Offshore race to bottom fosters shadow insurance industry, "may need bailout"

Posted from the Treasure Islands blog:

From the New York Times:

"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."

That is offshore business, and the race to the bottom - yet again. In fact, I wrote about this very issue - with a particular focus on Vermont (and Bermuda) a couple of years ago. This shabby story involves both U.S. states such as Missouri, Delaware, Iowa, South Carolina, Nebraska, and Vermont - and offshore tax havens such as the Cayman Islands.

So what exactly is this all about?

Well, essentially, insurers are using lax state and tax haven laws to cook their books, allowing them to appear safer than they really are, in a scam that lines executives' pockets but could lead to another taxpayer bailout. Insurers are supposed to set aside reserves against possible future claims, and to have adequate collateral  - but if they reinsure this business through special captives formed in lax jurisdictions, they can make those reserve and collateral requirements largely fall away.

"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”

These tens of billions of dollars that Lawsky uncovered affect policies worth trillions of dollars and are, as Lawsky's official report entitled Shining a Light on Shadow Insurance puts it,

"likely to be just the tip of the iceberg nationwide. There are almost certainly tens, if not hundreds, of billions of dollars of additional shadow insurance on the books of insurance companies across the country."

And worldwide, we should add. Where is the European equivalent of this report? This is a gigantic problem. As the report continues:

"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."

What a surprise. A race to the bottom, secrecy, lax financial regulation - and tax havens. The NYT adds:

"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."

Bloomberg describes the arrogance of the insurance companies, via an email from Metlife:

"The contracts are a “cost-effective way of addressing overly conservative reserving requirements."

In other words, we don't like the democratically mandated constraints that enable us to double up on risks to pay executive compensation - so we'll go offshore to get around the rules!

And here's another real surprise, from the NYT:

"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."

This ugly story will ring true with any reader of Treasure Islands. Lawsky's report adds, ominously:

"Shadow insurance also could potentially put the stability of the broader financial system at greater risk. Indeed, in a number of ways, shadow insurance is reminiscent of certain practices used in the run up to the financial crisis, such as issuing securities backed by subprime mortgages through structured investment vehicles (“SIVs”) and writing credit default swaps on higher-risk mortgage-backed securities (“MBS”). Those practices were used to water down capital buffers, as well as temporarily boost quarterly profits and stock prices at numerous financial institutions. Ultimately, these risky 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 multi-trillion dollar taxpayer bailout.

Similarly, shadow insurance could leave insurance companies on the hook for losses at their more weakly capitalized shell companies."

One more for the Economic Crisis + Offshore permanent webpage.