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ESSAYS ON ISSUES THE FEDERAL RESERVE BANK OF CHICAGO SEPTEMBER 2012 NUMBER 302 Chicago Fed Letter How liquid are U.S. life insurance liabilities? by Anna Paulson, vice president and director of financial research; Richard Rosen, senior financial economist and research advisor; Zain Mohey-Deen, business economist; Robert McMenamin, senior research analyst This article describes the liquidity of various life insurance products and provides a measure that can be used to characterize the liquidity of the liabilities of the industry as a whole or of a particular firm. Life insurance companies make up a sub- stantial share of the U.S. financial sector. At the end of 2011, they held $5.3 trillion in assets, which is about one-third the size of the $14.6 trillion banking sector.1 Life insurance companies play an important role in financing corporations, holding 18% of all outstanding corporate and foreign 1. Bank and life insurance balance sheets bonds in the U.S.2 Due to the size and Banks Life insurance companies importance of this Primary assets Loans Bonds and stocks segment of the finan(52% of total assets) (81% of total assets) cial sector, researchers Relatively illiquid More liquid than loans at the Chicago Fed Primary liabilities/ Customer deposits Policyholder liabilities Insurance Initiative funding (83% of total liabilities) (90% of total liabilities) are analyzing the role Very liquid Less liquid in general the life insurance secSources: Authors’ calculations based on fourth quarter, 2011, data from Federal Deposit tor plays in the econInsurance Corporation, Statistics on Depository Institutions, and SNL Financial. omy. (More details are available at www.chicagofed.org/ webpages/markets/insurance_initiative. cfm.) This Chicago Fed Letter presents our analysis relating to one specific characteristic, the liquidity of life insurer liabilities. The recent financial crisis and subsequent global recession have highlighted the vital role of liquidity in the health of financial institutions and markets. We start with a brief description of the life insurance industry. We then compare life insurers’ balance sheets with banks’ balance sheets, focusing on the liquidity of both assets and liabilities. Next, we describe the liquidity characteristics of various life insurance products and provide a liquidity profile of the industry’s liabilities. Description of life insurance companies Life insurance companies sell both protection and savings/investment services (see box A on last page). Protection services are what we traditionally think of as insurance—protection against loss. Some insurance products, e.g., term life, are pure protection products. Others, such as universal life insurance, can be viewed as primarily protection with a savings element. Annuities, which offer some protection against the risk of outliving one’s assets, are largely savings vehicles. Typically, insurers collect premiums from customers before, and in some cases well before, they have to pay out funds. For example, a customer may pay premiums for many years on a life insurance policy before there is a claim on the policy. To account for the possibility that an insurance or annuity policy might have to pay out funds, insurers set aside reserves. Reserves appear as a liability on the insurers’ balance sheets. Insurance companies invest reserves in assets such as corporate bonds. As we discuss below, their objective is to increase profit while retaining liquidity to meet potential payouts. The key liabilities of life insurers are reserves against policy claims, including insurance, annuity, and deposit-type contracts. Because premiums can be paid in long before a payout event occurs, Overall, life insurers have less liquid liabilities than banks do. Liability bucket Bucket description Product examples Banks fund themselves Zero liquidity Liabilities with Immediate annuities no redemption rights Disability insurance with highly liquid deLow liquidity Stable redemption Whole life mand deposits, which profile make up over 80% of Moderate liquidity Redeemable at Deferred annuities banks’ liabilities (see book value with Universal life figure 1).5 While life significant penalties insurers have some High liquidity Retail liabilities with Deferred annuities; GICs; demand deposit-like little impediment funding agreements to surrender; products, many of their redeemable/putable products have limitainstitutional liabilities tions on withdrawals. Source: Authors’ calculations based on information from Joel Levine, 2010, “Special Some of the life inreport: Moody’s global liquidity stress test for life insurance operating companies,” report, No. 121220, Moody’s Investor Services, March. surance products described in box A, insurers often invest in long-term assets such as term life and immediate annuities, cannot be withdrawn; other products, so that the duration of assets matches that of liabilities. Over half of life insurers’ such as deferred annuities, have a cash value that can be withdrawn by customers assets are invested in corporate, foreign, but