Next Bugaboo Awaiting Insurers: Bond Defaults & Reserve Deficiencies

Many insurers have reported net losses for 2008 with commensurate declines in shareholders’ equity. The losses stem primarily from lower returns and investment write-downs related to asset price declines in equities, mortgage-backed securities, and credit default swaps. While life insurers, particularly annuity firms, continue to see increasing disparity in rates offered under minimum guarantees and market returns, the general consensus is that the property-casualty business model is still valid.

However, there could be another shoe yet to fall, and it could hurt both the life and non-life sectors.

Fixed Income Conundrum

Everyone recognizes that 2008 was an extraordinary year in the financial markets, and continued volatility and risk remain part of the outlook for 2009. Much focus has been given to the government stimulus package as a means to provide economic boost to the economy. Nonetheless, insurer balance sheets remain highly exposed to further declines in asset valuations not only in equities, securitizations, and real estate but also in state and municipal bonds.

Insurers are traditionally large buyers of fixed income securities -- especially those of government agencies, and state and local governments. But most states and municipalities are seeing the largest budget deficits ever. While the massive stimulus package will certainly help boost state finances for the short term, what about the longer term effect once that federal funding is utilized?

States and municipalities generally raise revenue via taxes and fees. Even with help from the federal government to balance their budgets, states will likely need to raise taxes and/or cut spending and services going forward. However, the taxpayer base is seeing growing unemployment and declining incomes and cannot easily support higher taxes. Property taxes, which account for the bulk of some districts’ revenues, are based on appraised value, and clearly property valuations have been cut substantially.

Consequently, there may be increased state and municipal bond defaults. While historically there have been only isolated public entity bond defaults and bond insurance has been able to cover the losses, if bond defaults occur on a massive scale, the ability of the municipal bond insurers to cover such losses in their now depleted condition is questionable. This problem is significant for insurance company investment portfolios and also for the overall economy, since insurers are the largest purchasers of government and corporate debt, and thus help sustain those public and private entities.

Reserve Shortfalls, Too

Besides the potential for further investment losses on fixed income securities, another problem may be lurking. In the past few years, insurance reserves have proven redundant, and companies have taken those redundancies into earnings. But reduced investment income from dividend cuts on corporate securities, investment losses, write-downs, and near zero interest rates could lead managements to under-reserve, especially on lines where discounting is applied. While inflation is typically the reason reserve deficiencies develop, deflation could also lead to reserve shortfalls as premium revenues decline but claims frequency rises.

As such, not only could the investment portfolios of insurers be further eroded by bond defaults, but balance sheets could also be weakened by reserve deficiencies.

Insurer Dilemma: What to do?

What should insurers do to protect against such a situation?

Business models of both the property-casualty and the life insurance industries need major overhaul, particularly with respect to their risk profiles. Risk management must be strengthened across entire organizations and especially within the investment operations. No longer can companies afford to take a silo approach to risk or to assume that diversification alone will protect against market dislocations. Each investment security must be re-examined and portfolios must be stress-tested for recession. If the Madoff scandal is any guide, then alternative investments such as hedge funds, or fund of funds, also need to be reviewed more carefully. The most toxic asset securitizations need to be written down, sold, commuted, and/or otherwise segregated from performing investments. The toxic assets must be treated much like the toxic under-reserved insurance liabilities of the past.

On the reserve front, managements must re-evaluate reserve adequacy in a low return, low interest rate environment. Like investments, reserves should be stress-tested for recession, as claims tend to rise during periods of economic weakness. Companies need to be vigilant about maintaining disciplined underwriting, strong claims management and reserve adequacy.

The solutions do not present easy, simple, or quick reversal of fortunes, particularly when the economy is in deep recession that hurts balance sheets as well as income. However, the stronger more disciplined companies will emerge as the winners, while the losers may need to be merged, broken up, or otherwise rehabilitated.

Comments

[j_remington:]

Is it possible to determine the quality of the investment portfolios and the reserve deficiencies of ABK, GO, AIG, MBI? Others too GNW LNC PFG PRU TMK

Or will these companies need to be subjected to a govt. stress test?

Feb 27 09:12 AM

[walters:]

A decline in districts' income from declining real estate values is inaccurate; jusrisdictions in most cases will simply raise tax rates to meet the declines and collect the same revunue. The political ability of any district to accomplish this may be in doubt.

Feb 27 09:20 AM