Shadow Insurance 101: The downfall of the insurance industry?

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 about FIG as 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 Problem

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.

Comments (17)

 
Mar 9, 2015 - 10:33am

I'm also worried about hedge funds which are assuming non-traditional re-insurance roles for the 'float'.

Looking at entering into the insurance industry so I will look into this too; SB'd.

"It is better to have a friendship based on business, than a business based on friendship." - Rockefeller. "Live fast, die hard. Leave a good looking body." - Navy SEAL
 
Mar 9, 2015 - 11:15am

Yes, this is also something that may be concerning. As rates remain low, hedge funds will continue to flock to the reinsurance space in order to generate more alpha, as the traditional reinsurers can't compete. Reinsurance is already a pretty crowded space, and I think it's unclear how sustainable the hedge fund model will be going forward. Maybe I should write another piece about this if there is enough interest.

 
Mar 9, 2015 - 12:19pm

Great post! Insurance is a MASSIVE industry and while maybe not as sexy as banking/trading, is definitely a cash cow business. Old joke is: people buy insurance, get dinged in an accident, then don't report it so their insurance stays low, insurance company keeps taking payments and doesn't have to pay out......GREAT BUSINESS TO BE IN!

nkhanlegend:
Don't these shadow insurance transactions remind you of SIVs

Yes, they have similar destructive potential and there's not much information on what products are placed into captives.
nkhanlegend:
Though AG 48 has just kicked in, which may halt the potential impending doom.

Yes but the rule is not retroactive so you know someone's going to drive a Hummer through that loophole.

In addition to the potential black swan event that crushes large chunks of the industry on payouts, there's also the "other" insurance products that pose their own unique risks. For example, annuities are a huge business, larger than the entire PE industry. Many forms have large market exposures that have a great deal of interplay with the internal structures of the product: they can be simple fixed or they can be very sophisticated VAs where payouts are guaranteed AND somehow tied to market performance. Overall, larger companies like MetLife or Prudential are best positioned to cover unexpected losses by virtue of their large balance sheet to projected insurance risk ratio, but there's still a risk that I agree with you on: a lot of people just aren't paying attention to it.

Overall, these business lines are typically tightly managed, but it's cool to see someone paying attention to the topic. Please do post again, I'm looking forward to it!

Get busy living
 
Mar 9, 2015 - 12:49pm

Thanks a lot, really appreciate the kind words. I agree with you 100% about the other products in insurance, and to an extent about AG 48. Variable annuities are an entirely different beast that pose many risks. With VA in particular, the risk is pretty heavily concentrated in the market. It's something like the top 5 variable annuity writers (think MetLife, Prudential, ING/Voya, etc.) hold ~40% of variable annuity reserves in the entire industry--it's madness.

I always thought WSO was obsessed with the sexy stuff like IB/PE/HF..etc. Good to hear there's interest in other less sexy stuff. I will definitely do another post on insurance!

 
Mar 9, 2015 - 3:59pm

Interestingly the regulation of insurance in the USA is different than that of Europe. In Europe, banks are allowed to provide insurance (Bancassurance model), just like investment banking was never separated from commercial banking. Do you believe such deregulation will happen in the US? To allow banks to provide insurance products?

Colourful TV, colourless Life.
 
Mar 9, 2015 - 4:47pm

That will never happen in the US. Both banks and insurance companies are already under a lot of regulatory scrutiny. Banks being able to sell insurance products would just add fuel to the fire. However, banks do provide a lot of financing needs to insurers (i.e. letters of credit), but the NAIC has stated that structured letters of credit will no longer qualify as eligible assets for companies to meet their principle based reserve requirements or finance their excess reserve requirements. Banks who were issuing tons of letters of credit are now looking for new structures that will let them participate in the reserve financing game. Frankly, it's a shit show

 
Mar 11, 2015 - 12:55pm

nkhanlegend:
  • 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.
  • I'm no insurance expert, but I don't think the above is true. The purpose of an insurance captive is the following:
    (1) establish a new "clean" pure play insurance business which is easier to get licensed from a regulator because the captive's capital is clearly defined and unencumbered by the core business' operations
    (2) ring fence the insurance entity's capital, so that the main business isn't on the hook to make whole excess losses
    (3) serve as a reinsurance conduit

    The idea of an insurer "diverting reserves" is kind of misleading. Reserve levels are established (somewhat indirectly) by regulators, and the only way you can "divert" those reserves to another entity (affiliated or not) would be to transfer the risk to said entity.