only with a penalty. The reserves supand government bonds; and another 6% of assets are invested in commercial mort- porting insurance and annuity contracts gages.3 Most of these fixed-income invest- comprise 90% of life insurers’ liabilities ments have long durations, reflecting the (see figure 1).6 We explore the withdrawal long duration of insurance liabilities. profiles of reserves below, but in general, life insurance liabilities are more diffiLiquidity of banks and life insurers cult to withdraw than bank deposits, which means that they are less liquid. The liquidity of a particular investment measures the extent to which the asset In the event of a drawdown of liabilities can be bought or sold without affecting by depositors or policyholders, a firm’s its price. At the firm level, liquidity risk ability to respond will depend on the assets is the risk that a firm will have to take a the firm is holding and, in particular, on loss when it is forced to raise cash quickly. the liquidity characteristics of the assets. For insurers, liquidity risk is most likely Looking at bank assets, over half are in to occur when they have to pay customthe form of loans (see figure 1). Should ers an unexpectedly large amount. To a bank be forced to sell its loans quickly, do so, an insurer might have to liquidate it would most likely have to take signifiassets. If assets are illiquid, this can incant losses because loans are relatively volve selling at a loss (a so-called fire illiquid. Life insurers, however, have a large sale). So, liquidity risk is present when share of more liquid assets like bonds and liabilities are liquid (making unexpected equities that can typically be sold quickly payouts more likely) and when assets with relatively small losses. This combiare illiquid (making fire-sale losses more nation of a lower likelihood of liabilities likely). In extreme cases, liquidity risk being withdrawn (lower liability liquidity) can lead to runs. Runs occur when many and potentially smaller losses from sellliability holders rush to withdraw their ing assets quickly (higher asset liquidity) funds from an institution because they indicates that life insurers are less ex4 fear the money will run out. This rush posed to liquidity risk than banks. to withdraw funds can cause solvent institutions to turn insolvent because Categorizing liabilities by liquidity of fire-sale losses. This idea of a run is Although insurance companies have less a familiar concept in banking, where a liquidity risk than banks, they do have loss of confidence in a particular instiliquidity risk. Indeed, there have been tution can lead to scenes of customers runs on insurance companies. For examcrowding into their bank to demand ple, in 1999, there was a run on General immediate withdrawals. American Life Insurance Company (GA 2. Categorizing liquidity of life insurer liabilities Life).7 GA Life had issued funding agreements8 with a clause that gave customers the option to withdraw the value of their investments with seven days notice. When rating downgrades induced investors to withdraw their funds, GA Life could not satisfy their demands and the company was placed under supervision by the Missouri Insurance Department. The GA Life example illustrates that liquidity risk at insurance companies is a function of liability holders’ ability to withdraw liabilities. In addition, liability holders must exercise this option to withdraw funds. We can begin to quantify the liquidity characteristics of the life insurance sector by characterizing the liquidity of different types of life insurance products. This analysis combines information about a product’s contractual liquidity with information about a policyholder’s cost of withdrawing funds. We begin by dividing life insurance company liabilities into four buckets based on their liquidity risk (see figure 2).9 In assigning life insurer reserves to liquidity buckets, we consider whether a product can be cashed in, the cost of doing so from the policyholder’s perspective, and the likelihood that the need to satisfy surrenders would lead to unexpected cash outflows from the insurer.10 Zero liquidity On one end of the spectrum, life insurance product reserves with almost no liquidity risk to insurers include those backing products with no provisions for policyholders to extract cash immediately or to surrender their policy for a cash value. These include reserves for annuities that are already paying out (payout annuities), for term life insurance (which has no savings component), and for disability insurance. Low liquidity Low-liquidity liabilities are primarily made up of reserves that back products with some cash value, but where policyholders are likely to face high costs to replace them. Reserves supporting products like whole life, also known as ordinary life insurance, fall into this category. Low-liquidity products are primarily protection products, although they may have some savings/investment elements tied to them. These contracts may allow the 3. Liquidity profile of life insurance industry liabilities 2007 2008 2009 2010 