Locke Lord LLP
The NAIC, the IAIC, and a ban from the FHLB system—captives have their work cut out for them, as Rachel Coan of Locke Lord explains
What is the NAIC’s current focus in terms of captives?
The National Association Insurance Commissioners (NAIC) has mainly focused over the past three years on the use of captives by life insurers in connection with reserve funding transactions under regulations XXX (for term life policies with guaranteed level premiums) and AXXX (for universal life policies with secondary guarantees).
After studying actuarial models, consulting with outside advisors, compiling data on these transactions and examining the underlying deal documents, the NAIC in November 2014 adopted a draft of Actuarial Guideline 48 (AG 48), which set forth rules for new life reserve funding transactions after 1 January 2015, subject to certain grandfathering provisions.
The NAIC has tried to assure life insurers that it was not seeking to outlaw their use of captives and special purpose vehicles (SPVs), or to prevent them from employing structured finance to implement their funding goals, but rather to: (i) provide greater transparency to consumers on how life companies used these entities; (ii) assure greater consistency in how state insurance departments review and regulate these financings; and (iii) enhance the protection of policyholders of the underlying contracts by requiring more liquid collateral and increased solvency margins in order for the ceding company to obtain credit for reinsurance.
AG 48 was intended to be a temporary solution for reserve financing transactions until principle-based reserves requirements become effective. AG 48 will be superseded by individual state laws after the NAIC finalises a new Credit for Reinsurance Model Regulation and the states adopt responsive regulations of their own.
In 2015, the NAIC began a process to modify rules governing reserves, capital and hedge accounting for variable annuities to address issues that led insurers to establish variable annuity captives. It is anticipated the NAIC will develop its Variable Annuity (VA) Framework for Change in 2016 so the changes can be implemented in 2017. However, unlike AG 48, which applied only prospectively, the VA Framework is expected to apply to all variable annuity business issued since 1 January 1981.
AG 48 and the NAIC’s VA Framework will probably result in fewer captives being formed in the short term for use in connection in Reg. XXX and AXXX transactions and the issuance of variable annuities. The adoption of AG 48 complicates mergers and acquisitions involving companies with Regulations XXX and AXXX captives that now may require restructuring and may lead to tricky negotiations as to whether the buyer or seller assumes the regulatory risk of noncompliance. The VA Framework may impose significant burdens on existing variable annuity captives.
What are the implications of international regulatory oversight, specifically from the IAIS, on the regulation of US captives?
The International Association of Insurance Supervisors (IAIS) is a voluntary membership organisation of insurance supervisors and regulators from almost 140 countries. As a member of the Financial Stability Board, it serves as the international standard setting body responsible for developing principles, standards and supporting material for the oversight of the insurance industry and assisting in their implementation. In November 2015, the IAIS issued its detailed Application Paper on the Regulation and Supervision of Captive Insurers.
Along with tighter regulation of life insurance captives from the NAIC and stricter Internal Revenue Service (IRS) rules on the deductibility of premiums paid to small property and casualty captives reflected in recent amendments to IRS Code Section 831(b), the renewed attention paid to captives by the IAIS reflects a trend towards greater regulation of US captives generally.
While it is unclear whether the IAIS application paper will have a direct effect, its scope, incorporating 18 of the 28 IAIS Insurance Core Principles, is far-reaching, covering virtually all aspects of a captive’s operations. To the extent the IAIS application paper sounds themes, such as regulatory consistency, capital adequacy and greater accountability of captive owners, that echo those of the NAIC and the IRS, the IAIS guidelines will strengthen the impetus behind more stringent regulation of US captives.
What do you make of the the recent ban on captives having membership in the Federal Home Loan Bank system?
Federal Home Loan Bank (FHLB) members are eligible for low-cost mortgage loans. Under the FHLB Act, the Federal Housing Finance Agency (FHFA) is charged with regulating membership in the FHLBs. Under the act, traditional insurance companies that underwrite business for the general public have been eligible for membership. However, beginning in 2010, the FHFA became concerned about the practice whereby entities such as real estate investment trusts (REITs) that, themselves, do not qualify as FHLB members, established captive insurance subsidiaries as conduits to gain membership and low-cost FHLB funding.
In 2014, the FHFA issued a proposed rule that would amend its regulations on FHLB membership and, after considering more than 1,300 comment letters, released its final rule in January 2016.
In explaining why the final rules effectively exclude captives, the FHFA stated that, in contrast to traditional insurers: “The primary business of a captive … is underwriting insurance for its parent company or for other affiliates … and captives are generally easier and less expensive to charter, capitalise and operate.”
The FHFA noted that the practice of otherwise ineligible entities using captives to gain membership had been expanding and that it was concerned that it could “grow to include entities other than REITs, such as hedge funds, investment banks and finance companies”.
Although the FHFA noted that REITs play an important role in the residential real estate market, their use of captives was not authorised by or consistent with the FHLB Act.
It stated, in essence, that if Congress wanted to change the rule to expand access to FHLB membership, it could amend the FHLB Act.
What does this rule change mean for captives seeking access? And what about captives that currently hold FHLB membership?
The FHFA’s final rule would affect existing captives that are members of a FHLB in several ways.
For captives that became members before the FHFA published its proposed rule in 2014, they can remain members for five years following effectiveness of the final rule, though they are subject to limits on outstanding advances to 40 percent of their assets and on new advances and renewals with maturities beyond the five-year point.
For captives whose membership took effect after publication of the proposed rule, they must terminate membership within one year following effectiveness of the final rule, during which period they must pay existing advances and cease obtaining new advances or renewals of outstanding advances.
