Regulatory Competition in the US Life Insurance Industry

This paper quantitatively assesses the consequences of jurisdictional competition in the US life insurance industry, an $8 trillion market. The central question is whether competition between state regulators over capital requirements for captive reinsurance subsidiaries — a form of regulatory competition — increases or decreases total surplus, and by how much.

US life insurers are regulated at the state level. Since the early 2000s, states have competed to attract captive reinsurance subsidiaries (captives) by setting lower capital requirements on these entities. The externality structure is asymmetric: the captive state earns tax revenues on liabilities transferred to captives and sets their capital requirements, but bears default costs only for policyholders in its own state. Consumer states bear default costs for their own residents even when those policies have been transferred to an out-of-state captive. This mismatch between who sets capital requirements and who bears default costs creates the externality that drives the race-to-the-bottom dynamic studied in the paper.

The empirical setting draws on a novel dataset covering 66 US life insurers from 2005 to 2020, with total liabilities of $1.9 trillion (approximately 25% of the sector). Data sources include NAIC filings via S&P, CompuLife pricing data, A.M. Best ratings, SEC filings, and state legislative records. The author assembles novel data on captives’ capital levels from SEC filings, Iowa Insurance Department captive financial statements, and insurer reinsurance exhibits.

Three motivating empirical findings ground the structural model. First, captives materially reduce insurers’ capital: in 2019, risk-based capital ratios are 23% lower on average after accounting for captives, with the median insurer’s capital declining 24%, and this translates into an increase in 10-year default probability from 1.0% to 2.9%. Second, states’ capital requirements are the primary determinant of where insurers locate captives: a 1 percentage point increase in a state’s captive capital rate is associated with a 1.6 percentage point decrease in the probability an insurer chooses that state (against a 1.1 percentage point unconditional probability), and this holds when insurers switch states over time as capital requirements change. Tax rates, geographic proximity, and amenities are not meaningfully correlated with captive location choice. Third, a difference-in-differences design exploiting Regulation XXX (effective January 1, 2000), which raised capital requirements differentially across product term lengths, shows that 30-year term products — which faced the largest capital requirement increases — experienced price increases averaging 10.3% relative to 10-year term products, with quantities declining monotonically for longer-term products, consistent with an inward supply shift.

The paper develops a structural model of the insurance market with imperfectly competitive insurers, endogenous default following a Leland (1994) framework, discrete choice consumer demand (Berry, 1994), and state regulators who set captive capital rates to maximize a weighted objective over tax revenues, default costs, consumer surplus, and producer surplus. Regulators deviate from a utilitarian social planner in two ways: they are state-based (generating competition and default externalities) and face agency frictions (captured by welfare weights that differ from unity). The demand side implies an average price elasticity of 2.4. The regulator side reveals that state regulators are willing to trade $1 of default costs against $3.5 of tax revenues and $0.59 of consumer surplus — both diverging from the social planner’s equal weighting.

The main counterfactual finding is that eliminating competition by federalizing insurance regulation would cause regulators to raise capital requirements by 19% (3 percentage points), reducing expected default costs by $2.4 billion while lowering consumer surplus by $880 million, for a net total surplus gain of $1.5 billion. Regulator utility would increase by $3.3 billion in equivalent tax revenues. Because regulators over-value consumer surplus relative to default costs, competition exacerbates rather than counteracts their agency frictions, making competition unambiguously welfare-reducing in the baseline. A social planner would set capital requirements even higher than a federal regulator. On distribution, large states such as California and New York gain most from federalization (they bear substantial default costs), while Vermont — the largest captive state by market share — loses because it would forfeit captive tax revenues. Unilateral bans are found to have limited equilibrium consequences: a New York ban on captive use by insurers selling in New York would achieve only 23% of the national default cost reduction that federalization achieves, and a ban on captives domiciled in Vermont would achieve only 10%, as insurers would redirect captives to other states.

Q: What is a captive reinsurance subsidiary and why do states compete to attract them? A: A captive is a wholly-owned subsidiary of a life insurance holding company that reinsures policies written by the operating company, moving liabilities off the operating company’s balance sheet. Captive states earn tax revenues on liabilities transferred to captives and can set their own capital requirements on those entities, which are lower than the uniform NAIC standards applied to operating companies. Because captives are taxed by the state where they are domiciled — not the consumer’s state — captive states can earn tax revenues on policies sold elsewhere, incentivizing competition through lower capital requirements to attract insurers.

