The financial crisis dramatically changed perspectives on the stability of the banking sector for most market participants, academics and regulators. In response, policy makers all over the world are developing new forms of regulation and a great deal of academic research is attempting to quantify the costs and benefits of such reforms.
The important and worthwhile effort to understand and ensure the stability of the banking sector sharply contrasts with the limited attention received by the life insurance sector. In terms of balance sheets, US life insurers were responsible for $4.07trn in liabilities in 2012 compared to $6.98trn in savings deposits at US depository institutions. Clearly, the insurance sector is an important part of the financial sector. Moreover, while banks invest most of their assets in private lending, insurance companies mostly invest in corporate debt and may, therefore, be at least as relevant for allocating capital to productive investment projects and ultimately economic growth.
One reason for the lack of attention may be the traditional view that the life insurance sector is safe and financial constraints are not as important for insurers as they are for banks. The liabilities of a life insurance company are long term and not prone to runs. On the asset side, insurance companies are highly regulated, which limits the investment risk they can take. In support of this view, the US insurance sector has not experienced failures of large life insurance companies – although AIG may come to mind as an example, its failure was not caused by the company’s life insurance division. But we believe this traditional view of the insurance sector as boringly safe is no longer justified. Two key developments during the last 20 years changed the risk profile of US life insurers. The first change was triggered by the decision of firms to offer defined-contribution instead of defined-benefit pension plans. Even though this is often viewed as a risk shift from employers to employees, insurance companies recognised the demand for long-term guarantees and expanded their offering of variable annuities.
Variable annuities are long-term savings products in which the underlying assets are invested in traditional mutual funds. To make variable annuities more attractive to households, insurance companies add minimum-return guarantees. The long-term nature of these contracts presents a significant challenge for valuation and risk management. The trend from defined benefit to defined-contributions caused a risk shift from firms to life insurance companies. In 2012, $1.6trn was invested in the mutual funds that underlie the variable annuity products.
Insurance regulation is not designed to manage the risks embedded in variable annuity contracts. While adjustments have been made in recent years, the financial crisis caused large losses to variable annuity portfolios. Moreover, the subsequent low interest rate environment around the world poses challenges to fulfil the minimum-return guarantees. As the liabilities of insurance companies are not marked to market, variable annuity losses (and losses to other liabilities as a result of low interest rates) are not transparently reflected on current balance sheets.
The insurance sector responded to the financial crisis by reducing the generosity of newly-offered guarantees and limited, or even prohibited, additional investments in older products. Some companies, such as Hartford and Sun Life, exited the variable annuity market altogether.
The second key development that increased the riskiness of the insurance sector is the result of changes in life insurance regulation in 2000 and 2003. Insurance companies are regulated at the state level and report according to the statutory accounting rules for regulatory and rating purposes. Under the new regulation, which is commonly referred to as Regulation XXX/AXXX, insurance companies are required to hold more reserves for term and whole life insurance policies, respectively. This implies that with the same amount of capital, insurance companies can write fewer policies.
The statutory accounting rules for operating companies, which sell insurance products to consumers, differ from the GAAP accounting rules that apply to reinsurance companies. The GAAP rules are much less conservative. Traditionally, reinsurance has been used to share large risks among insurance companies or to benefit from a reinsurer’s underwriting expertise. As a result of Regulation XXX/ AXXX, the differential treatment of life insurance policies across accounting regimes added a new motive.
As a first response, insurance companies moved insurance policies to third-party, unaffiliated reinsurance companies. This comes at a cost: the price of reinsurance increased and the insurance profits are shared with the reinsurer. Recognising this problem, initially South Carolina passed new laws that allowed for affiliated reinsurance companies, so-called captives, which are also subject to GAAP accounting and laxer capital regulation. Thirty US states and offshore domiciles (e.g. Bermuda and Barbados) have now passed similar regulations allowing for affiliated reinsurance.
In 2012, US life insurers ceded $364bn to unrelated, affiliated reinsurers, or shadow reinsurers, up from just $11bn in 2002. This amounts to 250 per cent of the equity of the operating companies that cede the policies to the shadow reinsurers. As there are costs associated with setting up a shadow reinsurer, this form of regulatory arbitrage is mostly used by the largest insurance companies.
Measuring the solvency of shadow reinsurers is not straightforward as neither the capital structure nor the investment portfolio is disclosed publicly. The New York State Department of Financial Services reports that shadow reinsurers often use letters of credits provided by third parties, which are obtained with guarantees from the parent company, to fund the captives. As the letters of credit tend to be of shorter maturity than the insurance policies on the reinsurer’s balance sheet, the funding structure may be fragile. If the shadow entities are insolvent, the policies move back to the original insurance company’s balance sheet.
Our research suggests that shadow insurance adds significant financial risk for the companies involved, which is not reflected in their current ratings. Our conservative adjustment for shadow insurance reduces ratings by three notches for the average company. Furthermore, the adjusted ratings imply a ten-year default probability; four times that implied by the reported ratings.
Insurance during the crisis
The risks are not simply potential concerns going forward, but already severely impacted insurance companies during the financial crisis. We looked at the pricing behaviour of life insurance policies to measure the importance of financial constraints. In normal times, insurance prices exceed actuarially fair values by six to ten per cent. During the financial crisis, insurance prices declined and these products were sold at large discounts of 19 per cent on average for annuities and 57 per cent for life insurance (see our 2013 article for more on this). Figure 2 summarises the evidence for annuities.
What motivates insurance companies to sell insurance policies at large discounts during a deep recession? Pricing behaviour is the result of a combination of inadequate regulation and binding financial constraints. The discount rate that insurance companies can use to compute the value of the liabilities depends on corporate bond yields, rather than treasuries (debt bonds of sovereign governments).
