Is the Fed blowing bubbles in structured finance and insurance?
A number of commentators have raised the question of whether the low-interest rate policies of the Federal Reserve are stoking global inflation in commodities, food and energy. The answer to that question seems to be yes, but the inflationary pressure caused by the Fed’s purchases of US Treasury debt and zero short term interest rates is being manifested in many sectors and features the appearance of new “special purpose vehicles” in the insurance sector.
The reckless practices and financial transactions that led to the collapse of first Enron, then WorldCom and later American International Group (“AIG”) are alive and well, in large part due to the low-interest rate policies of the Fed and a good bit of credulity on the part of state legislators and insurance regulators.
Consider a hypothetical based on a real transaction outlined in a forthcoming paper which veteran insurance fraud investigator Tom Gober and I are writing:
You are a large, publicly traded health insurer. A leading New York dealer in OTC derivatives proposes a financing transaction that will enable the health insurer to create a surplus in its capital account and free up cash to fund a shareholder dividend. But first some background.
Wall Street sales literature refers to securitization as a boon to insurers: “Securitization provides a mechanism whereby contingent and deterministically scheduled cash flow streams arising out of a transaction can be unbundled and traded as separate financial instruments that appeal to different classes of investors,” said one presentation on demutualization circa 2007.
Another way besides simple asset securitization for insurers to move risk off the books was reinsurance and credit default swaps, as we learned with the failure of AIG. But the pattern really traces its roots back to off-balance sheet entities Enron executives used to commit fraud a decade earlier and with mortgage-backed securities and derivatives more recently. Now the game has moved to the world of structured notes and captive insurers, a once low risk and relatively pedestrian world which the AIG scandal only partly exposed.
Captives are lightly regulated entities that are meant to insure only internal obligations of a given company or entity. In effect, captives allow big commercial firms to self-insure risks without the tax disadvantages. Insurers get a current tax deduction for their liabilities, while corporates only get the deduction when losses are paid. Insurers hold a valuable timing advantage over corporates when it comes to taxes. Hence the desire of corporates to have a captive insurer available to deal with internal risks.
The expansion of the role of captive insurers in some states, however, has created a new avenue for financial mischief. Standard practice is for insurance regulators to set criteria for “admitted reinsurance.” That means the originating insurance (here, your health coverage) does not get to reduce liabilities, much less send good assets out of state, unless the assuming reinsurer is a responsible adult. But not all states are enforcing these standards of care in the same fashion.
In 2007 the State of Vermont passed legislation to greatly expand the use of captive insurers. The changes make Vermont the most permissive jurisdiction in the US along with South Carolina. Increasingly captives in states such as Vermont and South Carolina are being used to hide liabilities from third-party risk exposures from investors and regulators. These complex structured financial transactions may be within the letter of Vermont state law, but often seem to be pretty close to the classical definition of fraud.
Vermont now allows a captive to be used to reinsure any liability of the parent or a “controlling” party, the definition of which is sufficiently broad to accommodate most scenarios. The VT Department of Banking, Insurance, etc., etc., brags: “Over 860 companies have already realized the advantages of captive insurance operations licensed in Vermont. In fact, for several years now, Vermont has ranked as the number one captive domicile in the United States and the number three-ranked domicile internationally.”
Unfortunately, VT also has become a legal Cayman Islands for the insurance sector. An almost complete lack of disclosure and a liberal view on what constitutes an “affiliate” in VT enables major Wall Street OTC derivatives dealers to ply the structured finance trade and loot the insurance sector in the process. Indeed, the transaction described below in generic terms almost directly parallels the transactions initiated by the investment banks involved in the failure of AIG.
Here’s how one transaction worked. The health insurer creates a VT captive insurer and moves a significant chunk of assets and liabilities to this newco, call it “VT1.” The health insurer issues a press release bragging about the positive effect for investors in the new VT affiliate. The assets and liabilities of the parent company are reduced by the creation of VT1. This transaction also creates a surplus in the health insurer’s capital account. Now the parent shows only an investment in a captive insurer, but not the assets or liabilities of VT1.
Creating the surplus is a crucial event because it allows the health insurer to pay a dividend to its public shareholders. The liabilities received by the captive VT-based insurer we call VT1 are now off the books of the health insurer, even though the parent controls VT1 completely and, most important, is still on the hook for its liabilities in the form of health insurance policies. This is the Enron model, BTW, in case you recognize the pattern.
But it gets better. The health insurer now creates a Cayman Islands entity we’ll call “SPV1.” This “special purpose vehicle” encumbers the assets of the VT1 captive insurer in return for a worthless guarantee on its liabilities. The SPV1 vehicle then issues structured bonds, legally configured as a private placement and beyond US regulation, to bolster its supposed capital position. The SPV1 vehicle then simultaneously enters into an asset swap with the investment bank.
The Cayman domiciled SPV1 enters into what is essentially a repurchase transaction, taking inferior but higher yielding assets off the hands of the investment bank in return for much of the cash raised from the investors via the bond offering. The public investors in the health insurer see an investment grade exposure from VT1, this care of the intertwining guarantees of the parent and the “separate” SPV1. But the assets in the underlying SPV1 vehicle in the Cayman Islands are crap care of the investment bank.
The investment bank which conceived of and initiated all of these transactions is collecting fees from everybody and ends up with much of the cash in the transaction. The bank has also engaged in loss shifting by getting a pile of crap off of its books and safely stuffing them into a completely hidden Cayman Islands vehicle, SPV1. The investment bank collects a fee for placing the bonds with the investors, the true captives in this story of innovation and free enterprise in action.
Isn’t this a great deal for the shareholders and insured policyholders of the health insurer? The assets and future cash flow of the health insurer have been permanently reduced, even though the actual level of risk to the health insurer remains the same. The transaction appears to disadvantage the health insurer in the name of enriching the investment bank and the investors in the bonds of SPV1. And the best part is that a similar transaction involving AIG was recently disapproved by regulators, yet other insurers continue to engage in similar structured finance transactions with impunity.
This week in The Institutional Risk Analyst, we feature a comment titled “Inflation or Deflation? Or is it Global Weimar?” The deleterious effects of the Fed’s low interest rate policies is visible in the subsidies to banks and the low yields paid out to savers, but the negative influence is also seen in investor behavior.
The transaction above is by no means unique and typifies the norm in many transactions between regulated insurers and major OTC derivatives dealer banks today. But the question is this: Does anyone at the Fed or relevant insurance regulators know or care? One veteran insurance industry observer responded: “The Fed knows not, nor cares. A few insurance regulators get the joke. Of those, very few care enough to act: NY, California, Texas, perhaps still Illinois.”