New Frontiers in Financial Wrongdoing and Instability

Benjamin Lawsky is the very first Superintendent of the New York Department of Financial Services (DFS), a regulatory body created in 2011 through the merger of the New York State Banking and Insurance Departments.  Lawsky spoke recently at the Levy Institute’s annual Minsky conference and he began with an appropriately Minskyan tune:

There is a constant danger that putting a thumb in the dyke in one part of the financial system will cause a leak to spring somewhere else. It’s a danger that well-intentioned reforms could push risk to ever-darker corners of the financial system, to financial products not yet envisioned by even the most farsighted regulators. … This is not to say, as some have suggested, that the art of financial regulation is a futile endeavor. … It just means that we should approach the constantly evolving landscape of the financial sector with, in my opinion, a deep sense of humility about the capacity of any one set of reforms or safeguards to permanently preserve the stability of our kinetic, frenetic, global financial system.

Hyman Minsky had definite views about how the financial structure should (and should not) be altered so as to create a more stable and prosperous capitalism, but he also emphasized that the work of financial regulation is never done.  It is part of the nature, part of the bargain, as it were, of finance-driven capitalism that new practices and sources of instability are constantly emerging.

In his speech, Lawsky described some concerning new developments in the financial sector, including a below-the-radar practice that garnered the attention of the DFS (ultimately resulting in a series of settlements, one of which was announced about an hour before Lawsky’s speech).

The practice in question is in an area called “force-placed insurance.” Homeowners are typically required to insure their property as part of the terms of a mortgage.  When homeowners get into financial trouble, they often end up being delinquent on their insurance payments even before they miss their mortgage payments. In such circumstances, a bank will force the homeowner into a new insurance policy.  However, in many cases investigated by the DFS, the force-placed insurance policy, instead of being similar to the homeowner’s original insurance, had rates that were up to 10 times higher, and for good reason:  banks were actively shopping around for the highest premiums.  It turns out that banks had made deals with force-placed insurance companies in which a portion of the premium was being kicked back to the bank, and according to Lawsky, these kickbacks became an important profit center for banks as the financial crisis caused more and more homeowners to miss their insurance payments.

Lawsky also pointed to a recent trend in the financial sector that deserves more attention:  the increasing involvement of private equity in the insurance industry, specifically acquisitions of fixed and indexed annuity writers.  Lawsky reported that while only 7 percent of the indexed annuity market was controlled by private-equity-owned insurers a year ago, it’s now up to 30 percent (that’s as of mid-April) and rising.  As he suggested, we may not want private equity, which generally has a high-leverage, short-term-focused approach, involved so heavily in a product (annuities) that Americans typically rely on to help finance their retirement.

The speech, which you can listen to here, also touched on recent anti-money-laundering efforts, conflict-of-interest problems faced by bank monitors, and a practice that Lawsky dubbed “shadow insurance,” which sounds disturbingly similar to some of the financial schemes involved in the last crisis:

In a typical transaction, an insurance company creates a “captive” insurance subsidiary, which is essentially a shell company owned by the insurer’s parent. The company then “reinsures” a block of existing policy claims through the shell company — and diverts the reserves that it had previously set aside to pay policyholders to other purposes, since the reserve requirements for the captive shell company are typically lower. (Sometimes the parent company even effectively pays a commission to itself from the shell company when the transaction is complete.)

However, this financial alchemy, let’s call it ‘shadow insurance,’ does not actually transfer the risk for those insurance policies off the parent company’s books, because in many instances, the parent company is ultimately still on the hook for paying claims if the shell company’s weaker reserves are exhausted (this is called a “parental guarantee”). That means that when the time finally comes for a policyholder to collect their promised benefits after years of paying premiums – such as when there is a death in their family – there is a smaller reserve buffer available at the insurance company to ensure that the policyholders receive the benefits to which they are legally entitled.

(The full transcript of Lawsky’s speech is here [p. 48])