Are We Heading Toward a Reinsurance Bubble?
As a topic, “shadow insurance” may have a certain MEGO quality — that’s “My Eyes Glaze Over” — but a new paper called “Shadow Insurance” (abstract; PDF) by Ralph S.J. Koijen and Motohiro Yogo is well worth a look:
Life insurance and annuity liabilities of U.S. life insurers were $4,068 billion in 2012, which is substantial even when compared to $6,979 billion in savings deposits for U.S. depository institutions (Board of Governors of the Federal Reserve System 2013). However, there is little research on life insurer liabilities, especially in comparison to the large banking literature. The reason, perhaps, is the traditional view that life insurer liabilities are safe (and boring) because they are more predictable, longer maturity, and less vulnerable to runs. Hence, all of the interesting action is on the asset side, where life insurers take on some investment risk. This paper shows that developments in the life insurance industry over the last decade shatters this traditional view. As a consequence of changes in regulation, life insurers are now using reinsurance to move liabilities from operating companies that sell policies to less regulated and unrated shadow reinsurers. These shadow reinsurers are captives or special purpose vehicles in U.S. states (e.g., South Carolina and Vermont) or offshore domiciles (e.g., Bermuda, Barbados, and the Cayman Islands) with more favorable capital regulation or tax laws. In contrast to traditional reinsurance with third-party reinsurers, there is no risk transfer in these transactions because the liabilities stay within the same holding company. Using new data on all life and annuity reinsurance agreements for licensed companies in the U.S., we map out the financial plumbing of life insurer liabilities, paying particular attention to the shadow insurance sector. We find that the shadow insurance sector (i.e., liabilities ceded to shadow reinsurers) grew rapidly from $11 billion in 2002 to $363 billion in 2012. To put this figure into perspective, asset-backed commercial paper issued by the U.S. shadow banking sector was $650 billion in 2004, prior to its quick growth and spectacular collapse during the financial crisis (Acharya et al. 2013). Operating companies that are involved in shadow insurance are the largest in the industry that capture 50 percent of the market share for both life insurance and annuities. These companies ceded 28 cents of every dollar insured to shadow reinsurers in 2012, significantly up from only 2 cents in 2002. We find that shadow insurance adds a tremendous amount of financial risk for the companies involved, which is not reflected in their current ratings. Our adjustment for shadow insurance reduces risk-based capital by 49 percentage points, or 3 rating notches, for the median company. Hence, actual impairment probabilities are likely to be higher than what may be inferred from reported ratings. Our adjustment for shadow insurance raises expected loss by at least $15.7 billion for the industry. Through the state guaranty funds, this cost is ultimately borne by state taxpayers and the companies that are not involved in shadow insurance. Although shadow insurance clearly has these costs, its potential benefits are harder to measure.
Koijen and Yogo’s paper follows a damning report from the New York State Dept. of Financial Services, called “Shining a Light on Shadow Insurance: A Little-Known Loophole That Puts Insurance Policyholders and Taxpayers at Greater Risk.” A key excerpt:
Shadow insurance also could potentially put the stability of the broader financial system at greater risk. Indeed, in a number of ways, shadow insurance is reminiscent of certain practices used in the runup to the financial crisis, such as issuing securities backed by subprime mortgages through structured investment vehicles (“SIVs”) and writing credit default swaps on higher-risk mortgage-backed securities (“MBS”). Those practices were used to water down capital buffers, as well as temporarily boost quarterly profits and stock prices at numerous financial institutions. Ultimately, these risky practices left those very same companies on the hook for hundreds of billions of dollars in losses from risks hidden in the shadows, and led to a multi-trillion dollar taxpayer bailout.
And here’s an interesting response to that report from the financial advisory firm Colton Groome. It includes a response from some insurers. They call the practice “captive reinsurance” rather than “shadow insurance.” As MetLife puts it: “Captive reinsurance is a cost-effective way of addressing overly conservative reserving requirements.”
As of this writing, at least on my web browser, the top Google Search result for “shadow insurance” yields a Sephora cosmetic product called Too Faced, “an eye shadow primer guaranteed to go the distance.” If the worst fears of Koijen, Yogo, and New York State financial watchdogs come true, that won’t be the case for long.