2011 Zero liquidity 20.1 23.6 19.5 19.1 18.8 Low liquidity 29.2 28.1 28.9 26.8 27.0 Moderate liquidity 41.6 37.8 41.6 44.0 43.1 9.1 10.6 10.0 10.0 11.1 4.66 4.51 4.74 4.83 4.89 High liquidity Composite score Note: Numbers indicate percent of total, except composite score. Source: Authors’ calculations based on data from SNL Financial. savings portion to be withdrawn at the policyholder’s discretion, but historically these contracts have had relatively low and predictable redemption rates. The costs of replacing the policies and the losses on extracting value mean policyholders are unlikely to withdraw funds en masse. Moderate liquidity Moderate-liquidity liabilities are made up of reserves that back products with contract terms that allow for some liquidity, but restrict the timing of withdrawals or impose surrender charges (penalties) on withdrawals. Deferred annuities and universal life policies are examples of products that may have these features. These products have contractual provisions that allow policyholders to withdraw a certain amount of the policy’s built-up value under specific conditions. In addition to providing protection and savings, these products also provide liquidity. Policies with higher surrender charges are less liquid because accessing liquidity is more costly for the policyholder. High liquidity High-liquidity liabilities are reserves that back products that impose few limitations on or penalties for early withdrawal. These highly liquid liabilities include guaranteed investment contract (GICs) and funding agreements (which played a major role in GA Life’s downfall). In addition, reserves against deferred annuities where surrender penalties are very low and the policyholder has the ability to determine the timing of withdrawals are classified as high liquidity. In general, the most highly liquid life insurance liabilities are those associated with products that are easily redeemable with low penalties and products sold to institutional investors. These products are particularly liquid when they contain contract provisions that allow them to be withdrawn at will and at par, similar to bank demand deposits. Quantifying liability liquidity To quantify these liability buckets, we examine insurers’ statutory filings, which report the reserves held against various product categories. We supplement this with statutory information on the likely contractual terms of these products, such as the cost to withdraw funds. Zeroliquidity liabilities consist of accident and health (A&H) reserves, plus annuity and deposit-type liabilities that do not allow discretionary withdrawals. Low-liquidity liabilities consist of life contract reserves, or the reserves that do not back annuities, deposit-type contracts, or A&H. The moderate-liquidity bucket contains annuity and deposit contracts that allow discretionary withdrawals with penalties or withdrawals at fair value. Finally, the high-liquidity bucket is made up of reserves for annuity and deposit contracts that allow discretionary withdrawals at book value. This method classifies liabilities based on common characteristics across the product groups, rather than aggregating product-level information. Our analysis of the data indicates that life insurers had about 46% of liabilities in the zero- to low-liquidity categories and 54% in the moderate- to high-liquidity categories at the end of 2011 (see figure 3). This shows a slight shift toward more liquid liabilities since 2007, when zero- and low-liquidity liabilities represented about 49% of the total. Looking at the riskiest bucket, high liquidity, we see a rise to an 11% share in 2011 from 9% in 2007. These aggregate data mask considerable firm-level heterogeneity. For example, two of the largest ten life insurers, by assets, have more than 20% of liabilities in the high-liquidity category. To facilitate comparisons across firms and over time, we created a composite score, which is the weighted sum of the share of liabilities in each bucket. Zeroliquidity liabilities get a weight of 0, lowliquidity liabilities get a weight of 3.33, moderate-liquidity liabilities get a weight of 6.67, and high-liquidity liabilities get a weight of 10. From 2007 to 2011, the industry average composite liquidity score rose from 4.66 to 4.89, indicating a slight increase in liquidity (see figure 3). We view the liquidity measures that we have created as indicative approximations for the liquidity of the reserves of insurers. These measures have important limitations. As mentioned earlier, we are not looking directly at product liabilities when assessing liquidity risk. We use aggregate data about withdrawal characteristics of certain products to classify the risk, which masks some information about the true risk of the liabilities. In addition, this is a measure of the liquidity of liabilities only, not of the firm or the industry itself. The liquidity of the assets supporting the liabilities would be an important component of a more complete look at liquidity. It may be that as these companies have taken on more liquidity risk in their liabilities, they have