The C.V.Starr Professor of Economics at the New York University Stern School of Business said he sees systemic risk in the life insurance sector as companies deploy more regulatory arbitrage to reduce needed capital, push off liabilities and pursue riskier strategies that banks used to pursue.
Specifically, the professor, Viral V. Acharya, focused on recent research on captive reinsurance, which he termed off balance sheet shadow insurance, search for yields in the corporate bond market and a reduction in capital requirements for mortgage-backed securities. He said insurers seem to be filling the void left by banks who started exiting risky behavior after the crisis.
He specifically raised MetLife, especially, and Prudential Financial as life insurers that can fail if there is a housing market correction and an equity market collapse.
Speaking a part of a panel on global insurance regulation at the Brookings Institution on Oct. 14, he said he was “stunned” at the capital reduction requirements for residential (R) MBS since a 2009 reform by the NAIC reducing RMBS capital required by 67%. This capital relief for large and perhaps distressed – in 2009 insurers amounts to over $15 billion relative to the earlier risk-based system, he charged.
For his suggested failure scenario, Acharya faulted capital calculations based on expected losses.
“What about unexpected losses,?” he asked. A crisis is about unexpected losses not expected losses, he added.
Acharya said he doesn’t expect a run-on-the-bank scenario so much as a collapse in market values which will cause contagion “stop” the intermediation in the market by insurers, who will not be buying RMBS or any MBS and withdraw from bonds.
Later, Acharya explained in an email that raised an audience member’s question about insurance industry surplus (about $672 billion estimated) as a buffer that these surplus calculations “do not account for unexpected losses, I think, and ignore off balance sheet liabilities at captives. It also would be odd to give the firms capital relief for RMBS on one hand and tighten through surplus elsewhere,” he stated.
“The plan was to give capital relief to undercapitalized insurers and allow them to get into the space banks were withdrawing from, by earning fat yields on subIG (investment grade securities) …But even if justified in 2009, why should the relief be permanent?” he said in the email.
Acharya, who covered a chapter of a book he is writing (Chapter 9) with Matt Richardson, entitled Modernizing Insurance Regulation, (Wiley and Sons, Inc.) said it was worrisome that there seems to be insurance risk-taking across an investment grade classes, and fall at the edges of each investment class to the extent they can, and noted insurers have become the buyer of last resort for sub-investment fade RMBS at a time when banks are pulling back.
“There s a huge killing to be made here,” he said, guessing at insurers’ motivation, and there will be a housing crisis in the next 20 years and companies like MetLife could fail, he said.
He wanted to know why the NAIC has made permanent the capital relief it is giving insurers’ investments.
In the preface to the upcoming book, Acharya and Richardson write: “The insurance sector may be a source for systemic risk. In brief, we argue that the insurance industry is no longer traditional in the above sense and instead (i) offers products with non-diversifiable risk, (ii) is more prone to “runs” (iii) insures against macro-wide events and (iv) has expanded its role in financial markets. This can lead to the insurance sector performing particularly poorly in systemic states, that is, when other parts of the financial sector are struggling. We provide evidence using publicly available data on equities and credit default swaps. As an important source for products to the economy (i.e., insurance) and a source for financing (i.e., corporate bonds and commercial mortgages), disintermediation of the insurance sector can have dire consequences.”
In remarks to audience members gathered afterward, Acharya alleged that the company Google, for example, was safe, a certain pharmaceutical company was safe, but MetLife was not “safe.”
Earlier, in his presentation, Acharya, who has been an academic advisor to the Federal Reserve Banks of Cleveland, New York and Philadelphia and teaches credit risk, noted that MetLife owns an affiliated firm that reinsurers MetLife and that the AM Best rating ignores the captives. Its failure would costs state guarantees funds more the $15 billion, he said.
“Regulatory arbitrage” has allowed the insurance sector to free up reserves and increase its size, something over which various federal government offices are also noting.
He suggested insurers put pressure on state regulators to have the investment grade requirements for RMBS be almost the same as the sub-investment grade RMBS.
MetLife and Prudential were not in attendance and did not have a comment.
Acharya’s charts show high capital shortfalls for MetLife and Prudential in the case of a 40% market correction, above that of Bank of American and JP Morgan.
Insurance representatives and others weren’t buying it. Most have heard the warning bells about captive reinsurance before, but did not accept the scenario where the large insurers would fail in a housing crisis. The insurers would continue to buy in the market and people would continue to buy life insurance, one insurance representative noted.
Marty Carus, an industry consultant and former AIG and New York state insurance department official noted that RMBS performance from 2008 to 2010 in terms of cash flow was healthy. During this period, the industry lost minimal cash flows and cash flows are what was important as opposed to unrealized losses due market price decreases that caused write-downs, according to Carus. There is almost “no likelihood” of Prudential or MetLife failing with industry surplus,the long-time insurance regulatory official said.
Even if MetLife’s and Pru’s “RBC hit mandatory control level, they are eminently solvent (that is more assets than liabilities). Moreover, point estimates of required capital levels make little sense. If there is a temporary decline in asset values but no real loss of cash flows, companies can flow in and out of solvency. That is why during the Great Depression, valuations of debt securities (i.e., bonds) went to amortized values. Market values had decreased so markedly during 1930 that industry would be broke nominally but not actually,” Carus said in an email.
Acharya disagreed with arguemtns about this in general. “I think MetLife can fail,” Acharya said, charging that CDS fluctuated a great deal in 2008 and now almost 50% of RMBS are sub investment grade.
NAIC CEO Ben Nelson said on the panel in response to the myriad accusations that the “NAIC is on it,” and noted the NAIC work on principles-based reserving (PBR). Because of NAIC’s implementation of PBR, on will see “less use of the captives,” Nelson said. He reiterated the stance that the state system has worked and that the last crisis was not an insurance failure but an AIG failure.
But the professor warned that, “If we don’t harmonize insurance principles,” there will be problems and said this was a problem for the Financial Stability Oversight Council (FSOC) housed at Treasury. FSOC members and staff were among those in the audience. MetLife filed an appeal early this month to fight its proposed systemically risky financial institution (SIFI) designation by the FSOC. MetLife’s appeal will take place this fall, and if it fails, it could take the matter to court.
Failure would impact policyholders too, he said in a follow-up email.
“The insurance firms have been buying sub-IG tranches….So if losses exceed expected losses, for which they have not reserved and increasingly kept low equity cushion, policyholders and more likely federal taxpayers, will be on the hook,” Acharya said.