The NAIC’s Capital Markets Bureau monitors developments in the capital markets globally and analyzes their potential impact on the investment portfolios of US insurance companies. A list of archived Capital Markets Bureau Special Reports is available via the index
Foreign Exposure in the Insurance Industry
In recent months, volatility in the capital markets has increased due in part to the ongoing debt crisis in Europe, with the fate of Greece being a particular focus. In addition, there has been increased concern regarding the exposure of global financial institutions to sovereign debt, which could cause significant losses or even threaten their solvency. Given the volatility in these markets, the NAIC Capital Markets Bureau has been monitoring the insurance industry’s exposure to foreign entities, both corporate and sovereign. We recently reviewed direct exposure, such as that resulting from investments in bonds, common stock, preferred stock and derivatives, as well as indirect exposure from counterparty risk.
As of June 30, 2011, the insurance industry had total foreign exposure of $624.4 billion. This foreign exposure includes investments in bonds, common stock, preferred stock and replications through the use of derivative instruments. Foreign exposure is defined as any exposure to an entity not domiciled in the United States. Bonds represented the majority (92.4%) of the exposure, and life insurance companies held most (81.2%) of the exposure.
Foreign Bond Exposure
Total foreign bond exposure as of June 30, 2011, was $577.0 billion for the insurance industry. This represents an increase of 8.2% compared to total foreign bond exposure as of Dec. 31, 2010. It should be noted that total foreign bond exposure does not include structured securities that are technically domiciled in foreign countries (such as Bermuda, Cayman Islands and Ireland) for legal and tax reasons, but where there is obviously no apparent exposure to the economy of the respective country. Other structured securities where the disconnect is not so obvious were left in. In addition, other-than-temporary impairments (OTTI), if any were taken in the first half of 2011, are not reflected in the exposure numbers. Life insurance companies held the majority (84.2%) of the industry’s foreign bond exposure.
Although the debt crisis in Europe has generally been centered on Greece, the market has also continued to raise concerns with other countries, such as Spain and Italy. There have also been concerns that financial institutions in other European countries (such as Belgium and France) with significant exposure to the sovereign debt of distressed countries, such as Greece, could potentially result in solvency issues if their holdings would have to be written down. Given this dynamic, the focus of the exposure analysis has expanded beyond sovereign debt to include financial institutions in European countries. Almost two-thirds of the total foreign bond exposure was to investments in securities not related to foreign financial institutions or sovereigns; 20.0% and 15.7% of the exposure were to financial institutions and sovereign credits, respectively.
In absolute dollar terms, since year-end 2010, the insurance industry added the most exposure to the United Kingdom, Australia, the Cayman Islands, Canada and France, and was most active in reducing exposure to Portugal, Israel, Denmark, the Netherlands and Austria. The Cayman Islands exposure includes some structured securities that likely do not have any exposure to the economy of the Cayman Islands but were not easily identifiable. With respect to the more distressed Eurozone countries, the insurance industry increased exposure to Ireland, Italy and Spain by 10%, 5% and 1%, respectively, since year-end. Exposure to Greece and Portugal was reduced by 1% and 83%, respectively.
The top 10 foreign bond exposures totaled $454.5 billion (or 78.8%) of the total exposure. The top 10 includes five European Union (EU) countries, although none of the more financially distressed countries.
As mentioned previously, volatility and concern in the market has primarily been related to EU sovereign credits and financial institutions with exposure to these sovereign credits. The following table provides a detailed breakdown of the insurance industry’s exposure to all EU countries by type of issuer: financial institution, sovereign or other. The “other” category primarily includes corporate credits other than financial institutions and structured finance securities. The table also shows the individual exposure for the 17 countries that are using the euro as currency and the combined exposure for the remaining 10 countries (labeled “Other EU Members”) that do not. Total bond exposure to all EU countries totaled $229.0 billion as of June 30, 2011, with 57.9% of the exposure in countries that participate in the euro.