offset some or all of that by holding more liquid assets. Charles L. Evans, President ; Daniel G. Sullivan, Executive Vice President and Director of Research; Spencer Krane, Senior Vice President and Economic Advisor ; David Marshall, Senior Vice President, financial markets group ; Daniel Aaronson, Vice President, microeconomic policy research; Jonas D. M. Fisher, Vice President, macroeconomic policy research; Richard Heckinger,Vice President, markets team; Anna L. Paulson, Vice President, finance team; William A. Testa, Vice President, regional programs, and Economics Editor ; Helen O’D. Koshy and Han Y. Choi, Editors ; Rita Molloy and Julia Baker, Production Editors; Sheila A. Mangler, Editorial Assistant. Chicago Fed Letter is published by the Economic Research Department of the Federal Reserve Bank of Chicago. The views expressed are the authors’ and do not necessarily reflect the views of the Federal Reserve Bank of Chicago or the Federal Reserve System. © 2012 Federal Reserve Bank of Chicago Chicago Fed Letter articles may be reproduced in whole or in part, provided the articles are not reproduced or distributed for commercial gain and provided the source is appropriately credited. Prior written permission must be obtained for any other reproduction, distribution, republication, or creation of derivative works of Chicago Fed Letter articles. To request permission, please contact Helen Koshy, senior editor, at 312-322-5830 or email Helen.Koshy@chi.frb.org. Chicago Fed Letter and other Bank publications are available at www.chicagofed.org. ISSN 0895-0164 Box A. Life insurance products and their typical characteristics Product Payment structure Maturity Term life Fixed premium paid periodically Option to withdraw before maturity Protection element Set number of years None (contract will specify fixed number of years, e.g., 10, 15, or 20 years) Savings element (rate earned) Pays if death occurs None within a set number of years Disability insurance Group (institutional) Renewed annually None annual premium, adjusted for experience Pays monthly benefit if disability occurs before normal retirement None Whole life Fixed premium paid Age 100 periodically Pays regardless of when death occurs Low fixed rate Cash surrender value (increases over time) Universal life Flexible premium Age 95 or older Cash surrender value Pays regardless of when Current interest rate paid periodically (increases over time) death occurs with guaranteed minimum Immediate annuity Single premium Later of term certain None Pays fixed amount per paid upfront or death month during remaining lifetime None Deferred annuity Current interest rate or index return with guaranteed minimum Most commonly single premium paid upfront Funding agreement/ guaranteed investment contracts (GICs) Flexible (contract may specify fixed age, e.g., 80) Institutional product, Three to seven years single premium paid upfront Account value with Pays full account value penalty that decreases on death over time Account value with None Guaranteed fixed rate possible adjustment Note: The information in the box is meant to be illustrative and capture the important differences across product types; however, there is variation in contract terms within life insurance product categories that is not described here. Conclusion Life insurers are financial institutions that invest policyholder funds in return for providing protection against life’s risks as well as savings/investment services. This business model involves some level of liquidity risk. Although life insurers generally have less liquidity risk than banks, they are not immune from runs. 1 Based on data from the Board of Governors of the Federal Reserve System, 2012, Flow of Funds Accounts of the United States, statistical release, June 7, available at www.federalreserve.gov/releases/z1/ Current/z1.pdf. 3 SNL Financial. 4 Douglas W. Diamond and Philip H. Dybvig, 1983, “Bank runs, deposit insurance, and Moody’s, 1999, “General American: A case study in liquidity risk,” August. liquidity,” Journal of Political Economy, Vol. 91, No. 3, June, pp. 401–419. 5 2 Based on data from the Board of Governors of the Federal Reserve System, 2012. By examining the liabilities of life insurers, we can move toward quantifying liquidity risk and track changes in risk levels over time and across firms. Based on Federal Deposit Insurance Corporation, 2011, Statistics on Depository Institutions, report for all institutions, Washington, DC, December 31, available at www2.fdic.gov/sdi/. 6 SNL Financial. 7 See www.moodys.com/credit-ratings/GeneralAmerican-Life-Insurance-Company-creditrating-339600 (registration required) or 8 Funding agreements are similar to bank certificates of deposit. 9 Joel Levine, 2010, “Special report: Moody’s global liquidity stress test for life insurance operating companies,” report, No. 121220, Moody’s Investor Services, March. 10 While this is similar to the Moody’s methodology, Moody’s assigns higher liquidity risk than we do to expected cash outflows that are projected to occur in the near term.
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