In recent months at least two papers on this topic have been released. Ralph Koijen and Motohiro Yogo issued “Shadow Insurance” in April 2014, and Scott Harrington released “The Use of Captive Reinsurance in Life Insurance” in May 2014. The Harrington paper is largely a rebuttal to the Koijen/Yogo paper. If you’d like to read the full papers, please email me at firstname.lastname@example.org.
Meanwhile here are some of our observations after reviewing both papers:
- Shadow or captive reinsurance arrangements have become an increasingly common tool for life insurance companies to lower required reserves, thereby lowering the prices of products and increasing market share. By and large, the products involved in this discussion are Guaranteed Universal Life policies, also known as no-lapse or secondary guarantee insurance.
- Some are very considered about these arrangements because the financial statements of these shadow reinsurance companies are confidential to the public, rating agencies, and state regulators outside the company’s domicile (which can also be off-shore and lower regulatory scrutiny even further).
- These arrangements are not what people think of when they normally think about reinsurance. These arrangements do not transfer risk – they are simply a form of financial reinsurance that moves liabilities around within the same overall organization – and by strategically positioning those liabilities in less regulated or unregulated companies, the amount of liabilities carried on the books can be lowered.
- Koijen/Yogo present a very disturbing viewpoint, while Harrington largely dismisses their findings and concludes that the rating agencies have everything under control. It should come as no surprise that Koijen/Yogo use a more negative word (“Shadow”) to describe these arrangements than Harrington does (“Captive”).
- Koijen/Yogo provide precise conclusions about the impact of shadow reinsurance on the marketplace, including predictions about company ratings, default experience, price increases, and sales decreases.
- The precision of the Koijen/Yogo predictions provide much fodder for Harrington to exploit, and much of the Harrington paper ends up being directed at refuting the precise Koijen/Yogo predictions. Harrington makes a number of solid points, and I find many of his criticisms of the methodology and precision to be convincing.
- Unfortunately, I think that the significant discussion given by both reports to precise predictions ends up being somewhat of a red herring, taking attention away from the critical shift that is occurring within the industry. Koijen/Yogo point out that the amount of insurance ceded to shadow reinsurance companies increased from $11 billion in 2002 to $364 billion in 2012!
- Harrington seems to imply that there is something inherently wrong with the fact that statutory reserves are higher than economic reserves. I understand that intelligent people can disagree over the appropriate amount of margin contained within statutory reserves, but to start a conversation with the premise that any excess over economic reserves is redundant seems absurd. The point of statutory reserves is to define a conservative base that ensures that companies will be around many years down the road to fulfill their promises to policyholders. I concede that I may be reading too much between the lines.
- I am particularly troubled by many issues surrounding lapse-supported pricing, which is a key ingredient for developing a competitive guaranteed universal life policy. Only by counting on the profits from a significant number of policy lapses can companies develop a competitive premium for a guaranteed UL policy. Economic reserves are very dependent on lapse rates, and if a company overestimates the lapse rate, then they are hit with a double whammy – they will not have set enough reserves aside per unit of insurance in force, and they will have more units in force than they expected.
- I am in no position to quantity the potential magnitude of a reserving shortfall or whether or not it could chew up enough of a company’s surplus to trigger regulatory action – but I do think there is enough smoke surrounding this issue to be concerned about a legitimate fire when it comes to companies potentially exposing policyholder to undue risk through aggressive reserving tactics such as shadow reinsurance.