By DAVE LENCKUS, who has covered the captive insurance industry for more than two decades
In the post-Great Recession era, should risk managers and corporate executives consider expanding the corporate finance role of captive insurers? Or will federal regulators soon quash that possibility?
A budding concept is for captive owners, nonbank companies included, to use their captive insurers as portals to cheap bank credit under a federal banking law enacted decades before the first captive appeared.
While captive experts do not foresee the arrangement transforming captives into profit centers, some say it could enhance a facility's liquidity and claims-paying ability or assist its parent company in accessing tough-to-find credit or lowering borrowing costs.
Under the Federal Home Loan Bank Act of 1932, insurers, banks and thrifts can become members in their regional federal home loan banks and apply for low-rate cash advances.
An FHLB member can take a secured advance of up to 20 times its required investment in bank stock--an amount equal to 1 percent of the member's assets.
Captives are eligible members because the banking law does not distinguish between them and traditional insurers. Insurers are eligible because many life carriers made home loans 79 years ago.
The bank membership concept is one that Delaware's captive regulator would like the nation's 1,600 captive insurance owners and potential owners to consider for any captive insurer, even ones owned by companies likes manufacturers that have nothing to do with home financing. Among captive and finance experts, the idea has supporters and detractors.
Of course, before joining one of the nation's 12 federal home loan banks, there is more to consider than the availability of cheap credit, particularly the financial criteria required to join a bank and obtain an advance.
For example, to join a bank, a captive must demonstrate it has an adequate percentage of total assets in residential mortgage loans, which include mortgage pass-through securities issued by Freddie Mac and Ginnie Mae or various forms of direct loans. The bank act sets no minimum requirement for insurers but a 10 percent level for most other members.
Mortgage pass-through securities are among the "mix of assets you'd expect to see on an insurance company's balance sheet," including a captive insurer's, said insurance industry consultant and investment banking advisor John Wicher, principal at John Wicher & Associates Inc. of San Francisco.
Another consideration is that advances have to be collateralized at about 105 percent and secured by assets that support house financing, such as U.S. Treasury bills or various types of loans. Plus, every federal home loan bank might not support captive membership, a potentially significant problem since an applicant can seek membership in only its regional bank.
The federal regulatory position on this issue regarding captives should be clearer soon. The Federal Housing Finance Agency, which oversees the federal home loan banks, has issued an advanced notice of proposed rulemaking that considers barring captive insurers from FHLB membership. Among the agency's concerns is the adequacy of state regulation of captives.
The agency, which proposes toughening membership rules overall to ensure that members support the FHLB system's mission throughout their membership, is accepting public comments through March 28. No date for publishing final rules is set.
Representatives of various federal home loan banks largely deferred comments to their trade group, the Council of Federal Home Loan Banks in Washington.
However, a spokesman for the Pittsburgh bank--which covers the Delaware, Pennsylvania and West Virginia region--said the bank is "clearly interested" in supporting the membership application of "any insurer" that demonstrates its "sustainable commitment to housing finance."
John von Seggern, the trade group's president and chief executive officer, emphasized that each of the 12 regional banks is independent and "moves in the direction it's comfortable with."
EXPANDING A CONCEPT
About a half dozen captive insurers, mostly Vermont-domiciled, already are members of federal home loan banks, industry experts say. But, they noted, those captives' parent companies are significantly involved in home financing, and some are eligible for membership themselves.
Steve Kinion, director of captive and financial insurance products at the Delaware Department of Insurance in Wilmington, wants businesses in other industries to investigate bank membership and is promoting the concept with captive managers.
Kinion has a couple motivations.
One, he said, is it makes good business sense. Homebuilders and companies in developing industries, for example, face an extremely tight credit market, he said. Advances, which captives could pass to their parents through loans or dividends, could fund the expansion of operations, allowing the parents to thrive and create jobs, he said.
Or a captive could invest its advance in a vehicle that would generate a higher rate of return than the interest owed on the advance, Kinion said. The captive could use that float to help pay claims, he said.
