‘Shadow’ Transactions Raising More Risks
U.S. life insurers transferred more than $360 billion worth of liabilities to unrated affiliate reinsurers in less regulated onshore and offshore jurisdictions last year to reduce their taxes and capital requirements, a new report by two leading academics revealed.
The study into reinsurance agreements for U.S. life insurers between 2002 and 2012, published by Ralph Koijen, a professor at the London Business School, and Motohiro Yogo of the Federal Reserve Bank of Minneapolis, found that insurers have been put at substantial financial risk by an “unprecedented rise” in this “shadow insurance” over the past 10 years.
The increase in shadow insurance has resulted in operating companies moving their risks to off-balance-sheet reinsurers in domiciles such as Bermuda, Barbados, Vermont and South Carolina, after regulatory changes that increased reserve requirements for life insurers were introduced a decade ago.
Koijen told Risk & Insurance®: “There has been a massive trend towards these shadow entities. For every dollar of insurance that is sold in the U.S., it used to be the case 10 years ago that two cents went to the shadow entity, but now it is more like 30 cents.
“This means a major trade-off for the industry. On the one hand, the system gets riskier as a result of shadow insurance, with a significant decrease in risk-based capital and greater expected losses if the reinsurer’s liabilities were to be transferred back to the operating company.
“But the flipside is that the removal of shadow insurance would result in a price increase and a decline in the quantity of insurance sold, very similar to the effect of shutting down the shadow banking system,” he said.
U.S. regulators have become increasingly concerned about the increase in shadow insurance.
The National Association of Insurance Commissioners (NAIC) has formed a Captives and Special Purpose Vehicle Use Subgroup to assess the tightening of rules for captives and special purpose vehicles used by U.S. insurers.
Separately, New York State’s Superintendent of Financial Services Ben Lawsky has called for a moratorium on future approval of shadow insurance pending further investigation.
According to figures released by the NAIC, the report found that shadow insurance increased 33-fold from $11 billion in 2002 to $363 billion in 2012.
Although the shift toward shadow insurance has enabled many U.S. life insurers to set aside less reserve for future claims, it has also left companies vulnerable to a sudden spike in claims, the study revealed.
Furthermore, the report estimated that, on average, in the absence of shadow insurance, an insurer’s risk-based capital would fall dramatically as the amount of capital required by the operating company to support the additional liabilities would significantly rise.
Such a decline would be equivalent to a credit ratings drop of three notches and would imply an increase in additional expected losses of at least $15.7 billion for the industry, a cost ultimately borne by state taxpayers and other companies through state guaranty funds, the study said.
The report concluded: “We find that shadow insurance adds a tremendous amount of financial risk for the companies involved, which is not reflected in their ratings. When we adjust measures of financial risk for shadow insurance, risk-based capital drops by 49 percentage points for the median company, which is equivalent to three rating notches. Hence, default probabilities are likely to be higher than what may be inferred from their reported ratings.
“Our adjustments for shadow insurance implies an increase in the expected asset shortfall of $19 billion for the life insurance industry, which is a cost to the state guaranty funds (and ultimately taxpayers).”
However, the study also found that the removal of shadow insurance would result in a 1.8 percent rise in marginal costs on average for each company and a $1.4 billion decrease in the amount of annual insurance underwritten on aggregate, based on structural models.
Koijen concluded that the only “obvious rationale” for an increase in shadow insurance schemes was to “circumvent regulation.”
He said the surge in affiliated life and annuity reinsurance over the last decade pointed to capital and tax management as the main driver behind the use of shadow insurance.
American Council of Life Insurers spokesman Jack Dolan said: “Lack of transparency is a theme of this report. But it is important to recognize that captive reinsurance transactions are not only legitimate and safe but a carefully regulated means of fully satisfying required reserve requirements.
“At the same time, life insurers support added transparency and disclosure, which would dispel the notion that these transactions are ‘shadow’ arrangements. The states are currently working constructively to assure that captive transactions are appropriately disclosed and handled uniformly from state to state.”
Brad Kading, president and executive director of the Association of Bermuda Insurers and Reinsurers, concurred: “In group supervision, the impact of legal entity and affiliate transactions needs to be transparent and understood by the group supervisor and members of the regulatory college.”
Coping with Cancellations
Airlines typically can offset revenue losses for cancellations due to bad weather either by saving on fuel and salary costs or rerouting passengers on other flights, but this year’s revenue losses from the worst winter storm season in years might be too much for traditional measures.
At least one broker said the time may be right for airlines to consider crafting custom insurance programs to account for such devastating seasons.
