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.
- 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.