Sep 22, 2026
On Tuesday, September 22, Daniel Schwarcz, Fredrikson & Byron Professor of Law and Distinguished University Teaching Professor at the University of Minnesota Law School, joined us to discuss his influential paper “The Risks of Shadow Insurance” and how the concerns he identified more than a decade ago apply to today’s insurance markets. The full transcript, which has been modified slightly for accuracy, can be found below.
TEDDY DOWNEY: Hello, everyone. And welcome. I’m Teddy Downey, Executive Editor here at The Capitol Forum. Today, I am very pleased to be joined by Daniel Schwartz, Fredrikson & Byron Professor of Law and Distinguished University Teaching Professor at the University of Minnesota Law School.
We’ll be discussing his influential paper, “The Risks of Shadow Insurance,” published all the way back in 2015, and we’re revisiting the risks he identified more than a decade ago in light of today’s insurance markets. Daniel, thank you so much for doing this today.
DANIEL SCHWARCZ: Yeah, I’m happy to be here.
TEDDY DOWNEY: So, you’ve done a lot of work in your career as a legal scholar on insurance regulation. I was wondering if you could talk a little bit about your background and how you initially became interested in this topic.
DANIEL SCHWARCZ: Yeah. Well, I started off my journey as a lawyer, as a coverage lawyer, working on insurance coverage matters. And then when I switched and started to become a legal academic, I sort of realized there was this big gap between the importance of insurance to how the legal system operates and the extent to which it’s actually sort of studied in the legal academy. And so, it seems to me like the area was sort of ripe for exploration.
And over time, while I started off and I still do a lot of work in sort of the more coverage litigation space, which is where many lawyers are I became quite interested in the regulatory issues. Because, really, again, there was just this massive gap in terms of what was addressed in the legal academy even though there are just a ton of legal issues in terms of how insurance regulation operates, and there are tons of lawyers who work in that space it was not something that really anyone was working on in the legal academy.
So, it seemed to me like there were just a lot of interesting issues. And so, from there, I started to learn about it. I actually started working with the NAIC, at the NAIC, as a Consumer Representative. And that was really helpful for me in sort of understanding some of the minutiae of how regulation operated. And so, I’ve been working in the space now for, I don’t know, close to two decades.
TEDDY DOWNEY: And how do you think insurance regulation compares to banking and financial regulation more generally?
DANIEL SCHWARCZ: Well, obviously, there are some similarities and there are some differences. I mean, banking regulation in general is much more focused on systemic stability, much more focused, interconnected with, monetary policy. And obviously, the role of the federal government is much larger when it comes to banking regulation.
So, all of those trends are really evident in banking regulation. Whereas, with insurance historically, and still to this day the focus really is more on policyholder protection. 2008 changed that a little bit, but really not much in terms of thinking about more systemic types of concerns. And then obviously, states are still the principal actors in regulating the ecosystem. And so, that also changes how it operates.
So, I think from a big picture perspective, those are really the two big things that are different, right? The primacy of the states versus the federal government and the focus on policyholder protection rather than on more systemic, macroprudential, types of concerns that you find in banking.
TEDDY DOWNEY: I want to get into the weeds on life insurance and annuity regulation. But I have sort of a bigger picture question of how broken do you think insurance regulation is across the board? Because when I go and buy insurance and then I read the Wall Street Journal it feels a lot less like insurance these days and more like fraud. Because they’re making money by denying claims. They’re not making payouts.
You look at the percentage of how few payouts auto insurance is making, how the denials have just gone through the roof, property casualty. You talk to anyone that had their house burn down in the California wildfires. Most of those, they’re still dealing with it. They couldn’t get the claims paid. Just feels like fraud. And is that because the — am I wrong to think that? Am I a crazy person? Or has there been a sort of a real breakdown in regulation in insurance markets?
DANIEL SCHWARCZ: Yeah, I would definitely not go that far. So, I think a lot of it really is context-specific. I think there are a lot of problems in insurance markets. I think there are a lot of ways in which insurance regulation fails. I think there are also plenty of contexts in which insurance works, and insurance markets can operate pretty smoothly.
So, it’s just a massive scope. It’s a huge part of our economy when you’re talking about health insurance versus auto, versus life, versus property. I just think that there’s one needs not to I resist painting with such a broad brushstroke. Because a lot of times insurance markets actually do protect people. And a lot of times insurance markets can operate to make things safer.
And so, I think you’re absolutely right that there are real problems. And those problems exist in all markets. And there are real ways of improving the system. And there are real ways, I think, in which the regulatory system is not appropriately designed to optimize there. But at the same time, I do think that there’s a tendency to villainize insurers. It’s not always justified. Because they can and do provide an important service. They can and do protect people. And when they do, we tend to sort of just assume it’s fine.
