In the midst of the broader discussion within the insurance regulatory community regarding the financial risks potentially posed by captive reinsurers, the National Association of Insurance Commissioners (NAIC) has recently taken steps to evaluate the use of captive reinsurance for guaranteed elements in variable annuities (VA) and the hedging risks associated with such products. The NAIC’s review and assessment of these issues will have implications for VA issuers in general and will likely affect the manner in which they manage capital.

A. The Controversial Accreditation Proposal

On February 24, 2015, NAIC staff submitted proposed revisions to the preamble to Part A of the NAIC Accreditation Program Manual. The proposal, if adopted, would require all accredited states to subject any captive reinsuring variable annuities valued under Actuarial Guideline XLIII (AG 43), long-term care insurance, or XXX/AXXX policies, to the Part A accreditation standards (including statutory accounting principles and other requirements applicable to a traditional insurer) if the captive reinsures such policies written by a ceding insurer in at least two states.
 
For captives reinsuring VA risk and long-term care insurance, the proposal as currently drafted has no grandfathering and thus would impose retroactive application of the accreditation standards to existing VA and long-term care reinsurance captive arrangements.
 
Perhaps unsurprisingly, the accreditation proposal has received criticism from industry participants. In a March 20, 2015 comment letter from the American Council of Life Insurers (ACLI) to the NAIC’s Financial Regulation Standards and Accreditation (F) Committee, the ACLI stressed the need for the NAIC to gain a better understanding of the purpose of VA captive reinsurers, the way they operate, and their risk to the U.S. solvency regime before adopting the proposed measures. Specifically, the ACLI comment letter pointed out that with respect to the VA products, the “current NAIC reserve, asset valuation, and capital requirements have a mixture of book value and market value accounting, which produces artificial volatility and unpredictability of statutory requirements.”

The ACLI also noted that the purpose of VA captive reinsurance transactions is to properly align the accounting of the liabilities of VA guarantees with the accounting of the hedge assets that help mitigate the guarantee risk to the reinsurer on these transactions. As such, they provide a better measurement of the net income and capital positions of these blocks of business.

B. New NAIC Working Group to Study Hedging Risks

In light of the focus on VA captive reinsurance from several federal agencies, the Financial Condition (E) Committee created the Variable Annuities Issues (E) Working Group during the recently concluded NAIC Spring National Meeting. The working group will be chaired by Commissioner Nick Gerhart (Iowa), and will oversee the NAIC’s efforts to study and address, as appropriate, regulatory issues resulting in variable annuity captive reinsurance transactions.

Consistent with the comment made by the ACLI regarding the accreditation proposal, Superintendent Joseph Torti III (Rhode Island) confirmed during the meeting of the Financial Condition (E) Committee that the Variable Annuities Issues Working Group will work to better understand why insurers use VA captives.
 
We will be closely monitoring the progress of the new working group and providing updates on developments.

C. Federal Regulators Also Interested

Federal regulators have also evinced interest in the VA reinsurance issue. In its May 7, 2014 Annual Report, the Financial Stability Oversight Council expressed concern over the use of captives to reinsure VA risk, noting that of “particular concern is the use of captives to reinsure insurance products with liability valuations that are volatile, cyclically sensitive, or interest rate sensitive, such as variable annuities with guaranteed living benefits and long-term care insurance.”
 
Subsequently, the Federal Reserve Bank of Boston issued a report in October 2014 that was critical of the use of VA captive reinsurers. That report, which described how the use of these captives has accelerated over the past few years due to the comparatively low reserve and capital requirements for captives, concluded that this development has weakened the balance sheets of ceding insurers, including by reducing the amount of reported capital and the capital quality supporting these transactions relative to reserve levels.
 
Federal regulators are said to be waiting to see what measures will be taken by the NAIC once it has fully studied the use of VA reinsurance captives.

D. Potential for Litigation by Contract Holders

The use of reinsurance captives in the context of XXX/AXXX transactions has already yielded a handful of class action suits, so far all brought under New York law, alleging actionable misrepresentation by failure to disclose to consumers that the use of captive reinsurers undermines the strength of the financial support backing the policies. It is possible that if these suits gain traction, they may engender similar class litigation based on VA captive reinsurance. We will continue to monitor relevant class action and other captive-related litigation developments for any indications that similar claims might spread to the VA industry.