Last summer, the National Association of Insurance Commissioners (NAIC) was considering amendments to Actuarial Guideline 38 (AG 38) in an effort to address reserving deficiencies in universal life products that employ secondary guarantees (ULSG policies). Effective September 12, 2012, the NAIC revised AG 38.
Perhaps coincidentally, last summer, the New York Department of Financial Services (New York Department) sent a New York Insurance Law section 308 request (308 Request) to 80 New York domestic life insurance companies, requiring them to provide, 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. 1
- 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
Each company's response was to be executed by a senior officer under penalty of perjury.
The New York Department's investigation is still in the information gathering stage. There have been no public announcements regarding the progress of the investigation since its inception.
While the 308 Request does not set forth its purpose, we believe it likely that the New York Department's actions are at least in part motivated by its continuing interest in the various reserving issues surrounding Regulation XXX and Actuarial Guideline 38 (AG 38, also referred to as Regulation AXXX. 2
Prior to this latest 308 Request, the New York Department, in late 2010, sent letters to a number of carriers seeking detailed information regarding the reserves being held for ULSG policies. After reviewing the industry response, the New York Department believed (1) that insurers were not interpreting minimum premiums correctly3 and (2) that, as such, insurers were not in compliance with the spirit of New York Insurance Regulation 147, 11 NYCRR Part 98 (Valuation of Life Insurance Reserves) and AG 38. In short, the New York Department concluded that the life insurance industry does not hold adequate reserves for ULSG policies.
AG 38 was established in 2003 to clarify the NAIC's Valuation of Life Insurance Policies Model Regulation which sets forth reserve requirements for 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. These valuation methodologies employ formulas to determine mortality and interest rate risk at the time that the policy is issued.
Over the years, as new products entered the marketplace, many insurers believed that this "formula-based" methodology was too conservative regarding some products while it did not address the risks inherent in other products. Moreover, this methodology, which requires life insurers to hold significantly higher amounts of reserves than were previously mandated, led many carriers, and some regulators, to complain that this reserving methodology results in the holding of "redundant reserves." Insurers and industry analysts concluded that the need to retain unnecessary reserves has increased the cost of insurance products to consumers. Additionally, insurers claim that holding such excessive reserves has imposed a significant strain on capital, prompting life insurers to finance this burden through captive reinsurance arrangements. As a result, these NAIC Model Regulations along with New York Insurance Regulation 147 have been the subject of much controversy since their introduction more than 10 years ago. The NAIC Model Regulations have been amended numerous times, with AG 38 having been modified most recently in September 2012.
September 2012 Revisions to AG 38
The latest revisions to AG 38, which included the addition of sections 8D and 8E, were instituted in an effort to address this issue of so-called "redundant reserves." Section 8D sets forth reserve requirements for in-force business while section 8E delineates reserve requirements for new business. "In-force business" is defined as any policy or certificate issued prior to January 1, 2013, and in effect on December 31, 2012, or on any valuation date thereafter. In categorizing the policies in this manner, the revisions in effect have created a "closed block" of business that can be evaluated by company actuaries as a separate set of risks. "New business" is any policy or certificate issued after January 1, 2013.
The modifications to AG 38 involve the use of a principle-based reserve (PBR) methodology for calculating gross premium on "in-force" business. PBR represents a significant departure from the formula-based approach that was characteristic of the prior version of AG 38. PBR attempts to capture all identifiable material risks through the use of computer modeled, company-specific experience, risk analysis and risk management, rather than focusing solely on mortality and interest rate risk.
NAIC Valuation Manual
In another significant step to resolve the issue of "redundant reserves" through the implementation of a PBR methodology, the NAIC, at its December 2012 meeting, adopted the Valuation Manual, which sets forth the manner in which insurers may adopt a PBR approach to reserving. The Valuation Manual provides that the only risks that qualify under the PBR method are risks that are "associated with the policies or contracts being valued, or their supporting assets" and determined to be, or to become, material risks. Risks "associated with the policies or contracts" include such factors as lapse rates, separate account fund performance and contractual guarantees. General insurance company risks are not part of the PBR calculation of risk. The Valuation Manual also describes the minimum reserve requirements applicable to particular types of products, including which of these products are subject to PBR reserving, as well as experience monitoring reporting mandates.
