Following the release of the Federal Reserve's CCAR test results earlier this week, banks have been in the limelight, which should be expected. But some collateral damage may be seen once investors step back and take in a broader view. With three huge insurers -- American International Group (AIG 1.56%), Prudential Financial (PRU 1.90%), and MetLife (MET 1.34%) -- taking a hit following the banks' results, should investors be concerned?
Defining a drop
Though it's difficult to nail down any one reason for a stock's drop on a given day, the decline on Thursday for the three big-cap insurers is most likely in reaction to the Fed's strict ruling on the nation's big banks. Both Prudential Financial and MetLife fell more than 2%, while AIG had a smaller decline of 0.6%.
The one thing linking these three insurers to the CCAR rulings is the Fed itself. Both AIG and Prudential Financial have been designated as a Systemically Important Financial Institution, resulting in additional financial oversight from the Fed. MetLife is still in the latter stages of a SIFI review.
With increased oversight from the Fed in these insurers' futures, investors may be concerned that capital plans could be rejected (like Citigroup's) or reduced (like Bank of America's). But there's one thing sitting firmly in the insurers' favor -- they're not banks.
A big difference
While the Fed stress tests and resulting CCAR rulings are key measures of a bank's performance and security, an insurer is a much different beast; the same metrics should not be applied to an insurer to measure its strength. In fact, a coalition of seven big insurers marched on Washington to air their concerns about this exact problem. Included in the coalition was Prudential Financial and MetLife, while AIG was conspicuously absent.
At issue is the way that capital works within an insurer versus a bank. While the new stress tests and capital plan reviews may prevent banks from entering risky ventures, insurers often participate in transactions as the normal course of business that would be considered risky for a bank.
One easy example is the purchase of long-term bonds for the payout of benefits at a later date. For a bank, regulators would require that excess capital is held in order to offset the risk of losses from the bonds. Insurers argue that no such reserve of capital would be needed since the payment of benefits only occurs at the specified later date.
Insurers are often more concerned about assets-liabilities matching, while the regulator's use of Basel III guidelines focus solely on assets.
For investors, now is not the time to start worrying about the insurers and the future oversight from the Fed. The regulator hasn't specified the specific metrics that it will use for insurers once the SIFI terms are finalized -- the Fed has until January 2015 to figure out the details.
On top of that, the coalition's march to DC seems to have worked -- a new amendment to the Dodd-Frank law (which governs the SIFI oversight) has been introduced which would allow the Fed to tailor its rules for the companies it oversees. Specifically, the Fed can set capital reserve requirements for holding companies, but exclude firms that are participating in products and services considered as insurance under state regulations.
As for the three companies, AIG is no stranger to Fed oversight. Over the few years of governmental ownership following its near-collapse, the insurer developed a strong relationship with regulators from the Fed. This may explain why the thought of oversight may not have scared its investors as much on Thursday.
But the concept of stringent oversight is new for both Prudential Financial and MetLife, leading to a small, panicked sell-off. If you're still confident in the insurers as a business, ignore the crowd -- this quick drop could be a great opportunity to pick up some shares.