A federal financial system risk tracking unit talks a little about life insurers and a lot about COVID-19 in its new annual report to Congress.
Dino Falaschetti, director of the Office of Financial Research — an arm of the U.S. Treasury Department — writes in the report that the COVID-19 pandemic is an example of why the country needs the Office of Financial Research.
“This year’s report is unique in that it was written in the wake of a material threat to financial stability,” Falaschetti writes. “Economic indicators on the eve of the global pandemic showed little if any concern about a slowdown, let alone a sharp but short economic contraction.”
But the pandemic, and the response to the pandemic, caused the U.S. unemployment rate to spike to 14.7% in April, from 3.5% in February, Falaschetti writes.
- A copy of Office of Financial Research 2020 Annual Report to Congress is available here.
- An article about the 1918 influenza pandemic is available here.
“Our office plays a complementary role in supporting financial stability, which is always important, and especially so during the natural disaster triggered by COVID-19,” Falaschetti states.
Office analysts refer directly to life insurers in the report only briefly, in discussions of the state of the commercial real estate market, leverage in the financial markets, and insolvency risk.
Commercial Real Estate
In discussing commercial real estate, the analysts suggest that life insurers may be in a relatively safe position.
They note that life insurers invest directly in commercial real estate and also invest in commercial mortgage-backed securities.
Insurers have extensive experience with commercial real estate market and tend to have conservative holdings. They have relatively low levels of exposure to hotels and retail properties, which are now suffering due to COVID-19-related social distancing efforts, the report states.
But life insurers tended to see hotels and retail properties as being high-risk properties even before the pandemic started, the analysts say.
“Insurers have benefited from relatively favorable credit performance on their [commercial real estate] lending in past stress periods,” the analysts write. “This will likely be the case for the current credit cycle.”
In another section discussing leverage in the financial system, the Office of Financial Research analysts say that leverage, or use of debt, can increase a company’s returns but can also increase losses.
Life insurers have higher leverage ratios than other types of insurers, but they also began 2020 with healthy levels of capital, the analysts write.
“Generally, these capital cushions serve as buffers against unexpected insurance underwriting losses, investment impairments, or other adverse developments,” the analysts write. “Bond rating downgrades and defaults would strain insurers’ investment portfolios and lead to higher required capital charges. Life insurers’ investment and credit risk account for more than half of their total required capital.”
But leverage for each of the insurance sectors remains fairly consistent over time, and the current level is lower than those leading up to the “Great Recession” financial crisis that hit in 2007, the analysts say.
The Office of Financial Research analysts later refer directly to life insurers in a section on whether financial services firms might fail and the effects of a significant failure.
The analysts state that low interest rates are hurting U.S. life insurers by narrowing the spread between what the insurers earn on their own investments and the rates they pay holders of interest-sensitive life insurance policies and annuity contracts.
Rates had been rising gradually, but they fell sharply earlier this year, as central bankers around the world tried to use low rates to nurse the economy through the pandemic.
“A sustained period of lower interest rates exacerbates the narrowing of this spread between the amount of money the company can earn on investments and the crediting rate on insurance policies,” the analysts write.
“Insurers have tried several ways to enhance investment yields,” the analysts say. “These include extending the maturities of their investments and taking on more credit risk. They have also increased investments in less liquid and sometimes more complex securities. These include private placements, mortgage loans, and alternative investments. Insurers, particularly life insurers, have also used securities lending and repurchase agreements, funding agreement-backed securities, and Federal Home Loan Bank borrowing to earn spread income that enhances their portfolio yields.”
Office of Financial Research analysts also provide some clues about what they’re worrying about in the glossary at the end of the annual report. In 2019, for example, the analysts added “pension risk transfer.”
This year, they added the word “pandemic.”
— Read Treasury’s Little Insurance Meltdown Glossary, on ThinkAdvisor.