The views expressed are those of the authors at the time of writing. Individual teams may hold different views. The value of your investment may become worth more or less than at the time of original investment.
As the world’s foremost experts on assessing and managing risk, insurers are once again on the front line of a worldwide crisis. Unlike the global financial crisis (GFC) of 2008 – 2009, the ongoing COVID-19 pandemic is a threat to the entirety of an insurance company’s balance sheet. Below are excerpts from a recent webcast to the global insurance community, hosted by Multi-Asset Insurance Strategist Tim Antonelli.
What potential liquidity needs are insurers facing?
Insurers are likely facing significant liquidity needs in the near term:
- The increase in mortality and morbidity rates from the pandemic is troubling and could have ramifications for years to come, depending on how the disease is treated and managed over time.
- Premium refunds to policyholders of certain lines of business are becoming mandatory, as California announced recently. Other states could follow suit, with the methods used to implement these refunds possibly varying greatly from state to state.
- In addition, companies should expect more policies to lapse going forward as the unemployment rate creeps higher, preventing many policyholders from making premium payments.
- Finally, insurers are grappling with their potential exposure to coronavirus-related litigation, such as numerous recent examples of class-action lawsuits related to business-interruption coverage.
How dire do insurer balance sheets look, based on market activity?
Thankfully, many insurers went into this crisis in relatively good shape in terms of how they were capitalized. Lessons learned from the GFC forced financial institutions to improve the quality of their balance sheets considerably. However, given the significant market drawdowns of late, net investment income projections for the 2020 fiscal year were essentially rendered useless by the end of February, as the COVID-19 fallout continued to grow. The large unrealized gains in insurers’ equity allocations evaporated at the same time as interest rates plummeted to record lows on the back of aggressive central bank actions.
How have asset allocation shifts increased illiquidity?
The amount of traditional public-market liquidity in insurers’ portfolios has decreased significantly over the last decade. It’s no secret that the largest change in global insurers’ asset allocations has been a pronounced increase in illiquid investments like direct mortgage loans, real estate, private credit, and private equity. As rates remained compressed, the liquidity risk premia became a compelling option for insurance portfolios. That, coupled with favorable regulatory capital treatment across many risk capital regimes, made it a very compelling trade. For example, as of year-end 2019, US life insurers had 46% of their invested assets in mortgage loans, real estate, private credit, and alternative investments. The property and casualty industry had nearly 20% in these same asset classes. When liquidity evaporates from traditionally liquid asset classes, as we have seen during this crisis, insurers are left with few options to raise cash in a way that won’t result in material realized losses.
Have mark-to-market practices hurt company earnings?
The world has continued to move toward more “mark-to-market-like” accounting treatment for financial institutions. Both IFRS and GAAP accounting standards now utilize impairment allowances based on future expected credit losses, forcing insurers to assess the long-term outlook of their loans and fixed income portfolios and to establish reserves for potential credit losses. These loss allowances result in a day-one dampening of earnings and have the potential for substantial volatility when working through a financial crisis such as today’s.
These standards had been a challenge to implement on their own, now made even more difficult in the current environment. However, the NAIC’s statutory accounting working group just published updated guidance, including provisions for impairment deferrals due to COVID-related circumstances on certain mortgages, structured securities, and bank loans. On the equity front, GAAP accounting rules introduced in 2018 now require that equity changes in fair value must flow through the profit-and-loss statement on a quarterly basis, thus eliminating the cushion of classifying equities as available for sale and including market moves through “other comprehensive income” (OCI).1
What advice do you have for insurers? How have you been helping your clients weather this storm?
First and foremost, this pandemic is a living case study on the importance of having a robust enterprise risk-management framework in place. It’s a business-wide issue, and as such, organizational silos need to be broken down and cross-functional swat teams assembled. A strong first step is a full cash-flow analysis of the business, including a variety of “what-if” scenarios with different degrees of liability cash needs and asset stresses.
Once their baseline and stressed scenarios are assessed, insurers should get creative with examining alternative sources of liquidity. For example, the Federal Home Loan Bank (FHLB) continues to offer attractive borrowing terms for insurers to use. FHLB membership is useful not only for unexpected liquidity needs, but can also be used to fund compelling investment opportunities. It is critical to remember that buying into market dislocations and being a provider of market liquidity in challenging times can be the best way to generate investment returns. Look no further than after the last crisis, when opportunistic allocations to non-agency structured securities produced significant returns for investors that were able to add such allocations.
This is also a great time for insurers to upgrade the quality of individual positions in their portfolios and to perform relative-value swaps into companies with stronger fundamentals that have drawn down with the broader market.
Looking ahead, any final thoughts?
As we work with our clients to triage the impacts of COVID-19 on their business, we would encourage insurers to consider taking the following actions:
- Stress test cash-flow projections (both assets and liabilities).
- Establish additional sources of funds (e.g., FHLB borrowing, letters of credit) to invest opportunistically or cover emergency liquidity needs.
- Reexamine strategic asset allocations, reflecting current market levels and the changing nature of the firm’s liabilities.
- Consider opportunistic investment strategies designed to take advantage of market dislocations, both now and going forward as we move into a recessionary period.
For all of the above and more, we look forward to serving as a trusted thought partner as you work through this historic, difficult time.
1In business accounting, other comprehensive income (OCI) includes yet-to-be-realized revenues, expenses, gains, and losses.