Shadow Insurance - The Next Financial Sector Crisis?

Many Americans (and people in other nations around the world) do business with life insurance companies, either purchasing life insurance policies or annuities that they rely on to fund their golden years.  A recent analysis by Ralph Koijen and Motohiro Yogo at the Minneapolis Federal Reserve looks at shadow insurance, a means by which life insurers use reinsurance to move their liabilities from their regulated companies to less regulated wholly-owned entities and how this could create problems in the future.

Let's start by looking at the concept of reinsurance.  Here is a definition from Investopedia:

Reinsurance, also known as insurance for insurers or stop-loss insurance, is the practice of insurers transferring portions of risk portfolios to other parties by some form of agreement to reduce the likelihood of having to pay a large obligation resulting from an insurance claim. The party that diversifies its insurance portfolio is known as the ceding party. The party that accepts a portion of the potential obligation in exchange for a share of the insurance premium is known as the reinsurer.



Basically, insurance companies of all types use this scheme to reduce their risk by paying an insurance premium to a reinsurer that is not affiliated (i.e. an unaffiliated reinsurer) with the company that cedes its portfolio.  In a twist, and thanks to changes in regulations, life insurers can take huge amounts of their liabilities off their books by transferring the liabilities to "captive" companies that are wholly-owned subsidiaries.  It is probably easiest to think of captive companies as shell companies that are set up by the parent insurance company.  In 2000, changes in regulations forced life insurance companies to hold more capital against their life insurance liabilities to ensure that they had sufficient funding to pay out their policies and annuities.  After 2002, new state laws in 26 states allowed life insurers to establish captive companies to offset these new capital requirements.  In some cases, these special purpose entities or "shadow reinsurers" are located offshore in Bermuda, Barbados and the Cayman Islands as well as certain states including South Carolina and Vermont; these domiciles often have more favourable tax laws or capital regulations.  One thing that captives do not do is transfer risk outside of their company group; the issuing company is still ultimately responsible for the insurance and annuity liabilities.  What is concerning about this process is that the terms of many of the arrangements are not in the public domain, meaning that policy holders have no idea who really holds their insurance policies.  As well, the financial statements of captives are confidential to the public, ratings agencies and regulators outside of their state of domicile. 

Now that we have that background, let's look at the analysis by Koijen and Yogo.  They open by noting that the life insurance and annuity liabilities of U.S. life insurance companies were $4.068 trillion in 2012, a very substantial sum by any measure.  As I noted above, changes to regulations allowed insurance companies to create "captive" companies/shadow insurers; in 2002, $11 billion worth of life insurance liabilities were ceded to shadow insurers which grew to $364 billion in 2012, exceeding the total unaffiliated reinsurance (i.e. traditional reinsurance) which was $270 billion in 2012.  Here is a graph showing how the life reinsurance business has changed over the decade between 2002 and 2012:

You can easily see the significant growth in the use of affiliated reinsurers (i.e. captive companies or shadow insurers).

Here is a graph showing how the annuity reinsurance business has changed over the decade between 2002 and 2012:

Again, there has been significant growth in the use of affiliated reinsurers (solid line) and basically no growth in the use of traditional unaffiliated reinsurers (dashed line).

Life insurance companies that use shadow insurers tend to be larger companies; these companies have a 48 percent market share for both life insurance and annuities.  These companies ceded 25 cents of every dollar insured in 2012 to shadow insurers, up 1000 percent from 2 cents of every dollar back in 2002.

Here is a table which summarizes the statistics for both life and annuity reinsurance agreements combined:

Here is a table which summarizes the number of life insurers using shadow insurance and other key data:

The biggest risk involved is that life insurers are allowed to issue more policies for a given amount of equity since shadow insurers often do not fall under the same strict capital regulations.  On the upside for the insurance company, they are able to reduce the overall cost of issuing life insurance policies and annuities.  Overall tax liabilities can be reduced, particularly when the captive companies are located in an offshore shadow insurer.  Here is graphic showing the share of the affiliated reinsurance business by domicile with South Carolina and Vermont in grey, other U.S. states in dark blue, Bermuda, Barbados and the Cayman Islands in medium blue and other international locations in light blue:

The authors estimate that shadow insurance reduces life insurance prices by 10 percent for an average company, resulting in increases in annual life insurance issued by $6.8 billion.  While this may not seem like much, it amounts to 7 percent of the current life insurance market.

Now, let's look at how this practice could be problematic.  A June 2013 study by Benjamin Lawsky, Superintendent of Financial Services at the New York State Department of Financial Services (DFS) states the following:

"This financial alchemy, however, does not actually transfer the risk for those insurance policies because, in many instances, the parent company is ultimately still on the hook for paying claims if the shell company’s weaker reserves are exhausted (“a parental guarantee”). That means that when the time finally comes for a policyholder to collect promised benefits after years of paying premiums (such as when there is a death in their family), there is a smaller reserve buffer available at the insurance company to ensure that the policyholder receives the benefits to which they are legally entitled.

Shadow insurance also could potentially put the stability of the broader financial system at greater risk. Indeed, in a number of ways, shadow insurance is reminiscent of certain practices used in the run up to the financial crisis, such as issuing securities backed by subprime mortgages through structured investment vehicles (“SIVs”) and writing credit default swaps on higher-risk mortgage-backed securities (“MBS”). Those practices were used to water down capital buffers, as well as temporarily boost quarterly profits and stock prices at numerous financial institutions. Ultimately, these risky practices left those very same companies on the hook for hundreds of billions of dollars in losses from risks hidden in the shadows, and led to a multi-trillion dollar taxpayer bailout." (my bold)

Over an eleven month period in 2012 - 2013,  The New York DFS noted that there were at least $48 billion worth of shadow insurance transactions at New York-based insurers to lower the reserve and regulatory requirements of which 80 percent were not disclosed in their annual financial statements.  The life insurance industry's reserves, required by law to serve as a "shock absorber" against unexpected losses or financial shock, can be artificially boosted when the liabilities are "off-book"  through the use of shadow reinsurance which means that the company doesn't have to raise new capital or actually act to reduce risk.  This means that companies were allowed to divert their reserves for other purposes including:

1.) acquiring another company

2.) paying dividends to investors

...and, most importantly... 

3.) increasing executive compensation. 

I think that's more than enough information to digest in a single posting.  I realize that for many of us, this is a rather difficult subject to understand and I have tried to present it as simply as possible so that you can understand the potential risks involved in the life insurance business.  It always amazes me how companies find such creative ways to skirt laws that are designed to protect the public, in this case, holders of both life insurance and annuities.  Only time will tell whether this creativity ultimately costs American taxpayers in the same manner that Wall Street's creativity cost taxpayers hundreds of billions of dollars back in 2008 - 2009.