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Old 04-18-2009, 05:55 AM   #1
OffShore Man
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The Coming Insurance Industry Crisis?

FWIW: The Insurance etfs are KIE,PIC,IAK. I post that because I only knew of KIE.

Bridgewater Daily Observations

The Coming Insurance Industry Crisis

It seems to us that the insurance industry, especially the whole life part of it, is headed for a bigger crisis than even those close to it and policy makers in Washington now recognize. Contrary to what is generally believed, the problems that we expect can have meaningful, direct adverse effects on the cash flows to insurance companies, their clients and to those they provide capital to (e.g., insurance companies own nearly half of all US corporate bonds). Additionally, because we think that the extensiveness and implications of what we expect will come as a surprise to policy makers in Washington, and because there is no regulator in Washington that is responsible for the insurance industry (because it is state regulated), we are concerned that this problem, coming on top of other problems, could be difficult to handle well and promptly. Given these views we are keeping defensive in ways that one might imagine.

Anyone who pays attention to such things knows that the insurance sector in the US has already suffered a tremendous amount of damage in the capital markets because of the assets they hold. So, to some extent, these problems have been reflected in their pricing – e.g., insurance stocks have fallen sharply and yields on insurance company debt are greater than similarly rated corporate bonds. However, we don’t believe that the picture is yet fully discounted and, even if just the discounted picture materializes, it will have big, bad implications that are not well recognized. So, in a nutshell, we think the insurance industry now is essentially where the banking industry was 12 months ago, meaning that problems are widely recognized and prices reflect these perceptions, but that the future will get much worse than is recognized and that is discounted in pricing.

It seems to us that the problems now facing insurers are in some ways even more worrisome than those facing commercial and investment banks, yet they haven’t triggered big concerns about their systemic repercussions for two reasons – 1) their assets are not marked to market; instead they are carried on their balance sheets on an amortized cost basis and 2) due to the perceived sticky nature of insurance company liabilities, it is assumed that there could not be the equivalent of a “run on the bank.” It is widely believed that both of these structural characteristics insulate insurance companies from short term market fluctuations and minimize the potential systemic repercussions that they can cause. However, not marking assets to market leads to problems that are just different, not less, than those that arise from mark to market accounting – e.g., not marking them to market has allowed these problems to go undetected so they have grown bigger than they otherwise would have been. For example, if there was mark to market accounting in the insurance business, we would have already seen a) many of the insurance companies who have problems that aren’t being addressed even today having instead failed or raised capital, b) that the losses would have been contained at smaller levels and c) more developed plans in place for dealing with this situation. Another aspect of the insurance industry’s problems that is worse than the commercial banks’ problems is that the oversight and funding sources for insurance companies are less clear – i.e., unlike commercial banks, which have rather clear and centralized regulatory authorities in Washington (so they have known paths for creating semi-cohesive decision making and for obtaining capital), the insurance companies don’t have these things because they are overseen by state regulators who all have different points of view, different levels of skill and no clear access to money.

The current state of insurance company capital as we see it

The National Association of Insurance Companies (The NAIC) provides a risk based capital (RBC) methodology to state insurance regulators nationwide. The state insurance regulators then apply the recommended RBC guidelines to each of the member insurers they regulate. Generally, there is an agreed upon adherence to the NAIC governed RBC framework, but the state regulators do have some amount of latitude when determining statutory capital for each insurance company. RBC metrics are primarily driven by a ratings-based methodology applied to the investment portfolio of each insurer. AAA assets receive a certain capital allocation, AA assets a greater capital allocation, and so forth. Generally speaking, a life insurance company in good standing with its regulator and with Moody’s and S&P, given a typical portfolio of assets, can run approximately 10:1 leverage.
The way we see this crisis transpiring is that rating agencies will make their long awaited announcements of large scale ratings downgrades and negative reviews on structured products and corporate bonds, and that this will automatically put the capital ratios of insurance companies under pressure. As we describe above, RBC methodology is more or less ratings dependent.
Insurance companies are heavily exposed to rating changes. For example, over 1/3 of investment portfolios are in structured products and corporate bonds rated below A. We can see the pressures that this will likely create by looking at a table of the RBC ratings scale for capital. A bond downgraded from BBB to BB will result in capital costs being raised from 1.0% of amortized cost (i.e. book value) to 4.6%, while a reduction down to CCC would result in the capital charge being raised to 10.0%.

In order to figure out what this ratings impact would be on the capital position of the industry as a whole, we put together what we felt was a reasonable estimation of downgrades that are in the works and ran it through the RBC capital calculation methodology.

Applying the above assumptions to current company holdings, we estimate that downgrades alone (NOT any actual realized losses), would cause the regulatory capital requirements imposed on the industry by the NAIC to increase by 30%, or approximately $59B.

