FSOC: Reinsurance Captives, Low Interest Rates Could Undermine Stability of Life Insurers
May 9, 2014 by Jeff Jeffrey
WASHINGTON – State and federal regulators should continue to monitor life insurance companies’ use of captive reinsurance entities as well as their investment strategies amid the ongoing low-interest environment, according to findings included in the Financial Stability Oversight Council’s annual report. Both captives and investment strategies could pose threats to their financial stability, the report found.
The multi-agency report focused on potential risks to the U.S. financial system that could result from the business practices of a broad range of financial institutions, including insurance companies. It was released during the FSOC’s May 7 open meeting.“This report underscores the improvements the nation’s financial system has made since the financial crisis and shows the council’s commitment to look toward the future–and not just look in the rear-view mirror,” said Treasury Secretary Jacob “Jack” Lew, who chairs the 15-member FSOC.
The potential dangers associated with cybersecurity were a key theme of the report, which said cyber risks should be a top concern for all market players. Nearly every member of the council mentioned cybersecurity during their remarks.
The report concluded that the rising popularity of captive reinsurance entities could create risks that escape the notice of the traditional state-led regulatory system for insurance.
The report said that while captive reinsurance transactions must be approved by both the captive and primary insurers’ regulators, the opportunity for regulatory arbitrage arises because of state-by-state differences in oversight, accounting and capital requirements for the two types of entities.”
“In addition, in most instances, unlike primary insurers, reinsurance captives are required neither to file public statutory financial statements nor to follow the same regulatory accounting practices as primary insurers,” the report said.
The report notes that many life insurers have been using captive reinsurers, in part, to avoid having to meet certain regulatory requirements.
If captive reinsurers are not monitored properly, the report said they could exacerbate a troubled primary insurer’s financial problems.
As an example, the report lays out a scenario in which a parent company providing a guarantee to a captive suffers financial distress. If the parent company were unable to properly capitalize the captive, the primary insurer could lose credit for the reinsurance on its statutory balance sheet and could experience a capital shortfall. That could complicate the resolution of a large insurance company, the report said.
“Regulators and rating agencies have noted that the broad use of captive reinsurance by life insurers may result in regulatory capital ratios that potentially understate risk,” the report said.
During the meeting, S. Roy Woodall Jr., who serves as the independent member of FSOC with insurance expertise, said state regulators should take note of the report’s “express concerns” about the use of captive reinsurance entities in the life sector.
“It sends an important signal to our state insurance regulators as they address supervisory issues tied to the use of captive insurance,” Woodall said.
The FSOC’s report also reiterated a finding made by the council last year regarding the pressure insurers have been under during what has become a prolonged low-interest rate environment. The report said that as interest rates remain low, many life insurers have pursued investment strategies that pose greater risks than traditional investment-grade fixed-income investments.
The report said some insurers have increasingly turned to commercial mortgage loans, equity real estate and alternative assets such as private equity funds and hedge funds. All of those strategies are less liquid than traditional investments.
“Life insurers, which typically have investments in longer-duration fixed-income assets that are held to maturity to match long-tail liabilities, are vulnerable to interest rate volatility if they have to sell such assets prior to maturity to meet liability cash flow demands,” the report said.
The report recommended that the Federal Insurance Office and state regulators continue to monitor risks resulting from severe interest rate shocks.
The FSOC also adopted amendments to its transparency policy that will require the council to post meeting agendas and minutes to its website more quickly. When the FSOC decides to meet behind closed doors, the amendments require the council to provide information about why those decisions are made.
Missouri Insurance Director John Huff, who serves as a non-voting member of FSOC, praised the council’s adoption of an updated transparency policy, noting that the National Association of Insurance Commissioners recently updated its transparency policy.
But both Huff and Woodall said the FSOC should be more forceful in pressuring international regulatory bodies to be more transparent. The insurance industry has criticized the International Association of Insurance Supervisors and the G-20’s Financial Stability Board for making decisions without sufficient transparency.
“I am somewhat sympathetic to some of our colleagues who feel excluded, as I have been personally frustrated in similar fashion at the level of international transparency,” Woodall said.
In March, Woodall and the Federal Reserve joined the IAIS as observers. Their participation at the IAIS is expected to assist them in better monitoring the IAIS’ work related to global financial stability and also in consulting with international counterparts. Regulatory decisions will continue to be performed by voting insurance regulators on the IAIS.
Following the FSOC’s meeting, David Snyder, the Property Casualty Insurers Association of America’s vice president for international insurance policy, praised Huff and Woodall for calling for greater transparency at the international level.
“We clearly support the FSOC’s updated transparency policy, but it is especially important for international bodies, which have been making decisions behind closed doors,” Snyder said.