Kinion acknowledges that he envisions the concept as an engine of captive growth in Delaware, a smaller player in the captive industry, but "I'm not saying every captive should be a federal home loan bank member." While a captive in any domicile could seek membership in its regional federal home loan bank, Kinion said Delaware offers captives some advantages.
For example, the state's insurance code recognizes FHLB stock as an admitted asset. Not all state insurance codes do, he said. Delaware also would recognize collateral as an admitted asset, since the captive would continue to earn investment income on it.
Industry experts generally find the concept intriguing, including some who question its practicality.
"I think it's a very interesting concept," said Nancy Gray, the Burlington, Vt.-based regional managing director-Americas at Aon Global Insurance Managers. "The concept is very useful to our financial institution clients. It's a way to maximize their returns."
But, several factors make the concept unappealing to many parent companies in other industries, some experts maintained.
For example, Gray said: "You would have to have an amount of capital beyond what you need for your risk management program" to take an advance.
Financial institutions with captives "would be more comfortable" in that situation, because their facilities generally cover low-frequency risks, such as professional liability, she said, and don't pay much in claims.
A more basic problem is that parent companies not in financial services view captives as solely risk management tools, Gray said.
Michael Cormier, New York-based chief executive officer of the Global Captive Solutions Group at Marsh Inc., agreed that using a captive to produce float "would be a pretty sharp departure" from many captive owners' business strategy.
However, he would not necessarily advise against it.
Plus, he said: "Certainly, having access to a sufficient means of capital at attractive rates would always be attractive."
Cormier, however, questioned the value of that access if captives face restrictions on how they could use it, as the U.S. housing finance agency contemplates in its notice of proposed rule changes. "So I would be reluctant to advise clients until we understood this better."
Other likely deterrents include the negative perception of mortgage-backed securities and the minimum five-year membership commitment that federal home loan banks want, said Karin Landry, a managing partner with Spring Consulting Group LLC in Boston.
Still, Landry and other observers foresee promise in the concept.
Regarding the potential take-up of bank membership if the concept survives, Landry predicted: "I think it could grow. Will it be something for everyone? I don't think so."
The concept would allow a captive owner to lower corporate borrowing costs, she said. Residential builders could benefit, as well as healthcare institutions, which often extend loans to medical residents, she said.
Landry noted that federal home loan bank members also have access to low-cost letters of credit. So any captive owner that finances workers' compensation coverage through a fronted facility, which has to post a letter of credit for its fronting carrier, would be able to lower those costs, too, she said.
Captive management executive Jason Flaxbeard of Beecher Carlson Insurance Services, said the concept "sounds like a wonderful arbitrage opportunity."
"You put $1 in and borrow $20," said Flaxbeard, senior managing director for Beecher Carlson Insurance Services LLC in Denver. "You take on credit risk, and for that you get access to cheap funds."
Flaxbeard does not give much weight to the notion the concept is too unconventional for captive owners to consider. "These are living breathing organisms that will always be innovative. I'm always going to explore innovation," he said.
Wicher, the insurance industry consultant and investment banking advisor, likes the concept as long as captives use advances for balance sheet and liquidity management purposes, such as "smoothing out cash flow" or as a supplement to reinsurance.
The concept allows a captive to "borrow at a rate that most small or privately-held firms can't borrow at" and eliminate frictional borrowing costs, he said.
Plus, Wicher also noted, an advance is treated as a liability on the captive's balance sheet, which means the facility's risk-based capital ratio is not impaired.
"I don't care if you're building cars or running hotels, I think it's a prudent thing" for a captive owner to take advantage of the availability of low-cost capital, he said.
But Wicher, too, said the concept has its "downsides."
"Are you sophisticated enough to be getting into this level of financial engineering with your captive" and not use an advance for "something foolish?" he asked.
Many of the 16 rule changes the federal housing finance agency proposes are designed to apply to all FHLB members.
But the agency also clearly is concerned about captive insurers joining the system, lumping them and inactive shell companies together in its rules notice. The agency expresses concerns about whether either is adequately regulated or could meet the home-financing asset test that all federal home loan bank member applicants face.
