Regulators Raise Issue Of Early Warning Liquidity Signals

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Regulators are discussing possible weak points in insurers’ liquidity profiles as well as potential ways to make sure that there are early warning signals of any stress that lack of liquidity might cause.

During a recent discussion, regulators raised the possibility of such things occurring as an uptick in corporate bond defaults or another disaster like the World Trade Center attack and what the ramifications of these events would be.

“We need to understand an insurer’s concentration of risk,” said Larry Gorski, chief actuary with the Illinois insurance department, during a discussion among regulators conducted by the National Association of Insurance Commissioners.

Investments, reinsurance programs, and the smooth running of systems such as the settlement of bond agreements are all potential sources of liquidity risk, said Gorski and other regulators.

If corporate bond defaults increase, regulators might need to take more of a look at that area, he said.

Insurers hold sizable bond investments, according to the 2000 ACLI Life Insurers Fact Book. The American Council of Life Insurers in Washington says corporate debt represented 39% of life insurers’ assets in 1999.

To date, Gorski says he has not seen an uptick in insurers investing in junk bonds. He adds that one area regulators will need to watch is investments in collateralized debt obligations, which are fixed income securities that have cash flows linked to underlying debt collateral.

Rating agencies are aware of the potential problem.

Patrick Finnegan, a senior vice president with Moody’s Investors Service in New York says that although default risk has risen as a result of the Sept. 11 events, it is more of a disruption than a long-term threat. If a company is impacted and there is downgrade, it will probably not be more than a notch, he adds.

Collateralized debt obligations are an area of weakness that will need to be watched more closely, Finnegan says. And any increase in liquidity risk is at least in part the result of a change in insurers’ liabilities resulting from the kinds of contracts that they offer.

For instance, insurers that sell variable annuities or mutual funds may need to be more liquid to be ready for any possible increase in redemptions. Companies offering institutional products such as guaranteed funding agreements may also need to be more liquid, he adds.

At Fitch, John Bareiss, an analyst in the Chicago office, says that an analysis is currently being undertaken.

If insurers’ have a “heavy concentration in the wrong business, then they could be whacked” says Bareiss. For example, a heavy concentration in aircraft loans or mortgage loans on hotel properties could be a concern, he explains.

Bareiss says that private placement debt, while less liquid, does have the advantage of covenants the issuer is bound to follow.

Alexandra Berthault, an analyst with Moody’s Investors Service in New York, says the rating agency is forecasting a 10% default rate for speculative grade bond securities at year-end 2001.

In 2000, according to a report that Berthault co-authored, a total of 167 issuers defaulted on $49.1 billion.

Total bonds defaulted, according to Moody’s, were estimated to be approximately $5.5 billion last month. In August, the total was roughly $8 billion, a Moody’s report indicated.

It is not only the possibility of bond defaults, but also how a calamity such as the World Trade Center disaster on September 11 could impact processes such as bond settlements, that Gorski says regulators should be examining.

During his discussion with other regulators, Gorski said that one insurer was affected in two ways by the events of Sept. 11. The drop in the stock market made it necessary for the insurer to raise cash to meet margin calls. Margin calls are calls from a broker requiring additional cash or securities to cover required funding levels in a customer’s securities account.

But sales of bonds were delayed because systems were down as a result of the World Trade Center disaster, he added. Instead of the normal three-day settlement period, the settlement period was five days, according to Gorski. The company had enough cash to cover the margin call, but if the market drop had been more severe, that might not have been the case, he cautioned.

Thomas McMeekin, a newly appointed principal with Prudential Investment Management Company, Prudential Financial’s institutional asset management division, and Al Trank, senior vice president with the group, say that because of covenants, private placement debt investments can offer an insurer both return and safety. Historically, according to Trank, loss rates are nearly identical with public bonds.

Covenants, according to McMeekin, offer an insurer warning signs that would not be evident with public debt.

McMeekin says the recovery rate for private placement defaults over the past decade is 79% compared with a rate in the 40% range for public debt.


Reproduced from National Underwriter Life & Health/Financial Services Edition, October 15, 2001. Copyright 2001 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.


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