New York Says Insurers Evade Federal Taxes Through Captives

WASHINGTON – Concerns about the problems associated with use of captives by insurers and the fact they also provide a way to escape federal taxes were raised with Congress in a letter from New York’s chief financial services regulator.

“We write today to highlight a troubling regulatory loophole that threatens the financial stability of the insurance markets, puts everyday policyholders at substantial risk, and provides billions of dollars in unearned tax deductions to large, multi-national corporations,” wrote Benjamin M. Lawsky, superintendent of the New York Department of Financial Services (DFS), in a letter to the Senate Banking Committee released this week by Sen. Sherrod Brown, D-Ohio, ranking member of the committee.

“That loophole is life insurance companies’ use of ‘shadow insurance’ vehicles to divert policyholder reserves to other purposes, such as executive compensation, dividends and acquisitions,” Lawsky said in the letter.

He said that insurance “is often presented as a sleepy corner of the financial world that draws little attention,” but that, “under that cover, insurers have quietly sought to exploit differing rules and laws across state lines to lower their reserve requirements through shadow insurance vehicles.”

He said it is “absolutely essential” that regulators now take forceful action to address this textbook example of regulatory arbitrage in order to protect the state-based system of regulation.
Lawsky said in the letter that many state insurance commissioners believe that the use of captives will subside with the NAIC’s move toward principle-based reserving (“PBR”).

Lawsky is highly critical of PBR, which the industry hopes to have in widespread use by 2017 — if enough states sign on. In the letter, Lawsky criticized PBR as “a deregulatory initiative that scraps statutory reserve formulae in favor of a regime that enables life insurers to set their own (i.e., lower) reserves based primarily on company-specific models that regulators are ill-equipped to understand or challenge.”

Of equal concern, Lawsky said, is that life insurance companies and regulators have maintained that it will need to continue to resort to captive insurance structures irrespective of whether PBR ultimately is adopted on a national basis.

Lawsky said that as of now, life insurer captives have involved just term life insurance (“XXX reserves”) and universal life insurance with secondary guarantees (“AXXX reserves”).

But, life insurers are also using captives to reinsure their risks associated with long-term-care insurance and the guarantees under variable annuities with guaranteed living benefits (“VAGLBs”), he said.

Lawsky said in the letter to Brown that New York now collects data annually that captures information for all of these captives affiliated with New York licensed life insurers to get a more complete picture of the situation.

But, he warned, it is unclear at this time whether captives will expand to support even a greater number of products in the future whenever life insurers feel the reserves or RBC requirements are too high.

Lawsky added in the letter that it is “It is noteworthy” that the XXX and AXXX captive transactions also allow insurers to exploit a gaping tax loophole that provides billions of dollars of unearned and unwarranted tax deductions. He said that because reserves are a cost of doing business, they are typically tax deductible.

Lawsky said that although reserve requirements are lower in jurisdictions where captives are located, under current federal tax rules, insurers can still take a full tax deduction for the original amount of reserves they held before they engaged in the captive transaction.

“In other words, the insurers can have their cake and eat it, too,” Lawsky said, adding that New York has recommended that the IRS examine the gamesmanship associated with life-insurer owned captives, including ways to close that loophole.

InsuranceNewsNet Washington Bureau Chief Arthur D. Postal has covered regulatory and legislative issues for more than 30 years. He can be reached at arthur.postal@innfeedback.com.
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InsuranceNewsNet Washington Bureau Chief Arthur D. Postal has covered regulatory and legislative issues for more than 30 years. He can be reached at arthur.postal@innfeedback.com.