In response, the agency first proposes requiring all insurance company members to "actively" underwrite an unspecified amount of third-party business. Third-party underwriters historically have demonstrated they engage in lending or investment practices that support residential mortgage markets, the agency explains.
The agency also proposes that insurer members submit to active state insurer regulation.
Both Kinion of Delaware and David Provost, Vermont's deputy commissioner of captive insurance, defended their regulation of captive insurers.
Provost, however, is not as excited about parent companies in various industries utilizing their facilities to line up credit from federal home loan banks. Citing concerns about captive solvency and the reputation of Vermont insurance regulation, he said he would want "a lot of information" before supporting the concept. Vermont leads the nation with more than 900 captives domiciled there, 573 of which are active.
Still, both regulators suggested that the federal housing finance agency was misinformed about captives and captive regulation. Kinion said he would explain that in his written response to the agency's proposed rules. He also said he would meet with agency officials if that opportunity arose.
Kinion and Provost also agreed that the agency's concern about whether captives would have sufficient required assets seems misplaced. They reasoned that a federal home loan bank would quickly reject a captive or any applicant that fails the asset test.
The agency further laments that a captive might pass along an advance to a parent ineligible for federal home loan bank membership. The implication is the agency wants advances used only by bank members and only in ways that promote home financing. But no proposed rule addresses the issue.
And federal home loan banks currently have no rules on how advances must be used, noted von Seggern, head of the home loan banks trade group. "If the collateral exceeds (the advance), it doesn't make any difference," he said.
To ensure that members support the FHLB's mission, a system bank focuses on the collateral they post, he said.
Depending on an individual bank's rules, collateral could be U.S. Treasury bills; farm, agricultural business or small business loans; community development loans; and various mortgage-related assets, according to the federal housing finance agency.
Both Kinion and Provost said they would examine how captives intend to use advances.
Kinion said all intended uses must comply with Delaware insurance regulations. For example, advances could not be invested in junk bonds.
Provost said he would prefer that captives use the funds in a manner that supports home financing. He said parent companies could find better ways to line up credit but that he would consider allowing it if he was shown that the parent faced problems obtaining credit.
Regulators in two other popular captive domiciles, South Carolina and Utah, had not been following the issue.
After learning about it, they said the concept and the housing finance agency's proposed rules and stated concerns about the robustness of captive regulation piqued their interest. Both objected to the agency's slight of captive regulation, although they assumed it stemmed from not understanding the reach of state insurance regulation rather than an informed conclusion about it.
Still, both regulators have greater reservations than enthusiasm about the concept and would need more information about several elements of it before they would embrace it.
For example, Jeff Kehler, program manager-ARTS at the South Carolina Department of Insurance, said he would consult with officials at the federal home loan bank that is extending an advance to a captive to confirm the bank has no objections with how the proceeds would be used.
Ross Elliott, captive insurance director at the Utah Insurance Department, said he would want to be satisfied that the entire advance transaction would not threaten a captive's solvency.
And all of the regulators who commented about the concept said a captive owner also would have to demonstrate to them that its facility would be a true risk-transfer mechanism and not set up primarily to act as a conduit to FHLB system funds.
"We won't license a captive writing tidal wave coverage for a company in Oklahoma," South Carolina's Kehler said.
The Captive Insurance Cos. Association deferred comment to Richard P. Marshall, president of Phoenix-based Camelback Captive Services Inc. Camelback manages captives in Arizona, Delaware, Nevada and Washington, D.C.
Marshall, Arizona's first captive regulator, compared the concept to using captives to finance employee benefits. "I think it's in its embryonic stage right now," he said. "People are looking at it.''
Marshall said that risk managers would have to be convinced that bank membership is appropriate; then corporate chief financial officers would have to agree. Is the idea worth that level of review?
Beecher Carlson's Flaxbeard sees it this way: "Someone once told me, 'Tell me what I don't need to know.' Well, you need to know everything" about the marketplace and then decide how to proceed.
March 1, 2011
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