Thursday, March 12, 2009

The next domino? Insurance firms teeter on the brink

From the Economist:

IF BANKS go bang, life insurance firms sputter. That was the theory going into the crisis. Both hold financial assets, like corporate debt, that have incurred losses, but the nature of insurers’ liabilities should allow them to ride out short-term volatility. Banks depend on nervy depositors and wholesale lenders. Life insurers typically have low gearing, and the policyholders who fund the bulk of their assets are “sticky”, with long-term contracts that incur penalty charges if they are cancelled. As a result regulators and credit-rating agencies promised to avoid knee-jerk reactions to mark-to-market losses. They were further reassured by the shift of insurers in the past decade from equities into supposedly safer credit investments, and their low exposure to the toxic structured-credit assets that blew up many banks.

Yet a year and a half into the financial crisis, this defence looks hollow. America’s life insurers are now under siege, as fears mount about the losses on the non-government debt that forms about three-quarters of their assets. The symptoms are all too familiar: the firms’ share prices have collapsed (see chart), their credit spreads have opened up and the credit-rating agencies have downgraded them. Twelve life firms have applied for emergency capital infusions from the Treasury and are expected to hear back within weeks. In Europe the market reaction has been almost as violent, with firms singled out if they are exposed to America, Britain or the Netherlands (annuity products backed by corporate bonds are common in all three). So far only Aegon, of the Netherlands, has been bailed out, but a number of rating downgrades are now expected, which could push more firms to the brink.

Throughout all this, solvency regulators on both sides of the Atlantic have maintained a monastic calm. But market confidence in their judgments has ebbed. In America, where insurers are supervised on a state-by-state basis, regulators’ smoothed assessments of capital have been dwarfed by losses. Rob Haines, an analyst at CreditSights, a research firm, reckons that the big six life firms had regulatory capital of $43 billion at the end of 2008, but that this calculation excluded $80 billion of unrecognised mark-to-market losses, mainly on corporate bonds.

Likewise Europe’s Insurance Group Directive, which governs capital levels, shows that almost every big firm enjoys a capital surplus. But in most continental countries this test excludes unrealised losses. British firms boast that their regulatory capital is marked to market, but in at least some cases they are engaging in the curious practise of tweaking their liabilities downward to compensate for losses on assets. Matthew Lilley, an analyst at Nomura, quips that at least with banks investors are prepared to trust one side of the balance-sheet.

Will insurers suffer banks’ fate? A chunk of mark-to-market losses reflect illiquidity discounts on fairly high-quality bonds, which could unwind if markets normalise. But time is running out. Some American firms have reached a level of distress that will prompt customers to withdraw their business, whatever the penalties. And insurers do need to refinance some borrowings: $13 billion over the next four years for the big six American life firms, and $29 billion for the top 13 European insurers by assets. That will be difficult if solvency worries persist. The obvious solution is to raise more equity, but this is probably impossible given investors’ mistrust of insurance firms’ accounts, which can combine mind-numbing detail with mind-boggling sleights of hand.

All of which suggests that, faced with a gradual atrophying of their operations, many firms, particularly in America, are relying on a benevolent government to pump in cheap equity capital. Yet when it comes to bail-outs insurers differ from banks in another important respect: they are less important to the system. Their very lack of short-term depositors and wholesale counterparties means it should be possible to restructure insurers’ balance-sheets without causing a wider financial scare. That makes it more likely that the price of state support for zombie companies will be that bondholders take write-downs along with shareholders, in order to protect taxpayers and policy holders. Insurance firms may not go bang, but a few do look in real danger of going bust.

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