The myopia of insurance regulation
The charge from New York Superintendent of Financial Services Benjamin Lawsky is that life insurers domiciled in his state have overstated their financial strength to the tune of some $48 billion by claiming credit for reinsurance coverage written by affiliates organized as captives in states with relatively law oversight. While affiliate reinsurance is not a new phenomenon, Lawsky charges these captive reinsurance transactions are particularly opaque, and that the captives themselves may be backed by assets (such as guarantees from the corporate parent or “conditional” letters of credit) that never should have been approved as collateral.
If the question is whether this amounts to a shell game, the answer is: of course. Quite literally, any sufficiently complex corporate entity inevitably is going to use shell companies to shift its assets and liabilities around in ways that maximize returns on the former and minimize exposure to the latter. The more important question is whether this particular shell game is dangerous, and what it might tell us about the potential weaknesses of risk-based capital.
RBC is the system the states adopted in response to the threat of federal regulation (a threat levied at the time by then-House Commerce Committee Chairman John Dingell, D-Mich.) following a spate of major insurer insolvencies in the early 1990s. The system preserves each state as the primary regulator of insurance operating units domiciled within that state, but requires the states adopt standards (governing both insurers’ operations and the basic competency of the regulators) that are promulgated primarily by the National Association of Insurance Commissioners.
The system has worked more or less as designed, though regulators in general and the NAIC in particular are sometimes prone to hyperbole in their efforts to trumpet its merits. Among the more notable recent examples were the contortions regulators went through, while Congress was drafting what would become the Dodd-Frank Act, to disavow any responsibility whatsoever for the enormous black hole that lie at the center of the financial crisis — AIG.
Witness this NAIC press release from March 2009, the height of the anti-AIG furor that briefly gripped America, wherein the regulators attempted to sell Congress on the notion that AIG….wasn’t actually an insurance company:
First and foremost, AIG is typically described as the world’s largest insurance company. In fact, it is a global financial services conglomerate that does business in 130 countries. AIG owns 176 other companies, in addition to 71 U.S. state-regulated insurance subsidiaries.
Of course, while AIG was in lots of business, including consumer credit and airline leasing, the vast bulk of those other companies AIG owned were foreign insurance companies. And state insurance regulators had long asserted prior to the AIG debacle that they were perfectly capable of monitoring both insurers’ holding companies and all the international activities of U.S. insurance groups, signing scores of memoranda of understanding (MOUs) with foreign regulators to share data and oversight for precisely that purpose.
Notable among those MOUs was those with the People’s Republic of China, where AIG was for many, many years
- The only U.S. insurer doing business and
- The parent of AIA, the largest privately owned life insurer in all of Asia.
But in case Congress didn’t quite buy the line that AIG wasn’t an insurance company, the NAIC was prepared with a backup explanation – that AIG’s failure had nothing to do with its insurance operations.
Ario reiterated that AIG’s Financial Products operation – not its 71 U.S. insurance subsidiaries – created the systemic risk that caused the federal government to intercede
While, yes, it’s true that collateral calls on credit default swaps written by AIGFP were the biggest problem the company faced in late 2008, they were far from the only problem. Nearly as big of a black hole was opened by the company’s securities lending program, which was carried out by its U.S. life insurance subsidiaries and signed off on by state regulators.
Then there’s the fact that AIG wasn’t the only insurer to require federal assistance during the financial crisis (Hartford and Lincoln Financial both got TARP funds as well) or the fact that effectively ALL state-regulated insurers who wrote either mortgage guaranty or financial guaranty coverage would eventually find themselves in Chapter 11. Needless to say, while the financial crisis didn’t hit insurance as hard as it did some other financial services, one can hardly assert the industry came out unscathed.
So what does any of that have to do with Ben Lawsky’s investigation of captive reinsurance in the life industry? It actually goes to the heart of both what is good, and what is sorely inadequate, about state-based regulation. Back when she was the NAIC’s executive director, Terri Vaughan frequently used to tout the bright side this way:
“In our state-based regulatory system, we have many eyes focusing on an issue, including some 13,000 people across the states,” she said. “Because of that, we’re less likely to miss things and to come down on the side of dogmatic solutions.”
But the obvious down side of having “many eyes” is the condition known as myopia. There are thousands of insurance regulators looking at pieces of the industry. Notwithstanding Dodd-Frank’s creation of a Federal Insurance Office within the Treasury Department (which has yet to issue any of several reports that law mandated, including one that is now a full 18 months overdue), there really isn’t and has never been any effective, efficient way to aggregate that information into a big picture.
Thus, the question of whether captive reinsurance is a dangerous practice by life insurers is one that is impossible for someone in the lay public to answer. Statutory data can provide clues, but it is kept under lock and key by the NAIC itself, which profits handsomely from its sale to investment banks and business data firms. Even if the full set of data were publicly available (something we argue the FIO should make among its highest priorities) one must be prepared to conduct an exhaustive expedition through thousands of CUSIPs and legal entity org charts, not to mention mastery of an arcane accounting system that resembles that used by no other industry, before you will be able to conclude anything about the actual financial strength of just one modestly complex insurer.
In the end, consumers have no choice but to place an awful lot of faith in the competence of thousands of local regulators whose salaries are mostly paid by the very companies they’re regulating, or the opinions of rating agencies who face the exact same conflict.
What we can say with some confidence is that the practice of captive reinsurance is not limited to life insurers. In Florida, in particular, there is evidence that a number of the state’s domestic P&C insurers have been using captives as a source of reinsurance. A market conduct exam of Universal Property & Casualty Insurance Co., the third-largest property insurer in the state, last year revealed some irregularities in its captive reinsurance program, leading the Office of Insurance Regulation to hand down this order:
It is further ordered that any future captive reinsurance programs be 100% fully collateralized by UPCIC by depositing with the Bureau of Collateral Management in cash the sum of the total coverage provided. Any future captive reinsurance programs shall further comply with the terms of the Consent Order issued on September 18, 2012, in Case Number: 126101-12-CO. UPCIC is also ordered to structure all future captive reinsurance agreements such that there is no guarantee of profit to the reinsurer in accordance with Statement of Statutory Accounting Principle (“SSAP”) 62R.
As the captive reinsurance story gains legs and other regulators are inspired to conduct their own investigations, don’t be surprised to see more such orders coming down the pike in the months ahead.