It’s like when you’ve go on an airplane, right? And it flies you across the country, and everything’s fine. You’re like, oh, well, fine. We sort of ignore it when it’s fine. And then whenever there’s a problem, we’re all up in arms.
TEDDY DOWNEY: I do think for insurance markets, though, when you open the Wall Street Journal, and 50 percent of claims are getting paid, and the fine print is changing, there’s a couple of problems with that. One is you expect 90 percent. You expect it to work the vast majority of the times. Because that’s why you got it, right? And that’s how a functioning market will work. The vast majority of the time you’ve paid for something, you expect it to deliver when the thing goes wrong. And that percentage has gone from like 70/80 percent, all the way down to 50/40 percent sometimes.
DANIEL SCHWARCZ: Well, it depends on the product line. So, those numbers of claims payment rates, it’s very specific. And the other thing I would say is, actually, insurance is not supposed to pay every single time someone has a loss, right? It is a specific type of product that pays for specific losses for good reason.
Now, again, I don’t want to suggest that I’m not sympathetic to some of the points you’re making. I agree that sometimes insurers are too quick to deny claims. I agree that in certain product lines, the contract language is not well regulated. It’s not clear enough. It’s not standardized enough. I think these are huge problems.
But I also think that if one sort of suggests, well, the entire thing is fraud and everything is completely broken, that ends up not being the best way to approach the issues.
TEDDY DOWNEY: Well, maybe a better way to ask is like how big a problem they have. Because to me, as a consumer, I go out and try to purchase these products and I’m a sophisticated customer I find it impossible and endlessly frustrating. And so, to me, it feels like a 10 out of 10. It feels like fraud. It feels like I’m engaging with a con every single time I’m trying to read the contract, understand what I’m getting, every single interaction with the insurer.
Now, I’ve had a great experience recently with home insurance. I’ve had terrible experience with an auto insurance. So, I’ve had the gamut. And when it works, yeah, it’s great. But I had to pay a huge premium to get the good insurer. And then, like I said, I open the Wall Street Journal and that’s one of the only ones that actually pays consistently in terms of claims for the type of damage that I had. And so, I think there’s a real human cost to the poor regulation, the poor rules for competition. And I’m curious if you agree.
Obviously, it’s not all fraud. But it feels like fraud when you are trying to engage it as a customer. And so, how do you think about it in terms of the scale of the problem? Is it a 10 out of 10, 9 out of 10, 8 out of 10, in terms of are insurance markets working really the way they should for customers? I understand for some companies, yeah, it works fine. Yeah, for the company perspective, sure, it’s okay. I can make money. I can not pay these. I can pay these. But for the customer, it seems like pretty broken.
DANIEL SCHWARCZ: I would, again, say it depends on the product line and on the context. What I would say is let me try to be a little bit more specific. I do think that there’s certain things that are very broken about insurance markets and personalized insurance markets in particular.
One is that there is not a standard default baseline policy that everyone has to meet in many insurance markets. So, homeowners insurance policies, they have different language in ways that is very opaque and really impossible for people to see. And regulators have not sufficiently addressed that by standardizing policy language.
We used to have a standard policy, a fire insurance policy. We don’t have a standard homeowners policy that is mandated. We have a de facto standard policy that’s sort of the industry standard, and then insurers change it in all sorts of ways that are complicated and opaque.
We don’t have good data that is routinely provided by insurance regulators regarding how frequently different insurers pay claims and when they deny claims and what types of claims they deny. We don’t have good communication by insurers about what types of claims they will not pay at the outset and how you can adjust to that. Many people don’t even know that flood risks are not covered. And they don’t understand that. And that’s not communicated clearly. We have all these disclosure rules that are not effective.
So, there are a large number of difficulties that I think are linked to some of the complaints you’re rightly sort of alluding to, that I think are things that insurance regulators should fix. I’ve been arguing insurance regulators can fix for decades, and they’ve made very little, if any, progress on these issues. And they’re really easy.
Some of them are not terribly hard issues, right? There should be a completely uniform standard policy below which insurers cannot dip. We don’t have that. We should have routine reporting by insurers on how often claims are denied, how long it takes for them to process claims, how often they’re successfully sued for bad faith, how often they initially deny a claim and then reverse it when there’s a complaint. We should have all this information at our fingertips. We don’t. We should have transparency about what the key risks are that are not included in the standard policy, and better messaging about that. We don’t.
So, I think these are some of the problems we have, and I absolutely think they contribute to some of the frustration that you’re expressing, and that many people express, about the fact they have no idea what they’re buying. They feel like a lot of times when they buy something, it doesn’t actually come through for them in ways that they didn’t fully anticipate. And so, there are a massive number of problems there, and I think focusing in on those problems is really the key thing we want to do if we want to improve insurance markets.
