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Is insurance moving more into the shadows?

Insurance companies are taking advantage of new laws in roughly 30 states that help them hide risks, reduce costs, cut back on reserves and find friendlier regulators, according to a story in the New York Times.

From the story, by Mary Williams Walsh and Louise Story:

This has given rise to concern that a shadow insurance industry is emerging, with less regulation and more potential debt than policyholders know, raising the possibility that some companies will find themselves without enough money to pay future claims. Critics say this is much like the shadow banking system that contributed to the financial crisis.

A tip of the hat to The Audit, for alerting RepoWatch to the New York Times story.

For RepoWatch readers, more hidden insurance operations raise red flags because insurance companies are important repo borrowers and securities lenders. In those roles, they already build up significant debt that is hard to see. And, of course, they sell credit default swaps, as we learned from American International Group (AIG). That makes them key players in the two markets that regulators say created the fatal systemic risk in 2007 and 2008, repos and credit default swaps. 

Here’s one way insurers do repo trades and securities lending:

In the so-called securities lending market, a smaller cousin to the repo market, financial institutions like insurance companies or pension plans lend their stock holdings in return for cash. Securities lending is a common way for institutional investors that hold a lot of securities to make a little extra cash. But notice that it also means the securities lender, for example the insurer, is receiving money that it must repay. That’s debt.

While the securities lender holds the cash, it reinvests it, often in overnight repos, until the securities borrower wants the cash back. Securities borrowers are usually broker-dealers and speculators who need the borrowed stocks for trading purposes.

In 2008, nervous securities borrowers suddenly demanded their cash back. That was a problem for securities lenders who had used the cash to make repo loans collateralized by risky mortgage pools like CDOs, or who had used the cash to buy the CDOs outright. With the CDOs falling in value, the securities lenders had to make up the difference when the securities borrowers wanted their cash back.

After the federal government took control of AIG in September 2008, taxpayers had to pay $43.7 billion to securities borrowers, only $6 billion less than the better-known payouts on AIG’s credit default swaps.

AIG is suing firms that created some of the securities it bought with securities borrowers’ cash, accusing them of misleading AIG about the quality of the CDOs, according to The New York Times.

To prevent the next crisis, Americans need more transparency in these markets, not less. It will be critical for the Office of Financial Research to keep track of these dealings.

 

 

 

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