13 June 2013Analysis

NY regulator on the warpath against ‘shadow insurance’

The New York Department of Financial Services has released its report into the world of ‘shadow insurance’ in which certain insurers employ shell captives to reinsurer particular risks and artificially lower their capital requirements.

The report said that insurers use shadow insurance to “shift blocks of insurance policy claims to special entities”—often offshore—with such “practices...used to water down capital buffers”. The report argued that much like the subprime mortgage and mortgage-backed securities meltdown, “shadow insurance could potentially put the stability of the broader financial system at greater risk”.

Describing a traditional shadow transaction, the report found that “an insurance company creates a ‘captive’ insurance subsidiary, which is essentially a shell company owned by the insurer’s parent. The company then ‘reinsures’ a block of existing policy claims through the shell company — and diverts the reserves that it had previously set aside to pay policyholders to other purposes, since the reserve and collateral requirements for the captive shell company are typically lower. Sometimes the parent company even effectively pays a commission to itself from the shell company when the transaction is complete.”

“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.”

The report said that New York insurers and their affiliates were employing $48 billion in ‘shadow insurance’ in order to lower their reserve and regulatory requirements. The report said that the $48 billion uncovered by the investigation is likely “to be just the tip of the iceberg nationwide”.

The New York regulator has indicated that it will be working with the National Association of Insurance Commissioners and the newly formed Federal Insurance Office to investigate ‘shadow insurance’ transactions across the US and offshore.