Captive Reinsurance and Reserve-Credit Risk
Evergreen Life cedes a block of 20-year term policies to a special-purpose captive reinsurer. The block carries $800 million of statutory reserves but only $450 million of economically justified reserves. The captive is capitalized with $120 million of cash, a $100 million letter of credit from a money-center bank, and an $80 million parental guarantee, for $300 million of total assets. Evergreen takes full reserve credit on its statutory statements. The external auditor has flagged the structure under AG 48, questioning whether primary security is sufficient. The captive's assets are invested in a diversified corporate bond portfolio with an average rating of A- and a duration of 5.5 years, while the ceded reserves have a duration of 8.0 years. The CFO argues that the parental guarantee should count as primary security because Evergreen has a strong balance sheet. Evergreen reports $1.2 billion of TAC and a 450% RBC ratio.
1. Assess the reserve-credit risk in Evergreen's captive structure. Identify which elements likely qualify as primary security and which do not, and quantify the surplus impact if the auditor's challenge prevails.
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Primary security generally must be assets owned by the captive and readily available to support the ceded reserves. The $120 million of cash clearly qualifies. The $100 million letter of credit is typically treated as other security or collateral, not primary security. The $80 million parental guarantee is a contingent obligation of the parent, not an asset of the captive, so it should not count as primary security.
If the required primary security is 30% of $800 million, or $240 million, the structure is short by $120 million. If reserve credit is denied, Evergreen must add back the $800 million of reserves, reducing TAC from $1.2 billion to $400 million. The company action level is $1.2B / 4.50 = $266.7 million, so the pro forma RBC ratio becomes $400M / $266.7M = 150%. That is below the 200% company action level and would likely trigger regulatory action. The risk is therefore material, not a disclosure issue.
2. Recommend a remediation plan that restores compliance while minimizing the cost of holding redundant reserves. Compare at least two options.
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Option A: Contribute $120 million of cash to the captive. This brings primary security to $240 million. At a 10% cost of capital, the annual cost is about $12 million, plus the opportunity cost of holding low-yielding cash against redundant reserves.
Option B: Replace $120 million of parental guarantee with a bank letter of credit or eligible collateral. If an LOC costs 1.5% per year, the cost is about $1.8 million annually on $120 million, far below the cost of cash. The trade-off is counterparty and renewal risk; the LOC must be from an eligible bank and must not be drawn down at the same time as other collateral.
Option C: Recapture part of the block and reduce ceded reserves. If Evergreen recaptures enough business to bring ceded reserves down to a level supported by existing primary security, it reduces the financing need but gives up reserve credit and may increase statutory strain elsewhere. A blended approach-$60 million of cash plus $60 million of additional LOC-may be the lowest-cost compliant structure if the LOC is available.
3. Explain how the duration mismatch between captive assets (5.5 years) and reserves (8.0 years) affects the quality of the primary security and the company's risk profile.
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The captive's assets are shorter than the liabilities it supports. If interest rates fall, reserve values increase more than asset values, so the surplus in the captive shrinks and the primary security may become insufficient precisely when reserve credit is most needed. If rates rise, asset values fall less than reserves, which improves the captive's surplus but creates reinvestment risk as the shorter bonds mature.
A 2.5-year duration gap on $800 million of reserves implies roughly $20 million of value sensitivity per 100 basis point move before convexity. That is not enormous relative to the $240 million primary-security target, but it is directionally wrong for a structure that must maintain a hard minimum. The remediation plan should include extending asset duration toward 8.0 years, using longer corporate bonds or receive-fixed swaps, and stress-testing the primary-security ratio under ±200 basis point rate shocks.