For a good part of the country, including many parts of the Southeast, snow and ice storms have wreaked havoc on flight cancellations, with a mid-February storm being the worst of all. On Feb. 13, a snowstorm from Virginia to Maine caused airlines to scrub 7,561 U.S. flights, more than the 7,400 cancelled flights due to Hurricane Sandy, according to MasFlight, industry data tracker based in Bethesda, Md.
Roughly 100,000 flights have been canceled since Dec. 1, MasFlight said.
Just United, alone, the world’s second-largest airline, reported that it had cancelled 22,500 flights in January and February, 2014, according to Bloomberg. The airline’s completed regional flights was 87.1 percent, which was “an extraordinarily low level,” and almost 9 percentage points below its mainline operations, it reported.
And another potentially heavy snowfall was forecast for last weekend, from California to New England.
The sheer amount of cancellations this winter are likely straining airlines’ bottom lines, said Katie Connell, a spokeswoman for Airlines for America, a trade group for major U.S. airline companies.
“The airline industry’s fixed costs are high, therefore the majority of operating costs will still be incurred by airlines, even for canceled flights,” Connell wrote in an email. “If a flight is canceled due to weather, the only significant cost that the airline avoids is fuel; otherwise, it must still pay ownership costs for aircraft and ground equipment, maintenance costs and overhead and most crew costs. Extended storms and other sources of irregular operations are clear reminders of the industry’s operational and financial vulnerability to factors outside its control.”
Bob Mann, an independent airline analyst and consultant who is principal of R.W. Mann & Co. Inc. in Port Washington, N.Y., said that two-thirds of costs — fuel and labor — are short-term variable costs, but that fixed charges are “unfortunately incurred.” Airlines just typically absorb those costs.
“I am not aware of any airline that has considered taking out business interruption insurance for weather-related disruptions; it is simply a part of the business,” Mann said.
Chuck Cederroth, managing director at Aon Risk Solutions’ aviation practice, said carriers would probably not want to insure airlines against cancellations because airlines have control over whether a flight will be canceled, particularly if they don’t want to risk being fined up to $27,500 for each passenger by the Federal Aviation Administration when passengers are stuck on a tarmac for hours.
“How could an insurance product work when the insured is the one who controls the trigger?” Cederroth asked. “I think it would be a product that insurance companies would probably have a hard time providing.”
But Brad Meinhardt, U.S. aviation practice leader, for Arthur J. Gallagher & Co., said now may be the best time for airlines — and insurance carriers — to think about crafting a specialized insurance program to cover fluke years like this one.
“I would be stunned if this subject hasn’t made its way up into the C-suites of major and mid-sized airlines,” Meinhardt said. “When these events happen, people tend to look over their shoulder and ask if there is a solution for such events.”
Airlines often hedge losses from unknown variables such as varying fuel costs or interest rate fluctuations using derivatives, but those tools may not be enough for severe winters such as this year’s, he said. While products like business interruption insurance may not be used for airlines, they could look at weather-related insurance products that have very specific triggers.
For example, airlines could designate a period of time for such a “tough winter policy,” say from the period of November to March, in which they can manage cancellations due to 10 days of heavy snowfall, Meinhardt said. That amount could be designated their retention in such a policy, and anything in excess of the designated snowfall days could be a defined benefit that a carrier could pay if the policy is triggered. Possibly, the trigger would be inches of snowfall. “Custom solutions are the idea,” he said.
“Airlines are not likely buying any of these types of products now, but I think there’s probably some thinking along those lines right now as many might have to take losses as write-downs on their quarterly earnings and hope this doesn’t happen again,” he said. “There probably needs to be one airline making a trailblazing action on an insurance or derivative product — something that gets people talking about how to hedge against those losses in the future.”
Diversifying Top Management in Workers’ Comp
The panel at the inaugural Women in Workers’ Compensation (WiWC) Forum. From left to right: Eileen Ramallo, Elaine Vega, Nina Smith-Garmon, Nancy Hamlet, Michelle Weatherson, Nanette de la Torre, Danielle Lisenbey.
Across the country, the business community is engaged in a robust conversation about women being under-represented among c-level positions.
Why aren’t more women breaking into upper management roles? Does gender bias still exist? And, perhaps more importantly, what can women and men do to add more diversity to top leadership ranks?
Elaine Vega and Nancy Hamlet, of Healthcare Solutions, the Duluth, Ga.-based health services provider to the workers’ compensation and auto liability/PIP markets, have discussed the issue between themselves many times over the years.
