Abstract
Direct exposure to the epicenter of the financial crisis is probably one of the most substantially adverse challenges that the property, casualty, and life insurance companies have had to counter in the recent years. The crisis has impacted investment portfolios, manipulated the financial market valuations, and driven the outlook for activity downhill(Arner, 2009 p.91-136). Although the whole insurance sector is not under threat per se, current financial operations of insurance companies are still under manipulation of the long-felt effects. For instance, the insurance and reinsurance have become major investors in capital markets, losses have become an apparent occurrence where market-to-market security valuations are involved, and expected losses that were a direct result of the financial crisis have spread outside the subprime mortgage sphere(Arner, 2009 p.91-136).What is more, there has been a rising uncertainty with reference to outlook for underwriting though the high demand for safety appears to be positive in regard to the demand for insurance products.
In line with this, the purpose of this paper is to look into how the financial crisis has shaped current operations in the insurance sector as well as their wellbeing. Precisely, the author shall give an overview of the main forces and how they have shaped modern-day insurance atmosphere with regard to mortgage insurers, life insurance companies, financial guarantee insurance companies, and large insurance-dominated financial groups.
Impact of the Financial Crisis on the Insurance Industry
Over time specific insurance and sector segments have exposed concentrated exposures to market and credits risks. In this context, the financial health of mortgage insurers is hugely reliant on the housing market coupled with foreclosure developments, whose rapid improvement is not guaranteed. Secondly, life insurance companies are under considerable market valuation pressures chiefly because of losses relating to investment and the spiking costs of hedging to put a threshold on the downside of equity-based contracts with surefire returns (Arner, 2009 p.91-136). Thirdly, financial guarantee companies have been under the pressures of ratings and market pricing, with large entities seeing the loss of their triple-A rating, which was at the heart of their business models. Lastly, select large insurance-dominated financial groups have suffered from specific effects through investment-bank-like activities and their institutional links to banks(Arner, 2009 p.91-136). A good case in point is the world’s largest insurance group, which collapsed due to losses resulting from financial product units that turned out to be a major seller of credit protection at the time (Baluch, Mutenga, & Parsons, 201 p. 126-163).
Looking deeper into the case of US mortgage companies, it is evident that these insurance institutions have had the most direct exposure to mortgage credit risk, consequently making them the most rapidly hit. The scenario can partly be attributed to the fact that the crisis started in the residential mortgage market along with these entities’ core business consisting of guaranteeing other financial institutions whose major sourcesof value are huge portfolio of mortgages and individual loans. Additionally, these companies have a tendency to insure very high risks or non-standard loans in which the specific limits fall below the absolute amount of the loans.
Mortgage market developments in the course of the last one year have led to sizeable losses on these entities, further leading to depletion of substantial amounts of capital buffers which many of them had built earlier(Arner, 2009 p.91-136). A good example of a victim with regard to this is New Century Financial Corporation, which had already filed for chapter 11 bankruptcy protection in as early as April 2007.The largest mortgage insurers in the U.S. including PMI Group, MGIC Investment, and Radian recorded substantial quarterly and yearly losses at the same period. The widespread effects reflected the fall of share prices both for independent mortgage insurance firms and insurance companies with many mortgage subsidiaries. Additionally, prices for protection against their default rose considerably.
In retaliation, mortgage insurance companies unleashed a series of underwriting changes which would oversee more conservative credit portfolios in the future. However, the legacy portfolios still remain large and are yet to stabilize in relation to performance. It is highly unlikely that marketsin the U.S. will stabilize and foreclosure rates will fall with the current weak activity growth and rising unemployment. Even so, U.S. home prices are stabilizing based on the recent developments in the Federal Housing Finance Agency and Shiller-Case statistics.
