Insurance regulators, concerned about the safety of billions of dollars of U.S. annuity obligations that have been reinsured offshore, are working on proposed tests to see whether the arrangements protect consumers enough.
This is welcome news. We’ve expressed concern about the explosion in the offshore reinsurance of annuities, and the Federal Reserve and the International Monetary Fund have reservations, too. Both have said in research reports that under certain circumstances, the big concentration of annuities reinsured in Bermuda and other islands could pose a systemic risk — the kind of toxic chain reaction where a problem at one company starts spreading to other companies, then other sectors and other countries.
Moody’s Ratings has misgivings about the trend as well. “We view the overall movement of business offshore as a credit negative for the life insurance sector,” it said in a report last week. A “credit negative” is a factor that lowers Moody’s assessment of an entity’s financial strength.
But none of those organizations has a mandate to step in and protect consumers. State-based U.S. insurance regulators do.
“State regulators oversee the reserves and solvency of U.S. insurers,” said Fred Andersen, a regulator in Minnesota, at a meeting where the proposal was introduced and debated last month. “Reinsurance activity is taking place where reserves are held lower than U.S. statutory standards. In some cases, reserves are substantially lower, disappear, or can even be negative.”
He did not explain how negative reserves could possibly secure insurance obligations. But the reference underscored the differences between the U.S. and offshore regulatory approaches — differences that the U.S. regulators say they intend to bridge. The proposed tests are being developed by a task force of the National Association of Insurance Commissioners.
“Regulators are concerned that the level of policyholder protection may be declining,” said David Wolf, acting assistant commissioner of New Jersey’s Office of Solvency Regulation.
He addressed his remarks to the N.A.I.C.’s Life Actuarial Task Force, which is drafting amendments to the manual that actuaries use to calculate adequate reserves. The way things are now, he said, an actuary might not even notice how much less money an offshore reinsurer had to hold, compared to the amount required in the United States. But that seems to be the whole point: The ability to greatly reduce reserves appears to be one of the main drivers of the offshore reinsurance boom, he said.
Annuities have been growing exponentially in the United States, as millions of boomers approach retirement and old age. Life insurers sell annuities in all shapes and sizes, but the basic idea is to provide lifetime income, after a person stops working. The contracts can run for decades. In the beginning, the purchaser pays premiums, which the insurer invests; later on, the insurer sends the purchaser regular payments, much like Social Security. Life insurers underwrote some $360 billion of annuities last year, a record.
In the U.S., life insurance regulation is all about balance-sheet solvency. Insurers are required to hold enough invested assets to cover all their obligations as they come due. If they fall short, a state insurance commissioner can shut them down. The many calculations and rules that support this approach have the effect of making U.S. life insurers invest in very stable, predictable assets, like well-rated bonds.
Compliance with the rules was hard in the years after the global financial crisis, because interest rates were so low that insurers couldn’t find conservative bonds yielding enough to cover their obligations. Some insurers solved the problem by selling off blocks of business, typically to private equity firms, which then opened reinsurance companies offshore and discovered how profitable the business was, as long as you stayed outside the United States. That’s why so much of the annuity business has ended up in Bermuda.
Bermuda isn’t considered a fly-by-night jurisdiction, but it does work differently. It’s a British territory with a long history of hosting complicated business reinsurance deals under strict confidentiality laws. But confidentiality laws that work well for big business don’t make as much sense when you’re reinsuring annuities for retail consumers. In that case, confidentiality just seems to make it impossible for ordinary people — the ones U.S. regulators are bound to protect — to find out where their money is, how it’s being invested, or whether the reinsurers are using it to pay dividends to their shareholders.
In the states, insurance companies usually undergo an examination every four or five years. An examiner appears on site, sets up shop in a conference room, and goes through company records in detail, trying to make sure everything on paper matches reality. In cases where a holding company runs a whole family of insurers, examiners are supposed to fan out and examine all of the related insurers at once. Otherwise it would be too easy to hide all the problems in an insurer the examiners weren’t looking at.
But group examinations don’t include the offshore reinsurers that have assumed the insurers’ obligations. That’s true even though the life insurers that originally wrote the business still have ultimate responsibility for it. This means that if an offshore reinsurer is lowballing reserves, or investing in dicey assets, the examiner won’t see it because the examination doesn’t include the business offshore.
A good current example of this is 777 Re Ltd., which, as we’ve recounted here, got into trouble late last year and was taken over by the Bermuda Monetary Authority. In February A.M. Best, a specialized ratings firm, downgraded 777 Re to near oblivion, saying it had invested in too many illiquid assets of related parties.
While that was going on in Bermuda, 777 Re’s biggest reinsurance counterparty, Sentinel Security, was undergoing a special “targeted examination” in Utah, its regulatory domicile. The “target” was Sentinel’s investments. Some of them were, in fact, in the same related-party businesses that had caused so much trouble for 777 Re. But the official report of the examination, available on the website of the Utah Insurance Department, doesn’t say a word about that, or what implications 777 Re’s unsuccessful investments might have for Sentinel. The issue certainly seems material, but the examination left it out, apparently because it happened in Bermuda.
The N.A.I.C.’s proposal is meant to make sure an insurer has adequate assets to support its obligations, even if the obligations go offshore. Moody’s called the proposal “important” for “the transparency and governance surrounding offshore transactions.” The N.A.I.C. will be taking public comment through May 17.