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Captive Regulators Disappointed in New FHFA Rule

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A final rule released by the Federal Housing Finance Agency (FHFA) amended its regulation on Federal Home Loan Bank (FHLB) membership to specify that captive insurance companies can no longer be used as a conduit to membership of the organization. Membership offers entities access to low-cost FHLB funding and other benefits. Because insurers may become FHLB members, along with credit unions and savings and loans, the Federal Home Loan Bank Act has been revised to specify that the term “insurance company” excludes captives.

Housing regulators have viewed captive insurers as a loophole used to access low-cost, government-backed financing. “Real-estate investment trusts that invest in mortgages are normally ineligible for home-loan-bank membership, but over the past few years have created captive insurers to gain indirect access to cheap federal funding,” The Wall Street Journal wrote.

As a result of captives being admitted as members, “25 are owned by entities that are not themselves eligible for membership.” The FHFA said it is “concerned that this practice will continue to grow and there is no reason to believe it will not grow to include entities other than REITs (Real Estate Investment Trusts), such as hedge funds, investment banks and finance companies, some of which have already inquired about establishing captives to gain access to the FHLB System.”

FHFA Director Melvin L. Watt said in a statement, “FHFA has the authority and the duty to implement the statutory membership provisions of the Federal Home Loan Bank Act and by adopting the proposal to exclude captives from the definition of insurance company we are making sure that institutions can’t frustrate the intent of Congress.” He added, “Congress has amended the Federal Home Loan Bank Act in the past to allow additional entities to become members of a Federal Home Loan Bank and it can certainly do so again if it wants some of these entities to be eligible for membership.”

Captive regulators of Vermont and Delaware expressed disappointment in the decision. David Provost, deputy commissioner of captive insurance of the Vermont Department of photo_provostFinancial Regulation, said, “Vermont’s response to the proposed rule was pretty straightforward: Don’t ban captives from FHLB membership just because they are captives. Captive insurance companies are regulated insurance companies, licensed for a particular purpose, and regulated in a manner commensurate with their risk,” he said.

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Steve Kinion, director of the Bureau of Captive and Financial Insurance Products for the Delaware Insurance Department said, “The Delaware Insurance Department is disappointed that the Federal Housing FinancSteve Kinion (2)e Agency made the decision it made. In at least two comment letters, one in 2012 and the other in 2015, we have made attempts to work with the Federal Housing Finance Agency to help it understand captive insurers.” He added that what has been disappointing is that “our offers were never accepted. Delaware Insurance Commissioner Stewart continues to believe that captive insurers that are members of the FHLB system are well regulated and contribute to the FHLB’s mission of fostering housing in the United States.”

Kinion explained that that REITs have long sought membership in the Federal Home Loan Bank system, which was formed in 1932 to provide liquidity for the housing market. Because current law states that only certain types of institutions may become Home Loan Bank members, “captives have been a portal for membership. It’s unfortunate when well-regulated captive insurers are excluded from membership.

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 I only wish that, before it issued its regulation, the FHFA would have allowed me the opportunity to show what Delaware does at the state level to regulate captive insurers.”

Delaware had been seeing increased interest in REITs. The domicile has one such captive and others were in the pipeline. One reason Delaware likes them is the revenue they bring in. “Our regional Home Loan Bank is in Pittsburgh and 10% of the profits generated have to be designated for affordable housing programs,” Kinion said. “In Delaware, there are a number of organizations that receive grants from the bank to promote affordable housing, and that benefits the state.”

The REITs captive program was fostered by Delaware Insurance Commissioner Karen Weldin Stewart. Her rationale was that, through the program she could “help with affordable housing in Delaware, which she can’t do directly as insurance commissioner,” Kinion said. “This was an indirect means of helping Delaware’s affordable housing programs.

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Provost said that while he supports REITs captives, the new rule will have a negligible impact on Vermont. “We have studiously avoided jumping on bandwagons of forming captives that have no apparent insurance purpose solely for some ancillary advantage,” he said. “We have allowed captives to apply for membership to the FHLB, and so far five have joined. They will have one year or five years to leave the FHLB system, depending on when they joined.”

Kinion noted, “I wish the FHFA would have at least talked to us, so they could have seen how we regulate captive insurance companies. If regulation is a concern, they should have at least taken a step to find out what we do at the state level. But that didn’t happen.”

10 Insurance Tips for Risk Managers

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NEW ORLEANS—Most companies will at one time or another face coverage issues and lawsuits. In order to identify and avoid insurance-related issues and disputes before they arise, risk managers should take advantage of proven strategies for resolving difficult claims, advised Darin McMullen, attorney with Anderson Kill, P.C. at the RIMS 2015 Annual Conference & Exhibition here.