The NAIC's recent adoption of the Valuation Manual, including PBR standards, comes some three years after the NAIC adopted revisions to the Standard Valuation Law, recognizing the use of a PBR-type procedure.
Specifically, the 2009 modifications to the Standard Valuation Law make clear that an insurer using the PBR method must:
- Quantify benefits, guarantees and funding associated with the policies and their risks that reflect unfavorable circumstances that have a reasonable probability of happening
- Employ assumptions and risk analysis that is consistent with the company's overall risk assessment procedures
- Incorporate assumptions included in the Valuation Manual or, if not so included, should establish assumptions using company experience or other relevant data
- Provide margins for uncertainty.
Additionally, the revisions provide that an insurer choosing to use PBR shall:
- Create corporate governance procedures and oversight of the actuarial function
- Annually certify to the board of directors and regulators the effectiveness of internal controls
- Develop and file with the regulator, at the regulator's request, a principle-based valuation report that complies with the Valuation Manual.
Adoption of NAIC Initiatives by States
Beginning in 2013, these various NAIC initiatives can be taken up by the states; i.e., adoption of the revised Standard Valuation Law as well as the revised Valuation Manual. It is important to note that these measures will not become effective until the first day of January following their adoption by 42 states. In this regard, it appears that the New York Department as well as the California Department of Insurance (California Department) will likely oppose any legislative initiatives to enact PBR in those states, as both have questioned whether other state insurance regulators will follow these influential Departments and block passage in their states as well.
Specifically, in a letter addressed to the NAIC dated November 26, 2012, just one week prior to the adoption of the Valuation Manual, New York Department Superintendent Benjamin M. Lawsky expressed concerns over the implementation of PBR. Notably, Superintendent Lawsky stated that the need for insurers to demonstrate strong quarterly earnings and capital may prompt these carriers to opt for a PBR methodology at the expense of long-term solvency and claims-paying ability. In support of this contention, he points to the banking industry, which adopted a similar principle-based reserving procedure in the early 2000s, leading many banks to hold fewer reserves prior to the 2008 financial crisis. Additionally, Superintendent Lawsky maintains that it is not a foregone conclusion that relaxing reserve requirements will result in lower-cost life insurance for consumers, and that regulators are not prepared to evaluate the adequacy of PBR reserving since much of the methodology is based on insurer-specific experience.
This lack of regulator enforcement knowledge is the primary reason cited by California Department Commissioner Dave Jones in his statement of December 2, 2012, opposing the NAIC's adoption of the Valuation Manual. Specifically, Commissioner Jones expressed concerns regarding resources, cost and the lack of a consistent multi-state review process to evaluate insurer reserve levels.
Finally, Superintendent Lawsky points out that some regulators permit insurers to create captives or special-purpose vehicles (SPVs) to offload the burden of "redundant reserves" and thereby "free up" capital through reinsurance arrangements. Insurers who are not permitted by their domestic state regulator to use such arrangements are faced with a competitive disadvantage. Superintendent Lawsky then goes on to state that "reserve relief" can be had within a non-PBR environment, i.e., by updating mortality tables or addressing specific policy types or features rather than resorting to an untested and potentially damaging methodology.
Superintendent Lawsky's mention of the use of captives or SPVs to address the issue of redundant reserves in his recent letter to the NAIC may lend even more credence to the notion that the motivation for the New York Department's current investigation into the life insurance industry's use of captive reinsurers is grounded in the Regulation XXX, AG 38, and now PBR, controversy. It is likely that the New York 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 to all policyholders of the company. Given the New York Department's conclusion (in its 2010 investigation) that the industry is not holding adequate reserves for ULSG policies, it appears that the 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.
Insurance Industry Solution to "Redundant Reserves"
Over the past decade, as Regulation XXX and AG 38 took hold, the life insurance 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 New York Department's latest 308 Request, 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 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 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, 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.
