|By Rosen, Richard|
Researchers at the Chicago Fed Insurance Initiative are analyzing the role that the insurance industry plays in financial markets and the economy as a whole. This article presents an overview of life insurers' financial asset holdings, the industries they invest in, and how the value of their investments would change if there was a large negative shock to asset values.
U.S. life insurance companies own more than
Life insurers invest premiums that they receive from customers. They generally choose assets with features that are aligned with the characteristics of the insurance products that they sell. For example, proceeds from a long-term insurance product would be invested in a longduration asset. This means that the risks from insurance liabilities will generally be balanced by the risks insurers assume through their investment activities.
At a fundamental level, life insurance companies sell products to satisfy two types of long-term demand. Some customers want protection from adverse financial consequences resulting from loss of life (life insurance) or from the exhaustion of financial resources over time (annuities). Other customers seek to earn a return on their premiums that can be withdrawn in the future (annuities meet this demand) . Because customers often make claims on and withdrawals from their policies years after they have been issued, life insurers face the challenge of investing customer payments to ensure they will have sufficient funds available to satisfy claims and withdrawals in the distant future. This generally leads life insurers to invest in a collection of long-term assets.
Life insurance company asset holdings
Figure 1 presents a breakdown of the assets held by the life insurance industry. As the figure shows, life insurers segregate their assets (and, by extension, their liabilities) into two independent "accounts" on their balance sheets – the general account and the separate account General-account assets support liabilities that feature guaranteed returns to customers from the insurer. In contrast, separate-account assets support "passthrough" products, in which investment gains and losses are passed on to the customer and no more than a minimum return may be guaranteed.2 Typical general-account products include term life insurance, whole life insurance, fixed annuities, and disability insurance. Products whose payouts fluctuate based on the investment environment include variable annuities and variable life insurance. The assets that back these products are recorded on the separate account. The industry's aggregate general account held
In the general account, fixed-income assets like bonds and mortgages constituted the largest share of invested assets, at 75.5% and 9.6%, respectively. Separateaccount assets comprised primarily equities. Only 14.3% of separate-account invested assets were bonds, and mortgages made up only 0.5%. We focus our attention on general-account assets because life insurers typically do not pass investment gains and losses on these assets to their customers, so they must manage the associated valuation risk.
Corporate bonds make up the largest share of general-account assets. Insurers had
The recent global financial crisis was characterized by problems with financial firms and real estate. To measure the life insurance industry's exposure to these areas, we compare their holdings with the total credit market instruments outstanding in these sectors. Overall, 29.6% of corporate bonds in 2011 were issued by financial firms.4 This share is comparable to the sector's share of insurers' holdings at 26.7%.
Insurers' exposure to real estate comes through mortgage-backed securities (MBS) (14.8% of insurers' invested assets), mortgage loans (9.6%), and real estate owned (0. 6% ).5 Therefore, we look at real estate as a share of total credit market instruments. The 25.0% of total real-estate-related holdings on insurers' general account is somewhat less than the sector's 38.7% share of all outstanding credit market instruments.6 This suggests that insurers are not overexposed to this market sector. However, it is important to keep in mind that different real-estate-related investments have different risk profiles. For example, mortgage loans have direct to real estate risk, whereas MBS investments have indirect exposure. MBS issued by governmentsponsored agencies, such as
The financial crisis provided a powerful demonstration that asset values can decline quickly. Some of the asset classes heavily favored by insurers, especially nonagency MBS, experienced major losses during the crisis. We estimate the potential decrease in the value of insurer assets from an extreme downturn in asset markets using data on market prices for a variety of financial instruments over the period from
We use the distribution of life insurer investments in combination with data on price fluctuations to estimate the potential downside risk from changes in asset prices. To do this, we match asset classes to price indexes that are likely to track the value of those assets closely and use the performance of the index to estimate the performance of the matched asset class (see box A for details on the matching process) . For each day in the sample period, we calculate the change in each price index over the past month. We also calculate the past-month change for a weighted average of the indexes, where the weights are the shares of the matched asset classes from the aggregate life insurance balance sheet. We then compute the standard deviations of these changes and estimate the loss in value that occurs with a particular frequency. We focus on a loss that would occur one month in every 60 months, or once in five years. This corresponds to a 2.13 standard deviation price change. It is important to note that we are estimating a loss in market value, not in book value. Much of the change in market value for fixed-income assets, such as bonds, is due to changes in interest rates.
The once-in-five-years losses vary across asset categories (see figure 3). At the high end, nonagency MBS are estimated to lose 28.2% in market value. In contrast, the corporate bond portfolio is estimated to lose 6.9%. The oncein-five-years loss for life insurance assets as a whole is estimated to be 7.8%, reflecting some benefits from diversification. Note that the historical period that we analyze includes the financial crisis, so the estimates of potential losses may somewhat overstate the risk going forward. Then again, the period leading up to the crisis, which is also included in the data, was a period of unusual calm in financial markets.
Our back-of-the-envelope calculations suggest that a severe shock to asset prices could reduce the value of the industry's investments by 7.8%, or
We have shown that life insurers invest in a wide variety of financial assets. Corporate bonds make up the largest share of their assets. Although insurers invest in a diverse set of industries, they have significant investments in industrial and manufacturing firms, financial firms, and real-estate-related securities. A severe shock to asset prices would reduce the value of life insurers' asset holdings considerably. However, our calculations suggest that a significant portion of the losses on assets would be offset by gains on liabilities.
For more information about the Insurance Initiative, visit www.chicagofed.org/ webpages/markets/ insurance_initiative.cfm
Box A. Details on estimating asset risk
Agency MBS: Equal-weighted blend of
Treasury bonds: One-, three-, six-month and one-, two-, three-, five-, seven-, ten-, 20-, and 30-year Treasury yields for similar-maturity bonds.
Equities: S&P 500 index for common stock and S&P preferred stock index for preferred stock.
Index values were provided by Haver Analytics and
* We assume that the returns for corporate bonds and foreign bonds are similar, since we do not have a foreign bond index.
* We assume that standard deviations of returns for each ratings class of private corporate bonds are 1 percentage point higher than the corresponding returns for public corporate bonds, since we do not have a private corporate bond index.
* We assume that the returns for nonagency commercial mortgage-backed securities (CMBS) and nonagency residential mortgage-backed securities (RMBS) are similar, since we do not have a nonagency RMBS index.
* We assume that affiliated bonds have returns equal to the smallest daily return across the other categories of bonds.
* We assume that the returns for mortgage loans and real estate are similar to the returns for CMBS.
* We assume that policy loans and cash retain 1 00% of their value at all times. Policy loans are loans originated to policyholders that are financed by cash that has accrued in their policies. They do not depreciate in value because failure to repay a policy loan results in termination of the policy.
* We assume that derivatives and other investments have returns equal to the smallest daily return across the other categories of assets.
1 Based on 2012:Q3 data from the
2 Not all gains and losses on separate-account assets are necessarily passed on to customers. Separate-account liabilities often include embedded guarantees. These guarantees are claims against the general account, and are therefore supported by general-account assets. These guarantees are more likely to be triggered when interest rates have declined sharply and when equity returns are very low. We do not address potential risks from embedded guarantees in this article.
3 According to the
5 MBS includes nonagency MBS and agency MBS, as reported in figure 1 .
7 Insurance companies do a much more extensive set of stress tests that examine the sensitivity of their capital to shocks in asset and interest rate markets, among other scenarios. In our example, we examine one particular stress at the industry (rather than firm) level.
8 According to 2012:Q3 data from SNL Financial and authors' calculations.
9 See note 8.
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