Fitch Ratings’ initial analysis around rated U.S. insurers’ exposure to now-failed banks indicates little direct exposure. Rated life insurers with exposures should have sufficient capital to withstand losses and related market volatility.
Insurers’ stable liability and funding profiles will generally enable them to hold bonds until maturity, reducing pressure to sell them at a loss. However, financial system interconnectedness and second-order effects could present short-term challenges (see Impact of Inflation & Rising Interest Rates on Insurance Industry).
Insurers’ investments to the failed banks (Silicon Valley Bank, Silvergate and Signature Bank) are modest.
Fitch-rated insurance entities’ direct investment exposure to the failed banks (comprising debt and equity) is estimated to total $1.16 billion, with most of the exposure concentrated among life insurers.
Funding and Liquidity Remain Key Focus for U.S. Bank Ratings
Fitch Ratings continues to monitor the rapidly changing funding and liquidity environment for U.S. banks, in light of the recent failures of Silicon Valley Bank and Signature Bank and the related market volatility, highlighting the liquidity and funding challenges faced by banks as the Fed continues to raise the federal funds rate in its efforts to reduce inflation.
Quantitative tightening (QT) will cause industry deposits to shrink from pandemic highs, further pressuring bank funding and liquidity profiles.
The two bank failures prompted the Federal Reserve to create a special program, the Bank Term Funding Program (BTFP). Key features of the program allow banks to pledge U.S. Treasuries, agency debt and mortgage-backed securities, and other qualifying assets as collateral at par, which is intended to alleviate solvency concerns regarding unrealized losses on these securities.
In addition, the FDIC will ensure even uninsured depositors are made whole in the case of the two failed banks.
These actions will support system liquidity and reduce the risk of banks having to crystallize unrealized losses on high quality, but long duration securities portfolios.
However, it remains to be seen whether these measures will be sufficient to stabilize investor and depositor confidence in other vulnerable institutions or whether additional measures will be needed.
Funding & Liquidity assessment forms a key part of our rating criteria and deposit structure and access to contingent liquidity are important considerations within this assessment.
In the current environment, we are particularly assessing depositor behavior and liquidity profiles across our rated portfolio as these have the capacity to act as a ‘weakest link’ in ratings as depositor attrition may not be reversed.
In addition, deposit erosion can be negative for our rating assessment of a bank’s franchise and longer-term profitability.
Higher interest rates create certain challenges for U.S. insurers
While higher interest rates create certain challenges for U.S. insurers, Fitch views the liability profiles of insurers as being comparatively stable.
Life insurance products, whether protection or investment oriented, are generally intended to provide benefits over the long term or to fund long-term objectives, and often include surrender charges, which disincentivize withdrawals.
Non-life insurance contracts are designed to finance uncertain events (see TOP 10 Largest U.S. Auto Insurance Companies). These product features provide stability to insurers’ liability profiles and promote their ability to match asset and liability durations and maintain sufficient liquidity.
In contrast, banks have very short liability duration, where depositors can generally demand the return of their deposits on any date without penalty, which generally leads to an inherent asset/liability duration mismatch.
Like banks, U.S. insurers, particularly life insurers, are large bond investors. The value of insurers’ bonds declined markedly in 2022, and for many large insurers, contributed to an overall decline in shareholders’ equity.
Fitch recently published a review of U.S. Life Insurance GAAP Results for YE2022. The review noted that Fitch-rated U.S. life insurers reported an aggregate 59% decline in GAAP basis shareholders’ equity in 2022, primarily related to rising interest rates.
Pretax GAAP operating income declined approximately 27% on an aggregate basis in 2022, compared with 2021. The decrease reflects lower variable investment income from alternative investments and lower fee income as a result of less favorable equity markets, which were partially offset by the reduced impact of the pandemic (see Largest Life Insurance Companies in United States).
The average operating ROE for Fitch Ratings’ universe decreased to 10.5% in 2022 from 14.2% in 2021.
Lincoln National Corporation (LNC) and Prudential Financial, Inc.’s (PRU) 2022 operating ROEs were negatively affected by guaranteed universal life insurance reserve strengthening related to updating policyholder behavior assumptions, mainly reducing assumed lapses.
The reserve strengthening was in excess of $2 billion and $1 billion for LNC and PRU, respectively (see Largest Reinsurance Companies in the United States).
Notwithstanding these mark-to-market losses, Fitch believes that insurers’ stable liability and funding profiles will generally enable them to hold these bonds until maturity, reducing pressure to sell them at an interest-rate-driven loss.
