Report Warns of Impact of Tight Regulations on Life Captives
April 2, 2014 by Thomas Harman, associate editor, BestWeek: Tom.Harman@ambest.com
WASHINGTON – Tight capital regulations help ensure solvency for life insurers but could shrink the market considerably if applied too tightly to life captive reinsurance transactions, according to a new paper from the Federal Reserve Bank of Minneapolis that also calls for increased transparency for life captives.
It was issued as state regulators gather at the National Association of Insurance Commissioners Spring Meeting to discuss how to craft an interim method of using life captive reinsurance vehicles that supporters of principles-based reserving standards up for approval by states would like to ultimately restrict or eliminate (Best’s News Service, March 12, 2014).
The paper was written by Ralph S.J. Koijen of the London Business School and Motohiro Yogo of the Federal Reserve Bank of Minneapolis, and states the opinions expressed are those of the authors and not necessarily the Federal Reserve. Yogo, in an email, said the life insurance industry has changed dramatically in the past 15 years. “Most insurance regulators are aware of the issues that we raised,” he said. “However, that doesn’t mean that regulation has kept pace or that problems are easy to solve.”
The paper cites the dilemma faced by regulators and those in the insurance industry concerning the call for tighter capital regulation of what they referred to as “shadow” captives that are used by some life insurers to back term life insurance and no-lapse guarantee universal life products. That subset of the market grew from $11 billion in 2002 to $364 billion in 2012, the authors wrote, adding that companies using those types of captives in 2012 moved 25 cents of every $1 insured into those captives.
The authors estimate in the absence of life captives, life insurance prices would increase by 18% and the life insurance market would shrink by 23%. “Tighter capital regulation reduces the likelihood of failure, but it also raises prices and shrinks the size of consumer financial markets,” the paper said.
The American Council of Life Insurers disagreed with many of the paper’s assertions, including its findings on life captive reinsurance transactions. “These reinsurance transactions are a legitimate, safe and carefully regulated means of truly satisfying reserve requirements,” an ACLI statement said. “Life insurers want to bring more sunshine to these wrongly labeled ‘shadow’ transactions. We are working to assure that captive transactions are properly disclosed and handled uniformly from state to state.”
Life insurers are important to the nation’s economy and do not pose a systemic risk, ACLI said. “The fact that insurers are diverse and conservative in both the products they sell and the investments they make eliminates them as a systemic risk to the nation’s economy,” ACLI’s statement said.
Affordable Life Insurance Alliance Executive Director Scott Harrison told Best’s News Service the paper acknowledges the environment and the demand for life insurance products has changed. “I read this as pointing out that the regulatory system needs to keep pace with changes in the marketplace and that’s what [principles-based reserving] is intended to do,” he said.
Harrison agreed with the paper’s finding that a main reason companies have to use the kinds of captive reinsurance that are targeted for reduction or elimination by principles-based reserving is because the current standard valuation law is arcane and forces life insurers to hold excess reserves. “If we get [principles-based reserving] right, these things will die a natural death,” Harrison said.
Yogo said the authors seek more transparency for life captives, including financial statements that are available to the public.
The authors said two major sources of risk exist for life insurers — demand for minimum-return guarantees in variable annuity products, and the increasing use of captive reinsurance triggered by tighter capital requirements after 2000.
Two features of the insurance sector offer challenges for insurance regulation, the authors said. The growth of annuities and captives shows insurance companies are willing to take risk on the liability side, but the risks developed because accounting standards and capital regulation are less developed and more inconsistent than those on the asset side of company balance sheets, the report said. Existing capital requirements that apply to banks — short-term risk constraints designed to prevent runs — may not be appropriate for insurance companies. “We believe that insurance companies should be evaluated based on long-term, value-at-risk measures that are extensions of short-term measures for banks,” the paper said. The authors said there should be more discussion among academics and regulators on the costs and benefits of regulation.
However, quantifying long-term risk is complicated, because the market value of liabilities is unknown and data in financial statements needed to quantify risk is incomplete. “We see the recent trend toward captive reinsurance as a step in the wrong direction,” the paper said. “Complete and transparent financial statements are essential for rating agencies, investors and academics.”