TEDDY DOWNEY: And we are here to talk about life insurance and annuity policies really fundamentally. And so, with that, you’ve looked a lot into a lot of your work is around shadow insurance. Maybe a good way to start is can you define that for us so that we can kind of dig in from there?
DANIEL SCHWARCZ: Yeah. So, historically, the idea of shadow insurance and this is a term that actually got borrowed from shadow banking in the 2008 crisis. And the real idea was that insurers were using shell games to take risk that they had insured, and to engage in complicated transactions that effectively, at the end of the day, limited how much caution they had to take in terms of preparing to pay claims.
And so, a huge part of state insurance regulation is all about making sure that insurers have the financial capacity to pay claims. And there are a very lengthy set of elaborate rules about how insurers have to account for and hold capital for risks they insure.
And so, with shadow insurance, what insurers were doing was they were reinsuring – so, basically transferring risk they had insured to affiliated companies, that were subject to less rigorous, very non-rigorous, rules about solvency. And then they were then sort of taking full credit for that and saying, oh, well, we don’t have the real risk here. The risk has been transferred. So, we don’t have to account for it on our balance sheet.
And by moving it off to an affiliate’s balance sheet that was much less heavily regulated, they were really avoiding the sort of safeguards that state insurance regulation historically imposed on insurers to ensure that they would be able to pay claims when they became due.
TEDDY DOWNEY: And so, you’ve been studying this. You saw this happening ten years ago. What was some of the history behind how it started? And then maybe we can talk about how it’s evolved to today.
DANIEL SCHWARCZ: I think this is really important to understand. So, the basic idea behind this practice as it started was insurers were insuring these had a bunch of different types of insurance policies where sort of there was agreement from a lot of different folks that the rules regarding how they needed to account for them were like overly strict and were really making it too expensive to insure these policies and were sort of broken. And this had to do with certain life insurance policies, arguably certain annuity policies, but there was sort of like wide consensus that there were these formulas out there that were sort of not well calibrated to the risk.
TEDDY DOWNEY: And these were requiring you to hold too much capital against the risk that you were taking. Well, we could hold a little bit less and it would be okay.
DANIEL SCHWARCZ: Exactly. That’s right. So, they were operating through reserve requirements, which are basically sort of, on your balance sheet, how much you have to anticipate you might have to pay when you issue a policy.
TEDDY DOWNEY: And so, just to keep it here for one second, was the consensus among the industry people? Ot were the consumer groups also like, yeah, have less capital. It’s okay with us.
DANIEL SCHWARCZ: I would say it wasn’t just among the industry. I think regulators too recognized that some of these formulas were broken and that they were really sort of excessively conservative in ways that were problematic. I mean, if an insurer issues let’s say a million dollar policy you don’t want to say you have to have $5 million in the bank account, right? Because then they’re not going to issue the $5 million policy and it’s going to be too expensive.
So, it’s in everyone’s interest to have the rules well calibrated. And I think that there was a recognition, not just in the industry, but among a broader group that there were some problems with the way the technical details of these rules worked. And it was hard to fix the underlying problem at first.
So, what ended up happening is companies started saying, well, here’s what we can do. We can take these insurance policies that we’ve issued and we can transfer them to an affiliate that is technically a captive insurer. And a captive insurer is an insurer that only sort of insures one company. And once we’ve transferred the risk over to this affiliate, that affiliate can sort of engage in whatever accounting rules it wants because it’s subject to a much more restrictive set of regulatory rules. And meanwhile, over here because those risks are off our books we don’t have to deal with it.
And so, it was sort of this regulatory arbitrage that in a sense, everyone said, well, it’s permissible. It makes sense because it’s basically a way of dealing with this more fundamental problem of problematic reserve rules and problematic capital rules. And so, it was sort of like this big the big idea was, well, instead of fixing the underlying problem, let’s allow the entire industry to engage in this funny workaround where they basically move this capital to a less regulated entity and they take credit and will sort of because we recognize that there are reasons to do this, we’ll allow it. So, that’s the early history.
TEDDY DOWNEY: And that sounds kind of illegal. I mean, you’re just basically not going to follow the rules and change the rules through the channel that you’re supposed to, which is like go to your regulator, lobby them and get the rules changed. And instead, you just take it up your own accord. Well, I really don’t need all this capital. I’m just going to do it my own way.
DANIEL SCHWARCZ: Yeah, it wasn’t illegal because all of the underlying transactions were authorized. So, the regulators knew about them. And it was arbitrage, right? In the sense that you were engaging in transactions that reduced the amount of capital you had to hold. But it was arbitrage that regulators approved through permitted mechanisms and they had a reason to approve it.
So, it’s clearly not optimal. It was clearly suboptimal, right? You would say like, let’s just fix the underlying rules. Let’s fix the underlying rules so we don’t have to engage in these shenanigans.
