Insurance Companies Line Up for Treasury Bailout

One of the big stories on Friday and Saturday was the expansion of the Treasury recapitalization program to insurance companies. The Washington Post is acting as if it’s a done deal, while the Times and the Journal said only that it was being considered.

Insurance is one of the industries I know pretty well, as my company made software exclusively for property and casualty insurers, and I must admit I didn’t expect the crisis to show up in insurance so quickly.

To date, the crisis has mainly hit companies that lend long and borrow short – banks, and financial institutions that behave like banks – who found it difficult to roll over their short-term liabilities. Insurance companies have virtually no short-term debt, because they have a continuous stream of cash flowing in from the premiums their customers pay every month. Most of the “liabilities” on an insurer’s balance sheet are unpaid loss expenses, meaning claims that haven’t been paid yet or haven’t been reported yet. Furthermore, insurance companies are generally assumed (although perhaps not correctly) to be relatively conservative in their investments, since they can predict their loss payouts with reasonable accuracy and buy bonds with maturities to match those payouts. (AIG, the big exception, got in trouble primarily because it was selling credit default swaps, not because of its traditional insurance operations.)

However, the problems are showing up on the asset side of insurers’ balance sheets. In an economic slowdown, an “ordinary” company – one that buys or manufactures stuff and sells it to other people – is vulnerable to declining demand and hence falling sales. An insurance company is vulnerable to falling asset values, because at any moment most of its money is parked in securities of various kinds.

I’m going to look in detail at the balance sheet of one large insurer, which I chose because they are big, my company has no relationship with them, and I have no inside information about them. And on second thought I decided not to name them because I don’t want anyone to draw the conclusion that I think they are risky; I just can’t tell, because even reading the notes to the financial statements you can’t tell exactly what they are holding. As of June 30, 2008 they had well over $100 billion in investments. Of that, only 4% was in direct mortgage loans and 2% in hedge funds, venture capital, and other exotic asset classes. 30% was in equities and 57% in fixed-maturity products – bonds – and 95% of the bonds were investment-grade or US government. So on the face of it you would think they were pretty safe.

However:

  • Equities, as we know, have fallen over 30% (S&P 500) since the end of June
  • 21% of the bonds were commercial mortgage-backed securities, including CDOs
  • Another 12% were residential mortgage-backed securities, other mortgage-backed securities, collateralized mortgage obligations, or collateralized loan obligations
  • 14% were bonds of financial institutions, which have been at the center of the financial storm
  • 29% were other corporate bonds, which lose value as recession worries increase

Looked at another way, 23% of the fixed-income securities were Level 3, which basically means that they could only be valued using internal models. (In addition, they had credit default swaps with a face value over $6 billion, but in the majority of those swaps they were buying protection.)

With a portfolio like that, it’s entirely possible that the insurer has taken significant losses over the last month and a half. Because insurance policies are promises to make payments if customers suffer losses, insurers are regulated and required to maintain a sufficient capital margin; if their assets fall too far in value, they get nervous about that capital margin, hence the desire to get some from Treasury.

This still leaves open the question of whether the taxpayer should bail out insurers. The argument to do so is that, like banks, insurers play an important role in funding the real economy. Insurers take in vast amounts of cash from consumers and businesses – total premiums in the US are over $1 trillion per year and insurance company assets are over $4 trillion – and redistribute out the money to companies, primarily by buying their bonds. While we think of bank lending as the way that companies get credit, direct bank loans are overshadowed by the bond markets. If insurance companies start hoarding cash for fear of investing it – or start failing – that that money will not be available for the rest of the economy.

Of course, there’s a question of where it all stops; you could construct a similar (though not quite as strong) argument for bailing out just about anything, and I believe the auto companies are looking for their piece. But it’s hard to deny that insurers play an important role as financial intermediaries in the US.

5 responses to “Insurance Companies Line Up for Treasury Bailout

  1. This is insane. I understand how intertwined the financial system is but at some point we (The US Taxpayer) need to cut the losses. GM, Ford, and Chrysler are failing for reasons outside the credit crisis. They own their failures. To put it simply, every other car manufacturer on the planet has figured out how to produce cars here, the largest car market in the world, at a profit and they simply haven’t because their own leadership was so juiced into the fabric of this country for so long they didn’t feel they had to. Stereotypical “Fat Cat A-holes”. Tell me one meaningful modern technology they have developed in the past 15 years and we can start a debate on their value. The US auto industry missed the boat on their own merit. You can create a case study to describe their failures at every level and teach what not to do as part of a business model. It’s a joke. I feel no sorrow for them. Unless I am missing something they should go the way of Zenith and RCA. Seriously, is their a debate for saving them?

  2. On the auto companies: First of all, they already got their bailout; it just wasn’t under the cover of the financial crisis. The government gave $25 billion in low-interest loans to the automakers last month, ostensibly to support development of fuel-efficient vehicles (but money is fungible).

    Second, they are arguing for a piece of the Treasury money on the grounds that their financing arms are financial institutions.

    But I’m with you on this one. I don’t think they play a systemic role in the financial system (although I’d be open to arguments on that – I haven’t thought about it that much), and if the worry is that people won’t get car loans, there are other ways to solve that problem.

  3. Like many people these days I’m impressed with depth this whole crisis/mess/etc. is going on. It might be just that is late at night but reading this post I remembered that the markets, the states and the private property are just artifacts we had build to make are life simpler. And those artifacts are based on trust. Being the regulation just a link between a “state” artifact and the “markets” artifact. With the recapitalization we are buying trust on the markets paying with the trust on states, but we are still the same bunch of people. It is even more so since it all turned global.

  4. I am not surprised by the fact that insurance companies are the next begging at the Treasury bailout window after the banks. In the grand scheme of capitalism, insurance companies provide a great deal of funding in the capital markets for all sorts of endeavors. Companies or individuals looking for capital go the bank first and then they go to entities with capital to invest (read: insurance companies and private equity). We all know the problems at the banks and read about the hurt that hedge funds are in. Private equity firms such as Cerberus are sure to be in a lot of pain as well. Insurance companies are naturally the next in line.

    I think the question really starts to be, “what is the definition of a ‘financial institution’? Auto companies argue that they do financing (my current mortgage is with GMAC). Retail stores give you 10% off for signing up with their credit card. It seems that anybody who is anybody in the world of capitalism offers financing of some kind. And if they do, they can argue that they deserve some of that cheap capital from Treasury. Heck, if I loaned by brother in law $500 that I haven’t got paid back, don’t I deserve some “bailout” too?

    When assets of all kinds are falling in price, it’s hard to really know where this daisy chain stops. Eventually, asset prices get low enough to trigger some kind of capital requirement at some bank or insurance company when then leads to another cascade of selling and the cycle feeds on itself.

    We learn in economics that inflation is always and everywhere a monetary phenomenon. That means that eventually, the flood of dollars that the Fed is putting into the system is going to lead to inflation in assets of all kinds. When that will be, I have no idea but it will happen.

    (On a side note, I think that if we asked the Fed now if Lehman was too big to fail, they’d probably say YES.)

  5. Ya i certainly do agree
    with all of you’ll
    its insane .