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U.S. Insurance Industry’s Investment Exposure to the Financial Sector
Insurance companies are connected to other companies in the financial sector in many ways, including as significant debt and equity investors, and also as customers — depositing money at or trading securities through banks and brokerage firms, for example. Although the degree to which insurance companies are interconnected with other financial institutions is generally less significant than the interconnection among banks and brokerage firms, it has nonetheless been a market concern since the financial crisis in 2008. As such, the Capital Markets Bureau has continued to monitor trends in the U.S. insurance industry’s exposure to financial institutions, especially in corporate debt. This special report focuses on the U.S. insurance industry’s long-term corporate bond investments in the financial sector as of year-end 2011 and third quarter 2012, and provides recent trends in the corporate bond market.
Financial Sector Exposure
Table 1 illustrates the U.S. insurance industry’s $400 billion exposure to the financial sector’s long-term corporate bond debt as of Dec. 31, 2011. The three major categories within the financial sector are banking, finance and insurance. Life insurance companies held the majority of the U.S. insurance industry’s financial sector exposure at 75.4%, or $302 billion, followed by property/casualty (P/C) companies at 19.8%, or $79 billion. The banking industry (which includes domestic and foreign banks, as well as savings and loans banks) was the largest category in the financial sector at 50.5%, or $202 billion, followed by the finance industry (which includes commercial finance, diversified financial services, investment bankers/brokers, investment management/advisory, leasing companies, and others) at 25.4% and the insurance industry at 24.1%.
The financial sector was 7.7% of the U.S. insurance industry’s total cash and invested assets, and 21.8% of total corporate bonds held as of year-end 2011. As a percentage of corporate bond exposure, P/C companies had larger exposures to the financial sector vs. life companies. However, life companies had higher financial exposure as a percentage of cash and invested assets due to their relatively higher allocation to corporate bonds. Banks were the largest exposure within the financial sector, at 11% of total corporate bonds, while finance was 5.5% and insurance was 5.2%.
In addition to corporate bonds, the insurance industry also invests in the common stock and preferred stock of financial companies. The industry’s financial stock exposure as of year-end 2011 totaled $21.7 billion, or only 0.42% of total cash and invested assets, and included $15 billion in unaffiliated common stock (P/C, $9.6 billion; life, $4.2 billion) and $6.7 billion in unaffiliated preferred stock (P/C, $4.8 billion; life, $1.7 billion).
Insurers also enter into varying financial transactions — for example, derivatives transactions for hedging purposes — where another financial institution becomes a counterparty, or an entity through which an exposure to financial risk might exist. Insurers’ derivatives counterparty exposure was $1,378 billion notional amount as of year-end 2011, as per our special report on derivatives exposure published Jan. 9, 2013. Life insurers dominated, with a notional amount of $1,320 billion (or 96%) of the total U.S. insurance industry’s counterparty exposure. The top 10 exposures summed up to 74%, with Deutsche Bank, Credit Suisse, Goldman Sachs, Barclays and JP Morgan being the largest counterparties.
Based on the latest data in Table 2 below, the insurance industry increased its total exposure to the financial sector by 6.5% to $426 billion in the first three quarters of 2012 vs. year-end 2011. However, the exposure as a percentage of total corporate bonds remained relatively unchanged at 21.7%. Although life insurance companies increased their holdings of financial companies on a book/adjust carrying value (BACV) basis, their exposure as a percentage of the industry’s total decreased to 73.2% (as of third quarter 2012) due, in part, to a relatively larger increase in financial sector exposure by P/C and health insurers in the first three quarters of 2012.
The breakdown within the financial sector showed less allocation to the banking and insurance industries — with banks decreasing to 45.1% as of third quarter 2012 from 50.5% as of Dec. 31, 2011 — and an increased allocation to the finance industry to 31.6% as of third quarter 2012 from 25.4% as of year-end 2011.
Credit Quality Distribution
Overall, the credit quality of life insurers’ exposure to the financial sector is strong, with approximately 95.8% being investment grade — NAIC 1 or NAIC 2 designations — for the third quarter 2012 as shown in Table 3. This was unchanged vs. Dec. 31, 2011. However, the mix of NAIC 1 vs. NAIC 2 changed modestly as life insurers increased their exposure to NAIC 2 corporate bonds by 1.7 percentage points from year-end 2011 to third quarter 2012, perhaps to achieve better yields in today’s low interest-rate environment. The relatively small increase in NAIC 2 financial exposure is not a significant concern at this time, given the overall improving health of the financial sector. According to Fitch Ratings, the ratio of credit upgrades to downgrades improved in 2012, with rating upgrades of banking and finance sector corporate bonds totaling 4% while downgrades were 8.6%. This was a vast improvement over 2011 results, when upgrades were 3.4% and downgrades were 19.2%. Upgrades to insurance company corporate debt in 2012 were 2.5% vs. 0.6% in downgrades, which was mostly unchanged from 2011’s upgrades of 2.9% and downgrades of 0.3%. The increase in NAIC 2 might also be due, in part, to credit rating migrations as, according to Fitch Ratings, banking and finance sector downgrades have continued to outpace upgrades.
