Risky Business.
Free to read.
Mary’s latest looks into the Fed’s most recent Financial Stability Report and what it says about the solvency of the life insurance “industry.” One thing it says is: “over the past decade, the liquidity of life insurers’ assets steadily declined, and the liquidity of their liabilities slowly increased.” Another thing it says is: “Life insurers are growing more dependent on FHLB (Federal Home Loan Bank) funding.” Something about those two sentences seems….unsettling. Read what follows and see if you agree.
The Fed exists to oversee banking, but lately it’s been keeping an eye on life insurance, too. Its recent Financial Stability Report flagged some life-insurance practices that might make the system vulnerable. Some insurers invest in assets that “can suffer sudden increases in default risk,” the report said. And some use “nontraditional” funding sources that could dry up “on short notice.”
That sounds ominous. But not long after that, Jon Gray, the president of private-equity giant Blackstone, turned up in a Financial Times article, saying life insurers had the wherewithal to bolster America’s weakened regional banks.
Gray said private equity firms like Blackstone could get “very low-cost capital” from life insurers and extend it to regional banks, to fund their lending operations. That would be a boon, because the banks’ usual source of funding, customer deposits, has grown more expensive and flighty in the wake of this year’s bank failures. So the life insurers could help ease a credit squeeze.
And once the banks make the loans, Gray said, the insurers might like to acquire some of them as investments. Blackstone manages billions of dollars of insurance investments, and Gray said the firm was already talking with large, unnamed regional banks about such deals.
So, what’s up with life insurance? Is the industry so flush it can send money to shore up America’s weakened banks? If so, then what’s the Fed worried about?
As it happens, a group of Fed economists has some answers. They got under the hood of the life insurance industry and combed through the voluminous regulatory filings of more than a thousand life insurers in the years since the crash of 2008. The U.S. financial system was going through major changes then, and they wanted to understand how the insurers had navigated the changing landscape.
One trend they observed: First, America’s bailed-out banks, seen as having gambled with their depositors’ money, were brought under the broad financial-reform legislation known as Dodd-Frank. It steered them away from making any more loans to big, low-rated borrowers. Then, once the banks had departed that space, life insurers moved in.
As a result, “These insurers have become exponentially more vulnerable to an aggregate corporate sector shock,” wrote the three economists, Nathan Foley-Fisher, Nathan Heinrich, and Stéphane Verani, in a paper first published in February 2020 and updated in April of this year.
Their findings cast the life insurance industry in a very different light from the traditional image of dull, stable companies plodding along under the weight of big, safe, bond-laden investment portfolios.
“Within ten years, the U.S. life insurance industry has grown into one of the largest private debt investors in the world,” the three wrote.
At the end of 2020, life insurers managed one-fourth of all outstanding CLOs, or collateralized loan obligations – bond-like securities backed by pools of loans to large, low-rated borrowers. Because the underlying borrowers have low ratings, CLOs pay a higher yield than the high-grade corporate bonds a conventional life portfolio would hold.
The insurers were also using unusual sources of capital to fuel their growth (funding-agreement-backed repos, anyone?). Not all life insurers, but a certain cohort was doing the kind of business the big banks did before the financial crisis, “but without the corresponding regulation and supervision.”
The economists called it “a new shadow-banking business model that resembles investment banking in the run-up to the 2007-09 financial crisis.”
Their reports describe the trends in detail, but in measured tones. No flashing red lights or alarm bells. But they do tell how things could go south: “A widespread default of risky corporate loans could force life insurers to assume balance sheet losses” from their CLO holdings.
Institutional investors watch life insurers carefully and know where the shadow-banking activity is concentrated; they would presumably see the losses coming and withdraw from the affected insurers in time. That’s what we’ve been seeing in the regional banking sector this spring, where savvy investors have identified potential problem banks and sold or shorted their stocks. The trouble is, such trading can turn a potential problem into a real one.
Upshot: “U.S. life insurers may require government support to prevent shocks from being amplified and transmitted to the household sector,” the three warn.
In other words, another taxpayer bailout. They’re not saying it’s inevitable, but the fact that they’re even saying it’s possible is disturbing. How did this happen?
