Michael Appleton for The New York TimesBenjamin M. Lawsky, New York’s superintendent of financial services, has accused life insurers of using “shadow insurance.”New York State regulators are calling for a nationwide moratorium on transactions that life insurers are using to alter their books by billions of dollars, saying that the deals put policyholders at risk and could lead to another taxpayer bailout.
Insurers’ use of the secretive transactions has become widespread, nearly doubling over the last five years. The deals now affect life insurance policies worth trillions of dollars, according to an analysis done for The New York Times by SNL Financial, a research and data firm.
These complex private deals allow the companies to describe themselves as richer and stronger than they otherwise could in their communications with regulators, stockholders, the ratings agencies and customers, who often rely on ratings to buy insurance.
Benjamin M. Lawsky, New York’s superintendent of financial services, said that life insurers based in New York had alone burnished their books by $48 billion, using what he called “shadow insurance,” according to an investigation conducted by his department. He issued a report about the investigation late Tuesday.
The transactions are so opaque that Mr. Lawsky said it took his team of investigators nearly a year to follow the paper trail, even though they had the power to subpoena documents.
Insurance is regulated by the states, and Mr. Lawsky said his investigators found that life insurers in New York were seeking out states with looser regulations and setting up shell companies there for the deals. They then used those states’ tight secrecy laws to avoid scrutiny by the New York State regulators.
Insurance regulation is based squarely on the concept of solvency — the idea that future claims can be predicted fairly accurately and that each insurer should track them and keep enough reserves on hand to pay all of them. The states have detailed rules for what types of assets reserves can be invested in. Companies are also expected to keep a little more than they really expect to need — called their surplus — as a buffer against unexpected events. State regulators monitor the reserves and surpluses of companies and make sure none fall short.
Mr. Lawsky said that because the transactions made companies look richer than they otherwise would, some were diverting reserves to other uses, like executive compensation or stockholder dividends.
The most frequent use, he said, was to artificially increase companies’ risk-based capital ratios, an important measurement of solvency that was instituted after a series of life-insurance failures and near misses in the 1980s.
Mr. Lawsky said he was struck by similarities between what the life insurers were doing now and the issuing of structured mortgage securities in the run-up to the financial crisis of 2008.
“Those practices were used to water down capital buffers, as well as temporarily boost quarterly profits and stock prices,” Mr. Lawsky said. “And ultimately, those 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 multitrillion-dollar taxpayer bailout.”
The transactions at issue are modeled after reinsurance, a business in which an insurance company pays another company, a reinsurer, to take over some of its obligations to pay claims. Reinsurance is widely used and is considered beneficial because it allows insurers to spread their risks and remain stable as they grow. Conventional reinsurance deals are negotiated at arm’s length by independent companies; both sides understand the risk and can agree on a fair price for covering it. The obligations drop off the original insurer’s books because the reinsurer has picked them up.
Mr. Lawsky’s investigators found, though, that life insurance groups, including some of the best known, were creating their own shell companies in other states or countries — outside the regulators’ view — and saying that these so-called captives were selling them reinsurance. The value of policies reinsured through all affiliates, including captives, rose to $5.46 trillion in 2012, from $2.82 trillion in 2007.
The chief problem with captive reinsurance, Mr. Lawsky said, is that the risk is not being transferred to an independent reinsurer. Also, the deal is not at arm’s length. And confidentiality rules make it difficult to see what secures the obligations.
The New York State investigators subpoenaed this information and discovered that some states were approving deals backed by assets that would not be allowed in New York; Mr. Lawsky referred to “hollow assets,” “naked parental guarantees” and “conditional letters of credit.”
“Weaker collateral requirements mean the policyholders are at greater risk,” he said.
Insurers, unlike banks, have no prepaid fund like the Federal Deposit Insurance Corporation to make customers whole in the event of a collapse. That’s why Mr. Lawsky said he feared that taxpayers might have to be called to the rescue again.
Because New York has standing to investigate only life insurers based in the state, the administration of Gov. Andrew M. Cuomo is calling for other states, or the federal government, to “conduct similar investigations, to document a more complete picture of the full extent of shadow insurance written nationwide.”
Until then, Mr. Lawsky said, the deals should not be permitted. New York State has already stopped approving them, but other states have not.
The National Association of Insurance Commissioners has been examining the same type of transactions, but its members are sharply divided about their potential risk and what, if anything, to do about it. The group’s proposals must be adopted by 42 state legislatures to become effective. That seems unlikely; many states have recently passed laws allowing the formation of captives. Gov. Rick Perry made Texas the latest contender for the business when he signed such a law this month.
A new federal entity created under the Dodd-Frank financial reform law, the Federal Insurance Office, has also been monitoring the trend and is scheduled to discuss possible federal responses at an advisory committee meeting on Wednesday. Any federal action would be fought hard by the states, which have regulated insurance for more than 150 years.
New York’s investigators could not disclose which companies are the biggest users of reinsurance through captives because of the secrecy laws of other states. Their report did describe some of the transactions in detail, but with the names of the companies removed.
The separate analysis by SNL Financial, by contrast, was based on public regulatory filings. It did identify the life insurance companies that are the biggest users of the transactions, both in and out of New York. They include Transamerica, MetLife, Prudential, Hartford, Genworth, John Hancock, ReliaStar and Lincoln National, among others. Another insurer, Allstate, turned up in the sample even though its primary business is property and casualty, because it owns some life insurers.
The big users generally appear to be publicly traded companies, which have to meet Wall Street’s expectations for earnings growth and returns on capital. Life insurers that are owned by their policyholders, called mutual companies, do not have that pressure, and some, like State Farm, Guardian and New York Life, appear not to be reinsuring through captives at all.
MetLife said in a statement Tuesday that it “holds more than sufficient reserves to pay claims on its policies” and added that it used reinsurance subsidiaries “as a cost-effective way of addressing overly conservative reserving requirements” for certain insurance products. If it had to set aside that level of reserves more conventionally, it said, it would either have to borrow — putting its credit rating at risk — or raise the money by selling stock, dragging its returns below the level its stockholders require.
“Access to reinsurance subsidiaries significantly reduces costs to policyholders and in some cases is necessary to enable insurers to continue to offer certain coverage,” MetLife said.
Prudential said in a statement, “Our captives are capitalized to a level consistent with ‘AA’ financial strength rating targets of our issuing insurance entities.” It said that many of its captive reinsurance transactions were done in Prudential’s own home state, New Jersey, so the same regulators could see both ends of the deals.
In other cases, Prudential said it reinsured obligations through a captive entity in Arizona, Pruco Re, whose reserves were “subject to asset adequacy testing by our actuaries.” The company said these practices were disclosed to investors.
Other companies using this type of reinsurance said their transactions had been reviewed and approved by regulators, and helped them use capital efficiently. They also said the practice allowed them to charge lower prices, and in some cases made it possible to keep selling types of insurance that would otherwise have been discontinued. They also said it was appropriate to support their captives with contingent letters of credit in cases where the likelihood of big payouts was remote.
The Hartford said that it had sold its life insurance business to Prudential, and was no longer in the business of writing new life policies and reinsuring them.
Allstate said that captives and special-purpose vehicles were “a minor part of Allstate’s reinsurance business.”
SNL Financial’s data also made it possible to see which states are courting the transactions most eagerly — Vermont, South Carolina, Arizona, Hawaii, Iowa and Missouri.
“If we let our guard down and ignore this regulatory race to the bottom, taxpayers and insurance policyholders are the ones who could get left holding the bag,” Mr. Lawsky said in his report.