N.Y. Says Life Insurers’ Use of ‘Shadow Insurance’ Could Hurt Policyholders

New York State’s financial regulators issued a report today that found a widespread use of captive, reinsurance entities by New York-based life insurance companies.

Calling these arrangements “shadow insurance,” the report said life insurers used their captive entities, often based in offshore locations, to make it possible for parent companies to divert reserves for other purposes besides paying policyholder claims and to artificially boost the risk-based capital buffers reported to regulators. The 23-page report can be found at the New York Department of Financial Services’ website (a PDF file).

New York State Department of Financial Services (DFS) said its nearly year-long probe has uncovered that New York-based life insurers and their affiliates are “on the hook” for at least $48 billion in hidden shadow insurance deals through “shell companies in other states and offshore.” Regulators did not disclose names of any specific companies that were targets of their investigation.

Regulators said shadow insurance is a little-known loophole that puts policyholders and taxpayers at greater risk by allowing insurers to make their balance sheets appear artificially rosy and divert policyholder reserves to other purposes.

“Shadow insurance undermines transparency and accountability in the financial and insurance industries which is critical to our economy,” New York Gov. Andrew Cuomo said in a statement.

“It is vital that companies compete based on the quality of their products and services — rather than which ones can best exploit financial loopholes like shadow insurance that put consumers and taxpayers at greater risk,” said Gov. Cuomo.

“Our investigation shows that this is a problem all across the nation, so I encourage other state governments – as well as our federal officials – to look into these questionable transactions immediately to protect all consumers,” the governor said.

New York State’s Financial Services Superintendent Ben Lawsky said a key lesson of the financial crisis is that regulators have a responsibility to shine a light on questionable financial practices that shift risk out of sight and into the shadows.

“If we let our guard down and ignore this regulatory race to the bottom, taxpayers and insurance policyholders are the ones who could get left holding the bag. We as regulators should consider hitting the pause button on these sorts of transactions,” Lawsky said.

“The events at AIG’s Financial Products unit in the lead up to the financial crisis demonstrate that regulators must remain vigilant about potential threats lurking in unexpected business lines and at more weakly capitalized subsidiaries within a holding company system,” according to the report.

Regulators said that in a typical shadow insurance transaction, a life insurance company creates a captive insurance subsidiary that would serve as a shell company owned by the insurer’s parent. These subsidiaries are often in states outside where the companies are based, or else offshore such as the Cayman Islands with looser reserve and regulatory requirements.

Regulators said the parent company would then “reinsure” a block of existing policy claims through the subsidiary — and divert 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. Regulators said sometimes the parent company even effectively pays a commission to itself from the shell company when the transaction is complete.

New York Department of Financial Services said its investigation uncovered the following:

• $48 billion in shadow insurance at New York-based life insurers and their affiliates: New York-based life insurance companies and their affiliates engaged in at least $48 billion of shadow insurance transactions to lower their reserve and regulatory requirements.

• Inconsistent, spotty, and incomplete disclosures: New York-based life insurance companies failed to disclose the parental guarantees associated with nearly 80 percent ($38 billion) of that $48 billion in shadow insurance in their statutory, annual financial statements. And where those companies did make disclosures, those disclosures were often spotty and incomplete.

• Reserves diverted, artificially rosy capital buffers: Regulators said shadow insurance allows companies to divert reserves for other purposes besides paying policyholder claims. Those other purposes may include anything from an acquisition of another company to executive compensation to paying dividends to investors.

Regulators said that in most cases, though, DFS’s investigation revealed that insurance companies manipulated those reserves in order to artificially boost the risk-based capital (“RBC”) buffers that they reported to regulators, investors, and the broader public — all without actually raising any new capital or reducing risk. In other words, shadow insurance makes a company’s capital buffers — which serve as shock absorbers against unexpected losses or financial shocks — appear larger and rosier than they actually are.

• Weak transparency, regulatory blind spots: Most states have laws that provide for strict confidentiality on financial information related to shadow insurance. These confidentiality requirements prevent regulators from outside that state from having a full window into the risks that those transactions create. New York regulators said the current lack of transparency surrounding shadow insurance is what, in great part, drove DFS to undertake this investigation.

• Regulatory race to the bottom: A number of the other states outside New York where shadow insurance is written permit the use of riskier types of “collateral” to back shadow insurance claims, such as “hollow assets,” “naked parental guarantees,” and “conditional letters of credit.” Those weaker collateral requirements mean that policyholders are at greater risk.

As part of its investigation, under Section 308 of the New York Insurance Law, DFS required all life insurers based in New York to provide information on shadow insurance transactions.

However, regulators added, the findings of this investigation and DFS’s authority under Section 308 are limited to New York-based life insurers. As such, the $48 billion in shadow insurance transactions that DFS’s investigation uncovered are likely just a fraction of the total shadow insurance outstanding nationwide. There are almost certainly tens, if not hundreds, of billions of dollars of additional shadow insurance on the books of insurance companies across the country.

N.Y. Regulators’ Recommendations on Shadow Insurance

Given the findings uncovered during its investigation, DFS said it is making several immediate recommendations to address the potential risks and lack of transparency surrounding shadow insurance:

• Through its authority under New York Insurance Law, DFS will require detailed disclosure of shadow insurance transactions by New York-based insurers and their affiliates.

• In the interest of national uniformity, the National Association of Insurance Commissioners (“NAIC”) should develop enhanced disclosure requirements for shadow insurance across the country.

• The Federal Insurance Office (“FIO”), Office of Financial Research (“OFR”), the NAIC, and other state insurance commissioners should conduct investigations similar to DFS’s to document a more complete picture of the full extent of shadow insurance written nationwide.

• State insurance commissioners should consider an immediate national moratorium on approving additional shadow insurance transactions until those investigations are complete and a fuller picture emerges.

Source: New York State Department of Financial Services