Taking Shadow Insurance out of the Shadows: Regulatory Arbitrage, Taxes, and Capital

Abstract

Increasing trends in tax-motivated income shifting are an escalating concern among policymakers worldwide and a growing area of academic interest. However, we have a limited understanding of the real consequences of income shifting. We study one potential set of such consequences using a sample of firms engaged in shadow insurance, a complicated series of transactions designed to free up liquid assets typically held to pay life insurance policy claims. Aggregate shadow insurance exceeded $348 billion by the end of 2013 and ostensibly offers relief from unnecessary capital restrictions. However, critics argue the practice is tax-motivated, resembles the activities leading up to the 2007-09 financial crisis, and puts the larger economy at risk. Consistent with a tax-motivation, we find that five out of every six dollars of shadow insurance are located in tax havens and shadow insurers exhibit economically significant tax savings. We also find that firms using shadow insurance exhibit significantly higher credit default risk and hold considerably less high-quality assets, but make significantly greater payouts to shareholders and executives. Taken together, our findings suggest that shadow insurance practices are not only at least partially tax-motivated, but also lead to significant economic consequences.