiners to increase regulatory scrutiny with respect to the new models insurers may use to calculate their reserves.  The issues of financial captive reinsurance and PBR remain hotly-debated topics within the insurance industry and we will continue to report on any new developments.

In a related development, Steve Kinion, the Director of the Delaware Captives Bureau, has submitted a memorandum to the NAIC’s Financial Regulation Standards and Accreditation (F) Committee on behalf of Delaware Insurance Commissioner Karen Weldin Stewart found here opposing an NAIC proposal that would make accreditation standards applicable to multistate reinsurers.  The memorandum goes on to argue that such a proposal would have a negative impact on Delaware’s financial captive sector and is premature particularly given the early stage of the NAIC’s review of use of affiliated reinsurance captives and PBR.  Mr. Kinion’s memorandum is dated December 12, 2013 and does not specifically refer to the FIO report.