Shadow Insurance Usage and Capital Management in Life Insurance Groups

Abstract

This paper investigates why U.S. life insurance groups use shadow insurance, i.e., reinsure their risks using affiliated, unauthorized, and unrated off-balance sheet entities rather than traditional reinsurers, and how such activities are allocated to individual group members. We find that such regulatory arbitrage through shadow insurance activities is motivated by large deviation from an insurance group’s optimal capital structure and is primarily exercised by larger groups with already high risk-based capital ratios. Rather than smoothing capitalization across firms using affiliated reinsurers’ capacity, insurance groups allocate the amount of shadow insurance to only a few highly levered, less capitalized, and larger life insurers within the group, with leverage having the largest impact on shadow insurance usage.

Keywords: Regulatory Arbitrage, Capital Management, Life Insurers, Shadow Insurance, Internal Capital Markets.

JEL Classification: G01, G22, G23, G28