During the financial crisis, treasury yields declined while corporate bond yields increased. This implies that insurance companies can sell policies that are worth $10 and record only $7 in terms of liabilities. By pricing the product between $7 and $10, the insurance company recapitalises from a regulatory perspective, but realises an economic loss. The insurance companies that are most constrained also use more conventional channels to recapitalise by tilting their investment portfolio to securities with favourable risk charges, by cutting dividends and by issuing equity. Moreover, multiple insurance companies received bailouts (AIG, ING Group, Hartford, Lincoln National) or applied for bailouts through the Troubled Asset Relief Program (Genworth Financial, Phoenix Companies, Protective Life, and Prudential Life), but were rejected or withdrew their application.
Hartford and Lincoln National received capital injections through the TARP (Troubled Asset Relief Program). In order to qualify for funding, these companies actually had to acquire banks to qualify for TARP funds, indicating that insurance groups without bank divisions were also constrained.
Taken together, this evidence suggests that financial constraints did bind for insurance companies. Our estimates imply that the average company was willing to reduce current profits by $2.32 to boost regulatory capital by $1.
In the event of default…
One might wonder what the broader economic consequences would be from the default of a large life insurance company. There are at least three key channels. First, the funding of shadow reinsurers is typically provided to some extent by third-party banks or other financial institutions through letters of credit. To the extent that insurance companies draw upon the letters of credit, this may cause spill-over effects to other parts of the financial sector.
Second, if households experience substantial losses on their policies, they may no longer trust insurance companies and reduce their investments in life insurance and annuities. As these policies are very effective in managing important idiosyncratic risks faced by households, the welfare consequences could be large (see our 2013 article, ‘Health and Mortality Delta’ for more on this).
Third, insurance companies are among the largest investors in corporate bonds. If the insurance sector shrinks as a result of declining demand, then the demand for certain classes of corporate bonds will decline. Depending on the substitution from other investors, bond prices, and ultimately corporate investment and economic growth, may be affected.
What this means for regulation
The big picture that emerges from our work is that regulation has a first-order impact on insurance prices, product design and risk-taking by insurance companies. Thinking about optimal regulation is therefore central to understanding the equilibrium in insurance markets and to ensuring stability of the sector going forward. It is important, in thinking about optimal regulation, to account for several of the unique aspects of the insurance sector. First, where many of the regulatory challenges for banks occur on the asset side related to excessive risk-taking and of-balance sheet activities, in case of insurance companies most of the action happens on the liabilities side.
Second, the liabilities of insurance companies are not prone to runs in most countries. As a result, one needs to be careful importuning bank regulation, and in particular short-term risk regulation, to insurance companies. The same economic theories that result in short-term expected loss or value-at- risk constraints for banks, suggest long-term expected loss or value-at-risk measures for insurance companies. In fact, it can be shown that under realistic assumptions about asset markets, short-term risk constraints can increase the long-term risk that the insurance company cannot honour its policies.
Measuring long-term risk is challenging and different assumptions will produce different results. For this reason, it is important that investors, academics, and rating agencies have access to detailed information about the financial position of the insurance company so that all parties involved can make their own calculations and trade-offs. The recent trends related to shadow reinsurance, therefore, seem to be a step in the wrong direction and more transparency would be desirable.
A related question is to what extent shadow insurance should not be allowed in general. For example, the New York State Department of Financial Services has called for a national moratorium on further approval of shadow insurance. The Financial Stability Oversight Council has designated some life insurers as “systemically important” and placed them under Federal Reserve supervision, which could curtail shadow insurance through new reporting and capital requirements.
The consequences of shutting down the shadow insurance system are significant. As the cost of capital for insurance companies would rise, providing insurance becomes more expensive and insurance prices would rise. Our calculations imply that the cost of providing insurance would by 17.7 per cent for the average company. Higher prices mean that some potential customers would stay out of the life insurance market. Consequently, annual life insurance underwritten would fall by $21.4bn from its current level of $91.5bn.
Even though our work focuses on US insurance markets, there are direct links to, and implications for, global insurance markets. Most directly impacted by our findings are foreign insurance companies with US subsidiaries or foreign banks that provide funding to US shadow reinsurers.
The key risk factors that transformed US life insurance markets are also present in other markets. In several continental European countries, such as Germany and Italy, and in Japan, life insurers have sold large amounts of guaranteed investment products. As the balance sheets are not marked to market, it is unclear how large the losses are or what the risk exposures are. The recent Financial Stability Report from the European Insurance and Occupational Pensions Authority (EIOPA) indicates that the low interest rate environment poses a severe challenge for European insurers.
As in the United States, the European market for life reinsurance is large. However, measuring shadow reinsurance transactions is virtually impossible as the data is not made publicly available. Under the 2005 Reinsurance Directive, reinsurance companies can domicile anywhere in the European Union and are allowed to reinsure policies in other countries. For capital and tax reasons, many reinsurance companies are domiciled in Luxembourg and Ireland. It is unclear how Solvency II will address such loopholes.
Discussions in Europe about the discount rates insurance companies can use to discount future liabilities continue. In recent Solvency II proposals, insurance companies can add an adjustment to the risk-free discount rate that increases during bad economic periods as a way to implement regulatory forbearance. Our results imply that this regulation may distort product market pricing in severe ways and, as a result, the equilibrium we have traditionally observed in insurance markets.
The views expressed are those of the authors and not necessarily those of the Federal Reserve Bank of Minneapolis or the Federal Reserve System