Insurers fattening books with loads of risk

(MoneyWatch) You buy insurance to be on the safe side. But how safe is your insurance company?

That question emerged front and center late Tuesday when New York state's financial regulator issued a scathing report about how some of the country's biggest insurance companies may be putting policyholders and taxpayers at huge risk by their own risky practices. And, said Benjamin Lawsky, New York's superintendant of financial services, they're practices that in many cases are being used to help fatten the paydays of top executives and shareholders.

The system, which the New York State Department of Financial Services describes as "shadow insurance," works like this: A large insurance company creates a subsidiary. That subsidiary, really just a shell company, reinsures large blocks of the policies the parent company has written. For bookkeeping purposes, that transfers huge amounts of risk off the books of the parent. In reality, no risk has really been transferred because the shell company is merely a captive entity owned by the insurance company. But because the parent company on paper appears to be carrying less risk, it doesn't need to set aside as much money to cover losses.

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"That means that when the time finally comes for a policyholder to collect promised benefits after years of paying premiums (such as when there is a death in their family), there is a smaller reserve buffer available at the insurance company to ensure that the policyholder receives the benefits to which they are legally entitled," the report said.

The year-long investigation, which looked at all 80 New York-based life insurers, found that 17 companies conducted more than $48 billion in such shadow transactions over the course of the probe. While the investigators, because of statutory obligations, did not divulge names of the firms it found is engaging in the practices, it is certain that they include some of the biggest names in the business.

People with knowledge of the practice said the major providers of life insurance that make use of captive companies include Transamerica, Hartford, Metlife and Prudential, as well as property and casualty giant Allstate.

Lawsky's findings recall similarly risky practices in the so-called shadow banking sector in the years leading up to the 2008 financial crisis. Mortgage lenders and investment banks used dodgy accounting techniques in selling trillions of dollars in mortgage securities, practices that appeared to reduce their risks while bolstering their profits.

"Those practices were used to water down capital buffers, as well as temporarily boost quarterly profits and stock prices," Lawsky said in the report. "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."

Lawsky's report blamed in part a "regulatory race to the bottom" in states around the country, in which other insurance regulators allow shabby accounting to flourish. The report cited captive reinsurers located in Missouri, Delaware, Iowa, South Carolina, Nebraska and Vermont. The amount of money being shielded in these states through so-called conditional letters of credit that may not be available to policy holders in case of a crisis is nearly $10 billion.

"It is vital that companies compete based on the quality of their products and services -- rather than which ones can best exploit financial loopholes like shadow insurance that put consumers and taxpayers at greater risk," New York Gov. Andrew Cuomo said in a statement regarding Lawsky's findings. "Our investigation shows that this is a problem all across the nation, so I encourage other state governments -- as well as our federal officials -- to look into these questionable transactions immediately to protect all consumers."

The National Association of Insurance Commissioners, which sets state regulatory standards for insurance companies, acknowledges that the rules governing insurers' use of special purpose vehicles and other captive firms to offload risk need to be modified.

"Regulators need to be able to assess and monitor the risks that captives and SPVs may pose to the holding company system," said an NAIC group formed to study the issue in a document. "The current regulatory process should be enhanced to provide standardized tools and processes to be used by all regulators when reviewing such transactions. Commercial insurer owned captives and SPVs should not be used to avoid statutory accounting."

The number of captive insurance companies -- insurance entities created and owned by a non-insurance companies to insure the risks of its owner -- has surged in the last three decades, according to the NAIC. Today, there are more than 5,000 such firms worldwide, compared with 1,000 in 1980. Bermuda is the most popular location to legally register a captive firm, with the Cayman Islands, Guernsey in the Channel Islands, Luxembourg and Ireland also home to the companies. In the U.S., Vermont is the leader in captive firms.

Lawsky's office recommended that several steps be taken, including a national moratorium on approving additional shadow insurance transactions until further investigations are completed. It is also seeking detailed disclosure of shadow insurance transactions by New York insurers and their affiliates.

To industry watchers, the report is no surprise.

"This has been going on for years -- everybody is doing it," said Ed Leefeldt of consumer insurance website Insure.com. "Insurers have been setting up these captives so they can throw their excess risk to them to make their balance sheets look better. That way they don't have to keep so much [capital] in reserve."

For companies, more money on the books means bigger dividends for shareholders and fatter bonuses for top executives. For state officials, meanwhile, a thriving market in legally registered captive firms means more tax revenue.

"States and insurance companies are creatures of their states, and these people want that revenue," Leefeldt said. "So you can expect to see insurers set up captives all over the place. They're like offshore shell companies"

Editor's note: An earlier version of this story incorrectly identified New York Life as one of the insurance companies using captive companies. New York Life does not own a captive company. We regret the error.