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The report from the NY-DFS recounted how competition to attract insurance business among the several states creates "a race to the bottom" with regard to regulatory standards over the shell corporations.

Public Policy Analysis & Opinion

The shadow knows?

An Empire State regulator looks into the abyss and promptly goes sane

By Kevin P. Hennosy

In June 2013, the New York Department of Financial Services (NY-DFS) released a report, which lays bare the soft underbelly of the regulation of the insurance—and by extension the financial system.

The findings of the New York report should present concern to anyone who sells insurance, earns a living from an insurance company or remembers what happened when financial regulators allowed financiers to discard unwanted risk in financial markets. Furthermore, the report triggered a debate over the proper role of insurance regulation between the NY-DFS—a regulatory agency—and the NAIC.

The Empire State financial regulators issued a report entitled Shining A Light On Shadow Insurance. According to the report:

Insurance companies use shadow insurance to shift blocks of insurance policy claims to special entities—often in states outside where the companies are based, or else offshore (e.g., the Cayman Islands)—in order to take advantage of looser reserve and regulatory requirements.

These arrangements are often referred to by a collection of names: "captives," "captive insurers," "captive reinsurance" or "special purpose vehicles." The New York DFS report focuses on the use of these "shell-corporations" by insurers; which can provide insurers with ample opportunities to realize financial gain. (It should be noted that this article is concerned only with those special-purpose vehicles set up by insurance companies, not with captives in general.)

First, the accounting treatment of the transaction allows the insurer to write more business—which generally makes producers happy—without challenging risk-based capital limits.

Second, insurers achieve this increased capacity to write business without paying expensive reinsurance premiums.

Third, the transferred blocks of insurance policies carry with them treasure chests of financial reserves, to come to rest in "special entities" which legally reside in select jurisdictions which do not see fit to argue over the amount of reserve funds held to support the policies and allow access to "excess" or "redundant" reserves.

The knickerbocker-regulators took the extraordinary step of calling for national action in response to the findings of their report:

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. [Emphasis drawn from the original document.]

I have been working around the insurance sector for nearly 30 years, and I have never seen a statement like that one come from an insurance regulator. It is as if a public utilities commission started throwing around the place names such as Three Mile Island, Chernobyl, and Fukushima.

To understand this response, one must first understand the NY-DFS recent history. Between 1907 and 1995, New York State benefited from arguably the best and most professional insurance regulatory agency in the country.

That standing changed when the George Pataki Administration arrived. In 1995, the incoming Superintendent of Insurance even sent out correspondence to insurers—and not the news media—asking what sections of the regulatory framework that they wanted dismantled.

The NY-DFS fallen-status continued through two more gubernatorial administrations without regard to political party, until it hit rock bottom with the failure of American International Group (AIG)—which nearly threw the world economy into another Great Depression.

Cheap and unconvincing jurisdictional excuses aside, New York regulators held the clearest jurisdiction and closest proximity to the AIG Holding Company and everything that answered to it—but the former administrations decided not to make use of that position.

It appears clear that the Cuomo Administration and Superintendent of NY-DFS Benjamin Lawsky want to rebuild the agency's independence and expertise.

The alchemy

Insurance in the shadows is a magical place. The weight of risk simply disappears into a black box and is never worrisome again. Poof!

Ever since Blaise Paschal developed the underlying mathematical framework for statistics, the insurance mechanism has been an alchemy machine. Medieval alchemists sought to turn common lead into treasured gold. The insurance mechanism turns the common risk of financial loss into a profitable commodity.

However, the insurance mechanism operates on a rational basis, which employs mathematical tools to measure the risk of loss and charge a reasonable toll for transferring the burden of risk from one party to another. That transformation is only successfully achieved through careful measurement of raw materials, precise processing and very cautious distribution.

But the shadow insurance market is different from the insurance mechanism. The shadow insurance market harkens back to a more ancient traditional world. The shadows favor the slight-of-hand, blue smoke and mirrors, and shun scientific tests.

The entire transaction is based on locating jurisdictions that operate under the willing suspension of disbelief, and a myopic system of financial accounting. The "magic of the marketplace" makes all the risk evaporate into thin air, as long as pesky regulators stay out of the way.

Of course, a heretic might observe something could go terribly wrong. (See 2007-2008 and 1929 for more information.)

Still on the hook

The NY-DFS report notes that these shadow insurance transactions do not actually transfer the risk of financial loss from the primary insurer.

The transfer of risk test applies to traditional reinsurance treaties, if the insurer wants to claim credit for reinsurance on its annual financial statement. Under current rules, no such test is applied to shadow insurance transactions. As the report explains:

This financial alchemy, however, does not actually transfer the risk for those insurance policies because, in many instances, the parent company is ultimately still on the hook for paying claims if the shell company's weaker reserves are exhausted ("a parental guarantee").

