Frightened piggy bank (Image: Thinkstock)

Some life insurers’ deals with big, institutional clients could lead to sudden, dangerous demands for enormous amounts of cash, according to three economists at the Federal Reserve Board.

Nathan Foley-Fisher and two colleagues write, in an informal article published on the Fed website in May, that those life insurers could face spikes in demand for cash  that would amount to deadly “runs on the insurance company.”

“A life insurer’s asset holdings are a potentially misleading benchmark for the magnitude of their nontraditional liabilities,” the economists write. “We argue that a benchmark for the size of a life insurer’s nontraditional liabilities should be based on the cash flows of that insurer.”

(Related: 5 Ways Life and Annuity Issuers Could Break)

In a serious crisis, the economists write, institutional clients’ demands for cash could be so much bigger than a life insurer’s usual net cash-flow fluctuations that the insurer would have no practical way to come up with the required cash, even if, on paper, the insurer’s assets appeared to be much bigger than the institutional clients’ demands for cash.

Because of the way life insurers’ assets are invested, “dividing a life insurer’s nontraditional liabilities by its asset holdings is a potentially misleading benchmark for assessing the run risk,” the economists write.

Life Insurers vs. the Banks

Traditionally, life insurance sector executives and regulators have criticized bank regulators for over-emphasizing the possible risk of runs on life insurers.

Banks take in large amounts of cash, lend most of the cash out, and offer savers savings accounts and checking accounts that are supposed to provide instant access to cash. Banks face the risk that many customers could run in all at once and ask to empty out their checking accounts and savings accounts.

Life insurers, in contrast, create huge reserves, and they sell life insurance policies and annuity contracts that provide only limited access to the underlying cash value. Even when customers can cash out life insurance policies or surrender annuities, life insurers may have contract provisions and administrative procedures they can use to keep cash from rushing out the door.

Foley-Fisher and his colleagues write in the new article that many life insurers now have more “runnable liabilities,” because they are providing institutional customers with “wholesale funding instruments,” such as institutional funding agreements and securities lending arrangements.

Measuring the ‘Nontraditional Liabilities’

Life insurers have argued that their assets dwarf the size of their wholesale funding instrument liabilities.

“The assumption behind these assessments is that life insurers can easily sell parts of their enormous asset portfolios in the event of a run,” the economists write. “However, many of those assets are tied to the insurers’ traditional insurance liabilities and therefore cannot be sold for actuarial and/or regulatory reasons.”

During the 2007-2009 Great Recession, for example, one life insurer needed government help even though its securities lending program liabilities amounted to only about 6% of life company assets, and another needed help even though nontraditional liability obligations amounted to less than 1% of its assets, the economists write.

The economists contend that observers should estimate how big a sudden demand for cash would hit a life insurer by looking at how much the company’s new cash flow typically changes from quarter-to-quarter, rather the company’s assets.

Fourteen U.S. life insurers with nontraditional liabilities seem to have runnable traditional liabilities that are about 6.8 times the size of their usual quarter-to-quarter net cash-flow fluctuations, the economists write.

During the Great Recession, when a large insurer faced institutional program cash withdrawals equal to about seven times the company’s usual net cash-flow fluctuations, that company faced serious problems, the economists write.

“The data suggest that a run on some life insurers’ nontraditional liabilities would be equivalent to a very large adverse cash flow shock,” the economists write.

Resources

A copy of the Fed economists’ nontraditional liabilities article is available here.

— Read Geithner To Ask For More Powers, on ThinkAdvisor.

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