"The Credit Crisis as Opportunity"

Sydney M. Williams

Thought of the Day

“The Credit Crisis as Opportunity”

May 10, 2011

It turns out that nobody wanted the crisis to go to waste. The recent credit collapse spooked us all. Responses varied. The Federal Reserve and Treasury are intent on ensuring that capital will be plentiful and virtually free. Congress has deemed that we all must be protected from ourselves, so that the Consumer Protection Act has become an integral part of the Dodd Frank Bill. Investors have become skittish, with “long term” having been shortened to a few days. Virtually every financial author has seen the crisis as an opportunity to create a best-seller. Legislators rack up poll points (and keeping their coffers filled) by condemning bankers, while asking them for money. Union leaders have chosen to ignore the message of low returns relative to expectations. Banks, who went to the wall in terms of solvency and who were saved by tax payers, continue to benefit after the crisis has passed in being able to borrow from the Fed at virtually no cost, while paying themselves handsomely and only grudgingly raising dividends. And the Press, unsurprisingly, is milking the crisis – not so much to inform, as to sell papers.

At least that was my reading of the piece by Mary Williams Walsh and Louise Story in yesterday’s New York Times, entitled “Seeking Business, States Loosen Insurance Rules.” The article begins with the fact that “states…are aggressively remaking themselves as destinations of choice for complex private insurance transactions once done almost exclusively offshore.” But this is a “dog bites man” story, and the tone is cautionary rather than hopeful. Four years ago, in the New York Times, Lynnley Browning wrote a similar story, “Vermont Becomes ‘Offshore’ Insurance Haven” (April 4, 2007.) According to the Vermont Captive website, the state is home to more than 900 captive insurance companies. Four years ago, according to Ms. Browning, there were 560 such companies in Vermont. These businesses contribute 2% to Vermont’s budget. They are important, but they are not new.

The article by Ms. Walsh and Ms. Story cited a few situations to support the notion that states (Vermont in particular) have loosened rules to attract business. They mentioned Aetna, which recently used a Vermont subsidiary to refinance a block of health insurance policies, reaping $150 million in savings. Three weeks after the deal closed, Aetna announced it was increasing its dividend 15 fold – from $0.04 annually to $0.60, implying a connection between the two events. What they did not point out was that Aetna had just earned $215.6 million for the quarter versus $165.9 million a year earlier and that they had $1.2 billion in cash on their balance sheet. Dividends are the surest way to return cash to investors.

“In 2008,” the two write, “MetLife used a subsidiary in Vermont to handle a crucial $3.5 billion letter of credit, with help from Deutsche Bank, because the subsidiary was not subject to the same collateral requirements as in New York.” The contract, as they point out, prevented the company from having to come to the government for assistance. Met Life agreed to pay Deutsche Bank $3.5 million for fifteen years – a total cost of $52.5 million, an expense described as “locking itself into high costs for years.” First of all, should we not be pleased that MetLife did not have to come to the taxpayers, as did so many financial institutions? And, second, $52.5 million represents 1.5% for the credit line, not out of line for a letter of credit, especially when the interest is paid over a number of years.

To the best of my knowledge none of the captive insurance subsidiaries based in Vermont required bailouts during the recent credit crisis. That does not mean investors should be complacent about potential problems. The insurance business, by definition, involves risk.

Captive insurance businesses are insurance companies established for the specific objective of financing risk emanating from their parent company. It is a form of self insurance. They tend to be formed during periods of rising rates – hard markets, to use the vernacular – as a means of reducing costs. Historically they were formed offshore in jurisdictions requiring lower capital and reserve requirements, places like Bermuda, the Cayman Islands, Guernsey and Luxembourg – places famous for deflecting sunlight. According to Ms. Browning, Vermont Governor Howard Dean in 2001 decided his state would “overtake Bermuda as the place with the most insurance captives.” While that has not yet been accomplished, Vermont, as of 2008, does now rank third, behind only Bermuda and the Cayman Islands. Today, the business employs 1400 people and has created a billion dollars in the state. And Vermont is certainly more open than these offshore domiciles.

Vermont’s success has not gone unnoticed, in this time of weak unemployment. Among the top twenty-five domiciles for captive insurance companies – again, as of 2008 – are six other states (Hawaii, South Carolina, Nevada, Arizona, Utah and New York.) and the District of Columbia. Last year, according to Ms. Walsh and Ms. Story, the number of similar businesses in Delaware doubled; Michigan is entering the business, exempting captives from taxes and charging only a fee. Even Connecticut, home to so many insurance companies, recently adopted a law permitting captives. Certainly reserve requirements will have to be monitored, because, as we all know, insurance is inherently risky. But why send the business offshore when they can be operated from home?

The credit crisis manifested many weaknesses of our financial structures. Those deficiencies have been largely addressed. On the other hand, in an increasingly globally competitive world, we must expect more creativity on the part of business to help grow the economy in non-traditional ways. Such growth will provide challenges for state and federal regulators, but to dampen inspired imagination serves no one well.