The report from the NY-DFS also recounted how competition to attract insurance business among the several states creates "a race to the bottom" with regard to regulatory standards over the shell corporations. For example, some states allow the shell-corporations to hold "conditional letters of credit" in the place of financial reserves. The report provides other examples of regulatory slight-of-hand.

NAIC scheme

After reading the NY-DFS report, I expected to read or hear a reaction from the Delaware-chartered-corporation which does business as the NAIC.

An exhaustive search of the World Wide Web failed to locate any response to the superintendent's request for a moratorium from NAIC celebrity spokes-models, such as Amy Grant or retired-Senator Ben Nelson. What would silence this high-priced help?

Perhaps the NAIC was still busy considering the formation of a working group to look into the looming impact of typewriters on the insurance sector.

Or maybe the NAIC senior management has figured out how to make money off these insurance company transactions, so they quit following Superintendent Lawsky on Twitter and un-friended him on Facebook?

Actually, something was brewing at NAIC headquarters. For more than a year, an NAIC working group studied insurers' use of captives and special-purpose vehicles. From the working group's first convocation, the leadership made it clear that it would not look into the more general use of these shell-corporations by non-insurance parent-entities.

The working group published the results of its limited inquiry in the form of a "white paper" in July of 2013. Like so much of what the NAIC does, the white paper does not appear to be published for public distribution. Each page of the publication carries the warning: "For Regulatory Use Only."

The most important observation that the NAIC could make regarding the use of shell-corporations by insurers to move risk off the balance sheet—but not necessarily the books:

The implementation of principle-based reserving (PBR) could reduce the need for commercial insurers to create new captives and SPVs to address perceived reserve redundancies; however, existing captives and SPVs are likely to remain in existence for several years or decades, until the existing blocks of business are run-off.

The NAIC's PBR project seeks to radically change the financial reserve system for life insurers. Rather than insurers being subject to a statutory system of financial reserves subject to state regulatory oversight, the NAIC PBR scheme would allow life insurers to set their own reserves based on actuarial projections of the insurers' choosing.

So what the NAIC working group report really says is: Right now, insurers have to work hard to raid reserve funds, but after NAIC succeeds in pressuring states to repeal normative financial reserve requirements, insurers will not face that chore.

What could be the concern in allowing company actuaries or contractors to establish reserve requirements for insurers? I mean, company actuaries would never face pressure to keep reserves exceedingly low—and contract actuaries who always seem to arrive at the lowest reserve figures would never enjoy a competitive advantage! (Yes, Virginia, it's a joke.)

The NAIC has come up with a string of crazy proposals over the past 13 years, but the PBR project has to be the worst. Presumably the PBR proposal was spoon-fed to regulators by representatives of a small number of very large insurance carriers and the force-fed officials had no idea how the PBR system would work—or they knew it would not work.

The letter

The PBR scheme presents a serious break between the policy aims of the NY-FSB and other sensible jurisdictions, and the NAIC.

On September 11, 2013, Superintendent Lawsky distributed a letter which informed state regulators and the NAIC that the NY-DFS would not participate in the NAIC PBR scheme with regard to life insurance.

The letter reminded the NAIC that NY-DFS had informed the regulatory community as early as 2011 that companies operating in New York and Texas were under-reserved by an estimated $20 billion in support of certain investment-oriented products.

An NAIC brokered policy compromise aimed at securing support from regulators for the PBR scheme only provided a projected increase of less than $1 billion in reserves. Furthermore, as states implemented the PBR scheme, companies actually reduced their financial reserves by $4 billion.

The superintendent's decision should come as no surprise to the NAIC, or its puppet masters. On November 26, 2012, Superintendent Lawsky warned the NAIC that PBR was a bad idea and a scheme which failed badly when applied to banking. The superintendent wrote:

The [NAIC] has been moving steadily to adopt a [PBR] regime for life insurers, which would be a significant departure from the rules-based approach that has enabled the insurance industry to weather the economic storm that buffeted the banking sector in the aftermath of the 2008 financial crisis.

As a point of comparison, Superintendent Lawsky provided a very clear example of what happens when officials deregulate financial reserves through a PBR scheme:

…. when the banking industry transitioned under the Basel II regime in the early 2000s to a framework coincidentally called "principles based reserving," failure ensued. Indeed, banks like Lehman Brothers that reduced their reserves under the Basel II regime were hit hardest by the financial crisis.

Tell the US Treasury Department not to put away that checkbook that they used in 2008, because the NAIC PBR scheme could make the AIG collapse look like a day in the park.

The author

Kevin P. Hennosy is an insurance writer who specializes in the history and politics of insurance regulation. He began his insurance career in the regulatory compliance office of Nationwide Insurance Cos. and then served as public affairs manager for the National Association of Insurance Commissioners (NAIC). Since leaving the NAIC staff, he has written extensively on insurance regulation and testified before the NAIC as a consumer advocate.

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