The current size of the-called shadow insurance sector could lead to a possible loss of at least $15.7 billion for the life insurance industry, according to a new study by economists.
Economists at the regional Minneapolis Federal Reserve Bank and affiliated with the London Business School Department of Finance and the Cambridge, Mass.-based National Bureau of Economic Research, have written a paper, dated Nov. 15, on the scope of captives, or “the shadow insurance sector,” and its impact on the life insurance industry.
However, there are benefits, the study notes prominently, they say. Without captives in play, the marginal life insurance cost would rise by 5 percent or a $14.9 billion reduction in annual life insurance underwritten based on current demand, the study found. The insurance price falls when the operating company cedes reinsurance to the affiliated reinsurer, raising its equilibrium supply in the retail market, the study showed through applying differential equations.
This figure reports life and annuity reinsurance ceded by U.S. life insurers to affiliated and unaffiliated reinsurers. Reinsurance ceded is the sum of reserve credit taken and modified coinsurance reserve ceded.
Courtesy of the Shadow Insurance study.
Perhaps more worrisome, the economists found the possibility of systemic risk from captive transactions. The economists said they expect the actual experience — if things go south for larger life insurers that are involved in shadow insurance — to be more systemic, leading to larger losses for the industry. The study also laments to the lack of public disclosure by shadow reinsures which prevents “accurate assessment of their investment risk and the fragility of their funding arrangements.”
The shadow insurance sector grew rapidly from $11 billion in 2002 to $363 billion in 2012, note the authors, Ralph S.J. Koijen of the London Business School and Motohiro Yogo of the Minneapolis Fed.
Companies that are involved in shadow insurance, which capture 50 percent of the market share, ceded 25 cents of every dollar insured to shadow reinsurers in 2012, up from 2 cents in 2002.
The study refers to the recent attention the captive insurance market has received from New York regulators, in particular. New York Banking and Insurance Superintendent called for a moratorium on captive transactions until more information could be gathered.
Lawsky, too, has lamented public disclosure of captive transactions and the inability to see what fellow state regulators are doing with ceded liabilities. Like Lawsky, the economists worried about the shadow insurance that is funded by letters of credit, which it found to be about 30 percent, noting it is a weaker type of collateral than trust funds or funds withheld. Also, they cited Lawsky’s reports that most of these letters of credit involve parental guarantees, based on regulatory data that is not publicly available.
“This is an especially vulnerable funding arrangement in which the parent bears the entire equity risk,” the authors wrote.
Jack Dolan of the American Council of Life Insurers (ACLI) countered the "shadow" theme and its implciations, noting that captive reinsurance transactions represent an important component of risk management. They pay out $1.5 billion daily and are a legitimate, safe and carefully regulated means of fully satisfying reserve requirements, he said.
"Life insurers are financially strong, with more than $5 trillion in assets," Dolan said. "Life insurers want to bring more sunshine to these wrongly-labeled “shadow” transactions. We are working to assure that captive transactions are appropriately disclosed and handled uniformly from state to state.