Q: What is the default externality at the core of this paper’s argument? A: When an insurer defaults, the shortfall on policies sold to consumers in a given state is borne by that state’s guaranty fund and consumers, regardless of where the captive holding those liabilities is domiciled. So Vermont, as the captive state, sets the capital requirement on liabilities transferred from (for example) Massachusetts policyholders, but does not bear the default cost on those Massachusetts policies. This means Vermont internalizes only the default cost on its own consumers, leading it to set capital requirements lower than it would if it bore the full default cost — a classic externality.

Q: How large is the effect of captives on insurers’ capital levels? A: Using novel data on captives’ actual balance sheets, the author finds that in 2019, the size-weighted average risk-based capital ratio of sample insurers is 23% lower after consolidating captives into the operating company’s balance sheet. The median insurer’s capital ratio decreases by 24%. In terms of default risk, this adjustment corresponds to an increase in the 10-year default probability from 1.0% to 2.9% based on historical insurer default rates.

Q: What is the state of competition among captive domiciles in the data? A: Twenty-two states had passed laws allowing captives as of the sample period, with the set of competing states largely stabilizing after 2013. The market is moderately concentrated: the top five states (Vermont, Arizona, Delaware, Iowa, and South Carolina) account for 80% of all captive liabilities, and the Herfindahl-Hirschman Index is 0.20. Vermont has maintained its position as the largest captive state throughout the period.

Q: What evidence shows that capital requirements — rather than taxes or other factors — drive captive location choice? A: In a linear probability model of captive location with insurer-year fixed effects, a 1 percentage point increase in a state’s captive capital rate is associated with a 1.6 percentage point decrease in the probability that an insurer chooses that state (versus a 1.1 percentage point unconditional probability). Captive tax rates are not meaningfully correlated with location choice, consistent with federal tax laws prohibiting the use of reinsurance to reduce tax liabilities. A changes-on-changes specification confirms that insurers are more likely to shift their captives to states that lower their capital requirements over time.

Q: How does the Regulation XXX natural experiment identify the supply-side effect of capital requirements on insurance prices? A: Regulation XXX, effective January 1, 2000, increased reserve requirements for operating companies on a mechanical basis tied to policy term length, with longer-term products facing larger increases. Using a difference-in-differences design at the insurer-product-month level with insurer-product and month fixed effects, the paper finds that products with larger capital requirement increases experienced larger price increases immediately after the regulation took effect. Thirty-year term products experienced price increases averaging 10.3% relative to 10-year term products (the reference group) within three months. Quantities also declined monotonically for longer-term products, confirming an inward shift of the supply curve rather than a demand shift.

Q: What are the estimated regulator welfare weights, and what do they imply about agency frictions? A: Normalizing the weight on tax revenues to 1, the paper recovers that regulators value $1 of default costs as worth $0.29 (implying $3.5 of tax revenues trades off against $1 of default costs) and value consumer surplus at $0.59 per dollar. Because the social planner sets all weights equal to 1, these estimates show regulators over-weight tax revenues and consumer surplus relative to default costs. The higher weight on consumer surplus is consistent with political backlash from consumers facing high insurance prices.

Q: What is the total surplus effect of eliminating regulatory competition through federalization? A: Federalizing insurance regulation — modeled as a single federal regulator setting a uniform capital rate while holding fixed regulatory frictions — would lead regulators to raise captive capital requirements by 19% (3 percentage points) to internalize the default externality. Expected default costs would fall by $2.4 billion. However, higher capital requirements would raise insurance prices and reduce consumer surplus by $880 million. The net effect is a total surplus increase of $1.5 billion. Regulator utility (in equivalent tax revenues) would increase by $3.3 billion.

Q: Would eliminating both competition and regulatory frictions (i.e., a social planner) produce a different outcome than just federalizing? A: In the baseline estimates, a social planner would set capital requirements even higher than a federal regulator, because regulators’ agency frictions lead them to under-weight default costs relative to consumer surplus, pushing capital requirements below the socially optimal level even absent competition. Competition further exacerbates these frictions by providing an additional incentive to lower capital rates. Thus, in the baseline, competition unambiguously decreases total surplus. The paper also reports results under alternative assumptions, providing a “menu” for policymakers that maps different assumptions about regulators’ frictions to quantitative welfare statements.