TEDDY DOWNEY: Well, also this idea of permission of something that’s against the rules, it comes up a lot in our reporting and this industry. It’s just hard to get your head around.
DANIEL SCHWARCZ: But again, it’s not against the rules, right? It was consistent with the rules. It was just a way of shuffling the risk in a way that regulators had some transparency in and they approved that in a sense avoided the problem.
So, it was a band-aid, okay, originally, a band-aid to an underlying problem that regulators and states had with their systems that were hard for them to fix. And part of why it was hard for them to fix was that it’s very hard for states to coordinate because there are 50 of them about what the underlying rules were. And there was disagreement about what the rules should be.
So, everyone sort of agreed that the underlying rules that applied were excessively strict, but there was disagreement among the states about what should be done. Now, I think it’s important to sort of – so, not optimal at all, but to some extent understandable, certainly legal, if not problematic. And to what extent, from a policy perspective, from a social perspective, we should be troubled about it, say 15 years ago is unclear. But then sort of that’s where things start going, I think, sideways. I’m happy to sort of fast forward in the story a bit.
TEDDY DOWNEY: Yeah, yeah, yeah. Let’s see, how did things go? Because, okay, fine. At the beginning, all right. We get it. We’ll let you do a little of this. But it certainly becomes a big problem later on. How did that happen?
DANIEL SCHWARCZ: So, part of what happens is insurers start realizing that they can engage in these maneuvers, not just with respect to policies that, everyone agreed, sort of the rules were excessively strict, but to other types of policies where there was maybe more dispute. So, it moved from sort of certain life insurance policies to certain annuity products. They realized that they could reduce risk, not only in terms of the reserves which are sort of one of the ways that you calculate capital in a simplified manner, sort of assets minus liabilities and reserves are your major liability, but also through other mechanisms as well.
In particular, they realized that they could, by transferring liabilities, also affect sort of the amount of capital they needed rather than how the capital was calculated. And then they started realizing, well, we can actually choose who is going to be the regulator of these captives and choose not only less strict regulators, but really much less strict regulators. We can have all the different states competing with one another. And hey, not just the states, we can have international jurisdictions competing with one another.
And we can game some of the rules with respect to assurances what happens if these affiliated reinsurers can’t pay. And so, there started to be a lot more focus on using this mechanism, not as a way of fixing what was everyone agreed to be a problem, but as just more generally limiting the extent to which they had to have the capital to ensure that if things went south, claims would be paid.
In other words, they wanted to increase their risk. and increase their risk in a way that produced higher profits for them when things went badly. And then if things went really south, would ultimately be borne by policyholders and by taxpayers.
So, you see that trend accelerating in 2015, 16, 17, when it starts really sort of having a spotlight shown on it, when it starts seeming excessive, when people start raising questions about what is going on with these captive reinsurers and the states that are regulating that we got some indications that were real problems.
And so, what happens in the story around then and this is when I sort of published on this topic in 2015, 2016. And what happens is at least some of the underlying problems with the rules are fixed. So, it took five, six, seven years, but there were some fixes to the underlying rules regarding reserves for certain transactions that were excessive. And there were some fixes to arguably some of the problems associated with annuities. And so, it seems like, oh, okay, well, hopefully this problem will go away because we fixed the underlying problem.
TEDDY DOWNEY: When you say fixed the underlying problem, you made it a little bit easier so that they could hold less capital, so they wouldn’t need to do a shadow reinsurance.
DANIEL SCHWARCZ: Exactly. We fixed the underlying problem that caused insurers to have to hold excessive capital for certain types of life insurance products. We fixed that. Really, there were two fixes. There was in calculating reserves, which are sort of the amount you sort of have to hold for any policy. We went from this very rigid formula to what’s called principles-based reserving.
Now, there are problems with principles-based reserving. But basically, it gives in my view at least but basically, it gives insurers a lot more flexibility to account for how much of a liability they’re going to put on their balance sheet based on each insurance policy they sell. And so, that flexibility addressed some of the core underlying problems. And then there was also an effort to fix some of the risk-based capital calculations, which some people said excessively penalized market risk associated with variable annuities.
And so, there were technical fixes on that front. And so, the bottom line is that in 2016, 2017, there was a sense, arguably, that this problem was being tamed because we had fixed the underlying problem. And frankly, that’s what all of us me included, but not just me had been sort of saying this is ridiculous. Why are we engaging in these shenanigans to fix a problem that is, at its base, a problem with the insurance regulation in terms of how these if we all agree it’s a problem, fix the underlying problem. Don’t allow insurers to engage in this sort of arbitrage. And part of the reason for that is that the arbitrage itself creates risks.
So, one of the biggest risks associated with it is if you’re taking a risk from your balance sheet and moving it off to an affiliate, basically it becomes super opaque. It’s like hard to actually see what’s going on. We have a lot of transparency into the finances of insurance companies and regulators have a lot of transparency into that.
