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Fed Worries About Life Insurers' Leverage

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The Federal Reserve Board is worried enough about the health of life insurers to include them in the financial stability section of its new monetary policy report.

Federal Reserve Board Jerome Powell is briefing congressional committees on the report this week.

The Fed started off the report by emphasizing the impact of the COVID-19 outbreak.

“The COVID-19 outbreak is causing tremendous human and economic hardship across the United States and around the world,” the Fed says in the report summary.

Resources

  • A link to a House hearing on the Fed’s Semiannual Monetary Policy Report, which includes a link to a copy of the report, is available here.
  • An article about how the Fed chief sees the economy is available here.

Because of the strain, the Fed has taken unprecedented measures to keep the market moving, including setting up mechanism for pumping cash into the economy, the Fed says.

In a section of the report on “Developments Related to Financial Stability,” the Fed says that, in some ways, changes made in the wake of the 2007-2009 Great Recession have increased financial system resilience.

But ”financial system vulnerabilities — most notably those associated with liquidity and maturity transformation in the nonbank financial sector — have amplified some of the economic effects of the pandemic,” the Fed says. “Accordingly, financial-sector vulnerabilities are expected to be significant in the near term.”

“Maturity transformation” is the process of borrowing money at low, short-term interest rates and making a profit by lending the money out for long-term loans at higher rates. The reference to “maturity transformation” in the Fed report appears to refer mainly to banks, not to life insurers, because life insurers generally try to match the duration of their assets to the duration of their liabilities.

Life insurers usually have large holdings of cash and other liquid assets, but they may have derivatives arrangements or other financial arrangements set up in such a way that they must provide large amounts of cash collateral quickly when conditions change rapidly. That means it’s possible that the Fed’s reference to “liquidity” could, possibly relate to life insurers.

Later in the financial stability section, the Fed refers specifically to leverage — or ratios of debt to assets — at life insurers.

“Leverage at life insurance companies has reached post-2008 highs,” the Fed says. “Moreover, the capitalization of the life insurance sector is likely to deteriorate in coming quarters because of lower-than-expected asset valuations and lower long-term interest rates.”

The Fed does not assess the possible impact of its own actions to hold down interest rates and increase investment market liquidity on life insurance company capitalization levels.

Life insurers do invest heavily in corporate bonds.

The Fed says cash outflows at money market funds and bond mutual funds in March led to “severe strains in markets funded by these institutions — notably, commercial paper (CP) and corporate bond markets. The tensions began to ease only after the Federal Reserve took several actions targeted at these markets.”

The action with the most direct effect on life insurers is the Fed’s creation of the Secondary Market Corporate Credit Facility. The SMCCF buys corporate bonds that are already out in the market. Life insurers hold trillions of dollars of bonds that are already on the market.

The Fed says in its report that some observers have concerns about the emergency programs.

“The Federal Reserve is deeply committed to transparency and recognizes the need for transparency is heightened when it is called upon to use its emergency powers,” the Fed says. “Transparency helps promote the accountability of the Federal Reserve to the Congress and the public. For the few programs that are targeting financial market functioning, the Federal Reserve will provide a full accounting of transactions in these facilities. Real-time disclosure would risk stigmatizing participation in these facilities and undermining the Federal Reserve’s ability to provide assurance that these systemically important markets will continue their critical function in times of severe market stress. The delay in disclosure will be no longer than necessary to ensure that participants do not hesitate to participate. While the facilities are operating, the Federal Reserve will disclose extensive and regular aggregate information on total borrowing, collateral and fees, and interest income.”

— Read Uncle Sam’s SMCCF May Be Life Insurer CFOs’ New Friend: Moody’s Analystson ThinkAdvisor.

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