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Could ‘shadow insurance’ controversy bring Life back into ILS?


In the last few days the news has been awash with discussions of so-called ‘shadow insurance’, discussing the practices of life insurers in using captives and offshore vehicles as sources of reinsurance protection. A report published on Tuesday called out certain practices by life insurers as overly risky to both policyholders and taxpayers.

We’re not going to cover this in great detail as it’s been well discussed in the mainstream financial press. We’ll give a basic overview and then some thoughts on how it may be relevant to the markets covered on Artemis.

The New York Department of Financial Services published a report that said that certain New York-based life insurance companies and affiliates engaged in as much as $48 billion of these shadow insurance transactions. The regulator said that the aim of these transactions was to lower their reserve and regulatory requirements, but some failed to disclose guarantees associated with the deals or the disclosure was incomplete.

Regulators claimed that these transactions allow insurers to divert reserves to be used for purposes other than paying claims that arise on the subject business. Because these transactions often involve captives, or SPVs, established by or for the ceding insurer, the regulator said that these may not actually transfer the risk at all as the parent company would be liable for the captive or SPVs claims if reserves were exhausted.

The report cites this shadow insurance as being akin to; “Certain practices used in the run up to the financial crisis, such as issuing securities backed by subprime mortgages through structured investment vehicles and writing credit default swaps on higher-risk mortgage-backed securities.” Not a good comparison we’re sure you’ll agree.

So why do these shadow insurance deals get transacted?

The report claims that life insurers are setting up these complex transactions to help them meet reserving requirements. Under certain regulation, such as XXX and AXXX, life insurers are required to keep substantial reserves to enable them to meet potential future claims on books of life policies.

So insurers have been using a range of mechanisms to build reserves on their balance sheets, either by offloading risk in more traditional ways, such as reinsurance, private ILS deals and securitization, or by establishing these offshore captives and ceding risk in to them through reinsurance transactions. By reinsuring the risks in these captives the life insurer can then put the reserves it had built up to other uses, is the claim from regulators.

Some would say that by reinsuring the policies with their own affiliate the life insurers are not truly transferring the risks and that if the claims spike it would come back to bite the parent company in the end. Of course that depends on how a captive reinsurer is funded doesn’t it. The recent Bermuda Captive conference discussed this in detail and Business Insurance has a piece on why panellists at the event do not believe captive insurance to be shadow insurance.

What is interesting though is the fact that an alternative to these arrangements has existed in the form of life insurance securitization for a number of years and perhaps with this sudden focus on these so-called shadow deals, which have allowed life insurers to achieve a form of risk transfer, the opportunity may emerge for the ILS market to step in and offer a truer (to the regulator) transfer of these risks.

InsuranceRisk has published an excellent article today looking at some of the issues in this shadow insurance world. It discusses the fact that using offshore captives for reserving at life insurers is a big business and suggests that the current controversy may bring a focus down on the Regulation XXX/AXXX deals which are transacted today and open a door to bring life back into the ILS market.

The life insurance-linked securities (or life ILS) market was ticking along nicely and on the verge of becoming the preferred method of gaining true risk transfer, in a similar way to a cat bond deal, for the life insurer while also helping it meet the increasingly stringent reserving requirements.

Then, along came the financial crisis in 2007/8 and the interest in securitizing life insurance policies tailed off making bank funded letters of credit the preferred route to fund these deals again. The article suggests that once again life insurers are looking to move away from letters of credit, turning to reinsurance and dabbling in ILS type structures.

One particularly interesting point in the article is the comment from Jorge Fries from Credit Agricole who says that there are capital markets solutions emerging which see a bank repackaging a letter of credit into notes to be sold to ILS investors. Now this is an interesting way for an insurance-linked security fund or investor to gain exposure to life risks to complement its diversified portfolio, but we’re sure the investors would rather access the risk through reinsurance contracts or securitization of the risk itself, rather than the letter of credit. We may of course be wrong and this may be just what investors want and if you believe that’s the case we’d love you to tell us why in the comments below please.

The article also discusses the NAIC’s investigation into the use of captives and SPV’s for funding XXX/AXXX reserves, and suggests that this could see life insurers moving away from these methods, which could in turn see ILS recover favour in the life arena.

Could the current controversy help to stimulate activity in the life ILS market once again? It would certainly be welcomed by ILS investors who would view the opportunity to support considerable issuance of life-linked ILS as very attractive right now. It would come at an opportune time when catastrophe bond issuance appears to be growing again and a decent volume of diversified life ILS notes would potentially be of great interest to help ILS funds and investment managers grow.

It’s likely that this controversy surrounding so-called shadow insurance deals will drag on for a while and the longer it does the more likely an enterprising life insurer will begin to look seriously at ILS and securitization as a viable alternative, if it would meet its needs. We suspect that some life insurers will already be making enquiries about the alternatives available to them and even if a rated life ILS transaction does not come to market, we suspect a number of private ones might be quietly transacted.

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