We have very little transparency into the balance sheets of affiliated companies, particularly captives. And so, we didn’t really know what was going on there. And while there were some mechanisms in place to try to limit that risk, they really were not adequate for a variety of technical reasons that I could get into, but I’ll wait for now.
And what that meant is if things went south and your captive ended up not being as financially stable as you thought, that could end up undermining the actual insurer because they still had to pay. And so, we were creating fragility and opacity and potential risks in our system when the real problem could have just sort of been solved in a more direct way. And we thought we had solved it. At least, I thought it had been solved to some extent 2017, 2018 with these sort of fixes to the underlying system. But I think in some ways the sort of story gets even worse from that point if we want to move forward in time.
TEDDY DOWNEY: Yeah. No, let’s zoom ahead. I have some specific questions about how the regulators sort of allow for this, but how does the problem get even worse after that?
DANIEL SCHWARCZ: Yeah. Well, it’s during that time, sort of the private equity starts really making an aggressive push into insurance markets. It had been happening before, but I would say it was sort of the trend was accelerating. And for private equity, there’s just a tremendous incentive to want to take as much risk as possible in insurance markets.
And the real reason for that is the familiar story that when you take risk, there are potentially greater returns, but potentially greater losses. And the greater returns, they all go to you, if you own the insurance company. That’s great. You make a lot of money. If there are big downsides, if things really go south, there’s only so much you’re going to lose. You’re only going to lose the amount you put in.
And normally, policyholders would keep insurers honest. They would say, well, look, if you’re really taking on this risk, I don’t want to buy insurance from you. But one, a lot of policyholders have no idea. And two, there’s actually insurance against this for policyholders through state guarantee funds.
And so, there’s a great article that really spells this out recently that’s gotten a lot of press, though. Andrew Granato is a co-author on it. I forget the other co-author. But this is not a point that’s new though. I think they do an excellent job of spelling it out. That basically what happens is that if, look, as a consumer, I know I’m going to get paid one way or another for the most part if I buy an insurance policy. I’m just going to buy the cheapest one. And I’m not going to worry if my insurer is private equity backed and goes under because all the other insurers will have to come in and pay under the state guarantee fund.
And now that’s not free. That ends up getting paid for by future taxpayers and by other insurers. But it just means that there’s no one really policing this risk that an insurer is taking too much risk, except for the regulators. Consumers, for the most part, don’t care enough because they have protection. The folks who own the insurance companies, they want the risk because their downside is capped. And regulators, they’re the only ones left standing, in a sense, that have an incentive to make sure that the insurance company can pay when the bill comes due.
So, private equity starts entering this sphere and basically taking advantage of this and saying, well, let’s maximize the amount of risk we can take here. Because if we maximize the risk, we’ll maximize our return. And by the way, there’s a lot of money here waiting to be invested so we can take a lot more risk.
And so, they start using these cousins of the transactions that I’ve been mentioning to try to maximize the risk. And what ends up happening is really since 2016, 2017 the transactions that I’ve described migrate from captive reinsurance transactions to offshore reinsurance transactions.
And so, instead of sort of taking insurance policies and moving them to a captive that’s regulated by a state like Vermont or South Carolina, increasingly what they now do is they just set up an affiliated reinsurer of some type, okay, that’s like licensed in Bermuda or the Cayman Islands or something like that. And they move the risk to those affiliates.
And in part because of actually changes in insurance regulation that happened four or five or six years ago, basically certainly with Bermuda at least because it’s a recognized jurisdiction state regulators have to credit that. And Cayman Islands, less so because it sort of depends on the jurisdiction.
So, what ends up happening it’s the bottom line here is that a tremendous amount of the actual insurance regulation that’s happening, that is meant to protect policyholders, is actually happening in Bermuda or in the Cayman Islands and is basically invisible, or largely invisible, to state insurance regulators because it’s not on the balance sheets of the entities they’re regulating.
And so, we have now a system where there’s a lot of risk that many people don’t fully understand. It’s hidden because it’s all reinsured offshore in entities that are opaque. And we’re relying on these foreign jurisdictions to really protect policyholders and U.S. taxpayers. And the only reason we’re doing it and a lot of the reason why we’re doing this is because we had this system sort of set up 15 years ago to deal with a problem that doesn’t exist anymore.
There’s a really very simple solution, you would say, which is don’t allow insurers in the U.S. to engage in this moving risks off to foreign company balance sheets, to affiliated balance sheets. If they’re going to reinsure with non-affiliates, fine. But if they’re going to insure with affiliates, that’s problematic and we shouldn’t allow them to do that unless we’re really, really confident that there’s a good reason.