Q: What distributional consequences across states explain why federalization has not been adopted? A: Federalization would benefit large states such as California and New York most, because those states bear substantial default costs on large volumes of policies sold to their consumers. States with large captive market shares, primarily Vermont, would be made worse off because they would lose captive tax revenues. These predicted gains and losses align with actual state policy positions: New York has called for a national ban on captives, California forbids insurers from setting up captives there, and Vermont has been the most aggressive state in attracting captive domiciles.

Q: How effective are unilateral state bans as an alternative to federal coordination? A: The paper estimates that a unilateral ban by New York on insurers selling in New York from using captives would achieve only 23% of the national default cost reduction that full federalization would achieve. A unilateral ban on captives domiciled in Vermont — the largest captive state — would achieve only 10% of federalization’s default cost reduction, because insurers would simply relocate their captives to other states that still allow them. This finding underscores the importance of cross-state coordination for meaningful regulatory reform.

Q: What does the model’s demand estimation imply about consumer sensitivity to insurance prices? A: The discrete choice demand model estimated on state-level sales, prices, and product characteristics implies an average price elasticity of demand of 2.4 for life insurance products. This elasticity disciplines the quantitative impact of capital requirements on product markets through their effect on insurance prices.

Q: How does the paper recover regulators’ objective functions? A: The author uses the revealed preferences of state regulators, exploiting regulators’ utility maximization first-order conditions and performing numerical perturbations around those conditions to calibrate the welfare weights (lambdas) on each component of the regulators’ utility function. This approach recovers regulators’ tradeoff weights from their observed policy choices — specifically their captive capital rate decisions — without directly observing regulators’ preferences.

Captive reinsurance subsidiary: A wholly-owned subsidiary of a life insurance holding company that reinsures liabilities from the operating company. Unlike operating companies, captives are regulated by the state in which they are domiciled (the captive state) under that state’s own capital requirements, which are typically lower than the uniform NAIC standards. Captives allow insurers to reduce their overall capital requirements by allocating liabilities to the captive.

Default externality: The mismatch between who sets capital requirements for captives (the captive state) and who bears default costs when an insurer fails (the consumer’s state and its guaranty fund). Because the captive state bears default costs only for its own residents — not for residents of states where the insurer also sells — it has an incentive to set lower capital requirements than it would if it internalized the full default cost, leading to an externality on other states.

Risk-based capital ratio (adjusted for captives): The author’s measure of insurer capitalization after consolidating the captive’s balance sheet with the operating company’s. This adjusted ratio is lower than the statutory risk-based capital ratio that ignores captives, by 23-24% in the 2019 sample, and translates into meaningfully higher default probabilities (from 1.0% to 2.9% over 10 years).

Regulatory agency frictions: Deviations of state regulators’ objective functions from a utilitarian social planner’s, captured by welfare weights (lambdas) on each component of the regulator’s utility. In the paper’s estimates, regulators over-weight tax revenues ($3.5 of tax revenues per $1 of default costs) and consumer surplus ($0.59 per $1 of default costs) relative to the social planner’s equal weighting, consistent with political economy pressures from consumers and revenue incentives.

Captive capital rate: The state-level capital requirement on captives, defined empirically as the sum of capital divided by the sum of liabilities of all captives in the state each year. Higher values represent more stringent requirements. The mean in the sample is 4% with a standard deviation of 3%, and captive capital rates are lower on average than operating company capital rates.

Race to the bottom: The dynamic under which competition between state regulators leads each state to set lower capital requirements than it would absent competition, in order to attract captive tax revenues, resulting in a collectively worse equilibrium with higher default risks. The paper finds this outcome in the baseline: competition lowers capital requirements by 19% (3 percentage points) relative to a federal regulator.

External financing frictions: The costs insurers face in raising equity capital, modeled as a per-dollar cost theta on required capital. These frictions create the supply-side channel through which capital requirements affect insurance prices: higher capital requirements raise insurers’ marginal costs, leading to higher prices and lower quantities, as documented in the Regulation XXX natural experiment.