Shadow Insurance Research Articles

Cap-and-trade mechanisms, green technology investment, and shadow insurance in a black swan environment

This study aims to evaluate an insurer's equity during a black swan event by developing a capped call option model. The capped call captures the lending-borrowing relationship by integrating the credit risk from the carbon emission reductions of the carbon-intensive borrowing firm with the insurer's shadow insurance in an imperfectly competitive life insurance market. We show that the borrowing firm invests significantly in green technology, increasing its equity value and the insurer's interest margin, but harms policyholders. Increasing shadow insurance enhances the insurer's interest margin and firm equity. Moreover, we find that stringent cap regulation of the cap-and-trade scheme decreases the insurer's interest margin when the black swan impact becomes significant. This strict cap regulation helps policyholder protection, but harms borrowing firm equity. We suggest that the government shrink the cap of the cap-and-trade scheme, contributing to insurance stability. Colossal black swan increases the insurer's interest margin, policyholder protection, and borrowing firm equity. In conclusion, we show that the capped call option model is relevant to green finance for an insurer-borrowing firm.

Shadow Insurance? Money Market Fund Investors and Bank Sponsorship

Abstract We argue that bank holding companies (BHCs) extend shadow insurance to the prime institutional money market funds (PI-MMFs) they sponsor and that PI-MMFs price this shadow insurance by charging investors significantly higher expense ratios and paying lower net yields. We provide evidence that after September 2008, expense ratios at BHC-sponsored PI-MMFs increased more than at non-BHC-sponsored PI-MMFs. Despite higher expense ratios, BHC-sponsored PI-MMFs did not experience larger redemptions than non-BHC-sponsored PI-MMFs. In addition, we show that expense ratios increased with BHCs’ financial strength and the likelihood of their support; however, this expense ratio differential disappeared after the 2016 MMF reform. (JEL G2, G21, G23, G28, H12, H81)

Shadow Insurance? Money Market Fund Investors and Bank Sponsorship

Investors in prime institutional money market funds paid higher expense ratios and received lower net yields as compensation for implicit bank guarantees and indirect access to the federal bank safety net.

Shadow Insurance? Money Market Fund Investors and Bank Sponsorship

We argue that bank holding companies (BHCs) extend shadow insurance to the prime institutional money market funds (PI-MMFs) they sponsor and that PI-MMFs price this shadow insurance by charging investors significantly higher expense ratios and paying lower net yields. We provide evidence that after September 2008, expense ratios at BHC-sponsored PI-MMFs increased more than at non-BHC-sponsored PI-MMFs. Despite higher expense ratios, BHC-sponsored PI-MMFs did not experience larger redemptions than non-BHC-sponsored PI-MMFs. In addition, we show that expenses ratios increased with BHCs’ financial strength and the likelihood of their support; however, this expense ratio differential disappeared after the 2016 MMF reform.

The contribution of shadow insurance to systemic risk

Shadow insurance is a regulatory loophole exploited by certain insurance groups to increase risk exposure, potentially destabilising the financial system. In this paper, we evaluate the contribution of shadow insurance to systemic risk of the global financial sector using a sample of 215 international insurance entities covering the 2004–2017 period. We detect shadow insurance by examining every reinsurance agreement on the Schedule S filings. Using both ΔCoVaR and SRISK measures, we find that the practice of shadow insurance is a significant driver of global systemic risk.

Multiple shadow insurance activities and life insurance policyholder protection

This paper develops a contingent claim model to evaluate the equity and liabilities of a life insurer who operates multiple shadow insurance activities specified as wealth management products and entrusted loans. We show that multiple shadow insurance operations by the insurer produce superior return performance and help policyholder protection. Increasing the guaranteed rate at an increased optimal margin contributes to insurance stability whereas increasing the participation rate at a decreased optimal margin adversely affects insurance stability.

Borrower capital, shadow insurance, and life insurer performance

ABSTRACT The paper develops a ‘capped’ call option model by calibrating Briys and de Varenne (1994) with integrating Dermine and Lajeri (2001) that the borrowing-firm credit risk is introduced to the lending function of the insurer. Results show that shadow banking entrusted loans enhance policyholder protection and help the insurer from the standpoint of survival at the cost of insurer profitability. We also suggest that shadow insurance and lending to high-quality borrowing firms captured by low leverage might increase policyholder protection and insurer survival, thereby contributing to insurance stability.

The Contribution of Shadow Insurance to Systemic Risk

Shadow insurance is a regulatory loophole exploited by certain insurance groups to increase risk exposure, potentially destabilizing the financial system. In this paper, we evaluate the contribution of shadow insurance to systemic risk of the global financial sector using a sample of 215 international insurance entities covering the 2004-2017 period. We detect shadow insurance by examining every reinsurance agreement on the Schedule S filings. Using both DCoVaR and SRISK measures, we find that the practice of shadow insurance is a significant driver of global systemic risk.