TEDDY DOWNEY: You’ve talked about, in your work, regulatory approval processes for affiliated reinsurance deals. I’m curious about this aspect of there not being any actual approval sometimes for these deals. Where state law only requires the insurer to file with the regulator, and if the regulator doesn’t object, it goes through. Can you talk a little bit about that? You just mentioned, hey, we should just not allow this stuff. And then maybe we can go from there.
DANIEL SCHWARCZ: Yeah. So, any material transaction an insurer wants to enter into with an affiliate needs to be approved by the state regulator. Well, needs to be not disapproved. It depends on the state. So, if an insurer wants to engage in the transactions that I’ve described, it has to get approval from its regulator. But there are a lot of problems with this.
So, one problem is that, as I said, sometimes it’s affirmative approval. Sometimes it’s not disapproval. Those are different things. Many state regulators are pretty overwhelmed with work and they don’t have the manpower to really dig into these transactions.
Oftentimes, these transactions were actually approved years ago and they’re just continuing forward. And so, the approval already exists pursuant to sort of a long-term. And so, it’s not like it’s constantly coming up again and again and regulators don’t have great transparency into what’s happening.
And so, while there are formal safeguards in place, a tremendous amount of those formal safeguards just depend on us trusting that state regulators really aren’t going to allow these transactions to happen when they pose excessive risk. And it’s just structurally, there are good reasons to think that that’s not happening because they don’t have the resources and the expertise to look at these transactions in detail.
And again, there’s really not a good reason for them to happen anymore. That’s the key thing I want to sort of emphasize. This whole thing started because there was a problem in the system and we sort of authorized this weird workaround to deal with it. We then solved the problem.
But now we have all of these companies engaging in these same transactions. And now they’re basically trying to exploit some of the incentives created by our system. They’re doing so in a way that creates immense complexity, that creates immense opacity, and there’s no good reason to do it.
We should not allow it would be a simple fix. Let’s not allow U.S. insurers to reinsure with affiliates unless we have some very specific reasons for wanting to allow it. They can purchase reinsurance through non-affiliates all they want. They shouldn’t be allowed to do it through affiliates unless, you know. And that would solve a lot of our problems, I think.
TEDDY DOWNEY: What do the regulators say is their reason when they don’t have one? And remember, at the beginning of this conversation, you said, well, it’s legal because they have a reason. Is it still legal even if they approve it with no reason?
DANIEL SCHWARCZ: It’s legal if the state approves it. That’s the bottom line. If your state regulator, your domestic regulator, approves it, it’s legal.
Now, whether it’s a good idea is a different question. There are, in theory, some reasons why you might want to allow an insurer to reinsure with its own affiliate. There are theoretical reasons. They’re not terribly convincing for the most part, and they’re certainly not what’s going on here.
In theory, it might allow you to consolidate certain types of investment. It might allow certain efficiencies in terms of structure. It might allow capital to move around your family of affiliates more efficiently. There are limited theoretical reasons.
But at the end of the day, the main reason why reinsurance is valuable is because it allows an insurance company to move risk to another unaffiliated company so that you can spread risk out. When you’re reinsuring with an affiliate, you’re really not spreading risk in the same type of way.
TEDDY DOWNEY: You’re doing regulatory arbitrage, almost certainly.
DANIEL SCHWARCZ: Often. Now, again, it depends on how much – you know, the relationship among affiliated companies is complicated. Because there are meant to be certain safeguards against the risk that you’re exposed to these affiliate transactions. But bottom line, yeah, I think it’s really problematic. And I think that, for the most part, what’s happening is regulatory arbitrage where we’re just trying to ratchet up the risk and increase the potential rewards. And there’s not a good sort of social justification for these practices. And so, I think we’ve gotten ourselves very deep into a hole that we didn’t have to get into at all.
TEDDY DOWNEY: If you have listener questions, please put it in the chat or the Q&A function. I want to talk a little bit about what these reinsurers say are backing their policyholder promises. You get these guarantees. You get the collateral that’s kind of seems to be referring they’re always referring it back to each themselves. Obviously, they’re affiliate transactions. So, it’s hard to keep track of. What are some of these strategies to make it seem like or like excuses or the strategies that the reinsurers use to make it seem like they have the assets to back up the obligations?
DANIEL SCHWARCZ: So, back in the day, when I was working on this, when you were insuring with an unauthorized reinsurer and a captive might would be an unauthorized reinsurer for the most part basically, you had to have collateral that said, look, if the unauthorized reinsurer can’t pay, we can look to the collateral. And there were a lot of shenanigans that went on in terms of how that collateral was structured. But for the most part, that provided policyholder protection if it worked.
