Policyholders Join Regulators in Casting Light on Shadow Insurance

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The issue of “shadow insurance” has been the subject of increasing regulatory and governmental scrutiny. Policyholders are now joining the effort via five class action lawsuits against three different insurance companies, MetLife, AXA Equitable and Lincoln National, for their use of shadow insurance.

Shadow insurance usually refers to an insurance company’s attempt to re-allocate reserve and collateral funds.  The New York State Department of Financial Services describes shadow insurance as follows:

In a typical shadow insurance transaction, an insurance company creates a “captive” insurance subsidiary, which is essentially a shell company owned by the insurer’s parent. The company then “reinsures” a block of existing policy claims through the shell company — and diverts the reserves that it had previously set aside to pay policyholders to other purposes, since the reserve and collateral requirements for the captive shell company are typically lower. Sometimes the parent company even effectively pays a commission to itself from the shell company when the transaction is complete. This financial alchemy, however, does not actually transfer the risk for those insurance policies because, in many instances, the parent company is ultimately still on the hook for paying claims if the shell company’s weaker reserves are exhausted (“a parental guarantee”).

These transactions are often compared to shadow banking in that the transactions often take place behind the scenes and make it difficult for regulators and customers to monitor any transactions and can often present a picture that is not entirely accurate.  These concerns are on display in the these class action complaints.

For example, an article in Insurance News Net notes:

One suit against AXA relates to life insurance. It alleges that AXA violated New York insurance law by “engaging in various ‘shadow insurance’ transactions in connection with its life insurance business, which were not reported on its mandatory statutory annual statement and not properly disclosed to its principal regulator, to its credit rating agencies, or to its customers.”

“As a result, AXA’s representations concerning its own financial condition were materially misleading,” the suit alleged. The lawsuit against AXA regarding VAs alleges that when marketing its guaranteed benefits insurance riders and other life insurance products, “AXA touts its credit and insurance ratings, as well as the insurance company’s assurances of financial strength.” “These marketing efforts and references confirm that AXA’s representations about its financial condition, insurance ratings and overall financial health are material to its business,” the complaint read, but “AXA’s use of shadow insurance constituted a misrepresentation of the financial condition of AXA, and the adequacy of the reserves and reserve system upon which AXA operates.”

One of the lawsuits against MetLife also attempts to tie MetLife’s nonbank SIFI designation with allegations of conducting shadow insurance.  It alleges that by conducting shadow insurance transactions, MetLife is endangering its financial health and thus, could endanger the health of the system.

In the meantime, the NAIC and state regulators continue to monitor and evaluate their options for dealing with these transactions.