Vermont's SPFC Legislation Expands Captive Insurer Uses

A major amendment to Vermont's captive insurance law went into effect on July 1, which promises to keep the state at the forefront of captive domiciles.

The amendment establishes requirements and guidelines for the formation and operation of a special-purpose financial captive insurance company, or “SPFC.” These provisions are included in a new Subchapter 4 to Chapter 141, Title 8 of the Vermont Statutes Annotated.

Vermont enacted the SPFC legislation to create a flexible framework for captives used in sophisticated financing transactions. In the short term, the legislation responds to the growing trend in the life insurance industry of using captives to facilitate financing of life insurance triple-X and AXXX reserves, and releasing the embedded value of books of life insurance business.

Our expectation, however, is that in the long term the availability of the SPFC option will spur further development of creative financing solutions involving captive insurance arrangements.

As an assistant general counsel in the Department of Banking, Insurance, Securities and Health Care Administration, I worked closely with Len Crouse, deputy commissioner of captive insurance, and his team in the Captive Division to draft the new SPFC legislation and to present it to the Vermont Legislature.

Thanks are due to Leslie Jones, executive assistant and chief life actuary of the South Carolina Insurance Department, for her time and insights regarding South Carolina's experience with SPFCs. The South Carolina SPFC law went into effect in 2004.

Our drafting efforts also benefited greatly from the thoughtful comments of insurance industry members and their legal counsel.

Whatever the future possibilities for SPFCs may be, right now the buzz is about triple-X and AXXX securitizations using SPFCs. So, what is a captive securitization?

Traditionally, securitization refers to the conversion of a stream of future payments or future economic benefits into current cash, also known as an “asset securitization.”

In an asset securitization, the owner of the rights to the future payment stream (the “securitizer”) transfers those rights into a legal entity (the “securitization entity”) in exchange for a stock ownership interest in the securitization entity.

The securitization entity offers third-party investors the right to receive a portion of the future payment stream in exchange for an up-front investment of cash in the securitization entity.

The securitizer can use the funds invested in the securitization entity as working capital. The investor receives an equity interest, such as preferred stock, with dividend rights.

The investor also can receive a debt interest such as a bond or debenture, with rights to payment of interest, in exchange for the cash investment.

A triple-X or AXXX life insurance reserve securitization is a way for a life insurance company to obtain capital from outside investors to meet the company's requirement to establish reserves with respect to term life and universal life insurance policies.

The reserves are shown as liabilities on the life insurer's balance sheet, and as a result have the effect of decreasing the amount of the life insurer's surplus as compared to what the insurer's surplus would be without the reserve requirement.

A securitization of the reserves allows a life insurer to increase its available surplus, as follows.

The life insurer sets up an SPFC, which reinsures the life insurer and thereby takes on the life insurer's triple-X or AXXX reserve obligations.

The reinsurance by the SPFC effectively removes the reserve liability from the life insurer's balance sheet, thereby increasing the life insurer's surplus. The reserve liability is now a liability of the SPFC, which needs cash to fund this reserve obligation.

The SPFC obtains the funding needed from third-party investors, who lend cash to the SPFC through a surplus note, which is key to the securitization transaction.

Under statutory accounting principles, the SPFC is not required to show its repayment obligation under the surplus note as a liability on its balance sheet–the borrowed funds are recorded as an asset, which offsets the SPFC's reinsurance reserve liability and renders the SPFC solvent.

As the SPFC reduces the reinsurance reserves, the SPFC repays the surplus note, with interest, to the investors for the loaned funds. The investor may risk the loss of some or all of its investment if insurance losses occur and the SPFC makes indemnity or benefit payments under its insurance contracts.

In many of these securitization transactions, however, a third-party insurer issues a guaranty in favor of the investor, so that the investor will be paid all interest and principal, even if the SPFC fails to meet its repayment obligations on the surplus note.

This illustrates a basic SPFC securitization arrangement.

In Vermont we've seen this type of securitization and, increasingly, several variations on this basic program.

In the past few months, the Captive Division has met with a number of insurers regarding SPFC programs, and we expect substantial activity in licensing these captives during the remainder of 2007 and into 2008.

We're excited about the prospects for SPFCs as a new captive option, and we welcome inquiries about the SPFC law and SPFC programs in Vermont.