On July 18, 2012, the New York Department of Financial Services (Department) sent a New York Insurance Law section 308 request (308 Request) to 80 New York domestic life insurance companies, requiring them to provide, by August 8, 2012, in substance the following:
- The names of all ceding companies using affiliated captives or off-shore entities for reinsurance purposes, the names of the reinsurance entities, and the domicile of all such companies;
- A written description of each reinsurance treaty, including, among other things, the amount of statutory reserves transferred to the reinsurer, the amount of and a description regarding the collateral supporting the reserve credit taken by the ceding insurer, and a description of any guarantees provided by any entity within the holding company system that were used to secure any forms of collateral. [NOTE: Under New York Insurance Law section 1505 (d), domestic life insurers are required to file for approval with the Department all reinsurance treaties between affiliates. As a result, assuming the agreements were filed, the Department has previously approved the reinsurance agreements that are now the subject of their investigation. Similarly, under the same statute, any guarantees or letters of credit between domestic life insurers and their affiliates have to be filed and approved by the Department before they are executed. Accordingly, any affiliated collateral arrangements supporting these reinsurance transactions should have already been reviewed by the Department.];
- A summary of the rationale for entering into each reinsurance treaty;
- Any financial benefits inuring to the ceding insurer;
- Reports on examination of any of the entities referenced in the response;
- The percentage change in the insurer’s risk-based capital, taking into account the reinsurance transactions.
The company’s response had to be executed by a senior officer under penalty of perjury.
While the 308 Request does not set forth its purpose, it is likely that the Department's actions are at least in part motivated by the Department's continuing interest in the various reserving issues surrounding Regulation XXX and Actuarial Guideline 38 (“AG 38” or “Regulation AXXX”).
AG 38 was created in 2003 to clarify the National Association of Insurance Commissioners (NAIC) Valuation of Life Insurance Policies Model Regulation, also referred to as Regulation XXX, which sets forth reserve requirements for all universal life products that employ secondary guarantees with or without shadow accounts (ULSG policies). AG 38 and Regulation XXX impose conservative assumptions and valuation methodologies for determining the level of statutory reserves that insurers are required to maintain under statutory accounting principles (SAP) for term life insurance policies with long-term premium guarantees and for ULSG policies. Regulation XXX refers to the reserves required to be maintained for term life policies with long-term premium guarantees while Regulation AXXX or AG 38 refers to the reserves required to be maintained for ULSG policies.
These conservative assumptions have required life insurers to hold significantly higher amounts of reserves than were previously mandated, and have therefore limited the financial flexibility of these carriers. As a result, these NAIC Model Regulations, along with New York Insurance Regulation 147, 11 NYCRR Part 98 (Valuation of Life Insurance Reserves) have been the subject of much controversy since their introduction more than ten years ago. They have been amended numerous times in order to capture new products entering the marketplace.
In late 2010, the Department sent letters to a number of carriers seeking detailed information regarding the reserves being held for ULSG policies. After reviewing the industry response, the Department believed that insurers were not interpreting minimum premiums correctly (reserve calculations under these regulations are dictated by the minimum or specified premiums necessary to keep a ULSG policy in force on a guaranteed basis), and, as such, insurers were not in compliance with the spirit of Regulation 147 and AG 38. Accordingly, the Department concluded that the life insurance industry does not hold adequate reserves for ULSG policies. The Department's concern, which is shared by other regulators, prompted the NAIC to once again revisit AG 38 in the fall of 2011. Just last month, the NAIC sent out for public comment two proposed alternative approaches to address these perceived reserving deficiencies.
While regulators implemented Regulation XXX, AG 38 and Regulation 147, the life industry responded to the strain of holding higher reserves by entering into reinsurance transactions with affiliated captive reinsurers. These transactions, which are the subject of the Department's July 2012 letter, can take various forms but usually possess the following characteristics:
- The life insurer cedes its risk associated with ULSG policies to an affiliated captive reinsurer.
- As payment for assuming the risk, the ceding life insurer pays reinsurance premiums to the captive reinsurer.
- The life insurer also employs an affiliated or unaffiliated special-purpose vehicle (SPV) to sell securities in the capital market to finance the difference between the statutory reserve requirements and the policies’ economic value. Additionally, a financial guaranty, often from an affiliated entity, is given to purchasers of the securities from the SPV.
- A reinsurance trust is created by the captive reinsurer in order to secure the obligations of the captive to the ceding life insurer. The security contained in the reinsurance trust permits the ceding life insurer to take credit for the reinsurance on their financial statement where, as is often the case, the reinsurer is not licensed in the ceding life insurance company's domiciliary state. Further, under New York Insurance Regulation 114, in order to take credit for reinsurance, a reinsurance trust must enable the ceding life insurer to withdraw funds at any time without notice to the captive reinsurer.
Given the Department's conclusion in its 2010 investigation that the industry is not holding adequate reserves for ULSG policies, it appears that the Department's current inquiry may be designed to dismantle these captive reinsurance arrangements as part of its overall campaign to impose stricter solvency requirements on life insurers selling ULSG policies. It is likely that the Department is concerned that these transactions frequently involve entities that are affiliated with the life insurer, and that a financial downturn could adversely impact the ability of life insurers to meet their obligations not only to ULSG policyholders but also to all policyholders of the company.
In May 2011, a New York Times article compared captives to the “shadow banking system that contributed to the financial crisis.” The article did not cite examples of problems occurring in the industry as a result of the use of captives. In addition, the article did not distinguish between captives owned by non-insurance companies (to self-insure a portion of their risks) and captive reinsurance subsidiaries and insurance securitizations. In response to that article, captive experts noted that the article did not present a fair representation of the captive industry, because it focused on a small fraction (1 percent) of captives (Caroline McDonald, “NY Times Misses Mark on Captives,” National Underwriter, May 9, 2011) and that the vast majority of captives do not bear risk and have designed rules to ensure solvency (Shanique Hall, “Recent Developments in the Captive Insurance Industry,” CIPR Newsletter, NAIC Center for Insurance Policy and Regulation, January 2012).
Some regulators question whether the regulatory framework established to oversee captive insurers is appropriate for regulating a captive that has assumed third-party insurance risk. In response, the NAIC is examining how insurers use captives and determining whether there are regulatory changes that need to be made.
In October 2011, the NAIC Executive (EX) Committee charged the Financial Condition (E) Committee to: “Study insurers’ use of captives and special purpose vehicles to transfer third-party insurance risk in relation to existing state laws and regulations and establish appropriate regulatory requirements to address concerns identified in this study. The appropriate regulatory requirements may involve modifications to existing NAIC model laws and/or generation of a new NAIC model law.” (Shanique Hall, loc. cit.)