Rising Interest Rates: Is Silicon Valley Bank's Collapse Just the Beginning? What Insurance Companies Need to Watch Out For

Editor's Note: In light of the recent collapse of Silicon Valley Bank (SVB), triggered by a sharp and unanticipated increase in the yield curve, concerns are rising about the potential impact of rising interest rates on insurance companies. This article examines the reasons behind SVB's collapse, the broader effects of rising rates on financial assets, the differences between insurance companies and banks, and how insurance companies may be affected by the recent rise in interest rates.

Inflation continues to manifest throughout the financial world.?In the US, the Bureau of Labor Statistics published CPI figures in February bringing the total inflation before seasonal adjustment to a staggering 14.4% over the last 24 months.?In the UK, the Office for National Statistics reported February inflation data showing the CPI grew by more than 17% in the past 24 months.

When inflation goes up, the value of fixed-interest securities goes down.?In the case of Silicon Valley Bank (SVB), its long-term bond holdings went down a lot.?After the bank was forced to sell bonds at a loss, its stock price plummeted and depositors panicked, leading to a classic bank run. This was the second-largest bank failure in U.S. history.

The Trigger for SVB Collapse: Understanding the Role of Rising Interest Rates

SVB faced a collapse triggered by a series of risk management mistakes, particularly in the face of rising interest rates. These mistakes contributed to the bank's downfall and highlighted the potential impact of interest rate fluctuations on financial institutions, including insurance companies.

Risk Management Mistake 1: Mismatched Duration of Assets and Liabilities

One of SVB's risk management mistakes was not appropriately matching the duration of its assets to liabilities. SVB had long-term loans (assets) but short-term deposits (liabilities), resulting in a mismatch in duration. While banks often intentionally mismatch durations to generate returns, SVB's lack of adequate diversification in its assets and liabilities left it vulnerable to changes in interest rates. If SVB had immunized its portfolio, any change in interest rates would have generated a parallel change in both assets and liabilities, mitigating the impact of rising rates.

In addition, SVB invested heavily in fixed income securities including treasuries – ostensibly to manage credit risk.?However, a review of stable bank assets in the industry shows that they spread their long-duration-loan risk exposure using collateralized residential mortgages or securitized corporate loans that are diversified either by industry or geography.

Risk Management Mistake 2: Risky and Concentrated Assets

SVB's assets were also risky and concentrated, with a significant portion of its investments made in debt financing to companies in the start-up ecosystem. The bank had a history of concentrated lending and overlapping clients between its lending and deposit books, as warned by the Bank of England to US regulators prior to SVB's collapse.[1]?In addition, SVB invested heavily in fixed income securities including treasuries – ostensibly to manage credit risk.?However, to ensure stability in assets, best practice is to spread long-duration-loan risk exposure using collateralized residential mortgages or securitized corporate loans that are diversified either by industry or geography.

Risk Management Mistake 3: Shortage of Liquidity

SVB's relatively small size exempted it from certain liquidity requirements that larger, more systemically important banks are subject to.?However, as pointed out by a Yale School of Management blog who reviewed Silicon Valley Bank’s public financials, SVB's shortage of liquidity was evident in its liquidity coverage ratio (LCR), which would have been only 75% at the end of 2022, well below the required threshold. Furthermore, SVB would have passed the Net Stable Funding Ratio (NSFR) criteria but only if the banking supervisors had blindly applied an assumption that uninsured deposits were 50% ‘available’ for its use – something clearly inappropriate for SVB since its uninsured deposits were almost entirely from VC-funded companies – “many of which run negative cash flows every month and sustain their businesses through periodic injections of new capital”.[2]

In conclusion, SVB's collapse was triggered by a combination of poor risk management practices, including mismatched duration of assets and liabilities, risky and concentrated assets, and a shortage of liquidity. These mistakes highlight the importance of effective risk management, particularly in the face of rising interest rates, for financial institutions such as insurance companies to avoid similar pitfalls and safeguard their stability and resilience in the ever-changing financial landscape.

