‘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 Dreaming Team
Chris Thorn is known as one of the most creative risk managers in the business. After all, his risk management program hit the cover of Risk & Insurance® in March, 2012.
Now the senior manager, payments and risk, for Southwest Airlines is working with Riskonnect, a technology partner that he thinks can take his program to new heights.
“For us, it’s a platform that gives you so many different tools that if you can dream it, you can build it,” said Thorn.
Thorn ditched his legacy risk management information system in 2012 and started working with Riskonnect, initially using the platform solely for liability claims management.
But the system’s “do-it-yourself” accessibility almost immediately caught the eye of Thorn’s colleagues managing safety risk and workers’ compensation.
“They were seeking a software solution at the time and said, ‘Hey, we want to join the party,” Thorn recalls of his friends in safety and workers’ compensation.
“For us, it’s a platform that gives you so many different tools that if you can dream it, you can build it.”
–Chris Thorn, senior manager, payments and risk, Southwest Airlines
What was making Thorn’s colleagues so jealous was the system’s “smart question” process which allows any supervisor in the company to enter a claim, while at the same time freeing those supervisors from being claims adjusters.
The Riskonnect platform asks questions that direct the claim to the appropriate category without the supervisor having to take on the burden of performing that triage.
“They love it because all of the redundant questions are gone,” Thorn said.
The added beauty of the system, Thorn said, is that allows carriers and TPAs to work right alongside the Southwest team in claims files while maintaining rock-solid cyber security.
“This has sped up the process,” Thorn said.
“Any time you can speed up the process, the more success you’re going to have when you make offers to settle claims,” he said.
Since that initial splash in claims management, the Riskonnect platform has gone on to become a rock star at Southwest in a number of other areas. And as Thorn suggests, the possibilities of the system are limited only by the user’s imagination.
With a little creativity and help from Riskonnect as needed, a risk manager can add on system capabilities without having to go on bended knee to his own information technology department.
In the area of insurance policy management, for example, the Riskonnect platform as built by Thorn now holds data on all property values and exposures that can in turn be downloaded for use by underwriters.
Every time Southwest buys a new airplane, the enterprise platform sends out a notice to the airlines insurance broker, who in turn notifies the 16 or 17 carriers that are on the hull program.
Again, in that “anything’s possible” vein, the system has the capability of notifying the carriers, directly, a tool Thorn said he’s flirting with.
“It is capable of doing that,” he said.
“We’re testing out this functionality before we turn on it loose directly to the insurance companies.”
In alignment with the platform’s muscle in documenting, storing and reporting liability and property exposures, the system monitors and reports on insurance carrier financial strength.
If a rating agency downgrades a Southwest program carrier’s financial strength, for example, the system “pings” Thorn and his colleagues.
“Not only will we know about it, but we will also know all programs, present and past that they participated on, what the open reserves are for those policy years and policies,” Thorn said.
“That gives us even more comfort that we have good, solid financial backing of the insurance policies that are protecting us,” Thorn said.
Like many of us, Chris Thorn didn’t set out to work in risk management and insurance. Thorn is a Certified Public Accountant, and it’s that background that allows him to take creative advantage of the Riskonnect platform’s malleability in yet another way.
With the help of the Riskonnect customer service team, Thorn added a function to the platform that allows him to calculate the cost of insurance policies on a monthly basis, enter them into a general ledger and send them over to his colleagues in accounting.
“It’s very robust on handling financial information, date information, or anything with that much granularity,” Thorn said.
The sky is the limit
Thorn and Southwest are only two years into their relationship with Riskonnect and there are a number of places Thorn thinks the platform can take him that have yet to be explored, but certainly will be.
“It’s basically a repository of anything that’s risk-related, it continues to grow,” Thorn said.
“This has sped up the process. Any time you can speed up the process, the more success you’re going to have when you make offers to settle claims.”
–Chris Thorn, senior manager, payments and risk, Southwest Airlines
Not only have Southwest’s safety and workers’ compensation managers joined Thorn in his work with Riskonnect, business continuity has come knocking as well.
Thorn met in July with members of Southwest Airline’s business continuity team, which has a whole host of concerns, ranging from pandemics to cyber-attacks that it needs help in documenting the exposures and resiliency options for.
That Enterprise Risk Management approach will in the future also involve the system’s capability to provide risk alerts, telling Thorn and his team for example, that a hurricane or fast moving wildfire is threatening one of the company’s facilities.
Supply chain resiliency and managing certificates of insurance for foreign vendors are other areas where Thorn and his team plan to put the Riskonnect platform to good use.
“That’s all stuff that’s being worked on by us,” Thorn said.
“They’ve given us the tools, but we’re trying to develop how we’re going to use it,” he said.