There's a lesson for the nation's insurance regulators in the recent financial crisis. When the country's biggest banks hid their risk-taking on toxic mortgage-backed securities, even regulators were blindsided by the financial crisis that followed, requiring a trillion-dollar taxpayer buyout. Now a tactic increasingly used by large life insurance groups poses a similar risk, and regulators need to stop it. Florida officials say the strategy isn't happening with policies sold by Florida-regulated companies, but it shouldn't be allowed anywhere.
According to an investigation by New York's superintendent of financial services, life insurance groups are increasingly improving their bottom line by relying on secretive transactions to ostensibly shift liabilities to affiliated companies. It's a charade that misleads both policyholders and stockholders into believing an insurance company is healthier than it is. Investigators found that life insurers based in New York alone have exaggerated their solvency by $48 billion using "shadow insurance" that looks like reinsurance but may be more like an empty promise.
With reinsurance, an independent insurer is paid through an arm's-length transaction to absorb some of an insurance company's claim obligations. This kind of arrangement is a true buffer against extraordinary claims. However, life insurance groups are setting up affiliated shell companies in other states or countries, known as captives, that take on a portion of their claim obligations. The transactions are approved by regulators where the affiliate is located, often with lax rules on reserves and more secrecy than in the state of the parent company, making it difficult to provide oversight and protect policyholders. Some captive companies don't secure the transfer of risk with real assets, meaning the liabilities could revert back.
In 2007 the value of reinsured policies using affiliates was $2.82 trillion. By 2012, it was $5.46 trillion, the investigation found.
A New York Times analysis identified companies that were the biggest users of the transactions, including Transamerica, MetLife, Prudential and ING, among others. In general, the companies say their affiliates are sufficiently capitalized. But opaque transactions mean no one else can confirm that, including regulators, and raise the prospect of widespread catastrophic losses like those in the 2008 financial crisis that left taxpayers holding the bill.
New York regulators are asking for nationwide cooperation on a moratorium on captive reinsurance transactions. Florida Insurance Commissioner Kevin McCarty says he is involved in a task force of state insurance commissioners looking at the issue. But real action is needed soon. Some states, such as Vermont, South Carolina and Arizona, are courting these transactions, which could lead to a race to deregulate. The states with the loosest capital reserve requirements and strictest secrecy laws would win the business. Insurance consumers and potentially taxpayers would lose.