Why Should Life Insurers Be Bailed Out?

by James Kwak

That’s the question I woke up with yesterday morning. Sad, isn’t it.

The Wall Street Journal reported this week that Treasury will soon announce that it will use TARP funds to invest in life insurers, or at least those who snuck under the federal regulatory umbrella by buying a bank of some sort. The argument for the bailout is a version of the “No more Lehmans” theory: the failure of a large financial institution could have ripple effects on other financial markets and institutions that could cause systemic damage. For a bank, the ripple effect is primarily caused by two things: (a) defaulting on liabilities hurts bank creditors, and (b) defaulting on trades (primarily derivatives) hurts bank counterparties, if they aren’t sufficiently collateralized (think AIG).

My thought yesterday morning was that life insurance policies are long-term liabilities that are already guaranteed by state guarantee funds, so we don’t have to worry about (a), and hopefully most life insurers were not doing (b) - large, one-sided bets on credit risk like AIG. So why not just let them fail and let the states take over their subsidiaries? But then I checked the facts, and it turns out that the limits on state guarantee fund payouts are pretty low. So the scenario is this: you hear bad things about your life insurer, you decide to redeem your policy (usually at a significant loss to yourself), turning it into a short-term liability, and then the insurer has to start dumping assets into a lousy market, pushing the prices of everything further down and hurting everyone holding those assets. Would this really cause a systemic crisis worse than we’ve already got? I don’t know, but no one in Washington wants to take that risk.

Ultimately, though, this goes back to the question of whether this is a liquidity crisis or a solvency crisis. If it’s a liquidity crisis - in which case you would expect to see lots of people redeeming their policies already - then there are better ways to prevent a run on the life insurers. For one thing, if the insurers really do have good assets to cover their expected payouts, the government could just boost the limits on the state guarantees, charge the insurers a premium for the guarantee (insurers already pay a premium for the backstop they get from the states), and pocket the money. Alternatively, the government could act as a reinsurer, taking on some of the payout risk in exchange for a corresponding proportion of the assets and premiums. Using TARP money might work, but since it just adds a few billion dollars to the insurer’s capital (without guaranteeing anything), it’s not a surefire solution.

If it’s a solvency crisis, though, we have to ask whether a few billion dollars of TARP money is enough. The Hartford (HIG) estimates it is eligible for $1-3 billion of money. (I picked them because they are discussed in the WSJ story, not because I know anything else about them.) It also has $288 billion of assets. How do their assets compare with the assets of, say, a bank? In principle, insurance companies are more closely regulated, and their investment mix (in terms of bond ratings) is constrained. But it’s also true that insurers - especially the large ones - were investing in more sophisticated products in an attempt to earn higher yields. (For details, see pp. 156-76 of the Hartford’s latest 10-K.) And we know that you could lose a lot of money investing in AAA-rated assets. If this does turn out to be a solvency crisis, then this could be the first page of a long story.

Comments

[chleoku:]

let's hope the AIG bonus mess will not happen again:

www.wealthalchemist.co.../

Apr 12 10:12 PM

[Gardener:]

I feel sick

Apr 12 10:35 PM

[Ricard:]

After more than six months of bad news, I have to wonder whether or not this is becoming a self-fulfilling prophecy. It's quite possible that once the bad-news machinery gets up and running, it may take a long time (a lot longer than the market malaise, if you get my drift) before the machinery runs out of steam.

Seems the whole crux of the matter is whether or not the assets held are good. After six months, there has yet to emerge a consensus opinion on this one. That's bad. I'd feel a lot more comfortable if we had some sort of definitive answer on this one (like, say, a TARP that actually buys troubled assets). Maybe it was due to the political transition...the Geithner plan does seem to actually attempt to answer this question.

Apr 12 11:36 PM

[optionsgirl:]

This is not a question of bad news being a self- fulfilling process. Wake up! The U.S. is functionally bankrupt, and so are our major financial institutions. As to there being guarantees on insurance products, there are very few.

Apr 13 12:01 PM

[dybydx:]

A bailout is effectively an insurance policy against bankruptcy. Except the gov is offering the coverage in hindsight, paying out cash AFTER knowing the company is insolvent.

Nothing wrong with issuing these policies.... IF you charge enough premium for it.

So my guess is there will be some kind of deposit insurance equivalent for these industries which are often too-big-to-fail. In the 1930, it was the depository banks, in 2008 its the financial derivitive industry. The difficult part is, while insuring bank account deposits are very simple to calculate, the payout for derivitives are too difficult to estimate. Still, i think its possible to offer a blanket coverage up to a maximum loss of X dollars for the combined charges against a particular derivitive issuer.

Apr 13 02:51 PM

[Badgolfer:]

There are many more problems that are apparent on the surface which have had a long incubation period.In Florida,where we have had commercial and personal experience that until now had no complication by the Recession.
When Hurricane Andrew posted the largest losses in history,then Florida Insurance Commissioner Nelson refused to let the insurance companies recover there reserves in additional rates,which was his job.Instead, he "showboated" as the people's commissioner to boost his campaign for US Senate.You guessed it,Florida citizens(read: the great ill read)made him a US Senator.Speed forward to Hurricane Ivan and three other hurricanes.Insurance companies(those remaining in Florida)bailed out further.
Now comes the "Big R"(or is it "D"?).State Farm is withdrawing from Florida for insufficient rates plus another problem:their investments are worth a whole lot less and they can't back the business they already have.
Meanwhile,the State re-insurance fund rests finally on the taxpayers.
Like it or not,we have to back the insurance companies,or see trillions of loans go into default because of a regulatory default.

Apr 13 06:53 PM

[Marianthi:]

If something is too big to fail...it is TOO FRIGGIN BIG!!

About Florida...try walking a mile in someone's shoes before throwing stones...plummeting home values, plummeting investments and growing unemployment and then added insurance premiums...can you see WHY this would upset people?

Insurance companies are giant scams anyhow...I remember immediately after Hurricane Katrina there was some insurance company bigshot talking about some loophole in the policy that allowed them to not pay out policy holders that had just lost everything...and the SOB was SMIRKING!!!

The only reason I would not like all of these to vanish now is because so many people have needed income from pensions and annuities that rely on these things being solvent/bailed out...poor them...

Apr 13 10:48 PM