U.S. insurers’ regulatory capital
U.S. insurers’ regulatory capital ratio generally values bonds at amortized cost rather than market value. As a result, insurers’ interest-rate driven bond portfolio unrealized losses are unlikely to create regulatory capital funding needs.
In contrast, banks’ primary regulatory capital ratio, depending on the bank’s size and accounting treatment, incorporates a portion of interest-rate-driven unrealized losses.
The movement to higher market interest rates in the U.S. over the past 12 to 15 months has created near-term challenges for insurers, notwithstanding the liability profile mitigants mentioned above:
- in particular, an interest-rate driven decline in bond values and shareholders’ equity; lower equity market values;
- reductions in assets under management, fee income and variable investment income.
Additionally, insurers are grappling with heightened macroeconomic volatility and the potential for a recession driven by geopolitical uncertainty, as well as differing expectations on the Federal Reserve rate tightening path, which the aforementioned bank failure exacerbated.
Fitch views the current interest rate environment as favorable for insurers’ earnings, but notes that the benefits are derived over time as portfolios turn over and insurers reinvest at more favorable rates. Our sector outlooks for U.S. Life and U.S. P&C are ‘neutral’.
U.S. Bank Fallout Extends to Various Non-Bank Financial Sectors
While the recent and sudden deterioration of several U.S. banks has been most impactful to the depositors, shareholders and lenders to these institutions, non-bank financial institutions, insurance companies and funds have experienced a variety of knock-on effects that, although not yet material from a rating perspective, serve to underscore the risk of financial system interconnectedness, says Fitch Ratings.
A number of broader second-order effects on the financial system as a whole related to asset price volatility, increased market scrutiny of unrealized losses and general market-risk aversion, that could ultimately adversely impact the financial profiles and ratings of non-bank financial institutions, insurance companies and/or funds if sustained and material.
These effects have primarily been observed in North American and, to a lesser extent, European markets. Asian and Latin American markets appear largely unaffected to date, primarily due to the geographic footprints of the now-failed banks not extending to these regions.
With respect to direct balance sheet, investment portfolio or counterparty exposures to now-failed banks, recoveries are expected to be low, although given the modest degree of exposure, the impacts to earnings and capital are expected to be immaterial.
Fitch-rated insurance companies, for example, have an estimated $1.16 billion of debt and equity exposure to now-failed banks, primarily concentrated amongst life insurers, although this is mitigated by strong regulatory capital levels (no Fitch-rated insurer’s exposure is more than 1.5% of capital) and stable liability profiles.
For Fitch-rated funds, exposure to now-failed banks appears to be confined to a limited number of bond funds, closed-end funds and local government investment pools. Exposure amounts are limited, with no rating impacts expected.
Money market funds could be a particular area of rating sensitivity and systemic risk if investor risk aversion leads to elevated money market fund redemptions or if deposit outflows extend to more highly rated banks, which are the predominant component of money market fund portfolios. Conversely, money market funds could see inflows on the back of deposits being withdrawn from affected banks.
FED creates a backstop for uninsured deposits
Financial regulators are discussing two different facilities to manage the fallout from the closure of Silicon Valley Bank if no buyer materializes, according to a source close to the situation, according to CNBC.
One way that the regulators would step in would be to create a backstop for uninsured deposits at Silicon Valley Bank, using an authority from the Federal Deposit Insurance Act, according to the source.
The move would also touch the systemic risk exception that allows the Fed to take extraordinary action to stem contagion fears.
Such a move could spur confidence at similar regional banks and institutions ahead of Monday, when they open and customers can withdraw from their accounts.
An additional step would be a “general banking facility” from the Federal Reserve that would support other financials with direct exposure to SVB so they wouldn’t have to materially change their business or take steep losses.
The moves would likely only be necessary if the FDIC was unable to find a buyer for all of SVB, or at least key parts of it.
The Federal Deposit Insurance Corporation took control of the bank and started an auction process.
The collapse of SVB, which was a key player in the technology start-up world, is the largest U.S. bank failure since Washington Mutual in 2008.
That bank was then purchased by JPMorgan Chase in a deal that restored the uninsured deposits.
A total or partial acquisition by another bank is one of the options regulators are exploring. Regulators shut down Silicon Valley Bank, marking the largest U.S. bank failure since 2008. Tens of millions in customer deposits were withdrawn in a run on the bank.
AUTHORS: Nathan Flanders – Managing Director, Non-Bank Financial Institutions at Fitch Ratings, Doriana Gamboa – Managing Director, Head of North American Insurance at Fitch Ratings, Mark Rouck, CPA, CFA – Group Credit Officer at Fitch Ratings
Fact checked by Oleg Parashchak