A nearly year-long probe by New York's top financial-services regulator into life insurers' use of affiliated reinsurance entities has identified $48 billion in potentially troublesome transactions with "inconsistent, spotty and incomplete disclosures," officials said in a new report.
The report contains some of the most detailed information yet on the scale of the industry's dependence on the controversial entities-known as "captives"-- to help meet capital requirements.
In the report, New York Financial Services Superintendent Benjamin Lawsky calls on fellow regulators nationwide to develop "enhanced disclosure requirements," urges his state counterparts and a new national insurance office to conduct similar probes to develop a nationwide picture of the captive transactions, and recommends a possible "immediate national moratorium on approving additional" such transactions until those investigations are complete.
Mr. Lawsky's regulatory authority is limited to New York-based insurers, but the state operates one of the largest, most experienced insurance departments, so its moves carry weight across the U.S. It isn't clear what enforcement actions, if any, the state could take to eliminate use of existing captives: Insurers maintain that they are allowed under existing rules.
Life insurers' use of captives has drawn scrutiny over the past year from a growing number of regulators who are concerned that companies may be masking their financial health by moving business to the entities, which generally are subject to less-onerous funding requirements than the insurers themselves.
Across all states, insurers are required to estimate future claims obligations and to have bonds and other assets on hand to pay those claims. But many life insurers contend that the current formula-based rules lead to reserves that are far bigger than necessary for basic products such as term-life and some types of universal-life insurance.
Many of the insurers have acknowledged using captives in order to minimize the amount of assets they have to set aside to back up these policies. They say their use of affiliated entities extends just to those reserves deemed unnecessary, or "redundant," by their actuaries.
New York's report doesn't include any insurers' names, but The Wall Street Journal previously has reported that New York-based MetLife Inc. is one of the biggest users of the entities.
MetLife maintains that it holds more than sufficient reserves to pay claims on its policies and has cited its reinsurance subsidiaries as a cost-effective way of addressing what it and many other publicly traded insurers contend are excessively conservative reserving requirements for certain insurance products.
MetLife's biggest rival, Prudential Financial Inc., said in a statement on Wednesday that it uses captive reinsurance and said the captives are "are capitalized to a level consistent with 'AA' financial strength rating targets of our issuing insurance entities."
Nigel Dally, an insurance analyst with Morgan Stanley, said in a note to clients Wednesday morning that "in most circumstances, we believe the use of the captive insurance vehicles has been for legitimate reasons." But he added "there remains the potential for abuses."
In a typical transaction, an insurer creates a captive insurance subsidiary and then "reinsures" a block of existing policy claims through the entity. Sometimes the parent company even effectively pays a commission to itself in completing the transaction, New York's report states.
Use of the entities makes for "artificially rosy capital buffers," and the funds the insurers free up are available for purposes such as paying dividends, the report says.
"This financial alchemy, however, does not actually transfer the risk for those insurance policies because, in many instances, the parent company is ultimately still on the hook for paying claims if the shell company's weaker reserves are exhausted," the report states. The report notes that captives often rely on bank letters of credit, and a smaller number use "conditional" letters of credit-which can be drawn upon under stipulated circumstances.
"A conditional letter of credit is at greater risk of not being available to fund policyholder claims during periods of financial stress," the report states.
The department's inquiry also found instances of "naked parental guarantees." In such a case, a captive doesn't obtain a letter of credit, but "simply promises that its parent would cover any losses, without identifying specific, dedicated resources to pay for them." New York regulations don't permit such naked parental guarantees because, in the event of financial difficulties for the company, there wouldn't be readily available assets to turn to for help in paying claims.
In general, the insurers say their captives are appropriately funded and policyholders are protected. They note that in setting up an affiliated reinsurer, they typically must obtain approval from the insurance department where the company is based, in addition to the approval of the state where the captive is based.
States like Vermont, South Carolina and Iowa that allow the entities tend to be sympathetic to the insurers' complaints about the conservative nature of the formula-based capital requirements.
Many insurers and state regulators have long supported a plan for the National Association of Insurance Commissioners, a group of state regulators that sets solvency standards for adoption by states, to overhaul the rules for how life insurers set up their claims reserves, potentially eliminating the need for the captives. New York opposes a move away from the existing formula-based methodology.
New York's report says that the $48 billion in transactions identified in the state "are likely to be just the tip of the iceberg nationwide. There are almost certainly tens, if not hundreds, of billions of dollars of additional shadow insurance on the books of insurance companies across the country."