As of year-end 2011 for life companies, there was $888 million of financial corporate bonds in the two lowest NAIC designations: NAIC 5 ($503 million) and NAIC 6 ($385 million). Other-than-temporary impairments (OTTI) on these bonds were $120.5 million at year-end 2011. Foreign exposure represented approximately 42%, with exposure to financial institutions in the United Kingdom (UK), Germany and Russia representing the top three exposures.
In Table 4 below, as of the third quarter 2012, P/C insurers’ allocation to investment grade financial companies was relatively unchanged, with 96.7% as of third quarter 2012 vs. 96.8% as of Dec. 31, 2011. The mix of NAIC 1 vs. NAIC 2 for P/C insurers remained relatively the same, as well, with 75.4% in NAIC 1 and 21.3% in NAIC 2 (vs. year-end 2011’s 75.7% and 21.1%, respectively).
The credit quality of financial sector bonds held by health, fraternal and title insurance companies is also strong, with approximately 96.6% of bonds carrying an NAIC 1 or NAIC 2 designation as of the third quarter 2012, down slightly vs. 97.3% as of year-end 2011. Health, fraternal and title insurers also experienced a slight increase in NAIC 2 and a slight decrease in the NAIC 1 designations, likely to achieve higher yields, as well as due to credit rating migration. Table 5 below summarizes the credit quality of the financial exposure by insurer type.
Table 6 details the maturity profile of the life insurance industry’s financial sector exposure, which is heavily weighted in the “>1 year to 5 years,” “>5 years to 10 years” and “>20 years” maturities. Life insurers’ longer-dated liabilities call for more holdings in longer-term financial corporate bonds; therefore, the three categories with maturities of more than five years totaled 60.6% and the two categories with maturities of less than five years totaled 39.4% as of year-end 2011.
As of third quarter 2012, life companies increased the maturities of their financial corporate bond holdings, with the more meaningful changes occurring in the “1 year or less” and the “>10 years to 20 years” maturity ranges. The “1 year or less” category experienced a drop from 5.6% in 2011 to 1.5% in third quarter 2012, while the “>10 years to 20 years” category increased to 12.5% as of third quarter 2012 (vs.7.7% at year-end 2011). The increase in longer maturities could be due, in part, to 1) new issuances having longer average maturities; and/or 2) life insurers investing in longer maturities to take advantage of higher relative yields (please see Table 7 below).
Corporations have been taking advantage of the low interest-rate environment and issuing new debt to lock in low rates for longer periods, as it is likely that the Federal Reserve will not lower rates any further. According to the Securities Industry and Financial Markets Association (SIFMA), average maturities of new corporate bond issuance peaked in 2008 at 13.7 years, dropped in 2009 to 12 years and rose back to 13.7 years in 2012 (please see Table 8). Insurers are major participants in the corporate bond new issuance market, and with the longer maturities of new corporate bonds being issued, the maturity profile of their portfolios has been extended.
Table 9 details the maturity profile of the P/C insurance industry’s financial sector exposure in 2011, which is heavily weighted in the shorter maturities when compared to life insurers. Financial bonds with maturities up to 10 years totaled 93.9% of the P/C companies’ maturities distribution vs. life insurers’ maturities distribution, which was 70.5%. P/C companies’ shorter liabilities call for more holdings in shorter maturity assets; therefore, bonds with greater than 10 years’ maturities were only 6% of the total.
In Table 10, as of the third quarter 2012, P/C insurance companies extended the maturities of their financial corporate bond holdings, as the “1 year or less” and the “>1 year to 5 years” categories experienced declines and the “>5 years to 10 years” and the “>10 years to 20 years” maturities increased. Corporate financial bonds with maturities up to five years decreased from 69.5% as of Dec. 31, 2011, to 53.7% as of third quarter 2012. Bonds with maturities that were more than five years but less than 20 years increased significantly, from 26.4% at year-end 2011 to 39.9% by third quarter 2012. The increase in longer maturities could be due, in part, to 1) new issuances having longer average maturities; and/or 2) P/C insurers investing in longer maturities for their higher yields.
As of third quarter 2012, the majority (or 78.5%) of the financial sector bond maturities held by health, fraternal and title insurance companies was 10 years or less. This represents a decrease from 87.9% as of year-end 2011, likely due to similar reasons provided above for life and P/C companies.
