The Risks of Shadow Insurance

50 Pages Posted: 14 Jul 2015 Last revised: 15 Jan 2016

See all articles by Daniel Schwarcz

Daniel Schwarcz

University of Minnesota Law School

Date Written: September 1, 2015

Abstract

In a shadow insurance transaction, a life insurer purchases reinsurance from an affiliated company that is licensed as a captive insurer or Special Purpose Vehicle and is not an “authorized” reinsurer. Such transactions have been scrutinized in recent years by the Federal Insurance Office, the Financial Stability Oversight Council, the Federal Reserve Bank, the New York Department of Financial Services, and the National Association of Insurance Commissioners, among others. Nonetheless, the precise mechanisms by which shadow insurance may pose risks to policyholders, the insurance industry, and the broader financial system remain sketchy. At least partially for this reason, substantial debate continues to exist regarding the extent to which the traditional tools of state insurance regulation adequately address the risks of shadow insurance. This Article contributes to the debate by describing four distinct risks posed by shadow insurance transactions. First, such transactions create reinsurance default risk, or the risk that captive reinsurers will default on their obligations to the underlying insurers. Second, they can expose insurers to recapture risk, or the prospect that an insurer will no longer be allowed to receive favorable accounting treatment for the reinsurance transactions that are part of a larger shadow insurance scheme. Third, shadow insurance can create correlated parent company risk by magnifying the prospect that a single financial shock will similarly affect multiple individual companies within a broader financial conglomerate. Finally, shadow insurance transactions can generate interconnectedness risk by increasing the connections between the insurance and banking sectors. State insurance regulation has traditionally focused predominantly on reinsurance default risk, while largely ignoring the three other risks posed by shadow insurance. The Article concludes that while certain forms of shadow insurance may produce sensible relief from poorly-designed insurance regulations, the practice ultimately harms insurance markets by undermining the ability of policyholders, market intermediaries, and regulators to transparently trade off risk and return.

Keywords: Shadow Insurance, Systemic Risk, Insurance Regulation, Captive Reinsurance

Suggested Citation

Schwarcz, Daniel B., The Risks of Shadow Insurance (September 1, 2015). 50 Georgia Law Review 163 (2015). Available at SSRN: https://ssrn.com/abstract=2630176

Daniel B. Schwarcz (Contact Author)

University of Minnesota Law School ( email )

229 19th Avenue South
Minneapolis, MN 55455
United States

HOME PAGE: http://www.law.umn.edu/profiles/daniel-schwarcz

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