Leverage is Everywhere

| Mon May 9, 2011 10:57 AM EDT

States have always competed with each other to attract corporate business, just as cities and counties compete to attract retail business. Usually they do this by offering tax breaks, which produces a downward spiral in overall tax revenue but doesn't otherwise cause any damage to the overall economy. But now states are competing with each other to attract dodgy insurance subsidiaries:

Companies looking to do business in secret once had to travel to places like the Cayman Islands or Bermuda. Today, all it takes is a trip to Vermont.

....Aetna recently used a subsidiary in Vermont to refinance a block of health insurance policies, reaping $150 million in savings, according to its chief financial officer, Joseph M. Zubretsky. The main reason is that the insurer did not need to maintain conventional reserves at the same level as would have been required by insurance regulators in Aetna’s home state of Connecticut.

....For the states, attracting these insurance deals promotes business travel and creates jobs for lawyers, actuaries and other white-collar workers, who pay taxes. States have also found that they can impose modest taxes on the premiums collected by captives. For insurers, these subsidiaries offer ways to unlock some of the money tied up in reserves, making millions available for dividends, acquisitions, bonuses and other projects. Three weeks after Aetna’s deal closed, the company announced it was increasing its dividend fifteenfold.

This is all possible because, for historical reasons, the insurance industry is regulated at the state level, not the federal level. And it's yet another example of how the bright boys in the finance industry can always figure out new and innovative ways of increasing leverage anyplace that regulations can be gamed in some way: Reducing reserves is, basically, a way of increasing leverage, and it's a great way of making more money. Until it isn't, that is. Unfortunately, "when it isn't" is a timeframe that's hard to predict. The only thing you can really say about it is that it's pretty much inevitable, and when it finally happens a whole lot of people are going to feel a whole lot of pain.