Insurance Risks and Capital Markets

It's almost impossible to make a persuasive case that insurance industry companies were responsible for systemic risk in the last financial crisis.  Organizations like the OECD took that position way back in 2009.

Today, perhaps on the argument that regulation is looking forward, certain insurers, like Met Life and Prudential, are being bandied about as "systemically important financial institutions." Size would be the obvious measure to bring these companies under the microscope. Met Life's assets in 2012 were $562 billion, number one in the industry.  Number two was Prudential at $491 billion, both from the ACLI.  But, the business model, management capability, board oversight, and corporate cultures are what drove the bad actors in the last crisis to put the financial system on the brink.  Size, for the insurance business, was neither germane nor predictive.

John Cochrane of Chicago Booth and other scholars have talked about the fundamental importance of "runs" in financial crisis.  We know how banks have runs on deposits.  We now know how runs can create panic selling in asset markets, as they did in the last crisis.  Life insurers, with very long term liabilities, are unlikely to be be affected by policy holder runs, by the insureds demanding payment of cash values all at once. Fees and surrender charges provide insulation and disincentive, respectively.  Life insurance industry policy reserves were $1.3 trillion in 2012, and their share of policy reserves in total has been declining over recent years.  These reserves are built for mortality and longevity issues, not for unlikely or immaterial runs on policies.

What about AIG, though?  It is number four in assets of the life insurers in 2012, with $247 billion.  But, as we know, but sometimes forget, AIG's losses were caused by one, nominally small, unregulated, misunderstood, unmonitored renegade business called AIG Financial Products Group, a capital markets business.

Indeed, going forward, it will once again be the capital markets where the risks will be uncovered, after the fact.  The incentives and pressures for systemic riskiness are created by the continuing, artificial low interest rate environment which now cannot be unwound as quickly as it was put into place.

The low interest rate environment has put pressure on life insurers who have written variable life products with higher guaranteed crediting rates than today's levels.  The risk can be inferred from the composition of industry policy reserves.  Policy reserves for annuity products were $2.9 trillion in 2012, more than double the level for life policies, and 65% of policy reserves.

For pension fund sponsors, particularly in the public sector, enormous pressures are building from mismanagement, poor investment decisions, and mortality and and longevity risks.

Signs of a locus for the next crisis may be seen in some recent capital market and reinsurance market deals.

• In 2011, Rolls Royce transferred some $3 billion in pension fund liabilities to Deutsche Bank, which in turn transferred them to a group of insurers and reinsurers.  RR pays fixed premiums for coverage if an agreed upon longevity index exceeds a cap, in which case RR receives payment from its insurers.
• Aegon hedged its annuity portfolio by transferring 12 billion euros of longevity risk to Deutsche Bank in a swap.  
• Aegon completed a second deal in 2013 through a more complicated structure created by Societe Generale's CIB business. 

If one goes to the current financial disclosures of these companies, it is almost impossible to find much discussion of these new types of businesses and their risks.  While some observers have said that there are only $2-3 billion of U.S. deal volume in mortality and longevity transfers done annually, they also say that worldwide appetite for these structures could be as high as protection for $21 trillion in assets. This kind of deal market would strain the capacities of even the giants like Berkshire Hathaway.

Keep an eye on the capital markets players and these business structures, if you can find them, understand them, measure the risks and track them back to the counter parties.