New York Department of Financial Services Superintendent Ben Lawsky (AP photo/Mike Groll)

New York insurance regulators have the captives industry and private equity firms that own annuity companies under a microscope for their effect on financial solvency and stability, and the fear policyholders may be left holding the bag.

The use of captives by insurers places the stability of the broader financial system at greater risk, the New York State Department of Financial Services (DFS) lead supervisor said today in New York.

DFS Superintendent Ben Lawsky even invoked AIG and analogized the use of captives to the same risky practices that precipitated the 2008 financial crisis, issuing subprime mortgage-backed securities (MBS) through structured investment vehicles and writing credit default swaps on higher-risk MBS.

Lawsky also said his state regulators are ramping up their scrutiny of private equity firms that are acquiring insurance companies, particularly fixed and indexed annuity writers. He warned that their failure could put policyholders, retirees and the financial system at risk. 

He also suggested that regulators might need to beef up existing regulations to prevent the easy acquisition of annuity-rich insurance companies. 

The long term nature of the life insurance business raises similar issues, yet under current regulations it is less burdensome for a private equity firm to acquire an insurer than a bank.

The specific risk DFS is concerned about is whether these private equity firms are more short-term focused when this is a business that’s all about the long haul.

“There can be exceptions, but generally private equity firms follow a model of aggressive risk-taking and high leverage, typically making high-risk investments,” Lawsky said. “Private equity firms typically manage their investments with a much shorter time horizon – for example, three to five years — than is typically required for prudent insurance company management.”

If they don’t happen to be long-term players in the insurance industry, their short-term focus may result in an incentive to increase investment risk and leverage in order to boost short-term returns.

Private equity-controlled insurers now account for nearly 30 percent of the indexed annuity market (up from 7 percent a year ago) and 15 percent of the total fixed annuity market (up from 4 percent a year ago).

Lawsky said he hopes to “shed light on and further stimulate a national debate on the use of captive insurance companies and special purpose vehicles (SPVs) by some of the world’s largest financial firms.

He hopes to do this though the DFS’ ongoing “serious investigation” into what he believes is not even a true risk transfer.

Lawsky, who is superintendent of both banking and insurance in the state, suggested in his remarks the shaky ground of solvency upon which some insurers, he believes, are standing. When the time finally comes for a policyholder to collect their promised benefits, the reserves of insurers have shrunk so there is a smaller buffer available to ensure that the policyholders receive the benefits to which they are legally entitled, he explained.

Lawsky said that many times captives do not actually transfer the risk for policies off the parent company’s books because the parent company is ultimately still on the hook for paying claims if the shell company’s weaker reserves are exhausted.

Lawsky spoke of his concerns with what he terms “shadow insurance” or “financial alchemy” during a speech Thursday in New York City at the annual Hyman P. Minsky conference on the state of the U.S. and world economies organized by the Levy Economics Institute of Bard College.

Lawsky characterized insurers as using captive insurance companies to quietly “off-load risk and increase leverage.”

The DFS has been investigating the use of captives since July 2012.

Lawsky claims that insurance companies use these captives, or “shell companies,” to shift blocks of insurance policy claims to special entities – often in states outside where the companies are based, or else offshore – in order to take advantage of looser reserve and oversight requirements.

Then the insurer, he explains for this situation, diverts the reserves it saves – that it had previously set aside to pay policyholders – to other purposes.

Lawsky’s remarks on captives were part of a speech on regulating in an evolving financial landscape, and how state regulators lead on issues, partner with the federal government, partner with each other or sometimes act alone.

A subgroup of state regulators at the NAIC, led by Rhode Island’s lead insurance regulator Joe Torti III, is examining the use of captives by life insurers, with comments due on a draft white paper, toward the end of this month. Insurers have said they support the use of captives, regardless of whether the more liberal and specially-tailored reserving methods allowed under principles-based reserving (PBR) project of the NAIC is fully implemented.

The Federal Insurance Office (FIO) has also expressed interested in the issue, collecting information, disseminating articles and appointing a federal advisory task force on the issue. 

Lawsky said he wanted the department’s overall approach on issues to be a form of something called catalytic federalism, a force of change.

The superintendent described the various regulatory approaches the state takes in general – with collaborative federalism usually the best kind, he said – when the states work closely and together, as the DFS has been doing with the Consumer Financial Protection Bureau (CFPB) in the areas of debt collectors and payday lending.

Then there’s “persuasive federalism” – where the state tries to lead by example and stimulate national reform. DFS’ work in the force-placed insurance industry is one such example.

Coercive federalism, extreme but sometimes necessary, is when “a state must act alone to change the rules of the game.” DFS’ work on anti-money-laundering enforcement is an example, Lawsky said.

He did not say where the captives examination or the private equity scrutiny might fall, but said he hopes other states will join in on the latter. 

“Many life insurers use captives because they enable effective risk management and capital efficiency,” said the ACLI spokesman, Jack Dolan. “Appropriately regulated captives are a positive component of a diverse and innovative insurance market that can help life insurers provide consumers with affordable insurance products.