The Ripple Effect of Rising Rates: How Financial Assets are Impacted

Increasing interest rates can have a significant impact on the assets of financial institutions, as evidenced by a recent study conducted by researchers at the University of Southern California, Northwestern University Kellogg School of Management, Columbia Business School, and Stanford University. The study estimates that banks have already lost a staggering $2.2 trillion due to the same risk that led to the collapse of Silicon Valley Bank. This amount is equivalent to the entire equity capital of U.S. banks and represents approximately 8.5% of the U.S. Gross Domestic Product.

While the impact on banks has been substantial, insurance companies may be even more vulnerable to the effects of rising interest rates. However, despite these concerns, it is important to note that the collapse of insurance companies is not imminent.

In fact, the answer to the question posed at the beginning of this article is an emphatic NO.

Differences between Insurance Companies and Banks: Why Insurance Companies are Better Equipped to Mitigate Similar Risks

Insurance companies are adept at managing interest rate risk (sometimes to their own detriment but more about that in another article).?They apply significant resources to this management as a result of three important differences between Insurance companies and banks:?Regulation, Liability Duration, and Liquidity.

I - Regulation

Banks, particularly small banks, have been left exposed due to the lack of regulatory requirements compelling them to stress-test their tolerance to market changes, including fluctuations in the yield curve. In fact, a recent review by Bloomberg News of the Federal Reserve's annual bank stress tests revealed that these tests have ignored the possibility of rising interest rates, despite the Federal Reserve itself increasing its target for the federal funds rate from close to zero to over 4% in 2022.

In contrast, all insurance companies are currently and have always been subject to rigorous stress testing.[3]?Insurance company solvency capital requirements, such as the EU-based Solvency II (SII) and US-based Risk Based Capital (RBC), include numerous scenarios of unexpected and sudden changes in the yield curve.?In either regime, if an insurer fails to meet minimum capital requirements, it may be subject to disciplinary or corrective action including revocation of insurance licenses, liquidation of in-force business, and regulator assumption of company management.

Solvency II: Tail Events and Scenarios

·????????Under the Solvency II standard formula used throughout the European Union, specific upward and downward stress in interest rates are prescribed, and the capital requirement for interest rate risk is derived from the impact on assets and liabilities from the most severe scenario, whichever gives rise to the highest capital requirement. These scenarios are designed to represent a tail event with a probability of one occurrence in 200 years (i.e. 99.5% percentile event).

·????????Since the standard formula does not include explicit standard scenarios of changes to volatility and the structure of the yield curve, or to inflation or deflation, insurance companies are required to run these scenarios as part of their own risk and solvency assessment process.?Shocks in the volatility of the interest yield structure can be relevant where investment assets or insurance obligations contain embedded options and guarantees which are sensitive to changes in interest rate volatility.

Risk Based Capital: Consideration of Default Risk and Asset Adequacy

·????????The National Association of Insurance Commissions (NAIC) RBC regime[4] requires insurers to determine the possible effects of interest disintermediation and spread compression on default risk, particularly for insurance products that contain an incentive for policyholder withdrawal when interest rates change. Insurers are required to submit an unqualified actuarial opinion based on asset adequacy cash flow testing, often using stochastic generation of numerous interest rate yield curve scenarios.

·????????Unlike SII, the effect of higher interest rates on asset market values is considered less important in RBC, as it is assumed that fixed income assets will be held to maturity. RBC factors were developed based on the assumption of well-matched asset and liability durations, with a loading of 50 percent added on to represent the extra risk of less well-matched portfolios. In combination with statutory reserves, RBC minimum capital requirements are expected to be sufficient to protect insurer solvency 95% of the time.

In both SII and RBC, insurance companies that have poor Asset-Liability Duration Matching are heavily penalized by being subject to additional capital requirements. This ensures stability of cash flow in a volatile interest rate environment, providing policyholders with reassurance that their insurance policies are secure.