Shadow Insurance? Money Market Fund Investors and Bank Sponsorship

In this paper, we argue that bank-sponsored prime institutional money market funds (PI-MMFs) are different from non-bank-sponsored PI-MMFs. This difference can arise because the sponsoring bank holding companies (BHCs) can extend shadow insurance to ailing affiliated MMFs. We hypothesize that PI-MMFs price this shadow insurance through higher expense ratios. Indeed, after September 2008 when industry risk increased, expense ratios were seven basis points higher than those of non-BHC-sponsored MMFs. This increase is of similar size to the average deposit insurance premium charged by the FDIC in 2008. We also show, despite higher expense ratios, the redemptions in BHC sponsored MMFs were lower in contrast to expectations of prior literature.

Tax and Nontax Incentives in Income Shifting: Evidence from Shadow Insurers

ABSTRACTUsing the shadow insurance setting, we study the interplay between tax and nontax incentives in income shifting. Shadow insurance involves intercompany transactions designed to help firms meet regulatory capital requirements. However, prior to the Tax Cuts and Jobs Act of 2017 (TCJA), foreign-owned life insurance firms could save taxes by using shadow insurance to shift U.S. profits to tax havens. Consistent with expectations, we find that while nontax incentives appear to be the dominant factor behind firms' use of shadow insurance, tax considerations also played a role for certain firms. We also find that shadow insurance is associated with lower liquid asset holdings and increased credit risk. Overall, our results suggest that taxes were an important incentive for foreign-owned life insurance firms to use shadow insurance pre-TCJA. Moreover, in this setting, nontax considerations appeared to have motivated U.S.-owned firms' use of tax havens.

Issue Brief: Captive Reinsurance

Insurance companies, especially life insurance companies, often engage in “captive reinsurance” transactions involving captives that are located in states or foreign jurisdictions with more favorable capital regulation and tax laws, especially Bermuda and the Cayman Islands. These captives are entirely owned and operated by the parent company, but subject to the laws of the captive’s jurisdiction instead of those of the parent company’s jurisdiction. In a typical captive reinsurance transaction, a life insurance company effectively purchases an insurance policy from its own subsidiary. The insurance company (the “ceding” insurer) would have its captive (a legally separate corporate entity) “reinsure” an existing policy, or promise to cover payments owed to future policyholders on that policy. For some time, policymakers have raised concerns about the potential dangers of so-called “shadow insurance” arrangements that involve captive reinsurers. This memorandum provides information regarding the use and regulation of captive reinsurance companies.

Why Do Life Insurers Use Shadow Insurance?

This paper investigates why U.S. life insurers use shadow insurance, i.e., reinsure their risks using affiliated, unauthorized, and unrated off-balance sheet entities rather than traditional reinsurers. Using an instrumental variable approach and propensity score matching to address potential endogeneity, we find that the engagement in shadow insurance activities leads to greater market shares, reduced leverage, and improved risk-based capital ratios. Our findings suggest that life insurers do not use shadow insurance to increase risk-taking but rather exploit its cost advantages in order to grow, which benefits consumers through lower prices.

Taking Shadow Insurance out of the Shadows: Regulatory Arbitrage, Taxes, and Capital

Recent reports highlight life insurance firms’ widespread use of shadow insurance, a complicated series of accounting techniques, to free up liquid assets typically held as reserves to pay policy claims. Aggregate shadow insurance exceeded $348 billion by the end of 2013, and critics contend that shadow insurance is tax-motivated and allows firms to free up cash for shareholder payouts, investment, and compensation. They argue this practice induces tremendous financial risk and puts the larger economy at risk. Proponents counter that shadow insurance offers relief from exorbitant and unnecessary capital restrictions. We examine shadow insurance firms’ behavior from three angles: corporate tax behavior, payout policy, and executive cash compensation. We find that shadow insurance arrangements are concentrated in tax haven subsidiaries and are associated with significant tax savings: a one standard deviation increase in haven (domestic) shadow insurance usage is associated with an effective tax rate reduction of 3.72 (2.67) percentage points, which equates to $119 ($85) million in tax savings for the average public firm in our sample. We also find that shadow insurance use is associated with significantly greater cash payouts to shareholders and executives.

DANGER IN THE SHADOWS?

New research by Ralph Koijen of London Business School identifies shadow insurance as a key area of risk

Risks of Life Insurers: Recent Trends and Transmission Mechanisms

We summarize recent trends in risk exposure for U.S. life insurers from variable annuities, shadow insurance, securities lending, and derivatives. We discuss how these sources of risk could be amplified and transmitted to the rest of the financial sector and the real economy. More complete and transparent financial statements are necessary to accurately assess the overall risk mismatch in the insurance industry. We suggest ways to improve financial disclosure and draw some tentative conclusions for insurance regulation.

International Regulatory Developments and Improvement Issues for the Prudential Regulation of Financial Institutions - Focusing on the Shadow Banking System, Insurance Companies and Pension Funds -

International Regulatory Developments and Improvement Issues for the Prudential Regulation of Financial Institutions - Focusing on the Shadow Banking System, Insurance Companies and Pension Funds -

IS THE INSURANCE SECTOR AT RISK?

In the wake of the financial crisis, the insurance sector has been overlooked. Ralph SI Koijen and Motohiro Yogo shed new light on the rise of shadow insurance and increasing risk levels in American life insurance markets