U.S. Corporate Bond Market Trends and the Financial Sector
U.S. insurance companies are major investors in U.S. corporate bonds, with $1.8 trillion in holdings as of Dec. 31, 2011. According to Fitch Ratings, the financial sector’s exposure within the U.S. corporate bond market peaked at 50.6% in 2007 and has decreased every year thereafter, down to 29.3% in 2012, but still higher than the U.S. insurance industry’s nearly 22% exposure to the financial sector. Although the financial sector represents a smaller slice of the corporate bond markets today than it has in the past, the insurance industry’s exposure to these bonds has remained relatively stable in recent years. U.S. insurance companies owned $400 billion of financial corporate bonds as of Dec. 31 2011, which was 21.8% of the total insurance industry’s corporate bond holdings. As of third quarter 2012, this exposure grew 6.5% to $426 billion but remained unchanged at 21.7% of total corporate bond exposure. Financial bonds are attractive investments for insurance companies because they are typically liquid and highly rated by the major credit rating agencies. According to Fitch Ratings, for example, the AAA, AA and A-rated financial corporate bonds outstanding in 2012 were 71.2% of the exposure (on an aggregate basis), while BBB was 21.5%, for a total investment grade allocation of 92.7%. The financial sector rating distribution compares favorably to that for non-financials, which was 35.2% for AAA, AA and A-rated (combined), 36.5% for BBB and 28.3% for all non-investment grade-rated.
Fitch Ratings reported that U.S. corporate bond new issuance in 2011 was $683.8 billion (71.5% of which was investment grade), with the financial sector accounting for $197.9 billion (or 28.9%) of total corporate bond new issuance. In 2012, U.S. corporate bond new issuance increased by 32% to $905.6 billion (though the percentage of investment grade corporate bonds decreased slightly to 69.4%). In addition, the U.S. financial sector corporate bond new issuance grew 10.7% in 2012, and decreased to 24.2% of total corporate bond new issuance.
With the increased level of new issuance from the financial sector, insurers found attractive investment opportunities and, thus, increased their exposure to this sector in absolute terms. The Fed has maintained its pledge of not hiking interest rates until 2015, as U.S. economic growth has remained sluggish, Europe and Japan have remained in recession, and China’s economic growth rate has decelerated. This has kept yields on government bonds low, and so investors have increased their appetite for higher yielding securities such as corporate bonds. Investors have been comfortable buying corporate bonds due to the improving health of U.S. corporations (i.e., higher earnings and more cash on the balance sheet), including the financial sector. Companies have taken advantage of strong investor demand and, consequently, have taken on more debt, refinanced at lower interest rates and locked in low rates for longer periods.
2013 Outlook for U.S. Banks
According to the Federal Deposit Insurance Corporation (FDIC), banks achieved their second-highest ever net income in 2012 of $141.3 billion, second only to the peak in 2006. The improvement came from reduced provisions for loan losses, higher non-interest income, an increase in servicing income and a reduction in losses on foreclosed property sales. Industry net income bottomed in 2009 at negative $10 billion and net charge-offs peaked at $189 billion in the same year. Net charge-offs began to drastically improve in 2011 and have decreased to $83 billion in 2012. Fitch Ratings has a stable credit outlook for U.S. banks, as the funding, liquidity and capital profiles of banks have been strengthened. Interest rates will likely remain low, which will pressure net interest margins, and regulatory issues (e.g., the federal Dodd-Frank Wall Street Reform and Consumer Protection Act; Basel III) will pressure earnings via higher compliance costs, reduced high margin trading/investment businesses and higher required reserve capital. Notwithstanding, U.S. banks have significantly improved their capital position over the past few years, so they should be better prepared for future challenges. In addition, the recovering U.S. labor and housing markets are expected to continue to bolster bank earnings in 2013.
The financial sector exposure of insurance companies’ long-term corporate bond investments has remained relatively stable in percentage terms from 2011 to third quarter 2012, at nearly 22%. Insurers remain significant investors and holders of corporate bonds, particularly those issued by the financial sector. In terms of credit ratings, investment-grade designations of financial corporate bonds held by U.S. insurance companies were slightly above 96%, but there were slight increases in allocation to NAIC 2 bonds at the expense of NAIC 1 bonds. Maturity profile was extended as more bonds were allocated to the longer-dated maturities. Financial sector revenue and earnings have improved since the recent financial crisis, especially for banks.
The Capital Markets Bureau will continue to monitor and report any changes in the exposure of insurance companies to the financial sector.
Questions and comments are always welcome. Please contact the Capital Markets Bureau at CapitalMarkets@naic.org.
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