When fast-rising interest rates and worries about liquidity caused Silicon Valley Bank to fail last month, it set off a mini crisis in the banking sector. Life insurance companies could be the next group facing liquidity problems that jeopardize their financial health, although to a lesser extent, according to a new report by Barings.
Insurers have faced liquidity problems in the past for a variety of reasons: poor product management, such as writing policies that allowed large-scale, immediate policyholder cash-outs; inadequate liquidity in investment portfolios to fund redemptions; and poorly anticipated disintermediation risk due to changing economic conditions.
Better planning and stress testing could have saved most or all of the insurers that faced insolvency in the past, according to Barings. Now the asset manager is waiting to see whether those things will save life insurers this year.
The events of 2022 — high and unanticipated inflation, a sharp spike in interest rates, and steep declines in the prices of stocks and bonds — caused “a significant decline in asset values for all insurers, leading to grievous unrealized losses in their investment portfolios,” according to Barings.
Like banks, insurers use statutory book-value accounting so declines in their investment portfolios’ market value are harmless until they are realized. However, when gains and losses must be realized, they must run through an insurer’s interest maintenance reserve, or IMR, which regulation requires to be positive to act as a buffer. Regardless of how well assets are managed against liability needs, large amounts of realized losses will eventually begin to degrade surplus positions. (Property and casualty insurance companies don’t have this requirement.)
“The unnatural effect of this makes insurers reluctant to trade their portfolio, either for repositioning to improve credit risk management or to accommodate policyholders demanding cash for their policies. These forces create additional liquidity strains for insurers, where a record 26 percent of life insurers were in a negative IMR position as of year-end 2022,” Barings said.
The value of their assets isn’t the only challenge some life insurers might face. Many could be facing “uncharted lapse territory” in a recession.
There are always policyholders who stop paying their premiums under diverse economic conditions, but insurers can only make “educated estimates” about lapse rates for new products because they don’t have a historical track record, Barings says. Some index-linked equity products (policies that provide upside appreciation as equity markets rise as well as a downside floor to protect against market corrections) have become popular but not been around through many market cycles. Even products with long histories, such as deferred annuities, may lack lapse data gathered during a period of sustained higher interest rates, according to Barings.
Policyholders tend to stop paying when they can get something better from another insurer, as well as higher returns on bank deposits or other investments. “This creates a greater degree of uncertainty around the level of liquidity needed by insurers,” the Barings report said.
If policyholders were worried about an insurance company’s liquidity, a wave of them could suddenly withdraw their assets and create a liquidity problem similar to a run on a bank, Ken Griffin, head of insurance solutions at Barings, said. But that hasn’t happened to a life insurance company, partly because it has much longer-dated liabilities than a bank, he said. Instead of checking account deposits, life insurers have annuities and other products with penalties for cancelling.
More insurance companies are also using interest rate futures, bond forwards, receiver swaps, and other derivatives to protect against adverse market moves. But those strategies don’t have to go totally sideways to create a liquidity problem. A surge in volatility could force investors to make unexpected capital calls, like U.K. pension funds using liability-driven investing had to last year.
“Dynamic hedging platforms, which require frequent rebalancing to hedge gamma, or convexity risk, can cause additional realized losses, exacerbating the negative IMR restriction and straining capital even though this is a prudent risk management approach,” Barings said.
Risk management is more important than ever, according to the asset manager. “Insurers are currently in the throes of simultaneous liquidity stresses on the asset and liability sides of their balance sheet. They also must consider the prospect of even higher interest rates and lower equity returns in 2023 than those experienced in 2022.”
For years, life insurers wanted interest rates to be higher so that their business margins, and credit spreads, would widen. Griffin said the joke everyone tells is, “Hey, we’d really like rates to be higher — but just not all at once.”
Some life insurers could face worrisome challenges, but Griffin isn’t alarmed. There are ways that they can get liquidity if they need it. The Federal Home Loan Bank system can give cash advances to member insurers that hold investments that support housing finance and community investment. Insurers can also start allocating more money to cash, although most insurance CIOs say they are investing more in illiquid assets.
Insurers can also use the premiums from new sales to meet cash demands, although Barings advised against that.
“This approach of underwriting new business to pay for old concerns is fraught with peril as new business is sold with an assumption of new investment at today’s higher interest rates. Not actually investing at these high rates as cash from new premiums is spent elsewhere may only hurt future profitability and extend solvency concerns to a later date,” the report said.
