By Arthur D. Postal
WASHINGTON – The use of captives by life insurers to reduce federal taxes has prompted the head of the New York Department of Financial Services (DFS) to ask the Treasury Department to look at ways of stopping the practice.
In a letter to Treasury officials Nov. 21, DFS Superintendent Benjamin M. Lawsky said the use of captives is “in many ways similar to the exploitation of differing global tax rules across various countries through corporate tax inversions.”
Surprisingly enough, Lawsky said, “the scheme involves the gaming of varying insurance laws and regulations right here in our own nation across different states.”
Treasury officials declined comment, noting that it had been consistent in voicing concerns about the use of captives in the 2013 modernization report and the Financial Stability Oversight Council’s 2014 Annual Report.
Many carriers reinsure their liabilities through a captive, which acts as an in-house insurance company for the insurance carrier. The transaction allows an insurer to take credit for reserves ceded to the captive. Insurance carriers have found captives useful as a capital management tool as captives have allowed insurers to meet higher regulatory reserve requirements while also allowing underwriters to competitively price life insurance policies. As a result, the use of captives has grown over the past 15 years.
The American Council of Life Insurers took issue indirectly with Lawsky. In a statement, ACLI said reinsurance transactions with affiliated subsidiaries “are an important component of risk management.”
The ACLI statement said that, “These long-standing transactions are a legitimate, safe, and cost-effective means of fully satisfying reserve requirements.”
Lawsky’s latest concerns about use of captives were first reported Saturday in The New York Times, which cited examples of various states encouraging life insurance companies to switch their domiciles to their states in order to use captives as a means to reduce their federal taxes. The story cites Iowa as using “state of the art” language to entice insurers to domicile there as a means of taking maximum advantage of captive provisions.
Lawsky has repeatedly voiced concern about use of captives, and has tried to block their use in New York.
However, the Times story failed to disclose that his latest comments were written just four days after the Principle-Based Reserving Implementation (EX) Task Force approved new guidance, Accounting Guidance 48, that industry lawyers believe will provide reassurance to more state regulators to allow the practice.
A vote to approve AG 48 as a model law or rule is expected to be made by the full NAIC either Dec. 16 or 19, according to NAIC staff.
Lawyers at Mayer Brown said the new guidelines should give regulators, industry participants and financing parties involved in reserve financing deals more clarity than they have seen at any time since 2011, likely setting the stage for a substantive increase in these transactions. The law firm has a number of clients they advise on these deals, including insurers and banks and brokers that participate in these deals as advisors or brokers.
The guidelines apply only to a specific set (XXX/AXXX) of captives used by the life insurance industry. They are level premium term life insurance policies and reserves required for universal life insurance policies with sold secondary guarantees, NAIC staff officials said.
However, in a conference call with clients last week, David W. Alberts, a partner in Mayer Brown’s New York office, said the impact of AG 48 will likely be to expand the practice of using captives.
Alberts and other Mayer Brown lawyers also see the NAIC as expanding the scope of AG 48 to cover other life insurance products.
Alberts said the impact of AG 48 will not be to shut down reserve financing, “despite the position that the New York Department of Financial Services has taken. … Rather than shutting down reserve financing, there will be more disclosure requirements and an increasing consensus across different state regulators as to how much to finance and how to do so.”
In his letter to Treasury, Lawsky calls the use of captives to reinsure life insurance portfolios as a “gaping loophole that provides billions of dollars of unearned and unwarranted tax deductions.”
Lawsky said that through this maneuver, insurers create special purpose vehicles (SPVs) in states with looser reserve requirements, and then shift customers policies into these SPVs. He also noted that since reserves are the financial buffer insurers put aside policyholder claims, they are typically tax deductible.
“Since the reserve requirements are lower in the states with the SPV is located, this action allows insurers to redeploy their reserves for other purposes, including executive compensation, acquisitions, bonuses and dividends,” he said. “Nonetheless, under current federal tax rules, insurers can still take a full tax deduction on the original amount of reserves that they held before they engaged in this ‘financial alchemy’,” Lawsky said.
In other words, Lawsky said, “insurers are trying to have their cake and eat it, too. The firms siphon off cash for other purposes through these insurance inversions, then still take the full tax deduction on the original amount of reserves.
“This loophole defies any form of logic or common sense,” he concluded.
By contrast, the ACLI statement said captive reinsurance helps make “life insurance more affordable than it would be without them.”
The ACLI statement said that, “strict regulatory oversight ensures that life insurance companies use reinsurance subsidiaries appropriately to meet their promises to policyholders, and the reinsurance subsidiary responsible for the underlying risk is entitled to a tax deduction for the reserves of those risks.”
The statement also noted that the ACLI and its members “continue to work with our regulators to assure that these reinsurance transactions are appropriately disclosed and accounted for uniformly from state to state.”
According to a report by the Office of Financial Reserve released earlier this month, MetLife and Prudential Financial are the two largest users of captives to reinsure their life insurance portfolio risk. Among a group of the 21 largest insurers, it cites American International Group, Northwestern Mutual Insurance Co., New York Life Insurance Co., Securian Financial Group and the Hartford Financial Services Group as among the largest U.S. insurers who don’t use captives to reinsure their life insurance portfolios.
Others in the group of 21 largest insurers that use captives to reinsure their life insurance risk are AEGON NV; Voya Financial; Protective Life Corp.; Lincoln National; Manulife Financial; AXA; Sammons Enterprises; Nationwide; and Primerica, according to the report.
Arthur D. Postal has covered regulatory and legislative issues for more than 30 years in Washington, D.C. He can be reached at [email protected].
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