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Wednesday, June 12, 2013

Reinsurance as a Shell Game: Another Bailout to Come?

In the stock market, investors can be quite fastidious in demanding a certain quarterly profit or internal rate of return. The increasing activism of institutional investors exacerbates this trend, as they have the wherewithal to investigate the companies in which they hold stock and the incentive given the number of shares they typically hold in a certain company. This pressure can tempt managements to “go outside the box” in developing novel ways to inflate revenue or hid expenses and risk.[1] In theory at least, companies owned by their employees or customers do not have to contend with that sort of pressure, and thus can manage their books with more transparency and honesty. Has managerial capitalism become too reductionistic in relying so much on the corporate form of ownership? Have we as societies been opening ourselves up to too much financial risk as a result? Further, if shifting more regulatory authority from the state to the federal level in the US (and presumably in the EU as well), what would be the cost to the federal system? The answers for the U.S. and E.U. could differ, given where each union is in its development. The insurance industry in New York is a case in point.
According to Benjamin Lawsky,  the New York Superintendent of Financial Services, life insurance companies based in New York have been setting up shell companies in other states in the U.S. and around the world to buy some of the obligations to pay claims. Although reinsurance bought by a separate company does indeed reduce risk for the company that is selling, a subsidiary can get the obligations off the parent’s books but the overall risk is not reduced. With New York regulators seeing lower risk, they approve lower collateral requirements, which, according to Lawsky, means “the policyholders are at greater risk.”[2] The insurance companies have been able to get away with this shell game because the subsidiaries are located in other states, which have tight secrecy laws, so the parent company’s regulator never sees the whole picture.
Essentially, an insurance company understates its risk so it can reduce its required reserves. With the freed-up collateral, the company can boost profit in order to appease the stock market. Lawsky likens the practice to those that led up to the financial crisis in 2008. “Those practices were used to water down capital buffers, as well as temporarily boost quarterly profits and stock prices, [and] ultimately, those practices left those very same companies on the hook for hundreds of billions of dollars in losses from risks hidden in the shadows, and led to a multi-trillion-dollar taxpayer bailout.”[3]
Unfortunately, several states had passed laws allowing the shell companies, which could buy reinsurance from their own parent companies. With the states having regulated insurance for more than 150 years, federalizing the authority would face resistance from the states, at least according to the New York Times. Considering all of the power that had already been concentrated in the U.S. Government from the states, it is difficult to suppose that Congress would find any formidable obstacle from the state governments. Moreover, the prospect of federal regulators would mean that insurance companies like Transamerica, MetLife, Prudential, Hartford, Genworth, John Hancock, ReliaStar and Lincoln National would not be able to hide the risk in other states from the regulators.
However, shifting the authority to the federal government would risk further consolidation at the expense of the American system of federalism. The U.S. Senate was already considering a bill that “would create a new federal system that would automatically qualify anyone who obtains [an insurance agent] license in any state to sell insurance in every state.”[4] The assumption here is that the states do not differ significantly in terms of insured risks such as hurricanes, earthquakes, and dust storms. In other words, the ability of the diversity from state to state to “breathe” politically, which is a benefit of federalism, would be further hampered. "We don't mind having some kind of national license approach, but individual states ought to be able to stand up and say, 'Wait a minute, we're unique and need some additional standard,'" said Bob Hunter, director of insurance at the Consumer Federation of America.[5] Moreover, the state governments would be even less able to check abuses of power in the federal government.
In the case of the E.U., on the other hand, transferring the regulation to the federal level would actually fortify the federal system because the state governments dominate in the system and the E.U. federal government strains to check abuses by the state governments. Generally speaking, the decision on whether to further federalize a power held by the states should take into account where the federal system currently lies in terms of federal relative to state power. Both the E.U. and U.S. are out of balance in this respect, but federalizing would help one and hurt the other in terms of federalism.
As an alternative to federalizing the regulation in the U.S., the corporate form could be replaced by the mutual company form for insurance companies. That is to say, having policyholders rather than stockholders own the companies, the managements thereof would not face the pressure to show good quarterly earnings and internal rates of return even when the insurance industry is in a slump. According to the New York Times, life insurers “that are owned by their policyholders . . . do not have that pressure, and some, like State Farm, Guardian and New York Life, appear not to be reinsuring through [shell subsidiaries] at all.”[6] This stunning difference points to the corporate form as not fitting well in the insurance industry. Lest the prospect of the mutual form being used, presumably by law, seems too “radical” for those of a particularly cautious disposition, it can be noted that many advanced industrial states have single-payer health-insurance. That is, the assumption that health insurance companies are necessary is not true; the assumption can be critiqued, that is, without thinking outside the box.

[1] I have come to the conclusion that the expression, “thinking outside the box,” means different things to different people. Accordingly, anyone can define the expression ex nihilo and presume it to be legitimate. Strangely, “critical thinking” also seems to have become fair game for anyone to define for not only oneself, but also others, who are somehow bound to accept one's definition as valid. The declaring is itself rather funny in all its primped dress of presumptuousness. I have noticed the trend more broadly since the turn of the twenty-first century wherein people presume that they can create knowledge out of what is in actuality merely their own opinion. Education is no longer necessary, they conveniently assume without the sort of foundation that only an education can provide. For example, “Marilyn,” writing on Daniel Dotson’s “Shares” at Keep & Share, claims that critical thinking means thinking outside the box. Actually, questioning assumptions does not necessarily mean doing that because one can be critical of an assumption without leaving its paradigm. According to “Emma,” critical thinking is to be open-minded and to have an opinion. Actually, thinking critically about assumptions and inferences of a theory or argument involves analysis rather than opinion, and whether one is open-minded or not is irrelevant because reasoning is not an attitude or ideology. Rather, thinking is a skill innate to humans—an ability that can be sharpened with learning and practice. Therefore, just because an executive claims that he is thinking outside the box does not necessarily mean that he is in fact doing so. He could simply be entertaining an idea that is new to him. The underlying problem here may be the modern proclivity of a subjectivity to consider itself a fact that other subjectivities are obliged to accept as a fact.
[2] Mary Williams Walsh, “Insurers Inflating Books, New York Regulator Says,” The New York Times, June 11, 2013.
[3] Mary Williams Walsh, “Insurers Inflating Books, New York Regulator Says,” The New York Times, June 11, 2013.
[6] Mary Williams Walsh, “Insurers Inflating Books, New York Regulator Says,” The New York Times, June 11, 2013.