• By The Editorial Board / Bloomberg Opinion

Every year, millions of Americans send their hard-earned money to life insurance companies, in return for a promise that it would grow and provide them with regular income in old age. These fixed annuities make up a large part of the nation’s retirement savings — at last count, more than US$3 trillion.

They could also become a nexus of the next financial crisis, if regulators do not act to mitigate mounting risks.

The annuity business should be simple and boring. Invest in high-quality assets that mature when the time comes to pay policy holders; take a small cut of the returns for your efforts. Thanks to penalties for early withdrawal, insurers should not have to worry about customers suddenly demanding their money back, as sometimes happens to banks. As long as the company’s owners provide enough equity to cover the occasional bad investment, everyone should be fine.

In recent years, however, insurers have made things more complicated. In pursuit of cheaper funding, they have turned to shorter-term borrowing — via wholesale credit markets and Federal Home Loan Banks. They have juiced returns in part by investing in collateralized loan obligations (CLO), which contain loans to highly indebted businesses. They have channeled billions of dollars through affiliated reinsurers in Bermuda, where tax and other rules are less burdensome.

The transformation has coincided with a big shift in the industry’s ownership. Private investment firms have taken stakes in companies accounting for more than 10 percent of all US life and annuity assets. In some cases they might be adding value, by identifying higher-yielding yet hard-to-sell assets — such as corporate vehicle fleets — that serve annuity holders’ interests. Yet research suggests they are boosting returns primarily by increasing risks and by circumventing taxes and capital requirements. Much of the industry — comprising about US$2 trillion in annuity liabilities, including transferred corporate pension plans — has adopted similar strategies.

In effect, life insurers have become more like banks, but without their backstops and safeguards. Their funding has become less secure: Annuity holders could more easily afford withdrawal penalties when other investments are paying higher returns than before. Their assets are also vulnerable to rising corporate bankruptcies. Although CLOs have historically performed well, certain tranches carry a greater risk of total loss than a diversified portfolio of corporate bonds. All this increases the chances that an economic downturn or distress at one insurer could trigger a rush to the exits.

This worst-case scenario is not theoretical. Early annuity surrenders recently contributed to the failure of Italian insurer Eurovita. In 2008, wholesale creditors pulled funding from insurers such as AIG and The Hartford. Annuity providers with bank-like activities pay higher yields on short-term debt, suggesting markets view them as riskier. Overall, life insurers were holding about US$115 billion in non-AAA-rated CLO tranches at the end of last year. That is significant, set against their loss-absorbing capital of less than US$500 billion — which represents a smaller share of assets than just before the 2008 financial crisis.

Authorities are aware. The National Association of Insurance Commissioners has developed stress tests of US insurers’ liquidity and CLO holdings, and is working on stricter capital standards. Yet it is only a coordinating body for the patchwork of state regulators actually responsible for supervision, which in turn have little insight into insurers’ wider operations. The US is lagging behind international efforts to develop more comprehensive and comparable measures of capital adequacy.

The Financial Stability Oversight Council needs to reassert the power granted under the Dodd-Frank Act to subject systemically important insurance groups to Federal Reserve oversight. The Fed should apply prudent capital and liquidity requirements to reduce the risk of runs. Regulators should also insist that all covered insurers disclose the data required to assess their financial condition.

Some of the innovations in the annuity business might benefit consumers, making saving for retirement cheaper and more accessible — but this must not come with an unacceptable risk of disaster or of yet another taxpayer bailout. “Shadow banking” was deeply implicated in the last big financial crisis. Regulators need to heed that lesson.

The Editorial Board publishes the views of the editors across a range of national and global affairs.