Note: The EU is comprised of 27 member states. The Eurozone consists of 17 member states that use the euro as their sole currency. The 10 other EU members do not use the euro as their currency.
Almost all of the insurance industry’s $1.2 billion bond exposure in Greece is sovereign debt. The majority of the holdings is intermediate- and long-dated paper and has not been subject to the voluntary restructuring of Greek debt. For more details, see the section titled, “A Focus on Greece.”
The insurance industry’s bond exposure in Ireland totaled $11.3 billion. There was minimal exposure to sovereign debt, and 83% and 17% of the exposure was in “other” and financial institutions, respectively.
The industry’s $2.4 billion bond exposure to Italy was more evenly distributed, with 49%, 34% and 17% in “other,” sovereign debt and financial institutions, respectively.
Bond exposure in Portugal was limited in the insurance industry, with only $141.5 million in holdings. Only 22% was held in sovereign debt, and the remaining 78% was held in “other.” As noted previously, the insurance industry significantly reduced its holdings in Portugal during the first half of 2011.
The insurance industry’s bond holdings in Spain totaled $6.5 billion as of June 30, 2011. Financial institution and sovereign debt each represented 12% of the total, while “other” made up the balance.
A Focus on Greece
Of the European countries that are facing financial difficulties, Greece has been scrutinized the most. The U.S. insurance industry has a relatively modest exposure to Greek-related debt of $1.2 billion as of June 30, 2011, although most of it is sovereign debt. There were 23 individual insurance companies that had exposure to Greek debt, none of which are unmanageable concentrations. The largest Greek exposure was 5% of the company’s total cash and invested assets.
Reports were that private creditors agreed in July to a voluntary write-down of 21% on their Greek debt, a figure that now appears insufficient. More recently, Eurozone officials have been suggesting that the situation is more serious and that significantly larger concessions will be needed. Thus far, restructuring discussions have focused on shorter-term debt, whereas the insurance industry mostly held intermediate and longer-term bonds.
Greek sovereign debt is trading at depressed levels, reflecting continued concerns that Greece will not be able to meet its budget targets despite its best efforts to implement austerity measures, putting at risk further international financial aid and likely leading to a default. On Oct. 21, 2011, two-year Greek sovereign debt was bid at $38 and 10-year debt was bid at $37.
Foreign Common Stock and Preferred Stock Exposure
The insurance industry’s foreign common stock and preferred stock exposure as of June 30, 2011, totaled $44.1 billion and $2.9 billion, respectively. The largest exposures were to the United Kingdom, Bermuda, Canada, the Cayman Islands and Switzerland. Similar to the equity market in the United States, foreign equity markets have experienced significant declines in value in recent months. As of the close of business Oct. 19, 2011, the United Kingdom’s FTSE index and Germany’s DAX index were down 8.7% and 16.6%, respectively, since year-end 2010. For the same period, Japan’s Nikkei index was down 15.2%.
Foreign Replication Exposure
In addition to exposure through cash instruments, investors (including insurance companies) are also able to add to their exposure through derivatives. In the case of U.S. insurers, more than 90% of derivatives use is for hedging purposes. A strategy of managing or reducing risk would suggest that those transactions would not result in adding European exposure. On the other hand, U.S. insurers are able to add risk through replications.
Foreign exposure resulting from replication transactions, or a derivative transaction entered into in conjunction with other investments to reproduce the investment characteristics of otherwise permissible investments, totaled $469.4 million as of June 30, 2011. This total includes exposure to all foreign entities but excludes $90.8 million of exposure to the iTraxx, which is a European bond index that consists of approximately 125 European credits. Because the index exposure is diversified across many names, the additional exposure to any one particular country would be immaterial. The majority of the foreign exposure created by the replication transactions is to foreign corporate credits as opposed to sovereign credits.
