U.S. Department of the Treasury’s Office of Financial Research, or OFR, has issued a brief titled “Mind the Gaps: What Do New Disclosures Tell Us About Life Insurers’ Use of Off-Balance-Sheet Captives?” The brief analyzes recent regulatory reforms to strengthen disclosure and asset quality standards for U.S. life insurers’ use of captive reinsurance. Because of limitations and exemptions, disclosure requirements apply to only 35 percent of the captive industry.

Beginning in 2000, state regulators increased the reserve requirements for a large portion of the life insurance industry. The changes affected term life and universal life policies with secondary guarantees. Many life insurers, regulators, and rating agencies later agreed the new requirements were excessive. As a result, some states allowed insurers to finance a portion of these reserves through captive reinsurance companies. In a captive reinsurance transaction, a life insurance company transfers risk to a captive reinsurer that is part of the same parent group.

OFR has raised concerns about insurers’ use of captives. Many states do not hold captives to the same standards as traditional insurers because captive insurance laws were initially developed to address self-insurance by corporations. Some states have allowed captives to fund their reserves with nontraditional assets, such as bank letters of credit and parental guarantees. These assets are not diverse, high-quality investments and could be riskier than traditional assets.