‘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.”
A New Dawn in Civil Construction Underwriting
Pennsylvania school children know the tunnels on the Pennsylvania Turnpike by name — Blue Mountain, Kittatinny, Tuscarora, and Allegheny.
San Francisco owes much of its allure to the Golden Gate Bridge. The Delaware Memorial Bridge commemorates our fallen soldiers.
Our public sector infrastructure is much more than its function as a path for trucks and automobiles. It is part of our national and regional identity.
Yet it’s widely known that much of our infrastructure is inadequate. Given the number of structures designated as substandard, the task ahead is substantial.
The Civil Construction projects that can meet these challenges, however, carry a unique set of risks compared to other forms of construction.
“The bottom line is that there is always risk in a Civil Construction project. If the parties involved don’t understand what risk they carry, then the chances are there are going to be some problems, and the insurers would ideally like to understand the potential for these problems in advance.”
– Paul Hampshire, Vice President – Civil Construction, LIU
The good news is that recent developments in construction standards and risk management techniques provide a solid foundation for the type and risk allocation of Civil Construction projects they are underwriting. Carriers need to be able to adequately assess the client and design and construction teams that are involved.
For Builder’s Risk Programs, a successful approach prioritizes a focus on four key factors. These factors are looked at not only during the underwriting phase of the project but also in the all-important site construction phase, under the umbrella of a Risk Management Program, or RMP.
Four key factors
Four key factors that LIU focuses on in underwriting and providing risk management services on a Civil Construction project include:
1. Resource knowledge and experience: When creating a coverage plan, carriers work to understand who is delivering the project and how well suited key staff members are to addressing the project’s technical and management challenges. Research has shown that the knowledge and experience of those key players, combined with their ability to communicate effectively, is a big factor in the project’s success.
“We look to understand who is delivering a project, their expertise and experience in delivering projects of similar technical complexity in similar working conditions, even down to looking at the resumés of people in key positions,” said Paul Hampshire, Houston-based Vice President with Liberty International Underwriters.
2. Ground conditions and water: Soil and rock composition, the influence of ground and surface water, and foundation stability are key additional considerations in the construction of bridges, tunnels, and transit systems. If a suitable level of relevant ground (geotechnical) investigation and study has not been undertaken, or the results of such work not clearly interpreted, then it’s a red flag to underwriters, who would then question whether the project risk profile has been adequately evaluated and risks clearly and transparently allocated via suitable contract conditions.
“As we all know, ground is very rarely a homogenous element within Civil Construction projects,” LIU’s Hampshire said.
“It tends to vary from any proposed geotechnical baseline specification with the consequential potential for changes in behavior during construction. We need to understand who has assessed the condition of the ground, its behavior and design parameters when compared with a particular method of construction, and all importantly, who has been allocated the ground risk in a project and the upfront mechanisms for contractual ground risk sharing, if applicable,” he said.
Knowing how much water is associated with the in-situ ground conditions as well as the intensity, distribution and adequate accommodation (both in the temporary as well as in the permanent project configurations) of rainfall for a site location and topography are also key. Tunneling projects, for example, can be hampered by the presence of too much or unforeseen quantities of groundwater.
“In major tunneling infrastructure projects, the influence of in-situ groundwater pressures and /or water inflows is a major factor when considering the choice of excavation method and sequence as well as tunnel lining design requirements,” LIU’s Hampshire said.
According to a recent article in Risk & Insurance, tunneling under a body of water is one of the most challenging risk engineering feats. Adequate drainage layouts and their installation sequence for highway projects and, in particular, the protection of sub-grade works are also important. “But under all circumstances, we need to understand how the water conditions have been evaluated,” Hampshire said.
3. Technical Challenges: This risk factor encompasses the assessment of the technical novelty or prototypical nature of the project (or more often, specific elements of it) and how well the previously demonstrated experience of both the design and construction teams aligns with the project’s technical requirements and the form of contract determined for the project. The client can choose the team, but savvy underwriters will conduct their own assessment to see how well-suited the team is to technical demands of the project.
4. Evaluation of Time and Cost: With limited information generally provided, we need to be able to verify as best as possible the adequacy of both the time and cost elements of the project. Our belief is simply that projects that are insufficient in either one or both of these elements potentially pose an increased risk, as the construction consortium tries to compensate for these deficiencies during construction.
Small diameter Tunnel Boring Machine designed for mixed ground conditions and water pressures in excess of 2.5 bar.
In the 1990s and early years of this millennium, a series of high-profile tunnel failures across the globe resulted in major losses for Civil Construction underwriters and their insureds.
In the early 2000s, both the tunnel and insurance industries worked together to create new standards for high-risk tunneling projects.
A Code of Practice for the Risk Management of Tunnel Works (TCoP) is increasingly relied on by project managers and underwriters to define the best practices in tunnel construction projects. This process ideally starts at project inception (conceptual design stage or equivalent) and continues to the hand-over of the completed project.
LIU’s Hampshire said alongside TCoP, the project-specific Geotechnical Baseline Report and its interpretation and reference within the project contract conditions gives the underwriter greater clarity as to who recognizes and carries the ground risk and how it’s allocated.
“The bottom line is that there is always risk in a Civil Construction project,” Hampshire said. “Is the risk transparently allocated or is it buried? If the parties involved don’t understand what risk they carry, then the chances are there are going to be some problems, and the insurers would ideally like to understand the potential for these problems in advance,” Hampshire said.
Paul Hampshire can be reached at Paul.Hampshire@libertyiu.com.
To learn more about how Liberty International Underwriters can help you conduct a Civil Construction risk assessment before your next project, contact your broker.
This article was produced by the R&I Brand Studio, a unit of the advertising department of Risk & Insurance, in collaboration with Liberty International Underwriters. The editorial staff of Risk & Insurance had no role in its preparation.