Last month, losses on long-term bond investments led to the collapses of Silicon Valley Bank and Signature Bank, sparking broad investor concern about the banking system's stability.
Insurers also have significant paper losses on their bond holdings right now. According to AM Best, insurers have hundreds of billions of dollars in unrealized losses on their books. Investors may be concerned that these losses could become a problem for those companies. However, despite the challenges, insurers may be better equipped than banks to ride out the storm. Here's why.
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How insurers make money
Insurance is a simple business on the surface. Companies write automotive, property, and life insurance policies, among other types of coverage, to protect people from catastrophic losses. These companies collect insurance premiums up front and then pay out claims when and if they occur at some later date. In the time between, insurers generally invest their funds in municipal bonds, U.S. Treasuries, stocks and other investments.
Having extensive bond portfolios makes insurers sensitive to changes in interest rates. There is an inverse relationship between bonds' yields and their values. So when interest rates go up, the value of an older bond goes down.
This isn't a problem if the company can hold those bonds to maturity. However, if a company is in a cash crunch and needs to raise funds quickly, it may be forced to sell bonds before they mature, locking in those losses. This asset-liability mismatch is precisely what happened to Silicon Valley Bank last month after its customers began withdrawing their deposits en masse.
Will insurers face a liquidity crunch?
According to Morningstar, the likelihood of U.S. insurance companies facing a liquidity crunch is low. The financial services research firm notes that insurers have a more stable funding source than banks and do a good job of matching assets and liabilities.
For example, property and casualty (P&C) insurers tend to invest in shorter-term bonds to match their shorter-term insurance liabilities. Progressive is a top insurer in the U.S., and last year it had a fixed-income portfolio worth $46.6 billion with 73% of its fixed-maturity investments having maturity dates of five years or shorter.
In comparison, SVB Financial had $117 billion in investments, 79% of which were in bonds with a maturity of 10 years or longer. Because they have more appropriately matched their assets to their expected liabilities, P&C insurers are much less likely to face a liquidity crunch.
This type of insurer faces a bit more risk
Life insurers are more vulnerable to potential liquidity crunches. Life insurance companies have liabilities that last much longer than P&C insurers because their policies, in many cases, last a lifetime. They also offer annuity products that pay out customers fixed amounts of money regularly for extended periods.
The potential risk is that large numbers of policyholders may, for whatever reason, choose to cash in their policies before they mature or cancel them. This is called a mass lapse, and if it were to happen, it could force a life insurer to take losses on its bond holdings as it cashed them in to pay out policyholders. There are few instances of such runs on an insurer, and penalties and charges discourage customers from cashing out their policies.
Should you invest in insurers now?
Investors in insurers shouldn't be too concerned about the companies' paper losses on bonds. Life insurers could be vulnerable if customers withdraw large amounts of cash and cancel policies en masse. However, surrender fees and longer waiting periods could discourage customers from making a run on these insurers. For this reason, life insurers such as Prudential, Globe Life, and Unum Group, shares of which sank during the past month, could present solid buying opportunities for long-term-minded investors.
P&C insurers are much less vulnerable to these risks. The nature of this type of insurance and the shorter policy periods and shorter bond investment durations make runs on these insurers unlikely. The risk for P&C insurers is that they could face large losses on their policies. However, these companies use reinsurance -- essentially insurance for insurers -- and have other resources they could tap into to fill short-term funding gaps. For this reason, I especially like Progressive and speciality insurer Kinsale Capital -- which have displayed stellar underwriting discipline and have outperformed the broader market for years.
In the financial sector today, the funding issues seem to be isolated to a few banks with poor asset-liability matches -- and that's a problem that insurers by and large don't seem to have.
