Regulatory Enforcement and Off-Balance Sheet Entities: Evidence from the 'Shadow Insurance' Marke

Captive reinsurance ("shadow insurance") is a controversial form of non-traditional reinsurance that is associated with opaque statutory reporting in the insurance industry. Captive reinsurance subsidiaries are special purposes entities that are not consolidated under statutory accounting principles (SAP) and can be used to manage a firm's statutory reserve liabilities and premiums, which are reported net of reinsurance. This paper studies the relation between regulatory enforcement and an insurance firm's use of off-balance sheet captive insurance entities, as well as the implications of regulatory enforcement and captive reinsurance use for the firm's credit ratings and the degree of information asymmetry in the market for the firm's equity. I find that regulatory enforcement is negatively associated with the use of captive reinsurance among life insurers. Among life insurers, I find some evidence that credit rating agencies infer information about a firm's default risk from its regulatory enforcement environment, and that regulatory enforcement can reduce information asymmetry in the market. Contrary to what I hypothesize, the use of "shadow insurance" is negatively associated with proxies for information asymmetry in equity markets among pure property-casualty insurers. Overall, my findings suggest that regulated firms, credit rating agencies, and equity investors act as if regulatory enforcement increases the credibility of accounting reports and reduces information asymmetry in the market. Also, public awareness of accounting issues may be important for regulatory enforcement and its credibility. These findings should be of interest to regulators, investors, preparers, and other stakeholders impacted by accounting standards and their enforcement.