This life insurance industry solution to the problem of "redundant reserves" has generated a fair amount of concern among other regulators and has led some commentators to liken this use of captives to a sort of "shadow banking system." The clear implication of this characterization is to equate the regulatory deficiencies in the banking system that were revealed through the 2008 financial crisis to the life insurance industry's current use of captives.
Recent articles in the Wall Street Journal (WSJ) dated November 22, 2012, and the New York Times (NY Times), dated May 8, 2011 have suggested a more sinister purpose for the growing use of affiliated reinsurance captives to help meet capital requirements. For example, the WSJ article, entitled Life Insurers Ramp Up Use of 'Captives' suggested that the concern of the New York Department and other state regulators is that insurers have established affiliated reinsurers to "skirt stiff capital requirements that would apply if they kept the business on the books." The motive ascribed by the NY Times article, entitled Seeking Business, States Loosen Insurance Rules, is even more sinister, comparing captives to "the shadow banking system that contributed to the financial crisis."
Captives were originally recognized in the law as a means of permitting non-insurance companies to form subsidiaries to ensure their own risk. This new use of captives by insurance companies seems to have prompted the NAIC to form the Captive and Special Purpose Vehicle Use Subgroup under the Financial Condition Committee (Captive Subgroup) in early 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 regulatory changes need to be made.
At its December 2012 meeting, the Captive Subgroup discussed a draft of its White Paper on Captives and Special Purpose Vehicles. The White Paper, which was not well received by regulators and life insurers, is being revised based on industry comments. Perhaps one of the most controversial recommendations in the White Paper was the suggestion that life insurers could resolve excessive reserving issues through changes to their own internal accounting practices. The life industry does not believe that changes to their internal accounting procedures will cure the excess reserve problem. Additionally, the White Paper suggests that issues with the captive structure may be rectified through regulator review and approval of holding company transactions.
The Captive Subgroup also considered whether the use of captives to address "redundant reserves" presents a solvency issue for insurers. There was no consensus among the subgroup members as to whether the use of these mechanisms threatens insurer solvency. Members from states having "friendly" captive laws argued that the use of captives to overcome the life insurance reserving issue is appropriate given the scrutiny that such transactions receive from the captive state regulator as well as the domiciliary state regulator. Other members cautioned that the use of captives to finance redundant reserves presents a significant solvency issue for the life insurance industry. Some subgroup members referenced the adoption of the PBR reserving methodology, stating that this new procedure will likely eliminate the issue of "redundant reserves" and eventually the motivation for using captives to finance these types of transactions.
Adoption of Principle-Based Reserving Uncertain
While there was no general agreement concerning this solvency question, Captive Subgroup members did collectively acknowledge that, given the fact that 42 state legislatures must adopt the revisions to the Standard Valuation Law and the Valuation Manual before PBR can become effective, life insurers will continue to use captives for some time.
Finally, with states like New York and California opposing the adoption of PBR, its ultimate passage is more uncertain, and, if PBR is not enacted, the issue of "redundant reserves" may well remain unresolved. Moreover, with the outcome of the New York Department's section 308 inquiry still unknown, the impact of that investigation on the success of PBR, and the ongoing use of captives, cannot yet be assessed. One thing is certain: the issue of "redundant reserves" and the life insurers' use of captives to address this issue will continue to dominate the life insurance industry for the foreseeable future.
1. Under New York Insurance Law Section 1505 (d), domestic life insurers are required to file for approval with the New York Department all reinsurance treaties between affiliates. As a result, assuming the agreements were filed, the New York 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 also have to be filed and approved by the New York Department before they are executed. Accordingly, any affiliated collateral agreements supporting these reinsurance transactions should have already been reviewed by the New York Department.
2. Regulation XXX concerns the reserves required to be maintained for term life policies with long-term premium guarantees while Actuarial Guideline 38, or Regulation AXXX, deals with reserves required to be maintained for all universal life products that contain secondary guarantees with or without shadow accounts ("ULSG policies").
3. 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