The South Carolina Department of Insurance (the “SC DOI”) recently approved the first application for a Special Purpose Financial Captive (“SPFC”) that met specific modeling and financing standards included in the newly-proposed Actuarial Guideline XLVIII (“AG 48”) on SPFC reinsurance transactions. In 2004, South Carolina passed the first legislation in the country that allowed life insurance companies to create and use SPFCs as reinsurance vehicles to facilitate the funding of life insurance reserves required by the Valuation of Life Insurance Policies Model Regulation (“Regulation XXX”). So, it is appropriate that South Carolina be the first to license an SPFC using AG 48.
Background: A Need for Reinsurance
Private reinsurance of life insurance risk through SPFCs is the culmination of a long national regulatory debate on the proper calculation and funding of life insurance reserves. To understand why South Carolina is proud of having led the way in facilitating the process, one must first understand the economic forces driving it.1
State regulators hold life insurance companies to conservative solvency standards to provide protection to consumers. To ensure their ability to pay claims, prudent companies have long calculated and funded reserves using reasonable actuarial assumptions and methods (“Economic Reserves”). However, in 2000, the National Association of Insurance Commissioners (“NAIC”) promulgated Regulation XXX, which established significantly higher reserve requirements (“Statutory Reserves”). Regulation XXX includes mortality assumptions that are extremely conservative from an economic standpoint, ignoring improved longevity and better medical care available to the general population. Further, these reserve requirements do not uniformly account for variances in mortality experience among different classes of risk. Consequently, Regulation XXX requires term life insurance policies to be supported by reserves that are often two or even three times the amount (“Extra Reserves”). South Carolina and all other NAIC member states codified Regulation XXX along with statutory mortality valuations for universal life policies via Actuarial Guideline 38 (“A-XXX”), a natural evolution of the Regulation XXX requirements which invokes a similar conservative valuation assumption and creates similar Extra Reserves.
Life insurance companies have had trouble addressing reserve strain resulting from the application of Regulation XXX.2 Life insurance companies essentially have a Hobson’s choice to avoid statutory insolvency: redirect capital into Extra Reserves, where regulatory investment restrictions will prevent efficient use, or increase premiums to a level that will drive their products out of the marketplace. These developments led to a scramble for options to either affordably fund or eliminate the need to fund Extra Reserves.
The NAIC has been analyzing and debating whether relief from Regulation XXX and A-XXX reserve requirements should be granted, particularly in light of the economic upheaval in recent years. The implementation of Principal Based Reserving (“PBR”) was intended to provide that relief. A Subgroup of the NAIC’s Financial Condition (E) Committee (whose members included SC DOI staff) studied the life insurance industry’s use of SPFCs. Among other things, the NAIC Committee found that PBR would certainly reduce Extra Reserves and lessen the need for SPFC transactions, but not eliminate them. In December 2014, the NAIC promulgated AG 48 for adoption by the several states in response to these and other concerns about the funding of Extra Reserves. As of this time, AG 48 has not yet been adopted by the requisite number of states to become an official standard regulation.
Special Purpose Reinsurance and Capital Markets Financing
Utilizing PBR or other NAIC-approved changes will be difficult from a timing standpoint, given that they will apply only prospectively, and many of the identified alternatives would require statutory and/or regulatory changes by the member states. Unfortunately, the various methods used for funding Extra Reserves to date have also revealed some shortcomings. Life insurance company reserve portfolios suffer from the same poor conditions that affect the investment market in general. Funding from within a holding company structure might not be available or may tie up critical assets needed elsewhere in the company’s operations. Traditional reinsurance and retrocession premiums have risen and market capacity has been constrained. Recent macroeconomic volatility limited availability of letters of credit (“LOCs”) and, where they are offered, higher interest rates often prevent them from being a viable long-term funding alternative. In any event, because the underlying life insurance policy obligations may span a period of thirty years or more, many regulators have viewed the short-term nature of LOCs with disfavor.
