Alerts and Updates

Controversy Over Principles-Based Reserves & SPVs - Report from the NAIC Fall Meeting

December 7, 2012

Regulators from two major states, New York and California, as well as a handful of others, opposed adoption of the manual, and thus of PBR.

The Fall Meeting of the National Association of the Insurance Commissioners (NAIC) generated some controversy on two topics. First, regulators addressed a major change for life insurers—how reserves for many products will be determined. Although the change was accepted by the majority of the NAIC, certain key regulators did not accept it. Second, the use of captive insurers to fund reserves under existing reserving rules was questioned by some regulators, and defended by others. Both issues may engender further discussion.

Principles-Based Reserves

The adoption of the new Valuation Manual will likely result in life insurers using "principles-based reserves" (PBR) for life insurance products. PBR will replace the current formulaic reserve computation method with a new method based on, among other things, complex company-based models. The new reserving methodology has long been in the development phase, but the process is now closer to fruition: The manual, along with the associated Standard Valuation Law, which has been revised to reflect PBR, can now be presented to the states for adoption. Once 42 state legislatures adopt the Standard Valuation Law, and certain other criteria relating to the volume of business done in a state are met, PBR will become generally effective. The earliest anticipated date for application of PBR to newly written business is 2015.

The controversial aspect of this development is that regulators from two major states, New York and California, as well as a handful of others, opposed adoption of the manual, and thus of PBR. Their objections are two-fold: First, there is a concern that using company modeling may result in problems similar to those that led to the crisis in the banking industry; second, PBR requires a level of sophistication that many companies, and many insurance regulators, do not possess. It is difficult to predict what that opposition will mean, but it could result in further delay in the implementation of PBR.

Captives Insurers and Special Purpose Vehicles

The second controversial issue bears a relationship to PBR. The new reserving method is, among other things, intended to provide some relief from the current requirement for life insurers to carry what are referred to as "redundant" or "non-economic" reserves with respect to certain term and universal life insurance business. These reserves, commonly known as "XXX" and "AXXX" reserves, exceed the reserves that actuaries believe are necessary to satisfy liabilities under the relevant business, and cannot easily be funded by premiums and investment income earned from the premiums. Many life insurers have used captive life insurers (known as special purpose vehicles, or SPVs) as a means of financing these reserves on a cost efficient basis for many years.

As was reported in the November 30 edition of The New York Times, the Captive and Special Purpose Vehicle Use (E) Subgroup of the Financial Condition (E) Committee met to consider an exposure draft of a white paper on Captives and Special Purpose Vehicles (the White Paper), which was prepared in response to earlier articles in the press suggesting that the use of SPVs might constitute a "shadow insurance industry" that could lead to issues of the type that threatened the banking industry. An early draft of the White Paper showed that there were differing views with respect to SPVs within the NAIC membership. Comments on the draft White Paper that was discussed at the Fall Meeting were received from a number of trade groups, including the American Council of Life Insurers (ACLI), as well as from other regulators, such as those in Vermont, Delaware and Missouri, which have laws that favor the creation of SPVs and other types of captives.

Most written comments were quite critical of the White Paper, although one major life insurer submitted a paper that was generally supportive. It was clear from the comments that many had interpreted the draft White Paper as an attack on the use of SPVs in XXX and AXXX funding transactions. Critics particularly decried the reference to SPVs as constituting a "shadow insurance industry." The chair of the subgroup denied that the point of the White Paper was to attack the use of SPVs for this purpose; rather, the goal was to address captives generally. He admitted, however, that "there was confusion about the message" of the White Paper. He agreed to rethink, and possibly eliminate, the reference to the shadow industry.

The Subgroup's discussion then addressed the real issue raised in the White Paper: whether SPVs used in connection with XXX or AXXX reserve funding transactions are designed to "avoid statutory accounting rules," or designed, as many regulators and industry members contend, to solve problems created by statutory accounting rules, but within the overall scope and intent of these rules. The discussion revolved around whether using SPVs for reserve transactions presented a solvency risk to the companies that participate in these transactions, and more broadly, whether various states that allow SPVs to be formed in the state are undermining the overall solvency regime for insurers. Some regulators, including representatives of Rhode Island and New York, expressed concerns about a system in which individual states may permit the use of SPVs to ameliorate the effects of the XXX or AXXX reserving rules by the use of structures that did not shift the risk completely outside of the holding company system. In the view of some regulators, the adoption of PBR would reduce or eliminate current reserve redundancies.

A number of other regulators, including representatives of the District of Columbia, Delaware and Vermont, as well as industry groups, generally argued that the insurance industry needs the flexibility provided by the alternative risk transfer (ART) market, and that properly structured transactions using SPVs (including XXX and AXXX reserve transactions) were consistent with that need. The regulators pointed out that the transactions done to date have been structured to generally observe statutory accounting and risk transfer rules, and that deviations from the strict letter of those rules have been carefully reviewed by regulators. These regulators, as well as industry representatives, disagreed with the charge that the XXX and AXXX transactions were intended to avoid statutory accounting rules. There was some consensus that transactions using SPVs need transparency in the regulatory community, but regulators from states with favorable SPV laws stressed that there already is substantial disclosure required under both existing and newly-enacted insurance holding company laws.

There has clearly been no consensus on a number of issues. The White Paper will be revised, and presumably the issue of SPVs will be moved to the Financial Condition (E) Committee. In the meantime, it seems clear that although adoption of PBR may reduce some reserve redundancies, the issue of redundant reserves will not be eliminated. Moreover, the effective date of PBR continues to be uncertain. Companies will undoubtedly see the continuing need to finance non-economic reserves through SPVs.

About Duane Morris

Duane Morris prepared a paper that was submitted to the Subgroup by the Department of Insurance, Securities and Banking of the District of Columbia. A copy of the paper is available here.

For Further Information

If you would like more information about the topics discussed in this Alert, please contact Hugh T. McCormick, Alice T. Kane, Carla C. Small, any of the members of our Corporate Practice Group, any of the members in our Insurance and Reinsurance Practice Group or the attorney in the firm with whom you are regularly in contact.

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