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As an unintended consequence of a regulatory oversight, big life insurers set up captives to help them manage the redundant reserves on their guaranteed level term life insurance policies. South Carolina and Vermont are reaping the benefit.

It all began back in 2000, when the National Association of Insurance Commissioners passed Regulation 30. Known as Triple X, the rule required life insurers to increase the reserves on their term life insurance policies beyond the economic reserves. The unexpected result was that life insurers are now saddled with redundant reserves that escalate as the years go on.

Due to several factors that came together over the last few years to create a favorable environment, insurers found a warm welcome in South Carolina.

"South Carolina is recognized as the leader in this area," says Nancy Gray, head of captive management for Aon. "With that, you get a certain amount of traction, and they will probably continue to lead the charge in the licensing of these types of companies."

About 20 Triple X transactions have been done so far in South Carolina, five in Vermont--which has been a popular domicile for other captives--and one in Arizona. Most of the Triple X deals are being done onshore, rather than in popular offshore domiciles, for tax reasons, industry experts say. Outside the United States, Ireland has proved a popular domicile for Triple X deals, also for tax reasons.

Vermont, Gray says, has a good reputation for its captive business, and so it also will attract a fair amount of business.

"What we don't see is the geographic preference that we see with other captive formations," Gray says.

One reason for South Carolina's dominance is that it enacted a special purpose financial captive statute designed to meet the needs of the participants in Triple X deals.

"We got this legislation passed, and we were the only state for a while that had that on the books," says Leslie Jones, who is now executive assistant and consulting actuary for the South Carolina Insurance Department, but was in charge of the state's captive program when the first Triple X deals were being done.

In June, South Carolina announced that its special purpose financial captive insurance program securitized premium streams totaling more than $5 billion in the second quarter of 2007.

Other states, however, are hoping to challenge South Carolina's dominance and are reworking their existing captive laws to better compete for these deals, which can generate substantial tax revenue.

"Now some states are copying us, which is fine with me," Jones says. "There are lots of companies with lots of needs right now; I can't possibly accommodate all of them in South Carolina by myself."

Also in June, Vermont passed its own version of South Carolina's special purpose financial captive law, and Washington, D.C., is in the process of adopting a similar statute. Although several Triple X transactions were done in Vermont under its old statutes, the key participants told regulators they would prefer to set up their captives under a special purpose financial captive law.

"We did a few of these (Triple X transactions) under our old statute," says Len Crouse, deputy commissioner, Captive Insurance Division, Vermont Department of Banking, Insurance and Health Care Administration. "But the industry itself didn't think our laws covered it as thoroughly as it should have."

Now, Vermont believes it will be in a better position to capture more Triple X deals.

"We have done five of these up to now, and the interest in this is still very, very active," Crouse says. "It's an area that's going to continue to grow."

CLIMBING THE CURVE

While Triple X was passed in 2000, it took a while, however, before the first Triple X deal was completed. The first deal wasn't done until 2003, but now, as the reserve requirements begin to accelerate, the problem is becoming more acute.

"We're seven years into the bell curve, so the numbers are starting to attract a lot of attention," says Robert Johnson, who heads up Marsh & McLennan's South Carolina captive management business. Some life insurers, having done one Triple X securitization, are returning to the market for more.

Because of the expense, however, the deals only make sense for large life insurers, Johnson says.

"There's a lot of interest in the middle market because they have the same pressures on them, but to a lesser degree," Johnson says, adding, "if a deal is not worth more than $200 million, it doesn't makes economic sense because of the costs."

The fact that South Carolina has become the leader in the business is a strange tale.

One of the people at the table when the NAIC task force drafted Regulation 30 was none other than South Carolina's Jones, who says the regulators didn't really grasp the ramifications of the regulation.

After the regulation was approved and she returned to her office in South Carolina, she says she began to get calls from life insurers seeking to set up captives as part of a strategy to access the capital markets to fund the reserve requirements.

South Carolina, it turned out, had just passed a flexible captive regulation, and the state's insurance commissioner at the time, Ernie Csiszar, was seeking to build links between the insurance industry and the capital markets--and that made South Carolina a prime location to do these deals.

As a member of the NAIC task force that had developed the regulation, Jones was also very familiar with the rule and its reserving requirements.

"It did help that I understood what was going on, but I was horrified," she says. "It was just awful to think about."

"I was familiar with Triple X because I was one of the regulators that drafted it," Jones says. "In fact, when they (life insurers) first told me there was what they considered to be redundant reserves developing under Triple X, I was still on the task force."

Jones, who is now the vice chairwoman of the NAIC's life and health actuarial task force, says she told the insurers: "Why are you all here talking about forming a captive? Why were you not talking to me at the life and health actuarial task force about fixing this reserve requirement?" she says. "I said: 'You know, there's not a regulator at the table that recognizes this is a problem.' "

OTHER PEOPLE'S MONEY

Life insurers did indeed approach regulators about the problem, but in the meantime they needed a more immediate solution that would allow them to tap the capital markets to help fund these reserves.

"Instead of utilizing their own capital, they lay off the risk on a captive, and they rely on the outside investors to put that capital into play to support those reserves," says Ken MacKay, a senior vice president with the Willis captive practice. "So, in theory, what they're doing is using outside money from outside the group to capitalize the reserve obligation."

In exchange, investors are offered triple-A rated bonds backed by a guarantor such as Ambac Financial Group Inc. or MBIA Inc., says South Carolina's Jones.

McKay notes that "the investors that are out there take comfort because there's a guarantor involved in this."

The first Triple X deal was done by Genworth in 2003 under South Carolina's old special purpose reinsurance vehicle statute, which was originally intended to make it easier for property/casualty insurers to issue catastrophe bonds onshore.

But after that first deal, it became apparent that the people involved in these transactions wanted a new statute that would address their specific concerns. In particular, the bond guarantors were concerned that the existing statutory language could create the risk of a "rogue regulator" working against them. Investment banks and insurers also found the existing language to be too focused on property/casualty.

Although the Triple X deals are really a response to a miscalculation by regulators, Jones says some good has come from the experience.

"The markets had just never explored life risk very much, so now I think there's an increased level of understanding and increased recognition that there may be aspects of life contracts that can be funded reasonably with these collateralized securities," she says.

Securitizations of other kinds of life insurance risks are now emerging, including such things as life catastrophe bonds, Jones says.

"What I think is very valuable that's come out of this whole thing is that the markets are more comfortable with life insurance risk now."

PATRICIA VOWINKEL lives in New Jersey.

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August 1, 2007

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