The duo agreed that starting an industry-wide conversation would be an effective start to addressing the challenge. After three years of internal discussions, the inaugural Women in Workers’ Compensation (WiWC) Forum became reality. Judging by the attendance, content and feedback, it was an auspicious, very successful, debut.
Specifically, Healthcare Solutions and LRP Publications teamed up at the National Workers’ compensation and Disability Conference (NWCDC), held Nov. 18-21, 2014 in Las Vegas, to present the first WiWC event focused on the development of women as leaders within the industry. The WiWC debut featured a keynote speaker, a panel discussion and a networking cocktail hour.
“We believe this is just the beginning for the WiWC organization,” said Hamlet, senior vice president of marketing, adding that the event’s main theme was the conversation regarding challenges that still exist for women in the workplace is “current, real … and relevant.”
Originally the forum was allocated a room to hold 150 people. Vega and Hamlet worried about the room being too large, so they asked LRP what the contingency would be to make the room smaller if they couldn’t fill it. They needn’t have worried, as more than 400 women, and some men as well, registered and attended, requiring an even larger room.
“Clearly, the topic is relevant and there was plenty to discuss,” said Vega, senior vice president of account management.
Hamlet explained that WiWC was formed to create an open forum to promote a strong sense of community and support for current and future female leaders in the workers’ compensation industry. Going forward, the WiWC forum will provide insight and ideas with opportunities for members to:
- Engage … with accomplished industry professionals and build lasting relationships.
- Enrich … their knowledge base with tactical insights from speakers and panelists.
- Explore … opportunities and challenges facing women leaders today.
- Encounter … senior executives’ perspectives on leadership.
- Examine … leadership strategies and how to effectively apply the strategies.
- Empower … themselves and others to achieve success and groundbreaking results.
At the inaugural event, keynote speaker Peggy Holtman, co-author of “Leading at the Edge: Leadership Lessons from the Extraordinary Saga of Shackleton’s Antarctic Expedition,” discussed how a seemingly unconnected historical event can offer critical lessons on leadership in the workplace, especially for women looking to move into top executive spots.
After Holtman’s talk, a panel discussion, moderated by Vega, offered the perspectives of five workers’ compensation industry executives on ways in which women can navigate past the glass ceiling. Panelists included Eileen Ramallo , EVP Healthcare Solutions; Danielle Lisenbey, CEO Broadspire; Nanette de la Torre, VP Zenith; Nina Smith-Garmon, EVP Mitchell International; and Michelle Weatherson, Director, Claims Medical and Regulatory Division, State Fund of Calif.
The panelists discussed a wide range of topics related to women in workers’ compensation. For example, one topic focused on the need to take the big risks when it comes to moving past workplace barriers. Other topics included the importance of women in higher positions serving as sponsors and advocates for younger, less experienced women; and the impact of industry consolidation on women’s careers and how to best manage that change. Another topic was how women could best master conflict and emotions in the workplace.
“What’s clear is conflict has to be managed; it will not go away. It will only get worse,” said Healthcare Solutions’ Ramallo. “It then can create other rifts that won’t necessarily be visible immediately, but can have a very large impact. You have to be able to understand what it is early on from another’s perspective, why the situation exists, and then encourage and try to resolve a conflict situation, whatever may be driving it.”
In the wake of the first WiWC Forum, Hamlet noted that while there are countless general reports showing that women have not yet achieved equal representation in top leadership positions in the workplace, studies deal with averages rather than individual stories. And while women must continue to look at the data and work toward closing the gap, hearing from accomplished women in the workers’ compensation industry at NWCDC drove home critical messages on a person level.
Today, Vega and Hamlet are looking to expand WiWC to make it “truly owned” by the industry. For example, they expect to recruit companies interested in becoming sponsors, forming an advisory council, creating a charter and discussing future possibilities for the organization on both the national and regional levels.
“Much remains to be done, but I have confidence that we will come together and make the organization stronger so that it prospers for years to come,” Hamlet said. “After all, it’s clear that our industry is filled with talented women who can make things happen!”
Vega added that WiWC has already received requests to live stream the event in the future, so it will examine the feasibility of that option in an effort to be even more inclusive.
“We have a shared vision for improving opportunities for current and future women leaders in workers’ compensation,” Vega said. “It doesn’t matter our gender or our title, it’s all about supporting the greater vision. As was said several times at the event, this is just the beginning. We hope more women and men will join us in this continued dialogue.”
This article was produced by the R&I Brand Studio, a unit of the advertising department of Risk & Insurance, in collaboration with Healthcare Solutions. The editorial staff of Risk & Insurance had no role in its preparation.