Regulators Place Spotlight on Shadow Insurance

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Reports warn that spread of captive reinsurance companies could pose systemic market risk.

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Regulators in the U.S. are increasingly sounding the alarm over “shadow insurance,” a little-known and unregulated approach to risk pooling that has gained popularity among American companies over the last two decades. According to investigations by the New York State Department of Financial Services (DFS) and the Federal Reserve Bank of Minneapolis (FRBM), failing to regulate shadow insurance short-changes tax-payers and, in a worst case scenario, could place the entire economy at risk from cascading failures.

The term “shadow insurance” was introduced by DFS to describe high-risk practices associated with captive insurance companies. A “captive” company is a subsidiary created for the sole purpose of insuring its parent. By forming a captive insurer, a parent company can avoid paying fees to third-party insurance providers while retaining complete control over its own risk portfolio. Moreover, captives can be incorporated independently of a parent in jurisdictions with minimal taxes and lenient regulatory requirements.

Notably, captives can offer insurance coverage to other insurance companies. This practice, known as “reinsurance,” or “insurance for insurers” is meant to protect the parent company by reducing the likelihood of a large claim. Entities such as the DFS and FRBM are particularly concerned about captives that offer reinsurance, but have no real assets. For example, a captive’s main asset can be a promissory note from its parent, which promises to “reimburse” the captive if any large claims materialize. According to the DFS report, this situation becomes particularly dangerous if the parent company is functioning with lowered reserves—thus rendering the parent unable to pay the promissory note to the captive, and the captive unable to meet possible reinsurance liabilities.

DFS completed its investigation into captive insurance companies last year. The regulator looked at real-life business practices and concluded that several captives were in fact operating with these “hollow assets.” More recently, the Federal Reserve Bank of Minneapolis also issued a report on the potential market effects of hollow reinsurance captives. According to the FRBM report, if hollow reinsurance captives remain unregulated, shocks to the insurance industry could ripple across the wider economy.

In its report, DFS speculated that insurance companies are actively creating captives to lower their reserves. Reserves are funds kept by the company for a rainy day; they allow insurance companies to pay off existing liabilities, sudden losses, or unexpected claims. Captives can perform the same work as their parent insurance company, but are subject to significantly lower reserve requirements. By shifting risk coverage to captives, a parent company can “free” some of the cash they would normally be required to hold in their own reserves.

According to the DFS report, when the parent company issues a promissory note to its captive, the parent company is recycling—rather than shifting—its operational risk. In these cases, the under-reserved parent company will remain “on the hook” for all liabilities if the captive runs out of funds. Liabilities remain the same for the parent company, but because of lowered reserves, it has a diminished ability to respond to financial stress.

The FRBM report, written by Ralph Koijen and Motohiro Yogo, outlined three potential risks to the larger economy following these developments. First, if parent companies have insufficient reserves because they rely on reinsurance captives, the parent may be unable to cope with sudden losses. If parent companies are unable to meet these expenses, the acute demand for credit could squeeze the banking sector. Second, any shock to the insurance sector could lower consumer confidence, reduce consumer demand for insurance, and transfer operational risks to households, businesses, and consumers.

Finally, because insurance companies are the largest holders of corporate bonds, once the insurance industry becomes distressed, companies may experience difficulty raising capital from bonds. According to the FRBM report, these cascading failures are supported by the sheer size of the reinsurance market. In 2012, industry giants “moved 25 cents of every dollar insured to shadow reinsurers.” The market currently totals $270 billion.

One industry group has argued for an alternative approach to discourage high-risk reinsurance captives. The National Association of Insurance Commissioners (NAIC) recently suggested that deterring the use of high-risk captive reinsurance companies could be as simple as getting rid of reserve requirements. The NAIC has argued that uniform reserve requirements lead to “redundant reserves for some products, and inadequate reserves for others.” The NAIC suggests that insurance companies turn to captives as a tool to side-step non-adaptive reserve requirements and prevent what they see as misallocation of resources. Because captives allow a company to free cash held in reserve, the companies that establish captives gain a competitive edge over their reserve-holding peers. According to NAIC, eliminating mandatory reserve requirements would even the playing field and make captives unnecessary.

On paper, captives have been heralded as a great cost-reduction tool for companies. Risk management advisors and attorneys have written about the various ways that captives reduce operational costs and tax burdens. However, regulators do agree on one point: there is not enough empirical information on the extent and nature of captive use. As a result, new regulations may be unlikely in the near term. But with increased attention directed at “shadow insurance,” the industry can expect interest in regulatory oversight to continue into the future.