1. The purpose of insurance is to insure.

Don’t underestimate potential future problems and think of loss prevention and risk transfer rather than loss financing, he noted. Companies need to assess the types of risks they will face and make sure their program is tailored to meet these needs. Also important, he said, is making sure policies are designed to cover the losses the company will face on a day to day basis. For example, certain types of risks are seen in manufacturing and other risks are particular to an IT vendor. Risk managers need to examine any pitfalls or shortages that may exist in their current policies and seek legal opinions well in advance of renewal. They need to look at how exclusions might be interpreted as well, McMullen said.

Joshua Gold, also an attorney with Anderson Kill, added that risk managers’ jobs are more difficult than ever, with fragmentation in insurance programs existing, since many polices are purchased for a program. These may include directors and officers, product liability and cyber insurance. “There are products out there that try to assimilate them and make sure gaps in coverage are treated,” Gold said, adding that while the fine print in policies can be overwhelming, it can be key for proper coverage, especially when dealing with multiple lines, excess layers and towers of insurance.

2. Don’t limit insurance expertise to the risk management department.

All too often, “there are still going to be thorny claims and there still are going to be disputed claims, which are unavoidable,” McMullen said. He said that building expertise elsewhere within the company is critical to taking advantage of any and all available coverage. “We get the need for everybody to work together, but now, more than ever, this is important,” he said. Coverage should not just be delegated to risk or legal and collaboration is needed. For example, IT departments need to be included when planning for cyber coverage.

3. Lawyers and risk managers can be natural allies.

While there may be friction between departments in a company, legal generally recognizes the beneficial role risk managers play, McMullen said. He added that risk managers need to put any insurance-related communications in writing and assist in the analysis of policies and claims.

4. Insurance is an essential component of corporate resources and asset conservation plans.

Risk managers should purchase coverage with the intent of safeguarding the company’s own property and employees. They also need to recognize which mechanisms actually transfer risk and which do not.

5. Think insurance after a loss occurs.

This means looking to insurance coverage following all lawsuits, claim letters, product-related issues and financial losses. Risk professionals also need to analyze other sources of insurance that could possibly cover a claim.

6. Give notice of a claim or loss as soon as possible.

When faced with a claim or loss, McMullen advised risk managers not to hesitate to notify their broker, insurers and everyone in their tower of insurance as soon as possible.

7. When you make a claim, don’t accept “no” for an answer.

There is no downside to challenging an insurer’s denial of coverage. “You owe it to your company, you owe it to your organization to explore this and push back,” McMullen said, adding that determination and persistence often mean the difference between coverage and no coverage.

8. Find out where your company’s policies are.

Locate, collect and catalogue past insurance policies. Also acquire and keep policies of all entities related to your company.

9. Don’t panic if your insurer becomes insolvent.

If this is the case, McMullen advised risk professionals to file a proof of claim as a creditor and file a claim against the state guaranty fund in one or more possible jurisdictions. He recommended that they request the next layer of insurance companies to “drop down,” and also to consider litigation options.

10. Make sure your insurance team is conflict-free.

This means the team should be untainted–risk managers need to know where loyalty lies and if an attorney is representing both sides, McMullen said. “You want a conflict-free insurance team to take on the insurance company and to fight for the coverage that you are paying for,” he concluded.

 

Captives under Scrutiny

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A mere decade ago, captive insurers were viewed by most regulators as a small, even exotic part of the insurance industry. Most were assumed to be offshore and aroused little attention. Now, captives have gone mainstream. A sizable, but undetermined, portion of the property casualty coverage is placed through, or issued by, captives. A good guess is 30% to 40%, but no one has been able to establish an accurate number. Thirty-nine states have some form of captive or self-insurance law. Captives are now part of everyday life for regulators and the result is more scrutiny.

The issues now on the agenda for captives are significant:

• XXX and AXXX Reinsurance Captives

According to Superintendent Joseph Torti (Rhode Island), 80% to 85% of life and annuity insurance is ceded to reinsurers. Much of the so-called “excess reserves” required by Rules XXX and AXXX are ceded to captive reinsurers or special purpose vehicles owned by the same licensed life and annuity companies which cede the risk. Because the amount of this risk is so large, any trouble collecting this reinsurance could have a major effect on the industry. Some regulators, even a few who approved these cessions, have criticized these arrangements. In some cases, the collateral for the reserves has been subject to parental guarantees, which tends to undermine the confidence which can be placed in the transaction. The NAIC is continuing its examination and has met some stiff resistance from the industry.

