Why Your Life Insurer May Not Be as Healthy as It Seems

Life insurance companies have been treading water lately, beset by low returns on investments and an aging North American population. Now, a recent news item indicates that these entities may be even less robust than they claim.

New York's Department of Financial Services has initiated an inquiry into the use of captive insurance companies, according to The Wall Street Journal. The state is seeking answers regarding how life insurers use these companies to manage risk.

Captive insurers are proliferating
Captive insurance, a type of reinsurance, is nothing new. Large insurers make use of it for various reasons, primarily to make capital reserves look bigger. Also, when a company sets up its own captive subsidiary, fees paid by the parent company can be expensed, lightening the overall tax burden.

Once upon a time, most of these reinsurance subsidiaries were located overseas, usually in the Caribbean. In the early 1980s, Vermont led the way in allowing these entities to do business in that state, once it discovered how lucrative the sector could be. Other states are doing the same, and Prudential (NYS: PRU) opened the first captive insurance company in New Jersey last summer, noting that its purpose was to "manage risks in its life insurance and annuity businesses."

Tighter reserve requirements are spurring the largest insurers, such as Metlife (NYS: MET) , Lincoln National (NYS: LNC) , and Genworth Financial (NYS: GNW) , to make greater use of captive insurance, since they can transfer some of their liability to those subsidiaries, making the parent company look more solvent.

Metlife and Lincoln, which have been targeted in the investigation along with 78 other insurers, may have both used letters of credit from major banks to pad their balance sheets. Metlife's Vermont subsidiary hosted a $2.4 billion line of credit with Deutsche Bank in 2008, and Lincoln's captive holds a $550 million letter of credit from Credit Suisse (NYS: CS) .

In some states, these letters of credit are sufficient to guarantee the parent company's access to capital if needed. However, some worry that drawing on the line of credit could cause the bank to require repayment, possibly putting the insurer in default.

Fool's take
An article in TheNew York Times last year referred to the captive insurance industry as "shadow insurance," since, like shadow banking, it is largely unregulated. Though the captives are audited, most states allow those records to remain confidential. This lack of transparency, along with the fact that parent companies setting up captive subsidiaries in other states can bypass their home state's reserve rules, doesn't create a very comfortable environment for either life insurance customers or investors.

If you fall into either of these groups, you'd do well to keep informed regarding the ongoing investigation, as well as do your own due diligence. Who knows? Your favorite life insurer may not be as lively as you thought.

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The article Why Your Life Insurer May Not Be as Healthy as It Seems originally appeared on Fool.com.

Fool contributorAmanda Alixowns no shares in the companies mentioned above. The Motley Fool has adisclosure policy. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. Try any of our Foolish newsletter servicesfree for 30 days.

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