It was in this environment that the SC DOI took a standard, frequently-used funding mechanism from the property and casualty insurance arena and modified it into a viable option for funding Extra Reserves: securitization via the capital markets. Like a catastrophe bond, a life insurance securitization was a means of converting insurance risk into a financial product which was ultimately sold to sophisticated investors. The securitization generally involved two facets. The first was creating the SPFC, to which the parent or other counterparty ceded certain policy risks (and Extra Reserve requirements) for a specified actuarially determined premium that would fully fund the SPFC’s Economic Reserves. The second element involved a series of heavily regulated and carefully drafted financial transactions in which the SPFC would sell surplus notes in the full amount of its Extra Reserves to a SEC Regulation D “accredited investor” or an underwriter who would convert the notes into securities for sale to institutional investors. The securities are similar to a bond and pay interest until a specified maturity date. The SPFC’s premium revenue stream funds its special purpose. The proceeds from the sale of securities are held in a specially drafted trust, administered by a third-party financial institution. The trust funds enable the SPFC to provide statutory credit for reinsurance and are available to pay the obligations arising from the underlying insurance policies. In addition to providing a solid, long term solution to the Regulation XXX and A-XXX reserve requirements, securitization transactions allowed the life insurance industry to transfer risks by direct access to the financial markets and thereby expand, diversify capacity, and market affordable products to consumers.
In developing and implementing this financial mechanism, it quickly became evident how many life insurance companies were interested in utilizing securitization transactions as a means of accessing alternative sources of capital. The principal obstacle was the ultimate cost of the capital markets component, which essentially limited its application to larger reinsurance transactions. In an effort to reduce these costs, and prevent securitization from giving a market advantage to only the biggest life insurance companies, the South Carolina General Assembly unanimously passed the first legislation in the country to codify the process. This helped reduce costs by eliminating a variety of perceived risks and uncertainties for potential investors, the monoline underwriters, and rating agencies. For example, the law formalizes the specific costs and filing requirements and the standards the SC DOI must use in evaluating a proposed transaction. The long term nature of these transactions required them to be insulated from arbitrary interference, so the law requires that the approval of a securitization transaction be recorded in a comprehensive order from the South Carolina Director of Insurance. The law also provides a specific protocol under which that order could be amended and grounds under which it could be contested to the South Carolina Administrative Law Court, a state agency created specifically to hear appeals of administrative orders. This greatly facilitated the program and made it the envy of other states, which widely adopted South Carolina’s new law verbatim, even states that do not have an Administrative Law Court or its equivalent.
Apples and Oranges
The success of the South Carolina program begs for a bright line to be drawn separating life insurance securitizations from the much maligned sub-prime mortgage-backed securitizations. Shortly following the meltdown of the sub-prime mortgage market in 2008, the term “securitization” fell from favor. It painfully reminded investors that it is the quality of the underlying securitized asset that should be examined when grading the quality of a particular securitized transaction. Simply put, the sub-prime mortgage securitization market collapsed because the companies that securitized those loans originated them on terms the borrowing consumers could not repay. The underlying mortgages were inherently of poor quality and high risk. This is a far cry from the financially conservative underlying risk in the most common captive insurance securitizations: mortality, a risk not linked to the general economy.
In contrast with the relatively recent boom in sub-prime mortgage-backed securities, insurance companies have been managing risk in their assets for a much longer time frame and inherently have a more mature risk management structure than most of the nascent sub-prime mortgage companies. Risk management is a basic operating component of insurance companies, and risk managers constantly seek out ways to hedge this risk while creating value for company shareholders, or more directly, those who ultimately bear that very risk.
Risk is still present in insurance securitizations. Some of South Carolina’s SPFCs’ market stress case scenarios became acutely relevant in 2008 and 2009. Rather than having a deleterious effect, though, the financial market meltdown triggered certain built-in protection measures. For example, in some cases experience refunds were trapped in the SPFC, which provided assurance that there will be additional funds held at the captive level to ensure the SPFC would still meet its Extra Reserve requirements. In South Carolina, prior to licensure, each SPFC is required to produce a deal model output to reflect the maximum rate re-pricing scenario. There is a deal model scenario reflecting maximum interest expense in the event of a maximum rate re-pricing in order to ensure stability in the captive. Securitizations with a money-market securities component had built in an ultimate rate limit so that the maximum rate re-pricing in the worst market scenario was capped. As a result, each South Carolina-domiciled SPFC utilizing a money-market component came through this liquidity event financially strong.
