Life Insurance Company Risk Exposure: Market Evidence and Policy Implications

By Brewer, Elijah,, III; Mondschean, Thomas H. | Contemporary Policy Issues, October 1993 | Go to article overview

Life Insurance Company Risk Exposure: Market Evidence and Policy Implications


Brewer, Elijah,, III, Mondschean, Thomas H., Contemporary Policy Issues


I. INTRODUCTION

Failures of several large life insurance companies (LICs)--such as Mutual Benefit and Executive Life in 1991--raise the possibility of pervasive failures in yet another category of financial intermediaries that would require government intervention and taxpayer expense. ("LIC" refers to both life and life/health insurance companies.) Given the cost of the savings and loan (S&L) bailout to federal taxpayers and the importance of life insurance to millions of policyholders, evaluating the current risk exposure and regulatory structure of the U.S. life insurance industry is useful for several reasons: (i) The life insurance industry is a major supplier of funds to capital markets. Thus, insolvency problems could affect credit availability. (ii) State guarantee funds that protect policyholders might give LICs incentive to take risks they otherwise would not. Evaluating the current guarantee system's effect on LIC risk taking therefore is important. (For a discussion of incentive effects of deposit insurance, see Barth et al., 1989; Kane, 1989; Brewer and Mondschean, 1994.) (iii) Most states allow LICs to credit guarantee fund assessments against premium taxes. Insurance failures thus could reduce expected tax revenues to state governments.

Section II provides background information on recent industry performance and assesses the industry's current risk exposure. Section III analyzes several LICs that failed in 1991. Section IV examines the regulatory environment and the role of state guarantee funds. Section V reports empirical results on the stock market's assessment of LIC riskiness. Section VI discusses policy implications.

II. BACKGROUND

In the process of offering risk protection to customers, LICs expose themselves to a number of risks. Mortality and morbidity risk are related to the probability of a policyholder's dying, conditional on age, illness, and other variables. As financial intermediaries, LICs also face interest rate risk, credit risk, and liquidity risk arising from policyholders' right to borrow against policies or to cash in policies for their surrender value.

Table 1 contains industry balance sheet data for selected years from 1970 to 1991. As of the end of 1991, LICs held over $1.5 trillion in assets. In the early 1980s, government securities as a percentage of total assets rose sharply. In the latter 1980s, corporate bond holdings also grew, especially between 1986 and 1988 when they rose from 36.5 to 41.2 percent of total assets. This rise in part was due to the growth in corporate debt securities that were not of investment grade--that is, that were "junk" bonds. From 1970 to 1991, direct mortgage loans declined from over one-third to less than one-fifth of total assets. These portfolio changes reflect the movement toward greater securitization of financial instruments as well as rapid growth in corporate debt outstanding. These securities have enhanced LIC portfolio liquidity but also may have exposed LICs to prepayment risk (in the case of mortgage-backed securities) and credit risk (in the case of junk bonds). The tables do not separate corporate securities from mortgage-backed securities because state insurance commissioners do not require LICs to separate these two classes of debt when reporting balance sheet data.

Turning to the liability side of the balance sheet, one can observe the growing importance of pension and annuity business relative to traditional life insurance. Policy reserves for life insurance in force fell from 55.7 percent of total assets in 1970 to 24.0 percent in 1991 while reserves to cover annuity payments rose from 23.5 percent to 57.6 percent between 1970 and 1991. However, regulatory capital as a fraction of total industry assets declined from 9.4 percent in 1970 to 8.0 percent in 1991. Regulatory capital as a percent of general account assets (total assets less separate account assets) also fell from 9.7 percent in 1970 to 8. …

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