    My main point is, the idea of diverting reserves to another entity to use that money to do something else with is fairly misleading. In the absence of expertise, I default to your statement of captives having lower reserve requirements. All these guys are really doing is creating a cleaner pure play SPV from which to effect insurance business. That cleaner business has lower risk around it since the core non-insurance business isn't sharing a fungible capital pool with the insurer. So effectively having a "lock boxed" insurance entity, where capital cannot flow freely in/out, is a lower risk entity from regulators standpoint and therefore justifies lower capital levels. Even that language has a psychological impact to it. Why not consider a non-captive over-equitized by regulators. So a captive isn't required to be over-equitized for all the reasons I stated above.

    All the captive is doing is distributing excess capital to its shareholders... and not diverting reserves which are needed to pay future losses. It should be apparent by how the insurance entity's reserves are holding up.

    Again, I'm no expert but I have seen a fair share of busted insurance companies (captive and not). So correct me if any of my above statements are wrong.

    Array
     
    Mar 12, 2015 - 8:53am

    You're right, my phrasing was a bit misleading. You have more or less hit on the 'true' definition of a captive.

    On the point of reserves, captives generally have lower reserve requirements because of where they are domiciled relative to their parent entity. As you probably guessed, Bermuda houses the most captives offshore. In the states DE and VT are very popular places to domicile. New York has formally stated their opinion that they are against the use of captive structures. However, you are correct in that they are beneficial in that they allow insurers to more 'efficiently' use capital. When risk is segregated into a captive, companies can get third party financing at lower costs, and risk is spread because third party financing partners are now liable for the risk from their financing.

    Collateral in captives can take the form of assets held in trust, a letter of credit (LOC), funds withheld, or, in some states, a parental guarantee. My issue is that captives hold off balance sheet risks for the parent company. Additionally, there is a large issue with LOCs. They may not provide the funds needed upon draw (unsecured). There is also the case where the LOC is essentially a 'wrap around' type of arrangement where the LOC cedes the risk back to the parent company, which results in reduced reserves but there no no risk transfer in this scenario.

    My phrasing subtly (or not so subtly) hinted at the fact that I am against the use of captive structures--so thanks for pointing that out so I could further clarify.

     
    Mar 12, 2015 - 10:50am

    Everyone I talk to on a daily basis has generally risen up through the actuary path, gone up through the ranks of treasury, or corporate banking. I have seen people that have also lateraled from banks that were/weren't BBs (think Natixis, BNY, Standard Chartered, etc.) but they come from some sort of fixed income, corporate banking, derivatives, structured products, or collateral management background. No one is doing abstract algebra or anything, but their backgrounds do include some form of math. From my understanding, very few have an MBA and are pretty senior people. I don't work for an insurance company, but from my experience it seems like a space where people rise up internally.

    Edit: Also forgot that capital markets, and credit risk are also semi-common laterals that I have seen

     
    Mar 12, 2015 - 9:16am

    Solvency II is worthy of a post itself, so I will keep it brief. I think Solvency II is a step in the right direction for EU insurance companies (as it is coined a Basel II for insurance companies). It doesn't directly combat the issue of shadow insurance, but definitely hints at it in the language. There is still some time before implementation, and it has not really been a discussion at my shop. Maybe this will change--unsure.

     
    Mar 12, 2015 - 6:33pm

    I work for large insurance company

    Generally in the big ones, you have the usual departments:

    Product management
    Marketing
    Distribution
    Human resources
    Investments
    Legal/public affairs
    Corporate strategy & business development
    Claims

    Product management is where you'll see most of the actuarial people, but even there you have people w/o math backgrounds and/or MBA degrees

    All other departments tend to have lots of non-actuarial people

     
    Mar 20, 2015 - 12:49am

    Where's Underwriting?

    KPP:

    I work for large insurance company

    Generally in the big ones, you have the usual departments:

    Product management

    Marketing

    Distribution

    Human resources

    Investments

    Legal/public affairs

    Corporate strategy & business development

    Claims

    Product management is where you'll see most of the actuarial people, but even there you have people w/o math backgrounds and/or MBA degrees

    All other departments tend to have lots of non-actuarial people

     
    Mar 21, 2015 - 12:03pm

    Where I work, it is a group within the product management family

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