Shining a bright light on captive insurance

The captive insurance industry was criticized by the New York Department of Financial Services (NYDFS) earlier last year when Superintendent Benjamin Lawsky issued a report calling for an immediate national moratorium on the use of captive insurance companies (he called them ‘shadow insurance’ companies). His report was based on New York based life insurers using captives for reinsuring their risks, thus making more efficient use of their capital. 

It is interesting that the Cayman Islands is mentioned only once, in the second paragraph where it identifies Cayman as an example of an international jurisdiction, whereas the remainder of the report focuses only on the regulation of the “onshore” states.

Fortunately, for the captive insurance industry as a whole, the National Association of Insurance Commissioners (NAIC) responded meaningfully to the NYFSD stating that there would be no moratorium and reminding the Superintendent that the NAIC considers standards before imposing regulations. The Captive Insurance Companies Association (CICA) also commented on the report, reminding regulators that the industry supported moves for increasing transparency and that within the industry there is a long history of credible regulatory oversight.

What does all of this mean? As a useful start, it is worthwhile explaining how a captive insurance company works.

A captive insurance company is essentially self-insurance, for organizations that are looking to control and retain a portion of their overall risks. There are a number of reasons for a company to want to do this, for example: when commercial insurance for the risk is either unavailable or is exorbitantly expensive; the use of a captive insurance company reduces the overall cost of insurance, by enabling a company to achieve a lower premium rate on line by increasing via its captive its own risk retention, and as a result being able to purchase reinsurance at higher levels where the insurance rates are lower.

This is particularly useful when the company has a better unique loss experience history than its industry average.

Premiums retained can be applied to earn an investment return, taking advantage of the lag between the premium being received and a claim being incurred.

In the Cayman Islands, there is a forty-plus year history in the captive insurance industry, which has led to its status as the second largest international domicile.

This leadership role has been borne of a robust regulatory environment that endorses the concept of transparency and open dialogue – regulator-to-regulator, tax authority-to-tax authority and regulator-to-industry (and vice versa). The regulatory model is built upon simplification of processes and depends on the onshore regulator to be effectively fulfilling its function. This infrastructure includes a cadre of highly experienced professionals who service these vehicles. In view of this, the oblique mention of the Cayman Islands at the beginning of the report was misleading and disingenuous.

The concept behind the criticism is not “financial alchemy” as Mr. Lawsky accuses, but is a way of managing the continually increasing reserve amounts required under the formulaic approach to setting reserves, which often prescribes reserve amounts that require life insurers to be burdened with redundant reserves that escalate year on year, creating inefficiencies and therefore keeping insurance rates artificially high. A principles-based reserving system (PBR) is currently in the works that is seen as an improvement over the current approach, in that it is more tailored to each individual insurer program and risks, but this proposal is also being tested by the state-side regulators.

In working with the formulaic approach, the market innovated, as it will always do. Instead of tying up capital, life insurers looked to captive insurance companies and the investment returns possible from securitizing the reserves through the capital markets, or to otherwise find constructive uses for that capital outside of the reserve obligation. This option meant that the reserving process could be tailored to work for each specific product, rather than using the one-size-fits-all approach that regulators often like, but that tend to stifle innovation and overload some areas of the market, while underserving others. The fear in this case is that painting everything with the same brush can still lead to over or under reserving, which does nothing to protect the end user.

To further the discussion on an informed and reasoned basis, the NAIC has formed two committees which have been tasked with studying the situation and to analyze the critics’ concerns, which include the reduced security of policyholders and a potential increase in insurer insolvencies.

The point here is that the NAIC is taking seriously the claims made by the NYFSD, but at the same time is not dismissing the captive concept in a knee-jerk reaction. If a life insurer or a bank is using a captive insurance company as an unconventional form of reinsurance transaction does not mean that the entire traditional captive insurance market should be brought down? 

The irony is that the commotion has persuaded one particular insurer to repatriate its captive from Bermuda back to the United States. The superintendent may be pleased with that, as his pillorying of the international domiciles seemed to accomplish part of his goal, but in the end, one has to wonder if the captive is now in a domicile that is as well-regulated as either Bermuda or the Cayman Islands?