Firms facing financial strain due to rising interest rates and subpar product management, says Barings
A minor crisis in the banking industry began last month when Silicon Valley Bank failed due to rapidly rising interest rates and concerns about liquidity. According to recent analysis by Barings, life insurance businesses may be the next industry to experience liquidity issues that compromise their financial stability, albeit to a lower amount.
Insurance companies have experienced liquidity issues due to subpar product management, a lack of liquidity in investment portfolios, and poorly anticipated disintermediation risk. Better planning and stress testing may have prevented the insolvency of the majority or all of the insurers in the past, but asset management is now waiting to see if such measures can save life insurers this year.
"A significant decline in asset values for all insurers, leading to grievous unrealized losses in their investment portfolios," according to global investment manager Barings, was brought on by the events of 2022, which included strong and unforeseen inflation, a sudden increase in interest rates, and steep declines in the prices of stocks and bonds.
To guard against losses until they are realized, insurance firms utilize statutory book-value accounting for their investment portfolios. However, when profits and losses must be realized, they must pass through an insurer's interest maintenance reserve, which must be positive to serve as a safety net. Contrary to property and casualty insurance businesses, substantial realized losses will gradually erode surplus positions.
“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.
There are other difficulties some life insurers could have besides the value of their assets. In a recession, many people could be confronting "uncharted lapse territory."
There will always be policyholders who fail to pay their premiums in a variety of economic situations, but according to Barings, insurers can only make "educated estimates" regarding lapse rates for new products since they lack historical data. Some index-linked equities products have gained popularity but have not endured many market cycles.
These products offer downside protection against market corrections as well as upside appreciation as equity markets rise. Even products with lengthy histories, like delayed annuities, could not have lapse data acquired during a period of persistently higher interest rates, said Barings.
When another insurer offers a better deal or when bank savings or other assets offer greater returns, policyholders frequently quit making payments. The amount of liquidity that insurers require is made more unclear as a result.
A sudden surge of policyholders withholding their assets may cause a liquidity issue akin to a bank run if they were concerned about the liquidity of the insurance business. Unlike banks, life insurers have responsibilities that are longer in the future and provide products with cancellation fees such as annuities in place of checking account deposits.
Derivatives are being used by insurance companies as a hedge against market volatility. But if volatility rises, investors may have to make unplanned capital decisions, as happened in the U.K. last year when pension funds had to switch to liability-driven investing. This can cause a liquidity problem.
“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.
