Whenever you ask a promoter of captive insurance companies about the virtues of these special-purpose vehicles, you get a standard set of answers.

When there’s no property-casualty insurance on the market, or the premiums are too darned high, a company can set up a captive to self-insure its risks. Captives enable a business to price and underwrite its risks as it knows they should be priced or underwritten — not how the insurance industry says they should.

Captives also supply their parent companies with entrée into the reinsurance market (above a self-insured retention), and reinsurance tends to be a whole lot cheaper than traditional insurance. They can be a way of keeping investible cash under the corporate umbrella, rather than handing it over to an insurance company.

Then there’s the darker side of captives, which promoters don’t talk about much. They can provide an opaque means of shifting risk off of the balance sheet or legally avoiding taxes. In certain states, for instance, parent companies can deduct the premiums they pay to the captive and get breaks on the reserves the captive holds and the investment income it earns.

Not that there’s anything wrong with that.

But there very well may be something wrong with the way life insurance companies are using captives to “exploit financial loopholes” in a way that “put[s] consumers and taxpayers at greater risk,” asserts Benjamin Lawsky, the New York Superintendent of Financial Services.

In a report on a year-long probe of 80 New York-based life insurers that Lawsky’s office issued Wednesday, investigators found that the companies have cumulatively tied up $48 billion in “shadow insurance” transactions. They infer a much larger problem, since their data comes from insurers based in just one state. The insurers’ intent, the report alleges, is “to lower their reserve and regulatory requirements.”

The term “shadow insurance,” is a brand-new coinage we can credit to the New York financial regulators, since a Google search reveals that it mostly refers to eye-shadow primer and not to real insurance. Lawsky, who was traveling and could not be reached, seems to have wanted to echo the deep problems with the financial system suggested by “shadow banking.”

Indeed, the report contends that shadow insurance “could potentially put the stability of the broader financial system at greater risk,” according to the report by the Superintendent’s office. The findings of the probe reminded the regulators of practices that were widely blamed for contributing to the financial crisis, like the issuance of securities backed by subprime mortgages via structured investment vehicles (SIVs) and the writing of credit-default swaps on high-risk mortgage-backed securities.

“Those practices were used to water down capital buffers, as well as temporarily boost quarterly profits and stock prices at numerous financial institutions,” according to the report. “Similarly, shadow insurance could leave insurance companies on the hook for losses at their more weakly capitalized shell companies.”

No Big Whoop
On the surface, however, these life insurance industry practices seem less threatening than what went down prior to the financial crisis. In a typical transaction, an insurance company sets up a captive insurance subsidiary, either offshore or in one of the 30 or so states that have captive-enabling laws.

The company then uses the captive to reinsure a bunch of existing life-insurance policy claims. Lawsky’s report says the insurer typically “diverts the reserves that it had previously set aside to pay policyholders to other purposes.” But that’s the way captives have been legally operating for decades.

True, as the report contends, the companies lower their reserve and collateral requirements by shifting some of the risk to the captive. But that appears to be just good business sense, enabling the life insurers, as they have argued, to provide cheaper prices to their customers.

So what’s the big whoop? The devil becomes more apparent when you dig into the details of the report. Alarmingly, the regulators unearthed four widely used ploys of shadow insurance that they claim mask serious reserving weaknesses that could theoretically bring an insurer down if it’s hit with a wave of claims:

1. Conditional Letters of Credit. Such letters of credit (LOCs), which have stipulated conditions that must be met before the LOC can be drawn upon, put the captive at a bigger risk of not being able to fund policyholder claims during periods of financial stress. Typically, a captive obtains an LOC from the parent company as a way to guarantee that the parent will back the captive’s coverage. According to the report, which did not name individual insurance companies, five insurers guarantee a total of $7.3 billion via conditional LOC’s.

 2. Two-step Transactions. In such deals, New York-based insurers transfer insurance to other insurers outside of the state. Later, the out-of-state insurers transfer that risk back to the New York life insurer’s captive. “This complex shell game obscures the risks that insurers are taking on through shadow insurance,” the regulators assert. Six New York-based insurers reported engaging in two-step transactions.

 3. Hollow Assets. In these reinsurance transactions, an LOC with a parental guarantee is recorded as an asset on the captive’s books. The problem is that “the insurer counts the undrawn letter of credit as an asset — rather than a real asset that it actually holds, such as cash or a bond,” according to the report. Although New York doesn’t permit insurers to count hollow assets, other states do. The total amount of LOCs reported as assets by New York life insurers is about $9.6 billion.

 4. Naked Parental Guarantees. Via such guarantees, a captive “does not even bother to obtain a letter of credit — conditional or otherwise — as collateral. It simply promises that its parent company would cover potential losses, without identifying any specific, dedicated resources to pay for them,” the regulators contend. Roughly $1.7 billion is accounted for in this way by the state’s life insurers.

Rotten in Denmark
Those four devices flat-out don’t pass the smell test. Under fairly standard captive best practices, captives are supposed to at least have a solid business purpose even if they do provide tax and regulatory breaks along the way. Captives have no business being conduits for shifting assets off the books.

Lawsky and company have it right when they propose that The Federal Insurance Office, the Office of Financial Research, the National Association of Insurance Commissioners and other state insurance commissioners conduct similar probes to get a complete picture of such arrangements nationwide.

Until such probes are done, the New York regulators recommend, state insurance commissioners should mull an immediate national moratorium on approving additional shadow insurance transactions. That may be going too far, as it could trigger greater problems in an industry with one of the nation’s largest investment portfolios. But Lawsky is right to set the alarm.

The question remains of whether “shadow insurance” portends another AIG-style, system-threatening shortfall of capital reserves. At first glance, actuarially determined life insurance risks seem a good deal milder than mortgage-backed securities – and much less subject to a run on the bank.

That’s true if you think of the life insurance business’s main product as coverage that pays off when a policyholder dies, agrees Wayne Dalton, a senior analyst covering the insurance industry for SNL Financial, a financial services research firm.

In addition to straight term-life insurance, though, carriers have sold and are selling a whole lot of cash-value policies (such as whole-life and key-man insurance) that promise to pay policyholders a premium if the investment portion of the policy appreciates. There’s a big volatility risk there, he suggests.

According to SNL data, the life insurance holdings of AIG had more than 80 percent of their reinsurance load ceded to affiliates, including captives and special-purpose vehicles, in 2012. MetLife had a little more than 75 percent. Four of the other largest U.S. life insurers came in over 50 percent: Genworth Financial, ING, Allstate Corp. and Prudential Financial.

Those are some pretty big names. “With the amount of life insurance in force amounting to trillions of dollars,” says Dalton, if a couple of life insurers become insolvent, “they could make a big ripple in the pond.” That starts to sound a whole lot like a systemic ripple. 

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