On March 14, 2013, the Captive and Special Purpose Vehicle Use (E) Subgroup of the National Association of Insurance Commissioners (NAIC) exposed for comments a revised draft of its White Paper (available here) discussing the use by US commercial life insurers of affiliated special purpose reinsurers for certain financing activities. The Subgroup’s focus has been, and continues to be, primarily directed at transactions whereby life insurers transfer risks to affiliated special purpose reinsurers on blocks of (i) guaranteed premium term life insurance products subject to Regulation XXX and (ii) universal life insurance products with secondary guarantees subject to Actuarial Guideline 38 (also known as Regulation AXXX), in either case, to facilitate the financing of perceived reserve redundancies caused by the applicable regulation. Many US life insurers have used these types of financings as a means of capital relief since the advent of the regulations (dating back to the early 2000s), however, several 2011 articles suggesting that the use of special purpose reinsurers might constitute a “shadow insurance industry” prompted many US insurance regulators and the NAIC as a whole to re-examine such transactions in this post-financial crisis environment.

The latest iteration of the White Paper reveals the continuing lack of consensus among regulators over the existence, scope and pervasiveness of possible abuses related to captive reinsurer financings. Most of the White Paper’s recommendations point to the need for further information gathering and analysis rather than immediate legislative or regulatory action. Nevertheless, there are several subtle, but noteworthy changes in the current draft that appear to suggest that the Subgroup is tempering its posture in relation to reserve financings. First, all references to a “shadow insurance industry” were removed, which considerably softened the hostile tone of the prior draft. Second, the express purpose of the Subgroup’s charge, which previously drew an unsubstantiated analogy between captive reinsurer financings and risky banking transactions, was changed to a less dramatic “need to study whether policyholders of commercial insurers that had formed captive and special purpose vehicles could be subject to risk because of the differences in the regulation of such entities.” Finally, each characterization of conditional or contingent letters of credit (which are currently some of the most popular forms of collateral for captive reserve financings) was modified from some form of the conclusive “not permitted” to a more ambiguous “may not be permitted” or “not generally permitted,” and language was added advising that non-traditional collateral forms warrant further consideration. Overall, the slight shift in approach reflected in the White Paper should give some comfort to proponents of life insurance reserve financings.

At this point, US state insurance regulators who actively participate in the debate regarding captive financings appear to fall into three distinct camps: (i) those who view special purpose financing vehicles and life insurance reserve financing transactions the most skeptically, and would prefer they were abolished, (ii) those who are willing to tolerate complex financing structures as interim solutions pending the final adoption of a comprehensive principles-based reserving system that would negate the need for reserve financings and (iii) those who see life reserve financing structures as innovative tools for bringing much needed outside capital into the life insurance industry. Since any principles-based reserving solution would require regulators in either New York or California to reverse their current positions, the groups described in (ii) and (iii) above combined may have the upper hand in the discussions of captive reinsurer financings for the time being. That could all change abruptly, however, in the event that the investigation that the New York Department of Financial Services (DFS) is independently conducting into the use of captive financings uncovers some blatant wrongdoing.

The NAIC study of the use of captives for financing transactions, and the New York DFS’ investigation of insurers involved in such transactions, did not escape the attention of newly empowered US federal regulators. Just prior to the release of the latest White Paper draft, the Federal Insurance Office (FIO) indicated that it was separately investigating the use of captive reinsurers to finance life reserves. Toward that end, FIO Director Michael McRaith called for the creation of a federal task force that would report directly to the US Treasury Department. That announcement drew an immediate response from state insurance regulators. Connecticut Insurance Commissioner Thomas Leonardi said publicly that the FIO “might be unnecessarily overlapping state turf ” and that “duplications of efforts are costly, inefficient and an ineffective way to find solutions to issues.” This promises to be perhaps the first, but certainly not the last, difference of opinion between state and federal regulators regarding the most efficient and effective ways to regulate the business of insurance.

See also the articles on Life Reserve Financing and Regulatory Scrutiny of Use of Captives and Special Purpose Vehicles in our “Global Insurance Industry 2012 Year in Review” (available here).