These days, you oftentimes don’t even have collateral anymore. Because let’s just take Bermuda. Bermuda is a jurisdiction that is treated as having “equivalent” insurance regulation to the equivalent the U.S. “Equivalent” in air quotes. And what that means is that if you reinsure, if I’m insurer A and I move my assets to my Bermuda affiliate that is regulated by Bermuda, I don’t even have to have collateral because that’s viewed as an authorized reinsurance transaction. And so, basically, state insurance regulation treats that as legitimate. Like, okay, there’s no risk here because the reinsurer is regulated just like the insurer.
The problem is, we don’t actually know that. We don’t really know what’s going on in Bermuda at the same level, we know what’s going on here. They do have different rules. The reason why this transaction is happening is because Bermuda allows different things than the U.S. does. And the underlying risk is U.S. risk. It’s risk to U.S. taxpayers, to U.S. policyholders. And we’re basically allowing insurers to move that risk to Bermuda. And I don’t think that makes a lot of sense. I think that if it’s risk to U.S. taxpayers and to U.S. policyholders, it should be transparent to U.S. regulators. And it should be risk that we regulate according to our structures.
Because I’m not suggesting that Bermuda has a completely ineffective or dysfunctional system. I’m just suggesting it’s different. And I’m suggesting that what happens is that insurers engaging in these transactions are basically shopping for jurisdictions that are going to be more permissive in terms of how they calculate reserves, how they calculate assets, how they calculate capital. And so, I don’t think it’s an appropriate way for us to be regulating insurers to basically be outsourcing it to Bermuda.
TEDDY DOWNEY: And some of the strategies we’ve seen are these phantom assets like credit link notes and XOL agreements, sort of like promises that these obligations will get paid. Are those kind of the newer versions of what you wrote about in your paper, letters of credit, contingent notes, naked parental guarantees? Are we just sort of seeing the same thing with slightly different names as part of that game that you’re talking about? Well, it’s offshore, we can’t see it. And so, we just have all these promises that we can’t look at.
DANIEL SCHWARCZ: Part of the problem is that we don’t even there’s not as much transparency about exactly what the assets are that these offshore reinsurers are holding. So, we don’t know exactly what the assets are in the same way we do when we’re dealing with U.S. regulated insurers. We don’t know exactly how the reserves are calculated. We don’t know exactly how the required capital levels are calculated. Because it’s all happening under a different regulatory regime that’s less transparent. And so, the bottom line is, I don’t know. Like I don’t have that information.
Certainly, there are a lot of ways to engage in creative accounting to make an entity look financially stronger than it ought to be. It should be said, a lot of state insurance regulation is sort of biased towards conservatism because we want to make sure that insurers can pay. And so, we have rules that are pretty strict about how you calculate reserves, about what type of assets you can rely on.
For instance, under statutory accounting rules that apply to U.S. insurance companies, you can’t count assets that couldn’t plausibly be used to pay claims, certain intangible assets. You can’t count contingent assets. It’d have to be things you can use to pay claims because that’s ultimately what we care about.
Those same rules are not in place in foreign jurisdictions. And again, the problem really is that in some sense, if we just say you insurer can basically move all these liabilities off to any affiliated reinsurer that is regulated by a foreign jurisdiction, they’re just going to keep moving to the regulator that is most permissive. And then that creates dynamics for the regulator, where the regulator basically doesn’t have as much leverage.
And so, if the regulator is like, well, gee, I don’t know that I want you to count this particular asset in how you sort of calculate your capital. And there’s any sort of play in terms of how the rules are interpreted, the insurers leverage will say, well, fine. We’ll just move elsewhere. We’ll just move to the Cayman Islands.
So, it really changes the regulatory dynamic in troubling ways. And so, that’s a long answer to your question. The more direct answer is, I don’t know. I don’t know what the assets are that they have. And that’s part of the problem.
TEDDY DOWNEY: We’ve got four listener questions. We’ve got 10 minutes. Let’s try to zoom through these here.
First question seems a little technical. Newer regulations require disclosures around actuarial assumptions, Regulation 787 and Actuarial Guidance 55. But why cannot investors see them? Who sees these disclosures?
DANIEL SCHWARCZ: This is part of the mess of we’ve created arbitrage and we’re creating rules on top of the arbitrage. So, I mean, state regulators understand this is a problem. In fact, like, to some extent sounding the alarm. Just recently, like, oh, my gosh, there’s a lot more risk here than we realized we don’t have.
So, they’re starting to sort of try to, again, build complexity upon complexity upon complexity of, well, let’s now have. Instead of just banning this practice, which has only started in the first place because of this problem, let’s have insurers engaging new calculations where they calculate how much risk they would have if they recaptured some if they weren’t using reinsurance.
But it gets very technical and complicated about how they have to engage in those calculations. And the calculations we’ve seen are very troubling. And so, it is true that regulators are not blind to these issues and they are trying to address them, but they’re trying to address them by building complexity upon complexity upon complexity.