Again, it has to do with the government’s response to the financial crisis. While Congress was shooing the banks away from private credit, the Fed was keeping interest rates close to zero to pull the economy out of the Great Recession.
In the life-and-annuity business, protracted low interest rates are very bad news. Most life insurers really did hold conservative bonds in the past, and when rates fell to almost zero and stayed there, they couldn’t find any bonds that would yield enough to cover their obligations to policyholders and annuitants. For some, the only way out was to sell off their business in pieces. There wasn’t much demand, because most potential buyers had the same low-rate problem. But some life insurers had developed a new business model that got around low rates, and they had the means to pick up the bargains.
Often, they had joined hands with private-equity firms. Blackstone acquired 9.9 percent of A.I.G.’s life-and-annuity business, for example, on terms that made Blackstone the manager of $50 billion of A.I.G.’s assets right away, and $92.5 billion in five years.
Apollo bought Athene Holding Ltd., an insurer based in Bermuda that does most of its business through life-and-annuity subsidiaries in the United States. The acquisition made Apollo the manager of close to $200 billion in insurance assets.
KKR acquired Global Atlantic, bringing its insurance assets under management to $96 billion.
There were other acquisitions, too. Life insurers were attractive to private equity because they took in premiums today and wouldn’t have to make payouts until far in the future. Better yet, they could set up special-purpose subsidiaries, called captives, in insurer-friendly places like Bermuda, and use them to “reinsure” their obligations to their annuitants.
(I’m putting the word “reinsure” in quote marks because these captive transactions bear little resemblance to the arms-length deals struck with outside reinsurers like Swiss Re.)
Running your business through Bermuda offers tremendous tax advantages, along with other opportunities for regulatory arbitrage that can lower costs and increase the spreads to be earned when the money is invested. The private equity firms serve as the insurers’ asset managers, buying or originating risky corporate loans and pooling them together as CLOs. An accounting change, held over from the dark days of 2007-09, can still be used to let insurers holding CLOs calculate their regulatory capital as if they were really holding safe bonds. It’s a boon for aggressive investors.
The Fed researchers said the private-equity firms appear to be giving their affiliated insurers “some of the riskiest portions” of the CLOs that they package. Since risk and reward go hand in hand, presumably the insurers are getting better returns than they would from safe bonds.
But still, should America’s insurance regulators be allowing this? Remember, America’s banks were told to stop.
The National Association of Insurance Commissioners has, in fact, proposed a change in the post-crisis rule that’s been letting insurers count risky CLOs as if they were safe bonds.
But the NAIC isn’t a regulator; it’s a non-governmental organization that represents America’s 56 insurance regulators (one for each state, five for the territories, and one for the District of Columbia). The regulators often have different priorities and viewpoints, and when the NAIC makes a proposal, it can take years to get the necessary buy-in.
So here we are. Countless policyholders and annuitants are diligently paying their premiums to keep their contracts in force, unaware of these trends. The Fed’s economists see undisclosed risk, but the Fed has no legal authority to regulate insurers. The insurance regulators don’t seem in any rush to rein in the risk-takers. Keep in mind: Life-and-annuity is a $9 trillion industry that doesn’t have anything like the FDIC.
I know that if there’s ever a crisis, people will say, “Why didn’t the media warn us?” So consider yourself warned.
In the past 15 years, We, the taxpayers, have bailed out the banks; we rescued the trillion-dollar insurance group that A.I.G. once was; we’ve put the Teamsters Central States pension fund and others like it on life support; we essentially provided debtor-in-possession financing for two bankrupt car companies; we’ve rescued the tech wizards who had more than $250,000 apiece on deposit at Silicon Valley Bank; and in 2020, we effectively bailed out the U.S. economy when the global pandemic struck and most business had to shut down.
We’re getting pretty good at rescues, what with all this practice. And now Fed economists have painstakingly documented complex, black-box life-and-annuity transactions that may pose yet another problem some day, and I’m wondering: At some point, will we have exhausted our capacity for bailouts?
Unfortunately, that’s a question the Fed economists haven’t answered.