What new scrutiny of life insurance captives means for advisers

Regulatory attention means advisers may want to rethink which companies they work with

Jan 2, 2014 @ 2:02 pm

By Darla Mercado

As regulators scrutinize life insurers' use of “captive” entities — subsidiaries that reinsure blocks of existing business — advisers may need to rethink the way they evaluate the carriers they work with.

Life insurance companies set up captives to which they shift blocks of insurance policy business. These captives can be set up within the U.S. or offshore, in locations such as Bermuda or the Cayman Islands. Having a reinsurance captive means that the carrier can hold fewer assets to back claims that have been pushed off to the subsidiary.

Captives have been the subject of criticism recently by both the Securities and Exchange Commission and state insurance regulators. The SEC has sent letters to a handful of major insurers, asking about the captives and the ramifications if insurance regulators barred their usage, according to a Dec. 29 story in The Wall Street Journal.

New York State Financial Services Superintendent Ben Lawsky also has voiced criticism, based on the argument that carriers' use of captives allows them to carry smaller capital cushions to protect policyholders.

After creating the “captive,” an insurer “diverts the reserves that it had previously set aside to pay policyholders to other purposes, since the reserve and collateral requirements for the captive shell company are typically lower,” Mr. Lawsky wrote in a June report on the practice, which he dubbed “shadow insurance.” Poor disclosures behind the captives and their financial condition, as well as “artificially rosy capital buffers” for the carriers using the vehicles were among the regulator's chief criticisms of the practice.

“Shadow insurance could leave insurance companies on the hook for losses at their more weakly capitalized shell companies,” Mr. Lawsky noted in the report.

Advisers and broker-dealer executives, meanwhile, are in a tough spot. The idea of working with an insurer whose risk-based capital ratio isn't as strong as it appears — or even working with an insurer that liberally pours existing business into offshore entities — isn't exactly palatable. Getting the information needed to make such assessments of insurers, however, is far from easy.

“The whole idea of captive reinsurers was intended to obfuscate,” said Lawrence J. Rybka, chief executive of ValMark Securities Inc. “The practice is so widespread that if you said you wouldn't do business with [insurers that use captives], you wouldn't have anyone to do business with.”

Indeed, even researchers who dig through carriers' financial statements say that finding any details on the captives is difficult.

“The access to the captives' financials is almost nonexistent,” said David Paul, principal at Alirt Insurance Research. “We have to look at the balance sheets in order to make any kind of in-depth comment on these, and we haven't been able to in most cases.” He noted that onshore captives issue statutory statements, but those companies account for a small portion of the overall captive universe.

Rather than poring through carriers' risk-sharing agreements, advisers might want to rethink the way they evaluate the life insurance companies they work with.

Mr. Rybka recommends looking past the flashiness of the product and its features and instead taking a closer look at the issuing company — the actual entity issuing the contract and not just the parent — as well as the financial strength of that entity.

He also suggested that advisers consider whether life insurance is a core operation of the issuing company. Parent companies that aren't as committed to the life or annuity business might feel fine about spinning off their life insurance businesses and captives to another buyer that doesn't prioritize the policyholders.

Mr. Paul noted that carriers' use of captives is just one issue to look at when it comes to advisers' evaluating their carriers. To understand the companies, their goals and their commitment to the business, it makes sense to examine quarterly and annual financial statements, as well as to sit in on the earnings calls.

“Management is broadcasting to the investment community about their plans, which may be diametrically opposed to what they tell the distribution,” said Mr. Paul. “Don't try to figure out some arcane thing about the captive, but look at what they say about the company's direction over the next five to 10 years.”

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