A highly critical report issued by the New York State Department of Financial Services (DFS) on June 11, 2013, found that almost a quarter of New York life insurers were diverting a total of $48 billion of their policies to subsidiaries in a process the report referred to as "shadow insurance." The scrutinized practice involves "reinsurance" of some of an insurer's existing policies through a wholly owned subsidiary, characterized by the report as "shell companies," rather than through a third party. The subsidiaries are generally located outside New York State, and the report alleges that insurers are using such "shadow insurance" to avoid stricter New York State regulatory requirements and to "cook their books" by reducing the amounts that the insurers have to set aside as reserves. The DFS report is a clarion call for state and federal regulators, such as the Securities and Exchange Commission (SEC), to require more transparent public disclosures by insurers and to crack down on the growing practice. All insurers, irrespective of whether they utilize subsidiaries for reinsurance, need to be aware of increasing federal and state scrutiny and take proactive steps with the assistance of counsel to avoid attracting the unwarranted attention of regulators.

Known more formally as "captive insurance companies" or "captive reinsurance," these corporate structures differ from traditional reinsurance where risk is distributed to multiple, non-related entities through arm's length transactions. Captive reinsurance, by contrast, does not actually reallocate risk -- the parent company insurer owns the captive insurance company and generally offers a "parental guarantee" for the captive company's policies. Instead of reallocating risk, captive reinsurance is intended to allow insurance companies to maximize their resource allocations. This ultimately means that, although the policies redirected to the subsidiary are off the New York insurer's books, the risk has not changed hands. Because their parent insurers guarantee captive companies, the parent company remains on the hook for any claims from those policies should the captive company deplete or exhaust its resources.

Captive reinsurance reduces the risk-based capital a company is required to keep on hand to protect against unexpected losses or unanticipated claims. The DFS report concludes that the most common reason insurers use shadow insurance is to artificially inflate their financial health: "In other words, shadow insurance makes a company's capital buffers -- which serve as shock absorbers against unexpected losses or financial shocks -- appear larger and rosier than they actually are." Major insurers, though, ardently deny this characterization. They argue that captives are employed to maximize the efficient use of resources while dealing with differing state regulations that fail to reflect the business realities faced by such institutions.

Captive companies are often set up in states with less stringent regulatory requirements, such as Vermont, Nebraska, South Carolina, Iowa, Delaware and Missouri, or even abroad, where use of soft collateral, not just cash and bonds is allowed. The DFS report warns that this practice will lead to a "regulatory race to the bottom" that will increase the risk of firm failure. The report analogizes the risks of "shadow insurance" to the subprime mortgage crisis of 2008 and suggests that such insurer failures could ultimately necessitate another large-scale government bailout.

The DFS report also examines the public filings of more than a dozen insurers and finds that they have failed to adequately disclose their use of "shadow insurance" to shareholders. The report finds that "New York-based insurers and their non-New York-based affiliates failed to disclose nearly 80 percent ($38 billion) of the $48 billion in reserve collateral secured by parental guarantees in their statutory annual statements." Also noted in the report is the fact that:

Ten of the 17 responding insurers asserted that their holding company made relevant disclosures in SEC filings. DFS reviewed those SEC disclosures, however, and found that only five of them were what DFS would consider a "good" disclosure. The other five disclosures were either "fair" or "poor." Seven insurers made no disclosure whatsoever of parental guarantees in any disclosures in their filings with the SEC.

If these insurers' disclosures are indeed inadequate, the companies making them are exposed to substantial civil liability and potential investigation by the SEC.

As a result of the report, DFS will now require "detailed disclosure of shadow insurance transactions by New York-based insurers and their affiliates." The DFS report calls for comparable action by other regulators, including an immediate and total national moratorium on the approval of new captive reinsurance entities. Although many states have recently passed laws allowing the formation of captives, it is unlikely that other states or the federal government agencies will be as tolerant. In fact, the Federal Insurance Office, created by the Dodd-Frank Wall Street Reform and Consumer Protection Act, is reportedly already investigating the increasing use of captive entities by insurers.

As the issue of captive reinsurance is increasingly debated and investigated on both a state and national level, it is essential for companies to be cognizant of the evolving state of the law in this area. With the state of the law in flux, companies should review their current practices with counsel as a preemptive step to assess, address and minimize any existing liability. In particular, companies that have utilized forms of captive reinsurance should work with legal counsel to ensure that their business models conform to industry best practices and that their financial disclosures comply with SEC and other governmental regulations. Finally, all companies, regardless of whether they have ever use captive reinsurance, must be ready to adapt and respond to changes in the law and should develop and implement protocols and escalation procedures to respond quickly and effectively in the unfortunate event of any government investigation or shareholder lawsuit.