It seems to us that raising new capital will be very difficult in the current environment. If the insurance companies fail to raise capital, they can either sell assets or essentially do nothing and wait for the rating agencies to take action. We would think that selling assets, which are going to be marked below the carried cost on their books, will be quite difficult for the insurers. Realizing losses that they sincerely hope are temporary is not something that they would like to do, nor will they necessarily have the capital to do it. This will likely result in rating agency downgrades or at least some noise from the rating agencies that will in turn begin to attract more attention to the state of the insurance industry. State regulators are relatively powerless to assist in this matter as they can offer dispensation from raising additional capital to meet RBC requirements, but can offer no direct capital to keep the rating agencies from taking action against the insurance companies.

Commercial real estate loans (not in securitized form) will also adversely pressure insurance companies’ capital requirements. The life insurance industry is a large provider of credit to the commercial real estate industry in the form of raw loans, with approximately 10% of all life insurance investments in direct commercial real estate mortgage loans. While CMBS is allocated capital through the RBC bond rating approach, direct loans are allocated RBC in a different fashion. As losses or expected losses occur in commercial real estate, the capital charge on the mortgage loans increases via something known as the mortgage experience adjustment factor (MEAF). This is another complex capital methodology utilized by the insurance sector. Suffice to say that while the exact formula is arcane, the direction of the increase in capital charges is not. According to analysts we spoke with, a minor decrease in CRE performance will cause capital ratios to increase rather substantially. We don’t understand all the specifics, but it must be important because insurance companies have already petitioned the NAIC, and in some cases their state regulators, for relief from commercial real estate capital charges. The regulators have thus far denied this request. However, this is again a topic that can cause bad publicity and rating agency reviews whether regulators take action or not.

Losses and Impairments

So far, we have only looked at capital issues related to ratings actions. We also wanted to figure out what impact actual losses might have on insurance companies’ capital. As we mentioned, insurance companies account for nearly all of their assets on an accrual basis, which means that they carry assets on their books at amortized cost. They do, however, report the mark-to-market (MTM) of their portfolios. MTM losses do not result in a hit to capital as losses are supposed to reflect a “temporary market impairment” and not a permanent asset impairment (the argument being that since the asset is held to maturity the MTM losses will be recovered over time). Currently, reported temporary impairments are equal to about 15% of total assets. Given that insurance companies are levered about 10:1, if this MTM is realized, the entire capital of the industry would be wiped out and then some (this is also the reason that it would be difficult for insurers to sell assets to make up for the increase in regulatory capital requirements due to downgrades.) To figure what may occur, we ran our loss estimates of individual asset classes against insurance company holdings representing 50% of the life insurance industry. Our calculation suggests that even the 15% “temporarily impaired” calculations made by the insurers themselves may understate cumulative portfolio losses. An examination of actual balance sheet assets suggests that insurers are still undermarking certain securities and ignoring implied market pricing on less liquid assets like direct commercial real estate loans and certain structured products. The net result of our analysis is that life insurance industry company losses are in the vicinity of 20% of total assets, while the total amount of capital for the industry is only equal to approximately 10% of total assets. The table below shows our estimates by company.

Insurance Companies are on the hook for guaranteed return products linked to stock market performance

Now that we have covered some of the risks from insurers’ investment portfolios that we think are fairly visible, we also tried to understand what the potential hits are on guaranteed return products like variable annuities. These popular insurance company products offer policy holders the greater of: a given minimum accrual rate (i.e., a guaranteed return) or the appreciation of the stock market (typically the S&P 500). In order to hedge this product, insurers typically put on a combination of some version of a stock market replication strategy and some amount of fixed income duration (since they cannot hedge perfectly in the derivatives market due to tenor issues). When markets have massive movements like the recent drop in the S&P 500, it is very hard for the insurance companies to dynamically hedge, and as a result, large unrealized losses can result. As these hedging programs are opaque and complex, it is difficult to concretely assess the potential magnitude of losses. Nonetheless, industry wide writedowns on variable annuity hedging have already been several billion dollars and are likely to grow significantly given recent equity market performance.

Liquidity concerns even at insurance companies

The combination of factors which we just described above (i.e., ratings downgrades of insurance companies, the posting of real losses on investment assets, and the potential time bomb of guaranteed products) will likely bring a lot of unwanted attention to the weakness of insurance companies. Although this all sounds bad, most insurance analysts and experts don’t think those factors alone would actually cause individual policy holders to redeem their policies in mass, causing a liquidity problem for insurers. However, other economic developments which we are now seeing could have an impact on insurance companies’ liquidity. Unemployment rates continue to rise and other sources of consumer credit are drying up. History suggests that under these types of circumstances whole-life policy holders will draw on the cash value of their life insurance policies. This can happen in one of two ways. The policy holder can either draw a loan against the cash value of their policy, or they can surrender the policy for accrued cash value. In either case, the life insurance company will need to raise liquidity to fund the loan or redeem the policy. Putting numbers against this, current Federal Reserve data indicates that as of September 2008, the amount of current loans drawn against insurance policies in force was $117.2 billion, or 3.7% of par general account assets. During the early 1980s, policy lending reached a level of 9.3%, while during the Great Depression policy lending reached a record 15.2%. Policy surrenders can also reach very high levels; during the 1980s the cyclical high in policy surrenders was 12.3% (compared to 6.7% in 2007). Using the 1980s experience as a guide, it is likely that the life insurance industry will have liquidity needs approaching $500B during the next couple of years to meet policy holder demands. If we go through an environment like the Great Depression the liquidity needs could be $800B or more.