The South Carolina Difference
SPFC licensees in South Carolina receive a thorough testing and analysis during the review process. To the SC DOI, these SPFCs are not simply financial “deals”. They are true insurance companies, ongoing regulated entities, some with transactions spanning 30 years or more, and each is governed by a comprehensive regulatory Order of the Director of Insurance which often spans 50 pages or more. It could be argued that the SC DOI gives SPFC applications a higher degree of review and scrutiny than traditional UCAA applications. The SPFC application also receives independent, outsourced actuarial and legal review. This does not mean the heart of the review is outsourced; rather, it allows the SC DOI to focus on strengthening each transaction by relying on an independent review of the transaction protection measures.
From the very beginning, South Carolina has prudently required its SPFCs to provide full disclosure of their transactions to the domestic regulators of their counterparty insurance companies and obtain prior review and approval/non-disapproval of the SPFC reinsurance program via the Form A process. Once licensed, the SC DOI continues to have proactive, constructive dialogue with all of its SPFCs, and requires SPFCs to comply with all of the traditional annual audited and quarterly reporting requirements and provide copies to the ceding company’s regulators. This type of regulatory diligence, coupled with extremely competent, capable in-house staff, affords many investors, and certainly regulators in counterparty states, a great deal of comfort in the integrity of South Carolina SPFCs. South Carolina has set a solid standard with which the various counterparty regulators have been pleased.3
In addition to state insurance regulation, there are ongoing surveillance reviews by rating agencies, annual financial audits, and annual actuarial analysis to ensure the underlying block of insurance policies is performing as expected. In fact, in virtually every Regulation XXX transaction with which we have been associated, the liability projections (expected mortality, lapse, etc.) provided to the regulators and investors have been uncannily accurate. In some cases, these projections are over 10 years old and, with each passing year, experience shows them to have been very precise. Thorough, careful monitoring and extensive reporting ensures the proper performance of the insurance entities involved.
Insurance securitization has provided great benefits to both life insurance companies and consumers from the perspective of policy affordability and availability. Many insurers would be financially impaired, if not statutorily insolvent, without them. The number of SPFCs licensed in South Carolina demonstrates the great need of life insurance companies to finance the Excess Reserves required by Regulation XXX. Despite the attention the NAIC has given this subject, including the promulgation of AG 48, the problem of financing those reserves has not and seemingly will not go away. Insurance industry experts agree that even the highly touted shift to PBR would only reduce the size of the problem, not eliminate it. Life insurers need to obtain efficient capital for that which they do best: market their products at attractive rates.
The majority of the programs in South Carolina have funded Regulation XXX and A-XXX reserves, but we have seen our statutory ability to shift risk to the capital markets provide insurance companies with alternative forms of business financing for a number of other very practical purposes. In the current interest rate environment, the SPFC remains a viable alternative for accessing additional capital. It is an efficient financial management tool with a promising future. Dedicated reinsurance programs allow a ceding company to finance Extra Reserves more efficiently and enable consumers to benefit from lower premiums with no additional risk to the company.
South Carolina is known nationally for an innovative, business-friendly environment that has made it a home for great international companies like BMW, Boeing, Google, Michelin and Sonoco Products. The SC DOI’s captive insurance program reflects this by taking innovative, flexible, and responsive approaches to the formation and development of alternative risk transfer mechanisms. Specifically, the State has established a reputation as a world leader in utilizing alternative risk transfer platforms as vehicles for complex, well-regulated structured finance transactions. It is no accident that more SPFCs have been licensed in South Carolina than in any other state. It was the first onshore jurisdiction to authorize a life insurance capital markets securitization, and the first to pass comprehensive legislation to give investors and regulators greater certainty and specificity with respect to the transaction, thereby reducing risk and the ultimate cost of the transaction. South Carolina’s SPFC legislation is the gold standard, and we are rightfully proud of it. The list of states that have passed new captive legislation patterned after South Carolina’s law attests to this fact. Imitation is the sincerest form of flattery.
1. The authors are attorneys engaged in the private practice of law in South Carolina, not the agents, employees or spokesmen of the SC DOI. This article does not set forth any official or unofficial statements of policy or positions held by the SC DOI, which may hold different views.
2. The level of Extra Reserves required by A-XXX is more debatable, since those reserves are very sensitive to key assumptions for policyholder behavior and economic business.
3. Over the last 12 years, we have guided the formation and operation of 27 SPFC programs in South Carolina. This article in no way expresses the opinions or views of any of our current or former clients, wherever domiciled, or of their domestic insurance regulators.