Summary:
Despite the essential role of shadow insurance in financial stability, it has received much less attention than shadow banking. Shadow insurance is the transfer of insurance by insurers to unregulated or less-regulated affiliated insurers via reinsurance, effectively increasing leverage in the insurance sector and the fragility of the whole financial system. As the 2008 global financial crisis showed, excessive risk-taking by insurers can have destabilizing effects. However, due to the opacity of shadow insurance and the lack of appropriate natural experiments, the literature only presents some simple stylized facts or structural estimates based on limited data, while few studies seek to causally identify shadow insurance activities and their underlying risk-taking mechanisms. China's strengthening of the regulation surrounding the disclosure of affiliated reinsurance by Chinese insurers (treatment group) constitutes an ideal natural experiment to address this open question, given that the regulation policy changes mainly apply to Chinese insurers. Foreign insurers in China are the natural control group. The paper uses the micro-data of insurance companies from 2010 to 2019 and a difference-in-differences (DID) methodology to identify shadow insurance activities in China, providing more convincing empirical evidence for the risk-taking behavior and operational stability of insurance companies. The results show that the regulation reduces the shadow insurance activities of Chinese insurers by reducing reinsurance. Chinese insurers' leverage and return on equity decrease significantly by 0.035 and 0.319 respectively, and their operational stability improves significantly. The parallel trend test ensures the validity of our DID identification strategy, and the placebo test with counterfactual analysis corroborates the results. The paper further identifies how shadow insurance activities affect insurance companies' risk-taking behavior. First, due to the stark differences between the liability structures of life insurers and property insurers, life insurers carry out more shadow insurance activities motivated by capital management than property insurers. Therefore, strengthening the capital supervision of affiliated reinsurance has a significant impact on Chinese life insurers but not on Chinese property insurers. Second, shadow insurance increases life insurers' risk-taking behavior not only on the liability side by relaxing capital requirements but also on the asset side, amplifying the overall risk mismatch of the balance sheets. Strengthening the regulation of affiliated reinsurance can undermine this mechanism, improving the operational stability of the insurance industry and reducing the likelihood of systemic risk. Third, the heterogeneity analysis shows that the effects are greater for group insurers, meaning that strengthening the regulation of affiliated reinsurance has a greater impact on group insurers. The leverage of group insurers decreases and their operational stability improves more than those of non-group insurers, reducing the overall systemic risk of the financial market. This paper has important policy implications. First, the results of the paper shed light on the insurance sector's systemic importance in the financial system. To reduce the likelihood of contagious systemic risk, regulators need to pay more attention to the increasingly systemically important insurance sector, promote its high-quality development, and reduce its operational risks. By deepening the reform of the financial system, China can effectively prevent the build-up of systemic financial risks. Second, the paper shows that financial innovation (including innovation in insurance) is a double-edged sword and must be balanced against prudential regulations. Therefore, financial regulators can pay attention to the extent and scope of financial innovation. Third, because financial institutions spread systemic financial risks through balance sheet expansion, the paper's findings and methodology can shed light on the identification and regulation of shadow financial activities by financial institutions through (less-regulated) subsidiaries, especially systemically important financial institutions and holding companies. Shadow financial activities have already blurred the boundaries of financial institutions through various financial innovations, and a macro-prudential regulatory framework for financial activities will be more efficient. The paper also provides a solid academic foundation for designing a more holistic macro-prudential regulatory system.
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