By Saranya Kapur From Business Insider Australia

“These off-shore captive shadow reinsurers are based in less-regulated jurisdictions like South Carolina and the Cayman Islands”

U.S. insurers, particularly life insurers, have pushed up their credit ratings by offloading up to $US363 billion worth of their own liabilities to off-shore “captive shadow reinsurers,” according to an NBER paper by Ralph Koijen of the London Business School and Motohiro Yogo of the Minneapolis Fed.

These off-shore captive shadow reinsurers are based in less-regulated jurisdictions like South Carolina and the Cayman Islands.

Insurance companies are usually subject to regulations that require them to hold a certain amount of cash for every policy claim they sell. To circumvent this requirement, insurance companies are now setting up “captive” shell companies, usually registered in a low regulation state or country.

The insurance companies then reinsure the policy claims they hold through these shell companies, which means they no longer need to hold the cash reserve on the claim, and divert this excess cash to other uses.

The shell reinsurer, being based in a low-regulation area, usually does not have to hold much cash on its liabilities, and can take on much more risk than the insurance company. Here is a diagram of how it works:

While reinsurance usually transfers risk from the insurer to the reinsurer, this process of captive reinsurance effectively does almost nothing. When it becomes time for a policy claim to be paid out (when someone dies, for instance), the insurance company still has to pay out the claim, but has lower cash reserves to pay it out from.

The claim is then transferred to the shell company, which has even less reserves to pay it out from. The process thus reduces the likelihood of the claim ever being paid out.

What’s more, these risks aren’t reflected in the insurance company’s credit ratings.

The NBER paper estimates expected losses from shadow reinsurance to be up to $US15.7 billion, and that insurance companies indulging in it should be rated at least three notches lower than their current ratings.

The study finds that shadow insurance as a practice has boomed in the last decade due to a strange mix of stricter federal regulations and looser state-level regulations. In 2000, the federal-level National Association of Insurance Commissioners (NAIC) adopted a law known as Regulation XXX, which forced life insurers to hold a much higher level of cash reserves on their claims.

Two years later, South Carolina introduced a law that allowed insurance companies to set up shell reinsurance companies in order to free up reserve cash.

The combination of these two laws has led to a boom in shadow reinsurance, which grew from $US11 billion in 2002 to $US363 billion in 2012.

The NBER paper is based on a July 2013 report by a New York State Department of Financial Services titled “Shining a Light on Shadow Insurance: A Little-Known Loophole That Puts Insurance Policyholders and Taxpayers at Greater Risk”. That report finds that in New York alone, shadow insurance counts for $US48 billion.

For the NBER paper go to: http://www.dfs.ny.gov/reportpub/shadow_insurance_report_2013.pdf

For more on this story go to:

http://www.businessinsider.com.au/insurance-companies-creating-next-bubble-2013-11