• Multistate Insurers 

The proposal to amend the preamble to the NAIC Accreditation Standards to treat captive reinsurers as “multistate insurers” (with some limited exceptions) was withdrawn at the last NAIC meeting in Louisville. A new proposal should be forthcoming (and may have already been issued by the date of publication of this Newsletter). The premise of this proposed change is that non-domiciliary regulators need to know how insurance issued in another state may affect the citizens of their state. The opposite point of view is that the regulators of the domicile have done their job and should be trusted by their regulator colleagues and that the transaction should not affect third parties, anyway. Some say the risk to the domestic captive industry is existential. If enacted and enforced, the proposed change could, ironically, drive much of the industry offshore and therefore beyond the authority of the regulators promoting it.

• Nonadmitted Risk and Reinsurance Act

Captives have been inadvertently drawn into the regulatory structure imposed by this federal legislation intended to streamline the reporting and payment of surplus lines taxes. It has shined a spotlight on the payment (or non-payment) of state self-procurement taxes, but, ironically, does not in any way alter either the application of them or their payment. While risk retention groups (RRGs) were able to get an exemption from the law during its formative phase, captives, because they are (generally) single state entities and therefore not doing business as a “non-admitted” insurer, did not even attempt to get an exemption. Now there is a group, the Coalition for Captive Insurance Clarity, which is seeking a legislative exemption on Capitol Hill.

• Insurance Company Income Taxation

The Internal Revenue Service is investigating several insurance pooling mechanisms and, in some cases, the captives that have utilized them to establish third party risk—which is essential for an insurer to get the benefit of insurance tax treatment. This investigation is presumably a response to the rapid growth of “micro-captives” as mechanisms to assist with avoidance of taxation in estate planning and wealth transfer. This process is in its early stages, but is likely to produce some dramatic results.

• Federal Home Loan Bank (FHLB)

Who would have thought that the FHLB would have anything to do with captives?  It appears that some captives, and at least one risk retention group, are members of the FHLB, which allows them to obtain federal funds at advantageous rates. The Federal Housing Finance Agency (FHFA), which regulates the twelve FHLBs, has proposed a rule that would exclude all captives from membership by defining “insurance company” to mean an entity which “has as its primary business the underwriting of risk for nonaffiliated persons.”

Why is this happening now? While there are numerous reasons for these kinds of actions, there are two primary motivators. First, regulation is always subject to the problem of “what’s worth doing is worth overdoing.” Reasonable minds can differ on the interpretation of statutes and regulations. Each of the above includes an element of “pushing the envelope,” which can be significant or insignificant issues depending on your point of view. Second, captives have been caught in the vortex of regulatory competition. As we have discussed before in this column, the National Association of Insurance Commissioners (NAIC), the Federal Insurance Office (FIO), and the International Association of Insurance Supervisors (IAIS) are jockeying for position and power. Add to the mix the position of the Organization for Economic Cooperation and Development (OECD) that captives may be used as a device to avoid taxation (“base erosion” in OECD parlance), and you have a tumult of regulatory action which at the same time can be challenging and conflicting in its goals and implementation.

What does this bode for the future of captives? Once you have been seen on the radar, it is hard to drop off. Captives can expect more of the same for the foreseeable future.

This blog was previously published on the Morris, Manning & Martin, LLP website.

The Rise and Fall of Captive Reinsurers in the Mortgage Market

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Before the collapse of the housing market in 2008, it was common for large, high-volume mortgage lenders to form captives to spread their exposures to property mortgage insurance (PMI). But once the market bottomed-out, these arrangements fell under greater legal scrutiny and many courts are now finding them lacking. According to attorneys David McMahon and Peter Felsenfeld of Barger & Wolen, in a new online article in Risk Management magazine, the way premiums are collected by the captives may be a violation of federal law.

Mortgage reinsurance captives…are not funded by premiums paid by the parent company. Just like a standard reinsurer, they operate by collecting premiums from the PMI provider and sharing in the payment of losses. They are “captives” by virtue of their relationship to the parent institutional lender. In that way, they appear to the outside world just like any other wholly owned subsidiary of the lender.

Once commonplace, this arrangement may create legal exposure to lenders that outweighs the benefits of reinsuring through a captive. Courts are increasingly frowning on the captive mortgage reinsurer model, allowing class actions to proceed against lenders that allege the premiums generated constitute improper referral fees or even “kickbacks.”

As the authors report, court decisions over the last few years are increasingly chipping away at the concept of mortgage reinsurance captives and putting lenders on the defensive. For more, you can read the entire article at RMmagazine.com.