OFR: Financial System More Stable, but Life Insurers Continue to Pose Risks
December 15, 2016 by Frank Klimko
WASHINGTON – Life insurers still represent significant risks to the U.S. economy because carriers continue to struggle with the low interest rate environment and a decline in equity values that could increase their vulnerability to collapse, according to a new government report.
The latest assessment was made in the U.S. Office of Financial Research’s 2016 Annual Report to Congress and the OFR companion 2016 Financial Stability Report. The reports found in general, the U.S. financial system has become more resilient since the 2008 financial crisis, despite some ongoing headwinds for life insurers.
“The risk of industrywide problems due to common factors such as low interest rates is worrisome because the U.S. resolution framework for insurers relies largely on state guaranty funds,” according to the Financial Stability Report. “The state guaranty funds are not prefunded and rely on surviving firms in that state to cover shortfalls to policyholders of a failed insurer.”
The state-based guaranty fund system has not faced an industrywide solvency crisis, the report said. Past failures have been small and firm-specific, the report said.
“Life insurance companies could pose financial stability risk,” the report said. “We found that an increase in an insurer’s consolidated derivatives exposure consistently is associated with an increase in systemic risk indicators and in realized equity volatility.”
The FSR found two U.S. insurers, MetLife Inc. and Prudential Financial Inc. were among the top five riskiest firms and ranked about the same as investment banks on some risk evaluation scales. The contribution to systemic risk from U.S. global systemically important insurers appears to be rising and in some cases it may be higher than for some U.S. global systemically important banks, the report said.
Like banks, life insurance companies are locked into the costs of long-term liabilities, which means that declining yields from their assets reduce their earnings, the report said. Some carriers also have growing exposures to retirement products, including variable annuities and private pension obligations, that are sensitive to these risks, the report said.
The OFR is an independent agency within the Treasury Department; its research is used by the Financial Stability Oversight Council to prevent another economic meltdown. The report looked at both the banking system and non-financial businesses, like insurance companies.
Of particular concern is continuing weak global growth and the Brexit vote in June when the United Kingdom decided to leave the European Union, the report said. Markets recovered quickly, but the vote began a period of uncertainty that could last for years as details unfold, the report said.
Although direct exposures of U.S. life insurers to the EU are small relative to their $4 trillion in general account assets, U.S. insurers are also exposed to European banks through derivatives transactions and reinsurance, the report said.
Of all segments of the industry, life insurers occupy their own special risk category because they are interconnected with global systemically important banks and other financial institutions through institutional products and capital markets, the report said.
“The failure of a large insurer could lead to failures outside the industry or cause spillover effects due to asset fire-sales,” the report said. “Material financial distress at a large life insurer could result in contagion, which could impair other financial firms and markets.”
Although insurance regulation has improved since the crisis, key policy gaps remain.
“These gaps include the need for more robust stress testing industry wide, the adoption of a liquidity standard to address short-term liquidity risk for insurers materially engaging in activities such as derivatives and securities lending,” the report said, “and the evaluation of options for strengthening the resolution framework.”
The OFR report last year also concluded that better insurance company stress testing could act as a system-wide early-warning effort to root out unstable companies before they spark another financial meltdown (Best’s News Service, Dec. 15, 2015).
Jimi Grande, National Association of Mutual Insurance Companies senior vice president of federal and political affairs, questioned the usefulness of the reports.
“The OFR today released two reports totaling over 200 pages which employ a forest of various charts and graphs to conclude that the financial system is more resilient than before, but vulnerabilities remain,” Grande told Best’s News Service.
“That financial institutions might be threatened by a catastrophic cyberattack or that a low-interest rate environment can be difficult for a life insurance company are fairly obvious observations,” Grande said. “After reading the reports, one might be excused for wondering if systemic risk is now better understood or financial stability enhanced in any meaningful way.”
(By Frank Klimko, Washington correspondent, BestWeek: Frank.Klimko@ambest.com)
