A lot has been written regarding the exposure of both European and U.S. banks to the European debt crisis. But how are European insurers weathering this perfect storm?
You can pretty much summarize the revenue model of insurance companies as the following:
1. Take premiums from policyholders.
2. Invest those premiums to earn a return that should be greater than the claims and upside that you will ever have to pay out.
As with banking risk management is paramount– in both underwriting and investment management. Unfortunately, European insurers have the same exposure to sick sovereigns as do their banking brethren:
- direct exposure to governments that may be unable to repay their bondholders
- counterparty exposure to banks who are exposed, themselves
- slower growth leading to worsening economic conditions that are generally bad news. In horrible and correlated markets insurers and pension funds enjoy a double whammy: investment losses decrease their assets while low interest rates increase the net present value of policyholders’ claims.
However they also have one more transmission mechanism: as part of their search for higher yield they also tend to have investments in the banking industry. This is usually in the form of bonds, as insurers tend to shun the volatility associated with equity investments. Ironic, since it’s the credit markets and not the stock markets that have fueled both the Europe debt crisis and the MBS crisis that kicked things off in 2008.
As for advantages, they’ve got a few. First, they have more latitude with regard to marking the value of their investments to market than the banks have. There’s a new regulatory regime for European insurers called Solvency II which would have required the companies to aim for fair value assessment of both assets and liabilities. It was planned to be introduced in 2013, but now looks like it will come on line at 2014 at the earliest.
Second, insurers’ liabilities tend to be locked in for the long haul. This is different from deposit-taking banks which can, of course, always be hit with unanticipated withdrawal requests. (Northern Rock, take a bow.)
Finally, many insurers have arrangements with their policyholders that are known as “with-profit”, or “participating policies”. Under this arrangement the insurance companies split any profits made on investments with the policyholders. On the flipside they also share any eventual loss, as per the following excerpt from Businessweek:
Almost three-quarters of life insurance products sold to Europeans have a savings element that offers minimum returns or capital guarantees, according to Brussels-based CEA, the European insurance and reinsurance federation. The majority of the investment risk is borne by the policyholder.
Also, “Insurers maintain the right to withhold annual payments and may be unable to meet guarantees should their solvency come under threat….” All told the with-profit aspect is why it’s crucial to look at insurers’ net loss figures instead of gross.
Now then, back to the Europe debt crisis. Here’s what insurance rater AM Best had to say in September after stress-testing European insurers, emphasis mine:
Many major European (re)insurers have progressively reduced their exposure to Portugal, Ireland and Greece in the past year so that sovereign debt of these countries only represents approximately 1% of total investments and less than 10% of shareholders’ funds of the insurers tested. In isolation, these now reduced exposures did not have a significant impact once stressed, but larger exposures to Italy and Spain resulted in greater falls in risk-adjusted capitalisation. Italian and Spanish sovereign debt represents approximately 7% of total investments and more than 50% of shareholders’ funds of these companies, with Italy in particular representing a competitive market among large European (re)insurers.
And while Businessweek cites Bloomberg / JPMorgan data to estimate that “life policyholders will shoulder about two-thirds of the potential losses insurers face on their 235 billion euros ($335 billion) of Greek, Italian, Irish, Portuguese and Spanish debt,” some say that reality will be more nuanced. The following quote attributed to Trevor Moss, a London-based European insurance analyst at Berenberg Bank.
“The companies that think they can just freely pass it onto the policyholders are maybe living in Never-Never Land because they may be killing their business model,” he said. “There could be potential legal implications and mis-selling claims down the line.”
I do think that he has a point here. Remember all the financial institutions that felt compelled to support their supposedly off-balance sheet vehicles back when the going got rough? How much greater will that pressure be when the cries for help come not from sophisticated institutional investors but rather from pensioners, widows and orphans?