II - Liability Duration

Another difference between banks and insurance companies is the time horizon of their liabilities.

Bank liabilities primarily consist of short-term savings deposits, while insurance liabilities are composed of medium to long-term obligations. Bank depositors typically expect to have access to their funds at any time, whereas insurance policyholders expect to withdraw their funds only upon the occurrence of an insurable event, and sometimes face surrender charges or other inhibitions that extend the withdrawal process. The longer time horizon of insurance liabilities provides insurers with increased flexibility in managing their investments, as well as a wider range of investable assets to choose from, which can improve their return on assets and diversify their investment portfolio.

Importantly, the longer time horizon of insurance liabilities also gives insurers greater flexibility in risk management. With long-term obligations that can extend tens of years into the future, insurance companies have time to observe and respond to divergences between their assets and liabilities. This allows for continuous adjustments to the asset mix and trajectory of cash flows, which can be highly strategic and extend beyond investments to decisions related to product features and target customers.

III - Liquidity

Liquidity is another area where insurance companies differ from banks. Despite the reduction in marked-to-market asset values due to the rise in interest rates, insurance companies, especially life insurers, are unlikely to face immediate liquidity challenges. This is because the majority of insured deposits, such as pension savings or life annuity accounts, are designed for long-term horizons and are not expected to experience a sudden spike in withdrawals.

For example, Apollo, the parent company of reinsurer Athene, reassured investors in a March 13 quarterly update to shareholders that there is little risk of a 'run-on-the-bank' for Athene. Apollo highlighted several factors contributing to Athene's strong liquidity position. First, most of the annuities that Athene provides are non-surrendable or financially onerous to surrender, which means policyholders are unlikely to surrender their policies prematurely. Second, Athene had ample cash and liquidity to meet any potential withdrawals. Third, Athene's issuance of new annuity policies exceeded the policies that matured and other withdrawals, indicating a healthy inflow of new business. This situation is similar for other life insurance companies as well.

The longer-term horizon of insurance liabilities, combined with strategic liquidity management and diverse investment portfolios, provides insurance companies with greater flexibility and resilience in managing their liquidity needs compared to banks. This allows them to navigate market fluctuations and interest rate changes more effectively and mitigate the risk of liquidity-related issues.

Weathering the Storm: How Insurance Companies are Affected by the Recent Rise in Interest Rates

Insurance policyholders can take comfort in the fact that insurance companies anticipate changes in interest rates and take measures to ensure the security of their savings. However, it's important to note that these changes can still impact earnings.

How Insurance Companies Make Money

In a previous series of articles, I described how insurance companies make money.?Let’s review the salient points.

Insurance companies sell promises to pay an insured, in the event of a financial loss.?As a result, an insurance company does not have what is normally defined as “net working capital.” Instead, insurance company balance sheets consist of investment assets and insurance policy liabilities.?Unlike that of a non-financial company, the finance function in an insurance company is primary. Borrowing is not a tactical task – it is at the very core of its ability to create value.

Insurance company earnings are generated in two ways:

1. Underwriting gain:?the difference between premiums charged to policyholders and expenses and claims paid by the insurer, and
2. Investment income: investment yield on assets and leveraged cash flow, such income enabled by the time lag between premium collection and payment of expenses and claims.

The investment return to insurance company stockholders depends on the effectiveness of its management regarding investment, financial leverage, underwriting results and insurance exposure.

Financial leverage in insurance results from the deferred nature of insurance liabilities, and insurers may be willing to incur underwriting losses in order to build insurance exposure and have a larger pool of funds to invest. The underwriting loss in this strategy can be seen as the cost of borrowing, relying on yield generation to offset the loss for as long as the insurance contract remains in force.?

Considering this, it becomes evident that higher interest rates can have a significant impact on earnings. Modestly rising interest rates are generally viewed as positive for the insurance industry, although the effects may differ between Property and Casualty (P&C) insurers and Life insurers.

