Posted on 09 Aug 2011
Standard & Poor’s announced on August 5, 2011, that it “downgraded its long-term counterparty credit and financial strength ratings and related issue ratings on all AAA-rated U.S. insurance groups to AA+ with negative implications.”
In its July 15, 2011, warning that it would take this action S&P noted that “in the unexpected event of a U.S. default, we would expect these insurers’ losses, if any, to be modest and manageable relative to capital.”
The ultimate ramifications of a downgrade of long-term U.S. bonds are impossible to determine at this point but, in the short-term, a U.S. bond downgrade will not adversely affect the operations of U.S. property/casualty (P/C) insurers in any significant way, nor will it impact insurer solvency or liquidity. P/C insurers write auto, homeowners and business insurance coverage totaling more than $400 billion in premiums annually.
“The nation’s property/casualty insurers have very limited direct exposure to the U.S. government bond market and have collectively set aside hundreds of billions of dollars to pay unanticipated claims,” said Dr. Robert Hartwig, president of the I.I.I. and an economist. “Both of these factors will enable the industry to operate effectively despite the recent downgrade of long-term U.S. bonds.” Consequently, Hartwig added, “Existing policyholders, people and businesses filing claims and those seeking to purchase insurance will not experience any difficulties arising from the downgrade.”
In addition, according to the National Association of Insurance Commissioners, an organization representing state insurance regulators: “There is no impact on insurer investments in U.S. government and government-related securities from the actions recently taken by the rating agencies. Risk-based capital and asset valuation reserves are unaffected. State insurance regulators and the NAIC will consider changes to our regulatory treatment if it becomes necessary in the future.”
U.S. Government Bonds In P/C Insurer Portfolios
Property/Casualty insurers held $860 billion in bonds at year-end 2010. U.S. government bonds—but not state and local governments—constituted about $80 billion of the bond holdings. Total invested assets (including cash) held by P/C insurers exceeded $1.3 trillion at year-end 2010, meaning that holdings of U.S. Treasury bonds accounted for roughly 6 percent of the industry’s total invested assets.
One theoretical effect of a downgrade is that interest rates on newly issued U.S. government bonds and most other forms of fixed income securities would rise. This would mean that the market value of existing U.S. government bonds and other fixed income assets would fall. The extent of the drop in value would depend on many things, but the net impact on the value of assets held by P/C insurers should be modest and manageable.
As a general rule, longer term bonds would fall to a greater degree than shorter term bonds. In recent years, however, P/C insurers have been shortening the maturities on their bond investments, lessening the effect of an interest rate rise. In 2005, for example, bonds maturing in five years or longer constituted 55.8 percent of all bond holdings (including cash and short-term investments); by 2010, bonds maturing in five years or longer had dropped to 44.6 percent of all P/C insurer bond holdings (and of the longer term bonds, most were in the five- to 10-year maturity category).
Investment income is a comparatively small part of P/C insurer revenues when compared to the monies these insurers generate via premiums. Policyholder premiums paid to P/C insurers have totaled anywhere from $425 billion to $450 billion each year since 2003, with net investment gains ranging from $31 billion to $64 billion annually within this same time frame. A very small fraction of the net investment gains for P/C insurers come in the form of U.S. government bond income. And despite the downgrade all interest due will be paid by the U.S. government.
Premiums received in any given year generally cover P/C insurer claims and expenses for that 12-month period. As such, even if there were a drop-off in U.S. government bond income it would have an insignificant effect on insurers’ ability to pay claims and expenses.
Moreover, the industry’s policyholders’ surplus—the excess of assets over liabilities (what companies in other industries call “net worth”)—was a record $556.9 billion at year-end 2010, an 8.9 percent increase over where P/C insurers’ policyholders’ surplus stood as of December 31, 2009 ($511.4 billion).
So, even when envisioning an extremely unrealistic scenario whereby all U.S. government bond holdings were valued at half their nominal value, P/C insurers would still have the assets they needed to cover all of their liabilities plus a “cushion” for unexpected claims equal to $500 billion, the rough equivalent of 12 Hurricane Katrinas, the costliest natural disaster in U.S. history.