Insurance Could Be Next Credit Crunch Casualty

While banks appear to be stabilizing thanks to the backstopping of the Federal Deposit Insurance Company, the next casualty of the deflating credit bubble could be life insurance, according to the Financial Times.

Insurance companies are exposed to the same distortions in long-term bond interest rates, which is what caused Silicon Valley Bank, Signature Bank and First Republic to collapse, FT asserts in an editorial.

In addition, insurance companies held $2.5 trillion of risky and/or illiquid assets, including commercial real estate and corporate loans, at the end of 2021, according to the Federal Reserve’s recently released financial stability report, the latest available data.

Those assets are double the level insurance groups held in 2008, when the financial crisis occured, and now comprise a third of their portfolios. Fueling this trend has been the need to find returns in a low-interest rate environment in recent years.

More troubling is insurance companies’ exposure to non-traditional liabilities, including funding agreement-backed securities, Federal Home Loan Bank advances and cash obtained through repos and securities lending. Investors have the option to withdraw their assets from all of these types of investments on short notice.

A comparable report from Barings shows that a record 26% of life insurers were in a negative interest rate management position at the end of 2022.

In plain English, insurance companies could be far more susceptible to credit losses than previously thought.

In addition, insurance companies are heavily invested in illiquid assets. This could make it tougher for life insurers to meet any sudden rise in claims or withdrawals.

This leads to another troubling issue for the U.S. financial system, which is its increasing reliance on derivative deals through loans from the Federal Home Loan Bank system. The last evidence of this occurred at the onset of COVID in 2020, when insurance companies sidestepped a credit crunch by obtaining $63.5 billion in cash from the FHLB.

“So much for American free-market capitalism,” FT writes. “Such reliance also raises questions about the future, particularly if funding sources do flee and illiquid assets become impaired, or both. The latter seems highly likely, given that higher rates are already hurting commercial real estate and risky corporate loans.”

Right now, there is no cause to panic, as insurance contracts are even stickier assets than bank deposits, and the asset distortions that insurance companies, banks and other financial giants are exposed to will take years to unwind.

The bottom line, the Financial Times concludes, is that regulators need timely, accurate data and asset-liability matching controls to avoid potential insolvencies.

As for the health of the U.S. banking system, depositors can expect the FDIC to continue to backstop their money “by precedent, if not by law.”

However, it is almost certain that some of the 4,000-plus banks in the nation will be acquired by sounder banks, especially if they lose deposits, are not able to manage their funding costs in a higher interest rate environment, or see their commercial real estate exposure go sour.