And what that means is you’re right. Like, policyholders don’t see this stuff. Investors don’t see this stuff. All of this stuff is only seen by regulators. And by the way, regulators don’t fully understand what they’re seeing. Insurance companies don’t even understand fully how to comply. But when you build complexity upon complexity upon complexity, what you end up doing is creating more opportunity to game the system.
As opposed to saying, like, what’s the point of these transactions in the first place? Is there any good reason for them? Let’s just get rid of them. Let’s just change the underlying incentives to not allow companies to engage in affiliated reinsurance unless they’re doing it under these certain specific conditions. We can try to sort of put very specific quantitative thresholds on it and very specific permissions on it and not just allow it by default.
TEDDY DOWNEY: I mean, it makes a lot of sense to me. Complexity usually doesn’t end well in these types of situations.
We have another question here. Several captive-friendly states have enacted strict confidentiality laws that prohibit any view into the captives’ books. So, the problem is not that U.S. regulators have allowed offshore Bermuda to protect U.S. policyholders and taxpayers, correct? Isn’t there an issue with certain very captive-friendly states protecting insurers to the detriment of U.S. policyholders and taxpayers?
DANIEL SCHWARCZ: Yeah, I think, look, there are still problems with states that have rules that are very friendly to captives. The issue is my understanding and a lot of this is super contingent upon certain changing is that a lot of these transactions have moved offshore because those are then authorized transactions and you don’t even need capital. It’s still the case that if you’re using a captive reinsurance under a state, you’re going to need actually certain assurances.
And so, the nature of the regulatory arbitrage has changed over time, I think. So, that’s not to say that captive laws and states are perfect. They’re not. But it is to say that I think that the arbitrage now is sort of relying on a different type of strategy now, that in some ways is even more diabolical because you don’t actually have to have the collateral or the other assurances that if the captive can’t pay that you’re okay.
TEDDY DOWNEY: I want to end with a question about financial stability. Like, do you think that this problem is big enough that we have some broader systemic risk issues? It’s a pretty big market. There’s a lot of opaque accounting. You’ve had private equity in doing this strategy for ten plus years now. You’re starting to see cracks in the system Walter. But that’s really just an industry standard practice in many ways in terms of getting your affiliates maybe not necessarily lying about your affiliates, but just getting the regulators to okay it.
How big of a problem do you think this is? Is it a systemic risk issue? And is the system that you talked about in terms of state regulators, if even one big insurer is insolvent, do you feel confident that the system can resolve a big failure?
DANIEL SCHWARCZ: It is very hard to predict systemic risk. And so, especially without sort of really diving in a sort of detailed fashion, I wouldn’t be comfortable saying like this is sort of the next crisis, right? I don’t necessarily think that.
What I do think is that there are reasons to think that this is big enough of a problem, and large enough of a problem, that it could contribute. So, some numbers I’ve seen suggest that the amount of this practice and focusing in particular on re-insurance to affiliates is now over a trillion dollars, the amount of risk that’s been transferred over. So, it’s continued to grow even since 2015, 2016.
There are other problems here. In particular, like there are a lot of concerns about private credit and which a lot of insurers are holding private credit as assets. And there’s a lot of opacity there on how they should be valued. And so, do I think this could be part of a larger story if we had a financial panic that either involved the insurance industry? I think it’s possible. I cannot project.
More generally though, do I think that this could lead to insolvencies? Do I think that there are insurers out there that are less financially stable than we think they are? Do I think that, at the end of the day, there could be, and will be, insolvencies that end up being borne by taxpayers generally and by other insurers? That I’m more confident in.
And so, that’s not necessarily a systemic risk concern. It’s more of a policyholder protection, taxpayer protection, concern. But I do think that there’s more risk in the system than I think we know. And even more troublingly, we don’t know how much risk there is in the system. Policyholders don’t know. Investors don’t know. And I don’t really think state regulators know.
And there’s just no good reason for allowing the amount of risk that we’ve allowed to build up in the system given sort of the origin of these transactions. Let’s go back to these transactions, these affiliate reinsurance transactions of the type we’re talking about, they were all meant to deal with a fundamental problem with state insurance regulation that we fixed a decade ago. So, why are we still allowing them? Like that to me is the big takeaway.
TEDDY DOWNEY: Well, Professor Schwarcz, thank you so much for doing this. I learned a ton. I mean, you’ve got a tremendous amount of knowledge about this industry and I can’t thank you enough for taking the time to share it with us.
DANIEL SCHWARCZ: Great. Thanks so much for having me.
TEDDY DOWNEY: And before we wrap up The Capitol Forum, we’re going to keep doing these types of interviews and also join us at our Life and Annuity Industry at a Crossroads conference on November 12th at the National Press Club here in D.C. Thanks again for joining us, everyone. This concludes the call. Bye-bye.
