Insurance Industry Poses Increasing Risks, Fed Study Says
The U.S. life insurance industry may pose rising and poorly-understood risks to the financial system, according to a new study published by the Federal Reserve Bank of Minneapolis.
That’s because insurance firms account for quite a large portion of the financial sector, write Ralph Koijen, a London Business School professor, and Motohiro Yogo, a monetary advisor to the Minneapolis Fed.
“Although these risks have been growing rapidly over the past 15 years, they have received relatively little attention from academics and regulators,” write Messrs. Koijen and Yogo. “If unaddressed, these risks could cause severe problems.”
They noted that U.S. life insurance liabilities totaled $4.1 trillion in 2012, compared with total savings deposits of $7 trillion. Insurance firms also play a large role as investors in financial markets.
“As the largest institutional investors in the corporate bond market, insurance companies serve an important role in real investment and economic activity,” the authors say.
Particular dangers may lurk in the so-called “captive reinsurance” sector, which in some states has allowed life insurers “to set-up off-balance-sheet entities, known as ‘captives,’ subject to more advantageous accounting standards and capital regulation,” the study finds.
“By moving liabilities from operating companies that sell policies to captives, a holding company as a whole can reduce its required capital and increase leverage,” the authors say.
Sound familiar? Off-balance-sheet vehicles played some role in masking the building risks that erupted into the financial crisis of 2007-2008. While the government rescued American International Group Inc. during the crisis, the economists write, many more insurers applied for government bailout funds but were rejected or withdrew their applications.
As for what regulators should do about it, the authors focus on capital requirements that recognize the different business models of insurers and banks, allowing the former to assess their equity cushions from a long-term perspective.
“Capital requirements that apply to banks, especially short-term risk constraints designed to prevent runs, may not be appropriate for insurance companies. In fact, short-term risk constraints can actually increase the long-term risk of insurance companies,” Messrs. Koijen and Yogo conclude.