For life insurance companies, valuation pressures have remained the biggest adversary(Levine, 2010). Even though these companies have a lower exposure to structured financial instruments and low quality residential mortgage backed securities, they are nevertheless noteworthy investors in numerous market securities including corporate and equity bond markets where significant declines in valuation were experienced instantaneously. In regard to liabilities, the fall of interest rates of government bonds signified a corresponding increase in actuarial levels of liabilities. Life insurance companies have also written variable annuities contracts, some of which were guaranteeing minimum income streams and other similarly-costly guarantees in the deteriorating environments of low government bond interests and capital market valuations.
In the meantime the costs of hedging strategies that many companies adopted in the current years to limit the downsides on variable annuities have undergone the pressures of a heightened market vitality, leading to reduced profit margins. In response, many life insurance companies have made adjustments to their variable annuities pricing in an attempt to reduce exposure to risk of high hedging costs. This retrenchment may characterize a strategic reversal in terms of valuable business activities. In the recent years, insurance companies have increased their activity to target the potential baby boomer market through more elaborate minimum return promises(Chen at al., 2010). Besides hedging costs becoming costly, they have not undergone testing with regard to prolonged adverse market conditions. The positive side, however, is that leverage is now limited.
In the case of financial guarantee insurance companies, triple-A ratings, which were an important part of their business strategy, have been lost (Levine, 2010). Like life insurance companies have done with valuation pressures, these firms have experienced rating and market pricing tensions due to the mounting of write-offs and losses on mortgage-related structured securities. Notably, they had provided credit enhancements when such protection was mostly in form of financial derivatives sold. Naturally, financial guarantee companies are characterized by thin capital layers and high leverage and, consequently, forces related to deleverage during times of stressed market liquidity drive these institutions into adding dislocations in exacerbate systemic and credit market risks.
As financial guarantee insurance company ratingslower, their equity prices fall and premiums against credit default rise. The difficulties they experienced are fed back as the value of enhancements provided, further impacting securities negatively. This has tended to amplify downward pressures through various channels to financial markets(Chen at al., 2010). Additionally, there is a current rising interest in financial guarantee insurance which has further facilitated municipal bond issuance.Robust and effective supervisory and regulatory frameworks for financial guarantee insurance companies are now as well crucial.
On large insurance-dominated financial groups, the long-term effects of the financial crisis have been significant. Prior to the crisis, International American Group (AIG) was a key seller of credit protectionand one of the biggest insurance companies on a global scale, with a total of 176 financial institutions and 71 U.S-based insurance companies. In 2008, the company’s reported a sizeable loss of $10 billion for 2007, and more loss during the first half of the next year(Sjostrom, 2009). The loss reached a ceiling level when AIG recorded a $60 billion quarterly loss in March 2009. As a result, the company underwent a credit rating downgrade which led it into posting an additional collateral with support(Schich, 2010p.123-151). The U.S government provided a support package of $150 billion in 2008 on systematic grounds, part of which was used in funding an entity to enable the retirement of credit default swap contracts through the purchase of underlying assets from banks. Since then, AIG became an important counterparty to systemically vital banks (Brunnermeier, 2009 p.77-100).
Conclusion
In sum, the effects of the financial crisis on the insurance sector have highlighted various policy issues and served as lessons for future operations. The paper has shown that the magnitude Global Financial Crisis can be measured on the basis of reviewing overall premiums. A comparison between the premium volume in subsequent years and that of 2008 revealed a drastic drop in the most affected entities and countries.in particular, mortgage products experienced a huge decrease in sales volume as well as credit life cover related to consumer loans. Life insurers withdrew selected products that seemed to no longer contribute in the income streams as well as in their risk management. Similarly, low-interest environment made consumers skeptical on the value of life insurance products.
Overall, the effects of the financial crisis have illustrated the role of insurance companies in absorbing the shock in the crisis: Firstly, insurance companies are the main players in worldwide financial markets;secondly, insurance companies have a big role in adopting investment strategies with long-term horizons, and; thirdly, the function of insurance has had a stabilizing effect with regard to the crisis(Levine, 2010).
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