The following table shows the top 10 foreign replication exposures by country, which represented $343.6 million or 73.2% of the total. $141.6 million or 41.2% of the top 10 countries’ exposures were sovereign debt. All of the exposure to Chile, Egypt, Malaysia and Mexico were sovereign. Replications in foreign financial institutions totaled $10 million and were in Commonwealth Bank of Australia and Mizuho Bank (Japan).
Foreign Counterparty Exposure
In addition to any exposure to the reference entity, users of derivatives also have potential credit exposure to the counterparty. Counterparty risk is the risk faced by one party that the other party will not satisfy the obligations of a derivatives contract. As there have been market concerns about the stability of certain EU financial institutions, it is prudent to have a good understanding of the exposure that counterparty risk creates. In the event that a counterparty fails and a credit event occurs simultaneously, the insurer would not receive the intended credit protection or effect of a hedge. The insurer would also face additional costs in replacing the hedge. The cost to replace the hedges would be the carrying value or fair market value of the derivative positions.The following table lists all of the foreign derivatives counterparties as of June 30, 2011. The positive book adjusted carrying values (BACV) represent transactions where the counterparty “owes” the insurer, and the negative BACVs represent transactions where the insurer “owes” the counterparty.
Deutsche Bank and Credit Suisse were the counterparties that “owed” the most to insurers. To give this some context, the net amount owed by these two foreign counterparties was in line with the net amount for the largest domestic counterparties, including $1.4 billion owed by U.S.-based JP Morgan Chase.
Despite the concerns surrounding many EU financial institutions, their bonds are trading at or near par. The following quotes are as of Oct. 21, 2011, for 10-year senior unsecured bonds: Deutsche Bank – $100; Credit Suisse – $99; Barclays – $102; BNP Paribas – $100; and UBS – $101. The one exception is Société Generale, whose 10-year senior unsecured bond is quoted at $90.
Foreign Exposure in Securities Lending
Insurers generally reinvest the cash collateral posted by borrowers in a securities lending transaction. These investments are typically on balance sheet and, therefore, are already reflected in the totals discussed above. However, it is worth focusing on this information separately to give some idea of the exposure insurers might have if the securities borrowers decide to return the lent securities and request the return of the cash collateral. In stressed and volatile financial markets, the insurer might find it difficult to find liquidity or be forced to sell the securities at a lower price and receive less cash than was posted by the borrower.
Foreign exposure related to reinvested collateral from securities lending programs totaled $8.7 billion as of June 30, 2011. As with the foreign bond exposure, this total does not include structured securities that are technically domiciled in foreign countries (such as Bermuda, the Cayman Islands and Ireland) for legal and tax reasons, but where there is no apparent exposure to the economy of the respective country. Almost all (98.1%) of the exposure was to financial institutions. The total exposure includes exposure to the parent, as well as all of its subsidiaries. In many cases, the subsidiaries were based in the United States, but we decided to take a conservative approach and include this exposure in the totals on the theory that if the foreign parent suffered, it would likely be a drag on the U.S. subsidiary. Furthermore, a large percentage of the exposure is in relatively short-dated paper, including time deposits and certificates of deposit (CDs). There is little, if any, market risk in these securities.
Although total foreign exposure, including the net counterparty exposure, is sizable in terms of absolute dollars, it only represents 12.2% of the insurance industry’s cash and invested assets as of Dec. 31, 2010. The direct foreign exposure represents 12.1% of cash and invested assets, and the indirect counterparty exposure represents 0.1% of cash and invested assets. In addition, with almost two-thirds of the foreign exposure to investments in securities not related to foreign financial institutions or sovereigns, we do not expect the insurance industry’s foreign exposure to have a material impact on the credit quality of their asset portfolios. We will, however, continue to monitor OTTI trends in these exposures, particularly with respect to Greek-related debt.
The NAIC Capital Markets Bureau will continue to monitor the insurance industry’s foreign exposure, as well as developments in the EU and elsewhere around the world, that could have an impact on these exposures. We will provide updates as deemed appropriate.
Questions and comments are always welcome. Please contact the Capital Markets Bureau at CapitalMarkets@naic.org.
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