A lack of consensus among state regulators on captive insurance companies and reserves is creating an uncertain environment for the U.S. life insurers, which could ultimately adversely affect insurer ratings, according to a new Fitch Ratings' report.

The New York State Department of Financial Services (NYSDFS) recently published very critical commentary alleging weaknesses in the regulation exhibited by other states, as well as the oversight provided by the National Association of Insurance Commissioners (NAIC). The department's focus was on captive arrangements described as shadow insurance, Actuarial Guideline 38 (AG38) and principles-based reserving (PBR).

The NYSDFS also concluded that New York insurers have engaged in $48 billion of shadow insurance transactions, and that the related reserve transfers “artificially” inflate capital. Other states, according to the NYSDFS, may be “racing to the bottom” in governing such transactions, while simultaneously making information on their captives unavailable to other state regulators.

Other state regulators declined to implement a moratorium on captives, which New York did, and some criticized NYSDFS's allegations, adding that New York breached certain regulatory protocols in making its statements. There has also been push back on the issue of PBR.

The core issue giving rise to the regulatory debate on captives, shadow insurance and PBR is the question of redundant reserves. Statutory accounting for insurance products is largely formula based, and the reserving standards for level-premium term life (referred to as XXX) and universal life with secondary guarantees (referred to as AXXX) appear to be the most controversial.

The use of an accounting approach that includes redundant reserves creates significant friction. Fitch points out in the report that the life sector is a highly competitive and mature business where it is difficult to achieve organic growth and strong profit margins. “A need to hold redundant reserves adds insult to injury in the eyes of management, since it limits their ability to employ leverage to enhance returns on capital,” reads the report.

This is further exacerbated by insurers’ needs to hold high levels of capital to support the reporting of strong RBC ratios for competitive reasons and to manage market perceptions. Accordingly, insurance company management has strong incentives to find ways to eliminate or reduce the impact.

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