I work in the insurance sector, primarily dealing with derivatives and collateral needs for institutions. I haven't seen much on this site about the insurance sector in particular...though there has been some talk aboutas a whole. I thought this might be useful for educating some people about the perceived boring world of insurance. I've tried to boil this down to something very very basic, so I did not go into too much detail about certain things. I will do my best to field questions if there are any
What is insurance?
"An economic device transferring risk from an individual to a company and reducing the uncertainty of risk via pooling." (NAIC) "A contract (policy) in which an individual or entity receives financial protection or reimbursement against losses from an insurance company" (Investopedia). Most people have insurance (life, property, etc.), and it comes in many shapes and forms.
What is reinsurance?
"A transaction between a primary insurer and another licensed (re) insurer where the reinsurer agrees to cover all or part of the losses and/or loss adjustment expenses of the primary insurer. The assumption is in exchange for a premium." (NAIC). For simplicity, think of reinsurance as insurance for insurance.
What is a captive?
A captive is a subsidiary that is owned by an insurer's parent company. These subsidiaries are a form of risk management for insurance companies.
A typical shadow insurance transaction:
- Parent company creates a captive insurance subsidiary.
- The insurance company reinsures a block of existing policy claims through the captive.
- The company then diverts the reserves it had on hand to pay policyholders to other purposes. This is allowed because reserve and collateral requirements for the captives are generally lower.
The goal of using captives is to mitigate/transfer risk for insurance policies. However, the parent company is still responsible for paying claims if the captive's weaker reserves are exhausted. Now, what happens when a policyholder wants to collect their benefits after paying premiums for some years? The problem is that there is now a smaller reserve buffer available at the insurance company to ensure that the policyholder gets the money they are legally entitled to!
The Bigger Problem
Don't these shadow insurance transactions remind you of SIVs (Structured Investment Vehicles)? And if you don't recall what happened with SIVs, I'll let you google that yourselves. The moral of the story is simple. Shadow insurance has the potential to royally screw the insurance industry. Because of captive transactions, insurance companies run the risk of being weakly capitalized. I for one truly hope this does not blow up in the near future. Though AG 48 has just kicked in, which may halt the potential impending doom.
Note: This is expected to be an explanation for those who know nothing about insurance, so I missed/quickly went over key topics for the sake of simplicity.