The industry’s September 2008 cash and liquid assets position totaled $450B. So, if we stay in the range of 1980s cash demands, the insurance companies on an aggregate basis should be able to just barely handle policy holder needs. However, liquidity capacity varies widely on a company-by-company basis, so some companies could certainly be left without sufficient cash. Further, a 1980s-like liquidity demand would almost completely evaporate the aggregate industry’s cash buffer, leaving insurers vulnerable if the insured surrender policies or seek advances in greater numbers. Additionally, several insurance companies, notably Genworth, Prudential, and Lincoln National have lost access to the traditional short term funding market (including the Fed’s commercial paper funding facility program) due to company downgrades, thus removing a key source of alternate funding.

What will the Government and regulators do and how?

It is fairly clear that the life insurance industry has a capital problem and potentially a liquidity one as well. How do we think this may play out? As we have mentioned already, there is no national regulator in Washington to deal with the insurance industry. It seems to us that it will be difficult for anyone to deal with this situation at a national level until it reaches a critical juncture that the NAIC and state regulators are not equipped to handle. The first step is probably a hope trade on the part of the NAIC and state regulators. They can relax capital standards on an ad hoc or wholesale basis and hope that the industry possesses the capacity to earn its way out. We have already seen this with capital relief granted to Lincoln National and The Hartford. Unfortunately, this will likely not be enough as publicity from rating agency downgrades and real losses put too much pressure on the insurance companies. If things continue to spiral downward, at some point the Treasury or Fed will likely try to find a way to get capital to this industry. In fact several of the insurance companies have purchased banks or incorporated as thrifts in the hope of getting access to some TARP or CAP money. Nothing has yet been announced and that may be because there is no regulator in Washington to ponder this.
If no capital is forthcoming and insurance companies continue down this path that we think they will, the state regulators will probably be forced to try and do something. Each state has an insurance guarantee fund, which is set up to cover insurance company losses and ensure that policy holders that reside in their state are made whole. However, these state guarantee funds are not set up to handle the failure of one or more major insurance companies. The total capital in the entire 50 state guarantee funds is only $8 billion and in the last 25 years only $21 billion of policies have been processed through guarantee funds. We have seen how state regulators are currently dealing with the monolines and see this as a study of what may transpire. There is a lot of stalling and hope that someone else will deal with the problem. This may be all that can be done until someone in Washington decides insurance companies are systemically important.

We think that the life insurance industry is in a very precarious position. They have been a bit better insulated from the crisis than the banks up to this point due to their slightly lower leverage ratios, accrual accounting and sticky liability structure. However, as the economic downturn continues, the pressures on capital and liquidity will increase. It does not appear that some of the big insurance companies possess enough capital to weather the storm. Problems at these companies can have important knock-on effects. The implications of the problems with insurance companies on economy-wide credit creation are immense. Insurance companies direct lending (either via mortgages or corporate bonds) is equal to $3 trillion, which is equal to more than half of the direct lending done at commercial banks.

So, we think that it is likely that there will be a negative surprise coming from the insurance industry and, because it will come as a surprise, it will be more challenging to deal with. This adds to our defensiveness in the markets.

Other Industrialized Countries

Canadian Growth

Canadian growth has collapsed in the last few months. This is evident from every major stat, including retail sales, housing starts, production, exports, and employment. The Canadian economy is obviously very tied to the U.S. economy so there was no question it would be hit hard as the U.S. economy contracted. The drop in commodity prices doesn’t help either. But Canada is another example of a country that had seen a more modest increase in debt levels and had a healthier banking system going into the global credit crisis. But even countries without the direct exposure to the U.S. or commodities (such as Germany) are facing a huge drop in external demand. Countries that experienced the debt boom, countries that lend money to those countries, and countries that sold goods to the over-consuming countries all appear at least in the short-term to be facing contractions that are much more significant than typical cyclical exposures. For Canada the effects have been clearer since November, but the pattern is the same. At this point the Canadian economy doesn’t appear to be much better off than the U.S. economy, although having healthier banks and less debt will be helpful in the longer-term. The charts below scan the major stats. We show both monthly changes and annual changes. The recent monthly changes show a very bleak picture. We start off with retail sales (which to some extent are over-stated because of commodity price declines).

The annual figures and even the recent GDP numbers understate the degree and breadth of the contraction in economic activity since November. In the medium to long-term the Canadian economy will be better for having less of a housing problem and a healthier banking system. But the recent growth numbers actually look worse than what is being experienced in the U.S.
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