Apparently, 2% of the State of Vermont's budget comes from the "captive insurance industry", and the industry collectively is one of the state's top 10 employers. You know, that can make it tough to regulate an industry effectively, when there is so much riding on keeping the whole thing rolling along smoothly.
There are a lot of things that make me go, hmmm. Like, waiving safeguards. Reducing costs. Legally limiting the possibility of competition. Having origination be through one company but then having everything immediately sold to other, private, opaque, unrated companies.
It isn't a heavily covered topic, however. But you know, you really have to wonder. I mean if a wide swathe of the nation's pensions, labor insurance, and other insurance and reinsurance is all going through these weird vehicles, and they are all in one state and and and.
If someone doesn't exploit the hell out of this and make it blow up in all of our faces at some point, it would be a miracle. OTOH, I love some D00M, so maybe I'm just being paranoid.
A Priceless Paragraph:
"When there’s no property-casualty insurance on the market, or the premiums are too darned high, a company can set up a captive to self-insure its risks. Captives enable a business to price and underwrite its risks as it knows they should be priced or underwritten — not how the insurance industry says they should."
This is right up there with some of the liquid-alt vehicles out there currently that people are complaining about. There's no trading, but there is a last price quoted -- but in the even you actually need to sell, goddess only knows what price you might really get. The "alt" part of the description is right, but the liquid part is entirely a lie when the market has frozen solid.
"They can provide an opaque means of shifting risk off of the balance sheet"
Reinsurance is cheap, because the idea is that the first line insurance will probably pay, and the reinsurer only has to pay if the first line got blown away -- like tranches in all those you know whats. But if you make up a fake insurance company with no capacity to pay and it goes straight to the reinsurer, then the reinsurer is not charging enough. In the event of a wave of claims, the reinsurers would either have to hike rates to the sky going forward to make good their losses, or they would go under and who knows where the risk goes from there.
ETA: The insurance commissioners are trying to get this back under some semblance of control.
I'm not finding this as reassuring as I wish I did.
And this, this right here, this just seems evil.
A Priceless Paragraph:
"David Slenn, a lawyer at Quarles & Brady in Naples, Fla., and the chairman of the American Bar Association’s captive insurance committee, said the push to set up small captives had gotten out of hand. The interest in captives is being driven by lawyers and accountants who are seeking additional fees now that the estate tax exemption has been permanently set and there is not as much annual business, he said."
To be fair, things like this:
"People are marketing captives as a possible substitution for estate planning."
sound less like systemic risk and more like idiots looking to get into serious trouble with the IRS, altho at least one guy went to tax court and won. But really? Evading gift taxes and the remaining estate taxes? Bad behavior.
Okay, so let's assume that we've got two separate captives issues going on here. One, the increasing, substantial and fairly blatant attempt to avoid taxes, probably is NOT a systemic risk of any sort. Hopefully, the IRS will plug that hole at some point. I'm not going to lose any sleep over it (don't be an idiot and set up a captive as an estate planning tool, okay? It's not going to go well). Two, the fact that the entire reinsurance industry appears to have sewn itself together into a black hole, mostly located in and around Vermont [ETA: That's not really true. Reinsurance is centered in Europe. Captives are centered in Vermont. They are related, but not the same.], and if something really gnarly happens with any segment of any primary insurance industry (life, property, labor, etc.), there is massive counterparty risk. That is, when the primary insurer has a really horrible string of months and contacts its reinsurer, they may well find out that the reinsurer shrugs and say, hey, I'll get that money to you ... someday. Or, you know, maybe my bank will give you something to tide you over? I have a letter of credit? That really only has to happen, once? publicly, maybe a few times if it is successfully concealed, before the entire reinsurance industry locks up hard, and the primary companies have to hike rates like You Would Not Believe and Cannot Possibly Afford, because they are no longer able to sell off their tail risk.
This definitely seems like it is worth worrying about. I'm still trying to figure out if it qualifies as D00M, or just something that someone should someday fix and maybe not wait too long about it.
I love that people now write about "model risk" as a thing. Most excellent.
So, in the course of reading that thing at U Chic (shudder), I ran across a financial product I had previously been blissfully unaware of: Contingent Deferred Annuities. Described here, in inappropriately optimistic terms:
(I thought actuaries were supposed to be safe and boring. When did these people become so insane?)
This product is not the most ridiculous financial product I've ever heard of (maybe portfolio insurance, in the late 1970s/1980s?). But no one should sell it. No one should buy it. And we should regulate that fucker right out of existence.