The events in financial markets over the last year, and in particular the past few months, are a stark reminder that insurance enterprises have exposures well beyond the risks assumed from their insurance policies. The credit crisis, which initially began with an increase in the incidence of defaults on U.S. subprime mortgages, has quickly extended to every corner of the global financial market and resulted in a dramatic change in the competitive dynamics of the financial services sector.
At this critical juncture, insurance company management needs to protect the organization’s assets and capital base, maintain liquidity, and mitigate the exposures to losses that may be developing. These and other actions should be taken to protect ratings and to maintain the confidence of customers and distributors.
The business model for insurance enterprises is not likely to fundamentally change. However, a number of the implications of the current crisis are apparent.
The Impact from Equity and Fixed Income Markets
In a persistent equity market downturn, life insurers will likely experience a sales decline in equity-based products. Depressed equity markets result in reduced fees, increased guarantee values and diminished variable annuity/variable life earnings. Volatile equity markets have driven hedging costs higher, further reducing profitability. Products without guarantees may suffer a noticeable decline in cash inflows.
Additionally, products with guaranteed interest rates will need to be evaluated to determine how the current environment impacts the organization’s obligations. Moreover, the regulatory pressures that emanated from the banking sector will renew insurance regulators’ focus on product suitability and disclosure issues related to customer offerings.
Clearly, all types of insurance organizations have significant exposure to the debt and equity markets in their investment portfolios. Unrealized losses will further weaken balance sheets and Other Than Temporary Impairment (OTTI) changes will depress year-over-year earnings. As the profitability of certain lines of business is evaluated, management will need to consider whether its deferred acquisition cost asset is impaired.
Securities Lending Programs
Securities lending programs have historically been an avenue for insurance and other organizations to earn additional income from their investment portfolios. In these transactions the insurance organization may have the right to use the collateral provided by the borrowing entity and invest the funds in other securities. However, insurance organizations should be mindful that the collateral is typically short term in nature. Investing collateral in illiquid or less liquid positions can result in a duration mismatch when the collateral is required to be returned.
Insurance securitizations might be viewed as the industry’s version of packaged mortgage-backed securities. In the short term, the constriction of credit markets is eliminating the ability to execute these transactions. Heavy users of securitizations and off-balance sheet corporate vehicles to manage capital needs will come under greater scrutiny as investors evaluate these structures and the magnitude of such risk transfers. This is critically important for life insurance companies with significant XXX and AXXX exposures where bank letters of credit are becoming extremely scarce and expensive.
Global Regulatory Coordination
Insurance regulators worldwide are expressing concern about how multiple national regulators will manage the meltdown of a global institution. Without clear protocols for regulatory coordination, local regulators may reflexively strengthen their claims on local resources, dramatically reducing the benefits of geographic risk diversification and increasing consolidated capital requirements.
Available capital will be adversely affected by investment portfolio devaluations and impairment charges, increased life and annuity product guarantee values and weaker business volume. As regulators and rating agencies reevaluate capital issues, it is likely that requirements will increase. Upward pressure will come from mounting credit risk provisions and requirements for structured products, mortgage-backed securities and equities. Additional capital will be needed to cover reinsurance risks and provide protection from exposure to credit and liquidity risks.