P&C Insurers

?????Impact on Underwriting Gain:?

• Higher inflation may result in increasing claims costs and expenses, while yearly renewable premiums lag behind the rate of inflation. ?This can lead to rising combined ratios for P&C insurers.?
• Long-tail statutory claim reserves, which cover claims that occur over a longer period of time, may experience volatility due to rising medical costs and secular inflation. On the positive side, higher discount rates should result in lower GAAP reserves overall.

??????Impact on Investment Income:?

• P&C insurers hold a higher proportion of their investment portfolios in equity securities, alternative investments and cash compared to their Life counterparts.?In a low-yielding investment environment, P&C insurers further reduce their allocation to bonds[5] exposing their investment returns to market volatility.
• However, as available yields increase, insurers are more likely to revert to more stable and traditional fixed income investments, relying less on alternative asset classes.

Life insurers

??????Impact on Underwriting Gain:

• In the short term, life insurers will benefit from improved spreads due to higher reinvestment interest rates over the cost of funding liabilities.?Long-term rate guarantees will also be less expensive.
• Long-term, higher yields may create market pressure on insurers to increase rate guarantees, leading to an equilibrium where profit margins will stabilize.?We may also expect a decline in popularity of unit-linked equity products and an increase in production for traditional fixed income guaranteed products.

??????Impact on Investment Income:?

• In the short term, insurers that manage pension plans and provident funds (OPM) may experience earnings pressure.?These carriers earn substantial income from asset management fees which are directly tied to the amount of assets under management and the performance of plan’s underlying investments.?When asset values decline as interest rates rise, management fees also decline, significantly reducing insurance company earnings.
• In the long term, we can expect OPM portfolios to stabilize at lower asset levels with higher yields leading to higher overall management fees.?In addition, the surplus capital of many life insurers are often invested in more volatile and risky assets than the actuarial reserves which are matched to liabilities.?As with P&C insurers, higher interest rates will lead to higher allocation to traditional fixed income securities leading to lower investment earnings volatility and less capital strain.

By taking a proactive and strategic approach to managing their investments, liabilities, risk, liquidity, and business strategies, insurance companies can position themselves to potentially benefit from rising interest rates and generate profitable outcomes.

References

[1] https://www.ft.com/content/19d76cf1-4836-4dde-b228-26faee5c8126

[2] https://som.yale.edu/story/2023/lessons-applying-liquidity-coverage-ratio-silicon-valley-bank

https://som.yale.edu/story/2023/silicon-valley-banks-liquidity-part-two-what-about-net-stable-funding-ratio

[3] For a comparison of capital regulation in developed countries, see Eling & Holzmuller “An overview and comparison of risk-based capital standards”:?Canada and the US were among the first countries to introduce RBC standards in 1992 and 1994, respectively. In 1996, Japan followed with the Solvency Margin Standard; Australia introduced its General Insurance Reform Act in 2001. The United Kingdom introduced its concept of an “enhanced capital requirement” and “individual capital assessment” in 2004, and Switzerland enacted the Swiss Solvency Test in 2006. Finally the European Union (EU) issued Solvency II standards in 2009 and amended in 2014.

[4] https://content.naic.org/cipr-topics/risk-based-capital - “Regulators use RBC requirements to determine the minimum amount of capital required for an insurer to support its operations and write coverage. The RBC standard for life and property/casualty (P/C) companies is based on the?Risk-Based Capital (RBC) For Insurers Model Act?(#312), which the NAIC initially adopted in 1993 (latest revision, 2011). Likewise, the RBC standard for health insurers is the?Risk-Based Capital (RBC) for Health Organizations Model Act?(#315), which the NAIC initially adopted in 1998 (latest revision, 2009). The model laws outline methods for measuring this minimum amount of capital”.

[5] https://www.iii.org/publications/a-firm-foundation-how-insurance-supports-the-economy/investing-in-capital-markets/property-casualty-industry-investments